Gold: why I like the mines better than the metal

I'm a pretty normal guy. I work hard. I have a young family who I enjoy spending time with. I like good food and watching rugby when I get a spare moment. But when it comes to investing, there are a lot of people who would say I'm a little unhinged. Six years ago, I made the decision to invest 50% of my life savings in gold. And not only gold, but a specific type of gold-mining stock that I've spent years researching.

That's a personal choice. It suits me, but it's not the way that everyone invests, and it certainly wouldn't suit all investors. Hedge-fund manager Hugh Hendry, for example, recently told The Economist that "there is no rationale for owning a gold-mining equity. It's as close as you get to insanity." That is quite a statement especially from someone who is a fan of gold itself, as Hendry is.

So what bothers him about miners? "The reason is the risk goes up when the gold prices go up... More precarious societies across the world are more envious of your gold assets, and there is no valuation argument against the risk of confiscation." I can understand that view. You take on serious risks when you invest in a gold mine. In August last year, Hugo Chavez took one look at the gold price and decided that the best way to bring stability to Venezuela was to nationalise its gold mining industry. "We have one of the largest reserves of gold in the world," Mr Chavez told state TV over the phone. "Let's convert it into our international reserves because gold is increasing in its value."

Chavez isn't the only head of state eyeing his nation's gold mines. For the last year, Canadian gold miner Centerra Gold has been locked in a battle with the government of Kyrgyzstan to retain control of its interest in the massive Kumtor gold field, near the Chinese border. The dispute started over an environmental issue. But it has since snowballed as ministers have repeatedly called for the government to seize control of a field, which contains an estimated 9.7 million ounces of gold. The dispute has sent the entire economy into a tailspin Kumtor accounted for 12% of Kyrgyzstan's GDP last year. But it doesn't even seem to matter to these politicians. They see the price of gold. They see the size of the mine. They realise they have a way to ensure their re-election.

So why go to all the trouble of owning a gold mine? Why invite the political, environmental and financial risks of getting gold out of the ground? Why not just buy some physical gold and store it in a bank vault? It would be a lot easier. And even more than that why have I staked 50% of my savings in gold-mining stocks? Is Hugh Hendry right? Have I gone insane?

I have not gone insane

Let me start by saying that I take the risks of investing in gold-mining stocks very seriously. As a man with a young family and a huge proportion of my savings in gold-mining stocks, I have to. Hendry is absolutely right to point to the risk of confiscation. That's why I only invest in countries where I believe the gold mine will be safe from greedy politicians. That is paramount. I wouldn't dream of investing in a gold mine in China or Venezuela or Kyrgyzstan. You do not want to be awake glued to Bloomberg at 3am when civil war breaks out in some remote part of the world.

So I have invested the bulk of my savings in miners who are listed and operating in Canada and Australia. As a country, Canada is backed by hard assets. It has timber, it has water, and it is fast emerging as a major oil exporter on the back of the tar sands. Its government has also managed to keep a leash on its financial sector. I can't see how it would ever be desperate enough to resort to stealing the country's reserves. Australia, meanwhile, leads the world in economically recoverable reserves of commodities from nickel to lead, uranium, gold, silver and copper. What's more, the Australian government owns all the mineral wealth in the territory of Australia. So it remains solvent.

The Australian economy will, of course, suffer if the Chinese economy crashes. And there are other significant risks. Gold miners have been suffering from higher costs and uncertainty over the gold price. If you've followed gold-mining stocks over the past few years, you'll know what I mean. When gold fell from its peak of $1,920 per ounce on 6 September 2011, many junior miners simply crumbled. It was a painful experience for those investing in gold explorers in particular. But I have made provisions for that by investing in what I call supply kings'. Let me just explain my rules for investing in gold-mining stocks.

Rule 1: Only invest in producers

I don't like to invest in gold explorers. There is too much risk. The lead time for getting gold out of the ground is too long for explorers to benefit from a rising gold prices. Producers have already found the gold, raised capital, built infrastructure and now are digging it out of the ground. I also like producers because they generate cash. That means that if capital markets dry up at the next stage of the financial crisis, these supply king' miners can self-finance and potentially pick up other miners on the cheap. So cash flow is key.

