Gold Stock Investing 101

By: Adam Hamilton | Fri, Jun 7, 2002
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Last week, in my introduction essay to this Gold Investing 101 series, we discussed several important topics for all new gold investors to consider. These key foundational areas included the core strategic supply and demand fundamental reasons to consider gold investing at this moment in history, the difference between investment and speculation, and how to invest in physical gold itself.

I am writing these 101-series essays specifically for investors and speculators who are interested in entering the gold market for the first time but don't quite know where to begin. Gold, like every other investment sector, can be quite complex and my hope is that perhaps I can distill down some of the foundational basics to give new gold investors some prudent points of embarkation for their own fascinating journeys of gold discovery.

As I mentioned last week, the first time you are blessed with the opportunity to hold actual real gold coins in your own two hands will change your life. Physical gold has been the solid monetary foundation of trade, commerce, and sustainable economic booms for almost all of human history. Once you buy your first gold coins, you immediately begin to understand the timeless allure of the Ancient Metal of Kings down through the ages. We humans seem to be psychologically hardwired to have vast reverence for the warm yellow metal.

Once you have established a core position in gold itself, however, you may wish to consider deploying some capital in the wonderful world of gold stocks. A gold stock is simply a publicly-traded company, just like any other stock you can buy or sell in the open markets, that primarily engages in the fascinating business of chiseling gold out of the belly of the earth.

While I explained last week how incredibly easy it is to buy physical gold coins around the world, buying gold stocks is even easier in some ways if you already have a brokerage account. Once you have done your own due diligence and are ready to deploy capital, all you have to do is fire off a buy order to your broker and a few minutes later you will be the proud new owner of a real-life honest-to-goodness gold mine!

Remember that popular idiom that describes any lucrative venture as a "gold mine"? You can own the real thing! Gold mines have produced legendary and almost unfathomable wealth throughout six millennia of history, and they will continue to be fantastically rewarding in the future.

Before we begin, I would like to briefly review the Gold Investing 101 Portfolio from last week. Please recall that this portfolio is not for 100% of your total investment capital, only for the fraction of that 100% which you choose to deploy into gold-related investments after doing your own due diligence. The higher up the face of the pyramid you climb, the higher are both the risk and potential rewards of any given gold-related investment or speculation. This week we are discussing the giant yellow heart of the pyramid built on top of the green foundation of physical gold.

Gold Investing 101 Portfolio

Within the yellow core of the pyramid devoted to gold stocks, it is absolutely crucial to remember to remain diversified. Owning only one single gold stock is foolish and an invitation to financial disaster. I could write a whole other essay just detailing seemingly out-of-the-blue calamities that destroyed the stock prices of various individual gold mines over the years. A prudent gold stock portfolio is well diversified within the gold sector, with quality gold mines spanning the globe.

Investors can never afford to forget the timeless wisdom of ancient Israeli King Solomon, a man who had an unimaginable amount of gold, wealth, and power. His message is still immensely important even three millennia after he uttered it…

"Cast your bread upon the waters, for you will find it after many days. Give a portion to seven, or even to eight, for you know not what disaster may happen on earth." Ecclesiastes 11:1-2, King Solomon, ca 1000 BC

Gold mining is a risky business in many ways, and unlike physical gold coins you own, individual gold stocks can certainly plunge to zero in worst-case scenarios just like the tech darlings from the NASDAQ bubble days. Prudent diversification within your gold stock portfolio is absolutely essential because we are all mere mortals and no one can predict the future.

I would like to discuss what are, in my opinion, the two most important strategic concepts for all gold stock investors to fully understand, leverage and hedging.

A Tale of Two Gold Mines

First, let's embark upon a thought exercise!

Imagine that I told you about two gold mines, both well-managed, both unhedged, and both with equal annual gold production within the same political jurisdiction. The only real financial difference between our two mines is how much it costs them to extract each ounce of gold from the bowels of the earth. We will call these two almost-equal fictional companies LowCost and HighCost.

