Allocating Strategic Capital for your portfolio

Gold Ownership or Bullion or Stocks?
Assuming you have already decided to own Gold to diversify your overall portfolio, you may then ask the following question.
What form of Gold should I purchase?
Should I buy physical metal such as bullion coins or bars, or would mining stocks be better?

It is often recommended by portfolio managers to place your strategic capital into a combination of both physical metal and mining shares to maximize performance, and minimize risk. Owning physical metal enjoys certain advantages over owning the mining stocks and visa versa, but a combination provides the best way to protect and grow a portfolio in difficult and uncertain financial times. Gold investors must choose for themselves how to split up their Gold allocation. It is important for investors to be certain that the Gold items they own are the ones that will best serve their purposes. While each investor’s circumstances are different, the discussion that follows should give some ideas on how to best divide Gold holdings.

What are the differences between owning physical metal and owning stocks?

The obvious difference is risk. On the investment pyramid of risk, physical ownership of Gold would be on the lowest tier (least risk) with cash and life insurance, while ownership of Gold mining shares would be classified on the second or third tiers (higher risk) depending on whether you own shares relating to a major Gold producer or a junior mining company. In general terms, owning physical metal is more of a "saving", whilst owning mining shares would be considered more of a "investment". There is an increase in risk when investing in stocks. However, with increased risk comes greater opportunity for return. Thus both should be considered.

A second factor to remember is that a Gold mining share is not Gold. It is a company stock first and then secondly can be construed as Gold. A Gold mining share is NOT a substitute for the physical metal. It represents a claim against potential Gold deposits in the ground and not the actual Gold itself. Stock ownership often has inherent risks that are associated with investing in company stock. Stocks often represent debts, liabilities, risks – monetary, environmental, political, etc. Physical Gold is an asset, the only financial asset that is not simultaneously someone else's liability. Owning physical Gold is essentially risk-free as long as you retain possession. Obviously its value can go up or down according to market fundamentals/fluctuations, but you can hold it securely in your hands. Physical Gold does not need cash flow or management to insure its ultimate survival.

Some other items to consider:

Physical Gold ownership does not pay dividends. Mining stocks can pay dividends when profitable.

Physical Gold ownership has protected investors during periods of economic depression, wars and political unrest. Mining stocks could be negatively affected in such times as stock markets may be closed or adversely affected for a time.

Physical Gold can be used for barter or purchasing life sustaining items during crisis times. Mining shares would be harder to use for such purposes.

During a bull market in Gold, the physical metal prices will go higher, but the Gold mining shares are leveraged to the physical price. In other words, as the price of Gold rises, profits from mining stocks rise even more in percentage terms. Generally, over the longer term, the share prices of the major Gold producers rise by a factor of two to three times more than the price of Gold. Successful early stage junior mining and exploration companies can rise by a factor of 5 to 10 times more than the price of Gold. The reason for this leverage is that a rising Gold prices do not have any effect on the cost of production. Therefore, for companies that are already profitable, incremental revenues received from selling Gold at a higher price flow straight to the bottom line. A price rise also increases the value of "in the ground" reserves without capital investments. For mining companies that are not profitable, a rise in the Gold price can suddenly lift them into profitability.

Any potential investors would need to consider what their objectives are for considering Gold before they can correctly decide what class of items to purchase. Some people who are more savings oriented, tend to emphasize owning the metal, while others who are looking to make a big return would tend to emphasize the mining stocks. Mining stocks can produce spectacular returns at times, but can also exhibit volatility.

Why Invest in Junior & Exploration Companies?

Leverage is the simple answer. It is not uncommon for early stage junior mining and exploration companies (hereafter, Juniors) to experience huge gains (10 times or more) very quickly as news of a discovery is made. But before talking more about leverage here are some facts:

In the mining world, it is no secret that the majority of economic mineral deposits are found by the junior mining companies or prospectors. There are several reasons for this. Junior explorers are not slow-moving bureaucracies like many established and large resource companies (hereafter "Seniors"). This makes Juniors able to make fast decisions both in the boardroom and in the field.

Seniors generally have a different role to play, namely, to fund and place into production deposits discovered and developed by Juniors. But perhaps chief amongst the most important reason Juniors tend to make most discoveries is that they are hungry and entrepreneurial, in other words: the talent, motivation and dedication of their management team. Exploration is, to some extent, a creative enterprise.

