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Harry Koza

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As good as gold

Harry Koza

  

"O accursed hunger of gold, to what dost thou not compel human hearts!"

Virgil [Publius Vergilius Maro] (70-19 B.C.), Roman poet. Aeneas, in Aeneid, bk. 3, l. 56-7 (19 B.C.), trans. by J.W. MacKail (1908). Alluding to the story of Polydorus, who was killed for his gold by the treacherous King of Thrace during the Trojan War.

I wanted the gold, and I sought it;
I scrabbled and mucked like a slave,
Was it famine or scurvy-I fought it;
I hurled my youth into a grave.

Robert W Service, "The Spell of the Yukon."

TORONTO (GlobeinvestorGOLD) - Well, it's the "Trade by Numbers" commodities edition, and as usual, they've got me writing about gold. This is my fourth column on the yellow metal - see "Hard Currency for Hard Times," in August 2004, and "Re-Evaluating Gold," Dec 16, 2002, plus there was an even earlier one that has now scrolled off the website - and I'm running out of things to say on the subject. Not that that's ever stopped me before.

So, gold.

All the gold in the world, or at least that portion of it that is above ground, totals about 140,000,000 kg, or roughly 4.516 billion ounces. That would fit into a cube about 19 metres on a side - smaller than a tennis court. The world's total annual mining output of new gold is enough to grow the dimensions of that cube by about 12 centimetres a year, and it will take another 20 years to grow it big enough to cover a whole tennis court.

The US still has the world's largest gold reserves, at 8,139,000 kg. That would fit into a small apartment - Fort Knox is mostly empty space.

At $550/oz (all figures U.S.), the total value of that sub-tennis court cube is approximately $248-billion. That's a lot of money. Mind you, the current U.S. sovereign debt, not including future pension and health benefits, is, oh, about $7-trillion. Now, that's really a lot of money, which brings us to what gold is good for.

As Alan Greenspan once said, back in 1999, "Gold still represents the ultimate form of payment in the world."

You don't have to be one of those GATA conspiracy theorists or a survivalist bunkered down in the Nevada desert to have some of your portfolio invested in gold.

Ibbotson, a portfolio diversification and asset allocation firm in the States, conducted a study covering the 33-year period from February 1971 to December 2004, comparing the correlation among seven asset classes (bear in mind, that that period includes gold's big run-up in the early 80s). They concluded that precious metals - gold, silver and platinum - was the only one with a negative correlation to other asset classes, and also the only one with a positive coefficient to inflation. That means that precious metal is the only asset class that rises when the others are falling, and also rises when inflation is rising. In years when other asset classes - stocks, bonds, real estate, etc - had negative returns, precious metals had positive returns. For pension funds and other institutional investors, holding precious metals helps diversify their portfolios, reducing the volatility of their returns. That's a good strategy for individual investors, too.

For the individual investor, it used to be that owning some precious metals meant you had some krugerrands or a handful of gold assay beads stashed in the back of your sock drawer. No thief will ever find it there, right?

So physical bullion is out - you shouldn't keep it at home and it costs money to store it in a secure site. You can buy gold mining stocks instead. I dunno, the big cap ones always seem to trade at a premium to the gold price, and they've had some rocky recent years unwinding their hedge books. The junior ones are risky, require a lot of research, and while it's lots of fun when Moose Pasture Mines pulls a good drill hole and the stock goes to the moon, remember, it takes an average of ten years to put a new gold mine into production, so sell the bounce and buy it back later.

Back on August 6, 2004, I wrote about long-dated call options on gold as a good punt. Not RRSP eligible, though, so I didn't buy any myself. Woulda, coulda, shoulda! Back then, gold was $400 an ounce, and you could've bought a December 2006 $440 call option for around $34. One contract is 100 ounces, so that would set you back $3,400. Today (Jan 23, 2006), with gold around $557, that Dec $440 call was quoted at $142, or $14,200. A four-bagger, as Peter Lynch used to say. Nice pass.

Long-dated options on gold aren't nearly as cheap nowadays. For around $35 bucks, nearly what that call above cost, you can buy a Dec 2008 $760 call option. That seems a pretty bullish target for the price of gold to me, but, hey, if you're a bullion believer who's got the fever, and are looking for some leverage to gold prices, check out options. Talk to your advisor about hedging strategies, too. My friend Contango Bob, the derivatives trading maven, says that for every 10 long-dated call options on gold you buy, you should also sell two short-dated at-the-money put options. And, remember Harry's First Rule of Speculation: Don't bet the mortgage money.

There are other ways to invest in physical precious metals these days.

There's the Millennium Bullion Fund, which is RRSP eligible, a mutual fund holding equal proportions of platinum, silver and gold bullion. It has a MER of 3.46%, kind of high for my tastes, and year-to-date return of 3.58 per cent. Its one-year return is 12.51 per cent. Current price is $6.82.

There are two closed-end funds listed on the TSX. Central Gold Fund (GTU.UN) holds unencumbered, allocated, segregated and insured gold bullion. It trades at around $24 a unit, EPS of $2.39 (a P/E of 9.9), and at roughly a 3 per cent discount to net asset value. It is a pure proxy for owning gold: the price goes up or down with the gold price. Central Fund of Canada (CEF.NV.A) is a similar vehicle, holding a minimum of 90 per cent of its assets in gold and silver bullion, mainly bars, and also unencumbered, allocated, segregated and insured. It trades around$8.36, a 9.2% premium to asset value.

There are a couple of Exchange Traded Funds (ETFs) as well. There's the Streettracks Gold Trust (NYSE: GLD) and the iShares COMEX Gold trust (TSX: IGT-T, on AMEX: IAU). Both of these are likewise proxies for physical metal. There's also an iUnit that tracks the S&P/TSX Capped Gold Index, which holds a basket of TSX gold stocks and has a low MER (0.55 per cent).

These days there's a proliferation of new instruments: There are gold bullion iShare variants listed on stock exchanges in Johannesburg, Spain, and Australia as well, so you can get some currency risk to go with your market risk if you are so inclined.

There are even sportier options. There is something called the Short Precious Metals ProFund, which, as the name suggests, is designed to increase in value when the Dow Jones Precious Metals Index declines, and drop in price when the index rises.

It wouldn't surprise me to find out there is a fund out there that tracks the gold/oil price ratio. As they like to say on the Street, if you build it, they will punt.

As for my own portfolio, I thought about buying Eldorado Gold (TSX: ELD) a couple of times, back when it was cheap at $1.50 or so. Probably should've bought it - it closed at $5.26 today. I still own Dundee Precious Metals (DPM), which I bought around $5 a share back when it was still a closed end fund and was trading at a fat discount to asset value. It's now $10 and change and has an operating gold mine in Bulgaria (Chelopech, about to be expanded to 251,000 ounces a year), another one in development, and a hot development prospect in Nunavut (a 60 per cent interest in the Back River Project). It also still owns blocks of shares in several juniors with properties in Central Africa (Cassidy Gold and Gold Belt among them). I'm inclined to hold onto it for the foreseeable future.

Anyway, I could go on all day about others, but that's all I have room for right now. Take a look at some of the big cap gold stocks, too: Barrick, Agnico-Eagle. There's no shortage of ways to play gold.

Still, not to alarm anyone, but there is a bustle in the hedgerow, to paraphrase Led Zeppelin. One of the warning signals of a market that's getting long in the tooth (if not an outright bubble) is the proliferation of exotic new investment instruments. When I see things like mutual funds that are shorts on gold, I start thinking it's time to start looking for an exit.

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.

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