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Producers' shares are good as gold-sometimes better

A security guard watches a stack of display gold bullion bars at the Australian Bullion Co.'s office in Sydney

David Gray

Despite the plunge of more than $250 (U.S.) in the price of gold in September, there are still strong cases to be made for bullion and for gold stocks. But let's start by separating some fundamental gold truths from fundamental misconceptions.

First, bullion isn't really a safe haven during periods of stock market turmoil. Lately, it's been about as likely to decline as surge after stock markets plummet. Gold didn't do very well in the great market crash of 2008-2009, and it didn't do all that well in this year's September market swoon either.

However, there does appear to be a strong relationship between the price of gold and the health of the economy. More specifically, the price tends to rise along with the hum of the printing presses, i.e. the expansions of the money supply that central bankers use to try to stoke economic growth. Bullion performed quite nicely during QE1 and QE2—the U.S. Federal Reserve's two massive rounds of quantitative easing since 2008.

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Gold's surge stopped when the Fed decided not to pursue a full-blown QE3 this past September. Instead, the central bankers announced a plan to sell short-term bonds and buy long-term ones, in the hope of pushing down long-term interest rates. But Fed chairman Ben Bernanke is a student of the Great Depression and the tight-money policies that made it worse. It's doubtful he's given up on a big fat third round of quantitative easing, especially considering the U.S. presidential election next year.

My thesis is that fundamentals will prevail: Gold prices will rise over the long term as the U.S. money supply expands. There may be some hiccups along the way, however. In September, gold prices plunged even as the money supply continued to stealthily grow. Yes, it's possible that the direct relationship between the price of bullion and the money supply has broken down. But it's more likely that gold prices now respond to expected growth in money, as heralded by the Fed's easing announcements.

If you like this thesis, however, you may wonder why bullion itself has been a great investment but many large producers' shares have not. The trouble is that rising gold prices have been accompanied by rising oil, steel and labour costs, which were augmented by a sagging U.S. greenback. Gold is priced in dollars, but many costs borne by producers are in other currencies.

However, there's often a point late in gold rallies when bullion price increases start to flow directly to producers' bottom lines. It looks like we're at that point now. Cost inflation is slowing down and gold prices are still higher than they were a year ago. Although investors have been jittery about stocks in general recently, and gold stocks in particular, cash flow excites them.

The gold rally still seems to have legs. Franco-Nevada Corp's investor presentation has a chart that depicts trends in gold prices and the Dow Jones Industrials going back to 1900. That chart suggests that there's still plenty of upside potential in gold stocks. Yet many investors miss a final surge because they become fixated on levelling bullion prices.

Like many promising investment theses, this one requires intestinal fortitude.


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VALUE Winpak Ltd. Forward price/earnings ratio 10.1 You know those little plastic coffee creamers you get at the cafeteria? How about that package of boar bait at the local hunting shop? Interesting fact: The contents of both are often worth less than the packaging. This tidbit comes from the makers of said packaging, Winpak, a Winnipeg-based gem of a company that, while not recession-proof, is certainly defensive. What makes it better today is a falling Canadian dollar that will boost Winpak's foreign revenue. Now it's just a matter of boar bait sales holding up.

GROWTH Liquor Stores N.A. Ltd. Three-year revenue growth in earnings 87% With an 8% dividend yield, Liquor Stores N.A. beckons the income-hungry and defensive investor. Or it should. The stock has plunged recently. Conclusion: Liquor retailing, while defensive, isn't recession-proof, especially when two-thirds of the stores are in Alberta, a boom-and-bust economy. Still, the dividend payout ratio looks reasonable at about 70% of cash flow per share, and the company has a good track record of growth. The dividend appears pretty safe and it should increase over time. The weak share price might be temporary, so belly up to the bar.

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About the Author
Investment Columnist

Fabrice Taylor, CFA, publishes the President’s Club investment letter, for which he and The Globe and Mail have a distribution agreement. More

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