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Thursday, August 16, 2007

Intrinsic Value of Gold


Intrinsic Value Investing

When it comes to books written about investing in the stock market, two of the classics are "Security Analysis" and "The Intelligent Investor", both of which were written by Benjamin Graham and published in 1934 and 1949 respectively. Graham was a very successful investor in his own right, but is also well known as the mentor of Warren Buffett. Buffett built on the foundations provided by Graham's investment philosophy by adding a qualitative dimension to the completely quantitative approach adopted by his teacher. However, the basis of the success of these stock market legends was essentially the same - the realisation that the "intrinsic value" of a company was independent of its market price.

According to Graham, the market does not determine value. It is a "voting machine" in which countless people register choices that are the product partly of reason and partly of emotion. For most stocks the market tells you every minute of every day what it thinks those stocks are worth. The price that the market assigns may be much higher, much lower, or approximately equal to the intrinsic value. It is this difference between market price and intrinsic value which provides opportunities to investors astute enough to recognise it - the greater the difference the greater the opportunity. However, an investor who allows himself to become so concerned by a falling market price that he sells out has blown any advantage he may have had. "You are neither right nor wrong because the crowd disagrees with you".

The above thinking has been shown to work with phenomenal success when applied to stock market investment, but can it also be applied to investing in gold ? The intrinsic value of a stock can be determined using quantitative measures such as profit, net working capital, cashflow, and net tangible assets, and qualitative considerations such as the strength of the company's management. However, does gold have an intrinsic value which can be different from its market price and, if so, how could we go about calculating it ?

The Intrinsic Value of Gold

Supply Considerations

With such an enormous number of variables
affecting its price, including the
emotional response of individuals and the
whims of politicians throughout the
world, how can we possibly forecast a
future dollars per ounce gold price?

When there is an imbalance in supply versus demand, prices adjust to correct that imbalance. For example, if demand exceeds supply then prices will increase to the point where demand reduces or supply increases, thus correcting the imbalance. Because the "load" is forever changing, prices are continually adjusting. Vronsky's essay on gold's supply/demand dynamics in the "Analysis" section of the Gold Eagle website discusses the imbalance which has existed in the gold market for some time, with commercial demand greatly outstripping worldwide production. Had a similar situation prevailed with any other commodity then soaring prices would undoubtedly result. However, the fundamental difference between gold and all other commodities is that gold is not consumed, it is accumulated. Nearly 100% of all the gold mined in the history of the world forms part of today's aboveground gold stock. The total amount of this aboveground stock (currently around 120,000 tonnes) is an available source of supply at any time. During the past few weeks we have had some news regarding gold supply which has supposedly caused some fluctuations in the gold price. Firstly, Switzerland announced that it would sell some of its gold reserves (about 400 tonnes over a 10 year period). Secondly, the Busang gold deposit, which had been reported to contain up to 200 million ounces of gold, is now thought to be worthless. One event added future gold supply to the market whilst the other removed it. In my opinion both events were just "noise" as the amount of gold involved was trivial in comparison to the total aboveground supply of gold.

Another important point to note regarding the aboveground gold stock is that it increases at a fairly constant rate of around 1.7% per annum (during the last 50 years the largest annual increase was 2.1% whilst the smallest was 1.4%). Irrespective of what technological and political changes occur in the future, or how many more Busangs (real or otherwise) are discovered, it is reasonable to assume that the total supply of gold will continue to grow at an average rate of 1.7% per annum. In fact, technological improvements and vast new discoveries will be needed to maintain this growth rate.

Estimating a Future Gold Price

In other words, confidence in
US dollars is currently at a
historic high or, put another
way, gold is at its lowest
levels in 25 years relative to
the US dollar.

Further to the above we should be able to estimate, with a fair degree of accuracy, what the aboveground gold stock will be at some time in the future. It should also be possible to estimate the future commercial (fashion jewelry, industry, etc.) demand for gold. However, these considerations are only a small part of the equation. Much of the aboveground gold stock is held for monetary purposes and the willingness of the owners of this gold to sell at a particular price is dependent upon countless economic, political and psychological concerns. The willingness of others to purchase gold for monetary reasons at a certain price is dependent upon similar considerations. With such an enormous number of variables affecting its price, including the emotional response of individuals and the whims of politicians throughout the world, how can we possibly forecast a future dollars per ounce gold price? Yet another problem, in fact the very heart of the problem in forecasting a future gold price, is that we measure the price in terms of something which is constantly changing, that is, the US dollar (or any other national currency). Every day the US dollar changes its character due to changes in its quantity and quality, with its true value linked to something as fragile and fluctuating as faith in the financial and political system.

Although we cannot reliably estimate a future gold price, what we can do is calculate the relative values of gold and US dollars using the Fear Index. The Fear Index was developed by James Turk as a means of numerically expressing the competitive relationship between gold and dollars, and is calculated as follows :

Fear Index = (US Gold Reserve) X (Market Price of Gold)

Currently, with the gold price around $350 per ounce, M3 (total US money supply) of $5024.5 billion as of weekend 3rd March 1997, and a US gold reserve of 261.8 million ounces, we can calculate the Fear Index to be 1.82%.

