What do you think the price of gold will be in a year’s time?
I’ve no idea. Your guess will probably be at least as good as mine.
But it’s fair to say that the Western world is in a bit of a mess. Years of over-spending and borrowing too much have left many nations with crippling debts. Conditions are ripe for a nasty depression and years of falling prices.
While that would be painful, it’s probably what the economy actually needs. It would shut down a lot of bad businesses (including many banks), while falling prices would make us more cost competitive. It would also force the government to face facts – it is way too big and needs to slim down.
But this is unlikely to happen soon. The vested interests of politicians and the banking classes mean that the hard decisions will be avoided. A deflationary bust is their worst nightmare. Instead they will turn to the printing presses and destroy the value of our money.
This is why it makes sense to own some gold. But what’s the best way to do it?
A halfway house between mining shares and physical gold
We’ve been advising you to hold physical gold for a long time. This can be done by buying bullion yourself, or perhaps through a physically-backed gold exchange traded fund (ETF).
For free and impartial information on where and how to buy gold bullion coins and bars, see our comparison of leading gold brokers.
Another alternative is to buy the shares of gold mining companies. The theory here is that if the gold price rises, the profits of miners will rise even faster. This process is known as operational gearing. So you should make more money by owning gold miners than by owning plain old physical gold.
That’s the theory. Like many theories, it doesn’t always quite work out in practice. In recent years, gold miners have been underwhelming compared to gold itself. That’s mainly because the cost of getting the stuff out of the ground has soared.
We still like miners: as a sector, they look cheap, and when gold gets to the ‘bubble’ stage, they’ll rocket. My colleague Simon Popple has lots of good ideas about exactly which ones to buy – you can find out more about his gold research here.
But if you’re looking for a halfway house between a miner and a gold bar, there is one type of share you could take a look at. I’m talking about gold royalty or streaming companies.
What are gold royalty stocks?
Building and developing a gold mine can be expensive. Mining companies often don’t want to borrow money from banks as the terms are often too restrictive. So they turn to investors, such as gold royalty companies, instead.
These companies give the miners the money they need to help build their business. In return, the royalty company gets a percentage of the output of the mine for a specified period of time. For example, a royalty may be 5% of sales. So at $1,700 per ounce of gold at an output of 50,000 ounces, the royalty company would receive an income stream of $4.25m.
Another alternative is for the company to get a gold stream. This usually means having to invest a lot more money in the mine than under a royalty agreement. Here, the company agrees to buy a proportion of the mine’s output for a fixed price for a fixed period of time.
Let’s say it agrees to buy the first 10,000 ounces at a fixed price of $400 per ounce. In this case, at $1,700 per ounce, the streaming company would receive an income of $13m. (($1,700-$400) x 10,000). As the company has very little overheads, most of this income gets converted into profit.
The beauty of gold royalty and streaming companies is that they are not exposed to the running costs of the mine. If the costs go through the roof, they will not lose out like the owners of gold mining shares. But if the gold price goes up, they make lots of money.
There are other benefits too. Because they usually have interests in lots of mining companies, you take on less risk. Gold royalty companies also often benefit from production increases, as their money has been invested in mines that are still being developed.
So if you believe that the gold price is going to go up a lot, then these companies could make serious amounts of money. And during the last four years, compared to a basket of gold mining stocks, the share prices of gold royalty companies have gone ballistic.
Are royalty stocks too expensive?
|Stock||Share price||Market value||Est p/e||Est profit growth|
Prices as of 14/11/2012
That’s left the shares of gold royalty companies looking horribly expensive, as you can see from the table above. Normally, I wouldn’t dream of buying the shares of a company trading at nearly 50 times earnings. In fact, usually I’d say you’d have to be mad to do so.
But I’m not sure that you should ignore these companies. All of them expect to have a bigger share of mine production in the years ahead.
Sandstorm Gold should get its hands on around 34,000 ounces of gold this year but expects this to grow to 60,000 ounces by 2015. It can do so at a cash cost of just over $400 an ounce.
Royal Gold has interests in 202 gold developments, of which only 39 are currently in production. Its agreed cash costs to buy gold are even lower.
If you believe that the gold price is going to go up due to central bank money printing, then the cash flows of these companies could soar and today’s lofty share prices could end up looking very cheap. An added bonus is that they have invested in reasonably safe countries such as Canada, USA, Mexico, Brazil, Chile and Australia.
There’s still risk of course. Mine production might fall short of targets. The gold price could collapse. Cash-strapped governments might decide to tax the profits of gold mines more. But overall, if you are bullish on the gold price, it makes sense to have at least some of the money you’ve earmarked for precious metals in a gold royalty company or two.
• This article is taken from the free investment email Money Morning. Sign up to Money Morning here .
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