April 04, 2013 - 1:46pm EST by
2013 2014
Price: 13.01 EPS $0.00 $0.00
Shares Out. (in M): 195 P/E 0.0x 0.0x
Market Cap (in $M): 2,520 P/FCF 0.0x 0.0x
Net Debt (in $M): 0 EBIT 0 0
TEV (in $M): 0 TEV/EBIT 0.0x 0.0x

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  • Gold


I am recommending an arbitrage trade of buying PHYS fully hedged against GLD/gold futures. As I write this PHYS is currently trading at a 25-30bps premium to NAV. I think one can, after round trip transaction costs, enter this trade at a maximum of a ~35bps premium to NAV. I believe this trade represents a risk/reward of 5-10x depending on how you define downside (NAV or the put option). The trade is highly leveragable and with a profit potential of 100-300bps in what could be as short as a few weeks or even days should achieve a double digit IRR. The trade is rather timely today and simple so I will keep this short.

PHYS caters to what might be called the paranoid/zerohedge gold investor. I think the whole debate about the paper/financial gold vs physical is a bit much and the logic of a potential government confiscation ridiculous (gold was a highly important part of the monetary system in the 30s unlike today). However, whether the ability to redeem and the difference in how the gold is accounted for matters vs a normal gold ETF like GLD or IAU is not really relevant if others believe it matters. The circular logic of the 5000 year history of gold being a store of value being the basis of its value is similarly intractably tied to a main reason many people want to own gold in a tangible fashion and is not going to change. That said there are a few real advantages with the only downside (that nobody investing here thinks about) of a 47bps expense ratio to 40bps for GLD.

  1. PHYS has what is effectively a put option that you can exchange your units for bars of gold. The investors in this fund mostly cannot actually do this (which I don’t think they realize) as you need to take delivery in 420oz bars but it is a choice for any investor.
  2. PHYS can be treated as a capital gain for taxes rather than the 28% rate GLD falls into for taxes. This represents a logical reason for PHYS to sometimes trade at a premium as for some investors it would remain rational to hold it at a premium for reasons other than a greater fool trade.

Unlike similar discount mean reversion trades on closed end funds this is unique in that there is a hard floor controlled by the investor. While there are some other small costs, effectively the cost of delivery is $5/oz, meaning that at today’s gold price the put option is in the money at 99.65% of NAV.

As the below data shows PHYS has rarely and only very temporally traded below 1% and at times has traded as high as 20%. I believe those very high NAVs are no longer possible as they were the result of very high gold sentiment combined with this being a new product of much smaller size (it was launched with 40M units vs 195M today). I believe the realistic ceiling NAV could reach is a 500bps premium as it last did in September. This is the level Sprott has consistently done secondaries.

What makes this trade interesting and the best way to take advantage of this lucrative washout in gold/gold stocks is that an analysis of the history of the NAV premium suggests the premium is much less a function of absolute gold prices but instead a function of gold sentiment. Gold sentiment is at least as low today as it has been in 12 years, the only possible equal being 2008 which was not nearly as bad on a relative basis. A measure of sentiment, the Daily Sentiment index, registered two ratings of 3 out of 100, a record in 20 years of data at the February low. While one could make an argument that gold prices have peaked (I do not believe this although do expect lower prices especially in silver sometime in the next few years), but gold sentiment undoubtedly must at some point improve even if it comes at lower absolute gold prices.

The sister products PSLV and SPPP are also interesting right now but not as attractive. The put option of PSLV costs ~1.5% and while SPPP is similar to PHYS getting both platinum and platinum and hedging is a bit messier. That said I would watch these too for opportunities.

Most likely the premium will bounce back to ~100bps within the next 5-15 days (it was at 180bps as recently as Monday) and then one will have to choose to play for 300bps or take the quick gain and the chance to reload.

Below shows the recent history of the NAV premium. Even when gold has been out of favor (May 2012 end of last year) a 1-2% premium has been the norm.


As an aside gold stocks to gold seem more attractive than any time in the last decade especially relative to other assets today (whereas everything was attractive in 2008). This week’s washout might be the turn (and the premium collapse of PHYS is just one of many signposts of how washed out this sector is). One has to be extremely bearish on gold prices to not find value in the sector. It is a horrible business for a litany of reasons but a lot of the industry is finally getting some capital allocation religion and dividend yields/FCF are high for many majors. I’d like to start more of a discussion on this in the comments.  However given a free money world on risk adjusted basis this strikes me as an even better play.

I do not hold a position of employment, directorship, or consultancy with the issuer.
I and/or others I advise hold a material investment in the issuer's securities.


Improvement in Gold Sentiment
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