Article by The Research Works, LLC

Gold is seen by many financial professionals as a safe-haven investment for hard times and a hedge against inflation. The inflation-adjusted price of gold has remained stable on a centuries-long scale, although it has varied dramatically over shorter periods in response to such factors as war, inflation, monetary policy and consumer demand.



We are presently experiencing growing uncertainties regarding a large number of considerations, including runaway government spending, terrorism, Iran's nuclear ambitions, oil prices, the U.S. trade imbalance, entitlements gridlock, elevated residential housing prices, growing foreign markets, and an absence of confidence in both the President and Congress.

Gold Industry Statistics

Of the estimated 152,000 metric tons of gold that have been produced in the history of the world, approximately 129,000 metric tons remain in human hands. The remaining 15% of production has been consumed in dissipative industrial uses, lost or is otherwise unaccounted for. Holdings are in the form of world bank official stocks (approximately 33,000 metric tons), jewelry, bullion and coins. At year-end 2005, the U.S. Treasury held 8,140 metric tons, representing 24.7% of all central bank holdings. The recent advent of exchange-traded funds, which hold gold bullion, has boosted demand for bullion.

Mine production of gold for 2005 is estimated to have been 2,450 metric tons, representing a 0.8% year-to-year increase. South Africa accounted for 12.2% of the production, Australia 10.4%, the U.S. 10.2%, China 9.2%, and all of the remaining countries combined 58%. Of all of the gold produced in the U.S. in 2005, an estimated 83% was from Nevada. (Source: U.S. Geological Survey, Mineral Commodity Summaries, January 2006)

Investments in Gold

Holding physical gold might be a plus if economic conditions were to deteriorate into widespread chaos. Barring such a calamity, there are several drawbacks to taking physical delivery. These include costs for dealer markups, storage and insurance. In addition, some states charge sales tax on certain gold purchases.

Gold exchange-traded funds have advantages over physical holdings of gold. These funds take possession of gold and charge relatively modest amounts for overhead. In addition, broker dealer markups are not onerous. There are no state sales taxes, although the U.S. income tax code does not allow gold exchange-traded funds to benefit from the reduced 15% tax rate for long-term capital gains.

Investments in gold mining companies boosts the risks of investing in gold but also offers the possibility of leveraged upside potential if the commodity price were to rise. Risks include exploration, environmental concerns, permitting, production costs and fluctuations in the commodity price. The leverage stems from the fact that since production costs of established properties are relatively fixed, changes in the gold price can have a dramatic impact on margins and income.

Risks in Gold Exploration

Many gold exploration companies are striving to define reserve positions of significant size and richness to justify the start-up of production activities. These companies generally must drill a great number of core samples before engineers can decide whether the quantity, concentration and distribution of mineral are sufficient to sustain a profitable mine at prevailing prices. Even if mining looks economical, there are often complex and restrictive environmental permitting processes to be completed. A large amount of funding must also be secured, usually from a lender, to build the mine and any satellite facilities such as ore mills and leaching plants.

Every step of the process from the initial acquisition of the property to the production of metal adds value to a company, so long as it enhances the likelihood of actual profits. Valuations for sparsely explored properties are very low, often just a few million dollars, but if a company reports a few good drill intercepts, the market should take notice. The concentration of mineral required for economical production varies in the case of gold from as little as 0.05 ounces per ton (opt) to 0.5 opt, depending on other cost factors.

After tens of thousands of feet of drilling and consistently encouraging lab results, companies will submit their compiled data to a third party mining engineer to produce a resource calculation. This is the total quantity of mineral that can be inferred from the drilling thus far, and investors place great importance on it, as there must be enough to justify the company’s continued exploration activities. A promising exploration company at this stage might report a resource of a few hundred thousand to a million ounces or more of gold. The market may value the company at a few tens of millions of dollars at this point, still a substantial discount to the value of a producing company.

Once still more drilling is performed, often several years and several cycles of fund-raising after the founding of the company, management may decide that it is time to conduct a feasibility study to decide whether or not to build a mine. A green light from a third party engineer is a key announcement, and at this point the shares are likely to have appreciated an order of magnitude or more from their initial value.

Superior Risk-Reward Ratios Among the Smaller Companies

The Research Works focuses on opportunities in small stocks, and for risk-oriented investors, there is a strong case to be made for considering small exploration and mining companies rather than large, established producers. The large companies are typically thoroughly researched by the investment community, contributing to an efficient pricing of their shares to reflect their reserve positions, production costs and the current price of gold.

Smaller companies in all sectors are often under-researched, and gold stocks are no exception. In this bull market, there are a great number of small companies striving to take advantage of higher metals prices. Properties that were uneconomical when gold was $300 now offer the potential of profits. This is all part of the commodities cycle, as demand drives prices higher, luring the new investment that will increase supply and bring prices back down. However, these cycles can be quite long, as it takes a vast amount of exploration work before a mine can be even planned, let alone built and brought into production.

A Preference for North American Properties

There are sizable deposits of gold throughout many parts of the world. Our preference is for companies that focus their exploration efforts in the U.S. and Canada. Operations in other countries involve a host of political and other risks that are often difficult to quantify and diminish the appeal of the stock. 

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