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Sep 18, 2009

Stockhouse Gold and Silver Supplement

Stockhouse Gold and Silver Supplement

Physical gold not the best way to play precious metals?

Posted: 18 Sep 2009 01:50 PM PDT

Stocks and warrants can enhance returns without adding portfolio risk

In spite of the excessive, in-your-face, rhetoric in the hundreds, if not thousands, of newspaper and on-line articles this past week on gold bullion it does not warrant the hype - at least not yet. All one has to do is examine the performance of gold relative to the broad stock market indices and the various commodity-related indices to see that its rise above $1000/oz. is not really that impressive. Don't get me wrong, I think gold has a very bright future but what has happened over the past week, other than the fact that it is closing in on its all-time high, pales in comparison to all other associated precious metals investment vehicles. Frankly, gold is a laggard, any way one looks at it, as the table below so clearly illustrates:

(1) All calculations are based on U.S. dollar equivalents

(2) Week ending September 11, 2009

(3) HUI is the symbol of the AMEX Gold BUGS (Basket of Un-hedged Gold Stocks) Index. It is a modified equal dollar-weighted index of 15 large/mid cap gold mining companies that do not hedge their gold beyond 1.5 years.

(4) GDM is the symbol for the NYSE Arca Gold Miners Index. It is a modified market capitalization weighted index of 31 large/mid/small cap gold and silver mining companies.

(5) CDNX is the symbol for the S&P/TSX Venture Composite Index. It consists of 558 micro and nano cap companies, of which 44% are engaged in the mining, exploration and/or development of gold and/or silver and other mineral resources and 18% in oil or natural gas pursuits.

(6) SWI is in reference to the commodity-related Stocks with Warrants Index. It consists of all such warrants with at least 24 months duration outstanding trading on the Canadian and U.S. stock exchanges. Of the current 35 companies in the index four are large-cap, four mid-cap, four small-cap and 23 are micro- or nano-cap in size. The index represents 20 gold/silver/copper mining and/or royalty companies, nine miscellaneous mining companies, two oil and gas operators, three merchant banks and one mutual fund.

(7) CWI is in reference to the Commodity-related Warrants Index. It consists of 48 warrants, of at least 24 months duration, associated with the 35 SWI companies.

Sources: (prices); (exchange rates); (warrant data)
Whether we have continued deflation or limited inflation in the years to come it probably would be prudent to follow the advice of many of the non-mainstream financial advisors who suggest that one should have at least 5%, if not as much as 15%, of one's portfolio in gold (and silver) as financial "insurance" to withstand whatever transpires in the years to come. That being said, given the data in the table on the previous page, if one truly believes that gold and silver are going to double or triple in price in the next few years then it would seem logical to put a portion of that gold/silver allotment in either the stocks of the companies that mine it, the royalty companies that buy it from the miners at predetermined fixed prices or in certain of the long-term warrants offered by some of the mining and royalty companies to enhance one's returns.

Many investors are wary of investing in such a supposedly volatile asset class as gold stocks but old and new research shows that the judicious addition of gold stocks can enhance investor returns without adding portfolio risk. Research by Jeffrey Jaffe, which covered the period between 1971 and 1987, identified that, while adding gold and gold stocks to a large portfolio did, in fact, increase both risk and return, the additional return from these non-correlative assets more than compensated for the additional risk. On the risk side, gold and gold stocks had greater volatility, as measured by standard deviation, than the S&P 500 but Jaffe found that, due to their non-correlative qualities, adding gold-related assets to a diversified portfolio would likely reduce overall risk. Below is an updated chart of a portfolio holding 85% S&P 500 and 15% gold equities for the period from 1971 to this past May, 2009. It shows that such a portfolio had essentially the same volatility as the S&P 500 (horizontal axis) but delivered a 22% higher return (vertical axis) over that period of time (rebalanced annually) than a 100% S&P 500 portfolio. (Source: "Gold Stocks Can Add Returns With No Extra Volatility" by Frank Holmes)

Merits of owning gold and silver

Let me count the ways. Declining U.S. dollar value versus other foreign currencies; increasing likelihood of accelerating U.S. inflation; dwindling in-ground reserves; reduced annual production; shortage of new discoveries; increasing investment demand; declining supply due to company de-hedging and reduced central bank/IMF sales; susceptibility to future mania due to small market size and a number of other factors (subject of a future article) all strongly suggest that gold (and silver) has nowhere to go but up significantly in price in the near future.

