The best time to invest in gold shares

Those who read the magazine orwatch this website know that we like both gold and gold mining shares.

However, in recent years gold miners haven't done that well. Indeed, in the last year, the FTSE Gold Mines Index has gone down by 25%.

We think this presents an opportunity for investors who get their timing right. To understand the best time to invest, I recently spoke to Georges Lequime of Earth Resources Investment Group (ERIG). He helps run the award winning Earth Gold Fund.

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The cost of exploration and mining are rising

The core reason why we're bullish on gold is as a hedge against inflation. Whether it works to do anything for growth or not, we can expect the US and Europe in particular to print a lot more money over the next few years. At the same time, interest rates will remain rock bottom in nominal terms, and negative in real terms. We also think Asian demand, especially from an imploding China, will play a major role.

However, the costs of findinggold and getting it out of the ground are starting to rise. Ten years ago the major producers spent $194 in cash and $66 in capital expenditures for each ounce of gold produced. In the first quarter of this year, this had risen to a $627 in cash and $603 in capital. In total, each ounce of gold now costs $1,384 in Q1 2012, compared with $253 in 2002.

ERIG also note that along with increased costs, the remaining reserves of gold are harder to mine. In the 1950s, a ton of ore would yield 6g of solid gold on average. By 1980, the same amount would have only produced 2.32g. The average is now 1.1g and is still falling. Lower grades mean that more machines and tools are needed. In turn this has led to the rise of highly capital-intensive mega-mines, which attempt to take advantage of economies of scale.

Any company that has, or is able to find, cost-effective gold reserves should still do very well. But the pressure is mounting on the smallest players.

The three stages of gold companies

When investing in gold shares, or any mining or resource companies, it is important to find the right point to jump in. Most companies go through four stages.

In the first stage, companies try to find gold deposits. During this period they tend to have a very low value. These companies either run out of cash and fold, or manage to uncover evidence that there might be some gold reserves.

In the second stage, they try to examine these reserves and see whether they can be turned into a viable mine. These shares typically surge as investors pile in, attracted by the story. However, they quickly become bored with the lack of news. By the time the feasibility study is completed, they are usually back down to the level they were at the end of stage one.

If the report indicates that it is worth building a mine, then the final stage begins. During this period the firm tries to raise more capital and starts building the mine. As construction starts, gold starts coming out of the ground, and the company starts making money, brokers and institutions start becoming interested. The share price starts rising again.

Finally, the mine starts nearing the end of its natural life as reserves become exhausted. While the firm may be making large profits, and paying high dividends, it will need to find new opportunities in order to survive. This can be either through expansion, exploration or buying other mines.

While it is possible to make money during any part of the cycle, the best time to invest is at the end of stage two, or at the start of stage three. This is because the shares are cheap, thanks to bored investors, but the company is much closer to starting production.

In contrast, the most risky time to invest is at the start and middle of stage two during the 'hype' phase. While profits can be made in this period, you will need to be very good at reading sentiment, and predicting when it will change.

A gold miner to tuck away

One company that fits the profile is Eldorado Gold (NYSE: EGO). While it is technically a mature company, it has used the cash received from operations to takeover other firms that are in the process of building mines. In effect, it has transformed itself into a late second stage/early third stage company.

Of course, this doesn't come cheap. M&A costs and the capital investment involved in developing its new reserves have hit profits (the firm now trades at a price/earnings ratio(p/e) of 25). It also means that a large part of its business is now in Greece. Due to fears about the consequences of a possible Greek exit, shares in Eldorado have been hit badly.

However, it should secure the firm's long-term future. A Greek exit should be positive for exporters since it will bring down real wages more quickly than if Greece stayed in the euro. Unless Athens quits the EU altogether, it will still benefit from access to the European market.