Given the massive amount of money being pumped into the global economic system, higher prices down the road are a given. It’s possible that prices may fall in the short term, but no currency can withstand a determined onslaught by its own central bank and national government for long. I consider gold a no brainer in this environment. It’s a store of value that does well both in inflationary times and, as we saw last year, in deflationary times.
But I’m not content just to park my money in physical gold and leave it at that. The trader in me wants to make a leveraged play to make the most off of gold’s bright future. Gold mining shares would seem an excellent play then. Not only do you get exposure to the gold market, but you get the benefits of stock ownership. In the past, whenever I would introduce the idea of owning gold as a form of investment, people would laugh my suggestion off because they just couldn’t imagine how anything would be better than owning “stocks for the long run.” Of course, they aren’t saying that anymore.
Gold mining shares are a nice compromise in terms of investment philosophy. If the American dollar does fall from grace as we goldbugs suggest, then owning shares of a gold mining company will be a tremendous boon. If the dollar continues to stubbornly hang on, and we somehow manage to resume normal economic growth, then I still own equities and should get the traditional benefits of equity appreciation.
The theory of owning gold mining equities is pretty easy, but the reality can be rather treacherous. Should you chose an established company with a lot of reserves or a junior company that mainly has a lot of promising prospects? One is more dependable and the other has the potential to be far more rewarding. It’s a similar discussion to blue chip versus tech stock debate we saw towards the end of last century.
For myself, I wanted an established company. Junior mining companies need a healthy amount of credit to develop their mining operations, and that wasn’t a chance I was prepared to take given the credit collapse of last year. That narrowed my focus down to just a couple of companies: Newmont Mining (NYSE:NEM) and Barrick Gold (NYSE:ABX). I chose Barrick because it was the largest mining operation in the world and because, at the time, it was trading at a lower PE ratio than Newmont. As of this writing, Newmont has held up better over the last twelve months as shown in the graph below.
Really the two companies were performing in tandem until the last month or so. Then Barrick shares had a rather sudden loss of value. Part of this loss of value is probably related to the loss Barrick announced for its fourth quarter. The company was able to sell its gold at a good profit margin, despite the temporary fourth quarter fall in the price of gold, but the company also wrote off a large portion of the value of an oil company it had acquired in the prior year. Like so many decisions that turn out wrongly, it seemed like a good idea at the time. Oil is a significant cost in the mining of gold, so it would make sense to buy an oil company in a rising oil market as a hedge against an increase in the cost of mining. Oil’s subsequent fall caught even Warren Buffett by surprise.
Having to write off the value of an oil company due to a collapse in the oil market seems like a one time event. So let’s instead compare Barrick and Newmont on their forward PE ratios, rather than the past twelve months. Barrick closed yesterday trading at a forward Price-to-Earnings (PE) ratio of 15.71 compared to Newmont’s 16.43, which shows that you’re getting a discount for Barrick’s earnings over Newmont’s. The dividend ratio is even better: Barrick yields 1.4% compared to Newmont’s 1.0%. That’s 40% more money in your pocket for owning Barrick. Looking at these figures suggests Barrick is clearly the better company to own at these prices.
Going forward, it’s only a matter of time before the inflationary policies of the world’s central banks start forcing the gold price higher. However, Barrick will not perform well this year if we don’t see a return in the price of copper. There’s a significant amount of copper tied up in the gold ore that Barrick mines and in the past Barrick has been able to refine and sell it at a nice profit to held reduce the cost of its gold operations. For the year 2006-2008, Barrick was able to sell its copper at over $3 a pound and make a profit of over 50% on the sale. Yesterday copper closed around $1.65. If copper stays at that price the entire year, Barrick’s results will suffer. I’ve run a few simulations in a spreadsheet and here’s the numbers I get:
- If gold averages the year at $950 an ounce and copper stays at $1.65 a pound, Barrick will earn $.94 a share.
- If gold averages $1050 an ounce and copper stays at $1.65 a pound, Barrick will earn $1.78 a share.
- If gold averages $950 an ounce and copper returns to $3 a pound, Barrick will earn $1.51 a share.
As you can see, the return of copper to its former levels is going to be just as significant to Barrick’s earnings as gold appreciating in value.
Since analysts estimate a 2009 EPS of $1.85, Barrick could suffer a significant down year if we don’t start to see copper return soon.
Looking beyond a year, I believe Barrick is positioned well. It is set to make money from an appreciation in copper, oil, or gold. That makes it a great place to be as we feel the effects of inflation, but in the short term gold bullion may represent a better investment.
Disclosure: Barrick common stock represents a significant portion of my investment portfolio.