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What Happened Last November Should Be a Wake Up Call for Gold Investors

By Reuben Gregg Brewer - Jan 21, 2021 at 6:22AM

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Gold had a good year in 2020, but something changed toward the end of the year that you can't afford to ignore.

The price of gold was up nearly 25% in 2020, using SPDR Gold Shares as a proxy. That's an impressive gain for this precious metal, and helped to push shares of miners like industry giant Newmont Mining up 37%, and relatively tiny Eldorado Gold higher by 65%. So far, 2020 looks like an incredible year for gold and the companies that mined for it. But dig in a little bit and there's a reason to be worried about the future -- November 2020 may prove to have been a pivotal month.

The big advance

On the surface, the gold story in 2020 is pretty easy to understand. Gold is viewed as a safe haven asset, which investors have historically bought when they are concerned about the stock market and the world more broadly. Gold and bonds often compete for the safe haven trade, but with rates so low, one of the key attractions of bonds -- their ability to earn interest -- wasn't as big an issue. So gold had a little extra wind behind it in 2020. 

A woman holding up her arms that are adorned with gold bangles.

Image source: Getty Images.

And there were plenty of reasons for investors to seek out safe havens in 2020. The most notable, of course, was the global coronavirus pandemic. With countries around the world effectively shutting down their economies to help slow the spread of the novel illness, the world entered into a forced recession. And while equity markets quickly rebounded from a swift bear market early in the year, the economic headwinds were basically as bad as feared when gross domestic product numbers came in. 

However, there's a more subtle issue that investors need to think about. One of the biggest drivers of gold demand in 2020 was from gold-linked exchange-traded funds (ETFs). These entities buy physical gold, allowing investors to trade the metal without having to deal with taking ownership of it. And the ETFs can be bought and sold all day long, something that's a bit more difficult to achieve with gold bullion and bars. The numbers here are telling.

Less demand for gold?

Through the first nine months of 2020 gold demand actually declined 10% year-over-year, according to industry trade group the World Gold Council. That's not shocking, given that jewelry is one of the main uses of the metal. So why did gold's price increase when demand was down? The answer is that demand for physical gold through the first three quarters of 2020 increased by nearly 50%, with much of that increase coming from ETFs. Indeed, ETFs saw inflows hit record levels in 2020. 

An ETF that is linked to gold basically has to buy gold when it gets new cash. Thus, these ETFs helped bid up the price of the so-called barbarous metal.

But there was a notable change in November that continued into December. Those strong inflows turned into outflows.

Inflows for the entire year were still strongly positive, but there could be a notable change taking shape. On that front, it is worth noting that gold peaked at a gain of 36% in 2020, so the price of the metal may already be starting to react to reduced investment demand -- which is basically what ETFs represent. 

What this could mean for gold stocks

Gold is a commodity, so there's no way to really tell which direction gold will go from here. However, gold miners are leveraged to the price of the metal. That's why Newmont and Eldorado rose so much in 2020. That leverage, however, can hurt if gold prices start to fall and investors jump out of the sector, quickly pinching profit margins for even the best-run miners. Thus the shift in demand for gold-linked ETFs could easily be read as an indication that risk is increasing. And if that's the case, then shifting toward more stable gold options might be a good choice as 2021 gets under way. 

Two that stand out are Royal Gold (RGLD 0.13%) and Franco-Nevada (FNV -1.50%). These two companies own royalty and streaming rights, not mines. They pay an up-front sum to miners, which agree to sell them gold at reduced rates in the future. It's basically a way for a miner to access cash for things like mine expansions and developments without having to sell stock or take on additional debt. However, because Royal Gold and Franco-Nevada's gold costs are contractually low, they tend to have wide operating margins in both good gold markets and bad. Gold miners' margins, by contrast, can be far more variable, often dipping into the red when gold prices decline.

NEM Operating Margin (TTM) Chart

NEM Operating Margin (TTM) data by YCharts

To be fair, even an advantaged business model won't stop shares of streamers from falling along with gold. But the ability to continue to produce strong operating margins even during hard times means the businesses themselves hold up better. For example, both Royal Gold and Franco-Nevada have increased their dividends annually for more than a decade. And that, in turn, has led to more consistent stock price growth over time as these companies expand their investment portfolios. 

That brings up another reason to like streamers: diversification. Because they are buying streaming rights to mines, Royal Gold and Franco-Nevada have hundreds of investments. Although many are in early-stage developments, the producing mines they have in their portfolio span across multiple miners. So these companies also allow investors to offset some of the company-specific risks involved with buying individual miners. 

NEM Chart

NEM data by YCharts

All in all, if you are looking at gold and gold miners today, the shift in demand from exchange-traded funds in late 2020 suggests that a more cautious approach to the sector might be in order. And one way to ratchet down the risk would be to focus on gold streamers over precious metals miners.

The real reason to own gold

Gold is a commodity historically prone to swift and dramatic price swings. It's not a great idea to try and time the price moves here. However, it can make sense to own a small amount of precious metals for diversification purposes. One of the best ways to do that is probably by investing in streamers like Royal Gold and Franco-Nevada. If you are worried about the market as it soars to new heights, don't take the big gold run in 2020 as a sign to go "all in" with precious metals. The story is more nuanced, and now might actually be a good time to hedge your gold bet a little bit with a streaming company.

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Stocks Mentioned

Royal Gold, Inc. Stock Quote
Royal Gold, Inc.
$110.29 (0.13%) $0.14
Franco-Nevada Stock Quote
$137.50 (-1.50%) $-2.10

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