Thomas Kertsos is a portfolio manager and senior research analyst at First Eagle Investment Management. He joined First Eagle’s Global Value team in May 2014 as a research analyst covering precious metals and marine transportation. In March 2015 he was named an associate portfolio manager of the First Eagle Gold Fund, and in March 2016 he became a portfolio manager of this fund. Prior to joining the firm, Thomas spent six years as an associate analyst covering precious metals and mining in the Global Research Group of Fidelity Management & Research.
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| Thomas Kertsos |
As of June 30, the First Eagle Gold Fund (SGGSX) has returned 5.37% since its inception, on 8/31/93. That is 645 basis points better than its benchmark, the FTSE Gold Mines Index (-1.08%).
Tell me about the mandate for the First Eagle Gold Fund (SGGDX). What are the portfolio-construction and risk-management processes?
We have a distinct philosophy on gold at First Eagle. We believe that gold has unique risk-reward characteristics to be able to potentially preserve value in real terms in the long-term and provide diversification and resilience for a portfolio. We use gold as a potential hedge. We don’t own gold to speculate on its price in the next six to 12 months. We don’t forecast the price of gold.
In terms of our specific mandate, our benchmark is the FTSE Gold Mines Index and we seek to outperform both that and the gold bullion price through the market cycle. We also seek to realize absolute returns through the cycle.
In terms of the portfolio-construction process, we own gold as a potential hedge, not only through gold bullion but also through gold mining companies. We actively manage the allocation between gold bullion and gold mining companies in the following way. If we can find undervalued gold mining companies we will invest in them. But to the extent that we cannot find cheap enough equities, then we tend to keep our client’s capital in gold bullion until such opportunity presents itself.
We have an analytical investment process and we look for four key attributes in the gold mining companies we own. First, we look for valuation. Second, and very importantly, we look for resilience. Third, we look for growth, and fourth, we look for duration and long-term mine life.
Since we view gold as a potential hedge, the most important part of our stock picking and portfolio construction process is our focus on resilience and risk-management. We look at what can go wrong with the specific company. We analyze every security and try to determine how low the gold price has to go to create a financial problem for that specific company. In order to test this resilience, we will look closely at the balance sheet, the cost structure, the quality of the assets and specific technical and political risks. Among other things, we analyze the track record of the management team and assess the operational execution risk, to see if the management can operate effectively and minimize the capital allocation risk. We want to see that the management team has a good track record in operational execution and in making good capital-allocation decisions, and is also conservative in its financial management.
We are constantly asking what can go wrong with any specific company.
How does your fund differ from other gold funds?
First, we don’t forecast the price of gold. Therefore, we don’t give the benefit of doubt to any company because of a potentially higher gold price before adding it to the portfolio. We focus on resilience and seeking wealth preservation. We try diligently to maximize risk-reward and pay a lot of attention to what can go wrong. As a result, we tend to have a concentrated portfolio.
Some of the results of our investment process are the following. First, as we said, our fund is concentrated. We own only around 25 equity positions in addition to the bullion. Second, we have low turnover, only around 15%. Third, we own gold bullion; the last published number was around 18%, which we believe increases the resilience of the First Eagle Gold Fund. Fourth, since we don’t focus on the price of gold, we tend to avoid pre-production and exploration companies that don’t generate gold or cash flow, and are not resilient according to our standards. Fifth, performance-wise, we seek to outperform our benchmark, but we also seek the additional goal of realizing absolute returns through the market cycle while attempting to minimize risk.
What are some of the recent and current trends in the gold market?
The gold price has been quite volatile since 2015. It has largely responded to the Fed announcements regarding rate hikes and also to political developments. Gold is up 8% year-to-date, and there have been three corrections this year. One was in March 2017, due to the Fed rate hike. The second was in May 2017 due to the positive market reaction to the French election. The third correction was mid-June 2017 due to the latest Fed rate hike.
We see how the Fed communication about rate hikes and election outcomes appear to have been the main drivers of the gold price fluctuations in 2017, as they were in late 2015 and 2016. Remember that in September 2015 the Fed was pretty much focused on raising rates, and that proved to be a negative inflection point for the gold price, when it dropped to a six-year low in December of $1,051 per ounce. When the Fed turned dovish in early January 2016 it proved to be another inflection point for the gold price, and it started rallying in early January 2016. Then hawkish comments from the Fed created a sell-off in the gold price in the second half of 2016. And during 2016 we had two big spikes in the gold price from the Brexit vote and the U.S. elections.
