Over the past 10 years gold has rose over 6 times in value. Will it continue to soar in the long-run? More recently, gold has made a pull-back of almost 16%. Might gold continue to slide back down to sub-$1000 levels? Furthermore, how should an investor gain exposure to gold – and how much exposure is warranted?
These questions plague gold investors as they analyse macro-economic conditions around the globe. Considerations range from sovereign monetary policy, debt levels, inflation, consumer sentiment, and more. If you are wondering whether or not it is time to add gold to your portfolio, read on.
The Case for Gold
Gold is not your typical commodity – it is also used as an alternative source of money. The different types of individuals trading gold are as diverse as their reasons for doing so. What are some of the reasons why investors are still long-term bullish on gold?
When economies are crashing, gold has often been turned to as a safe-haven. During the 2007 – 09 crisis, gold popped from $700 to $1200US. The Safe Haven status enjoyed by gold can be somewhat temperamental as the year 2011 has proved. The problems in the Euro-zone are not immediately leading to higher gold prices. Why?
At the moment, the US dollar appears safer than the Euro. The AAA credit rating downgrade and inflationary measures of quantitative easing are quickly being forgotten from the Euro-zone sovereign debt fears. There is renewed interest in the US dollar as a safe haven. This has a double-whammy effect since some may sell gold to buy US dollars which further compounds the apparent loss of gold value since it is listed in US dollars. This has exacerbated the recent pull-back in gold prices.
What may further stimulate the price of gold looking forward? More quantitative easing from the US Federal Reserve would once again inflate US dollar values and drive up the price of gold. If the Euro-zone problems worsen, fear of fiat currency could reach new highs helping the safe haven status of gold. Jewelry demand in China remains high, and the other big buyer of gold, India, is showing signs of recovery from the 2007-2009 downturn.
Why Buy and How Much?
While investors may be long-term bullish on the price of gold, why should you buy when prices are near historical highs? Wouldn’t other investment products have a higher chance of producing superior returns? Possibly, but total dollar return is only one of the factors to consider when investing. Diversification and hedging are two other reasons to consider buying gold.
Diversification. The key to a portfolio with low volatility is diversification. True diversification exists when you have a variety of products that are not correlated to each other. This means that buying silver, gold and platinum is not a good method to diversify since these products are similar and will rise and fall together. Buying gold, bread, and a t-shirt for investment purposes would provide a smoother ride for your portfolio as the link between these three items is weak.
Gold has an interesting relationship with the S&P 500. It swings from positive to negative correlation, making gold a good product to diversify your portfolio with. If you have a long-term bullish view of gold, you should add some exposure to your equity portfolio to dampen volatility.
Hedging. Gold can also act as a hedge against currency risk. Since gold is a commodity, it should rise somewhat over time with inflation – although the relationship is not as linear as one would hope. If you have exposure to the US dollar in your portfolio, gold can act as a hedge. Speaking in general terms when the value of the US dollar goes up, gold drops, and vice versa.
So if you want to diversify your portfolio for fewer price swings, hedge against currency risk while still hoping to gain a long-term profit, gold may be the investment you are looking to acquire. But how much gold should you buy? The answer to that depends on your portfolio allocation. Analysts give a range of 5 – 10%. If you have more exposure to the American dollar, a higher amount for hedging purposes would be suitable. If you do not have currency risk, 5% may be adequate.
Which Gold Products Should I Buy?
While there are oodles of gold-based investments that you can buy, these typically fall into two broad categories: physical gold and gold mining companies. Should bet on the changing prices of the precious metal or invest in the company that explores, mines, and produces it?
There is a good argument for buying gold stocks at this time. The price of gold has rose an annualised 27% over the past 5 years (US) while the S&P ASX All Ordinaries Gold has only popped an annualized 10%. Why the difference? There are many considerations but one may be rooted in the belief that gold prices are unsustainable at this level. Once investors start to realise that high gold prices are here to stay, gold-based stocks should receive higher valuations. As well, much of the fundamental valuing of gold-based stocks by analysts was performed at lower gold prices. As these are revised upwards, the stock prices will look even cheaper.
Also, with wide profit margins due to the high price of gold, this could spur a revival of mines, exploration, and production in coming years. Higher profit margins can also lead to dividend increases which could further boost share price returns.
Which Stocks are Best?
For a massive market capitalisation stock with good value, Newcrest Mining (NCM) is an excellent starting point for investors looking for broad portfolio diversification. Sales have risen from under half a billion dollars in 2002 to over $4 billion in 2011. This is largely expected to jump somewhere between $5 and $7.7 billion by 2013. The next 5 years are expected to grow at a whopping 29.27% rate per year. If you compare this to the price-to-earnings ratio, the stock is grossly undervalued making it an attractive buy.
Ramelius Resources (RMS) is smaller exploration and gold producing company with roughly $400 million in market capitalisation. This growing company has a low cost of gold, less than $500 AU, which gives it a wide margin of profit. The Mt Magnet gold property should start producing by January 2012 with other new projects in the pipeline. Over the next two years this company has the aggressive prospects of virtually doubling their mining production. With extremely low debt and enough cash on hand to cover expansion, they are well positioned for growth with very low valuations based on earnings, sales, and cash flows.
The last pick is higher on the risk totem pole being a tiny gold exploration company. Gold Road Resources (GOR) has a small market cap of 120 million. The risk of buying a small exploration company is higher due to the potential for share dilution and a lack of mining ability which means no profit. They do have new high-grade gold discoveries, they have identified a new gold region of Yamarna, and are aggressively drilling for more opportunities. As prices have fallen from 80 cents down to 33 cents this year, it may be time to watch closely as support of 30 cents is near. 25 to 30 cents could make a good timely entry in this speculative stock pick.
Gold, Gold, Gold
Trying to drown out the noise from gold bulls and bears can be difficult. Some say that prices will fall sharply while others claim $8,000 per ounce is near as they climb down into their bunkers with shotguns and can openers. The truth is that gold provides a decent currency hedge, in addition to providing your portfolio with some much needed uncorrelated diversification. Lastly, the horizon for gold prices still looks overall bullish which should lift up the precious metal stock prices that have not kept pace.