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A little gold is portfolio insurance
Gold offers precious protection against market downturns and inflation, among other things. But don't hoard it -- prices can be unpredictable, and gold stocks are difficult to evaluate.
By Harry Domash
Whats up with gold?
Gold prices seemed stuck in a $260 to $290 per-ounce trading range for years, until January 2002, when it popped up to $300, and hasnt looked back much since. The last time I looked, gold was trading at around $360 per ounce.
Does it makes sense for individual investors to play the gold market, and if so, how?
No one knows for sure which way gold prices are headed, but many see it as a worthwhile hedge against negative events such as stock-market downturns, strong inflation or a weakening dollar. Demand for gold moves up in uncertain times because investors see it as a haven.
You probably dont need reminding that although last year was tough for the stock market (the S&P 500 ($INX) plummeted 23%), gold prices moved up 24%. (Thats not always the case; there have been years when both the market and gold prices moved in the same direction.)
The last time inflation ran wild was in the late 1970s and early 1980s, when interest rates approached 20%. As a result, gold prices soared, surpassing $800 an ounce in January 1980.
This year, gold prices were weak in the early going, touching a low of around $321 in April, down 7% from $346. Its recovered since then and is now trading around $360, up 4% for the year.
Prices are also affected by any hint of crisis; when the U.N. headquarters in Iraq was bombed, prices rose $3.
Since you cant predict such events, some experts advise holding a small percentage of your portfolio, say 5% or so, in gold or gold-related investments, as sort of an insurance policy.
Digging up gold stocks
If you have the bucks, you can invest in gold by buying gold bars or gold coins. However, many investors prefer gold-mining stocks. They are easier to buy, and most usually move in the same direction as gold prices.
Analyzing gold-mining stocks, however, can be daunting, so Im going to suggest some shortcuts. Why? Heres a rundown of factors you need to consider if you do your own analysis.- Gold reserves versus current production: Each mine has only a finite amount of gold to offer. Because gold miners take the easy shots first, production costs skyrocket when a mine nears depletion. So your first order of business is to get a read on how long a company can keep pulling gold out at a reasonable production cost.
- Profit margins: The cost to pull an ounce of gold out of a mine can range from the low $100 range to upwards of $250. Since gold sells for the same price, regardless of its production costs, mining-company profit margins vary widely.
- New resource pipeline: Because they are using up their current resources, gold-mining companies must continuously search out new gold fields. Despite that reality, some mining companies cut back on their exploration efforts when gold prices were stuck in the mid- to high-$200 range. Guess what? Now these companies are facing declining production because they dont have enough new resources coming online to replace depleted mines.
- New resource profit margins: You must forecast each new mines profit margins to estimate its impact on earnings.
- Hedging: Some mining companies employ hedging techniques to even out the effects of gold price changes. That is, they enter into contracts to sell gold at fixed prices at future dates. If they do it right, future gold price dips wont hurt their profits much. But its a double-edged sword, because hedging prevents them from enjoying the fruits of a strong upsurge in gold prices. You need to know how much of a companys future production is hedged to assess the effects of gold price swings on earnings.
Work smarter this time
You can find most of the data you need to do these analyses by scrutinizing each companys quarterly and annual SEC reports. But, at least in my view, this is one instance where it pays to work smarter, not harder. Here are two ideas.
First, gold stock analysts spend their days crunching these same numbers, and the results of their labors, in the form of analysts earnings-growth forecasts, are available for the asking. Your bottom line would be an earnings-growth forecast if you did all the work yourself, so it makes sense to use the analysts consensus forecasts.
As an alternative, because several mutual funds focus exclusively on gold-mining stocks, why not just buy one of those funds and let the fund manager do the heavy lifting?
Ill start with the first alternative, piggybacking on the analysts earnings-growth forecasts.
Checking out gold analysts forecasts
Yes, I know that some analysts have been caught doing bad things. Nevertheless, in my experience, analysts generally do a good job of forecasting earnings. Its mostly their buy/sell ratings that are found wanting.
