Investing in Gold

Investing in gold means investing in a pure commodity '” an option rarely taken by most retail investors. But gold offers a very different prospect compared to "working" metals such as lead and zinc. The Australian gold market is one of the most advanced in the world: Investors can buy gold directly, through gold certificates or gold coins. There is also the option of managed funds that specialise in gold and financial instruments, such as futures, based on gold.

And then there is the mesmerising world of Australia's listed gold stocks. Only two of those '” Lihir and Newcrest '” are within the ASX200. However, thanks to the booming gold price over the past year, six gold stocks enjoy a market capitalisation of more than $1 billion and 13 stocks are capitalised at more than $400 million .

With the gold price running at its highest levels for more than 25 years, there is no doubt that gold '” and gold stocks '” are enjoying a bull run. But longer-term investors have invested in gold not for the prospect of a speculative gamble but as an asset allocation option. Gold has been proven over a long period to offer a "low-to-negative" correlation with mainstream investments such as the sharemarket. In many ways, gold is the original alternative investment acting in the way many hedge funds act today.

Gold experts unanimously predict a higher gold price in the near future. On January 11, Macquarie Bank, one of the most powerful players in the local commodities market, upgraded its mid-range forecasts for the average price of gold in 2006 from $US475 to $US565, suggesting the commodity would hit a peak of $US600 in the June quarter.

As Grant Craighead, a veteran gold analyst and director of Stock Resource, a specialist resources research house, suggests: "Nobody really knows how high the gold price will go; it's a lottery. There are so many variables, you can see a range of numbers. I've seen estimates as high as $US1,000 an ounce.

So how do you buy gold? The first option is to physically buy gold '” the commodity '” in its purest form. For retail investors, the most common point of entry is the West Australian Government-owned Perth Mint.

At the mint's website, it's possible to simply order an ounce of gold; it will cost you about $800. The mint sells gold coins and gold certificates where investors can buy and hold certificates representing ownership of gold. The minimum entry for gold certificates is $8,000; gold coins have a wide range of prices.

You can also buy a limited number of managed funds that specialise in gold; two are listed on the ASX, an index fund called Gold Bullion Securities and a hedge fund called GoldLink Income Plus. Like any other shares, these gold funds can be bought for a few hundred dollars at a time from any broker. Separately, there is the unlisted, open-ended gold-based managed fund Select Gold Fund.

The Gold Bullion Securities fund is a simple index fund that aims to perfectly match the gold price. It listed on the ASX in 2003.

To date the Gold Bullion fund has raised about $200 million, which it has used to purchase pure gold kept in a vault at the HSBC bank. "We have about 30% of our fund held by retail investors, they like the fact that we are a very direct connection with the gold price and we've got very low fees," says Gregory Burgess, Gold Bullion's company secretary.

For long-term investors looking for low fees, the management expense ratio (MER) at Gold Bullion Securities is 0.4%, compared to 1.5–3% at most managed funds.

GoldLink Income Plus is a more complex gold-based hedge fund that tries to make money from movements '” up or down '” in the gold price. Unlike the Bullion Fund, the Gold Link Fund has hedge fund style fees with an MER of 1.5% and performance fees on top of that, but it pays franked dividends. The GoldLink Income Plus fund has a market value of more than $100 million and it enjoyed an 80% increase in 2005. (To read a transcript of Michael Pascoe's interview with Richard Kovacs of the GoldLink fund, click here.)

The Select Gold Fund is an unlisted trust that returned 30% last year. Unlike the listed funds that do not have a minimum entry, there is a minimum entry level of $50,000.

Eureka Report believes that many investors will be best suited to either pure gold in the form of gold certificates or gold holdings through index funds, because the fees are very low and the funds will always mirror the commodity price of gold. Most retail investors, however, prefer to invest in the volatile '” and often exciting '” option of shares in gold mining companies. Long-term investors in the resources sector usually purchase stocks in widely diversified resource houses such as BHP Billiton and Rio Tinto.

Be aware: gold investing is something of a world of its own where different rules apply. The Australian gold sector has almost 100 stocks, the majority of which are gold exploration companies or companies that are underpinned by relatively insignificant assets such as a single mine.

Unless you wish to make an entirely speculative gamble, the most reliable way into gold shares will be through a large listed company with a market capitalisation of at least $200 million. This cut-off figure removes dozens of potential investments from your radar, but it also removes any companies that are much too risky for long-term investors seeking to hold gold an asset within a diversified portfolio, while seeking to enjoy some potential upside from the expected lift in gold prices due to continue at least through 2006.

Although the largest Australian gold miners have been in a splendid position to enjoy the rising gold price, unfortunately a range of management and production problems mixed with high shares prices means there are slim pickings for long-term value in the gold sector.

For example, Newcrest Mining, which released its quarterly results on Tuesday, there is the issue of high debt levels and a number of start-up ventures that may prove costly. However, Newcrest is often noted as Australia's top takeover target, so speculative investors will like this stock.

Lihir Gold, Newcrest's offsider in the ASX200 is a perennially disappointing company that is also open to political risk in Papua New Guinea. Market leader Oxiana is also heavily dependent on an offshore investment, in Laos, where the company's Sepron project is seen as offering strong potential. Unfortunately, much of that potential is already built into the share price. Similar issues dog virtually every single gold stock; there is no BHP Billiton of the gold sector; it is a punter's market.

As Grant Craighead at Stock Resource points out, many of the traditional factors used for valuing listed companies, such as price/earnings multiples are barely relevant with gold miners that often have exploration ventures that skew the figures. However, Craighead, a former gold analyst at Macquarie Bank, says one of the important indicators is net present value. He says the gold stock sector is trading at up to two times net present value; only five years ago, during the doldrums of the late 1990s, the sector was hovering below net present value: He warns: "It's a hot market right now, and its dominated by speculators."