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Our lives are in his hands,
We pay in Kruggerrands,
The currency of pain to help
— The Human League's "Dreams of Leaving," from the LP "Travelogue", Virgin Records, 5/31/80
TORONTO (GlobeinvestorGOLD) — The world is a dangerous place these days. Of course, it always was, but one of the things about living in the age of instantaneous information flow is the way that any exogenous event—war, earthquake, volcanic eruptions, a third-world dictator with biological or nuclear weapons, an outbreak of mutated emergent diseases like SARS or Ebola, a giant meteorite impact, or just the latest in what is becoming an appallingly quotidian schedule of terrorist atrocities—is the immediacy with which investment markets react.
Uncertainty and fear create extreme volatility. Your portfolio can take a huge hit. Of course, if the meteorite or the terrorists hit your immediate vicinity, the damage to your portfolio will be the least of your concerns.
Now, there are traders out there who relish extreme volatility, generally professionals with nerves of steel, who also generally are playing with Other People's Money. For most of us, however, in uncertain times, there's comfort in safety. And when things go to hell on a sled, it is nice to have some portion of your capital in something that will retain its value no matter what happens.
There are stocks that benefit from geopolitical uncertainty of one stripe or another—defence contractors, airport security equipment manufacturers, arms manufacturers—but that sort of thing gives a lot of people the willies. No one likes to bet on the misfortune of others, after all, except maybe when it comes to participants in "reality" TV shows.
So, how does one protect one's money during times of global insecurity? There've been dozens of books written on the theme of "crisis investing." Carried to its ultimate extreme, this school of thought is represented by the guys who built Y2K bunkers out in the Nevada desert, stocked with freeze-dried food, automatic weapons, diesel generators, bottled water, gold bars and attack dogs. Some of them may still be out there, like those Japanese soldiers abandoned on tropical islands in the Second World War who were still turning up every once in a while back in the sixties.
But many of the bunker wing-nuts had at least one thing right: they were all gold bugs. And, in one form or another, gold is the ultimate currency for hard times. Our entire system of paper and electronic money is, in some ways, an incredibly tenuous construct, built of gossamer threads and held aloft by everyone holding hands and believing really hard. When the going gets really hard, really hard currency comes into favour.
On the Yap Islands in Micronesia they had an incredibly hard currency—giant nine-ton stone coins. To get one, the Yap islanders had to travel 210 nautical miles to the island of Palau, cut a slab of limestone from a cave, carve it into a full-moon shape with a hole in the middle, and then, by sticking a pole through the hole and applying a lot of brute strength, roll it onto a dugout canoe and bring it home to one of the 14 Yap Islands. Naturally this was incredibly arduous and very dangerous, which made the stones extremely valuable, and they became a store of value and the medium of exchange of the Yap economy. (Interestingly, around 1878, an Irish sailor named David O'Keefe was shipwrecked on Yap, and noted the high regard the natives had for this stone money. So he went to Pulau, hired a gang of natives and industrialized the manufacture of the giant stone coins, trading them with the Yap Islanders for copra and coral. His coins were not valued as much as the originals and had the main result of introducing inflation to an economy that had never known it, ultimately destroying it.).
Gold, not giant stone coins, is our hardest currency. There are many ways to invest in gold. First, there's physical bullion. Gold coins or wafers held in third-party storage (there was third-party-storage gold buried in the collapse of the World Trade Center), or in safety deposit boxes, or under your mattress or buried in the back yard. There are plenty of people with physical gold stashed away, prompted by the notion that if things really fall apart, you need to be able to get at your gold. A large portion of the world's gold supply is held in this way in India, in tola bars (one tola is three-eights of a Troy ounce, or 11.66 grams) and jewelry.
Back in the early '80s, when the Hunt brothers were trying to corner the world silver market, and had driven the price of silver to $50 (U.S.) an ounce, I happened to meet two elderly Russian gentlemen whose families had immigrated to Canada just ahead of the Revolution, bringing with them their life savings in one-ounce pure silver rubles. Once safe in Canada, they buried it in their backyards, and when the price of an ounce of silver hit fifty dollars, they dug it up and dragged it all, in huge burlap bags, to the Johnson Matthey refinery in Brampton, which is where I ran into them. (I was there selling some gold—which was also peaking in price—that I'd recovered that summer from some old mining machinery, but that's another story.).
