In parts one and two of this series, we compared gold to Hostess Twinkies (similar in color and indestructibility) and to McDonald’s Big Macs (indicative of relative currency values across international borders).
We concluded that gold can make sense as a defensive investment because “its true value is its ability to store value.” In times of exceptional financial uncertainty, one may deem it prudent to devote a small investment allocation to the only investment literally as good as gold. But how does one buy gold?
During the Great Depression, legendary stock investor Bernard Baruch faced this question as numerous countries fled the gold standard and, according to his biographer James Grant, “relative to the worlds’ new paper money, the value of gold was rising. In light of the news Baruch decided that a man might prudently lay in some gold for himself.” Baruch began with gold mining shares, but also bought supplies of gold bullion – actual gold bars. Again, according to Grant, “The decision to buy gold bullion was a more considered one, because in ordinary circumstances there was every reason not to own it. It paid no interest or dividend, cost money to store and would go nowhere in price if the government kept its solemn monetary promises…”
The arguments against bullion stand today, including the big “if” about government keeping its monetary promises. Since Federal Reserve Chairman Ben Bernanke earned the nickname “Helicopter Ben” by proclaiming he could drop dollars from helicopters to fight deflation, we note that gold will do well if the Fed takes steps that inflate the currency. We also note that despite the arguments against bullion, Baruch’s doubts about U.S. currency grew so severe that he installed massive safes in his New York apartment and owned one of the world’s largest private collections of gold – until Franklin Roosevelt made it illegal.
Gold can also be purchased as coins or jewelry, but these “investments” introduce valuation complications through issues of collectability, fashion, and other emotion-based factors. Gold coins typically sell at a premium to their gold value, and also include, to a greater degree than bullion purchases, retail fees and commissions that cloud their value as an investment.
Stock in mining companies must be considered as thoroughly as any other equity purchase, because the value of the company’s gold reserves could be compromised by operational, environmental, or management issues. Mining equities present interesting opportunities and, of course, interesting risks. Mining operations have high fixed costs but relatively low variable costs, so increases in the price of gold disproportionately increase the value of a mining company (and decreases in the price of gold can create precisely the opposite effect).
One alternative to buying gold in a vault is to buy it in the ground. Many believe that we have reached peak gold production, and data supports this conclusion as global gold production has declined since 2005 while prices have increased dramatically. As a result, large producers such as Newmont Mining (NYSE:NEM) and Barrick Gold (NYSE:ABX) are cash rich and resource poor, making resource rich junior miners appear attractive as acquisition candidates.
Investors in one smaller mining company have exposure to more than 1 ounce of gold and 226 pounds of copper per share of stock, which currently trades at less than $25. Production of these estimated resources will require a significant amount of capital and time, but entrepreneurial investors may find that it can be more lucrative to buy gold in the ground than from the mint.
The volatility of mining company stocks may be too much for timid investors to bear, but options unavailable to Bernard Baruch can soothe their fears. More cautious investors can choose exchange-traded funds (ETFs) and mutual funds that represent broad bullion or mining interests. While ETFs and mutual funds rarely make sense for an entrepreneurial investor’s portfolio, the defensive nature of a gold purchase makes them more palatable, presuming one takes care to avoid excessive fees.
We hasten to point out that by the time one sees frequent television infomercials about a particular investment opportunity, the real opportunity may be long gone. The price of gold rose steeply during the second half of 2009, and one might conclude that the easy money has been made. But remember that gold’s real investment function is as a store of value. For those wary of the economy in general and the currency in particular, gold could be a sensible investment. For those with a more entrepreneurial approach, undervalued mining stocks could still represent opportunity for capital appreciation.