Century Management’s Gold Valuation Analysis
For purposes of our research, we do not need to reconcile whether gold should be viewed as a commodity or as money, or why gold prices rise or fall. The focus of our research is to determine the price at which gold becomes an attractive investment.
Gold has confounded economists and investors throughout time. Nathan Meyer Rothschild (1777-1836), the top financier of the early 19th century, said, "There are only two people who understand gold: One is a director in the Bank of England, and the other an obscure clerk in the Bank of France. Unfortunately, they disagree."
Today, nearly 200 years later, Ben Bernanke, the former Chairman of the U.S. Federal Reserve, remains equally perplexed when it comes to gold. In a statement to Congress on October 7, 2013, he said, "Nobody really understands gold prices and I don't pretend to really understand them either." In addition, Janet Yellen, the current Chair of the U.S. Federal Reserve, stated in her testimony to Congress on November 14, 2013, "Well, I don't think anybody has a very good model of what makes gold prices go up or down."
With all the different opinions surrounding gold, there are basically only two different ways of looking at gold: as a commodity or as money. Some believe gold's sole value is that of a commodity, where it is most often used in jewelry, industry, medicine, dentistry, technology, electronics, and aerospace. Others believe as financier, banker, and philanthropist John Pierpont "J.P." Morgan (1837–1913) did: "Gold is money." Investor demand has served as the biggest swing factor on the price of gold over time, as central governments, institutions and consumers have frequently invested large sums in gold during periods of great uncertainty, deflation or high inflation. For purposes of our research, we do not need to reconcile whether gold should be viewed as a commodity or as money, or why gold prices rise or fall. The focus of our research is to determine the price at which gold becomes an attractive investment. After having analyzed gold from five different viewpoints, we summarize our gold price zones in Chart 1.
Our research suggests gold, which has been trading between $1,225 and $1,326 per ounce as of the first two months of 2014, is in a fair value zone. We believe the downside risk to gold is approximately $600 to $700 per ounce, and the extreme upside is between $1,800 and $2,200 per ounce. We believe gold is currently trading in a fair value zone and therefore not at an attractive price to buy as a commodity. However, in our February 21, 2014, newsletter titled Inflation, Gold, and Gold Mining Companies, we illustrated that a number of the 40-plus gold mining companies we researched and bought at the end of 2013 were priced as if gold were trading between $800 and $900 per ounce. While gold is currently trading in our fair value zone and would not qualify under our investment discipline as a buy today, we would recommend the purchase of gold for those who want to own it as a hedge against potential higher inflation or a currency crisis rather than for pure investment purposes. Century Management Gold Valuation Methodology To arrive at our gold valuation zone prices sited in Chart 1, we used these five methods of valuation:
- The price of gold over time, adjusted for inflation
- How much gold prices dropped during gold bear markets
- The price of gold compared to the price of oil, housing, and commodities
- The price of gold compared to the U.S. Consumer Price Index
- The actual cost of producing an ounce of gold
The remainder of this report details how we arrived at our gold valuation zones using each method. Comparing each method, some approaches yielded significantly different price ranges and valuation zones. These differences occur because, when compared to gold, other assets do not always reach their peaks or their bottoms at the same time. For example, the ratios of Gold-to-Housing and Gold-to-Oil suggest that housing is currently more depressed than the oil market. However, by averaging these ratios, we gain the benefit of insight from each market.
Method 1: Historical Gold Prices, Adjusted For Inflation
Chart 3 highlights the low and high prices for gold from 1968 through 2013. These prices are historical, meaning not adjusted for inflation. Using this approach, we benefit from observing the market's determination of gold prices at extremes.
Chart 4 also shows the low and high prices for gold, except these prices are adjusted for inflation as measured by the U.S. Consumer Price Index (CPI). Now let's compare Charts 3 and 4 to see the impact of inflation on gold prices. The peak gold price was $850 per ounce on 1/21/1980 (Chart 3). Using the same date of 1/21/1980, but now looking at Chart 4, the price of gold is $2,546 in today's dollars (i.e. adjusted for inflation). The difference in price between these two charts suggests that inflation has averaged an annualized rate of 3.28% over the past 34 years.
Method 2: How Much Gold Prices Dropped During Gold Bear Markets
Chart 6 shows gold's bear markets over the past 40 plus years. We define a gold bear market as a minimum 25% decline from peak gold prices. During the six gold bear markets between 1974 and 2008, the price of gold declined 43% on average. The largest decline, which occurred from January 21, 1980 through June 21, 1982, was 65%. The current gold bear market, which started on September 5, 2011, and, in theory, ended on June 28, 2013, saw the price of gold decline 37%. However, based on gold's $1,225 to $1,326 per ounce trading range during the first two months of 2014, the jury is still out on whether June 2013 was the end of this last bear market. Only time will tell. Regardless, by analyzing gold's bear markets, we believe we can estimate a good worst case and buy price for gold.