The Russian gentlemen told me they'd kept the rubles buried in the backyard all those years as a kind of insurance against, well, against another Bolshevik revolution happening in Canada, but now, being of advancing years, and, it not looking very likely that like the NDP would be forming the federal government any time during their remaining lifetimes, they had decided to cash in and put the money into term deposits, which at the time were yielding well into the double digits. Sounded like good logic to me.
Many of the "Crisis Investing" guides recommend a pyramid structure for your gold holdings, with 5 per cent in physical gold that you can lay your hands on when you need it. They say you should hold another chunk in third-party storage. The bulk of your gold holdings (72 per cent to 90 per cent) should be in gold investments, divided among world-class, unhedged, leveraged major gold mines; producing but out of favour top 25 gold mines and producing junior gold mines. Finally, 5 per cent to 10 per cent should be speculative gold investments, junior exploration companies, futures and options.
Naturally, the crisis investing advocates think you should put a goodly chunk of your portfolio into gold in one form or another. That depends on your own risk tolerance and your investment goals—talk to your account executive or financial advisor to determine the optimal weighting for your own needs.
I've been in and out of gold stocks from time to time over the years, mostly juniors. The majors always seem rather fully-priced for my taste—they always seem to be valued at $400 gold when gold is trading at $350—so I'll leave that sector to those more sophisticated than me. Junior miners are lottery tickets unless you do a lot of homework. Physical gold has its downside, too. While it is the ultimate disaster currency, it pays no interest or dividends, costs money to store, and can easily get stolen from that peanut butter jar at the back of your fridge that you thought no burglar would ever find.
So that leaves us with long-dated options on gold, one of the most cost-effective ways of getting some gold exposure for your portfolio. I've written about these before as an interesting way to speculate on the price of gold, and as a pure punt, or even as a form of portfolio insurance, they can make sense.
Today, gold is quoted at around $400 an ounce. A December 2006 $440 call option contract costs roughly $34 today (Tuesday, July 6). One contract represents 100 ounces, so your total cost would be $3,400. Say there's some sudden geopolitical event that causes turmoil in global markets and gold spikes up to say, US$420 an ounce. Suddenly, your option is worth $50. If you sell it, you've made $5,000, a 47 per cent profit, while the price of gold has risen a little over 5 per cent (from $400 to $420).
You've got almost two and a half years of time before your option must be exercised or it expires worthless. Naturally, as you get closer to December 2006, your option loses its time value and the price will decay. But you can always sell your option along the way and roll out into a longer-dated one. My derivatives trading friend, Contango Bob, says that for every 10 long-dated call options on gold you buy, you should also sell a short-dated at-the-money put option.
As always, don't put the mortgage money into this kind of thing. It's a good way to speculate on gold that offers nice leverage, but it is not without risk. Personally, while I find the options intriguing, I have not bought any myself. My sole gold-related investment at the moment is Dundee Precious Metals, which I bought a while back because it was trading well under its net asset value. It still trades at a price-to-earnings multiple of 4 times, and has $1.51 (Canadian) in annual earnings per share. It currently trades around $6.00, and at the end of the first quarter 2004 had a net asset value of $7.10 per share. With a broad and diverse portfolio of gold mining investments, DPM seemed like a low-risk way to make a small bet on gold. The company has now converted itself into an operating mining company, with a producing mine in Bulgaria and another Bulgarian property close to production.
If you really want to invest in physical gold the Royal Canadian Mint offers one-ounce gold Maple Leaf coins. These cost a premium over the current gold price. Gold bars and wafers are more cost effective, and can be purchased at bullion dealers like Friedberg, and Scotia Mocatta.
That's about all I have to say on the subject of gold right now. It has a place in every portfolio. If you are really paranoid, however, and want the ultimate crisis investment, you may want to emulate those bunker-dwelling desert rats and make your portfolio allocations 50 per cent cash and 50 per cent canned goods.
Harry Koza is Senior Analyst in Canadian markets for Thomson Financial/IFR. At various times in his career, Mr. Koza has been a prospector, metallurgist, project manager, engineer, as well as an institutional bond salesman for 15 years. His current area of expertise is in high-yield distressed securities and corporate bonds in general.