why is gold considered so special as an investment

8/9/2019 Why is Gold Considered So Special as an Investment

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Why is gold considered so special as aninvestment?

A rare metalGold is an unusual metal. It exists in the Earths crust as an element. Itsnot chemically combined with other metals. Silver and copper are the onlyother metals naturally found in their elemental form.

Gold is considered a universal symbol of status wealth and power. Its !rstuse for decorative ob"ects dates bac# more than $%%% years.

Gold is a relatively rare element with an average concentration of %.%%&parts per million in the Earths crust. Its relatively scarce and di'cult toextract. (or every )&% truc#s containing )% tons of roc# and dirt extractedfrom the Earth "ust about )% grams of gold is extractable.

Properties of goldEarlier the fascination with gold was only based on its aestheticproperties. Its other properties however are e*ually important.

+alleable, It can easily be beaten into a thin !lm. (or example only one gram

of gold can be beaten into a thin !lm covering ten s*uare feet.


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-uctile, It can be drawn into a wire under tension without brea#ing.

on/corrosive, Gold is extremely non/reactive and doesnt tarnish.

0hats why gold "ewelry can remain almost unchanged for thousands of years.

1onductive, Its a good conductor of heat and electricity.

Negative carry2nli#e most other investments gold has a negative carry. 0his means itdoesnt pay any dividend or coupon. In fact it has to be stored safelywhich entails costs. 3ut this re*uirement hasnt been able to deterinvestors from investing in gold as its considered a store for value.Its not under obligation as a pure asset unli#e a bond or a currency.

0hats why historically it has been used to bac# currencies.

Major companies0here are many companies worldwide that supply gold. 3ut big companiesli#e Goldcorp Inc. 4GG5 3arric# Gold 1orp. 46375 ewmont +ining

1orporation 4E+5 6gnico Eagle +ines 46E+5 and 8amana Gold 46285dominate the gold mar#et.

E0(s are also a good way to access the gold mar#et. 0he S9-: Gold 0rust4G;-5 is the largest physically based gold E0( in the world. 0he Gold+iners Index 4G-75 invests in all the above/mentioned companies.

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Pre-feasibility and feasibility pases0he pre/feasibility phase is used to determine if a deposit has reasonablyrobust economic bene!ts in order to "ustify the cost of the next stage ofstudies. 0he feasibility phase de!nes the extent location and value of theore body. Expenditures will rise signi!cantly during feasibilityF andpermitting.

!onstr"ctionExpenditures then rise to their pea# during construction. 6t this point theinow of investment the construction of supporting infrastructure and

direct employment are li#ely to be their highest.

In countries without an established mining sector or s#ills base this mayhowever be a period of high dependence upon imported capital goodsservices and s#ills.

Prod"ction6fter %D& years of outows revenues are generated for the miningcompany for the !rst time as the mine comes into production. 9rior toopening signi!cant investment has to be made in training. ow the minewill have a settled wor#force.

Mat"rity


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6s the mine reaches maturity local supply chains will reach their pea#and investors will receive a return on their investment. 0hen as themines production begins to decline often with lower grades investmentwill increasingly be devoted to preparing for orderly closuredecommissioning and ongoing management of environmental liabilities.

6ll successful mines for stoc#s li#e Goldcorp Inc. 4GG5 3arric# Gold 1orp.46375 ewmont +ining 1orporation 4E+5 6gnico Eagle +ines 46E+5and 8amana Gold 46285 have to go through the above stages. Gold/bac#ed E0(s li#e the S9-: Gold 0rust 4G;-5 are another way of playinggold while E0(s li#e the Gold +iners Index 4G-75 are a good way ofinvesting in gold miners without exposure to individual companies.

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Goldcorp 'GG(Goldcorp is one of the senior 1anadian gold producers with !ve mines in1anada and the 2.S. three mines in +exico and two mines in 1entral andSouth 6merica. f the companys production =&@ is from 1anada and the2.S. >@ is from +exico and )=@ is from 1entral and South 6merica.

0he company primarily sells gold in the ;ondon spot mar#et. It alsoproduces silver copper lead and JincKmainly from concentrate

produced at its 9eLas*uito mine and 6lumbrera mineKwhich it sells tothird/party re!ners. GG wants to develop reserves and operate in safe

"urisdictions across the 6mericas and oMer gold exposure to investors byremaining %%@ unhedged. 6s of -ecember )%> the company hadproven and probable reserves of &=.= million ounces of gold.

