Risk / Reward GO KRY

Leverage is the key to the possibility of still making good gains in marginal gold stocks should the price continue to rise - or at least remain above $1,000.

Author: Lawrence Williams
Posted: Thursday , 08 Oct 2009

LONDON -

With some gold junior stocks gaining over 1,000% since last October's meltdown in prices the investor may be wondering if such gains are still possible as the yellow metal continues on its upwards path. To an extent this obviously depends on the strength and duration of the gold price, but with most gold juniors still well below their pre-crash levels there do have to be opportunities out there for the discerning investor who does his/her homework - albeit with increasing risk.

There does seem to be a consensus among most gold analysts that $1,000 gold may well be here to stay, and there certainly seems to have been strong resistance over the past couple of weeks to the price falling back through $990 - and then again yesterday against it falling back below $1,040, but as we all know high and low resistance points are mostly eventually breached, so nothing here is certain. The general expectation does seem to be that gold is headed for $1,200 - perhaps this year. If this is the case then there are almost certainly a good number of bargains to be found still in gold stocks - particularly among producers with relatively high cost levels and among some of the explorers with large low grade mine potential.

There are some warnings that need to be taken into account though. Some of the marginal gold stocks with the biggest reserves are in South Africa, but here the Rand has been an extremely strong currency which is creating problems of its own for the miners who are faced with dollar revenues and Rand costs. So long as the Rand remains strong against the U.S. dollar this can lead to smaller gains than might otherwise be the case.

What is the advantage though of investment in a marginal producer? The answer is leverage. A mine which is scraping a profit at $900 gold will see its margins increase very sharply in percentage terms at $1,000 gold and higher, whereas the corresponding margin increase for a company mining at a cost of say $400 an ounce is much smaller - although of course the latter is a much safer investment should there be a gold price collapse.

This is thus a question of risk vs reward. The greatest potential rewards tend to be available by investing in companies with the highest risk provided of course that the potential downside does not come into play. This could also be true of political risk, but here the caution is that a hostile government dealing with such an emotive metal as gold, can completely decimate a stock's value virtually at a stroke of the pen - as for example has been seen in Venezuela.

But, if you are convinced that current gold price levels, or higher are here to stay then marginal and unhedged mines in relatively safe political environments - particularly where the local currency is largely tied to the U.S. dollar - could provide an element of a gold-based portfolio which would take advantage in particular of strong and increasing gold prices.

These are not investments for widows and orphans, but for those who are prepared to add a higher risk element into their holdings. For the convinced gold bull that suggests perhaps an investment balance which includes bullion itself, or ETFs, plus blue chip gold stocks, plus explorers who have the financial strength to survive any temporary downturn, plus middle of the range low to medium cost producers plus the high risk marginal element which would provide the cream should gold accelerate further.

Mineweb said last October that mining stocks had fallen too far too fast and that there were bargains available for the clever investor - From an article on October 8th last year entitled "The good, the bad and the ugly. Pick the right mining stocks." - about a week or so before the absolute market bottom - we said "Those who had the foresight to pull out of the markets early and keep their assets in cash will have the opportunity of buying back in at a substantially lower cost, and if they can call the bottom of the market, will likely make fortunes as long as they are selective, because the good stocks have been brought down alongside the bad and the ugly." This has definitely been true - but as noted above not so many bargains are left among what we may have classified then as the ‘good' stocks, although there will likely be further appreciation if prices continue to rise. But the marginals then were struggling to survive at all and those that have done so may yet provide good returns even from current levels.