It is often said in the mining business, that if an exploration geologist finds a mine it is likely that he will find others. It is a fact that fewer than 5% of all exploration geologists will ever have the credit of a discovery that leads to a mine, which proceeds to the production stage. This is because those few select, gifted explorers who find numerous mines, seem to possess a sixth sense that moves them to succeed in this area. Most of the true and successful leaders in mineral exploration are geologists that don’t necessarily fit into the corporate culture. They are field geologists who do not generally sit behind desks, stare at computer monitors and talk on the phone, preferring instead to be out in the field. Whilst the majority of geologists may have a firm grip on the theory of mineral exploration, they cannot take it to the next level to unravel Mother Nature’s secrets.

As is often the case Juniors are managed by men and women who have had success working for both Senior and other Junior companies. So why would someone want to be a director of a junior mining company that has no revenue and sometimes not even a decent salary to offer. It is the potentially huge rewards that can come when a discovery is made that attracts the top talent of the mining sector into the Juniors. In other words, they want to work for themselves and get the big payoff, instead of earning a nice salary with some kudos if they made the discovery whilst working for a Senior company. In a major mining company, a successful exploration geologist who made a significant discovery might get a pat on the back and a new credenza, if they’re lucky. As part of a junior mining company, the geologist who made that same discovery might profit considerably from the $10 million, $20 million, or a $100 million capital gain from any discovery made on the part of their efforts. In the life cycle of a mining share, it is the exploration phase that provides the biggest move (leverage) in share price. The best and brightest "mine-finders" of course know this and are highly motivated to search the world over to make a new discovery. When they do, the monetary rewards are substantial, for both the management team and its investors.

Because the mining sector has been in a long-term bear market, very little major corporate mining money has been going into the search for new deposits. Exploration expenditures declined drastically from 1997 into 2001 as the brunt of the bear market took its toll. Since then, we have seen the start of what looks to be a major bull market in the precious and base metals. Exploration budgets are cranking up again as the search for new deposits is greatly needed to replenish depleting reserves. With this renewed interest in exploration, demand for good exploration companies is increasing in the capital markets and the junior mining sector is once again showing spectacular gains. As the spot prices of the minerals continue to rise, we are also likely to see an exponential rise in the share prices as additional capital comes their way.

One source, Richard Russell (a prominent writer on mining and commodities investments), has this to say about the current bull market in precious metals:

"..I believe that fortunes will be made in the years ahead by those who are now establishing major positions in Gold and Gold shares. These primary moves last longer than anyone thinks possible – and they take the items higher than anyone thinks possible. We are now in a primary bull market in Gold. I believe Gold (and very probably silver) will make fortunes for those who now take major positions in the precious metals…"

Huge Leverage

The increase in the mineral prices not only focuses more attention on the sector, but also causes even more money to be spent on exploration thereby increasing the probability of finding new deposits. It also increases the value of any potential discovery through leverage. Mineral deposits are gauged, in financial terms, by the "Net Present Value of Future Cash Flows" formula should the deposit be mined. Say for example we find a million ounce deposit of Gold and an engineering study suggests it could be mined over ten years at a cost of $250 an ounce, including capital. Let’s assume Gold is at $350 an ounce. Lets also assume a 10% discount rate (over 10 years) and we find that the deposit would be worth roughly $70 million. However if the Gold price were to increase to $400 an ounce (a 15% increase) the value of the same Gold (with the same parameters) increases to $100 million (almost 50%). That is over 300% leverage to the Gold price. Increases, obviously, have an increment benefit.

Suggestions for Gold Investors Options for acquiring gold can take several forms. Investors interested in gold may want to consider investments in gold producing companies either as an alternative to or along with any bullion type of investment. Improved sentiment towards precious metals is producing an equity financing boom for gold companies, from substantial producers to junior explorers. There is a tremendous demand for gold shares at the moment. The gold price is rising and many astute investors are turning to the smaller "Junior" gold mining companies that enjoy a debt free history, un-hedged production and large reserves still to be mined. Many investors feel these smaller mining companies will continue to reflect the movement of gold as it continues to advance, albeit without the unnecessary risks attributed to investments in both the bullion and futures markets.

While gold continues to rise, the search is on to find these "Junior" mining companies still in an early stage of growth. In addition, a race is on by the "Senior" companies to take over smaller mining companies holding proven reserves, and investments in Senior companies which have recently acquired large reserves should also be considered.

With the expectation of aggressive returns, however, great attention must be paid to the technical factors of: yields, testing results, reserves and operational cost(s).