The lower the Fear Index the higher the value of dollars relative to gold, that is, the higher the level of confidence (or the lower the level of fear) in paper currency. To put the above calculated figure of 1.82% into perspective, this is the lowest value for the Fear Index since 1972. In fact, the last 3 months have seen the Fear Index move below 2% for the first time since 1972. In other words, confidence in US dollars is currently at a historic high or, put another way, gold is at its lowest levels in 25 years relative to the US dollar.

I would also be interested in calculating a modified Fear Index where the total above ground stock of gold is substituted for the US Gold Reserve. However, this will have to be the subject of a separate discussion.

Gold Investment Based On Value

The above discussion suggests that although we cannot estimate a future gold price with any degree of accuracy, we can at least determine that gold is currently very cheap and should be purchased by investors seeking value. However, I believe that many people who identify that gold currently represents excellent value will lose money in their attempts to profit from this realisation. This is because they will attempt to profit from their well-founded conclusion via short term trading. The following quote from Benjamin Graham was written about stock speculation, but it can be equally well applied to the short term trading of commodities : "....speculation is largely a matter of A trying to decide what B, C and D are likely to think - with B, C and D trying to do the same". It is likely that many of the investors who purchase gold or gold related investments based on sound fundamental reasoning will sell out at a loss because they were unable to predict what others would do in the short term.


Friday, August 3, 2007

Winner of Best Local Hedge Fund (Singapore)- BEST??

Octagon Capital is the largest boutique quantitative investment company in Singapore. It is founded and majority owned by the partners of the firm – Nelson Chia and Lam Poh Min, both of whom worked previously for the Government of Singapore Investment Corporation (GIC).

Octagon currently manages two Cayman domiciled funds namely the Octagon Pan Asia Fund and the Octagon Tactical Short Fund. The Octagon Pan Asia Fund is awarded the "Best Local Hedge Fund (Singapore)" at Asian Masters of Hedge Fund Awards 2007.

Octagon’s global clientele comprises largely institutions such as government agencies, endowment, family offices, fund of funds and financial institutions. The company adopts a quantitative and systematic approach to investing, believing that investment discipline is the key to consistently superior risk-adjusted returns. Its investment philosophy centers on the following 4 principles:

1. Breadth - exploit breadth of opportunity set to improve risk-adjusted returns
2. Expectations - focus on identifying market expectations and capitalising on them
3. Asymmetry - rely on return asymmetry to generate superior performance
4. Defence - employ strict defence mechanisms so as 'to win by not losing'

OCTAGON PAN ASIA FUND Octagon Pan Asia Fund is awarded the "Best Local Hedge Fund (Singapore)" at Asian Masters of Hedge Fund Awards 2007. It is a Cayman-domiciled long/short equity fund that invests across Asia. The current investment universe consists of 14 markets, namely Australia, China/Hong Kong, India, Indonesia, Japan, Korea, Malaysia, Philippines, Pakistan, Singapore, Taiwan, Thailand and Vietnam, covering 2,000+ stocks across all market capitalisations. The strategy aims to generate attractive absolute returns, while preserving capital and controlling downside volatility. Investment decisions are made via a technically-based systematic process. The key driver is a trend following model which is premised on the assumption that profitable trends will exists in a large and heterogeneous universe. Accordingly, the model seeks to identify the best trending stocks to be bought and sold based on a proprietary momentum measure. This is complemented by qualitative judgment, particularly used in portfolio construction and execution, in view of the implementation constraints in Asia. The strategy is likely to have a slight net long bias over time. Gross exposure is not expected to exceed 140%. Net exposure will range from -40% to +100%.

Note: Eurekahedge Asian HF index is not adjusted for survivorship bias and is provided for information only

The Best Place to Be?

Interview With Jim Rogers: 'The Best Place To Be Is In Commodities'
Posted on Apr 10th, 2007

Hard Assets Investor submits: Jim Rogers (pictured) is widely known as one of the most insightful – and irreverent – commodities bulls in the market today. Rogers, who made his (first) fortune as George Soros’ partner in the Quantum Fund, has been championing commodities to investors since at least 2004, when his book “Hot Commodities” laid out the case for a long-term bull market in hard assets.

Rogers, who runs his own index to capture the growth in commodities, argues that the commodities market runs in what might be called “supercycles”; 10-20 year stretches when pent-up demand meets the long lead times required to bring on new supply, sending prices steadily higher. With China and India growing fast, he thinks the current commodities bull market has plenty of room to go..

The editor’s of Hard Assets Investor recently spoke by phone with Rogers, to get his view of the current situation in the commodities market.

HardAssetsInvestor [HAI]: With recent fluctuations in the commodities market, are you sticking with your “supercycle” theory? Where are we in the cycle?