Rule 2: Find deeply undervalued opportunities

Too many investors pay over the odds for a decent gold producer. They invest in the biggest stocks. But that's crazy when there's currently such good value to be found in the gold-mining sector. I aim for nothing less than good double-digit gains from gold miners.

Rule 3: Look for exploration potential

Established miners have the know-how to turn prospects into cash. So they're the best type of organisation to solve the problems that come with prospecting for gold. That gives established miners with exploration interests the potential for explosive gains. My mantra when choosing a gold investment is that cash is king'. Gold explorers can make great discoveries and promise the earth but if they can't get the permits, build infrastructure in a remote region and raise capital, then the investment can disappear. I keep it simple and focus only on the companies who've already cleared these obstacles.

Why miners beat physical gold

But I also believe that investing in supply kings' is the best way to buy gold. The gold price has surged in the last year and I'll explain in a minute why I think it'll soon go to $2,500. But gold miners remain inexpensive relative to gold. That will change. As gold moves steadily higher, I believe that gold stocks will start to catch up. Take a look at the 30-year chart below. This shows courtesy of James Turk at GoldMoney the XAU Gold Mining Index (an index of 16 precious metal miners) measured in terms of gold, rather than dollars. As you can see, gold stocks have never before been this undervalued relative to the price of the metal they produce.

We may have had a 12-year bull market in gold, but measured in gold terms it's been accompanied by a 15-year bear market in mining shares. When this turns around, the potential upside could be extraordinary. Indeed, some of the supply kings I recommended in MoneyWeek a few months ago have risen strongly since then. In the box on page 26 I explain why they could go a lot higher from here.

But the key reason to invest in gold miners is to benefit from a rising gold price. So why do I think gold will keeping rising? I made the decision to invest heavily in gold in 2006. Back then, you didn't hear much about gold in the financial press or on the news. There were a few voices warning of a credit bubble. But the party was in full swing, and nobody wanted to hear it. We all know what happened next.

Gold has been on a remarkable journey since then. Today gold is taking its place at the heart of the financial system. The world's most successful investors and conservative institutions are loading up on the stuff we're talking about legendary investors such as Bill Gross, George Soros and John Paulson. Gross, the bond king' manager of the world's largest debt fund, recently said that only gold and real assets will thrive as central banks around the world print money.

Central bankers are feverishly stockpiling gold too. And the Bank for International Settlements the central bank' to the world's central banks is even considering making gold a tier 1 asset for commercial banks with a 100% weighting, rather than a tier 3 asset with a 50% risk weighting, as it is today. This would be a momentous change. It would mark official recognition that gold is real money. That recognition could send gold a great deal higher from here. I don't how high gold will go but I wouldn't be surprised to see it breach $2,500 in the next two years.

Let's just consider the base case here. We have money printing on a vast scale. We've had assurances that the European Central Bank (ECB) will do whatever it takes' to prevent the euro from collapse. Many European banks are still in dire trouble. So whatever it takes' could mean unlimited money printing'. As the eurozone disintegrates, expect billions upon billions of new euros from the ECB.

In Japan, Shinzo Abe, the probable next prime minister, has been calling loudly for aggressive monetary policy in Japan and a higher inflation target. If he gets his way the Bank of Japan will pursue unlimited' money printing. Ben Bernanke, meanwhile, has convinced the Federal Reserve board to go all in' the Fed is going to print $40bn every month, indefinitely. The first two batches of quantitative easing (QE) didn't work, so now we have QE infinity. The Fed has only one idea. And it isn't a good one.

Here in Britain, the economic establishment is simply falling apart. On 24 October, Sir Mervyn King warned about the limits of QE and dismissed the idea that the Bank of England would ever monetise Britain's national debt. A few weeks later, the Treasury grabbed £35bn in interest payments it paid the Bank monetising the debt in all but name. A few weeks after that, King announced that as the economy is slowing, he's considering more QE. In short, to a man with a hammer, everything looks like a nail.

Big investors are also falling for gold. In April of last year, the University of Texas announced that its endowment fund (the second-largest in the country after Harvard's) had bought a million dollars worth of physical gold. The gold market is tiny compared to the bond, real estate and equity markets. That means it's far more sensitive to money entering and leaving it. All the gold that's ever been mined is estimated to be worth about $8trn. Compared to the $100trn bond market, the gold market is tiny.