0he company has a mine life of N> years based on reserves. 0his life isreasonably long relative to other senior producers. 0he company alsooperates some very low/cost 46IS15 mines li#e +arlin 4


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ewmont is a gold and copper producer. Its one of the largest publiclytraded gold companies. It has assets in 6ustralia Ghana Indonesia+exico ew Oealand 9eru and the 2.S. 0he company had total goldreserves of BB.= million ounces as of -ecember )%>.

+amana Gold 'A,+(8amana is a 1anada/based gold producer with signi!cant gold and copper/gold producing assets in 6merica. It has seven operating mines in 3raJil1hile and the 2.S. as well as gold development stage propertiesexploration properties and land positions throughout orth and South6merica.

In )%> the companys production was .)% million GE. In )%= thecompany expected production is .=) million GE. ote that silver istreated as gold/e*uivalent at a ratio of &%,.

Agnico Eagle 'AEM(6gnico is a 1anada/based gold producer with operations in 1anada(inland and +exico as well as exploration and development activitiesextending to the 2.S.

0he company transformed itself from a regionally focused single/mineproducer to a multi/mine international gold producer with seven operating%%@ owned mines and one advanced exploration pro"ect. It has a high*uality reserve base with reserve life of approximately & years. Its totalgold reserves were $.C million ounces as of -ecember )%>.

&ey E$s0he Gold +iners Index 4G-75 invests in all the above stoc#s. 0he S9-:Gold Shares 4G;-5 is also a good way of playing physical spot gold.

GG .B& /B@

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6 companys choice of mining method is determined by the characteristicsof each gold deposit. 3ased on these characteristics there are mainly two#inds of minesKopen/pit and underground.

/pen pitpen pitF refers to deposits above the ground. 0hese generally ta#e theform of small yellow grains and a#es or even small nuggets on the bedsof fast/owing rivers and streams. atural erosion ooding glacialmovement et cetera also free the gold from mountain roc#s.

Excavation at open/pit mines wor#s through explosive charges which

loosen the bedroc# for removal. 6dvances in mining techni*ues havemade open/pit mining more economical.

,ndergro"nd0hese mines vary more than open/pit mines as the roc# formations andconditions found deep underground are very diverse. Gold often occurs inunderground veins of *uartJ which is made up of silica and oxygen andis often a good indicator for gold presence. Gold occurs less fre*uently inother minerals li#e pyrite granite and mica slate. 0hese veins can beanywhere from half an inch to several feet wide.

0he deepest gold mines in South 6frica are located some !ve #ilometresbelow ground. 6round B%@ of the gold mined today comes from these


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sources. 0he primary techni*ues employed to dig gold from these minesare called long holeF and cut and !ll.F

0y is "ndergro"nd mining costlier tan open-pit mining12nderground mining is generally more expensive both in terms of capital

investment and operating cost than surface mining because companieshave to drill more and use more expensive and complicated machines.6lso they have to ma#e additional arrangements for the safety of minewor#ers li#e complex ventilation or area and local ground support.

6s economical deposits above ground are exhausted mining companiesli#e Goldcorp Inc. 4GG5 3arric# Gold 1orp. 46375 ewmont +ining1orporation 4E+5 6gnico Eagle +ines 46E+5 and Pinross 4PG15 areprospecting for gold underground. 0his trend is adding to their costs. Welltal# in detail about that development in a later part of this series.

E0(s li#e the S9-: Gold 0rust 4G;-5 that trac# spot gold prices are also agood way of investing in gold.

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copper and iron. 0he molten gold is then poured into a mold and allowed to cool.

0he resulting bar is #nown as dorQF which is C)@ pure gold.

:e!ning, +ines then send dorQ bars to re!neries where the remaining

impurities are removed to create gold of CC.&@ purity or higher. Gold of even

CC.CC@ purity is created my more complex and expensive electrochemicalprocesses.

#etailing gold:etailing gold has shifted east with growing demand for the metal from1hina and India. India has traditionally been the largest mar#et for gold

"ewelry in the world absorbing A=$ tons of gold in )%%. 1hinacontributed =%% tons. 3ut from )% onwards 1hina too# over India asthe largest gold consumer. It remains the fastest/growing mar#et for gold

"ewelry in the world.

