Going For The Gold: How Fund Managers And Investors Play The Asset Class

Feb 10 2011 | 11:42am ET

When it comes to protecting wealth, it seems there’s nothing quite as good as gold. Little wonder then, given the state of global finances over the past two years, that gold prices have touched record highs.

“People are concerned about the long-term value of the dollar or the euro,” says Olivier Garret, CEO of the investment research firm Casey Research. “More and more, people are looking at shifting into gold, not as investment but as protection against devaluation.”

Casey Research is bullish on gold, and that’s true despite the metal’s lackluster performance in January 2011.

“If the price of gold were a patient,” said Garret, “my diagnosis would be ‘normal.’”

Garret says gold was up 30% in 2010 and 18.5% since its low on July 23, 2010, so “a pullback here is perfectly normal and even expected.” Seasonally, he says, gold usually hits its annual low in January or February. Fundamentally, he sees no sign the gold bull market is over:

“Debt is still rising, sovereign debt risks haven’t disappeared, governments are still printing money, politicians are still spending more money than they make, real interest rates are still negative, the dollar problems are far from over, inflation isn’t high yet, gold supply is tight, demand is unrelenting (especially for the physical metal), production is flat in spite of much higher metal prices, economic woes (bank closures, unemployment, etc) aren’t going away, and I still don’t trust Iran and North Korea.”

All of this is “unfortunately positive” for the price of gold, says Garret. “I say unfortunately because there is more pain ahead, much more inflation ahead, and this is the role where gold serves its ultimate purpose. A structural change is almost certainly needed in our monetary and political systems—and gold is the best protection in that transition.”

To understand the pain ahead, it helps to consider the pain in the recent past.

Crisis Mode

In responding to the 2007/2008 crisis, says Garret, governments in both the U.S. and Europe took the problem of “too much private debt” and shifted it from individuals and private companies onto their own books.

 “In the process of trying to prop up the economy they have added a lot more to that debt,” says Garret, with the result that there is a “huge potential sovereign debt crisis looming, certainly in Europe also in the U.S.—serious issues with states unable to support debt loads, serious signs of default by states and municipalities.”

The response of U.S. and European governments to the crisis (QE2 and similar packages in Europe) shows the governments of developed countries will “do whatever it will take to avoid deflation and they will print whatever it will take” says Garret. “We anticipate that QE2 is going to go from $600 billion to $1 trillion because it won’t stop in June, and if there is a crisis in a state like California, there will probably be a QE3… therefore, we anticipate that instead of a deflationary period we will have an acceleration of inflation.”

Rising inflation will erode the real purchasing power of the dollar, and investors will turn to gold to protect themselves against devaluation. But supplies of gold are limited, both in absolute terms and due to underproduction in the sector (as gold prices fell in the ‘80s and ‘90s, many mines were left undeveloped) and the combination of increasing demand and limited supply could result in “explosive” price growth.

“So we definitely have a very challenging situation and that’s why we like gold. We’ve never been gold bugs but 10 years ago we saw that it was very undervalued; now, because of what happened in 2008…we like it as a hedge against future inflation which we see as absolutely impossible to avoid.”

So You Want to Buy Some Gold?

Assuming Garret’s arguments have convinced you (or maybe you’re a ‘gold bug’ from way back) you may want to buy some gold for yourself. There are a number of ways to do it—and Garret agreed to walk us through some of them.

Bullion (Bars and Coins)

“The advantage of gold bullion is that you have physical possession, you have something that is tangible, it is not someone else’s liability, it is a real asset,” says Garret.

The disadvantage? You have physical possession, which means you have to store it and it could be threatened by theft or fire. If you do store it in a vault in Switzerland (or an undisclosed warehouse in Queens, New York, if you’re David Einhorn of Greenlight Capital) it will cost you.

“At a time when gold is increasing fast in value, not too big a problem,” says Garret. “When you get into situation like in the ‘80s and ‘90s when gold is stagnant or declining, the 1% or 2% per year storage cost eats into your profit.”

Other times, buying bullion can be difficult: “In the fall of 2008, if you wanted to buy bullion, you had to place the order pay for it, get a receipt, and then only take delivery three or four months after you bought it,” says Garret.

Exchange-Traded Funds

The advantage of gold ETFs is that they are tradable—you can “buy and sell from computer any time,” says Garret—and the carrying costs and charges associated with them are very low.

The disadvantage is that you must “depend on [an] organization and decide whether they truly own the gold they say they own,” he says. “There’s still some risk associated with fact that you own paper assets redeemable in gold.”

Casey Research recommends both: ETFs, if investors want to speculate on the price of gold; physical gold if they want a percentage of their assets in gold.

Unallocated Storage

This means you buy gold but don’t take physical delivery. Your supplier stores 400-ounce bars and you own a percentage of the total. “To take delivery of say, 10 ounces,” says Garret, “You can take coins or small bars and pay a manufacturing charge.” This method is halfway between owning physical gold and owning paper assets—you own title to gold but it’s not allocated to you.

Mining Stocks

Buying stock in a gold mining company, says Garret, you can “buy many ounces of gold in the ground—the reserves of the mining stock—at a much lower price.”

If gold prices rise and extraction costs remain constant, the companies’ margins increase. But “if gold declines, it works the other way around—it’s the same idea as financial leverage, if you invest on the margin you get a bigger kick on the upside but obviously you can get hammered much more on the downside.”

But Casey Research is currently confident that mining stocks are “a great place to invest money,” says Garret. “We are very bullish on mining stocks because we anticipate gold prices will continue to rise over the next five years.”

Exploration Stocks

“If you want the ultimate leverage, you go after exploration stocks—those are companies looking at properties that have potential to become mines but at this point they are not proven.”

But beware: Once you get into exploration stocks, says Garret, “98% of the companies are worthless.”

“The saying in the industry is that when you buy an exploration company you buy a ‘moose pasture’—basically, somewhere in the Yukon you buy mining rights on hundreds of thousands of acres of land and most of it is worthless and really what you’re buying is the expertise of the team that is going to conduct that research.”

Screening exploration companies requires in-depth industry knowledge, and Garret says that’s where Casey Research comes in. “Fortunately, it’s a relatively small industry and we have, for many years now, really cornered it.”

Exploration companies are generally small-cap ($10 million to $100 million) and their stocks are highly volatile. A couple of good drill holes, says Garret, can drive stocks from 10 or 15 cents to $5 or $10 in weeks. That volatility has proved the downfall of some would-be investors:

“[In] 2006/2007 we saw some funds coming into this sector, investing not only in mining but also exploration stocks, and they had no idea of the volatility and lost a lot of money…Some of those stocks, during the fall of 2008, did not trade one share for three weeks, not one share... Then on good news, like right now, when the market is very bullish, you could have the same stocks that would trade 1 million shares in a day.”

Exploration stocks, he says, are not for everybody, the sector is volatile but it can provide extraordinary returns to those who know how to manage the risks.

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