We see that the Fed communications about rate hikes, and election outcomes continue to be significant drivers of the gold price in 2017, exactly as they were in 2016.
Given that all the money printing that has occurred since the financial crisis in 2008, why hasn’t the price of gold gone up more than it has?
The gold price hasn’t increased significantly since that time, because real interest rates have increased over the past few years as there has been strong economic growth expectations in the market. Especially after 2013, real interest rates have increased, which is a strong signal to the market of strong expectations of economic growth. That is why even though we don’t focus on the price of gold, we like to say that a catalyst for higher gold prices in US dollars is lower US economic growth.
Despite the countercyclical monetary and fiscal policies that policymakers implemented, as long as there are such strong expectations that money printing works and that we are going to have good economic growth, other assets like equities will perform well as they have already done, and real interest rates will tend to increase, which will likely limit any gold price upside.
You use gold as a potential hedge against extreme market outcomes. Can you talk about what makes it an ideal hedge? Gold performed well in the high inflation years of the 1970s and the low inflation of the 2000s. Can you explain that relationship?
There are several characteristics of gold that we think makes it an ideal potential hedge. Gold has unique risk-reward characteristics that give it the potential to preserve value in real terms both under inflation and under deflation.
There are several inflationary assets like commodities that can provide the potential hedge in inflation and there are several deflationary assets like cash or bonds that can provide a potential hedge in deflation. But gold is unique in the sense that it may provide a potential hedge and a potential store of value in real terms, both under inflation and deflation. That is a rare characteristic.
Gold is also a long-duration hedge. One ounce of gold is virtually indestructible. Unlike put options or futures, you don’t need to time the market or rollover your futures positions, which can be costly to maintain a hedge.
Gold also doesn’t have counterparty risk. JP Morgan has been quoted to have said that “Gold is money and everything else is credit.” Even if you had predicted the 2008 crisis, and if you had bought put options on Lehman Brothers before the global financial crisis, what would have happened if you owned them but your counterparty failed? During significant periods of stress in the monetary and financial system, owning gold is a different proposition for preserving our shareholder’s capital than other potential hedges that do expose the capital of our clients to counterparty risk.
Also unlike other financial assets, gold has a unique track record that proves those qualities. You can go back hundreds of years and do statistical analysis to see how gold has performed in real terms during adverse macroeconomic and geopolitical environments. Very few financial or real assets have such a unique track record as gold.
In terms of the performance of gold in the high inflation of the 1970s and the low inflation of the 2000s, the main reason for gold performing well under both environments is that the key driver of the gold price is not inflation per se, but real interest rates, which are the difference between nominal interest rates and inflation. Gold does not provide any yield and real interest rates represent the opportunity cost of owning gold. If real interest rates move higher, the gold price moves lower and vice versa. The single most important relationship that explains the gold price is the direction of real interest rates.
In the 1970s and 2000s, despite differences in inflation rates, both were periods of low real interest rates and low expectations of economic growth. That’s primarily why gold did well during both periods despite differences in the inflation rates.
You’ve talked about some of the things that drive the price of gold, including real interest rates and Fed policy. What else drives the price of gold?
We believe that the single most important relationship to explain the gold price is the direction of real interest rates. That’s where everything gets aggregated that affects the price of gold.
Essentially, the biggest pushback against gold is that it does not provide any yield. That is why real interest rates, because they provide real yield, represent the opportunity cost of owning gold. If investors are able to earn a real yield then they will sell gold and try to gain real yield. If real interest rates are low, then investors tend to buy gold.
Gold prices are inversely correlated to real interest rates in the short- and long-term. This is the single most important relationship that explains the gold price.
How do you view gold mining stocks versus gold bullion? Why do you have both in your portfolio? Gold bullion has outperformed diversified portfolio gold mining stocks since the early 2000s. Why is that?
