Do Gold and Value Investing Mix?

I own gold stocks, and yet I consider myself a value investor. Am I a walking contradiction?

It might seem so.

Many value investors dismiss gold as having no intrinsic value, because it has few industrial uses and produces no income. It's impossible to invest with a margin of safety if you can't estimate intrinsic value with any confidence, therefore gold and gold-related investments are seemingly off limits.

I agree with detractors that gold's intrinsic value is difficult, if not impossible, to pin down. Gold Fields' (NYSE: GFI  ) CEO, Nick Holland, says that the industry's all-in costs of production fall in the $800 to $900 range. If gold were consumed like natural gas or pork bellies, you would expect the price to at least roughly track the marginal producer's cost. Most gold is not consumed, however. It's worn as jewelry or stashed in a vault somewhere. As a result, a fair chunk of annual supply comes out of above-ground holdings. The pricing dynamics of gold are thus very different from those of other commodities.

It don't mean a thing ...
Saudi Arabia is known as the world's "swing producer" of oil, as the country has the rare ability to ratchet production up or down in a quantity significant enough to impact global supply -- and by extension, prices. I don't see large miners like Newmont Mining (NYSE: NEM  ) or Goldcorp (NYSE: GG  ) sitting on a bunch of excess capacity. These firms seek to grow production at a steady clip, and replace reserves as best they can. The excess capacity in gold supply exists above ground, in the hands of central banks, investors, and consumers.

I would argue that the folks that own all that above-ground gold are collectively the closest thing that exists to a global "swing producer" of gold. Some of these holders will sit on their gold regardless of the quoted spot price. Most, however, are no doubt willing to sell if offered what they perceive as a fair quantity of dollars or other paper currency in exchange. The more these owners hold their gold dear, the higher the price they'll demand to part with it.

This is all a very long-winded way of saying that to some extent, perceptions of gold's value -- both among potential investors and its existing owners -- help drive the price of gold. The makings of a self-perpetuating feedback loop are clear enough. This is exactly why George Soros, who holds outsized positions in NovaGold Resources (AMEX: NG  ) and Kinross Gold (NYSE: KGC  ) , has taken to calling gold the ultimate bubble. Perception shapes reality. This is potentially a value investor's nightmare.

Abandon all hope?
There are two saving graces here, from my perspective.

One is that precious metals prices move in a persistent fashion. Gold has notched gains for nine straight years, and it's steady as she goes so far in 2010. There are intermittent corrections along the way, but true reversals in the long-term direction of the gold price only come once every two decades or so. This is a dramatically longer cycle than we see in commodities like natural gas, which swing much harder, much faster.

This trend persistence is helpful for mine operators, because new discoveries can take over a decade to bring into production. It also lends confidence to those providing the financing, which includes equity investors. (That's us!) Do I know where gold will trade in 12 months? Absolutely not. Am I reasonably comfortable that it will trade in a wide range of between, say, $900 and $1,500 an ounce? Yeah, I am.

That's where the value investor's trusty tool, the margin of safety, comes in. If you invest in a mining junior looking to build a mine that looks viable at $1,200 gold and fantastically profitable at $1,500 gold, but will break even or lose money at $900 gold, you aren't leaving yourself much room for error. For this reason, stocks like Seabridge Gold (AMEX: SA  ) hold little appeal for me. The projected economics of the firm's flagship KSM project don't appear to hold up very well at lower prices.

Fortunately, not all prospective gold mines require four-figure gold prices. I recently picked up shares of a Latin America-focused junior that trades for around half of the value of nonproducing peers -- and it's bringing an economically robust project into production in a matter of months. (For more on my preferred measures of mine profitability, see this article).

In terms of producers and near-producers, a combination of quality management and quality assets available at a discount price is exactly what value investors should be searching for. I can't quite agree with my colleague Chris Barker that bargain stocks still abound in the gold and silver mining space, but they are certainly out there.

Fool contributor Toby Shute doesn't have a position in any company mentioned. Check out his CAPS profile or follow his articles using Twitter or RSS. Try any of our Foolish newsletter services free for 30 days. True to its name, The Motley Fool is made up of a motley assortment of writers and analysts, each with a unique perspective; sometimes we agree, sometimes we disagree, but we all believe in the power of learning from each other through our Foolish community. The Motley Fool has a disclosure policy.


Read/Post Comments (3) | Recommend This Article (9)

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Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On September 20, 2010, at 9:15 AM, mhonarvar wrote:

    walk by most jewlery stores...almost always have 50% off sales....

    I like to call it the...double the price, then take half off sale....

  • Report this Comment On September 20, 2010, at 12:59 PM, rfaramir wrote:

    "but will break even or lose money at $900 gold, you aren't leaving yourself much room for error"

    Actually, break even at $900 is okay now. We will probably never see $900 gold again in our lifetime, since the supply of US dollars has been raised so significantly compared to the supply of gold. There seems to be a floor at around $1000 (or a little higher), with buyers coming out in droves when the price subsides to near that level. China may be one significant buyer, but it's not the only one.

  • Report this Comment On September 26, 2010, at 1:08 PM, jennifergmd wrote:

    Toby,

    I don't think you have the experience to really talk much about mining stocks. If you have never been to the "Golden Triangle" in British Columbia and don't understand the logistical issues going on there, I don't think you can talk about a stock like Seabridge Gold. Or SSRI for that matter as their fates are intertwined.... If you talked to the management and understood the logistical issues, i.e. supply of energy for the mines, you would have a different analysis perhaps.

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