e-fundresearch: Which fundamental factors are currently the most important for gold? What is your general outlook for gold and precious metals over the next 6-12 months?
Sacks: Gold began the year well and rose by 11% during January. The gold price rallied by $200, from the lows of $1,550 to $1,750, due to a weaker US dollar after the Federal Reserve Bank (Fed) signalled they would keep interest rates lower for longer than previously expected. The release of the Federal Open Market Committee (FOMC) members’ expectations on the timing of interest rate actions provided an insight into how long the Fed expects to keep rates low. This, along with changed language in the statement, suggests rates aren’t expected to rise until at least late 2014 if growth continues on its current trajectory, with the Fed leaning toward more easing rather than remaining on hold.
Higher interest rates are the key risk to the investment thesis of many buyers and holders of gold, but this risk seems to be shifting further and further away.
Subsequently, gold prices should be able to be sustained at high levels for longer.
Interest rates have remarkably shifted even lower, with 10-year Treasury Inflation-Protected Securities (TIPS) still showing a negative yield. This, along with a weaker dollar, is bullish for gold at current price levels. Gold is also receiving support from higher oil prices. As discussed above, the agreement by European Union (EU) governments to ban the import of Iranian oil has prompted renewed threats by Iran to close the key Strait of Hormuz oil shipping channel. This boosted oil prices and by doing so supported oil prices too.
The World Gold Council published a report estimating that central bank gold purchases may have hit 450 tonnes (t) in 2011. Thus, the official sector outstripped gold exchange-traded fund demand (which increased gold offtake by 155t) in 2011 by almost threefold. Even more recent International Monetary Fund (IMF) data reveals that more central banks added gold in December, most notably Russia with 9.8t, Kazakhstan with 3.1t and Mongolia with 1.2t. Although reported volumes are not very large, it is still an extension of the official sector accumulation trend. Fundamentally and politically, this is certainly positive for gold.
The outlook for central bank gold purchases remains positive for this year, based on the likelihood that emerging market central banks will continue to diversify away from the US dollar. If the US continues to run substantial trade and current account deficits then according to economic theory the US dollar reserves of those countries that the US runs a trade deficit with, will rise. Since US dollar foreign exchange holdings are already at record levels in many countries, we believe these nations will seek to increase gold reserves, in a bid to diversify their US dollar-laden reserves. While we do not expect official sector activity to move the market in the near term, we regard central bank purchases as a bulwark of the long-run gold rally. We believe that at current prices the market is indeed supported by strong fundamentals.
In particular, the recent pledge to keep interest rates low and on hold for the next 3 years by the Fed, allows for the continuation of negative real interest rates. This makes the case for owning gold as an alternate currency (in a negative yield environment) very compelling, particularly as the possibility of renewed quantitative easing may further debase fiat currencies and fuel future inflation.
Looking next at platinum, the platinum price started the year strongly, up 13% over the month to end at $1588/oz as supply disruptions out of South Africa (SA) and improvements in global demand helped to lift the metal. With 35% less production coming from SA, palladium lagged up only 5%. Looking ahead, we continue to remain cautious on the outlook for European automobile sales. With exposure to Europe being the greatest for platinum, we feel that the current macro environment is not conducive to strong volumes. Furthermore, a lack of emissions legislation change next year and a diesel to gasoline ratio that has normalised creates little new demand for the metal. Notwithstanding this demand outlook, there is every opportunity for South African supply to disappoint. As increased focus is applied to safety and cost pressures continue to mount, the producers are unable to produce the desired amount of platinum profitably. Approved electricity price increases of 25% p.a. over the coming years, will continue to keep costs elevated and make new deeper mines less viable. At current prices, South African miners enjoy little margin when total capital expenditure is incorporated and hence new projects or prospective junior platinum mines struggle to make sufficient returns to justify project development. Add to this the recently gazetted Indigenisation bill which requires Zimbabwe based mining companies to sell 51% of their equity to local entities and the supply side for platinum group metals (PGMs) looks fragile. Zimbabwe produces 4% of the world’s platinum and this latest round of nationalisation threatens future investment in the PGM industry. While short-term demand for platinum remains uncertain, we believe the long-term story remains intact. This coupled with supply that continues to disappoint will deliver a tight market in a few years’ time.
e-fundresearch: Which are the most important elements in your investment process?