To calculate a worst-case price for gold, we used the September 5, 2011 peak gold price of $1,895 and multiplied the number by 35%, which represents one minus the 65% maximum gold bear market decline from 1972 to 2013. The worst case based on this calculation is $663.25. To calculate a buy price for gold, we multiplied the September 5, 2011, peak gold price of $1,895 by 57%, which represents one minus the 43% average gold price decline during gold bear markets between 1972 and 2008. This calculation suggests a buy price of $1,080.
In addition to gold, we have also analyzed how other commodities behave in periods of decline. As shown on Chart 9, the maximum decline for the average of these 16 commodities is 67% versus a maximumdecline of 65% for gold as shown on Chart 7. The average decline for these 16 commodities is 42% versus an average decline of 43% for gold. We believe these results provide support for this method of quantifying a buy point and a worst case price for gold.
For those of you interested in seeing what the price of gold would be in our worst case and buy case scenarios by reviewing the change in oil prices to gold, please see Exhibit 1. Note, adding these figures to our gold framework would not cause our summary gold worst case or buy zones to vary by more than 4%.
Method 3: The Price of Gold Compared to the Price of Oil, Housing, and Commodities
Gold vs. West Texas Intermediate Crude Oil (WTI)
Chart 10 shows the relationship between gold and West Texas Intermediate Crude Oil (i.e. Gold/WTI). The higher the ratio, the more barrels of oil needed to buy an ounce of gold. Over the past 40 years, it has taken, on average, 15.37 barrels of oil to buy one ounce of gold (or 15.37 times Gold/WTI). The ratio of Gold-to-WTI typically troughs at 7.5 times, and it generally peaks between 25 and 27 times. We believe 12 times Gold-to-WTI represents a good buy point. The Gold-to-WTI trading range of 12 to 13 times during the first two months of 2014 suggests that gold looks attractive relative to oil.
Chart 11 shows the results of $100 invested in gold and $100 invested in oil from December 31, 1971 (when gold started trading freely) through December 31, 2013. As you can see, despite the short-term volatility, gold and oil trade very close to each other over the long run.
The WTI price as of December 31, 2013, multiplied by the Gold/WTI ratio suggests the following gold prices as shown on Chart 12:
We have also analyzed the supply and demand of oil to determine reasonable oil price ranges. By using the average 15.37 Gold/WTI ratio and multiplying it by our reasonable range of WTI, we estimate the following gold prices.
Gold-to-US Existing Home Median Price
Chart 14 shows the percentage of a house that one ounce of gold can buy. The rationale in comparing this relationship is that gold and home prices are competing for investment dollars. Gold appeared relatively attractive during the housing bubble in the early-to-mid 2000s. During 2010-2012, gold became relatively expensive compared to the existing home median price as investors worried about future inflation. As of January 31, 2014, the relationship of gold priced at $1,251 per ounce to the US existing home median price of $188,900 (as reported by the National Association of Realtors) is 0.66%. This 0.66% figure is well above the past 42-year average. Thus, gold is relatively expensive versus the US median home price despite the recent housing recovery.
The current US existing home median price divided by the percentage of a US existing home you can buy with an ounce of gold suggests the following gold prices as shown on Chart 15:
Gold-to-Commodity Research Bureau (CRB) Metals Index
Chart 16 shows gold prices versus the Commodity Research Bureau (CRB) Metals Index. This index consists of copper scrap, lead scrap, steel scrap, tin and zinc. CRB Metals data became available in late 1984, so we began our analysis on that date. The approach is based on the premise that gold should trade like other metals over time, as gold investor demand will ebb and flow. The relationship between gold and the CRB Metals Index is fairly tight over time and the ratio is currently near its historical average as shown on Chart 16.
The current CRB Metals Index multiplied by the Gold/CRB Metals Index ratio suggests the following gold price ranges as shown on Chart 17:
Method 4: The Price of Gold Compared to the U.S. Consumer Price Index (CPI)
We compared gold against the basket of goods used in calculating the United States Consumer Price Index (CPI). We used this approach because gold is periodically purchased by investors as a way to protect against inflation and deflation. Today's Gold-to-CPI ratio suggests gold looks relatively expensive versus the basket of goods. One reason that gold looks more expensive than this basket of goods is because, in our opinion, the CPI is currently understating inflation. We believe a better measure of inflation can be found in the Everyday Pricing Index produced by the American Institute for Economic Research (AIER). Nevertheless, we will use the official inflation statistic, CPI, since it is commonly used by investors and government officials.
The current U.S. Consumer Price Index multiplied by the Gold-to-CPI ratio suggests the following gold prices as shown on Chart 19:
Method 5: The Actual Cost to Produce One Ounce of Gold
We tracked how gold prices compare to marginal production costs over time. While some people believe that gold prices follow costs, others believe costs follow gold prices. Regardless of which theory you subscribe to, history suggests gold costs and prices track one another over time. Therefore, it is our contention there is utility to using a marginal production cost approach.
