Trading and Investing in Gold Stocks Myth, Reality and Changing Trends

January 13, 2003

"Gold that's put to use more gold begets" Shakespeare

In the mid 80's, gold lost much of its function as a hedge against inflation and political adversity. Less and less, it operated as a store of value, as an alternative currency and as a safe haven. Fundamental changes in supply, demand, international currency structures and trade regulations helped transform it from a hoarded asset to a tradable commodity. In this transformation it has returned to its original use as decoration, jewelry and conspicuous consumption. Over the past two hundred years gold assumed the role of a refuge; a bet against your fellow man giving the investor a stake in disorder, inflation and a call option on calamity, but as each year passes this role becomes overwhelmed by fabrication demand.

Over time, the correlation of gold to other asset classes has also changed. In the 1970's, it bore a strong correlation to oil prices, especially between 1972 and 1979, whereas, between 1980 and 1989, it bore a strong correlation with 90-day Treasury rates.

Over the past twenty years, gold has operated primarily as a hedge against capital gains. There have been times when gold bullion was a good investment. For instance, when Warren Buffet began his first partnership it was worth half an ounce of gold ($17.50). Fifteen years later it was still worth a half an ounce of gold ($177.50).

In the 1970's when gold came into its own as a hedge, U.S. gold mining was insignificant. Few derivatives or hedging instruments existed and gold mines outside of South Africa did not sell production forward. Currency restrictions were in force in most western countries.

In some respects, gold has always been a hedge against inflation and has always been a better hedge against 'cost push inflation', as in the 1970's, than against 'demand pull inflation'. Once regarded as a portfolio diversification tool, it now works best in this capacity only when the whole equities market is in decline as happened in the 28 months following the March 2000 'bubble burst'. For diversification purposes, gold has virtually no relationship with small stocks, long-term bonds or real estate.

In the 1980's, speculators shunned the gold bullion market knowing that any price rise would be capped by the producers selling forward. Barrick Gold was the foremost exponent of hedging in order to expand production at a rapid rate in the Carlin Belt in Nevada. This enabled them to reduce their price risk and to raise the necessary equity from investment bankers. In the early years, Barrick Gold earned more from interest on the forward sales than from gold mining. Many marginal mines would have remained on hold if it had not been for forward selling.

Pierce Lassonde, of Newmont, estimates that hedging by gold mines brings down the price of gold by about $5.00 an ounce for every 100 tonnes sold forward. It prevents mine closures of uneconomic deposits when supply overtakes demand.

Higher lease rates and lower dollar interest rates have undercut the 'gold carriage trade'. Severe losses by Cambior and Ashanti when gold spiked in 1999 have deterred many independents from hedging. The decision of gold stock investors to avoid hedged gold mines has also hurt many gold mining shareholders in Barrick and Placer Dome.

When viewed on a long-term secular basis the demand and supply of gold has remained remarkably stable. The amount of gold per person has remained constant over the centuries at two-thirds of an ounce per person. Gold demand has grown at a steady 1.75% per annum over this period.

Non-monetary demand has almost doubled in each of the past two decades while monetary/investment demand has been negative. Non-investment demand now consumes over 2,000 tons a year.

Fifty-percent of all gold ever mined, has been produced since 1960. The largest percentage increases in production took place between 1930 and 1940 when world production went from 600 tons per annum to 1,300 tonnes and from 1980 to 2000 when production went from 1,200 tonnes per annum to 2,700 tonnes. Annual production stabilized in 2000 and 2001, and is not expected to increase over the next five to seven years. There is a long time lag before gold supply reacts to increased prices. Gold peaked in 1980, but world gold output did not increase until three years later.

In modern times, most mined gold has come from the English speaking former British Colonies, the U.S.A, Canada, South Africa and Australia.

By 1996, the U.S. produced eleven times as much gold as was produced in 1980, as the U.S. changed to a net exporter from a net importer.

Australia has also increased production ten times since 1980, due to tax holidays and the abundance of easily accessible oxide ores amenable to heap leaching.

The biggest increase in demand for both gold and oil over the past twenty years has come from Asia.

By 1989, Asia had overtaken Europe as the largest regional consumer of gold jewelry. Today, the largest consumer of gold jewelry is India, followed by the U.S.A. and China.

The biggest increases in demand have come from countries along the 'Old Silk Road' - from Turkey through to newly emerging Asian countries. In the 1970's and 1980's, the most rapid economic growth occurred in the so called 'City States' - Seoul, Hong Kong, Taipei, Kuala Lumpur, Bangkok and Singapore, small countries dominated by their capitals. In the 1990's, development moved to the continents of Mainland China and India, where economic development caused a large increase in gold jewelry consumers. If China imported as much gold as the rest of S.E. Asia, in relation to its GDP, the country would have to import 2,000 tons per annum. In both India and China when government restraints on gold ownership were lifted consumption doubled.

The growing influence of Asia on gold tends to have a stabilizing effect. Unlike in the West, where people buy high and sell low, Asians tend to buy low and sell high.

