Why you should bag junior gold miners

Jim Slater, author of The Zulu Principle, is not a gold bug. But he believes the gold price will keep rising. And one of the best ways to play the gold price, he says, is to buy miners. Here he investigates the sector and tips three to buy now.

I am not a gold bug, but I believe that, while there will be the occasional setback, the gold price is likely to keep rising.

First, the US and UK authorities are printing money as if there was no tomorrow, so it is little wonder that both sterling and the dollar are weakening. Although the immediate outlook is deflationary, this is likely to be followed by gold-friendly inflation as the money-printing continues.

Unlike paper money, the supply of gold is very limited. All the gold ever mined could easily be fitted into two Olympic-sized swimming pools, and its supply can only increase as rapidly as miners get it out of the ground. That is becoming harder most of the easily found high-grade gold has already been extracted, so future production will be more difficult and costly. Relative to paper money, gold's value should keep rising. The world's biggest gold miners agree with me. They have stopped hedging their forward production because they believe they will be able to command a better price in the future.

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On the demand side, the Chinese are being actively encouraged by their government to buy physical gold and silver. China has only 1,054 tonnes of gold, accounting for just 2% of its foreign exchange reserves. It is very likely to buy more. In fact, central banks across the world, previously a major source of supply, are likely to become net buyers this year.

While jewellery demand has slackened and scrap sales are up, this has been dwarfed by the 1,700 tonnes of gold purchased so far by investors through exchange-traded funds (ETFs). This strong investment demand should continue.

Low interest rates mean that gold's carrying cost (the cash return you sacrifice for holding it) is low. While at $1,060 an ounce the gold price may seem high, remember that it was $800 in 1980. Since then, compared with copper, zinc and tin, it has been a laggard.

How to invest in gold

So how do you invest in gold? You could buy physical bullion, or use ETFs, but I prefer gold-mining stocks. After the financial crisis, gold benefited from its 'safe haven' status, but gold miners fell substantially as hedge funds were forced to sell mining shares to fund redemptions. So the gap between the gold price and gold-mining stock valuations (which are usually correlated) is wider than usual.

Also, gold miners offer leverage. A mine producing gold for $500 per ounce would double its profit if the gold price rose from say $1,000 to $1,500. Gold miners' share prices outperform gold both on the way up and the way down. A final reason for preferring gold mining stocks is that the market capitalisation of all of them put together is about the same as Wal-Mart's. Most investment funds have only a very small percentage of gold shares in their portfolios. Imagine the effect if they raised this by even 1%.

So which mining stocks should you buy? Junior gold miners are by far the best bet. A company capitalised at say £10bn will find it much harder to double than a minnow. While a significant find might push a major's share price up a few pennies, a junior will often turn into a multi-bagger many have already risen more than tenfold this year. Because of their size, juniors are also much more likely to be taken over. You can read about my favourite junior miners below.

The best bets in the sector

Small companies are under-researched, so you are more likely to find a hidden gem. An excellent example is Norseman Gold (LSE: NGL) in western Australia, in which I have an interest of more than 4%. It has A$35m of cash, no debt and a very attractive price/cash-flow ratio (PCF) of about a third of the average of its peer group. Norseman has a mill working at only 60% of capacity with plans to bring two further mines on stream during the next two years, which could increase production from 80,000 oz a year to an eventual 140,000 oz. This would result in a reduction in costs of A$100 per ounce A$14m a year. The higher production would also provide 75% more revenue. As Norseman already has such an attractive PCF this should bring about a significant rise in the share price.

Mistakes can be made with junior miners, so a spread is essential. I helped to found the Junior Mining Fund administered by Marlborough (tel: 0808-145 2501) and managed by Angelos Damaskos. It is investing 70% in gold, 10% in other precious metals, 10% in uranium and 10% in base metals. I have a 35% share in the management firm and a £3.5m stake in the fund.

Two further core holdings in the fund are Medusa (LSE: MML) and Centamin Egypt (LSE: CEY). Philippines-based Medusa has a very high-grade mine with enormous cash flow. The deposit is open to further discoveries and the company also has substantial copper deposits with hopes for Chinese involvement. Centamin is about to be listed on the main market and should then compare very favourably with other fully listed companies.

I find it reassuring that the American investor, John Paulson, who anticipated the credit crunch so well, has 13% of Centamin in his fund, which is heavily invested in quoted gold-mining stocks. I like the company of very savvy investors.

You can read more from Jim at www.jimslater.org.uk .