Investing in gold via financial assets

How to play Long Gold thesis?

I am from Varna, Bulgaria. My city is the home of one of the world's archeological mysteries. The treasure from the Chalcolithic Necropolis near Varna discovered nearly 50 years ago, is recognized as the oldest processed gold in the world. According to various estimates, gold artifacts are 6,500 years old. Picture via TheArcheologist.org.

We like to forget, but gold has been around for millennia. During all epochs, the affluent of its time knew that gold was an integral part of generational wealth. If gold has been highly regarded for 6,500 years, I do not expect that to change. Let’s not forget about the Lindy Effect.

This is The Old Economy Substack, not Bulgarian Indiana Jones diary. After the archeological interlude, let’s discuss gold in the context of investing.

Gold covers the three pillars of sound money: store of value, medium of exchange, and unit of account. This fact makes it different than all other metals, even the precious ones.

Platinum Group Metals and silver have extensive industrial applications. Silver has been used as a monetary metal for centuries. Yet, nowadays, it is primarily an industrial metal. Gold, on the other hand, is a monetary metal. Gold industrial applications play an insignificant role in its demand.

This makes gold an extraordinary asset. It is one of a few assets that does not have counterparty risk. To be fair, cryptocurrencies are almost there. However, they carry two significant risks: power outages and hardware (dis)integrity. Accordingly, many things can go wrong.

Gold is not subject to blackouts or digital infrastructure issues. It is tangible peace of wealth. To emphasize, Bitcoin has its strengths, and gold has its shortcomings. However, they are not the subject of today’s discussion. Today’s focus is on how to play gold via financial assets.

Long Gold thesis in 404 words

I am bullish on gold. The stars are aligned for a bull run in the long term. Let’s review a few reasons why gold demand will rise in the coming years:

• Long-term: Gold is moving (again) from the West to the East. We are too shortsighted and dislike learning from history. It is not the first time that gold has traveled from the West to the East. The Age of Discovery made the Viceroyalty of Peru the center of global gold and silver mining. The Potosi silver mine in today’s Bolivia has become a source of wealth for the Habsburg Empire. Much of that gold and silver traveled to the East in exchange for spices. The East again built its gold reserves by stripping gold from the West. In my opinion, the process that just started would act as a long-term tailwind for the gold price.

• Mid-term: Rising geopolitical entropy favors gold, which is one reason the East hoards it. At some point, I believe the West will awake from its “woke and green” dreams, realizing the importance of energy independence and sound money. So, it will rush back to the future, i.e., gold and energy.

• Short term: Lower interest rates (for a while) will spark another asset rotation from fixed income to equities and gold. This is a self-explanatory mechanism. The lower the interest rates, the higher the bond prices and the lower the yields. So, the risk premium between risk-on assets and fixed income shrinks, which motivates investors to seek better risk-reward.

Unsurprisingly, gold mining suffers from the same issues as the other metals miners: a lack of significant new discoveries, a shortage of personnel, and almost nonexistent CAPEX.

In summary, gold demand will grow in the coming years. The prime driver is East. On the other hand, the gold supply is stagnating. Economics 101, decreasing supply and increasing demand leads to higher prices.

Another fact, too, has to be accounted for. In politically correct wording, I mean delicate gold price adjustments by JP Morgan and London Bullion banks. This is a story for another write-up. Let’s focus on the basics: demand and supply.

Being bullish on gold is insufficient to create and execute a profitable trade. To express a thesis, we have many tools at our disposal. Rule number one: there is no “one size fits all” approach.

How to play gold

Gold is a monetary metal. However, my framework for playing industrial metal miners is applicable. In summary, pick the few largest gold mines and buy some LEAPS calls, then buy leveraged ETC for direct exposure to gold spot price.

However, unlike the industrial metals for gold, we have more alternatives. Royalty and streaming companies, mining financiers, and bullion sellers come to mind.

Today, I compare options for playing long gold via financial assets. I intentionally exclude physical assets because they serve other purposes, and different motives drive their ownership.

To bet on the gold bull market, we can buy:

• Direct exposure to gold via ETN, ETC, ETF, futures contracts, or call options

• Equity exposure via producing miners

• Equity exposure via juniors and developers

• Equity exposure via gold mining financiers (royalty and streaming, alternative financiers)

• Equity exposure via bullion sellers

• Where applicable, all equity plays can be expressed via call options, too

Every choice has its pros and cons. Accordingly, it suits a certain investor profile, considering his/her goals, risk appetite, and experience. There is not one size fits all.

Analysts have covered large gold miners extensively, so I will not focus on repeating well-known facts. The major miners have one massive advantage over the smaller ones because they have highly liquid call options, measured in volume and open interest.

This makes names like Agnico Eagle, Barrick Gold, and Newmont excellent LEAPS call plays. Of course, under specific considerations. Besides liquidity, we must buy options with implicit volatility below 40% and expiration in the next 12-18 months. If such contracts are unavailable, the LEAPS strategy is not a viable choice.