Heres a simple screen you can run using MSN Moneys Deluxe Screener and the parameters used to identify worthwhile gold-mining candidates based on analysts growth forecasts.
Industry Name = Gold
MSN Moneys gold industry includes some mining companies that derive most of their profits from mining metals other than gold. These metals have different price-movement patterns than gold and wont provide the same event-hedging characteristics. Weed those non-gold plays out by clicking on each companys ticker symbol in the results list to see MSNs Company Description report. The report gives you enough information to determine if the companys revenues and profits come from gold mining.
EPS Growth Next 5-Years >= 10%
This is the bottom line. The companies with the highest expected growth would likely have the most to gain if gold prices move up further than expected. Even better, these companies will probably fare the best if gold prices falter.
EPS Growth Next Year >= 5%
This is a reality check. Analysts can be slow to change their 5-year forecasts when they become disenchanted with a stock. Requiring next years forecast EPS growth to be at least half the long-term forecast helps to eliminate stocks carrying unrealistic long-term forecasts.
Debt/Equity Ratio <= 0.5
The debt-to-equity ratio compares long-term debt to shareholders equity. The higher the ratio, the higher the debt. Interest rates already have moved up strongly and that trend will probably continue. In a rising interest-rate environment, high-debt companies are likely to experience higher-than-expected debt-servicing costs, which translate into negative earnings surprises.
Four worth their weight in earnings
My screen turned up six stocks, but I eliminated two: Alumina Limited (AWC, news, msgs) is not a gold-mining company, and Meridian Gold (MDG, news, msgs), despite its name, mines far more silver than gold.
Of the remaining candidates, Glamis Gold (GLG, news, msgs), a company operating primarily in California, topped the list in terms of earnings-growth forecasts. Glamis, with trailing 12-month (TTM) sales totaling only $85 million, is the smallest operator of the four. Analysts expect Glamis to grow earnings 40% annually, on average, over the next five years. Next year, theyre looking for 19% earnings growth.
AngloGold (AU, news, msgs), which is expected to grow earnings around 23% annually, was next in terms of forecasted long-term growth. The firm racked up TTM sales of $2 billion, making it the second-biggest player in the screen results. Although headquartered in South Africa, AngloGold also has operations in South America, Mali, Namibia, Tanzania and the United States.
Placer Dome (PDG, news, msgs), with $1.5 billion in sales, operates in the United States and a variety of other countries. Analysts expect Placer to grow earnings around 15% annually.
Newmont Mining (NEM, news, msgs), with $3 billion in sales, is the largest gold-mining operator on the globe. Although it operates in many countries, more than two-thirds of its production comes from the United States, Canada and Australia. Analysts peg Newmonts expected long-term annual earnings growth at 11%.
What glitters about gold mutual funds
Investing in mutual funds specializing in gold-mining stocks offers a couple of advantages over buying individual stocks. Besides sparing you the agony of figuring out each companys outlook, you get automatic diversification. Since most of these funds hold 50 or so mining stocks, its no big deal if one of the holdings tanks.
Morningstar lists two five-star-rated funds specializing in gold-mining stocks. One, Tocqueville Gold (TGLDX), is no-load. The other, First Eagle Gold (SGGDX), charges a 5% front load. You dont get much extra for the 5% charge. Tocqueville returned 26.71% annually, on average, over the past five years, compared to 22.29% for First Eagle.
Another no-load fund, American Century Global Gold Investors (BGEIX), returned 16.79% over the past five years, on average, and thus garnered only a three-star rating from Morningstar.
Some analysts see gold, fueled by forecasts of declining production and a weakening U.S. dollar, moving higher in coming months. Nevertheless, gold has historically been risky business and should be a small part of your portfolio.
At the time of publication, Harry Domash did not own or control positions in any of the stocks mentioned in this column.
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