LowCost employs newer mining technology called heap leaching. It digs open-pit mines, blasting vast amounts of raw rock out of the earth. The broken rock, known as ore, is hauled to and dumped into a crusher at a mill, which pulverizes it into even smaller rocks. The fine rocks are then further processed and ultimately dumped on top of a giant impermeable pad and a weak cyanide solution is sprayed on top of the broken ore pile. The solution leaches down through the rock fragments and actually dissolves gold particles on its way through. The gold-laden solution is then collected at the bottom of the pad, processed, and the valuable gold is removed.

The relatively new technology of heap leaching is very cost effective. Some modern operations can recover 85% of the gold present in ore rock, an amazing level of efficiency. Because of its open-pit mining and cyanide recovery, LowCost can produce an ounce of gold for only US$150 per ounce.

(If, like me, you would have trouble telling the difference between an igneous rock and rock-band Incubus, the best short layman's guide I have ever seen on mining was published by The Northern Miner. The book by James Whyte is called "Mining Explained" and is well worth getting your hands on if you are interested in the technical side of mining outlined so normal non-engineer non-geologist types, the vast majority of investors, can understand it.)

On the other hand, our second company is called HighCost. HighCost uses more traditional methods of gold mining. Rather than digging large open pits with colossal heavy machinery, HighCost delicately carves shafts out of the rock with surgical precision to follow rich gold veins, rock high in embedded gold. Because of the complex logistics, high risk, and life-support involved (such as pumping in cool air, pumping out gases and water), shaft mining is generally much more expensive than open-pit mining. The deeper into the earth one digs, the more expensive operations become. HighCost, primarily because it is digging deep for gold, can produce an ounce of gold for US$270 per ounce.

Adding in one more crucial datapoint for our little model, let's assume the Ancient Metal of Kings is trading in world markets at around $275 per ounce.

LowCost can mine gold for $150 per ounce and sell it for $275 on the open market, netting an impressive $125 per ounce profit. Our friends at HighCost, on the other hand, can liberate an ounce of gold from the earth for $270, yet they are still only able to sell it at the market price of $275. HighCost is only scraping by with $5 per ounce profits at $275 gold!

Disregarding the differences in their mining strategies and technical methodologies, which company do you intuitively think is a better investment if gold is expected to rally from $275 to $350? Would you rather own LowCost, already raking in the dough at $275 gold, or HighCost, struggling to show a profit?

Leverage, the Holy Grail of Gold Stock Investing

Ultimately, the only logical reason to invest in gold stocks is if you believe, after you have done your own due diligence and research, that the gold price is going higher. If you arrive at the conclusion that gold is heading lower, you are better off not owning any gold stocks. Gold stock investing ultimately boils down to a bet for higher gold prices.

As the gold price runs higher, a crucial concept known as "operating leverage" or "accounting leverage" kicks in. Leverage, in my opinion, is the single most important concept to understand when investing in any stock of any commodity-producing company. I don't believe it is possible to be a successful gold stock investor reaping legendary profits in a major gold rally unless one fully understands the key idea of leverage.

Before we dig into leverage, a brief digression is in order.

In the stock markets, there is nothing more important to long-term stock prices than corporate earnings. The only reason equity investors are willing to shoulder the considerable risks of investing in stocks is because, in turn for their capital and risk, they are offered a fractional share of future earnings spun off by a corporation. A company's earnings are the ultimate driver of its long-term stock price. While a given stock's price can certainly be buffeted short-term by the powerful investor emotions of greed and fear, it always eventually regresses back to some reasonable multiple of the underlying company's earnings. Earnings are everything!

In gold stocks, leverage is so immensely powerful because it directly multiplies corporate earnings which ultimately drive gold stock prices over the long-run.

In terms of our thought exercise above, the difference in leverage between LowCost and HighCost totally alters the optimal investment strategy. Without knowledge of leverage, most investors would probably intuitively choose to deploy capital in LowCost because it was the most profitable at $275 gold. When leverage enters the picture in a gold bull market, however, the tables are turned dramatically.

Our first graph this week illustrates gold stock leverage, using LowCost and HighCost as models. The red lines apply to LowCost, the blue lines apply to HighCost, and the yellow line is gold itself. The X-axis at the bottom of the graph shows the gold price between $275 and $350 per ounce. The left axis of the graph outlines the actual dollar-per-ounce profits that both LowCost and HighCost can earn at various gold prices. The dashed lines are profit lines tied to this left profits axis. The right axis, to which the solid lines belong, is the percentage gains in profits and the gold price.