Gold stocks tend to perform two-times the price-performance of gold, both on the upside and the downside. Gold stocks are leveraged to the gold price both on the upside and downside. But this leverage usually manifests itself more in the beginning of the cycle than at the end. Usually in the beginning of the cycle, gold stocks tend to do very well, significantly more than two-times the performance of the gold price, but as the cycle matures this leverage tends to dissipate. Overall, through the up-cycle they tend to do twice as well as the gold price even though the price-performance is stronger at the beginning of the cycle.
Even though gold bullion may have performed better than gold stocks since the early 2000s, there have been significant period when gold stocks have strongly outperformed the gold price.
During the period of 2000 to 2005, gold stocks outperformed gold by a significant margin. Last year, a diversified basket of gold names performed around seven- to eight-times better than the gold price. Gold stocks tend to outperform gold bullion in periods when they are cheap.
Also, even though we are talking about gold stocks in general, gold stocks are a very large universe and no two gold stocks are the same. The dispersion of returns among gold stocks is very large. There is a small subset of gold stocks that has done very well and has vastly outperformed the gold price since 2000 or since when they IPOed, even including the recent correction in the gold price since 2011. So, it is important to highlight that despite many gold stocks underperforming the gold price since 2000 there are some structural winners that have significantly outperformed the gold price.
Overall, we try to own our gold exposure through a mix of gold bullion and gold miners, even though we recognize that stock picking and valuation analysis is very critical. We believe combining gold bullion and gold miners offers a better risk-reward profile.
You own both operating gold mines and gold royalty companies. What is the argument for owning a portfolio of gold mines over gold royalty?
Gold royalties belong somewhere between gold bullion and gold mining companies in terms of resilience and upside price leverage. Operating gold mining companies usually provide more leverage than the gold price and gold-royalty companies. Royalty companies have very strong fundamentals and are more resilient than operating companies if managed well.
Because of their business model, gold-royalty companies tend to avoid cost inflation, CAPEX inflation and other risks that erode the profit margin of the gold mining companies in the later stage of a gold upcycle. Still, though, gold-royalty companies don’t offer the operating leverage of gold mining producers, especially when gold the price rises quickly, as we saw in 2016. Especially during the early stages of a gold price up cycle, gold mining producers tend to provide significantly more upside leverage than gold bullion or gold royalty companies.
Also, due to the significant returns that can be generated from successful exploration, gold mining companies that are good at exploration tend to match and even sometimes outperform gold-royalty companies through time.
You also invest in silver. Why is that?
Gold and silver are highly correlated in the medium- and long-term. But silver tends to underperform gold during a gold price downturn, and significantly outperform gold during a gold price upturn. Silver is effectively a high-beta version of gold. When there is a significant selloff in precious metals, as we have seen over the past few years, and when the silver price becomes historically cheap against the gold price, there is an opportunity to own some silver as it can be resilient and can provide more leverage to a potential upturn than the gold price, and can potentially improve the risk-reward profile of the Gold Fund.
Several gold mining companies operate in politically unstable countries in Africa. How do you approach the political risk for those investments?
We usually look for the track record of the management team operating in such jurisdictions. We look to see if the company works hard to secure the social license to operate in the specific countries and regions where it operates. Mining is a tough business, and to effectively license and operate a mine, you need both a government and social license.
The social license is very important. A mining company must engage with the local communities, create a partnership culture, and gain the respect and the trust not just of the shareholders but all stakeholders as there are always costs and misconceptions associated with mining.
It is about being able to monitor the risk and opportunities in the specific region where you operate. Some companies have had success in some of the most difficult environments, and some miners have had problems in relatively less risky jurisdictions, which shows that the underlying risk is management risk, not country-specific risk.
We travel to and visit those operations to make our own assessment of what the mining company does well, and what they do not. In some cases, we also talk to political analysts, especially during periods of elections in specific countries. But effectively, we focus on whether and how a company gains its social license and respects the environment, and is able to operate successfully in the regions where its mines are located.
Can you speak about one of your holdings, Fresnillo, which is a gold mining company?
One of our biggest positions is Fresnillo. We believe it has a strong management team. Its assets are located in Mexico. It produces currently around 900,000 ounces of gold and 56 million ounces of silver, and has a market capitalization of around $14 billion. We have visited the company, and we know their operations in Mexico quite well. The company is usually expensive because it is high-quality, accumulated shares in this company during downturns at depressed levels.
