Closing the gap between gold price and gold mining companies prices

on Oct 25, 2012 in Equity, Home, Precious metals | 2,422 comments

In an environment of ballooning sovereign debts and major central banks expanding their balance sheets aggressively, real assets, such as gold, should increase in value. Over the last few years, the physical price of gold has risen steadily, outperforming the S&P Metals & Mining Select Industry Index which tracks the world’s leading gold companies. The divergence of gold price and gold mining share prices is an example of a market dislocation. Historically, the two move tightly together. The logic is simple: When gold price rises, the mining companies sell their gold for higher prices, and increase therefore there bottom line. The two main reasons for this performance bridge are the following: Through the invention of Exchange Traded Funds, investments have been drawing away from gold equities. These funds, allow investors to own gold without having to worry about storage, insurance, transportation, purity, reselling…Gold ETF’s have grown significantly in size and are now a big player in commodity investing. The mining shares have additional risks related to production costs, geopolitical risks, fraud and corruption, resource nationalism, infrastructure access…A decade ago the average cost of extracting an ounce of gold from the ground stood at USD 200. Nowadays replacing depleted reserves is becoming harder. For instance, Barrick Gold’s extraction cost went up from USD 440/oz to 505 USD/oz in 2011 and this trend is likely to continue. However, as more investors move towards gold as an investment, people will look for new ways to be long gold without actually holding gold bullion or buying an ETF like SPDR Gold Shares. One way to bridge this performance gap is throughout dividends. Due to higher cash flows that these miners are generating, they have greatly increased their dividend payouts. Some miners have become even more creative and linked their dividends to the gold price itself, and I believe that these attractive dividend schemes could help persuade some investors into the miners instead of into gold. Such changes to dividend policy could mark a paradigm shift in the industry! To conclude, mining companies have had to be more creative to differentiate themselves from other investment vehicles. But would that be...

Key ratios for value investors

on Oct 18, 2012 in Equity, Home | 1,324 comments

Value investing implies chasing shares worth less than they should be and therefore considered undervalued. Because a share’s price is a combination of investor estimates for growth, revenue and dividends, it is also a matter of opinion as to whether that share is undervalued. The most common way to apply a value measure to a share is Price/Earnings ratio. Dividing a share’s price by its earnings per share is a standard way to grab a snapshot of a share’s value. A very high P/E implies that the share is considered overvalued, however lower P/E doesn’t always account for growth potential. By combining the P/E ratio with a share’s expected 12 month growth rate you derive the PEG ratio. It is one of the best ways to screen shares because it summarizes information about a company’s financial performance in an understandable way. The PEG ratio can offer a suggestion of whether a company’s high P/E ratio reflects an excessively high share price or is a reflection of promising growth prospects for the company. PEG ratio = (Price/Earnings ratio) / annual EPS growth PEG is a widely used indicator of a share’s potential value. It is favoured by many over the Price/Earnings ratio because it also accounts for growth potential. Similar to the P/E ratio, a lower PEG means that the share price is undervalued. An investor would probably be wise to check out the future growth rate by determining how much the most recent quarter’s earnings have grown, as a percentage, over the same quarter one year ago. Dividing this number into the future P/E ratio can provide a more realistic PEG ratio. Occasionally share price reflects more investors’ sentiment rather than a company’s long term profitability. Over time, inefficiencies are corrected and prices realign with intrinsic values. Value investors seek to buy companies whose shares appear underpriced relative to the underlying...

