There are four basic ways to buy gold: physical gold, gold jewelry, gold-related mutual funds or ETFs, and gold mining stocks.
1. Physical gold
By this I mean that you actually take possession of gold bars or coins that have been refined to certain specifications of purity. There may be a big bid-asked spread, but ultimately the gold is sold by weight. This is the dominant form of gold buying in Asia.
What would be reasons for holding physical gold?
a. few other alternatives. Developing countries may not have well-functioning stock or bond markets, so investment choices for most people might be limited to bank deposits or participation in “chit club” loans;
b. political instability. In war-torn areas, the need to flee from violence might mean it would be good to have one’s wealth close by and in portable form;
c. distrust of the financial system. In some countries, one might have to worry about nationalization of bank deposits. Or, as in the case of China during the Cultural Revolution, it might not be a good thing to show evidence of having wealth.
d. unofficial economy. In a country beset by hyperinflation, tangible goods may be the preferred form of payment over fast-depreciating paper money.
e. diversification. A generation ago, standard financial advice in the US would be to hold, say, 5% of one’s assets in precious metals of some type. Foreign stocks were the preferred diversification for a while. In today’s world, the recommendation might be to hold base metals stocks, or natural resources funds.
f. few subjective factors in determining value. This is unlike the case with other tangibles, like diamonds, colored stones or used cars. Weight and purity are all that matters.
g. physical characteristics. Durability is one. Gold can also be broken into smaller pieces without loss of value.
g. it’s super-cool.
The major drawback of physical gold is the need for secure storage. What constitutes security depends on the circumstances. I had a friend in London who told me during the stock market collapse in October 1987 that he had foreseen the crash and expected it to lead to economic chaos, including widespread bank failures. In anticipation he had sold all his possessions and bought gold bars with the proceeds. He was storing the bars in a bank vault. I’ve often wondered how he was intending to get into the vault after his bank failed.
2. Gold jewelry
This is more or less the same as buying gold bars, except jewelry can easily be worn.
The important distinction is between 22k or 24k jewelry bought as an investment and 14k or 18k gold jewelry bought in a brand-name Western jewelry store. The latter two are only 58% and 75% gold, respectively. Also, as a glance any publicly-listed jeweler’s annual report will show, the markup on a typical jewelry item will be 100% over cost of goods. So these are fashion accessories, not investments.
3. Gold-related ETFs and mutual funds
For all practical purposes, for most people this method of holding gold is probably the easiest. It’s very important, however, to understand exactly what the fund does. Does it hold physical gold, or gold futures or mining stock–or all of them? What discretion in changing the proportions of each does the manager have? In particular, you should understand the characteristics of a leveraged ETF, if that’s what you choose. (You might take a look at my post on leveraged and inverse ETFs, for example.)
4. Gold mining stocks
Picking an individual stock takes some security analysis skills. When you get down to it, however, mining companies are relatively simple operations. They’re holes in the ground that a special kind of dirt comes out of.
The key factors in determining profits are: how many ounces of gold can the company extract in a year? how much will that cost per ounce? and, what is the selling price? The value of the company will be a function of its profitability and of the reserves of gold that it has mineral rights to. This will be disclosed in the company’s annual report.
The combination that everyone strives for is low p/e and high sustainable earnings growth. The latter probably translates in this case into an assessment of the potential for rising mine production at low cost. It’s also important to keep in mind the possibility of adverse political changes in the country where the production is located.
Three quirks of miners to look out for:
–For most miners, development is much more important than exploration. In many cases, miners own adjacent property to their mines that they suspect will prove as profitable as their existing operations. But because they haven’t yet actually drilled on the land, they can’t list the gold that is most likely there as reserves. This is why good miners always seem to have seven years of mine life left, even though they’ve just sold a year’s worth of production.
–As prices rise, miners typically shift to producing less-rich ore and to doing more extensive land preparation work. This allows them to shift to richer ore, and still stay profitable, if prices decline. As a result, operating leverage isn’t as big as you might suspect. In the mining industry, though, this is a good thing.
–Mining companies sometimes hedge part of their production through gold borrowing arrangements with central banks. This makes it a little harder to figure what their net revenues are. It’s a bigger issue when prices are low (as they were in the Eighties and Nineties) than now, but sill something to ask about if a firm’s revenues don’t seem to reconcile with the prevailing gold price.
Predicting the gold price
There are a couple of rules, though, about seeing tops and bottoms.
The gold price will bottom as the highest-cost mines begin to shut down (because the gold price is below their cash costs).
When the gold price peaks, large amounts of inventory (remember, inventories dwarf production) begin to be liquidated. In 1979-80, for example, when silver prices shot up during the Hunt brothers’ try at cornering the silver market, trucks started appearing in vacant lots in our town, with scales on the back, so you could bring the family’s silver and sell it for cash on the spot (no one asked whether it was your family’s silver or someone else’s).
Last year, there was large-scale liquidation of gold inventories from India. Right now, gold recyclers are advertising on TV, radio and billboards. I’ve never seen that before.
It’s hard to know whether this is a signal of a peak or whether it reflects hard economic times. At the very least, it’s not a strong buy signal.
One final thing. Over short periods of time, I’d expect the gold price to be stable in the hardest currencies and rise in weaker ones. This is a decades-long rule of thumb, which the oil market has only recently mimicked.