Thursday, March 5, 2009

Are Gold Stocks Good Investments?

Are gold and silver mining stocks good investments today?
Owning physical gold is the single best way to invest in gold and benefit from increasing gold prices. But one way to diversify your gold investments is to own gold mining stocks, which are a solid investment. They have the reputation of being risky ventures that can collapse and make your investment evaporate, but that fear only has a basis if we're talking about junior exploration companies. These junior gold companies which have little or no gold discoveries yet can see their share price absolutely skyrocket when they do make a discovery, offering huge exponential returns. But these companies are also huge risks. When we look at the established major mining companies who already control extensive gold deposits, it is a different matter. It is those established players that I'm concerned with.

What are the pros and cons of major mining stocks?

One of the benefits of gold mining stocks is that they perform extremely well in deflationary environments, because the gold price rises during deflationary times but
the costs of the company's operations decrease due to deflation. Because of this diverging movement of costs and earnings, your return on investment can be much greater than on gold bullion. As the United States seems to be headed into a deflationary era, gold mining stocks will likely perform very well. Gold stocks
performed extremely well during the deflationary period of the 1930, also known as The Great Depression.

However, a drawback of investing in gold mining companies is that they may not perform as well as physical bullion during times of inflation. That is because even though the price of gold will certainly increase during times of inflation, the costs of production will inflate, and if the cost of production increases more sharply than the price of gold, profit margins will narrow. Such inflationary costs include the price of oil, but also other materials, labour, etc. In the case of a slow grinding inflation, the gold stock may underperform physical gold, but if the rate of inflation increases to the point that it worries investors into seeking a safe-haven, then the price of gold may rise sharply enough to make up for the increase in operation costs.

So gold mining stocks are a good bet in general, but an amazing catch in deflationary times. The key is to guess whether the US government and federal reserve's measures to inflate (AKA "stimulate") the economy will be successful. I tend to think they won't be, if we look to the 1930s as a model. When the US government threw piles of money into the economy, credit was still scarce and the economy still deflated. In fact, the extra money injection created more debt that
prolonged the deflation. This will quite likely be the case again. If this is the case, gold mining stocks will be the place to have your money.

Some industry insiders report that labour costs, at least in North America, have been falling in the gold mining industry, because of mine closures in the base metals industry, particulary copper mines. With an oversupply of laid-off mining workers, labour costs are coming down, increasing the profitability of mining companies. This is a deflationary sign. The price of copper is commonly viewed as an indicator of which direction the economy is going. With the price of copper having dropped drastically and copper mines shutting down, we know that the global economy is in the beginning of a deflationary period, which is resulting in less industrial demand for copper.

I personally don't own any individual gold stocks. I do, however, invest in the Blackrock World Gold A2 fund which consists of a basket of the top gold producers (around 70% of the fund's total), along with a certain amount of exposure to producers of the other main types of precious metals: silver and platinum (around 30% of the fund's total). I like this fund because it's diversified and thus limits the risks to individual companies or countries due to labor disputes, complications with environmental regulations, etc. So I can invest in the general movement of the gold mining industry. And even though this is an investment in companies, and not in gold itself, you can see from the comparison below that these companies' stock prices more or less follow the price of gold, at least its general trends. It's no match for the physical gold bullion that I'm holding in my hand, but it is a way to invest in precious metals inside my retirement fund, which currently does not have an option for physical gold.

This is a 5 year history of the Blackrock World Gold A2 fund.
Blackrock World Gold Fund A2 - diversified gold mining fund

And here's a 5 year history of gold spot prices.

5 year gold price chart, compared to gold mining stock prices above

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