Description

To keep things simple, I will call this a long position in Central Goldtrust.  GTU is a closed end fund consisting almost entirely of physical gold, and selling at a record ~11% discount to the net asset value of its holdings.  This discount reflects both the last few years of terrible performance of gold priced in US dollars, the recent intense selling from technicians when gold broke below its previous bottom at $1180, and probably some year end tax loss selling.  For most of GTU’s eight year existence it has actually sold at a small premium to NAV.

For those who would rather not have a bullish bet on gold, GTU would be a great pair trade with a short of GLD which, as an exchange traded fund that is also a pure bet on gold prices, always sells extremely close to its NAV.  If a year from now GTU has returned to NAV the pair will have brought a ~11% nearly risk free return.  If it takes three years to return to NAV, that’ll give you a 3.67% return nearly risk free. 

Description:  GTU owns 698,496 ounces of gold, and certificates for another 6,156 ounces, plus $10.7 million in cash.  There are 19,299,000 shares (since it is a trust, called “units”) outstanding.  Using the second London gold fixing, the assets divided by the number of units gives you net asset value.  The trust states that its “physical gold holdings may not be loaned, pledged, subjected to options or otherwise encumbered in any way…Gold bullion is stored on an allocated and segregated basis in the underground treasury vaults of the Canadian Imperial Bank of Commerce, one of the major banks in Canada.”

That means that there is no counter-party risk, so except for some Goldfinger like nuclear attack on the CIBC vault, one only has to worry about the price of gold, not whether GTU could sell the gold if it wanted to.

There are many reasons why closed end funds often sell at discounts, but most don’t apply here.  Liquidity of the underlying assets are not an issue; while $800 million worth of gold is a large amount, that market is usually so deep that it could all be sold in a day or two without much impact on the price.  We know what the underlying asset is and always will be, so one doesn’t have to worry that the manager will sell winning investments and use the money to buy bad ones, which is sometimes a worry in other closed end funds.  Expenses are very low at 0.28% of assets as of the most recent quarter, well below most closed end funds.

The liquidity of the underlying asset, and the ability of some potential activist investor interested in liquidating the company to hedge the investment with a short in GLD, suggests there is a limit as to how deep the discount to NAV is likely to go before attracting buyers.  Moreover, if one wants to own gold, this is a good way to do so.  You don’t have to worry about the safety of gold coins you have stored under your bed, nor your safe deposit box being rifled, nor whether that gold ingot you bought is really 99% pure gold or counterfeit in some way. 

History:  GTU went public in a very small way in 2003, but only after subsequent offerings and a listing in the US in 2006 was NAV released every day.  In the eight years since 2006, the average premium/discount to NAV was a premium of 2.38%.  In its history it has usually sold at a premium, except for about five months in 2007, a few stray days around gold market lows in 2008, and a few days in early 2011 before the final gold market blowoff later that year.  It stayed at a premium through all of 2012, and only in Q2 2013, when gold started plummeting in earnest, did it go to a discount to NAV and stayed there ever since.

Until the last few days, the biggest discount ever was during tax selling season in 2013, at about -7.9% near Thanksgiving.  Yesterday it closed at a 10.7% discount, its biggest ever, and as I write this gold is down about 1.9% from its close yesterday, perhaps on the election results, while GTU is down 2.6%, meaning an even greater discount right now than its record yesterday.  To contrast, at the gold market top in 2010 it regular sold at a 10% premium and the premium was still over 5% a year after the top.

OK, you might say, you can understand why closed end funds sell at discounts, but why would GTU ever sell at a 5% or 10% premium, when one can always buy ETFs like GLD or PHYS at a sub 1% variation from NAV?

Closed end fund have a tax advantage over commodity ETFs.  For reasons that I lack the legal training or interest to pursue, a closed end fund is considered by the IRS to be similar to that of any stock, such that if one sells it for a profit after holding it for more than a year, taxes are at capital gains rates, currently at 20% federal.  ETFs like GLD are considered an investment in “collectibles” in which long term gains are taxed federally at 28%.  (The one proviso is that you have to fill out something called an IRS form 8621 to take advantage of that; please do not listen to me on this - check with your tax advisor.)

So at market tops people are optimistic, they expect capital gains, so they are willing to pay more than NAV when there are cheaper alternatives, because they want to save on taxes when they take their gains.  At market bottoms people are pessimistic and have no hope of long term gains, so that premium disappears, and then some.

Two ways to play:  The safest way to make money is to do a pair trade with a short of GLD.  There is a reason why I think GLD is a better short for this purpose than PHYS, which I’ll discuss in the comments if anyone asks.  Even if you think gold is going to $0/ounce first, at some point it will stop going down and start going up again.  When that happens the discount will disappear and possibly move to a premium.  You’ll make the ~11% differential when you close out both sides at NAV, and do better if GTU can be sold at a premium.

The other approach is to consider GTU as a long only.  It is easy to find extensive commentary both bullish and bearish on the prospects for gold over different time periods.  I won’t waste any space here on those arguments.  I’ll just point out that the premium or discount compared to NAV that GTU sells for, since it is a good measure of the bullish or bearish sentiment in the gold market, has proven to be a reasonably good predictor of which way gold is going next.

GTU’s history in that regard only exists since 2006.  Prior to that we can use the record of CEF, a similar closed end fund, run by the same people, that owns silver as well as gold.  CEF also has averaged a small (1.56%) premium over about 25 years.  Its history is that after a 20 year bear market, gold bottomed out in 2000, when investor confidence in the “Maestro” Greenspan Fed and in the limitless upside of the new internet economy, was at its highest point.  CEF, and presumably GTU had it existed then, went to a discount to its NAV in early 2000 and stayed there for about two years while gold was bottoming and starting to move up.  For most of the next ten years it sold at a premium.

Looking at the long term record of CEF’s relationship with its NAV, which goes back to 1987, we cannot say that a discount only shows up at bottoms or a premium only at tops of the gold market.  What we can say is that every time there was a gold market bottom, CEF sold either at a discount or a substantially reduced premium from where it had been.

Let me put it this way.  Anything can happen.  Maybe gold will go down for many years and bottom out much lower than current prices.  Nothing can be ruled out.  But if gold is close to a bottom here, and about to embark on a bull market taking it back to its previous highs or beyond, one could look back a few years from now at the discount that both GTU and CEF currently have, both in terms of the size of the discount and the extended length of time that they both have been trading at discounts, and conclude that the bottom in late 2014 should have been obvious at the time.

That’s the case for just going long GTU, but there is nothing wrong with getting a nearly risk free hedged return by going long GTU, short GLD, and waiting.

Catalyst

A turn in the gold market, plus a reduction of the steep discount to its NAV.