Today I’d like to talk to you about gold. Because despite the worsening situation in Europe, gold has been decidedly downbeat since last summer’s dash to $1,920. And I suspect that many people are beginning to lose interest.
I think that is a huge mistake.
Recently gold has broken out of its short-term trading range and there are some big buyers appearing on the scene. Hedge fund managers George Soros and John Paulson have both recently upped their exposure to old yella.
But perhaps more importantly, China has adopted a more aggressive stance towards the yellow stuff. Two Chinese state owned companies have been circling London-listed African Barrick Gold. And I think that’s an important development.
Today I’ll explain why and how you could profit from it.
China has a cash problem
On Monday we looked at the UK's national balance sheet. We saw that practically all our wealth resides in property – most of it on our green and pleasant isles. When it comes to productive assets, we have precious few to speak of.
Now, emerging-market countries may have little wealth. But they have something much better, and that is the means of creating wealth. Even as the global economy turns down, countries like China are still raking in dollars from international trade. In fact, one of their biggest problems is finding a safe place to stash their spoils.
Where are they going to stash that wealth?
Well it won’t be in Western currencies. Chinese officials are painfully aware of what we, in the West, are doing to our currencies. Their appetite for US Treasury bills is waning too.
But gold? Well they can’t get enough of it. They recognise something that we pointed out on Monday – gold is the only financial asset without a liability attached. It’s not dependent on any vacuous promises made by Western politicians.
The trouble is that the gold market is small. China can’t simply buy the stuff in the market because the price would fly and they’d soon find themselves priced out.
So China has to find another way of satisfying its voracious appetite for gold. And the way they’ve done that is by mining the stuff. According to Grant Sporre of Deutsche Bank “China is currently the largest producer of gold at 11.9 million ounces in 2011...”
Not only do they mine a lot of gold, they also keep a tight hold of it once it’s out of the ground. But they’re not content. That’s why they’ve been sniffing around looking to buy more mine capacity overseas. That brings us to Africa…
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Buying miners could be a great business
China has the biggest currency reserves in the world, but their gold holdings are pretty insignificant. According to the World Gold Council (2010 figures), the EU has nearly 16,000 tonnes; the US over 8,000 tonnes, while China has a trifling 1,000 tonnes. China needs to catch up.
They can do that by buying mines. By doing that, they'll also avoid bidding up the price of gold. And that’s a fantastic benefit for China. If they can lock into African gold in the ground at today’s prices, all they need to do is get the stuff out of the ground and they could be building their gold holdings for years to come.
I’ve previously argued that the gold miners are cheap. Today, most of the large miners are trading on earnings multiples in the low teens. I’ve not seen them this cheap before.
So what’s the best way into gold?
I’m often asked this question.
And it’s a tough question to answer. There are loads of things to consider. If you’re in it to diversify your pot away from the financial system, then undoubtedly physical possession of coins or bars can’t be beaten – providing you’ve got somewhere safe to stash it, that is.
Any other holding introduces counter-party risk. It may be that this risk is small – for instance, allocated gold (where your name is registered against physical gold) in theory is just like holding physical. Many exchange-traded funds (ETFs) also claim to hold physical gold – and serious players like hedge fund managers George Soros and John Paulson have recently upped their stakes in popular US gold ETFs.
I hold the popular UK-listed ETSF physical gold (LON:PHAU) . In the words of the provider, “PHAU is backed by physical allocated gold held by HSBC Bank USA (the custodian). Only metal that conforms with the London Bullion Market Association's (LBMA) rules for Good Delivery can be accepted by the custodian. Each physical bar is segregated, individually identified and allocated.”
Gold miners look seriously cheap
In many ways ETFs take much of the hassle out of owning physical gold. But there are other considerations. Considerations like squeezing a return out of gold. Because it’s true, gold pays no interest and no dividend.
But many gold miners do. And to my mind the miners are cheap at the moment. In a rising gold market (which I expect to see again very soon), the miners can rise faster. That’s because they’ve got ‘operational gearing’... so long as their production costs rise by less than the gold price increase, they can produce leveraged returns on the gold price.
But bear in mind, though the miners can do better than the bullion price they can certainly do worse too. I’ve had my fingers burned on the miners over the past year. Though they looked cheap, they got even cheaper.
But recently the tide seems to have turned. I’ve been talking to Simon Popple, who has started writing about gold miners for MoneyWeek. He has some very interesting ideas about exactly what gold miners will profit from the rise in gold. Simon is launching a newsletter very soon. But you can get a taste of what he has in mind in his recent cover story: Gold still looks good – but miners look even better.
No doubt, the aggressive Chinese stance will also helped lift sentiment on the sector. And remember, if the deal goes through to buy African Barrick, it’ll likely mean that its production will now head to China. That means less supply for everyone else.
I’d say things are looking up for gold. And gold miners could be just the ticket.
I’ll keep us tuned into this great story in the weeks ahead.
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