Value investing is often thought of as buying cheap stocks, but a broader definition of value investing is to invest in any company that is trading for a lower price than you think the company is worth fundamentally in terms of the cash flows it is expected to produce over the long term.
The key theme, though, is to use conservative and quantitative evaluation metrics to judge what price to pay for decent returns.
I usually include an allocation to gold and gold stocks in my portfolio, and currently have 5-7% exposure to precious metals in general. Gold is a mostly non-correlated asset class to stocks, which makes it useful for improving risk-adjusted returns, and it can potentially serve well for defensive positioning in some contexts.
Gold stocks, meaning companies that mine gold or finance gold production, can potentially throw a wrench in a value investor’s plan. Gold is an esoteric commodity; a substance that has ideal characteristics to store wealth but is endlessly debated on how to value it. It produces no cash flows, which throws out discounted cash flow analysis as a valuation tool. The bulk of it is not consumed by industry, so the immediate balance between supply and demand does not dictate price, since most gold ever mined is still stored and can be sold. And yet, in order to value gold stocks as businesses, we need to be able to determine if gold is grossly overvalued, deeply undervalued, or somewhere in the middle. Hence the problem.
While I do look at many metrics, including production levels, there are two simple charts I focus on when it comes to forming a back-of-the-envelope approximation of whether gold is overvalued, fairly-valued, or undervalued.
These charts are not useful for short-term traders or details of whether gold should be 5 or 10% higher or lower. For that, sentiment and technical analysis may serve you well. My personal goal with gold is never short-term trading; it is about determining what, if any, allocation to gold I want in my overall portfolio as a long-term position. I’m happy to own gold and gold stocks for a small part of my portfolio as long as gold is not demonstrably overvalued, so my primary purpose is to determine major periods of overvaluation or undervaluation to prepare for multi-year bear or bull markets in gold.
Two Fundamental Charts for Gold Valuation
I focus primarily on gold priced in dollars, because both gold and dollars are highly liquid and traded around the world.
The supply of gold increases about 1-2% per year, which also happens to be similar to the current human population growth rate. Thus, the amount of gold per person remains relatively static over long periods of time. Data from the World Gold Council suggests that there is in the ballpark of about 1 ounce of above-ground gold for each person on earth.
On the other hand, the number of dollars per American (and per human, worldwide) keeps increasing. The same is true for other currencies. Because of this, the purchasing power for fiat currencies declines over time.
A mistake that many investors and traders make is that they assume that gold is simply a hedge against price inflation, when in fact, the price of gold has increased much faster than price inflation over the past five decades. A more accurate driver of gold price is monetary inflation, or the increase in the per-capita supply of money itself.
The first chart I focus is the supply of broad money per capita compared to the price of gold. Over time, the amount of dollars per person keeps increasing, even as the amount of gold per person remains relatively static. Thus, we should intuitively expect the price of gold to gradually rise in dollar terms over time.
This chart shows the broad money supply per capita (blue line) compared to the gold price (red line) over time, indexed to 100 in 1995:
Gold has risen in price over the past 47 years in dollar terms at almost exactly the same rate as the increase in M2 money supply per capita in the United States, which is over 5% per year on average.
This chart has served me well; I sold all my gold in 2011 and started buying again in 2016. I’m happy to buy gold whenever its price is roughly in line with this chart or below it.
But as the chart shows, gold is more volatile than the M2 supply growth rate, and can have decade-long periods of negative returns in some cases. Why does gold sometimes run ahead of the growth of money supply and other times fall below it? That’s where the second chart comes into play:
The red line in this chart shows the percent increase or decrease in the price of gold each year.
The blue line shows the 10-year treasury yield minus the price inflation rate, aka the real price-inflation-adjusted treasury yield. It is magnified by a factor of 20 on the chart for clarity.
The chart shows that the change in the price of gold is strongly inversely correlated to real interest rates. And this makes intuitive sense. When you can put your money in a bank or in treasuries and make a good real return, there is less incentive to hold gold. On the other hand, when holding money in the bank or in treasuries produces low or negative real returns, investors often look to gold as a store of purchasing power.
During periods of currency uncertainty in 1980 and again in 2011 during periods of negative real rates, the gold price significantly outpaced the broad money supply per capita and went into a bubble. Investors were fearful in 1980 about very high inflation, and were fearful in 2011 of Federal Reserve money-printing. Those concerns never led to the dramatically negative outcome that some assumed, so the gold price eventually drifted back down to the long-term growth trend line of M2 money supply per capita.
On the other hand, the price of gold dipped below the M2 per-capita trendline for about a decade from the late 1990’s through the late 2000’s. This was during a period of stable growth and high real interest rates, which are bullish for cash and bearish for gold demand and gold prices.
Gold is currently fairly-valued against the trendline of broad money supply per-capita (first chart). In addition, the low real interest rates in the United States and the negative real interest rates in Europe and Japan are supportive of the price of gold at or above the long-term trendline (second chart).
Therefore, I have a constructive outlook toward gold and gold stocks over the next 5 years. Silver is more volatile but by most metrics is more undervalued than gold.
I can’t tell you what gold will do over weeks or months. EWT or another technical analysis method may be your guide for that timeframe. But over the long term, evidence suggests gold and gold stocks will do well over the long-term and may improve risk-adjusted returns within a diversified portfolio. In this environment, I maintain a 5-7% allocation to precious metals and gold/silver stocks with occasional rebalancing.
For my portfolio, I focus on more conservative gold stocks, meaning gold miners with low debt and low AISC, or gold streaming and royalty companies.