By: Julian D. W. Phillips, Gold/Silver Forecaster - Global Watch - GoldForecaster.com

-- Posted Thursday, 17 June 2010 | Digg This Article | Share this article | Source: GoldSeek.com

Gold share prices have not moved up in line with the gold price, why? This has shaken quite a few investors, who based on past market moves, expect share prices to move roughly in line with the gold price in the belief that holding gold mining shares will produce the same if not more gains. It’s time to look at the ‘why’ of this.

What is a Gold Share?

This is the most important question investors must ask of himself, when deciding what to invest in, in the gold world.

1. We have to recognize that a gold share is not gold. It is a share in a corporation that is involved with gold mining. There is no guarantee that the gold price being earned is going to feed through to the investor.

2. The gold mining company in terms of corporate risk, is no different than any other corporation. The risks involve employees, Directors, Unions, resources, production, cash flows, Dividend policies, to name some of the risks.

3. Now add to that market conditions [Bull or bear markets], liquidity of shares in the market [which may have nothing to do with the quality of the corporation] and price earnings ratios.

4. On the bright side, gold shares have the ability to perform better that gold itself for the good ones have a better profit capacity than the gold price [through profit margins] than gold itself.

5. The income to a gold mining company accrues by the quarter or longer, so it is reliant on the average gold price over the period, for its income.

6. There is no doubt that a carefully chosen gold mining share that performs well in a ‘bear’ market, does outperform the gold price over time and can be a better investment than gold itself [such as the shares we favor in this newsletter]

Gold itself

1. Gold bullion carries no corporate risk at all.

2. It is not dependent on people’s efforts.

3. It has so many more aspects than shares in a mining company.

4. It is considered as the real money in many parts of the world.

5. It is considered as an important reserve asset by central banks.

6. It is unprintable.

7. It is a ‘counter’ to the risks inherent in currencies.

8. It is money, ‘in extremis’.

Gold from a Fund Manager’s point of view

There you are, a fund manager who wants to invest in gold. You look at the different options in front of you. Your task is to maximize total return on capital employed. But, you have to achieve this minimizing risk, as far as possible in the present investment climate. Unfortunately, the risk-reward ratio in today’s investment climate is far higher than seen before 2007.

So now you look at gold bullion and gold shares. What points do you factor in? The first is that it is not one or the other, but can be both. Factors you would look at would include: -

· In the eighties, the gold price shot ahead of gold shares when it flew to its peak at around $850, leaving the solid gold shares far behind. Is today a similar scene?

· If not you would likely look at the biggest most solid gold mining shares out there, after all, they won’t go bust easily? But are they likely to live up to the growth expectations of companies whose growth of production is rapid. As it is the majors are currently struggling to replace waning current production.

· A company that is expected to grow income, irrespective of the gold price, promises to perform far better than a major.

· As it is the risks in all markets are high, so you may well balance this against an expectation of a higher return. Good Juniors mining shares would likely fall into this category [see ours below in this newsletter].

· There is no doubt about it, such shares would warrant the increased risk.

“In Extremis?”

Of course, gold itself would remove a tremendous degree of risk, as opposed to gold mining shares, in extreme times. Many investors in the past turned to the biggest and most solid gold shares to reduce risk, saying they won’t go bust, but that’s not what you look for as an investor, surely? So you would measure one of these reliable but underperforming big gold shares against gold itself? After all, holding gold for the same period as one of these would give a similar return, would it not? This is because a gold share should, over that time, reflect the average of the gold price over the same period? In this case, gold itself would offer less risk and over time be a better investment, on a risk-reward measure.

But big investors go for gold itself, for far more than its profit potential today. When you consider that gold will rise in value as times get worse, whereas corporate risks rise dramatically in such times [refer to mid + 2007], then gold’s additional qualities take it into a category of its own, way ahead of most equities. That’s why central banks hold it and that’s why very big investors hold it.

So, Will shares catch up to the gold price?

The answer to such questions is never as easy as we would like, because the world is never simple. In fact, there are a series of answers:

· In extreme times investors shy away from equities, so gold shares would not keep up with a rising gold price.

· In inflationary times equities in general do rise, as does the gold price. In such a scene, gold shares will rise and perhaps outperform the gold price.

· When deflation is hammering values, gold will rise but investor capacities are reduced, taking most equities down with them, including exerting a restraint on gold shares.

· Should an environment exist that precipitate a government confiscation of gold, then international gold prices will rise, but gold price in that country will not. Should gold mines in that country have to receive a government ‘Fixed” gold price, then those gold share will underperform international gold prices. Post 1933, this is what happened in the U.S.A.

So there is a place for both, in different economic scenes at different times. But one should require a good performance from good gold shares that will do well in bad times too.