Its also important to note that E0(s li#e the S9-: Gold 0rust 4G;-5 whichtrac#s spot gold prices and the Gold +iners Index 4G-75 which replicatesthe 8SE Gold +ining Index are also a good way of investing in gold andgold stoc#s.

In the next part of this series well discuss the demand and supplydynamics of gold.

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6t the end of )%> there were AA)%% tons of gold inventories aboveground.

Mine prod"ction

Global mine production increased by &@ from )=CB tons in )%%A to)B$ tons in )%). ew supply is coming up because of a sharp increasein gold prices which more than doubled between )%%A and )%). 1hina isthe largest producer of mined gold extracting => tons in )%). 1hinasproduction is around =.&@ of the world total.

#ecycling gold:ecyclingF refers to gold sourced from previously fabricated productsthat are subse*uently re!ned bac# into bars. 0he 2.S. and Italy are thetwo top sources of recycled gold followed by 1hina and India. 0he supply

response from recycling is more signi!cant than mine production wheredevelopment lead times and other barriers limit rapid responses.

,ni5"e s"pply dynamicsSupply dynamics for gold are however *uite diMerent from supplydynamics for other commodities. Gold isnt consumableF in thetraditional sense of the word. Its stored away somewhere for safe#eeping.

So the supply at any given time can come from sources other than minesupply and gold held for recycling. (or example

supply could include central ban#s individual investors or E0( outows.

6o* does tis di7erence a7ect gold stoc)s16s we discussed above mine supply is signi!cant but other sources canalso signi!cantly inuence gold prices by selling gold in the mar#et. 0heseother sources in turn aMect stoc# prices for stoc#s li#e Goldcorp Inc. 4GG53arric# Gold 1orp. 46375 ewmont +ining 1orporation 4E+5 and 6gnicoEagle +ines 46E+5. 0hey also aMect gold/bac#ed E0(s li#e the S9-: Gold

0rust 4G;-5 and stoc#/based E0(s li#e the Gold +iners Index 4G-75signi!cantly.

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0at are te total operating costs for te gold miners made "pof11osts are one of the most important metrics to loo# at for gold miningcompanies. Well discuss each cost category for a company and what it

includes.

Direct cost of mining0his cost forms the bul# of the reported costs for a company. It includescosts directly associated with operating mines and removing ore frommines. It includes labor energy and consumables stripping royaltiessmelting and re!ning costs. 0his cost is net of by/product credits. So if acompany produces more than one metal thats incidental to theproduction of the main metal then the company can deduct the revenue

from that metal from the total cost. 0his is #nown as by/product credit.F

0his cost has risen the fastest for gold miners in recent years.

4"staining capital e8pendit"re0his cost includes expenditure to sustain existing production levels. It mayinclude anything from additional e*uipment and mine development toexploration expenses which are re*uired to maintain the current level ofproduction.

General and administrative costs

0hese costs include costs related to supporting a companys corporatestructure at the head o'ce level. 0hese costs usually include rentutilities insurance and managerial salaries.

E8ploration costs0hese costs include costs of discovering new mineraliJed material andconverting it into proven and probable reserves. 0hey result in thediscovery of additional deposits near the existing mine. Existinginfrastructure can be used for its development.

#emediation costs0hese costs include accretion expenses related to asset retirementobligations and amortiJation related to asset retirement cost. 0hey reectthe periodic costs of reclamation and remediation associated with goldproduction. 0heyre re*uired in order to restore the mines land bac# to itsnatural state.

!ost brea)"p0he above chart shows the brea#up by category for Goldcorp 4GG5 3arric#46375 ewmont 4E+5 and Pinross 4PG15. 0he Gold +iners Index 4G-75invests in all these stoc#s.

Gold/bac#ed E0(s li#e the S9-: Gold Shares 4G;-5 are also a good way toget exposure to the physical spot goldmar#et.
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note that costs are net of by/product credits. Well discuss this in moredetail in the next part of this series.