Central banks have reduced their holdings by 10% over the past thirty years. Despite extensive media hype, this is not a very important factor on the supply side of the equation.

Base metals, unlike gold and oil, have no restraint on inventory because they are easier to store and hold, especially when interest rates are low. Demand for non-monetary gold is very 'price elastic'. In 1980, when gold hit $850, scrap gold brought to market increased from 6 million ounces in 1978 to 21 million ounces. When gold prices fall, breakeven grades and mining company reserves fall. The demand and supply of gold is as malleable as the metal itself. When real inflation rates decline, the gold price is determined more by its own supply and demand characteristics than by macroeconomics.

Like all commodities and currencies, demand is much more important than supply in determining prices especially in the short run. While demand for base metals correlates 95% to changes in industrial output, gold bullion demand for jewelry correlates most closely with consumer confidence. Supply is determined not by annual mining production so much as the total reserves above ground. Unlike platinum and silver, which tend to be consumed, gold reserves are extremely large in relation to annual mined production.

A major change in gold volatility took place in October 1979 when Paul Volker took over at the Federal Reserve. Fed policy switched from controlling and fine-tuning interest rates to controlling money supply. As inflation is always a monetary problem, the gold market adjusted to the new constraints placed on inflation.

The original contention that gold is an accurate reflection of inflation because it is not involved in the economy no longer holds. Jewelry and fabrication are now the largest end users of gold production.

By 1980, jewelry demand on a worldwide basis had caught up with currency demand; each consumed 540 tons per annum. By 1990, world jewelry demand had increased to 2,000 tons and exceeded mine production by 250 tons.

Since 1968, world gold jewelry demand has grown in step with world GDP growth. Since 1850, world gold jewelry demand has increased one hundred times, while world population has increased five times.

The twentieth century has seen an ever-widening audience for what was once the preserve of the rich and powerful. Today, jewelry is mass marketed and democratized.

There has been a quantum leap in demand from Asia. In 1984 Beijing lifted the ban on the sale of gold jewelry. Today, the average Chinese consumer consumes a fraction of a gram versus over 10 grams per capita in Hong Kong and Taiwan. In a typical year India imports 800 tonnes, 95% of which goes into gold jewelry.

In the industrialized countries the typical markup is 200 to 400%. In Asia and the Middle East, a 10 to 20% markup is standard. A Western wedding ring contains approximately 4 grams of gold, while in India it can contain 100 grams. The average wedding in India involves at least a kilo of gold.

Trading Gold and Precious Metals Securities

If we applied the same yardstick to gold and precious metals securities that we apply to other securities nobody would ever buy them at their inflated prices. In the real world a $1,000 ingot of zinc is worth the same as $1,000 worth of gold. In the marketplace, a company producing $10,000,000 worth of gold can be worth two to four times as much as a company producing the equivalent amount of base metals, assuming they are equally as profitable as each other.

Since 1970, the average price earnings ratio has been twice that of the market as a whole, despite the fact that gold stocks pay few if any dividends and many of them have survival problems. World gold mining securities comprise a tiny fraction of tradable securities. The total market capitalization is less than one-third that of Coca-Cola. As a group, they make for poor long-term investments, but can be extremely lucrative for the informed and astute investor if he chooses the right security and the right time frames to trade them.

Gold mining securities perform a dual role, first as an instrument of gold and secondly as equities. At times, they behave as a thermometer, reflecting gold price changes, and at times as a barometer, forecasting the economic and political weather in the near future. Gold itself has often behaved as a better forecaster than it has been a commodity to be forecasted. Traditionally viewed as a hedge against adversity and political turmoil, its function in this capacity has been complicated by gold miners hedging the commodity itself.

The market, in recent times, has shunned companies such as Barrick Gold and Placer Dome, who have 'hedged the hedge'.

Most mining analysts, gold bugs and pundits, when writing about gold and gold mining securities, still view gold as a hedge against adversity and look for long-term appreciation from investors and speculators hoarding activities. They still view it as a potential store of monetary value. When gold, which has been in a twenty-year secular bear market, does not perform as expected blame is placed on central banks. Over the past twenty years, lower central bank reserves have remained relatively stable. Sales by Australia, Canada and the United Kingdom have been offset by emerging countries central bank purchases. To date, central banks have not sold into gold rallies, as they are primarily concerned with the value of their total gold holding. One should remember banking in the Western world owes its origins to goldsmiths who lent out their gold inventories to earn a profit and in the process laid the foundation of modern day debt and credit markets.

The growing commoditization of gold bullion, its decline in importance as a monetary store of value and the growing use of derivatives as an alternative form of hedging has made gold stocks the favorite vehicle for gold bugs and gold speculators.

Unlike base metals, gold mining and demand for its end product is still a growth industry. Demand for gold has become very price elastic, especially gold jewelry demand. A one percent increase in demand leads to a three percent decline in jewelry demand and vice versa. The long-term demand growth in gold jewelry is now a function of prosperity not adversity.

