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The Better Way to Follow This Hedge Fund Giant’s Gold Advice

Reuben Gregg Brewer, The Motley Fool

When Ray Dalio talks, Wall Street listens. That's because he helped to build Bridgewater Associates into one of the largest and most successful hedge fund companies in the world. Today he's telling the world that change is in the air, and that gold will be an important asset to own. Here's why he's making this very public call -- and the best way for you to follow his advice.

Change happens

Dalio's view of the world is generally built around what he calls paradigms. Effectively, these are long periods of time when things work in a similar way. This recognition can be both good and bad. It's good when an individual investor can identify a paradigm early on and ride it while it plays out; it's bad when more and more investors catch on to the paradigm and incorrectly extrapolate the current market environment out to the indefinite future.

Two people looking at a computer screen with a stock graph on it

Image source: Getty Images

Essentially, investors get to the point where they think things will never change and start to bid the "in favor" assets up to absurd heights. Then things change, and what worked before no longer works. This is a paradigm shift, often precipitated by investors using leverage to invest in a particular way until they can't support the weight of the debt.

Although this is simplifying his logic a lot, Dalio believes the world is awash in debt, and that has benefited companies and the owners of companies (notably including those who invest via the stock market). This has led to a widening rift between those who have assets and those who do not. With so many long-term obligations on a global scale (some of which are not considered debt, like Social Security) and discontent among the less well off, Dalio believes inflation will be allowed to increase to ease the debt burden. And in that environment, he sees gold as an important asset to include in your portfolio.

He sums his thoughts up in this way: 

So, the big question worth pondering at this time is which investments will perform well in a reflationary environment accompanied by large liabilities coming due and with significant internal conflict between capitalists and socialists, as well as external conflicts. It is also a good time to ask what will be the next-best currency or storehold of wealth to have when most reserve currency central bankers want to devalue their currencies in a fiat currency system.

A little bit of a hedge

Gold is, indeed, viewed by many investors as the ultimate store of wealth. But there are different ways to own gold. The most direct is to buy gold bullion or an exchange-traded fund tied directly to gold, like the SPDR Gold Shares ETF. These are fine, but there's no growth potential -- an ounce of gold will never be anything more than an ounce of gold. It is the price of gold that will be the sole determiner of your ultimate success. If Dalio's paradigm shift doesn't play out as expected, or unfolds unevenly over a long period of time, it could be hard to stick out an investment in physical gold.

On the other hand, owning gold miners like Barrick Gold or Newmont Goldcorp provides exposure to gold and other precious metals, since that's what these companies produce. However, it also allows investors to benefit from the investments in production-enhancing projects that miners make over time. Thus, there's growth potential. The downside is that gold prices can be volatile, and building and operating mines is costly. When costs are high and gold is low, miners can end up losing a lot of money until they can adjust their operations to the new environment. 

That's why most investors are probably better off owning a streaming company like Royal Gold (NASDAQ: RGLD), Franco-Nevada (NYSE: FNV), or Wheaton Precious Metals (NYSE: WPM). To simplify a bit, these companies provide cash up front to miners in exchange for the right to buy gold and other metals at reduced rates in the future. These agreements contractually lock in low prices, often set as a percentage of going spot prices, and lead to generally wide margins in both good markets and bad. 

FNV Profit Margin (TTM) Chart

FNV Profit Margin (TTM) data by YCharts

Miners use the cash to build new mines, expand existing ones, fund mergers, and sometimes just reduce leverage. The streaming companies benefit from both the locked-in low prices and the growth that the cash they provide is often used to fund. Meanwhile, the streamers avoid the risk inherent in operating a mine (notably the frequent mismatch between the cost of running a mine and the price of precious metals). Streamers are a generally lower-risk way to invest in gold while still availing yourself of the growth potential provided by owning a miner.

Royal Gold has the largest exposure to the yellow metal, with gold making up 77% of revenue. Silver, another precious metal and hard asset, chips in 9%. The company has investments in 191 operating mines and development projects around the world. Wheaton provides the greatest balance between gold and silver, with gold accounting for around 55% of revenue, silver 43%, and other precious metals (palladium group metals) the rest. The company has a more focused portfolio, with 28 investments. Wheaton currently provides the most exposure to precious metals, since 100% of its revenue come from this source, while Royal Gold's top line is rounded out by industrial metal copper.

The most diversified of the group, meanwhile, is Franco-Nevada, but that's because this streamer ventures further afield. Gold makes up around two-thirds of its revenue. Silver and other precious metals round its precious metals revenue out to 85% of total revenue. Copper and oil and natural gas investments (which clearly aren't even metals) account for the rest. The company is also the most diversified with regard to its portfolio, with 290 operating and development mining investments and 80 investments on the energy side of the ledger. Although this isn't the purest play on Dalio's advice, the diversification of the portfolio into the energy space provides a little bit of a backstop should Dalio be wrong or the paradigm shift he expects takes a long time to materialize.

Even if Dalio is wrong

Precious metals, most notably gold, are a diversifying asset because they tend to move differently from other assets, like stocks and bonds. They are a good thing to have in your portfolio in modest quantities. The truth is, even with Dalio's outlook, you probably shouldn't load up on gold. But if you don't own any gold at all, his concerns might be enough to get you thinking about the idea of adding some to the mix to increase the diversification of your portfolio. And if you do, gold streamers like Royal Gold, Wheaton Precious Metals, and Franco-Nevada are a good way to go about it. 

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Reuben Gregg Brewer has a position in Franco-Nevada. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.

This article was originally published on Fool.com