The best way to profit from the gold bull

published 5 July 2006

It is appropriate in this conclusion to reappraise some of those fundamentals and at the same time consider the link between gold mining share prices and the yellow metal. In doing so, we can satisfy ourselves about the very good reasons for looking upon investments such as the Merrill Lynch Gold & General Fund, as remarkable long-term investment opportunities.

Investing in gold: why you should vote for gold

Overwhelmingly, the plight of the dollar and the scale of the US current account deficit will underpin the future gold price. The reasons for this are to be found in the words of George Bernard Shaw:

"You have to choose as a voter between trusting to the natural stability of gold and the natural stability and intelligence of the members of the government. And with due respect to these gentleman, I advise you as long as the capital system lasts, to vote for gold."

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Since January 2001, when gold was priced at about $250oz, its steady rise proves that growing numbers are voting for gold and it is inevitable that this should continue.

This dollar view is well supported by Paul Volcker, former Fed Chairman, who said a year or two ago: "We are consuming about 6% more than we are producing. What holds the world together is a massive flow of capital from abroad. It's what feeds our consumption binge. The United States economy is growing on the savings of the poor. A big adjustment will inevitably become necessary...we are skating on increasingly thin ice..."

To cap that the highly regarded Bill Gross, of Pimco, very recently said, "To be blunt, the dollar must go down".

Investing in gold: why the dollar must fall

The eventual resolution of the American current account deficit cannot be avoided. Its resolution is bound to include a dollar at much lower levels. Holders of dollars, such as central banks, particularly in oil-exporting countries (some of which are unfriendly to the US), and China and Japan, will seek to gradually diversify away from the US dollar. Part of that procedure will almost certainly be an increase in the percentage of gold held in their currency reserves.

There is evidence that this has started. The share of developing nations' foreign exchange reserves held in US dollars have, since 2001, fallen from 70% to 60%. Those central banks overweight US dollars are the ones who are most underweight gold bullion. China has 1% in gold bullion, Saudi Arabia 7% and Russia 9% - this compares to the developed world, where the US holds 58%, the Netherlands 87% and Switzerland 36%.

The logic is hard to dispute. The imbalances riddling the global economy are such that the dollar's decline is inevitable. As its decline develops, so the inevitable attractiveness of gold will become more apparent. It is for that reason that in spite of periodic setbacks we think it is certain that gold will rise much higher and in due course test $1,000oz.

Investing in gold: commodities are now seen as an investment class

Alongside the inevitable move from dollars to gold is the awakening of investment interest by institutional and private investors. Commodities, including gold, have now become an accepted asset class.

We see no lessening of that development, particularly because since the launch of Exchanged Traded Funds it is now so easy to own gold bullion without the problems of storage or insurance. Since their launch, 14.5 million ounces have moved into the ETFs, equivalent to 18% of annual mine production.

This is happening at a time of supply constraints, caused by the sharply lower exploration expenditure that occurred up to the late 1990s. It has only increased in the last two years. Couple that with skill and equipment shortages and it means a considerable time-lag before supply can meaningfully increase to soak up the growing demand.

The other additional source of supply is central bank sales. These continue at the rate of about 500,000 ounces per annum and may prove for those suffering deficits a tempting option. So far central banks sales have not subdued the market. The Bank of England poses no risk because Gordon Brown cleared out much of our gold reserves and in doing so set the low for gold bullion at $250oz.

Investing in gold: why gold mining shares will outperform gold

There is a gearing effect from owning the shares rather than the metals. According to Merrill Lynch, over the last five years gold bullion has risen by 146.5%, but their Gold funds have risen by 479.7%. It is relatively simple to extrapolate those figures forward and consider the potential benefit for holding gold mining shares if the gold bullion price is to rise to $1,000oz.

As we explain below, the price today for gold mining shares relative to gold bullion is extremely favourable and from here we would expect a protracted period of out-performance of shares versus the metal. Even if the gold price falls further, which it might, share prices should fall by less and once the gold price stabilises and starts to rise, the rise in share prices is likely to be very significant indeed.

As we have explained before, the long-term relationship between the shares and the metal is best measured by using a ratio calculated by dividing the gold price by the price of the Philadelphia Gold and Silver Index.

This ratio was very recently at five. It generally moves from five to three then back again. The last time the ratio was five was in May 2005. In the year that followed MLG&G rose by 100%.

MLG&G has recently retraced to a decent support (30 week moving average). Generally speaking in a long-term bull market retracements to the 30-week moving average happen repeatedly and represent a level at which we expect support and a return to growth.

Coincidently, the view recently expressed by Graham Birch, who runs MLG&G, is that gold mining companies' profitability in 2006 is likely to improve because previously rising costs should stabilise and that would mean that their margins will improve and therefore shareholder returns should move sharply higher.

At RHAM we are very comfortable to maintain core holdings in these investments which should, over the next few years, continue to deliver significantly above-average returns.

By John Robson & Andrew Selsby at RH Asset Management Limited, as published in the Onassis Newsletter, a fortnightly newsletter that gives insight into the investment markets.