Inflation breakeven rate

on Oct 11, 2012 in Economy, Home | 1,401 comments

Inflation breakeven rate refers to the difference between the nominal yield on a traditional bond and the real yield on an inflation-linked bond with the same maturity. It has been used as a tool to obtain the expected inflation. Nominal rate ≈ real rate + inflation expectation In fact, the nominal rate of return incorporates the real rate, expected inflation, inflation risk premium and a liquidity risk premium. Nevertheless, assuming the inflation and liquidity risk premium to be fairly stable over a short period of time, the changes in the breakeven inflation rate capture the changes in inflation expectations. Your fixed-income investments may not consequently provide the real return investors seek during periods of high inflation. It’s important to know whether your traditional fixed-income investment breaks-even with inflation. If inflation averages more than the break-even, the inflation-linked investment will outperform the fixed-rate. Inversely, if inflation averages below the break-even, the fixed-rate will outperform the inflation-linked. It is possible to benefit from the rise in inflation while being hedged against rising interest rates by buying inflation-linked bonds and selling traditional sovereign bonds with similar maturity. Ultimately, for inflation-linked bonds to offer a potentially safe way to preserve real wealth they should not have any credit exposure. However, Italian inflation-linked bonds as well as their nominal counterparts trade at a discount to compensate for the higher volatility and credit risks. Most investors realize that they should be cautious when using the break-even rate, because many other factors enter into bond prices besides inflation expectations, including inflation risk premium and a liquidity risk premium and also credit risks....

Currency trade strategy

on Oct 4, 2012 in Currency, Home | 2,249 comments

Markets that offer the highest returns on investment will be the ones that gen­erally attract the most capital. As interest rates rise, investment will follow, which can in turn increase the value of the currency. On the other hand, the investor also should pay attention to the health of the economy from the currency pair to ensure the market will move to in his favour. The carry trade strategy is popular among investors and takes advantage of the interest rate differentials between two currencies while also hoping to benefit from the positive trend in the pair. As an example, you borrow JPY and convert them into USD and invest in cash solutions or in fixed income product for the equivalent amount. Let’s assume that the investment pays you 2% and the Japanese interest rate is almost 0%. The investor makes a profit of 2% as long as the exchange rate remains stable. Carry trade must be conducted with caution due to potential volatility on the currency pairs. Tension in markets can have drastic effects on currency pairs and can be drained by brutal turn. For many years, the JPY has been the most favoured carry trade strategy because of its traditionally low or no interest rate governmental policy. By matching the yen with a high-yielding currency from a growing economy, you can earn interest due to the difference in yield. By choosing a nation coming out of a recession and on its way to solid long-term growth with the possibility of rising interest rates, you can expect earn a decent yield. There is a fair amount of risk to the carry trade strategy mainly related to the uncertainty of exchange rates. Using the example above, if the USD was to fall in value relative to the JPY, then the investor would run the risk of losing money. When risk aversion prevails among investors and exchange rate volatility is high, the carry trade often starts to look less attractive. On the other hand, when stability has returned to the currency market, the risk appetite of investors then tends to increase. They start looking for higher returns, even if it means taking more...

What is a LEAP option?

on Sep 27, 2012 in Derivative, Home | 1,824 comments

Long-Term Equity Anticipation Securities or LEAPs are very similar to standard options except for the fact that expiration occurs 36 months after purchase. They can be safer than traditional options because it is somewhat easier to predict share movements over longer periods. Therefore, they can be effective for both leverage and hedging purposes. For leverage: Investors can purchase a LEAP call option contracts instead of shares of a company in order to get similar long-term investment benefits with less capital outlay. Substituting a financial derivative for a share is known as a share replacement strategy, and is used to improve overall capital efficiency. LEAP call options may be purchased and then rolled over for many years, which allows the underlying security to continue to compound as the investor simply pays the roll forward costs. For hedging: Investors could purchase LEAPS put options as long term insurance against a catastrophic fall. In terms of price, LEAPS put options cost much lesser than all the short term monthly put options added together. This is why investors seeking to hedge for the long term should not hedge using short term put options. Hedging using short term options also result in more trades as short term options expire, resulting in higher commissions...

