Gold prices have fallen over the last few years, and anyone taking long positions on gold equities has taken a beating, but that doesn’t mean it’s impossible to invest even as commodities continue to decline. Jeff Evans CFA at CIBC argues in a recent report that investors should consider taking a long-short position on gold, taking the sector-wide risk out of the investment and allowing them to effectively bet on individual firms.
The basic idea behind a long-short investment is that the long position is the company you expect to beat the rest of the sector, while the short position is meant to be representative of the market’s overall trajectory. Roughly speaking, your long position doesn’t actually have to grow in real terms for the investment to pan out, it only has to grow faster (or shrink less quickly) than the short.
Gold long-short positions balance the risks
And CIBC has already had significant success with this approach. “Despite the downward trend in gold and gold supplies, our long/short approach has been able to generate significant positive alpha – roughly 13 percent per annum since 2008,” writes Evans.
But you still have to be able to pick winners out of the field for a long-short strategy to work. According to Evans profitability is an important factor to consider because it is ‘persistent’ over time, but “although profitability measured as return on equity has been very successful for stock selection within the gold industry, profit margins have been even more successful over time.” It’s also better to go long on companies with positive price momentum and short companies with negative momentum.
Gold investors must study leverage vs. reserves
Now that gold prices have collapsed, many gold companies are cash-flow negative, but some companies were already highly leveraged before gold started to tank, which should be taken as a sign of additional risk separate from overall market trends. Evans points out that focusing on leverage when choosing companies actually nets investors no return going back to 2002, but highly leveraged firms are still too risky for a long position.
For the same reason, gold companies with significant cash reserves are less of a risk because they will be able to survive the drop in prices, and possibly take advantage of cheap assets that come to the market as rivals fumble. Cash on hand may not be a predictor of success, but it provides a stock with more upside.