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The golden debate

Two leading gold fund managers go head to head on the best way to exposure your clients to gold.

Sector Investment Managers chief executive and Junior Mining fund advisor Angelos Damaskos

In early March 2009, when global equity markets were trading at levels not seen in decades  gold shares were sold down dramatically, despite the relatively stable gold price.

In spite of the recent strong run we have witnessed in the markets since then, there remain many opportunities for the re-rating of smaller capitalisation gold mining companies’ shares.  Even if gold prices remain at current levels, junior gold miners with significant reserves in the ground, growth in cashflow, little or no debt and competent management teams that continue to explore and add to their reserve base, should outperform the market, the gold price and the sector. 

Most established gold producers operate at a marginal cost of production between $200 and $850 per ounce.  Given the high fixed-cost structure of the mining industry, the higher the sale prices of the output, that is the higher the gold spot price rises, the greater the profitability.  Companies operating with a low production cost have greater capacity to withstand a drop in gold prices than those that operate with costs closer to the spot price.  High-cost producers’ profitability is more geared to a rising gold price environment and so their share prices are likely to be more volatile in response to rises, or falls in gold prices.  It is therefore important to have a good balance of production cost in an equity portfolio of gold miners.

In 2009 investors focused on the more liquid middle-capitalisation companies with trading liquidity that would enable a swift switch in strategy.  In 2010, that focus is likely to shift to the smaller capitalisation companies which did not benefit as much last year.

There are several arguments in favour of investing in smaller capitalisation companies. It is much easier for a smaller company’s share price to double or treble than that of a larger one.  The very fact that smaller companies tend to focus on just a few mining assets makes it easier for an experienced investor to identify outstanding value.  Junior mining companies are less researched and, as they develop successfully, new investors are encouraged to recognise the real value of their projects.  They are also more likely to be taken over as the majors try to add to their reserves and the industry continues to consolidate.  As smaller companies tend to explore more actively in their areas of specialisation, a new discovery can have a disproportionate effect on their valuations.

Good examples of companies with outstanding potential include:

Centamin Egypt:  Operates in Egypt, politically safer than the Middle-East; in the process of becoming a significant producer with 200,000 ounces/year initial production; 13milliion ounces of gold resources; a strong possibility of major upgrade in resources; $70m of cash with no debt; no hedging.

Medusa Mining: Rapidly growing production of high gold grade ore; very low average production costs of about US$290/oz; debt free with $40m of cash flow in the year to date; no hedging.

Norseman Gold: Australia’s longest operating mine with 19 million ounces of resources produced so far; debt free with very strong cashflow; mill working at 60% of capacity; third mine planned and strong possibility of a fourth mine will substantially reduce costs;  no hedging.

Mining for gold is not a simple business; many things can go wrong and push operating costs beyond expectations.  It is important, when investing in gold mining shares, to have a properly diversified portfolio that includes established producers, development stage projects and some exploration that can add materially to overall performance.  This approach not only enables investors to gain exposure to gold, but also offers the potential to outperform the gold spot price.


Julius Baer Physical Gold Fund and Swiss & Global Asset Management executive director Stephan Mueller

Holdings in gold can be built in different ways, but it is possible unknowingly to take huge risks without receiving a corresponding premium to compensate for this risk.

Gold is viewed as a safe haven. It is a real asset which although subject to price volatility, will never lose its physical value.  It is also used as a hedge against inflation; inflation destroys the value of nominal capital, while the value of real assets is preserved.

It seems somewhat counterintuitive to invest in this asset through a vehicle which diminishes gold’s safe haven status.

Investing in mining or exploration companies enables an investor to participate directly in the business success of these companies, but also bears the associated risks, for example arising from environmental influences or amendments to laws and regulations in the countries of exploration.

With the exception of investment funds, gold investment instruments, such as derivatives entail full issuer risk. If the issuer is in financial distress  the investors‘ assets are at risk as under bankruptcy law the investment value is included in the issuer‘s estate.

Investing in physical gold, a tangible asset, can offer investors psychological reassurance.  Investing directly in gold bars or coins allows full participation in the gold price, but production costs can be high and there is no flexibility to cash in just part of the investment. Safe storage and insurance also has to be arranged, which can be inconvenient and comes at a price.

Exchange traded funds (ETFs) offer the advantage of daily liquidity, and investors can invest and disinvest in single shares.

Certain commodity ETFs which invest through futures contracts have recently been criticised for significantly underperforming spot prices. The futures contracts are rolled over before expiry and investors can lose out when futures are trading at a price which is higher than the expected future spot price for the relevant commodity. Over time the future price will have to fall to equal the spot price and therefore loses value.

Physical gold ETFs are not subject to this distortion as they invest directly in the asset. ETFs are generally low cost products and providing this is the case, investors in physical gold ETFs gain almost perfect correlation to the gold price.

A fund structure eliminates issuer risk as assets are ring fenced and not held on the issuer’s balance sheet. If the product provider is in financial difficulty, the client’s investment will be protected.

Most importantly, without currency hedging, gold does not offer the security which investors expect.

As gold is traded in US dollars, there is inevitably a foreign exchange risk for investors who are investing in any other currency, for example sterling or the euro. This adverse effect comes into play whenever the dollar starts to slide.

In today’s uncertain economic environment exchange rates can change dramatically overnight. Opting for an unhedged investment means that investors are not just participating in the gold market, but also playing the currency markets.

In order to achieve the same risk/return profile as for a basic investment in gold, the unwanted currency components must be neutralised via currency hedging. The main argument against hedging relates to the costs involved, however it is possible to manage the cost, in which case it is negligible in relation to the risks otherwise taken.

Since gold is always bought as a protection against inflation, it is only logical that the purchasing power of the investor’s own currency should be hedged against the dollar. Unhedged products should be left to experienced investors who can arrange their own currency hedging.


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