Finally, real interest rates (the interest rate minus the inflation rate) are negative and look set to stay that way. Gold does well under these conditions. Negative real interest rates show that inflation is destroying the value of cash faster than investment can replenish it. During gold's 20-year bear market in the 1980s and 1990s, the average real interest rate was around 4%. Real interest rates were negative only 5.9% of the time during that period. But during the gold bull market of the 1970s, real rates were negative for 54% of the time.

Since the current bull run began in 2000, real rates have been negative for 51% of the time. This is a perfect environment for gold. A combination of high leverage and money printing points towards negative real interest rates into the future. In the box on page 26 I point to some of my favourite supply kings' to buy now.

My four top gold supply kings'

I recommended three supply kings' in my last cover story for MoneyWeek.

First was Yamana Gold (TSX: YRI), which is up 24% since. Yamana has two major operations in Brazil. There is Chapada an open-pit gold and copper mine with 6.7 million ounces of gold and 2.4 million tonnes of copper. And there is Jacobina a complex of underground mines and a processing plant located in Bahia State, with two million ounces of gold. Yamana produces a great deal of cash. It has $1.4bn in available funds, including cash balances of $698.9m and unused credit facilities. This means it doesn't need to raise money for further exploration. In fact, the company grew its exploration budget for this year to $125m up 10%. Third-quarter results at the end of last month were encouraging. Production was at a record level of 310,490 gold equivalent ounces, an 11% rise on the same period a year ago. Costs were up 13.4% to $531 per ounce, but given where the gold price is that's no real concern. Similarly 2012 production guidance was slightly lowered, but that's factored into the price.

The company is building four new mines, so within 12 to 18 months there should be a surge in production, which I'd expect to take the stock to new highs. I would buy up to C$25. In terms of risk, the recent acquisition of Extorre puts Yamana in Argentina. But I'm not concerned as this is a small part of overall production. And the local government will receive a royalty on all production at Cerro Moro, so they'll need to see the mine start producing before they think of stealing anything.

Silver Lake Resources (ASX: SLR) is up 19% since I tipped it. Silver Lake is a gold producer and explorer with a resource base in highly prospective regions, such as Mount Monger and the Murchison goldfields of western Australia. It produces a nice amount of cash, and looks very cheap.

The big news recently for Silver Lake was its merger, via a scheme of arrangement with Integra Mining. This has created a major Australian gold producer with a 6.6 million ounce resource base (including 1.8 million ounces of ore reserves), current production of 200,000 ounces a year, and forecast annual production of 400,000 ounces in 2014. Both stocks have benefited from the merger as there are real benefits to these firms combining, given the proximity of operating mines and mills. It also gives Integra access to Silver Lake's underground mining expertise. The stock is worth holding.

Franco Nevada Corp (TSX: FNV) is up 28% since June. It is a hugely profitable gold-focused royalty and streaming company with interests in platinum group metals. Third-quarter numbers announced In November saw net income leap for the nine month period jump from US$98.6m to US$135.7m. Again, this is a hold.

I have one new recommendation for you: Osisko Mining (TSX: OSK). Osisko's flagship project is the Canadian Malartic gold mine located in the Abitibi mining district. This currently represents the single biggest gold reserve in production in Canada, with proven and probable reserves of 10.7 million ounces of gold, and growing.

The firm is also exploring on a number of properties, including the Hammond Reef Gold Project in Northern Ontario. This hosts an inferred resource of 10.5 million ounces of gold, providing Osisko with the potential to become a one million ounce a year gold producer by 2016. Osisko produces a serious amount of cash. The company is expected to grow its cash pile from C$206m in 2012 to C$1.5bn by 2016. And it's at least 50% undervalued in my opinion.

In terms of risks, I'd draw your attention the fact that although Hammond Reef has huge inferred resources, the average grade is significantly lower than at Canadian Malartic at 0.62g/t versus 0.99g/t.Although this is clearly a commercial grade, especially at these gold prices, should there be a marked deterioration in the gold price below around C$1100 and a reduction in this grade following further analysis, then the viability of this project may have to be re-evaluated. I would buy up to C$14.50.

Simon Popple writes the Metals & Miners newsletter .