The charm of playing the majors via call options is that we get a junior miner's upside potential with a major's downside risk. In other words, we have attractive risk rewards with odds skewed in our favor.

Nevertheless, juniors can be very profitable, too. But we must remember that the junior mining universe shares similarities with shipping nano caps: share dilution, obscure reporting, and generous C-suite compensations.

Like shipping nanos, mining nanocaps are uninvestable in most cases. If the investor is well versed in geology and corporate gimmicks, juniors are an excellent play. If not, better bet on majors or directly on gold.

The royalty and streaming companies are attractive bets. They finance the gold miners. Being a geologist is not a prerequisite for investing. Moreover, household names like Franco Nevada and Wheaton Precious Metals offer liquid call options, too.

Of course, we have small-cap royalty companies. Like junior miners, many of them are, at least to say, questionable. Mediocre assets, share dilution, and lavish compensations are common for those companies.

At first glance, alternative financiers seem like an exciting way to bet on gold. These companies do not generate revenues. Their focus is on equity and warrants. All mining financiers' priorities are strong returns, not regular cash flows.

However, if you examine those companies diligently, you will see that many of them are simply milking cows for their major shareholders. Palisades Gold is an illustrious example.

Despite the promising presentation filled with uplifting quotes, reality tells a different story. Considering Palisades's market cap and performance, consultancy fees, salaries, and share base compensation are too generous for a company at that size and stage of development.

I treat Palisades and all alternative mining financiers as investment funds. They pool investors’ money and then invest the funds. The funds generate revenue primarily from AUM-based fees and performance fees. The former incentivizes the managers to focus on growing AUM and neglect the funds` performance. Of course, this is not always the case, but major mutual funds are prime examples. They have mediocre performance, but their managers receive generous AUM-based compensation.

On the other hand, funds gain revenues solely from performance fees. In my opinion, this is the right incentive. Guy Spier and his Aquamarine fund are excellent examples of zero management fees (AUM-based fees).

To recap, I start from the page reporting executives’ compensation, fees, and awards when considering alternative mining financiers. Usually, a short glimpse is enough to figure out what’s going on.

Last but not least, we can bet on gold via bullion sellers. A-Mark is the major player in that league. The company has a few ways to generate revenue: wholesaling precious metals, customer sales, and minting bullion. Unlike mining, it is an assets-light business. One shortcoming is the tiny margins in the 1-2% range. A-Mark scored impressive YoY revenue growth for the last five years. Nevertheless, the small margins and volatile gold prices did not translate into income and FCF growth.

Since 2020, AMRK outperformed all gold financial instruments. The chart below compares:

• Gold majors: Barrick Gold and Agnico Eagle, GOLD and AEM

• Royalty majors: Franko Nevada and Wheaton Precious, FNV and WPM

• Alternative financier: Palisades, PALI

• Bullion seller: A-Mark, AMRK

• Levered ETN: DB Gold Double Long ETN, DGP

• Gold price, GC1

A-Mark significantly outperforms all contenders. However, this does not mean it is the best way to bet on gold or that it will deliver the same results in the future.

The whole purpose of today’s article is to show various alternatives to playing gold via financial assets. There are no fixed rules for investing in gold. Depending on the investor’s goals, experience, and risk appetite, he or she can create a portfolio using some or all of the tools I discussed.

My way to play gold is via LEAPS calls on gold majors. I believe gold miners are incredibly undervalued, compared to gold sport price. The charts below compare VanEck Gold Miners (GDX) vs. gold price and VanEck Junior Gold Miners (GDXJ) vs. gold price.

So, having direct exposure to gold comes with high opportunity costs for me. It is worth mentioning that companies listed in GDXJ are no longer junior, as the fund’s name implies. Most of them own and operate a few producing assets. Nevertheless, they are smaller than the companies included in GDX.

I have had many incarnations as a market participant. I tested multiple instruments, strategies, and assets until I figured out what didn’t work. Simply put, I made tons of stupid decisions that cost me a lot, both in financial and emotional capital. Yet, in the long term, all those failures are stepping stones in my growth path as a market participant.

At one point in my growth, I was a hardcore gold bug. I had everything in gold, including physical and equities. As with every extreme, this was the wrong approach, too. Nevertheless, I learned much about gold as an investment and mining universe. In today's write-up, I shared some of that knowledge.

My forecast is that the gold spot will reach $5,000/oz by the end of the present decade. It may sound like an outrageous number, yet this is my conservative scenario. Accordingly, the importance of gold as an Alpha generator will grow.

Treat today’s write-up as a toolbox. According to the task and required skills, pick your tools wisely.

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Everything described in this report has been created for educational purposes only. It does not constitute advice, recommendation, or counsel for investing in securities.

The opinions expressed in such publications are those of the author and are subject to change without notice. You are advised to do your own research and discuss your investments with financial advisers to understand whether any investment suits your needs and goals.