Time to Buy Gold Stocks and Not the Metal?

By: Julian_DW_Phillips

The gold price average over the last year has risen to close to the current price. This means that the gold sales income of the mining companies has persisted for long-enough for the mining companies to have income available for payout to shareholders or to improve their Balance Sheet. This makes mining companies with their leverage to the gold price more attractive than the metal itself, currently. We let our subscribers know the shares we believe will give them the greatest overall return on their investment, so we restrict ourselves in this article to the underlying principles that guide us in our choice.

Restraints on Large Investors

Many large funds need the shares they deal in to have a sufficiently high market liquidity to accommodate the huge investment they have the potential to make. Rather like sea-going liners that have large numbers of passengers they cannot choose the smaller sail-boat like shares because it would be both an insignificant investment and a difficult one to get out of if needs be were the investment too large. So these companies often find themselves holding shares that neither payout large dividends, nor see much overall impact from a slightly higher gold price.

For investors capable of investing in smaller companies or companies on whom a small increase in price will take the bottom line from a loss to a profit [marginal mines] the choice of investment widens. So what principles should guide such an investor in these gold shares?

Share Investment Principles for best overall returns

1. To set our minds to the right perspective, let's start by saying that our investment should be able to do well in a bear market. It should hold its value in bad times as well. Many believe that the gold market is "too volatile" a place for investment funds. Following this principle will remove many of the dangers that come from the [perceived] gold market. You can be sure that when the markets turn bullish, these are the shares that will outperform the rest. Nevertheless, the emphasis must be on holding value in bear markets. Investors will outperform all others if this criterion is rigidly followed.

2. This principle implies so much in the company. For instance if the gold price were to hold still or fall, what will happen to its gold production levels? In a junior mine which is growing its production and will do so for many years the income to the company will continue to rise even when the gold price falls. Most such mines therefore continue to see a rise in profits in this situation, making it very desirable and falling-gold-price resistant.

3. An examination of its "Break-Even Point" will tell you just how much a rising gold price will benefit the percentage profit it will achieve. If the next $50 rise in the gold price takes it into profit from a loss, then it will run ahead of its peers in capital increase. If it is earning say $300 profit on the gold price already then another $50 will only increase profits another 16%, which is unlikely to make the share price race.

4. Soundness of Balance Sheet almost goes without saying, it is so important. When markets turn down and stress is brought to bear on the company and ready outside capital is not so easily available [in a credit crunch?], can the company fund such requirements internally or go to the shareholders and get their support for the supply of capital?

5. Soundness of Shareholders implies more in a gold mine than in many other sectors. Where the main shareholder is an important big gold mine with a solid income stream and large capital base, there is a strong likelihood that as the mine develops and grows the major mine will increase its stake and or/ supply capital to ensure that growth continues. It's rather like having a banker ready to supply interest free loans [shareholdings] ready to maximize growth. The expertise of such shareholders is also available to the mine management to ensure the best advice even to small companies. Such support goes a very long way to ensure the success of the mine even in the dark days of a bear market.

6. Can the company control its costs effectively or do they rise with a rising gold price and stall when it falls? This asks one to look at the shape of costs. How vulnerable to oil price rises will the company be, or is it capital intensive. Will the Unions cripple profit levels by excessive demands? In different countries this changes. In North America mines are highly mechanized with a relatively small dependence on labor. In others where labor is cheap wages can be a telling cost. Are the mines disciplined enough to hold wage levels for one or two years at a time? In the last three years the vulnerability to fuel costs was well demonstrated in mechanized mines as the oil price rose to $145. In South Africa, the incompetence of the Electricity Supply Commission in supplying power has stalled growth. Now those same mines are racing to supply their own power and lose their dependence on the company. Once this is in place growth can resume and although electricity costs jumped to high levels once-off, the threats to power supplies is being eliminated. A very long-term mine such as South Deep of Goldfields [57 years?] becomes ideal in this climate, but only for long-term large investors.

7. Exchange rates the mines receive their income in can play havoc with profits. In a gold/platinum producing country like South Africa we have seen the Rand rise alongside the rising gold price and largely neutralize rising prices of the metal. There the mines pay their costs [labor intensive] in Rands. They also receive their income from gold in Rands, without the option of retaining them in foreign currencies. So not only has this lowered their income, but allowed rising costs to reduce profitability. Where an exchange rate is falling [such as the States and Canada] gold mines are enjoying rising income with a rising gold price. The long-term view on these currencies supports investments in these countries.

8. What is the potential [not so much their present] interference by the government of the country in which the mine is based? When commodity and metal price in general were surging before the credit crunch, we witnessed growing greed on the part of the gold mining host nations with a few exceptions. In countries like Mali, government interference is minimal, but further afield saw governments ready to impose "Windfall Taxes" on mining and other companies suddenly making huge profits. Profits fell away under such fire. In South Africa, Royalties were and, I believe, still are being worked out based not on profits, but on Turnover, making profit potential extremely restricted. Is it any wonder that South African gold production is moving to 200 tonnes a year from its peak in the past of over 1,000 tonnes? Even U.S. Mining Laws are vulnerable at the moment, so investors have to extend their analysis to this side of life too. The worst that has happened is that government interference can lead to the Nationalization of commodity producers as we have seen in South America.

9. Dividend policy? It seems this subject is still largely a thing of the past. We do feel that investors should know what a company's policy on paying shareholders income for their investments will be at all times. In days where rosy futures are things of the past income and capital values will grab the attention of all investors and their investments will follow paying companies. Once companies see their share prices benefit from good dividend policies on what are wasting assets, then shareholder rewards will gain favor. It is always as well to measure potential income growth with fixed interest low risk debt instruments to assess the future value. Rosy futures allowed for share prices to get out of hand in all sectors until the credit crunch and then the pain set in! Income streams will help to offset falling share prices and help companies to hold share price levels even in bear markets! What good is an investment in a mining company where they simply mine metal? If the shareholders are not rewarded why invest?

10. Competence of Management. Management with good professional records on the mining front and the financial front will ensure that mines reach their full potential. As we said above, an investor should not simply invest so miners can keep on mining. Part of a professional miner's competence is to ensure he has the backing of investors who want a reward for their investment. So earnings and dividends do count!

In conclusion we do suggest that provided the above principles are followed we do like gold shares above gold itself until the gold price shows it will climb significantly. Below are our personal favorites - Subscribers-only

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By Julian D. W. Phillips
Gold-Authentic Money

Copyright 2009 Authentic Money. All Rights Reserved.
Julian Phillips - was receiving his qualifications to join the London Stock Exchange. He was already deeply immersed in the currency turmoil engulfing world in 1970 and the Institutional Gold Markets, and writing for magazines such as "Accountancy" and the "International Currency Review" He still writes for the ICR.

What is Gold-Authentic Money all about ? Our business is GOLD! Whether it be trends, charts, reports or other factors that have bearing on the price of gold, our aim is to enable you to understand and profit from the Gold Market.

Disclaimer - This document is not and should not be construed as an offer to sell or the solicitation of an offer to purchase or subscribe for any investment. Gold-Authentic Money / Julian D. W. Phillips, have based this document on information obtained from sources it believes to be reliable but which it has not independently verified; Gold-Authentic Money / Julian D. W. Phillips make no guarantee, representation or warranty and accepts no responsibility or liability as to its accuracy or completeness. Expressions of opinion are those of Gold-Authentic Money / Julian D. W. Phillips only and are subject to change without notice.

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