Synthetic ETF: as an investor you should remain cautious

on Sep 20, 2012 in Derivative, Home | 1,544 comments

The old investors’ advice to “Never invest in something you don’t understand” strikes for synthetic exchange traded fund.  A synthetic exchange traded fund is an investment that mimics the behaviour of an exchange traded fund through the use of derivatives such as swaps. The most obvious way to track an index is to own all (or most) of its component securities in the same proportion as that index. However the synthetic ETF can imitate an index without owning a single one of the benchmark’s securities. In fact, well-known providers such as Lyxor and db x-trackers are both swap based. Why would an investor invest into a synthetic ETF when they could simply use a plain vanilla index fund? The answer is that the swap structure provides a low tracking error. While most managed index funds follow their benchmarks closely, it’s not unusual for tracking errors to be a drag on returns. With a swap structure, the counterparty must deliver the return of the index precisely. So why go to the trouble of actually owning the shares of an index when you can deliver its return using swaps? However the reduction in tracking error comes at the cost of heightened counterparty risk. In the worst case scenario – counterparty default – the ETF’s source of return is cut-off and it’s time to fall back on the collateral. Even though ETF must be backed by collateral worth at least 90% of its market value and in practice, ETF are often over collateralized – meaning backed up to 120% of its value in collateral – there is no requirement for collateral to be held in the same securities that the ETF tracks. It implies that the ETF’s collateral basket can include illiquid assets! I recommend investors greater scrutiny of collateral pools to avoid being soaked up in a downturn by applicable...

The TIPS spread

on Sep 13, 2012 in Fixed Income, Home | 1,563 comments

The US Treasury sells notes of different yields and maturities. One type of those notes is known as TIPS or Treasury Inflation Protection Securities. A TIPS note’s yield moves based on changes in the level of CPI or consumer price inflation. If CPI or inflation is rising, the face value of a TIPS note increases and similarly the face value may fall if CPI falls. This means that TIPS are a hedge against inflation! Comparing the yields between Treasury securities and TIPS can provide a useful measure of the market’s expectation of future CPI inflation. Why? The yield-to-maturity on a Treasury bond that pays its holder a fixed nominal coupon and principal must compensate the investor for future inflation. Thus, this nominal yield includes two components: the real rate of interest and the inflation compensation over the maturity horizon of the bond. For TIPS, the coupons and principal rise and fall with the CPI, so the yield includes only the real rate of interest. Therefore, the difference, roughly speaking, between the two yields reflects the inflation compensation over that maturity horizon. The wider the spread between the two yields, the higher investors’ expectations are and vice versa. From a fundamental perspective it seems that we can count on higher levels of inflation in the long term. From a portfolio management perspective TIPS are a good way to add protection against inflation and to insert an element of fixed income to your diversification strategy. Bottom line: Higher rates of inflation can be turned into an opportunity at the investor’s...

Should you invest in the pharmaceutical sector?

on Aug 30, 2012 in Equity, Home |

The pharmaceutical sector can be a good place to invest. Pharmaceutical firms can enjoy hefty profit margins and have a clearer and longer flow of earnings, especially if they develop the next blockbuster drug or lifesaving treatment, despite the potentially high-risk nature of a business heavily dependent on research and development of new products, and patent protection. At the same time, the developed world is trying to rein in the cost of government-subsidized healthcare. Many investors have abandoned the pharmaceutical industry lately due to the lack of drug pipelines, blockbuster patent expirations, a more stringent FDA, generic competition, research failures, and drug safety concerns. Big pharmaceutical companies have realized the evolving market place and many are undergoing heavy transformations to change the way they do business. For example, many of them are now focused on cutting out the “fat” that they’ve accumulated over the years. Companies are also developing new systems, technologies and sales tools to combat the increasingly hostile environment. Instead of focusing on developing blockbuster drugs, companies are spreading their resources into more focused indications on smaller patient populations. They’re entering newer markets, particularly in Asia where significant growth opportunities exist. They’re also participating in more joint ventures, and acquisitions to prop up their pipelines. Finally, companies are outsourcing many activities like R&D, clinical research and sales to third-parties. The pharmaceutical industry is not only attractive for its high-paying dividend yields. In addition, many companies are currently trading at low multiples to earnings and to sales. Instead of looking for the next blockbuster, the prudent investor will look for where true value exists. There are still great benefits to be reaped! In the end, how can you beat a business that makes a pill for a few cents and sells for a few Swiss...