Gold Stock Leverage Illustrated

LowCost can produce gold at $150, HighCost at $270, and the gold price is rising 27% from $275 to $350. Which company benefits more and has the highest potential investment returns in this gold rally environment?

Each $5 increase in the gold price translates into the same $5 per ounce profit increase for both LowCost and HighCost. This is evident in the graph above with the two dashed profit lines for each company, which are exactly parallel. The magic of leverage enters the picture because each company is coming from vastly different base levels of profits.

LowCost could sell gold for a $125 profit at $275 gold, very impressive. As gold rallies up to $350, it still costs LowCost the same $150 to produce an ounce of gold, but it can now sell it at $350 for a $200 per ounce profit.  LowCost, with only a 27% increase in the global price of gold, was able to see its profits per ounce increase 60% from $125 to $200. Therefore it follows that eventually the market should factor in the new higher profits to LowCost's stock price which, ceteris paribus, should also ultimately see a 60% rally.

HighCost on the other hand, while struggling with tiny $5 per ounce profits at $275 gold, witnesses an enormous explosion in total profits as gold rallies 27% to $350. HighCosts's costs remain constant at $270 per ounce, but its profits explode by 16 times from $5 to $80 per ounce, a massive 1500% gain! Because earnings ultimately drive stock prices, the market will factor in HighCost's glorious new profit picture and, given a constant earnings multiple, HighCost's stock price will eventually rally by 1500% as gold stock investors bid on it.

The exact same modest $75 rally in gold that added 60% to LowCost's bottom line was like manna from heaven for HighCost, driving its huge 1500% bottom-line profit gain. By deploying capital in LowCost an investor could have reaped a 60% gain from a 27% gold rally, not too bad. But, by instead deploying capital in HighCost, the same 27% gold rally could yield a monstrous 1500% windfall for its shareholders.

Behold the power of leverage!

Now please realize that leverage is certainly not the only important factor in selecting gold stocks. If a company has high costs, it may have serious problems that should best be avoided. High-cost stocks must be carefully investigated before deploying capital in them. High-cost gold mines are often marginal producers and are much riskier investments than low-cost producers.

Leverage is very important to consider, but investment decisions should never be made based solely on it. Nevertheless, the greatest gold stock gains are inevitably born from the gold stocks with the highest leverages.

Lost Leverage Regained

The primary problem with gold stock leverage is that it decreases as the gold price runs higher. Have no fear if you are new to gold investing and are concerned you missed the amazing leverage from $275 gold!

Using our example above, HighCost's leverage from $275 to $350 gold ($5 to $80 profits, +1500%) is vastly higher than its leverage from $350 to $425 gold ($80 to $155 profits, +94%). Thankfully, existing companies do have ways to regain some of their lost leverage throughout a gold rally. The most common way is by placing higher-cost mines into production.

Most gold mining companies have a whole portfolio of separate mine properties. Because of the vast local variations in the way the Earth's crust formed, some gold is much more expensive to extract than other gold, sometimes even within the same physical mine. As the gold price runs higher, gold mines can begin mining higher-cost ore. For example, after gold has already run to $350, once a given gold mine's management is reasonably convinced that the gold price will stay at least that high for a few years into the future, they can begin digging and processing additional gold ore that costs $340 per ounce to produce.

With a small $10 profit on that particular ore body, new operating leverage is gained that did not exist before at lower gold prices. This new leverage is diluted across all the rest of the other low-cost gold a given company already produces, but it can still be powerful. Other ways also exist to regain gold leverage, including buying other high-cost gold mines and exploring for new more difficult to extract gold ore bodies.

Gold stock leverage, even though most powerful and potent at the beginning of a gold run, can be found throughout an entire gold bull cycle if an investor looks carefully.

Hedging, the Scourge of Gold Stock Investing

After leverage, all gold stock investors must understand hedging.

Hedging, in the gold stock world, has evolved into something more closely resembling pure speculation as retired Swiss banker Ferdinand Lips documents in his awesome new book "Gold Wars". A good thing in theory has been transformed today into a nightmare of a mess for some gold mining companies.

