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Insights: Finance—Golden Reflections

After two decades of doldrums, the future may be brightening for gold investments
Mario J. Gabelli, Caesar Bryan
From the Print Edition:
Gene Hackman, Sep/Oct 00

Wealth is increased and preserved through ownership of many investment vehicles. One that is out of fashion is the ownership of gold and silver, an asset class that has been around a long time. In this article, Caesar Bryan, who manages our open-end, no-load Gabelli Gold Fund, shares with us his reflections on gold.  

The Egyptian pharaoh Tutankhamen was buried in a solid-gold casket weighing 240 pounds. At gold's 1980 peak of $875 per ounce, this casket was worth $3,360,000. At the recent $272 per ounce price, the boy-king's final resting place is worth just $1,044,480. Tut isn't concerned about the precipitous decline in gold prices over the last two decades, but investors holding gold over this period may be wishing they were in his slippers.  

What is responsible for gold's demise? The same forces--low inflation, exceptional economic growth and disciplined monetary policy--that have propelled the dollar and fueled the long-term bull market in stocks and bonds. As long as investors worldwide have faith in the dollar and/or other major currencies, and confidence in financial assets remains strong, gold is not likely to challenge its 1980 highs. However, we believe economic and market forces will fuel a significant rise in gold prices over the next several years. This means opportunity for gold and gold stock investors.  

THE LAW OF SUPPLY AND DEMAND

In a free market, the price of any item is determined by supply and demand. If supply materially exceeds demand, prices fall. If demand significantly exceeds supply, prices rise. In 1999, demand for gold was at record levels--as much as 50 million ounces over annual production.

However, gold is not consumed like other commodities, and therefore, production does not equate to supply. Gold isn't burned like oil, eaten like grain or beef, and, with the exception of those wedding rings that disappear down bathroom drains, it generally isn't thrown away. In essence, most of the gold that has come out of the ground is still around, much of it in the form of gold reserves held by central banks throughout the world. These gold reserves have been providing the supply that has offset rising demand.  

Central banks have been significantly reducing their gold reserves through sales in the open market and gold leasing--lending reserves to gold producers employing hedging strategies and to financial engineers taking advantage of low gold-leasing rates of 1 to 2 percent to finance other investments. This supply may be restrained going forward. Last September, 15 European central banks announced they would limit gold sales and gold leasing for at least five years. In what is being called the Washington Agreement, the United States, Japan and the International Monetary Fund agreed to honor this policy. Gold immediately spiked $70 per ounce to $330, severely damaging the earnings and balance sheets of the more aggressively hedged gold producers and hammering speculators who had effectively shorted gold by selling their borrowed bullion in hope of replacing it with cheaper gold at a later date.  

However, several central banks, most notably the Dutch Central Bank and the Bank of England, responded to higher gold prices by selling gold. The sales were well within the limits of the central bank agreement, but coming so soon after the accord, it sent the wrong signal to the market. Gold quickly gave back most of its gains, undermining the central banks' desire to maintain the value of gold reserves. We suspect that this market whipsaw will make central bank sellers and lenders, and gold borrowers like gold mining companies, hedge funds, and other speculators, more cautious in the future.  

A SHORT SQUEEZE?

Demand for gold should remain relatively strong, supported by healthy U.S. and European economies and the recovery in Asia, whose population traditionally has valued gold both as jewelry and protection against the region's volatile currencies. Growth in production will be restrained by today's low gold price--currently below the cost of production for many gold-mining companies--and the difficulty in attracting capital for additional exploration and development. So, we should continue to see a demand/production imbalance favoring a higher price for gold. If central banks around the world honor their agreement to limit gold sales and leasing, readily available supply will also be constrained.  

What will inspire central banks to hold on more tightly to their gold? A weaker dollar and less robust returns from financial assets. Worldwide faith in the mighty dollar has arguably been the single biggest factor restraining gold prices. Currently, the U.S. balance of trade deficit is around 4 percent of the gross domestic product, historically a danger zone for any currency. The world has been willing to finance this trade deficit by buying U.S. stocks and bonds. If the stock and bond markets continue to slump, money will likely go elsewhere, putting pressure on the dollar and improving the prospects for alternatives, including the Euro and gold.  

A rise in gold prices, which we believe is economically justified by the current supply/production imbalance and the probability of more limited open-market supply, might result in a classic "short squeeze," whereby entities that have sold borrowed gold must cover their short positions by aggressively buying gold in the marketplace. Although central banks do not supply information on how much gold they have leased, it is estimated that 150 million to 300 million ounces of reserves--the equivalent of two to four years of annual gold production--are on loan. The unwinding of this large short position in gold could result in a buying panic that would provide some additional momentum for gold.  

We believe that the most rewarding way to take advantage of a rise in gold prices is through buying the stocks of reserve-rich, low-cost gold producers with significant operating leverage. Let us assume that gold goes from $270 to $400 an ounce (please note I said, assume). If you own gold bullion, you would make about 48 percent on your investment minus the cost of taking delivery and storing your gold. That's not a bad deal. Now let's look at what this price rise does to a gold company's cash earnings. Assume the company is producing gold at $200 per ounce and generating $70 per ounce in cash earnings. At $400 per ounce, cash earnings grow to $200 per ounce, a 185 percent increase. You can imagine the impact this would have on the company's stock price.  

Just how cheap are gold stocks today? With gold at around $390 per ounce in 1996, the XAU, the most widely followed gold stock index, was above 140. As this issue goes to press, it's at 59. So, if we do see gold hit $400, a 150 percent increase for the XAU would appear quite reasonable.  

GOLD STOCKS WORTH EXPLORING

We own 32 different stocks (including several silver- and platinum-mining companies) in the Gabelli Gold Fund. The following three are among our favorites.  

Barrick Gold Corp. (NYSE, ABX, 17 5/8--all stock quotes as of press time) is one of the world's leading gold mining companies. Much of Barrick's growth has come from its very high-quality mines near Elko, Nevada, which the company purchased in 1987. Barrick has used cash flow from its Nevada mines and the profits from the industry's most successful hedging programs to acquire other gold assets in North America and overseas. Barrick has low operating costs, a strong balance sheet and entrepreneurial management.  

Harmony Gold Mining Co. Ltd. (NASDAQ, HGMCY, 5 1/8) is a medium-sized gold company producing more than 2 million ounces of gold annually. The company has developed a core competency in mining low-grade ore very efficiently. Harmony has applied these skills to other poorly managed mines with great success. Because the company is largely unhedged (few short gold positions), any increase in the gold price will likely have a very positive impact on profits.  

Newmont Mining Corp. (NYSE, NEM, 19 13/16) is North America's largest gold producer at upwards of 4 million ounces annually. The company has used cash flow from its very successful Nevada operations to expand overseas. Newmont has a 51 percent interest in Minera Yanacocha (Latin America's largest gold mine), a 50 percent interest in a joint venture in Uzbekistan, and an interest in Indonesia's first heap-leaching operation. Newmont is only modestly hedged and, therefore, a rise in gold prices would leverage earnings significantly.  

After a 20-year bear market, gold is arguably the most out-of-favor asset class in the financial world. We have seen more than a few gold stock mutual funds fold their tents in recent years. We've kept the Gabelli Gold Fund open, anticipating the kind of opportunity we see today. Whether you buy selected gold stocks, our fund or another reputable gold stock fund, we think you will be seizing a golden opportunity.    

Mario J. Gabelli is the founder and chairman of Gabelli Funds Inc., a Rye, New York-based financial services company. He appears regularly on CNN and CNBC.

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