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Portfolio > Economy & Markets > Stocks

Part I: Golden Opportunities?

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By crackey, I remember the days when you didn’t even need to own a shovel or swish a tin pan to make money out of them thar hills. Wait a minute. You still can, sonny. Right? First, you need to follow our core investment principle of knowing what you’re thinking about buying before you wind up owning it. Gold is simple enough to understand, you begin to say. Sure, simple–about as simple as explaining the concept of infinity to a five-year-old.

Despite my caveats of last summer (see the August 2001 issue), gold–the commodity and the mining stocks–has continued climbing to higher highs, while the overall market hasn’t produced much more than plugged nickels. Not surprisingly, client interest in gold has also resurfaced from the cavernous vault of safety- and profit-consciousness. With terrorism, wars, rumors of war, and consumers’ steadfast irrational exuberance in the face of bear market facts–all of which have their own logic–no doubt investing in gold has become a topic of many client conversations.

Given the level of global instability, it’s hard to argue with the idea of putting some of your assets into gold or, better yet, gold mining stocks–or better still, an actively managed gold fund (we’ll get to that in a minute). But let’s hope that it’s the worst-performing of your asset classes; if it isn’t, that means all hell has broken loose. Still, before you become a glitter bug, or let a client succumb to one, let’s mine the negatives for what they’re worth. The truth is that, over longer periods, owning gold hasn’t panned out.

First, gold doesn’t always do all that well when the world looks as if it’s going to hell. If you knew last August what would happen on September 11, you’d probably have expected the price of gold to rise–and it did. But it was only a flash in the pan: 5.6% in September 2001. (Not that you’d have regretted holding it for that gain, especially given what other investments were doing.) With geopolitical factors more stable, however, gold has gained more substantially this year, with prices up 18% through May.

Glitter Bugs

For a commodity, gold prices actually haven’t been all that volatile over the past two decades, but gold stocks are considerably more volatile. It’s not uncommon to see short-term periods where gold stocks are among the best of investments, but longer term, the sector sinks, with most gold-related investments actually showing a negative return since 1980. On the other hand, gold sparkled throughout the ’70s, thanks in large measure to our own mismanagement of the dollar and inflation. It’s conceivable that such mistakes could be repeated, or that difficult choices (war- and/or oil-related crunches) may lead to inflation, a falling dollar, and a falling stock market. In that case, gold might again do well for some time to come. In fact, as you well know, the only thing missing from the above equation is inflation, and, since we’re no longer pegged to the gold standard, gold isn’t an inflation hedge.

Historical context? We wouldn’t bank on gold faring as well as the last time around. An ounce of gold went from $40 in 1971 to a peak of $850 in 1980; that twentyfold increase was primarily caused by the dollar’s being cut in half by inflation. As we’ve seen since 1980, gold, which is to say, gold investors, overreacted in 1980. Gold is arguably 22 years into a bear market, and 9 months into its own bull market. Will this last? Hold on, we’re bringing up the crystal ball from storage. The likelier scenario involves shorter-term moves, with gold doing well for, say, a year based on any given form of bad news, like a falling dollar and inflation, one or more nuclear explosions, or Alan Greenspan retiring. (If buying gold leads you to actually root for such bad news, then maybe you should stick to stodgier investments for your health’s sake.) Long-term gains in the real price of gold would lead to increased supply; the prospect of really cleaning up long-term in this field is probably no better than the probability of OPEC ruling the world.

What are your options for gold investing? Primarily: bullion and coins (gold itself), gold mining stocks, and gold mutual funds.

Buying the Shiny Stuff

Bullion: First, if it dissolves in water and smells like chicken, you’ve been had. Second, we have to distinguish between bullion and bullion coins, such as the Krugerrand and the Maple Leaf, which sell for only slightly above bullion prices, and relatively rare, or numismatic, coins, which sell for a substantial amount above bullion prices. Other factors you and your clients need to know: You need to either pay for storage, or you pay to take possession of the gold. In the latter case you are likely subject to sales tax, you have to guard and/or insure the gold, and you will likely need to have it assayed (if it’s bullion) or at least visually inspected/graded (if you have coins) when you want to sell. And silver, at least, is rather heavy for easy transport. With a value of $5 per ounce, a $10,000 silver haul would weigh 125 pounds. (Silver coins would tend to come in relatively spendable amounts if you’re trying to recreate a post-apocalyptic, cash-alternative society.) Of course, for some clients the “feel factor” and ability to show off their safe and collection of silver bullion and gold coins may be worth a $30,000 investment for these reasons alone. As expensive hobbies go, collecting precious metals can’t perform worse than sinking $30,000 into a fishing boat.

Bid/ask spreads range from under 1% for bulk bullion to perhaps 30% for rare coins. (Leave the riskiest investments, futures and options on precious metals, to those in the precious metals business and those who trade futures and options full-time). Gold is generally the most liquid of the precious metals, with bid/ask spreads a fraction of 1% for bullion. Gold is also the least subject to industrial demand, while silver is used heavily in industry for its electrical and thermal conductivity (e.g., in soldering) and in photography, and platinum and palladium are crucial components of the catalytic converters found in many automobiles. To be sure, gold’s conductivity and virtually absolute immunity to corrosion even in harsh conditions makes it highly useful for plating electrical connections in electronic, automotive, and audio devices.)

All three metals are also used for essentially decorative purposes, such as in jewelry and silverware. They are also bought by financial speculators and others seeking to hold a store of value against the prospect of inflation or expropriation, especially where governments are not known for respecting the value of paper money and other implicit contracts.

Gold Mining Stocks

There are a large number of obscure mining firms, and a few big, multinational ones. But even the largest–Newmont Mining (NEM) and Barrick Gold (ABX) recently had market caps of about $12 billion each, making them arguably mid-cap stocks. The market in gold mining shares is quite bifurcated. Such senior gold mining stocks are producing significant amounts of gold, and often, but not always, earning a profit.

Junior gold mining stocks tend to be small-cap firms with a single mining location that is not yet producing significant amounts of gold. They are much riskier (some might go to zero), but also have much greater upside potential. Unless you work for one or have the time and expertise to pick a diverse portfolio of such stocks without getting burned (the industry is notorious), stick with the senior stocks, or a gold mutual fund.

Although people often throw around terms like “gold stock” and gold investing, investors should note that there are few pure plays on gold or any other single metal. The major mining firms operate in more than one area, and most gold mines also include silver, copper, or other metals. (Hence the name Freeport-McMoran Copper & Gold (FCX), for which gold accounts for just over a third of sales.) Further, three-quarters of silver production comes from mines where the primary (in terms of dollars) production is of lead/zinc, copper, or gold. So it’s really “precious metals investing,” and at that it has a lot of exposure to non-ferrous metals.

This further complicates any picture of the supply/demand function for precious metals. Industrial slowdown means less demand for, and mining of, copper, lead, and zinc. And that means less production of gold and silver. So although recession means less demand for precious metals in jewelry, silverware, and industrial uses, if it’s a “stagflation” type of environment (i.e., slow economy with inflation, such as in the 1970s), then reduced precious metals supply can mean higher prices.

But why dig your own hole, when there are many active managers with headlamps already aglow? Most advisors and clients would be advised to focus their attention on mutual funds invested in mining stocks. And so, that’s what we’ll do for you.


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