Are gold stocks really gold?

published 14 December 2011

The fallout from MF Global's implosion is still working its way through the system. And newspapers are full of horror stories about the new credit crunch in Europe. All told, things are looking pretty bleak across the financial landscape.

This is all about deleveraging. Bankers are petrified about who they deal with. Once they put their money down, they may never see it again! That's why money's pouring into central banks' coffers.

You might think gold would be the order of the day. After all, gold is gold there are no paper promises here. But as we've discussed before, gold can easily get taken down along with the rest of the market. The problem is the gold price you see quoted in the paper is mostly based on a paper market in Chicago and that can prove incredibly volatile. If you're the type of person who keeps an eye on the gold price, you'll know it's been hit hard these past few days.

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The important thing to keep in mind is that gold can bounce back harder and stronger than just about anything during a financial calamity. So despite its recent weakness, I'd hold on tight to it now.

So where should you put your gold? As I've explained before, I like a diversified approach to gold: bullion, coins, ETFs and even spread betting.

And although it's not often considered, I think gold mining stocks could provide an element of safety here. In many ways a gold mining stock is like owning your own little piece of a great big gold vault. Okay, that vault may be in some far-flung country in Africa, Asia or South America. And the gold may be held within hundreds of thousands of tonnes of rock.

But those attributes may serve to protect' your investment from the financial system. Holding gold mining shares may prove more appealing than you might think.

Are gold stocks gold or equities?

One Right Side reader asked this question recently. And it's a great one. Can a stock a paper-based asset really be considered an investment in gold? Should a stock form part of your asset allocation to precious metals?

I would argue yes. If you think about it, a stock is owned in the same way as a house or a car. With both those assets you get a registration document. It's the same with a stock. Your registration' means that you own something tangible.

Your certificate is a lot more than just a piece of paper it's important! In fact, for many investors that I talk to, having proper certification means that they want the stock registered in their own name. Holding stocks in a pooled nominee' account with a stockbroker won't do. And I can see the logic in that.

I mean, if you're holding gold as financial catastrophe insurance, then it makes sense to consider what could happen if disaster strikes. If you're concerned, then ask your broker about taking possession of your own certificates or opening a personal Crest registration. If your broker goes bust, then a couple of simple steps now could save you a lot of bother down the line.

But which stocks should you go for?

They're not all as good as gold

When I talk about gold miners, I'm talking about the guys that are currently in production. I'm not talking about gold exploration companies. In terms of asset allocation, gold explorers would definitely sit in the speculative equities' class.

Unless the business has proven resources and the means of getting at them then you've not got gold. What you've actually got is more like a lottery ticket. So for now, I'm sticking to the big boys the ones which have gold in the ground and are producing it. And to my mind, the best way to do that is through the New York-quoted Market Vectors Gold Miners ETF (NYSE:GDX).

I first wrote about this fund back in October and since then it has come off from $59.50 to around $54 today. That's a fall of just under 10% in just six weeks.

It just goes to show that even though the bull-case for gold may strengthen, it doesn't mean the price of gold stocks will. After all, you're not just buying into a gold vault in the sand. You're buying a business that needs to extract and sell the stuff too. There are many variables at play here.

But as part of a diversified gold holding, I like it. It may not fully negate all counterparty risk, but with the stock registered to your name, there's some element of safety here.

And if the price of gold can get above $2,000 and stay there, I suspect many of these miners will start to look very cheap. Not just because they're sitting on a pot of gold, but because they're producing whopping profits with fat dividends. That should attract the attention of fund managers that have, up until now, been sceptical.

GDX five-year performance: 2006 (from inception 16 May) +7.2% | 2007 +14.83% | 2008 -26.07% | 2009 +36.39% | 2010 +33.02% | 2011 (to 13 November) 11.43%

An ETF's performance relies on the performance of the underlying investments.

This article is taken from the free investment email The Right side. Sign up to The Right Side here.

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Bengt graduated from Reading University in 1994 and followed up with a master's degree in business economics.

He started stock market investing at the age of 13, and this eventually led to a job in the City of London in 1995. He started on a bond desk at Cantor Fitzgerald and ended up running a desk at stockbroker's Cazenove.

Bengt left the City in 2000 to start up his own import and beauty products business which he still runs today.