Investment Idea #14
Investment Idea #14
A dollar is an IOU from the country's central bank. It's a promissory note that doesn't actually promise anything - political satarist
While this newsletter discussed a couple of stock ideas i.e. businesses generating solid free cashflow, there are a few non-stock investments that we should discuss. One of which was the very first idea - buying 6 months T-bills issued by the Singapore Government with our cash. It is as good as cash, and cash is important because it provides us optionality to buy more stocks when opportunity knocks i.e. when market corrects.
Today, we shall discuss another investment that acts as portfolio insurance or the ultimate fail-safe should our financial system collapse. This is not an impossible scenario. It happened in 1929 and it happened in Singapore during WWII with the now infamous banana money and in recent years it happened in Venezuela (see pic below).
Hyper-inflation in Venezuela reached 1,700,000% in 2018 and when its economy collapsed. Inflation hitting 1,700,000% cannot be comprehended by our human minds. It simply means Bolivar notes were worth less than toilet paper, which was why they were made into art and craft (above). Millions of citizens fled the country and USD became the transaction currency of choice. In late 2021, the government decided to cut 6 zeros off and rebased the currency. However turmoils in the global economy continue to plague the country and it seemed that the Bolivar is still not out of the woods and could continue to depreciate. They may have to trim more zeros in time to come.
This could happen to the global fiat currency system and by extension, all things in today’s global financial framework. At the height of the Global Financial Crisis (GFC), it was believed that we were days away from such an epic meltdown. Millions of banks could fail, all our savings in banks gone, currencies breaking down (like the Bolivar) and globally, billons of workers losing billions of jobs. Basically, it could be Financial Armageddon and the Great Depression all over again. Luckily we averted that, but who knows, it is not zero probability that this doomsday scenario cannot happen in our lifetimes.
Another scenario that could render all our financial assets worthless is WWIII. Again, who knows whether that could or couldn’t happen? We just saw two major conflicts escalating into wars in the last two years.
The only investment that can help us in such dire scenarios is gold (or maybe a combination of gold, silver, diamond and luxury watches, essentially physical items possessing perceived value to other human beings, but to make things simple, just gold today). I have written about gold on the original infosite and it is perhaps helpful to reiterate some key points here:
Gold is a unique asset class. It represents the ultimate store of value because its status had been independently verified by our various ancestors in different parts of the world and its value had since evolved with the collective human consciousness over time. All ancient civilizations used gold as a status symbol, in decorating temples and tombs alike. In modern times, it was the standard for the global currency exchange and even when that broke down, it remained as a safe haven asset class in times of crisis. It is the universal currency which would transcend failures of the financial system.
Hence, it makes sense to have a bit of gold in our portfolios. Gold is the origin of the global financial system built on centuries of our species' adoration for this metal. Gold has no meaning to a monkey. Between banana and gold, the monkey will always choose banana. But to humans, although it will not generate cashflow, it is the best manifestation of physical wealth. To me, this makes gold a kind of “fail safe wealth” should modern finance breaks down. Therefore, it is prudent to have just that bit of gold in case our modern financial system collapses.
Now that we have introduced the thesis, let’s discuss the usual fundamentals and technicals:
1. Fundamentals
According to my simple searches on google, the gold industry mines 3,000 tons of gold annually and all the gold that has ever been mined amounts to 190,000 tons. 1 ton of gold is worth c.USD65m and that means that the annual output is around USD200bn. By any measure, that is a huge industry. We discussed gaming in one of the previous ideas and that industry is USD180-190bn. And if we calculate that value of all the gold that has ever been mined, it amounts to c.USD12.5trn. That’s bigger than the market cap of the FAANGs combined. So, you get the idea, gold and gold mining is big.
Fun fact: While gold was mined and used by the Egyptians, the Greeks, the Romans, the Aztecs and the Chinese, all the gold that has ever been mined can fit into a 23 metre cube and all gold both mined and still underground will never fill an Olympic size swimming pool.