In the 1980's and 1990's, speculators shunned the gold bullion market knowing that producers were ready to sell into any rally. This caused speculators to focus almost exclusively on un-hedged mining securities for potential capital appreciation.

Over the past ten to twenty years, there have been many fundamental and influential changes in both the gold bullion demand/supply equation and in the nature and structure of publicly traded gold mining securities.

Because gold miners are commodity producers, investors wishing to find potential long-term buy-and-holds must follow the same criteria as any other commodity sector such as steel and oil. It must have large increases in physical production, cash flow and earnings per share. If we compare Nucor to Bethleham Steel, CNQ to Imperial Oil, we see the same rules prevailing in those industries that determine long-term success in the gold mining industry. For instance, in 1986 Barrick Gold had a market capitalization of $86 million U.S., which went to over $6 billion U.S. due to large increases in physical production.

Early in a gold bull market the companies that have increased production, cash flow or reserves, in the bear market are the first to appreciate. In the recent gold bull market, these were Goldcorp, Agnico-Eagle, IAMGold, Meridian Gold and Glamis Gold. In fact, Glamis Gold has been the best performing stock in the TSE 300 since March 2000.

When the market expects gold to appreciate, in terms of U.S. dollars, it needs to ignore companies such as Placer Dome and Barrick Gold, which are heavily hedged in U.S. dollar terms.

In the next phase the market rushes to fund the marginal producers or the companies with marginal deposits left over from the last bull phase - e.g. Kinross, Bema Gold and TVX. In the third phase, attention switches to new discoveries.

A review of gold, oil and base metal bull markets over the past thirty years shows that most of the action or price appreciation occurs over very short time frames of six to eight weeks. In most cases, corrections of 50 to 60% occur even on some of the quality stocks or leaders. The secular bull market contains many of these 'bursts'. One way to tell when a correction is due is to look for 'sheet highs'; by this we mean a two to four week period in which all of the stocks in the sector are setting new twelve-month highs. This occurred in the last two weeks of May 2002, setting up the correction in the first two weeks of June 2002 when over one hundred gold and precious metal stocks all peaked at the same time.

At these junctures, gold stocks behave like 'fat bottomed ladies'; when the bullion price backs off, hedged and un-hedged gold mining stocks head south.

Most peaks occur when U.S. ownership is at its highest. This can be gauged by watching the relative volumes traded on inter-listed stocks such as Glamis Gold, Agnico-Eagle and Goldcorp on U.S. markets versus Canadian markets.

The investor needs to be aware of companies that pay too much for acquisitions, such as Placer Dome. Most major acquisitions have led to write-downs. One study done of acquisitions by major mining companies over the past twenty years showed that 80% of the benefits went to the company being acquired.

Small mining exploration companies have been likened to slot machines emptying the pockets of investors. However, at the right phase of the gold exploration cycle they can be very profitable. As in all sectors, the largest gains are made in stocks that go from small cap to large cap status.

In the past two to three years, investors began to realize how profitable high-grade mines could be. Agnico-Eagle, Goldcorp and Franco-Nevada have all been extremely profitable with high-grade underground mines, causing substantial price appreciation.

Ten years ago, analysts only looked at companies doing 100,000 ounces per annum. Rapid growth by industry leaders has pushed the bar to 250,000 ounces.

These mid-tier companies such as Goldcorp, Agnico-Eagle, Meridian and IAMGold have been star performers in the recent gold bull market. Unlike Barrick Gold and Placer Dome which have sold forward a large part of production these companies are either un-hedged or have closed out their hedges.

While it is true that great ore bodies can create great companies - e.g. Barrick, Newmont and Goldcorp - gold mining companies still need to make new discoveries to keep the market interested on a sustained basis.

In the late 1980's, Newmont and Barrick both drilled deep in the Carlin belt. Previously, operators had been content to mine the very profitable low-grade surface ore. Barrick went on to become the first gold mining company to produce 1,000,000 ounces in North America. The most significant trend over the past five years has been 'deep drilling'. It has turned marginal mines at Agnico-Eagle and Goldcorp into highly productive cash flow machines. The second important trend has been the increased exploration activity in non-English speaking countries. The third significant trend has been the increased importance of gold as a byproduct of base metals mining which now accounts for 20% of total production.

The long-term secular trend in gold prices is now affected more by the level of world prosperity, especially outside of Europe and North America, whereas, short-term volatility and trends are determined by the U.S. dollar and economic and political dislocations.

As a result of these trends quality has become as important as quantity when assessing gold mining shares.

Over the past two to three years I have been working on a stock selection and screening methodology based purely on the quantitative characteristics of successful Canadian securities with the potential for above average capital appreciation potential over relatively short time frames.

Tuning in or screening for liquid gold stocks over the period September 2000 to June 30, 2002, the following gold and precious metal stocks showed up on our radar screen long before the whole sector broke out in October 2001.

Reginald Ogden is an Investment Executive with Canaccord Capital Corp. inVancouver, BC. He may be reached at 1-800-663-8061 or [email protected]