Consider This Model Gold Portfolio

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There are a lot of ways to play the gold market. There are various exchange-traded funds, mining companies, and royalty companies. All of them have various risks, leverage to the gold price, and income potential. There is no “right” gold vehicle. Rather, investors should choose a few that work together in order to create a well-rounded portfolio. In what follows, I suggest a portfolio of four gold-related holdings that investors should consider for themselves. It achieves the following:

  • Offers leverage to the gold price while offering downside protection.
  • Consists of both low-risk and higher risk assets.
  • Pays a dividend that exceeds that of the S&P 500 if each asset is equally weighted at 25 percent.

Let us see how this can be achieved.

1. Credit Suisse Gold Shares Covered Call ETN (OTCMKTS:GLDI)

This fund is designed to track the price of gold while selling covered calls against its gold holdings. By selling covered calls against gold, the fund is able to generate a significant amount of income — more than 13 percent annualized.  Furthermore, it offers protection to the downside if the gold price falls, considering that by selling calls, the fund is effectively taking a small short position against the gold market. 

This sounds almost too good to be true. The downside is that this fund offers limited upside if the gold market becomes especially strong. By selling covered calls, the fund is giving the buyer of these calls the right to buy the gold holdings from the fund at a fixed price regardless of the price of gold. So for instance, the fund might sell a covered call that forces it to sell its gold at $1,400 per ounce even if the gold price spikes to $1,500 per ounce.

That’s bad news if you are bullish of gold. However, the other three holdings I have chosen should perform extremely well if the gold price rises. Thus, this ETF is designed to be a sort of hedge, although keep in mind that it will lose value if the gold price falls and it will gain value if the gold price rises. It is just that these losses and gains will be smaller than those of the spot price of gold.

2. Royal Gold (NASDAQ:RGLD)

Royal Gold is a royalty and streaming company. It makes its money by making payments to mining companies in exchange for the right to receive (or buy at a fixed price) a certain amount of gold. The specifics are arrived at by Royal Gold and the mining company that it is dealing with. For instance, Royal Gold’s most recent deal was to buy the right to purchase 6.3 percent of the gold produced by Rubicon Minerals (NYSEMKT:RBY) at its Phoenix gold mine at 25 percent of the spot price of gold. It bought this right for $75 million, which will go toward developing the Phoenix mine.

Royal Gold has performed extremely well. Since the beginning of the gold bull market, the stock is up more than 2,000 percent. While investors are pricing in success, we also have to keep in mind that the royalty business is relatively low risk. While mining companies have a lot of expenses, many of which are unknown, royalty companies like Royal Gold have fewer expenses, and these are fixed.

The company has grown its sales, profits, and book value substantially over the years. Furthermore, the company pays a dividend of 1.32 percent, and it has been raising its dividend every year — it even did so last year, despite the weak gold price market. Ultimately I expect the company to continue to make accretive deals while maintaining a low-risk portfolio and outperforming the gold mining sector.

3. Agnico Eagle Mines (NYSE:AEM)

This is one of the lower-risk mining companies. The company is expected to have very low production costs at just $950 per ounce. This means that even if the gold price remains weak that Agnico Eagle will be profitable.  Furthermore, the company has all of its mines in low-risk mining jurisdictions: Canada, Mexico, and Finland.  These countries have relatively little social unrest and straightforward mining regulations. This makes it easier to predict operating metrics for the company’s mines, and therefore its future cash flow is more valuable to a present-day investor.

While the company was forced to take some write-downs due to a falling gold price, and while it cut its dividend from 88 cents per share to 32 cents per share, Agnico Eagle Mines is a well-capitalized company that is going to be able to produce over 1 million ounces of gold inexpensively.

Furthermore, this production will be growing, albeit modestly. If the company wants additional growth, it has the capital to purchase another mining company. Ultimately, this company is not as low-risk as Royal Gold, considering that the cost of mining fluctuates whereas Royal Gold’s costs do not. Nevertheless, of the mining companies, there are few that have limited downside risks, and this makes it a solid holding as a part of this gold portfolio.

4. AngloGold Ashanti (NYSE:AU)

I had to throw in one high-risk name that will perform extraordinarily well if the gold price really flies. While there is no shortage of high-risk gold mining stocks out there, this is one worth considering, and it is one that the market has appreciated as of late, with the shares up 50 percent for 2014.

I still think the stock is inexpensive considering what it is worth if we assume a much higher gold price. The company is valued at just $7 billion but it produces more than 4 million ounces of gold annually. That’s four times what Agnico Eagle Mines produces, and that company is valued at $5.5 billion.

There’s a reason for this valuation disparity. First, AngloGold Ashanti cannot make money with the gold price at $1,300 per ounce. It needs $1,360 per ounce or higher, given its own 2014 estimates. Second, many of the company’s mines are located in high risk jurisdictions such as South Africa. This means that there is a higher probability of the company facing labor issues or punitive capricious government action against them.

Third, the company has had a history of high production costs and declining production, which makes it more difficult for investors to believe that the company can achieve the lowered production costs and increased production that it is promising.

Nevertheless, if nothing or if very little goes wrong and if the gold price rises, this is a stock that can really fly. If it doesn’t, then at least you are protected by the lower risk holdings that I recommend above.

Conclusory remark

This is not the only way to construct a well-balanced gold portfolio. There are a plethora of gold mining companies that have various attributes. For instance, there are some smaller gold mining companies with extremely high dividend yields.

There are companies that operate mines in parts of the world that I don’t cover here. For instance, Eldorado Gold (EGO) operates mines in China, Turkey, and Greece. However, the portfolio I provide offers diversification, a balanced approached to risk, and yield, and it is an excellent model for investors to follow if they are looking for a strategy for buying gold.

Disclosure: Ben Kramer-Miller is long Royal Gold shares.