Gold hedging, in its most basic sense, is simply the contractually locking-in of a price today to be paid later in the future when gold is actually produced. A hedging gold mine makes private deals with bankers to sell the gold it will mine in the future at a fixed price regardless of whether the actual gold price in the future turns out to be higher or lower than the agreed upon contractual price.

Originally, gold hedging was the legitimate pursuit by gold mine managers of protecting a small portion of their cashflows to ensure their operations would survive without interruption if there was an unforeseen gold price drop.  By hedging on the order of 10% of their total annual production, gold mines could ensure in a worst-case scenario that they would have sufficient cashflows to pay operating expenses through lean times.

Unfortunately today, gold hedging has ballooned far beyond a legitimate business practice and far beyond speculation into naked Vegas-style gambling. A speculator is someone who takes large risks to make a bet on a future price in the hopes of large rewards. Speculation is ultimately little more than professional gambling.

Wall Street bankers chasing fat profits for themselves, gold stock shareholders be damned, have seduced most of today's hedger gold companies into making enormous bets that the gold price is going to fall forever. What lunacy! No price moves in one direction forever! Yet some of today's major gold mines hedge an incredible 300%+ (multi-years) of their total annual gold production, a stupendously large bet!

While a 10% of annual production hedge may be a legitimate business transaction, a 300%+ of annual production hedge is nothing more than pure gambling. I call any gold mine that in total has the equivalent of over 100% of its annual production hedged a "mega-hedger". All gold stock investors should avoid the mega-hedgers like the Black Death! Hedging kills profits and robs shareholders. It is exceedingly dangerous and yet remains widely practiced today.

Hedging is such a huge problem because hedging kills leverage. Using our HighCost example from above, imagine if HighCost's management had sold 100% of its future gold through hedges at a fixed price of $300 per ounce when gold was only $275.

Initially, the hedging may have looked intelligent, because HighCost locked in future gold prices higher than today's. But, as gold begins to rally, massive problems arise. When gold crosses $300, HighCost's profits can no longer rise because it has a private deal with bankers to sell its gold at a contractually-fixed $300 price. At $350 gold, each HighCost ounce of gold mined carries a huge $50 opportunity cost. HighCost can only sell an ounce of gold at $300 per its hedging contracts, but the market price of gold is $50 higher.

If HighCost was aggressively hedging, its shareholders' profits will be slashed by 2/3 using our example above! Instead of HighCost's profits and stock price soaring up by 1500% in a 27% gold rally, they would top off at 500% regardless of how high gold runs. Investors begin hemorrhaging potential returns they are entitled to at the $300 hedge price. All profits after that are effectively stolen from shareholders and handed to bankers. The higher the gold price goes, the worse the situation becomes for hedged gold mines. Shareholder losses begin to grow exponentially as the gold price marches higher.

The glorious gold mine leverage described up above is effectively assassinated by gold mine managers who stoop to aggressive "hedging" (read gambling) practices.

Amazingly enough, if gold mines are particularly aggressive hedgers a rapid spike in the price of gold can actually push them into bankruptcy! There is something very wrong with a gold mine if higher gold prices, which should help it, actually prove lethal due to the complex and unpredictable derivatives hedging contracts.

In his fantastic new "Gold Wars" book mentioned above, Mr. Lips reports that once-strong Ghanan miner Ashanti Goldfields, which was ruined in the sharp gold rally in September 1999, had entered into no less than 2,500 separate derivatives contracts with 17 different banks! As I have explained in depth in past essays, derivatives can be extraordinarily dangerous in volatile environments.

The global markets definitely realize how foolish gold derivatives are while gold is in a multi-year strategic bull market, so they mercilessly punish the companies whose managements betray shareholders with excessive derivatives abuse. The following graph (from "Gold Defies Naysayers") compares the unhedged companies in the American Stock Exchange Gold BUGS (Basket of Unhedged Gold Stocks) Index (symbol HUI) with the heavily-hedged companies in the Philadelphia Stock Exchange Gold and Silver Index (symbol XAU). Unhedged stock performance is slaughtering the hedgers!