Sacks: We believe in active management of our commodities and resources portfolios. In our view, given that commodities and resources markets are inefficient, prices can overshoot and with thorough fundamental research we can outperform markets.
We use detailed supply and demand models of the precious metal universe to discover commodities in fundamental deficit. It is when commodity markets are in deficit that price appreciation occurs. The opposite is true of markets in surplus.
We also believe that opportunities exist in both commodities and resource equities, with commodity prices key to both asset classes. In our view, in order to efficiently access the investment opportunities available in commodities and resource markets, it is important to combine investments in both commodities and resource equities. Resource equities are likely to outperform the price of the underlying commodity over the long term as a result of resources companies’ operational leverage and their ability to expand their business and deliver value through exploration and addition of resources. At certain points in the cycle, it is particularly desirable to have the flexibility to express a view via either resource equities or commodities. Combining commodities and resource equities also enables us to exploit the widest possible opportunity set. Within the resource equity opportunity set we look for companies exhibiting a number of characteristics, for example growing production profiles or forecast cost reductions (giving the company the ability to grow earnings without the benefit of a rising metal price), attractive valuations, those that are un-hedged and thus fully exposed to spot metal prices, and those with long life, low cost mines.
e-fundresearch: Which over- and underweight positions in stocks do you have currently implemented in your fund (ISIN: LU0345780281)?
Sacks: We believe that selective gold equities are poised to benefit from the strong underlying gold price, and that their upside potential may look even greater than that of the precious metal itself. In our view, from a historical perspective, certain gold equities look very attractively valued.
Companies that have significant free cash generation, a production growth profile, and have implemented their austerity measures in 2008/09 and are managing operating costs below $500/oz, should exhibit improving operating margins. This may show significant upside in 2012, possibly by as much as double that of gold itself. Lastly, if gold companies continue with strong free cash flow generation and remain disciplined on the merger and acquisition front then there is a possibility that certain companies may look to pay a dividend to shareholders.
We are also currently bullish on Palladium. The combination of restricted supply from South Africa, the cessation of Russian stockpile sales, and a resumption of demand from auto manufacturers (particularly from the petrol-heavy Chinese car markets which use palladium-rich catalytic converters), should lead to a market showing multi-year deficits. Palladium has large upside potential from this fundamental perspective, as well as from an investment point of view. Palladium ETFs are attracting much investor interest as the metal looks very cheap, particularly relative to its sister metal, platinum.
We have positioned the Fund overweight gold producers, specifically those which we believe have good cost control with operating costs sub $500/oz, operations (costs) in weakening currencies, have strong balance sheets and do not require funding, are exhibiting growing production profiles, and most importantly strong free cash flow generation. Specific examples of such companies in which we have overweight positions include Newcrest, Goldcorp, Semafo and NewGold. We also have a large position in palladium, via the palladium ETF, which provides physically backed exposure to the underlying commodity.
e-fundresearch: Please comment on the performance and risk parameters of your fund in the current year as well as over the past 3 and 5 years.
Investec Asset Management (IAM) has a three-layered approach to investment risk: We recognise that properly structuring investment processes is the best form of risk control, making risk control a pro-active activity rather than merely a monitoring one. Therefore, risk is embedded into the quality of the investment process. Secondly, when managing a portfolio we try to exploit rather than avoid risk. Market risk management is a process to identify where we are taking risks and to make sure risk is consistent with conviction level. We also try to identify unintended bets that may hinder full expression of the investment view. Finally, we continually attempt to identify weaknesses, evolve processes, and ensure that the risk our funds exhibit are in line with expectations.