How to Make an Income Through Gold

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One of the most common objections to an investment in gold is the fact that gold doesn’t pay a dividend. It just “sits there,” and because of this, it evokes the “greater fool” theory from skeptics — that “the only reason to buy gold is so that you can find another sucker to sell it to at a higher price.”

Nevertheless, since the beginning of the 21st century, gold has outperformed virtually all income-generating assets. The reason for this is that gold retains its value, while fiat currencies such as dollars and euros do not: Central banks can create as much of these currencies as they want to, and it doesn’t really matter how much dividend income you can generate if the currency you are being paid in is losing value. Thus, so long as the rate of interest is lower than the rate at which fiat currencies are losing value, it makes sense to hold gold.

While this is a fairly straightforward principle, investors still want income with their gold. One solution is to buy gold miners. After all, these are businesses that, if run property, generate free cash flow and pay income to stock holders. There are many gold mining companies that do this. However, several of them cut their dividends last year as the price of gold fell, while the cost of mining it did not. Some examples include:

The list goes on, but the point is made.

Nevertheless, there is hope for investors who want to generate income while retaining and even leveraging their exposure to the gold price. In fact, there are several options. Here are a couple of them.

The first is to buy the Credit Suisse Gold Shares Covered Call ETF (OTC:GLDI). This fund buys gold futures contracts and then sells call options against its gold holdings. The fund distributes the proceeds from the sale of covered calls to shareholders in the form of a hefty dividend, which exceeds 13 percent.

A call option gives the owner the right to buy gold at an agreed-upon price regardless of the actual market price of gold. So, for instance, if the fund sells a covered call with a strike price of $1,400 per ounce, the call’s owner has the right to purchase gold at $1,400 per ounce even if the gold price is $1,500 per ounce. The call’s seller hopes that the call expires worthless (i.e., that by the time the call expires, the gold price is below $1,400 per ounce, so that the call’s owner has no incentive to act upon the agreement).

The good news is that this enables investors to generate income from an asset that normally doesn’t generate income. The bad news is that if the gold price soars, then investors in GLDI shares don’t get to participate in much of the upside because they have sold this right to the owner of the call. Given that the income on this fund is so high, a good strategy might be to buy a small part of your gold holdings through this fund. You can still retain a lot of exposure to the gold price and collect a small dividend on your entire gold holdings.

The second is the buy a gold royalty company. There are two large ones: Franco Nevada Corp. (NYSE:FNV) and Royal Gold (NASDAQ:RGLD). Both of these stocks have outperformed the gold price and the S&P 500 in the long run, and they have created a lot of value for shareholders.

These companies buy royalty agreements from gold miners. This means that they make a payment to a gold miner, and the gold miner then agrees to give these companies an agreed-upon amount of gold. The mining companies agree to this because they need capital with which to develop their mines – a lot of the mining companies involved are smaller companies that have just one or two mines that require capital to build. Thus, the relationship is symbiotic.

Royalty companies are very profitable because they have such low fixed costs. They have also paid steady dividends to shareholders, and, in fact, while most gold mining companies cut their dividends last year, these two companies recently announced dividend increases.

While these companies pay small dividends, they have a strong track record of raising these dividends. Furthermore, they have excellent balance sheets, strong pipelines of future royalty income from various gold miners, and very little risk. Investors looking to generate income from their gold holdings should therefore seriously consider taking a position in one or both of these companies.

Finally, investors do have other options in the mining space if they dig deep enough. If you don’t mind owning small mining companies or thinly traded ones, you can collect healthy dividends. A couple of examples include:

  • Caledonia Mining (OTCBB:CALVF), which is a $40 million market cap company operating in Zimbabwe, but which pays a 7.3 percent dividend that it can afford to sustain.
  • Mandalay Resources (OTCMKTS:MNDJF), which has agreed to pay 6 percent of its trailing revenues to shareholders in the form of dividends. It operates two mines, one in Australia and another in Chile, and it pays a nearly 4 percent dividend.
  • Alacer Gold (OTCMKTS:ALIAF), which is a small mining company with a mine in Turkey. While its peers were cutting dividends, Alacer Gold initiated a 3 percent annual payout.

These aren’t low-risk investments, but considering their strong dividend policies, one could make the case that they are more appealing than their larger counterparts, which took huge write-downs and cut their dividends.

A strategy that incorporates a combination of the three elements listed in this article will enable you to own gold and collect a nice dividend at the same time.

Gold is not the only asset you should focus on. Earlier, we took a look at two other assets that help investors with portfolio diversification, which is good practice for avoiding risk of huge losses. Here is a recap from our earlier article:

1. Foreign Assets

Many investors in the U.S. are U.S.-centric in their investing. We have better access to knowledge about U.S. companies as Americans, and we don’t have access to many foreign investments. However, there are a lot of excellent foreign investments. Many foreign stock markets are substantially cheaper than the S&P 500, and many of them also pay higher dividends. Furthermore, there are economies out there that have significant potential. For instance, many emerging economies have young, growing populations that are becoming more affluent and more productive as they get older.

Fortunately, we live in the age of ETFs and ADRs (American depository receipts), and these make it very easy to get access to funds holding several foreign stocks as well as individual foreign stocks. Investors have several options for gaining international stock exposure. For instance, a simple way to do so without taking on individual stock or country risk is to buy an ETF such as the Vanguard Total International Stock ETF (NASDAQ:VXUS). This fund is comprised of shares of the major companies traded throughout the world.

More aggressive investors –or those who have the time to investigate the benefits and detriments of investing in specific economies — have access to various individual country ETFs. For instance, one of the best performing stock markets this year is the Turkish Stock Market. Investors sold off Turkish shares last year in the wake of social unrest, and that created a great buying opportunity to invest in one of the world’s fastest growing economies at just 12 times earnings. Investors who are interested in Turkish stocks can conveniently buy the iShares Turkish ETF (NYSEARCA:TUR).

 

2. Income-Generating Assets

You need to have an investment that pays a substantial dividend. Income stocks will protect you in a down market, especially since the best dividend paying stocks are more defensive than your typical non-dividend paying stocks.

Finding a good high dividend paying stock is a little tricky in this low interest rate market environment. While there is no shortage of options, many companies pay high dividends because investors are concerned that they will not be able to sustain the dividend. Therefore, a good strategy is to look for companies that have stable businesses that are distributing a large portion of their profits to shareholders. The downside is that these profits cannot go into growing the business, but you can invest in growth companies with some of your other assets.

There are several good places to look for high dividend paying stocks. For instance, one option is the tobacco industry. These companies don’t have rapid growth, and it doesn’t have many outlets for investing their profits, and so it pays outsized dividends that exceed 5 percent. Other options include telecommunications companies such as AT&T (NYSE:T) and Verizon (NYSE:VZ), which have steady income streams and pay dividends that are substantially larger than your typical S&P 500 company. More aggressive investors can look into smaller, higher dividend paying companies such as the prison owners and operators – Corrections Corp. of America (NYSE:CXW) and the Geo Group (NYSE:GEO), which pay 6.3 percent and 6.9 percent dividends, respectively.

Disclosure: Ben Kramer-Miller is long Royal Gold and Caledonia Mining.

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