A:4! ; A step in te rigt directionSo the *uestion now arises of whether investors would now #now how

much it costs to produce an ounce of gold for a gold producer. 0he answerto that *uestion is a no. 0hats because even 6IS1 doesnt include!nancing costs and taxes. 0hese are genuine business cost that reducecash ows yet theyre excluded from 6IS1. 0hese exclusions can favorcompanies with higher !nancial leverage or higher cost of capital andcompanies with higher taxation. 9lus sustaining capital should include islargely up to company discretion.

So even 6IS1 doesnt give a full picture. 3ut its much better atrepresenting the cost dynamics of a gold producer. ver time it could

improve to correct its sub"ectivity as much as possible.

Investors can also consider investing in gold/bac#ed E0(s li#e S9-: GoldShares 4G;-5 or gold producerDbac#ed E0(s li#e the Gold +iners E0(4G-75 and Runior Gold +iners E0( 4G-7R5.

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0he above table provides a *uic# snapshot for the items generallyincluded by gold mining companies in their cost reporting.

0en can a company "se by-prod"ct and co-prod"ct acco"ntingmetods1

0he diMerence between by/product and co/product accounting depends onthe contribution of each metal to overall revenues. Generally to use by/product accounting a single metal has to contribute at least B%@ ofrevenues while the other metals contribute )%@ of revenues and can beconsidered by/products.

By-prod"ct acco"nting2nder by/product accounting companies can deduct the revenue receivedfrom by/products from the costs incurred in producing all the metals froma mine. 0his reduces the costs per unit for a company. 6ll the companies

reporting negative costs per unit of production use by/product accounting.

(or example say a mine produces both gold 4%%% ounces


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and future economics of the mine. 0he residual low/grade reserve willbecome economical only at very high gold prices.Gold/bac#ed E0(s li#e the S9-: Gold 0rust 4G;-5 are also a good way toget exposure to gold.In the next part of this series well discuss some additional factors to loo#

for in gold stoc#s.

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prices being the same for all players the companies with the lowest costswould bene!t the most in any given price scenario.

0he above chart shows the cost curve for gold miners. 0he ones on theleft/hand side have lower costs compared to the ones on the right/hand

side. 0he width of the bar depicts the volume of production. 0hose minesproducing at above the spot gold price are unpro!table and cant continuefor long if the current price situation prevails.

1omparing gold stoc#s li#e Goldcorp Inc. 4GG5 3arric# Gold 1orp. 46375ewmont +ining 1orporation 4E+5 6gnico Eagle +ines 46E+5 and

8amana Gold 46285 across these factors should lead to insightful details.Gold/bac#ed E0(s li#e S9-: Gold 0rust 4G;-5 are also a good way to getexposure to gold.

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increasingly negative owing to problems with 1hile mines and pressureon cash costs. 8amana Gold 46285 has started doing well after its recentac*uisition of sis#o +ining. 0he SX9 is positive but still has a 33V ratingwhich is the highest speculative/grade rating. Goldcorp 4GG5 is doingwell overall.

A *orsening debt-to-e5"ity pro@le10he debt/to/e*uity ratio indicates long/ and short/term debts proportionto shareholders e*uity. 6 higher ratio indicates a higher proportion of debtin the capital structure.

n this measure 637 isnt doing great either. It has the highest ratioamong peers and had reached a pea# of ).>& in Y) )%> beforestabiliJing at .AB for the last three *uarters.

GG is doing the best on this measure as well. It has a ratio of only %.B. Itshould be able to ta#e credit from the mar#et at a competitive interestrate.

(or ewmont 4E+5 the ratio is steadily rising. 6long with a negativeoutloo# from rating agencies this trend would hamper thecompanys future debt issuances and may come at an increased interestrate.

0here are other measuresKli#e interest coverage ratios 6ltman/O scoresand li*uidity ratiosKthat you should also use to form a holistic view.

0he Gold +iners Index E0( 4G-75 is another way of gaining exposure tothis sector. It invests in all the above/mentioned stoc#s. 0he S9-: GoldShares 4G;-5 trac#s the spot gold price.

GG .B& /B@

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0at are GDX and GDX1G-7 focuses on large/cap names li#e Goldcorp Inc. 4GG5 3arric# Gold1orp. 46375 ewmont +ining 1orp. 4E+5 and Silver Wheaton 1orp.4S;W5. G-7R focuses on "unior or small/cap gold miners li#e Sandstorm

Gold ;td. 4S6-5 and Endeavour Silver 1orp. 4E7P5.G-7 is designed to replicate the performance of the 8SE 6rca Gold+iners Index a benchmar# that consists of publicly traded companiesinvolved in gold mining.

