By Michael Peltz
Gold is coming back from a long southward trip. To get in on this commodity's rise, investors should take a gander at the mining companies that produce it.
Here's an interesting fact about gold: Of the 140,000 metric tons produced since the yellow metal was first crafted into jewelry or melted into ingots, about 120,000 tons are still in existence, in the vaults of central banks, in museums, in drawers, or even dangling from navels. Unlike most commodities, gold is accumulated, not consumed. Thanks to its almost magical combination of properties, gold is soft and radiant yet indestructible. And because it doesn't react with oxygen, gold never rusts, corrodes, or tarnishes.
The same cannot be said for investors' perception of gold, which has been heavily tarnished by a two-decade-long bear market in the metal. Although gold, at a recent price of $320 an ounce, is up about 18 percent this year, it is still down more than 60 percent since its peak of $850 an ounce in January 1980. 'Investors have a lot of psychological baggage when it comes to gold,' says Prescott Crocker, co-manager of the $125 million Evergreen Precious Metals Fund. 'Many have come to believe that it is supposed to go down.'
It's time for a mental readjustment. The price of gold is poised to go higher—potentially much higher. With interest rates at 40-year lows, the opportunity cost in physically owning gold, which doesn't pay any interest, is no longer a big concern. Gold has also benefited from the recent uncertainties around the world. Talk of invading Iraq, new terrorist cells, more corporate scandals, and a double-dip recession will drive up the price as investors seek safe havens. Those moves could be sharp, sudden, and short-term, but gold should get a more sustainable boost from a weak dollar. After all, in many ways gold is just another currency. 'The dollar and gold are in competition as a place for individuals to store their wealth and liquidity,' explains James Turk, who writes the Freemarket Gold & Money Report. 'As the dollar drops, gold will go up.'
Turk measures the relationship between gold and the dollar through what he calls the fear index, which he calculates every month by dividing the dollar value of the U.S. gold reserve by the total amount of dollars in circulation. As the fear factor increases, investors shift assets from dollars into gold, and the index rises. The fear index had been declining for six years before reversing course this spring, and Turk thinks the reversal marks the start of a major bullish cycle in gold that could last at least two years and see prices reach $400 to $500 an ounce. He argues that after inflation is taken into account gold is a better value today at $320 an ounce than it was at $35 in August 1971 when the United States last abandoned the gold standard.
Unlike other gold rallies, this one will be driven largely by demand. Remember the 120,000 tons I told you about? That existing aboveground gold supply remains relatively unchanged from year to year; the 2,500 tons of new gold produced by mining companies in 2001 represent just 2 percent of it. Gold production has largely been flat since 1998, and the World Gold Council expects it to decline 3 to 5 percent a year for the next several years because of falloffs in exploration and in output at existing mines (mines typically have a life span of 10 to 15 years). New gold production, in fact, meets only about 70 percent of actual demand; the other 30 percent comes from sales by central banks and individuals. Although central banks had been heavy sellers from 1995 through early this year—replacing gold with greenbacks—they are likely to rethink that policy if the dollar keeps weakening.
For investors, the best way to play a gold rally is by buying shares of mining companies. They have an even greater scarcity value than the actual gold they produce. The world's publicly traded gold-mining stocks have a total market capitalization of roughly $60 billion (less than the market cap of Dell Computer, PepsiCo, or UPS). The three largest producers, Newmont Mining, AngloGold, and Barrick Gold, account for nearly half of that.
The gold-mining industry has seen tremendous consolidation. Barrick has made seven acquisitions since it was founded in Toronto in 1983, including its $2.2 billion purchase of California's Homestake Mining in December 2001. Denver's Newmont has been equally acquisitive. In February, it completed a three-way merger with Franco-Nevada and Australia's Normandy Mining. For its part, AngloGold owns a minority stake in fellow South African company Gold Fields, which last year bought two gold mines from Australia's WMC.
Confused? Most longtime gold investors try to simplify the mining sector by classifying companies as either hedgers or nonhedgers. Traditional hedgers such as Barrick lock in a price for much of their gold well in advance by selling forward contracts that obligate them to deliver gold at a set date in the future. That protects them from any drop in the price of gold and earns them a nice spread over the spot, or current, price. By contrast, nonhedgers sell most if not all of their gold into the spot market and are thus better positioned to take advantage of any upward price move. In an environment of rising gold prices such as we've seen this year, investors tend to favor nonhedgers such as Newmont: Its shares were up 53 percent through September 20, while Barrick's rose just 12 percent. Consolidation, however, has blurred the distinction between hedgers and nonhedgers. Newmont pledged to close the hedge book of 7.6 million committed ounces of gold it inherited when it bought Normandy, but that process could take a few years to complete.
Investors need to drill deeper. 'People have been so focused on hedging versus nonhedging, they seem to think that's all there is to gold companies,' Barrick CEO Randall Oliphant told me a few days after his company announced a massive $2 billion mine-development program. Barrick plans to invest that money over five years in four different mines, which it expects to produce a combined 2 million ounces of gold a year by 2008, supporting Oliphant's claim that his is the only major gold company that can organically increase production. Barrick also announced plans to reduce its forward sales position by the end of 2003, from 17.9 million ounces to a target of 12 million ounces, or roughly 15 percent of current reserves. Some investors see the move as a stunt to boost its share price, but Oliphant dismisses that notion. 'Just because we hedge, people think we're negative on the price of gold,' he says. 'It's like life insurance; you don't buy it because you think you're going to die.'
True goldbugs prefer to stick with Newmont's 'no hedging' policy. A far better strategy would be to buy shares in both Newmont and Barrick as part of a gold basket, which I'd supplement with smaller mining companies such as Agnico-Eagle, Goldcorp, and Meridian Gold that are increasing their reserves. It's best to avoid AngloGold and other South African mining companies. This summer, the South African parliament passed a bill that could ultimately force those companies to cede some of their mines to new black-owned enterprises.
Michael Peltz is a Worth executive editor.