It is estimated that 600-800 tons of gold is used in jewellery and ornaments with India and China being the largest users. Gold does have some industrial use but, as you can imagine, the next largest use would be as store of wealth (c.30% of annual gold production), with both the global central banks buying for their reserves as well as corporates, financial institutions and individual buying for investment. As such, after reading this post, we should expect gold demand to further increase once readers are convinced of my investment thesis :)
Risks
As with most discussion previously, we should think about the risk of owning gold. There is a clarification we have make here. In this post, I am talking about owning physical gold since our intent is to hedge the risk of a global financial meltdown. If you own a gold ETF, it will not be much help, because when the system breaks, you will not be able to sell the gold ETF, get cash and buy bread. But you can sell / barter your physical gold coin, or nugget or bar for rice, bread and what not.
So the risk of owning physical gold would be more physical in nature. We risk it being stolen or taken away by force. There will also be storage issues and there is also the risk that it is not actually gold. It could be a chocolate bar wrap in gold foil if you are not careful! So it is important to buy from credible sources. My recommendation will be going to Raffles Place UOB branch in Singapore and buy from the bank counter. UOB is a reputable bank and they have done this for decades. There is no way they have cheated all these years without being found out and no merit for them to try today.
But, to me, the risk of not having this insurance in the portfolio is far greater. It should not be a big part of the portfolio. Maybe just a couple of percentage points, say 3%. With global inflation, gold prices should go up over time. But if the unthinkable Financial Armageddon happens, everything else in the portfolio will be worth nothing and this 3% is what will help us tide through the months, if not years, until the world rebuilds in a new financial order.
Let’s think about this hypothetically. Imagine you are in Ukraine in early 2022. Russia has lined up its troops. The war is going to happen. Your bank account is frozen. All your stocks, bonds, investments are gone. You have some petty cash and you packed food, essentials and you are ready to drive your family in your car for two days to Poland and start afresh. If, you have that 3% of your portfolio in physical gold, wouldn’t that make all the difference? This is the investment thesis for having gold.
Yes, we are not in Ukraine. China will not attack Taiwan. North Korea will not be stupid enough to do anything crazy. Therefore WWIII will not happen. But a second war did just broke out in Israel. Is it zero probability? I am not saying put 20% in gold. Just a small amount, something you are comfortable with.
2. Technicals
There is one last risk we should discuss more deeply and that is a technical drawdown in gold price. So this is a good segue into technicals. By financial definition, drawdown refers to peak to trough decline usually described in percentage terms and we can see that gold has suffered big and small drawdowns over the last 50-60 years. The big drawdowns are quite long, usually spanning c.4 years and deep at c.40% decline. They also tend to come after huge run ups.
Notably, the two biggest drawdowns from the chart above are easy to spot. The first around 1980 after the oil shocks and the second after the GFC in 2012, albeit with a three year delay. Both were quite treacherous and we should bear this in mind. Gold investing means being able to stomach long term volatility. As such, to make it clear again, this should not be a big part of the portfolio. Gold is a hedge and a fail-safe.
With gold prices at all time high, I would also recommend that we start really small and top up should gold prices correct. We can start with just 1% of the portfolio or even smaller and use time diversification to build up to 3% over a few tranches.
3. Valuation
It is very difficult to ascribe valuation to gold. There is no earnings, no cashflow and obviously no dividends. If we look at other commodities, people tend to look at the cost of extraction and work from there. For instance, in the case of a barrel of oil, the current cost ranges from USD20-90 with the average being at USD70. So many market participants believe that oil cannot fall below USD70 for an extended period. (But prices can go negative as it did during the pandemic)
For gold, the industry uses the metric called All In Sustaining Cost (AISC) and similarly there is cost curve ranging from USD800-1,200. From the chart above, we can see that gold prices have stayed above this cost for the last 15 years and in recent years, broadly speaking at c.2x of this cost. If we believe inflation is here to stay, the AISC will rise over time at inflation rate of c.4-5%. This means that the future AISC could be c.USD1,300 and then multiplying 2x give us gold’s intrinsic value of USD2,600 which is c.20% upside from today’s price.
However, this price could mark a multi-year peak which could be followed by a large drawdown as we have seen in 1980 and 2012. So exercise prudence and always use gold as the portfolio hedge / fail safe!
Huat Ah!
Main blog:
http://8percentpa.blogspot.com/
This post does not constitute investment advice and should not be deemed to be an offer to buy or sell or a solicitation of an offer to buy or sell any securities or other financial instruments.