We believe it is a resilient company. The company’s main production comes from the Fresnillo geological trend in Mexico, which we believe is one of the best precious metals assets in the world. The Fresnillo mine has been in operation for more than 100 years and the company knows the operations very well. The management team has owned and mined it successfully for decades, since the 1960s. The company has more cash than debt on its balance sheet, so we believe it has a very strong balance sheet. It is also one of the lowest cost precious metals producers globally.
The company is a senior precious metals producer with one of the strongest organic production growth profiles amongst all seniors. The company is extremely conservative with its capital in terms of capital allocation. It is a long duration company. Its mine life is around 10 years on reserves, but we believe , there is likely opportunity for organic growth as this region has been generating silver and gold for more than 100 years.
In our opinion, despite the volatility, this is a resilient and long-duration company with limited risk of permanent impairment of capital.
And we believe the company provides optionality to potentially higher gold and silver prices and also to possible exploration success.
If an operating gold mine is losing money at current prices, isn’t it a wasting asset, and at best a speculation on gold futures?
It really depends on which gold mining business you own. Gold mining has been going on for thousands of years and despite strong cyclicality, it is a very resilient business. One of the reasons is that the quality deposits very rarely go out of business. That is one of the reasons that we strive to own high-quality, low-cost producers with management teams that we feel can operate effectively, and are prudent capital allocators, and conservative about financial management.
The recent downturn in the gold price has allowed us to own companies, which we view as having these characteristics, at what we feel are good prices. The problems tend to manifest themselves mainly in high cost producers, or companies where the management teams have leveraged the balance sheet significantly and stretched the technical expertise to build low quality assets or too many assets at the same time. These are companies that we try to avoid owning.
What is of the argument for owning gold over bitcoins? Do you see any value or advantages for owning bitcoins?
I don’t believe there is value in owning bitcoin over gold, if someone owns gold for the same reason we do, which is for seeking wealth preservation and adding potential downside protection to a portfolio. As we talked, gold has has historically been able to preserve value in real terms. That has been true in several macroeconomic scenarios, including inflation and deflation, geopolitical risks and different regulatory and political environments over a period of hundreds of years. You can look at these characteristics going back centuries in the gold price.
Bitcoin has a history of around seven to eight years, and we haven’t seen its performance under stress, such as during the last financial crisis in 2008. You also haven’t seen how the bitcoin price can withstand legal authority-imposed restrictions or how it behaves during a stock market selloff.
I’m not making a case against bitcoin. Bitcoin can increase in price. It could be a great speculative vehicle. But for the purpose of seeking downside protection during adverse macroeconomic scenarios like inflation or deflation, or against geopolitical risks, gold has a unique long-term track record that bitcoin cannot match.
Twice, in 2013 and 2014, bitcoins dropped around 70% in a period of a few months. Bitcoins may increase in price going forward, but we don’t want such volatility.
How do you respond to Warren Buffett’s assertion that it’s better to own productive assets than an inert metal?
There are two ways to invest; invest to strive to become rich or invest to remain rich. Gold serves the latter purpose. For purposes of seeking wealth preservation, businesses don’t have the same track record as gold does. We saw how large-capitalization stocks as measured by Dow Jones performed in the deflation of the 1930s, or in the 1970s in a period of inflation. They dropped significantly. Those are periods when owning gold would have served an investor well.
Stocks and other productive assets need an environment of economic growth and price stability. When that happens they tend to significantly outperform gold. But if deflationary pressures emerge in the economy, stocks, even high-quality stocks, tend to experience substantial drawdowns. The same happens when prices start to increase like we saw in the 1970s, and inflation creeps up higher than the 2% that the Fed targets. Then businesses, even the ones with strong pricing power, as we saw in the 1970s, tend to start lagging and can drop significantly in real terms. In periods of economic growth, stocks tend to do better, but in periods of inflation and deflation, gold has proven to be able to preserve its value in real terms better than stocks.
And we don’t recommend owning a portfolio consisting only of gold. We own around 10% of gold in our diversified funds, while the significant majority of our assets is in equities. In this way, we seek to enjoy the benefits of human productivity and economic growth, but we do own some gold as a potential hedge.
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