Tales from a Reluctant Gold Bull

Richard Croft
February 29, 2016
6 minutes read
Tales from a Reluctant Gold Bull

In an effort to provide full disclosure I am not now nor have I ever been a raging gold bull. I am not convinced that gold provides crisis insurance or any kind of hedge against economic Armageddon. Personally if the global economy collapses under the weight of a currency crisis (note: the collapse of paper currency is the latest fear mongering strategy intended to boost golds’ value), I would prefer to own a farm.

Having laid bare my biases a case can be made that a small amount of gold can play a useful role in a portfolio. My preference is gold mining companies because in a perverted way, mining stocks and I share a similar view. Preferring to sell gold at the margin rather than holding it as an insurance policy!

The appeal of gold stocks is that they are more volatile and tend to be non-correlated to other sectors of the economy. As such they can be an excellent diversifier within a portfolio if you are mindful of the risks. And there are many!

For starters trying to predict where gold prices are likely to go is like trying to forecast the path of an oncoming tornado. One would think given the global debt tsunami, zero to negative short term interest rates, instability among some of the worlds’ largest banks and mounting economic uncertainties that gold would shine. Yet until this year gold and gold stocks, as witnessed by the performance of iShares S&P/TSX Global Gold Index ETF (TMX: XGD, Friday’s close $11.12), have been in a five-year bear market. One could argue that, even with XGDs’ recent surge, the monthly charts have still not broken the longer term downtrend.

Still I have given up trying to pick bottoms. The best we can do is look for a reversal – which the performance in January seems to imply – and then examine the fundamentals. On the surface the fundamentals look decent. There appears to be a supply / demand deficit caused by a pickup in demand for jewelry mainly from India. Demand for Jewelry constitutes 55% of the 4,200 tonnes of global supply. Add to the mix, the aforementioned instability of some large European banks and negative interest rates most notably in Japan, and we have the makings of a melting pot that should support prices over the near term.

As for the risks, higher gold prices do not always translate into above average performance of the miners. Higher gold prices mean higher revenue but that can also be accompanied by higher costs. Not to mention, flooding, war, and labor unrest which can render mines useless for long periods of time. The point; when it comes to gold stocks… timing is everything!

The trick is to work with what the market is giving you. For gold stocks that is above average volatility which translates into above average option premiums. If you buy into the bull scenario for gold, writing covered calls on gold stocks can yield some decent results.

To make the point consider Goldcorp (TMX: G) which closed on Friday at $21.25. The Goldcorp April 22 calls closed Friday at $1.55. If you buy the shares and write the April 22 calls, the 53-day return, if exercised, is 10.8%.

Agnico Eagle (TMX: AEM) is another example. AEM closed Friday at $47.62 and the AEM April 48 calls were trading around $3.40. That translates into a 53-day return, if exercised, of 7.9%.

If you are looking for a more aggressive position take a look at Franco Nevada (TMX: FNV, Friday’s close $78.75). The company has issued purchase warrants (TMX: FNV.WT) that can be used to cover the sale of a call option.

The FNV purchase warrants expire on June 16th, 2017 and have a strike price of $75 per share which means they are $3.75 in-the-money. The long dated nature of the warrants will cause their time value to erode at a much slower pace than will occur for the near term at-the-money or slightly out-of-the-money calls. The FNV warrants closed Friday at $14.00 per share.

You could buy the FNV warrants and sell, say, the FNV March 80 calls at $3.30. If the calls expire worthless over the next 25 days, your return will approximate 23.6% depending of course on the value of the warrants at the March expiration.

Think of this trade as you would a time or calendar spread. The idea is to continue writing short term (i.e. one month) at-the-money or slightly out-of-the-money calls covered by the FNV warrants. As the calls expire you are effectively reducing the cost of your long warrants. However, this is a more aggressive trade which will require you to monitor it on a daily basis.

Richard Croft
Richard Croft http://www.croftgroup.com/

President, CIO & Portfolio Manager

Croft Financial Group

Richard Croft has been in the securities business since 1975. Since February 1993, Mr. Croft has been licensed as an investment counselor/portfolio manager, operating under the corporate name R. N. Croft Financial Group Inc. Richard has written extensively on utilizing individual stocks, mutual funds and exchangetraded funds within a portfolio model. His work includes nine books and thousands of articles and commentaries for Canada’s largest media channels. In 1998, Richard co‐developed three FPX Indexes geared to average Canadian investors for the National Post. In 2004, he extended that concept to include three RealWorld portfolio indexes, which demonstrate the performance of the FPX portfolio indexes adjusted for real-world costs. He also developed two option writing indexes for the Montreal Exchange, and developed the FundLine methodology, which is a graphic interpretation of portfolio diversification. Richard has also developed a Manager Value Added Index for rating the performance of fund managers on a risk adjusted basis relative to a benchmark. And In 1999, he co-developed a portfolio management system for Charles Schwab Canada. As global portfolio manager who focuses on risk-adjusted performance. Richard believes that performance is not just about return, it is about how that return was achieved.

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