G-7R is a relatively new fund. It was established in ovember )%%C. It hasbecome *uite popular and its total assets have increased to


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Pey things to loo# out for when youinvest in "unior gold stoc#s3y 6nnie Gilroy H Sep )) )%= ,&= am ES0

"nior players0he "unior mining space is very ris#y given very limited options in termsof mines and their involvement in early stages. So its very important toidentify the right "unior stoc#.

ne approach could be to rely on the due diligence and expertise of thelarger mining companies and to see where theyre investing their money.ne very recent example is 6gnico Eagle 46E+5 and 8amana Golds 46285ac*uisition of sis#o +ining 4SP((5.

$ings to *atc o"t for *it gold j"niors0here are additional things you need to consider especially for "uniormining companies.

Management trac) record, Runiors often have only one mine so its very

important that management has a proven execution trac# record and more

importantly management must be ruthless when it comes to bailing out a pro"ect

thats not proving out.

Location, ;ocation is doubly important for "unior miners. 0heir focus is usually

one or two mines at a time. 0he pro"ects that are near the currently operatingmines are usually a safer bet. 6lso properties in the proximity of #nown

mineraliJation usually have access to infrastructure li#e roads water and

electricity.

Political environment, 9olitical pressures can cause governments to change

policies overnight. ugo 1haveJ in ZeneJuela nationaliJed the gold mining sector

while the fate of many "uniors hung in the balance. So its very important to

identify "uniors that are operating in politically stable environments.

Major so"rces of f"t"re s"pply:eserves for ma"ors are declining fast. 0heyre high/grading their minesmining only the high/grade part of the reserves and leaving the low/gradeparts alone. So now is the time to identify the "unior gold companiesthat will be a source of future supply to ma"ors. 2sually ma"ors dontma#e an oMer before a company publishes a preliminary economicassessment 4or 9E65. So investors should loo# for 9E6s with high netpresent value and low capital costs.

8ou can also stic# with the Gold +iners Index 4G-75 and Runior Gold +inersIndex 4G-7R5 if you dont want to do so much due diligence. 0hese E0(sinvest in gold ma"ors and gold "uniors respectively. 0he S9-: Gold Shares

fund 4G;-5 is also a good way to play spotgold.
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AEM ).A>


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Net asset val"e or NAC0his method calculates the present value of a gold mining

companys future cash ows. 0here are a number of estimates you haveto ma#e for each of the mines li#e the long/term gold price cash costsand the production rate. 6fter calculating cash ows a discount rate isapplied to bring the cash ows to the present date. 0his discount rateshould include various ris#s li#e !nancial ris# or country ris#.

0en not to "se NAC8ou shouldnt use the net asset value method when gold prices are veryvolatile or when its very di'cult to get a reasonable long/term price for acommodity li#e gold. 0he long/term price assumption is one of the #ey

assumptions for this valuation method.

0here are other drawbac#s this method suMers from. Its *uite di'cult tocapture the country geological and economic ris#s in a single discountrate number which can have a signi!cant impact on acompanys valuation.

Advantages over te m"ltiples metod0his method is superior to many other methods. Its also helpful whenmultiples for comparable companies arent available. It ta#es into account*uite a lot of fundamental concepts for a company li#e its reserves mine/

life and cost structure. +ultiples/based methods dont account for theseconcepts.


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3ut along with valuation metrics investors should loo# at other factorsli#e the business assets and #ey drivers for gold prices before comingto a conclusion regarding investment in gold stoc#s li#e Goldcorp Inc.4GG5 3arric# Gold 1orp. 46375 ewmont +ining 1orporation 4E+56gnico Eagle +ines 46E+5 and 8amana Gold 46285 or gold/bac#ed E0(s

li#e the S9-: Gold 0rust 4G;-5 and Gold +iners Index 4G-75.

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Enterprise val"e or EC to reserveEnterprise value 4or EZ5 is the mar#et capitaliJation of the companyad"usted to eliminate the eMect of a companys !nancial assets andobligations.