Jim Rogers (Rogers): Supercycle is your term, not mine, so I won’t say that. But I will say that we are in a bull market for commodities.

We are in a bull market for commodities because supply and demand got terribly out of whack years ago, and they are still out of whack.

I also wouldn’t call it a theory. Nobody has discovered a gigantic oil field for thirty years. That’s not a theory; that’s a basic fact. In the meantime, demand for oil has been going up for many years. That’s not a theory, either; that’s a simple fact. Likewise, there has been one lead mine open in the world for the past twenty years, and the last lead smelter was built in the U.S. in 1979. I could continue: the number of acres devoted to wheat farming has been declining for 20 years.

Those are simple facts that lead me—and, I think, any rational person—to conclude that we’re in a bull market for commodities that has a ways to go.

HAI: What about the recent pullback?

Rogers: There have been consolidations along the way; there always will be. In the stock bull during the 1980s and 1990s, there were huge corrections that scared the pants off some people. But the people who really knew what was going on, they bought more stock during those consolidations, and they did well. It was the same during the gold bull market in the 1970s. There was a stretch when gold went down every month for two years, and eventually ended down 50-plus percent. Everyone was scared. But then gold turned around and went straight back to $820/ounce, a new high.

That’s how markets work. There will be awesome corrections in the commodities markets during this period of time, and I hope that I’m smart enough to recognize them for what they are.

HAI: The market panicked when China’s stock market fell in February. Was that a blip, or signs of a bubble beginning to burst?

Rogers: Anybody who sold stock in the West or in Japan because China had a 9 percent drop in one day is a little bit nuts. The Chinese market has almost zero percent impact on the rest of the world. Foreigners can’t invest in China, and the Chinese can’t invest here. The idea that what goes on in China’s market matters to us is nuts.

I’m sure that people worry about China’s growth. That’s understandable. The Chinese government is trying to slow down growth. But let’s say that they succeed, and that China’s growth slows from 10 percent GDP growth to 3 percent GDP. That’s still growth. People still need to buy more tires and more eggs.

HAI: The commodities markets have been in deep contango recently. Is that situation permanent, and is it harming the thesis to invest in commodities? Are investors better off in physicals?

Rogers: Some sectors of the market have been in contango, and some have not. I’m not sure I agree with your assertion.

HAI: I was referring specifically to energy.

Rogers: Well, energy is just three or four commodities out of fifty…

Oil and energy have been in contango recently for a variety of reasons, and partly because of the index funds. I’ve seen contango come and go for decades. Usually, when the market gets out of whack, the people who need to buy the oil come along and take advantage of it. If people come along and there’s contango, people will make money off it [presumably, buy buying oil today and storing it to sell in the future]. Likewise, when there’s backwardation. People who need oil will find the best price and the best place to buy oil, and they will do so. They take advantage of the discrepancies and then the discrepancies disappear.

HAI: What are the most pressing issues that commodity investors should understand?

Rogers: They should understand that until somebody brings on a lot of supply, commodities will do well. If people start seeing windmills on every roof and solar panels on every house, then maybe this [commodities boom] is coming to an end. If somebody discovers a gigantic gas field in Berlin, maybe this will start to change. Investors need to watch and see when and if new sources of supply develop.

Bur really, short of worldwide economic collapse, the best place to be is in commodities. There is no shortage of stocks. The world is cranking out new stocks every day. No one is cranking out new lead mines every day. People need to get a basic understanding of supply and demand, and then they’ll figure out what the big picture is, and they will make money.

HAI: Are agricultural commodities a different animal from metals and energy, in that their supply is more elastic. Does that change the analysis there?

Rogers: They are not much more elastic. It takes five years for a coffee tree to mature. If you decide to go into the coffee business today, it might take five or seven years before you come to market. It takes ten years to bring on a new coal mine, but many plantations take a long time, too.

In theory, we can increase our acreage devoted to corn, as America did recently [per the USDA’s perspective plantings report]. But farmers did that at the expense of soybeans and cotton and everything else. It’s not as if the world has created a lot more land. Even when farmers do bring on more acreage, it takes a few years and it costs money and time.

Moreover, when you have acreage lying fallow, it’s always the marginal acreage. When farmers take acreage out of production, they keep the good acreage in production. Doubling the number of acres devoted to corn will not double production. Yes, in theory, you can bring on more corn quickly. But it is at the expense of other things.

HAI: Does active management have a role in the commodities space?

Rogers: The world has demonstrated repeatedly that index investors outperform 80 percent of active managers year after year after year. If you can find a good active manager who can beat the market consistently, invest with her, and introduce me to her, too. But my index fund has been running since August 1998, and it has done 500 percent better than the average CTA over that time.

HAI: Last year, we saw the London Metals Exchange intervene in the nickel markets. With supplies tight for many commodities, will we see that happen again? Will it become more frequent?

Rogers: I suspect it will happen less. The more it happens, the more credibility the exchange loses. With the internet and electronic trading, it’s very easy for a new market to develop. And any exchange where that happens frequently will lose its market.

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