Unhedged Gold Stocks Soar

Since their bottom in mid-November 2000, unhedged gold stocks have rocketed up by 278% while hedged stocks have only managed a 95% gain. I call the difference the "Hedge Tax", a tragic but voluntary opportunity-cost penalty that investors pay by investing in hedged gold mines. On the exact same 21% gain in gold over the same 18 months, investors deploying capital in hedging gold stocks made 183% less than investors deploying capital in unhedged gold stocks! It is amazing anyone still holds the hedgers!

On an individual company level, notorious mega-hedger Barrick Gold (symbol ABX) was only up 60% between mid-November 2000 and today while similarly-sized world-class unhedged miner Gold Fields (new symbol GFI, formerly GOLD) managed a stellar 369% gain. The differences between these two top-10 global gold mines' share price performance could not be more striking! Unhedged gold companies soar while hedged gold companies trail miserably in the dust.

Gold mine hedging, by destroying profit leverage to the gold price, annihilates investors' returns.

Always avoid aggressive gold hedgers like the plague when selecting gold stocks for investment in a gold bull market!

Gold in the Ground, Reserves and Resources

Another factor to consider when looking at a gold stock are its reserves and its resources, basically the amount of gold it has left in the ground.

Before sinking the massive amounts of capital necessary to construct an operating gold mine, gold mining companies drill all kinds of small exploratory holes to extract rock core samples. Using these rock cores mining geologists can, with enough separate cores, extrapolate how extensive a given gold-rich ore body is underground. Mines are only built if enough gold exists underground that is extractable at a favorable cost to lead to significant profits in the current gold price environment.

This gold ore still in the ground is known as reserves and resources. Reserves can be farther subdivided into "proven reserves" and "probable reserves".

Proven reserves are a solid number determined by drilling lots and lots of holes and sampling large quantities of rock. The science of mining geology has advanced to such a degree that these numbers can be amazingly accurate and as an investor I generally trust them as long as they come from trustworthy managements. Probable reserves have significantly less sampling data behind them and are not as certain.

Resources, often larger than reserves, are derived from fuzzier data based on much fewer drill holes and rock cores. Resources are more a probability game than a near sure thing like proven reserves. These resources, however, are often where new higher-cost gold lies which can be used to continue augmenting operating leverage in a major gold rally.

When contemplating investment in any gold mine, it is important to consider its reserves and resources data. I generally like to see reserves equal to at least 5-10 years worth of current annual production if I am considering a long-term investment in a gold mine. If I am buying it purely for the short-term speculative part of my portfolio, I will settle for lower reserve numbers.

In general, the larger a mine's reserves and resources, the longer its life and the higher its worth. Gold in the ground is the lifeblood for gold mines, the more the better!

Political Risk

It is important to also remember that gold mining is politically risky, for many reasons.

Gold mines cannot be moved and they are very capital intensive, making them very tempting targets for abuse by governments or organized labor. Even though some world regions are considered riskier than others due to different property-rights traditions and current geopolitical events, ultimately every gold mine on earth bears some level of political risk. While gold mines in Africa can be outright confiscated by malicious Marxist governments, gold mines in the West can be shut down just as easily by fringe groups like radical environmentalists bending the ears of liberal politicians.

Thankfully these unfortunate events are very rare, but they are one of the key reasons why it is so, so important to diversify your gold stock portfolio across different quality gold mines and different regions of the world!

As a new gold stock investor, just please be aware that political risk is simply part of the game in gold stock investing. It can be managed but it can never be eliminated. If you are interested, I discussed this important concept in greater depth in the new June issue of our private Zeal Intelligence newsletter for our clients.

Scaling the Gold Investing 101 Portfolio Pyramid

At the base of the gold stock portion of the Gold Investing 101 Portfolio pyramid, the least risky gold stocks are world-class, unhedged, leveraged, major gold mines. Now you know what this definition means! These companies are generally among the top-10 or 15 largest gold mining companies on the planet. The best of this elite group are unhedged and fully-leveraged to the price of gold. Hedging practices and leverage vary widely among these mammoth gold mining companies so you have to carefully research any in which you are considering investing.