EV = Market Capitalization + Debt + Minority Interest Cash & CashEquivalents Investments2nder this method EZ is divided by the total attributable ounces to thecompany in terms of reserves. 0his ratio is helpful for assessing miningcompanies valuation because its di'cult to assess the exact amount ofdeposits. So companies valuations follow the mar#et value of theirreserves. 1ompanies with proven trac# records of successful explorationcommand a premium.

Enterprise val"e to earnings be interest ta8es depreciation and

amortiFation ; ECEB:$DA0his is a ratio of the EZ of a company to its E3I0-6. 0his is preferablecompared to EZUE3I0 because mining companies have high capitalexpenditures and the timing could be diMerent for diMerent companiesproviding a distorted view.

Some !rms might have negative earnings. 0his ratio is better for thosecompanies.

/"tloo)3ased on these metrics Pinross 4PG15 appears to be cheap compared to

peers. +eanwhile the mar#et is putting *uite a high value on 3arric#Golds 46375 and Goldcorps 4GG5 reservesKprobably because theyre inpolitically stable "urisdictions.+ultiples/based methods are easier to use than the net assetvalue approach. 3ut deciding on the premium or discount that needs to beapplied to a comparable peer set is *uite sub"ective and could vary thevalue of the company signi!cantly.

ne very important thing to #eep in mind while using the multiplesapproach is that you should only value the companies comparable in

terms of siJe of deposit grade depth of the deposit 4deeperFgenerally refers to the cost per ounce5 infrastructure availability etcetera using multiples.

Gold/bac#ed E0(s li#e the S9-: Gold Shares 4G;-5 and Gold +iners Index4G-75 are also a good way of investing in gold and gold stoc#srespectively.

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gold can appreciate in value over time it doesnt oMer anything in termsof regular cash ows.

PerformanceH Gold vers"s gold stoc)sistorical evidence has shown that between )%%A and )%> gold prices

outperformed the share price of e*uities as is clear in the above chart.0here are several reasons why gold stoc# prices lagged behind gold pricesin the recent past.

:ncreasing cas cost, 0he *uality of mines is deteriorating and more and

more tons need to turn out in order to get the same amount of gold as a few years

ago. 0his has pressured labor energy and e*uipment costs.

:ncreasing cape8 needs, 6s mines deplete companies have to put

additional capital and exploration budgets in place in order to replace the old and

depleted mines.Gold or gold stoc)s1When gold prices are on a sustained upward move gold stoc#s provideproportionately higher returns. 0hey de!nitely show greater volatility inboth directions due to the added factors apart from gold price.

So more ris#/ta#ing investors can go for gold stoc#s li#e Goldcorp Inc.4GG5 3arric# Gold 1orp. 46375 ewmont +ining 1orporation 4E+56gnico Eagle +ines 46E+5 and 8amana Gold 46285. 8ou can also considerthe Gold +iners Index 4G-75 an E0( that invests in these stoc#s. 0heseare good choices when indicators show positive prospects for gold.

3ut if the ob"ective is to preserve wealth from ination and central ban#policy changes buying gold or gold/bac#ed E0(s li#e the S9-: Gold 0rust4G;-5 would ma#e more sense.

0o learn more about factors aMecting gold price and investing in gold

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price fall of )%> stoc#s li#e Goldcorp Inc. 4GG5 3arric# Gold 1orp. 46375ewmont +ining 1orporation 4E+5 and Pinross 4PG15 were down fromtheir pea#s in )%). 0heyve been sliding since then.

Declining pro@tabilitynly the producers with the lowest costs are ma#ing decent pro!ts. 6tcash costs of


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:np"t cost i)es, Input costsKnamely labor energy and e*uipmentKhave

risen dramatically after the gold price rally that continued for ) years and ended

in )%>. 1osts also increased because the new pro"ect locations are situated in

not/so/easily/accessible areas adding to wor#ers wages and other site charges.

1osts are now very di'cult to curtail beyond a point for long so minerswill only become pro!table if gold prices rise in response to demand andother macro/economic factors. Gold/bac#ed E0(s li#e the S9-: Gold 0rust4G;-5 are also a good way to get exposure to gold.

0o read more about drivers aMecting gold prices and investing in gold see+ar#et :ealists guide to investing in gold.

&G! .=% %.BC@

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why is gold considered so special as an investment

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