Deep Dive: Investing in Gold Royalties (FNV, SAND, NSR.TO)
Gold as part of a bottom-up portfolio
As investors, we constantly evolve. When I started my investing journey, I devoured everything written by Buffett and Munger. It all made sense to me because it all made sense to them - and they were my heroes. On gold, Buffett said the following:
“Gold gets dug out of the ground in Africa, or someplace. Then we melt it down, dig another hole, bury it again and pay people to stand around guarding it. It has no utility. Anyone watching from Mars would be scratching their head.”
If you dig deeper, Buffett is really saying that you can exchange your dollars for gold or you can exchange your dollars for a productive asset such as farmland or an operating business. With the latter, you get some yield from the investment with which you can then buy more farmland or operating businesses and thus compound your capital. Snowball. If you buy gold, it provides no income and instead you have to pay someone to store it for you so it, in essence, has a negative yield. Made perfect sense! Hence, I never spent any time thinking about gold or gold linked-investments.
In 2018, I heard this Tony Deden interview on Real Vision. Grant Williams conducts a beautiful long form interview in the Swiss Alps where Tony opens up about his investment philosophy; a large part of which involves owning physical gold as well as gold related equities. When asked about holding gold vs. cash, he said the following:
“This reserve can be in the form of treasury bills, commercial papers, short term bonds or time deposits. The problem with these so-called 'paper assets' is that they are actually debt. So you do not want your liquidity to be somebody else's liability. Physical Gold solves that problem. Gold gives scarcity, permanence and independence from the financial system..no one actually owes you anything when you hold gold. It's not a claim on anything. Has a sense of peace to it as it possesses a financial strength that even some financial institutions can't boast about.”
Reminded me of a JP Morgan quote I had seen a long time ago,
“Gold is money, everything else is credit”
Tony had started buying gold after the GFC. That episode, and the subsequent central bank interventions, shook his faith in the financial system and he wanted an asset that was outside the system. I think it shook everyone’s faith but as soon as the markets normalized and we saw our accounts get back to par, we forgot about the fact that none of the problems which led to the GFC were fixed. The opposite, in fact, occurred. The Fed was now ever so powerful and intervened in the economy on a regular basis to keep its wheels greased.
We have had recurring crises since 1987. In each and every subsequent crisis the Fed has increased its role and interfered to stabilize the system. The consequence of this policy has been that debt in the system has increased and increased and increased some more. Since 1982, bond yields have been declining with a trend of lower highs and lower lows. Every time these yields perk up, there is an ‘accident’ which forces the Fed to intervene with even more easing. In 2019, there was a repo crisis, and the Fed had to fix it with “not QE”. In March 2020, along with the market melt-down, the credit markets came to a halt. Stopped. It was not until the Fed directly intervened in the corporate bond market that these companies could start rolling their paper again.
Lets Invert. Imagine for a moment that the Fed could not get the credit markets to open. Imagine that, American corporations, big and small, could not roll their paper. A lot of astute investors bought these wonderful stocks on dips because they were cheap based on the calculations of earnings power. A question one might ask oneself is - what is this earnings power in a world where you cannot issue or roll over debt? What is the ‘bear case earnings power’ in that situation? Even if you do a well placed purchase of a good quality company with a net-cash balance sheet - what about their customers, their suppliers, their employees? It's all connected! One has to be intellectually honest to admit, no matter how ‘bottom up’ your analysis, that at the end of the day, your whole investment operation is dependent on the Fed!
There is a ‘myth’ out there that gold is speculative or that gold is only for ‘gold bugs’ or people who are waiting for the end of the world. This is not true! We believe gold is an asset that helps hedge a bottom up portfolio against these risks. Gold is not a new addition to a value investor’s portfolio. Jean-Marie Eveillard (and his firm First Eagle) always had an allocation to gold in their portfolios. Here is Jean-Marie in his own words:
“If for whatever reason, things become extremely difficult, I may be running more risk than I thought in my funds. So gold is a nice insurance policy. The 5%-7% weighting would partially offset the hit we would take on equities. Because we know we have partial insurance policy, we feel comfortable when we come up with a security we like. We'll think, "Boy, it's attractive, but we should have some cash." But we don't need to, because our insurance policy is gold.”
Further, we showcase a superior way to get exposure to gold where an investor can obtain the benefits of a hedge while not leaking capital over the cycle.
The Macro Picture