What about the gold miners?

A mine is a hole in the ground with a liar at the top
Attributed to Mark Twain

Well, I've said several times how much I like gold bullion, but what about the mining companies? There's plenty of discussion about gold mining shares on the web, probably more than there is gold itself (there is, after all, more to write about with a company than a slab of metal), and the investment merits of the two do tend to get confused. I'll admit it now, I've been invested in numerous gold mining issues for many years, and still have a sizeable position.

So, why have I been reluctant to discuss gold mining shares on this blog? Well, in the first instance, because I think that investing in mining equities (and especially gold miners) is a highly specialised field, where you do need expert guidance. I'm no geologist; I seek (and pay for) expert guidance when it comes to my gold mining investments. And, therefore, there is only a limited amount I can reveal about exactly which shares I have invested in, without breaching confidentiality agreements.

However, I do think that my experience can be useful, in general terms, to anyone thinking about entering this field. With that thought in mind, here are a few things that I have learned.

Physical gold (and derivatives like GBS) and the miners are not the same thing
Which may be a statement of the bleedin' obvious, but has some important ramifications. Gold is just gold: a lump of metal which, by virtue of its rarity, physical beauty and historical connotations, is a universal store of value that serves, in reality, as a stateless currency (and one where the supply can be increased at only a very low rate). Gold mining shares, by contrast, are simply shares in companies whose business happens to be mining (or exploring for) gold; their value is ultimately determined by company profitability.

Now, obviously there is a connection between the price of gold bullion and that of gold mining equities; all other things being equal, a higher gold price will mean higher gold miner profits and will so boost mining equities. In theory, mining equities can act as a leveraged play on gold, viz.:

Mining costs $700 per oz; gold price $800 per oz.; profit $100 per oz.
Mining costs $700 per oz; gold price $900 per oz.; profit $200 per oz. (i.e., doubled)

Unfortunately, things are rarely equal, and one reason why gold mining shares have not performed as well as some pundits expected is simply because mining costs have increased at least as fast as the gold price. As I noted last September, before the Lehman Disaster, gold was a mediocre performer compared to other commodities; oil, for instance, increased more than ten times from its 1999 nadir to its 2008 peak, versus only a four-fold gold appreciation. And energy, of course, is one of the major costs of any mining operation.

What's interesting, of course, is that gold has significantly outperformed oil and other commodities since then. My GBS gold ETF was at $81.31 on September 18th, and is $84.26 today; the Brent Crude equivalent (OILB) was well over $60 and is $34.61 today. This supports my thesis that the true gold bull market only started after last September's implosion, with gold assuming the role of an alternative currency rather than another commodity. And, of course, the gold mining shares as leveraged plays thesis could now prove accurate.

Gold mining plays are speculative
No sh*t, Sherlock. Yes, you can get burned badly on gold miners, as that leverage works both ways. As I said, I've been into gold miners for a long time, and while I made excellent returns from 2001-2007, last year's crash hit them hard, with 90% falls in some of my most speculative plays. Fortunately, as I believe in diversification, my position sizes were small enough to avoid any real hurt.

Mining is a depleting business
Another statement of the bleedin' obvious, perhaps, but remember that a mining company's main asset are its mineral reserves. And, with every ounce they mine, that's an ounce less they have. Most of the majors will shortly and urgently need to find fresh reserves, or see their business fade away.

In practice, I find the best way to compare mining valuations is to divide the market cap by their total reserve figure, so giving a dollar-per-ounce value. While this is, of course, a crude metric (and you have to allow for producers versus explorers, proven versus probable reserves, location and grade, etc., etc.), it does give a basis for comparison. I must admit, I tend to find the $10 per ounce figure pretty irresistible.

Small-cap gold explorers are even more speculative
Yes, if actual profitable multi-million dollar cap producing gold miners are speculative, then the small-cap exploration companies, with no profits, no mine, and maybe just a bunch of theories and moose pasture ... well ... Yeeehaaa!! Welcome to the Wild West, baby! Before you even consider thinking about shares in one of these, heed the words of Mark Twain, read the story of Bre-X, and check whether any of their geologists have “fallen” out of a helicopter.

So, why do I think that the small cap explorers are actually the best investment opportunity? Well, it comes down to the bit about mines being depleting resources. Mining companies have to obtain fresh reserves if they are to stay in business, and few of the majors do much in the way of greenfield exploration these days – that's what the junior sector is for, so that the risky exploration business can be performed by entrepreneurial types, and get funded by the gamblers who like to speculate on the Toronto Venture Exchange and AIM. So, in practice, a small-cap explorer that makes a worthwhile discovery will, sooner or later, likely end up being bought out by a major (or, will end up becoming a producer itself).

And, the rewards from the juniors can be dramatic. For example, Almaden Minerals (AMM.TO), a Canadian junior explorer, traded for just C$0.17 in October 2001, and for over $3.40 in February 2006. Is a 1900% profit enough for you? Of course, it's been downhill all the way last year, with AMM back to C$0.44 last November (but a near double since to C$0.86 today).

For me, I suppose the bottom line is that all gold mining shares are speculative, so you might as well go for the most speculative, and try to hit the serious rewards.

So, how to invest?
As I've said, you really do need some specialised advice, especially if you are going for the juniors, to give you some chance of dodging the shysters who run half of these companies. The easiest way to take a position in the majors (i.e., actual gold miners) is to buy the Market Vectors Gold Miners ETF (GDX.NYSE), currently trading at $31.52 (£20.71).

Its top-ten holdings include the likes of Barrick, Gold Fields, Kinross, Newmont, Yamana, etc. I'm officially adding GDX to the CCI portfolio, as a representative of several big cap gold miners which I do personally hold.

As regards the juniors, I doubt that a collective approach would really work, as (frankly) most of them are garbage and any fund would contain too many dogs. What you need to do is to put the work in to discover the few worth buying.