Gold, Banks, or Small-Caps?
Monday, 17 August 2020
By Greg Canavan
Over the weekend, there was a lot of noise about Warren Buffett ‘buying gold’.
But did he?
And what does it mean?
To be clear, Buffett bought a stake in Canadian miner Barrick Gold during the June quarter. It was the only stock his investment company Berkshire Hathaway added to the portfolio. He sold out of investment bank Goldman Sachs, while reducing his stake in JPMorgan and Wells Fargo.
So clearly, one of the world’s best investors didn’t see long-term opportunities emerge in the March sell-off.
Except for gold.
Which is weird. Because Buffett has always disparaged gold. His biggest criticism is that it doesn’t produce an income stream. If something doesn’t generate an income, you can’t compound it.
But Barrick is different.
It’s a gold mining company that does indeed produce an income stream. Knowing how Buffett values companies, we can get a sense of what long-term returns he’s expecting from the investment.
But the fact that Berkshire is buying a gold company — finally — is a double-edged sword for gold bulls.
On the one hand, it tells you that even former critics of gold acknowledge that in today’s world of interventionist central banking, with negative real rates becoming more common, the long-term picture for gold is sound.
But in the short term, it could well signal a short-term top for the gold price.
When gold’s biggest critic finally throws in the towel and buys in, it tells you that — in the short term at least — nearly EVERYONE is in.
So, I see Buffett’s move as bullish in the long term, but bearish in the short term.
Let’s take a look at what Buffett is getting for his purchase in Barrick.
Based on consensus forecasts for FY21, the company will generate a return on equity (ROE) of 11.3%. It’s paying out only 25% of profits as a dividend, which means it is reinvesting and COMPOUNDING the other 75%.
At what rate it compounds these reinvested profits depends on the gold price and the quality of its ore bodies.
Let’s assume the company can generate a sustainable ROE of 10%.
If Buffett paid book (or equity) value for the company, he would indeed earn a 10% return. But Barrick trades at a premium to book value. Based on FY21 forecasts, Barrick trades on 1.9 times book value.
(This is just another way of saying that the market price is 1.9 times the equity/book/net asset value of the company.)
Simply dividing the 10% ROE by the price-to-book multiple gives 5.26%. That’s the return Berkshire would earn on the investment if Barrick paid out all its earnings as a dividend. But we know its reinvesting around 75% of its profits back into the business.
Accounting for this compounding of earnings, I estimate that Berkshire will generate an annual return of around 7% from its holding in Barrick.
This has nothing to do with what the share price will do in the short term, by the way. It’s a result of dividend income and an increase in net assets (equity value) that occur via reinvested profits.
Given the 10-year US government Treasury yield is sub-1%, a 7% return is more than enough for Buffett.
What about Goldman Sachs? This is where things get interesting.
Berkshire sold out of this investment completely in the June quarter.
Consensus estimates forecast ROE of 9.5% for FY21. Like Barrick, Goldman is reinvesting around 75% of profits. But it’s trading at a DISCOUNT-to-book value. Based on FY21 estimates, it trades on a price-to-book multiple of 0.83.
By buying at current prices (and assuming Goldman can generate a sustainable ROE of 9.5%), I estimate that long-term owners of the stock will generate a return on investment of just over 10%.
But Berkshire is selling Goldman and buying Barrick.
What’s going on?
Well, on the surface, it simply looks like a comment on broader financial market conditions. As more government paper trades on negative real (or nominal) yields, investment banks like Goldman will find it harder to generate decent profits.
And as more government debt trades with negative real (or nominal) yields, the gold price should march higher.
Buffett, then, is bullish on real assets and bearish on paper assets.
Having said all that, keep in mind that a lot of this commentary is just noise. The Barrick stake (so far) represents just 0.3% of Berkshire’s portfolio. So you can’t read too much into it.
And while Berkshire sold out of Goldman, it still holds other banking stocks.
If there is a message to take away, the buying of Barrick and selling out of many other exposures suggests that Berkshire remains broadly bearish on the market. Given its size, it doesn’t have the luxury of being able to buy smaller stocks and generating outperformance that way. It needs larger, liquid stocks to buy into.
Not so for Ryan Dinse’s Small-Cap Momentum Alert, which is designed for the nimbler trader.
Out of the 15 open positions in the portfolio currently, four are triple-digit gainers (with three of those only recommended this year), four are double-digit winners, and of the three losers, two are in single digits and the largest is down just 17%.
That’s a solid performance.
Yes, it’s a reflection of the bullish market we’re in right now. But it’s also a reflection of Ryan’s proprietary momentum indicator being able to pick stocks that have the potential to make big moves.
In this type of bifurcated market especially, being able to tag onto a stock’s momentum is especially important in generating some quickfire gains. As I’m sure Ryan’s readers would attest to, his system is definitely proving it’s worth right now.
For analysis on how markets are poised at the start of this trading week, scroll down below for Pivot Trader Murray Dawes’ ‘The Week Ahead’.
[WATCH] Are US Bond Yields about to Rise?
By Murray Dawes
[Click on the picture above to see why Murray thinks you should add US bonds to your watchlist. He also analyses gold and the ASX 200.]
Last week saw a sharp sell-off in US bonds after a poor 30-year bond auction. The yield on the US 10-year bond rose from around 0.5% to 0.72%.
If we see a continued increase in US bond yields there will be ramifications for other markets.
The large sell-off in gold last week happened at the same time as the US bond sell-off and that makes sense when you see the strong inverse correlation between gold prices and real yields.
I show you in the update above why my weekly charts are now bearish on gold. The big picture remains extremely bullish, and I expect the recent all-time high to be surpassed at some point, but the risk in the short term is to the downside.
Stocks have been rallying on the back of the low and flat yield curve as well.
The stratospheric rise in leading US tech stocks would be tested if US bonds sell-off sharply.
The US Fed has made it clear they are considering yield curve control if bonds sell-off. So perhaps their threat will be enough to keep yields within the current range.
But the technical picture has deteriorated in US bonds for the time being and it will be interesting to see how far yields rise and whether other markets take fright.
I finish up today’s ‘Week Ahead’ update by looking at the current technical picture in the ASX 200.
Editor, Pivot Trader