Marginal production costs refer to the incremental costs incurred to produce an ounce of gold. This approach suggests that if gold prices fall significantly and are sustained over a period of time, operators will shut down higher cost mines, causing marginal costs to fall.
Miners have used many definitions of cost over time. We focused our analysis on two of the most commonly understood definitions that we believe offer the best visibility into incremental costs: cash costsand all-in sustaining costs.
Cash Costs
Cash costs highlight the on-site cash costs involved in producing an ounce of gold. Cash costs include operating-site mining expenses, general and administrative expenses, stripping costs, smelting costs, refining and transportation costs, royalties and production taxes, mine community costs, mine permitting costs, realized gains/losses on hedges related to mine operations, and byproduct credits.
Cash costs have increased significantly since 2000 due to lower grades being mined, increased energy costs, as well as consumables and labor costs. Gold has typically traded between 1.6 and 2.1 times cash costs over time. See Chart 20.
The current cash costs multiplied by the Gold-to-Cash Costs ratio suggests the following gold prices as shown on Chart 21:
All-In Sustainable Costs
We also incorporated all-in sustainable costs into our gold valuation framework. We used this particular calculation because all-in sustainable costs include support activities and non-cash expenses that are required to maintain production. The World Gold Council provided a detailed framework on this cost measure in 2013.
All-in sustainable costs recognize site cash costs, site based non-cash compensation, and stock pile and inventory write-downs. All-in sustainable costs also include reclamation, remediation, corporate overhead, exploration, stripping and underground mine
development costs (both capitalized and expensed), and capital expenditures necessary to maintain the same level of production volume. Today, we believe the industry all-in sustaining cost of production to be $1,300 per ounce. We used this figure in our fair value estimate for gold.
Chart 22 summarizes the line-item details of all five valuation methods.
On Chart 23, we have taken the summary results shown on Chart 22 and created valuation zones for the price of gold. We believe it is more instructive to rely on a valuation price zone rather than just one number for each of our valuation categories. Chart 23 is the same as Chart 1 that was shown at the beginning of the report.
We believe that in order to achieve attractive investment returns, we must stick to our investment discipline and only buy when the security or commodity is at the right price. As Benjamin Graham said, "price determines return." For example, if you had bought gold on January 3, 1972, when gold traded freely, and held it through December 31, 2013, you would have earned an 8.2% annualized rate of return. On the other hand, if you had bought gold on January 21, 1980, when gold was at a peak and held it through December 31, 2013, you would have only earned a 0.7% annualized rate of return.
Having witnessed one gold bear market decline of 65% and numerous gold bear market declines of 43% over the past 45 years, we are confident that exercising patience and buying gold in the buy point zone should provide good returns into the future. See Exhibit 2 at the end of this report to see the returns by major asset classes compared to gold.
Written By:
Arnold Van Den Berg, CEO, Co-Chief Investment Officer Bill Hawes, CFA, Portfolio Manager, Senior Analyst
Contributions By:
Scott Van Den Berg, CFP, President Jim Brilliant, CFA, Co-Chief Investment Officer, Portfolio Manager Stephen Shipman, CFA, Portfolio Manager Casey Vaught, Equity Analyst Lisa Stroud, CMFC, Assistant Editor Kara Bell, Assistant Editor
Disclosures: The gold pricing in this report is measured using the London PM Fixing price, quoted in U.S. dollars per ounce. Past performance is not indicative of future results. Century Management reserves the right to modify its current investment strategies and techniques based on changing market dynamics or client needs.
The content of this report/letter should not be deemed, nor is it intended to be considered an investment recommendation to purchase or sell any particular security or an offer to sell any product.
Certain statements included herein contain forward-looking statements, comments, beliefs, assumptions, and opinions that are based on Century Management's current expectations, estimates, projections, assumptions and beliefs. Words such as "expects," "anticipates," "believes," "estimates," and any variations of such words or other similar expressions are intended to identify such forward-looking statements.
These statements, beliefs, comments, opinions and assumptions are not guarantees of future performance and involve certain risks, uncertainties and assumptions which are difficult to predict. Therefore, actual outcomes and results may differ materially from what is expressed or forecasted in, or implied by, such forward-looking statements.
Viewers are cautioned not to place undue reliance on these forward-looking statements, which reflect Century Management's judgment only as of the date of this report/letter. Century Management disclaims any responsibility to update its views, as well as any of these forward-looking statements, to reflect new information, future events or otherwise.
Factual material referenced in this report/letter is obtained from sources believed to be reliable and is provided without warranties of any kind, including, without limitation, no warranties regarding the accuracy or completeness of the material.
Century Management is a registered investment adviser. More information about Century Management, including its advisory services and fee schedules, can be found in its Form ADV Part 2 which is available upon request or you can download from our website at www.centman.com.