Merits of owning gold and silver mining stocks

If gold were to escalate considerably in price (i.e. to $2,000, $3,000, or even more) in the next few years it would have a significantly positive impact on the profitability of the companies who mine it and the royalty companies that buy it from marginal producers. For example, with gold priced at $1,000/oz., and the cost of production at perhaps $400/oz. the gross profit margin is 60.0%. If two years from now, however, gold has risen to $2,000 and the cost of production has increased by only 20% to $480/oz. then the mining companies' gross profit margins will have gone up from $600/oz. to $1520/oz. or 153%.

With such a dramatic increase in their operational profits one could reasonably expect that the share prices of such companies' stocks would go up dramatically too. That, coupled with the fact that most gold and silver based stocks are still significantly below what they were at their highs back in 2007 would lead one to expect truly major increases in their stock prices. That is the rationale for finding and investing in those gold and silver mining and/or royalty companies with the right mix of capable management, strong financing, major resources and geographically and politically well-located properties to reap the benefits of such a surge in the price of gold and silver. Were the trend in appreciation of the large- and mid-cap producers versus gold remain constant at approximately 3 to 1 (as depicted above) such profits would be exceptional.

Merits of owning royalty gold and silver company stocks

The companies involved in just buying producing miners' marginal gold or silver production at predetermined fixed prices (i.e. royalty companies) have a license to print money. They have no production risks, no staffing risks, no financing risks, no – you get my gist – so if the price of gold and silver goes up dramatically their gross and net profit margins will go up even more so than those of the producers themselves provided they have strong management.

Merits of owning certain warrants of certain gold and silver mining and royalty companies

However, for those who are prudent enough to do their homework and buy the right long-term warrants associated with the right gold and silver mining companies at today's undervalued prices, their returns could quite possibly be two to three times greater than had they invested in the stocks themselves. So if gold and silver were to go up 100% in the next year or two or three then the stock of many of the companies that mine these products could well go up 200% - 300% and even more if the circumstances were just right. Taking this one step further, if a stock with warrants were to go up 300%, for example, one might well earn an enhanced return of two to three times (the current average leverage factor) that of owning the warrant instead of the stock itself depending on the duration of the warrant chosen (some are as long as four years, a few in excess of five years) and the stock price appreciation realized. Warrants are the only true buy-and-hold investment enabling an astute investor to seize the opportunity to buy in at depressed price and ride out the fluctuations the day-to-day price of a stock until the warrant has risen enough (before its expiry date) to surpass the price originally established, i.e. the exercise price, to convert the warrant into a share. If you are a 'gold bug' then warrants are the ideal investment vehicle to reap the maximum benefits of any ensuing major increase in the price of gold (and silver).

While the process is straightforward enough most people don't have a clue what a warrant is, which companies have them, which ones have the best leverage/time values and exactly how to go about buying them. If you are interested in warrants please visit our site and check out our free database of such companies and our learning center to learn all there is to know on the subject. If you catch the gold fever that is going around and just have to own some warrants, then a modestly-priced subscription would assist you immeasurably in selecting the right warrants of the companies you have determined to have the greatest future prospects.

In conclusion it is important not to get all caught up in the hype surrounding gold's ascent beyond $1000. If you are a true 'gold bug' then better profits are to be had by broadening one's investment horizon to include some large- or mid-cap gold and silver producers, a royalty company or two and a handful of the right warrants of the right gold and silver small-, micro- and nano-cap companies, be they small producers in the development stage and ripe for a buy-out or determined explorers with encouraging prospects. Remember the old refrain "Got Gold?" Perhaps it is time to change it to "Got Gold Stocks and Warrants?"

To my readers:

I receive many emails with questions and comments regarding my articles and I make a point of replying to each and every one. Don't be shy - drop me a line or two at To all you closet authors/commentators out there; if you are interested in becoming a periodic Guest Contributors send me a draft of your proposed article for consideration.

Read more Stockhouse articles by Lorimer Wilson

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