The outlook for precious metals is bright, but the risks are still there.
Gold bugs began beating the tom-toms when the price
of gold hit $500 an ounce last December. It should be no surprise that,
after enduring two bleak decades, these folks say that the economics
signal higher gold prices due to strong demand in relation to the short
supply of the metal.
But can gold and precious metals mutual funds
continue their stellar performance after a few years of outstanding
returns? Some analysts believe the price of gold could hit $800 an
ounce, as it did in the 1980s.
In the next few years, the price of gold could
approach the record price reached on January 21, 1980, of $850 per
ounce, says Rob Lutts, chief investment officer at Cabot Money
Management in Salem, Mass.
Like many observers, Lutts believes that commodities
in general should be a top market performer for the next five to seven
years and provide value in a stock market that will be stuck in a
trading range.
The reason for Lutts' optimism: Jewelry demand from
the emerging markets of India and China is strong. India consumption is
up 47% over 2004. China consumption is up 11%. These countries have a
strong demand for gold jewelry as they build new wealth.
Gold production has been constrained and is not
expected to rise substantially. Producers have curtailed production
over the past ten years when prices were low. Even though gold prices
are rising, increases in production should be limited.
Investment demand is rising. StreetTRACKS Gold
Shares, an exchange-traded fund launched through a partnership between
State Street Global Advisors and a subsidiary of the World Gold
Council, has attracted $3.6 billion in assets, primarily from
institutional investors, since its November 2004 launch.
Frank Holmes, CEO and Chief Investment Officer of
U.S. Global Investors in San Antonio, believes gold could go to $700
per ounce once U.S. investors start buying. "We are not seeing a
commitment by U.S. investors like we did in previous cycles," Holmes
says. "I don't know when that will take place."
Besides a favorable supply and demand situation,
Holmes believes a number of other unique factors could propel gold
prices. The fear of a slowing U.S. Gross Domestic Product (GDP) could
result in negative real interest rates. When the return on bonds is
lower than inflation, gold becomes attractive. Oil exporting countries,
flush with cash, are increasing their gold reserves; so are Asian
countries. Plus, demand for gold coins and jewelry is on the rise.
Mark Skousen, economist and editor of Forecasts
& Strategies in New York, recommends buying precious metals if
there is a sharp slowdown in foreign purchases of U.S. debt. The
reason: This will force the U.S. Treasury to raise interest rates to
keep foreign governments from unloading Treasury bonds. To avoid U.S.
bond market losses, central banks from China to Argentina quietly are
shifting into gold and precious metals to diversify their portfolios.
"Buy gold, and especially silver and palladium stocks," Skousen says.
"Palladium is the cheapest of all precious metals; it has fallen 80% in
value since 2000, but is now staging a comeback."
Not all money managers are raving bulls. Shanquan
Li, manager of the Oppenheimer Gold & Special Minerals Fund, cites
problems after you strip away all the hype about gold. As a result, he
invested in well-capitalized senior and intermediate producers and has
10% of his portfolio in other minerals.
Here's the rub: The cost of mining gold has shot up
dramatically over the past five years, from about $250 per ounce to
more than $360 per ounce. Without huge investor demand driving gold
prices, mining company profits are not as attractive. The costs of
fuel, cement to build facilities and steel used in construction are
rising dramatically. Financial costs also are rising. But over the
longer term, increasing supplies of gold should temper gold prices.
Li concentrates on core holdings of well-capitalized
producers, and takes a market weighting approach on exploration and
small-capitalized companies. The holdings of gold-related shares should
be more stable because of his emphasis on senior and intermediate
producers with lower cash cost and highly liquid shares. "The rally in
gold is supporting the industry," he says. "But most companies don't
make money. My portfolio is invested in safer plays."
Li's largest holdings include Glamis Gold Ltd., a
lower-cost producer with proven reserves in North America, Central
America and Latin America. The company has several new projects in the
pipeline that should be highly profitable at current gold prices.
He also owns large South African producers, like
AngloGold Ashanti Ltd. and Gold Fields Ltd. The stocks have not
performed well due to the strength of the South African Rand. But they
are undervalued relative to non-South African companies. South African
mining stocks, he believes, should perform well when the Rand weakens
against the dollar. Li also has a stake in NovaGold Resources Inc., a
small exploration and development company, which has discovered almost
17 million ounces of gold deposits in Alaska and Canada. The company,
though, has not begun mining. Li has cut back on his large position in
Newmount Mining. The company wants to acquire Placer Dome Inc., a large
U.S. competitor. The acquisition, he argues, is too costly.
Investing in gold makes a compelling
story-particularly during periods of worldwide uncertainty about
inflation and political turmoil. Nevertheless, gold is risky and
volatile. For example, in periods ending in 2001, the average precious
metals fund lost 3.2% annually over the prior 10 years and 11.7%
annually over the prior five years. Gold bullion prices slumped over
the same ten-year period, losing 2.6% annually. Gold has performed so
poorly over the past 20 years that Lutts, of Cabot Money Management,
says investors have forsaken gold as a way to diversify equity and bond
portfolios.
Today, though, it's a different ball game. The
average precious metals fund grew at a 29.4% annual rate in the three
years ending last November. Gold bullion prices increased a total of
more than 33% since 2002.
However, Holmes, of U.S. Global Investors, says the
recent run-up in gold bullion prices could be followed by a 20%
correction, but then might gain another 40%. If central banks
accelerate or increase gold sales, prices should decline. But as long
as the real return on bonds is low, gold should remain attractive, he
says.
Lutts says jewelry demand in the emerging markets is
a major force driving up gold prices, and greater institutional and
U.S. retail investor demand might push prices to about $700 per ounce.
Every 1% increase in the price of gold typically
results in a 3% increase in the price of mining stocks, Holmes notes.
The reason: operating leverage. Many mining companies are highly
profitable when the price of gold is $500 per ounce because the average
cost of mining ore runs about $150 per ounce less. Holmes says his
World Precious Metals Fund is invested in small and mid-size mining
companies, most with proven reserves. They are expected to increase
production and have strong cash flow and profit margins.
The returns on smaller mining outfits lagged larger
companies in 2005. But Holmes says earnings are growing and merger and
acquisition activity is heating up. He expects Northern Orion
Resources, the fund's largest holding, to be acquired. The company
mines both copper and gold, and is benefiting from rising prices of
both metals. Another play on both copper and gold is Freeport-McMoRan
Copper & Gold Inc. Holmes also likes Silver Wheaton Corp. Like
gold, silver prices are moving higher. The company, with high profit
margins, collects 2% royalties from financing silver mining operations.
The fund's other large holdings: Gold Corp., Bolivar
Gold, Lundin Mining, Meridian Gold and Newmount Mining. Holmes is
avoiding large South African companies due to the strength of the Rand.
He believes revenues of South African companies should only improve
when the Rand weakens against the dollar.
Although the outlook for mining stocks looks
favorable, gold bullion also is attractive. Unlike paper assets, like
mining stocks, which can decline in value to zero, gold has a price
floor that reflects the cost of mining.
Gold bullion and mining stock prices take turns
leading and lagging one another at various intervals. As a result, a
mix of both is less volatile than a 100% stake in mining stocks. "Gold
prices typically run ahead of gold stocks, Holmes says. "But there is a
mean reversion, so owning both makes sense.