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Why it's not time to go for the gold: Physical gold has outperformed but gold stocks have not

           

Gold holds a special place in our imaginations, from the very first gold coins minted thousands of years ago to the great Yukon gold rush. Today gold still has its uses, though they're somewhat less glamorous. But it's no longer just about making jewelry and money, it's a key component in many electronics and it's also used as a safe haven asset for central banks in times of uncertainty and geopolitical stress. Gold's role in that “flight to safety" has meant that prices for the precious metal tend to rise along with global economic and political instability.

Uncertainty the culprit for the recent gold spike

Not surprisingly, the last few months of growing global uncertainty have led to a spike in the price of gold. Amidst worries over trade wars and a slowdown in global economic growth, gold prices have climbed to a multi-year high, with the spot gold price reaching US$1,422.85 on June 25, the highest in six years.

While it's hard to predict where gold prices will head next, one thing is clear—more uncertainty looms on the horizon, with growth slowing in most countries and markets predicting a rate cut by the U.S. Federal Reserve later this month.

Performance of gold ≠ performance of gold companies

While all this could be great for gold prices, it doesn't necessarily make gold companies a good investment. Gold company stocks have simply not kept up with the price of the physical metal. Here in Canada, gold's influence on the market has been declining steadily—gold companies represent just 5.43% of the S&P/TSX index, down significantly from a decade ago.

At MD Financial Management we have historically been underweight gold in our Canadian equity and Canadian dividend funds and pools because gold companies tend to be poor allocators of capital. In fact, gold companies have delivered poor return on equity compared to the S&P/TSX Composite Index (11%) as a whole.

This is largely because the gold industry is highly capital intensive and the business is dominated by uncertainty both over price and how much of the metal can be extracted. Such factors weigh negatively on free cash flow or earnings left over after expenses. It also leaves little or no room for dividends, which historically have provided investors another source of strong returns. Moreover, gold companies are relatively expensive right now, trading at levels of earnings, sales and cash flow that exceed the index.

Gold bullion can play a role in your portfolio, but the business economics of the gold industry lead us to allocate capital to more productive industries within the Canadian economy.

About the Author

Lawrence Eyamie, BSS in Economics, is a Financial Consultant with MD Management Ltd. and is pursuing a Certified Financial Planner® (CFP) designation. He provides his clients with individualized financial planning advice and strategies they need to help build wealth and achieve their financial goals

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