If you do a Google search on the Internet, you can find listings of the largest gold mines on earth, the companies that produce the most gold each year. Unfortunately I can't recommend a specific URL to you because I haven't yet found such a list on the web that is actively maintained and stays current. As a general rule of thumb, the elite major companies mine in the high hundreds of thousands to low millions of ounces or more of gold each year.

Moving up a bit on the risk-reward continuum in the center of the pyramid, the next group to consider is top-25 gold mines that are producing gold but currently out of favor with investors. This is a very fun part of your portfolio where you can exercise your finely-honed killer contrarian instincts and take the opposite bet of the crowd.

Good mines fall out of favor from time to time for many reasons. For example, if they have major operations in a geopolitically-explosive area, violence in a neighboring country can spook investors even if it doesn't directly threaten a company's mines. Sometimes underground disasters tragically occur, including rock failures and deaths. At other times mines can be flooded by excessive rains or ground water. There are dozens and dozens of major things that can go wrong at almost any mine at any time.

If you are monitoring gold stocks and see a good mine's share price get beat up on short-term news, it may be a perfect opportunity to consider deploying some of your more speculative capital into the stock and waiting for the rebound.

Even riskier than out-of-favor major gold mines, but with much higher potential rewards, are producing junior gold mines. Unlike the majors mining millions of ounces of gold a year from multiple mines, juniors often only have one or two mines and only produce a few hundred thousand ounces of gold per year or less. Because they are much smaller and often younger companies with less diversified mine holdings, they are far riskier than the battle-scarred and tried-and-true majors.

Finally, in the pure speculation category in red at the apex of the pyramid, are very small juniors that are not yet producing and selling gold and exploration companies that are actively looking for gold. Although the riskiest gold stock speculations by far, non-producing juniors and exploration companies have vast potential rewards if you are fortunate enough to pick the right company. These stocks can literally explode from mere pennies per share to over $10 per share in days or weeks if a big discovery is made! Early-stage juniors and exploration companies are a very exciting but extremely risky speculation arena.

Don't risk important core investment capital in non-producing juniors and exploration companies, only speculative capital that you wouldn't shed a tear if it was lost. Gold exploration is an exceptionally risky business!

Conclusion

Well, I apologize, but we are not going to get to gold derivatives speculations in this essay as I anticipated last week. Perhaps in the future I will write one more essay to make this a trilogy, "Gold Derivatives Speculating 101". Gold derivatives and gold-stock derivatives speculations are a whole other ballgame with entirely different rules that are beyond the scope of this essay.

When I began thinking about this gold stock investing essay a few weeks ago, I originally thought about writing an essay profiling great individual gold companies within each portfolio pyramid category. I changed my mind because one of our missions at Zeal is to equip investors to think for themselves. Rather than give you a fish in the form of a few stock recommendations we happen to like at the moment, I felt it was vastly more valuable to attempt to give you our actual fishing pole and offer you some foundational thoughts on how to use it.

Catching your own fish in the investment world is infinitely more rewarding than simply eating leftover fish scraps from others!

As I have articulated in past essays, I fully expect this fledgling gold rally to last many years, perhaps even culminating in a classic gold speculative mania in 5 to 7 years. In such a major strategic gold rally, there will be countless opportunities to multiply capital many times over by investing in the gold stock arena. The legendary profits for gold stock investors, in my opinion, are not behind us but still lie ahead. If you are a new gold stock investor you still have ample time to research the sector, get up to speed, and begin deploying a portion of your capital in this incredibly exciting arena. Carpe Diem!

Thank you for your valuable time. I wish you Godspeed and great fortune in the coming gold stock rally!


 

Adam Hamilton

Author: Adam Hamilton

Adam Hamilton, CPA
Zeal LLC.com

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Mr. Hamilton, a private investor and contrarian analyst, publishes Zeal Intelligence, an in-depth monthly strategic and tactical analysis of markets, geopolitics, economics, finance, and investing delivered from an explicitly pro-free market and laissez faire perspective. Please visit www.ZealLLC.com for more information, www.zealllc.com/samples.htm for a free sample, and www.zealllc.com/subscribe.htm to subscribe.

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