All that glitters: Golden opportunity?

All that glitters: Golden opportunity?

With political unrest and natural disasters around the world in recent weeks, investors rushed to gold as a safe haven and sent prices soaring. However, assessing the intrinsic value of gold is difficult because it lacks the supply/demand fundamentals that typically influence a commodity’s price. And while investors choose gold for many reasons, they may find that some gold–mining companies are a more attractive investment than the bullion itself.

The weakness in this hard asset
Today, the weakness in the U.S. dollar and the lack of yield in other short–term investment alternatives helps gold look attractive to investors. In 2010 alone, gold jumped 30% and demand reached a 10–year high. The interest in the precious metal has continued in 2011 and on April 21, the price of gold reached a record high of $1,504.00 (IHS Global Insight, World Gold Council).

Gold provides no yield, and its returns are based solely on price appreciation. But prices change based more on macroeconomic factors rather than typical supply/demand fundamentals. For example, the average cash cost to produce an ounce of gold for most miners is about $557, yet today’s prices have hovered between $1,300 and $1,400 per ounce. The highest end of the global cost curve does not support today’s prices.

While many investors buy gold as a hedge against inflation, the reality is that gold has not kept pace with inflation for the past three decades. If it had, gold would be selling for more than $2,400 an ounce. Investors may also be seeking to invest in gold as a non–correlated asset for portfolio diversification, something that moves in the opposite direction of most other asset classes. While gold may fill that need, there may be other investment alternatives that fulfill that need and offer an income yield as well. And it’s noteworthy that during the 2008 market meltdown, all asset classes, including gold, moved in the same direction. Gold was not a safe haven then and arguably it may not be a safe haven in the future.

Ways to invest
There are several ways for individual investors to get exposure to gold. Investors may purchase gold through a gold bullion exchange traded fund (ETF). These ETFs own a percentage of the total value of gold which is then stored in a warehouse. The introduction of the gold ETF within the past 10 years has on the margin helped support a higher gold price.

A second option for investors is to buy physical gold, but there are many costs, including transactional and storage costs, that can make it too expensive.

A third strategy is to buy the stocks of gold–mining companies that may have the potential to grow earnings at a higher rate than the increase in gold prices, or to own a fund that invests in gold stocks that offer significant growth potential in both reserves and production. As earnings grow the equity multiple should also increase.

Junior gold mining companies offer opportunities
Putnam Global Natural Resources Fund owns a synthetic collection of junior gold companies that may need more capital and offer the potential for significant production and reserve growth. This type of junior miner is an attractive takeout target. This key investment theme differentiates Putnam’s fund within the gold fund category.

Still, the portfolio has an underweight in the gold mining subsector versus its benchmark. We typically look for well–managed companies and many gold companies are still not the best financial operators. There is a clear trend over the last decade of senior management teams elsewhere in the natural resources sector being led by financial professionals and not by former operators/geologists. These individuals in general are much more focused on growing the bottom line and are doing a much better job of creating shareholder value than most gold companies.

The fund’s strategy directs more investment in other commodities where there is a structural shortfall between supply and demand.

As for gold, there is more than enough supply of the physical commodity above ground held mainly at sovereign banks around the world. It is never a good idea to start investing in a commodity when supply exceeds demand.

A significant amount of risk already priced in
To try to understand the movement of gold prices you have to consider macroeconomic risks. But who could have forecast the current trouble in the Middle East or the earthquake in Japan? How can anyone predict how much the dollar will decline, or what will happen next in the world, and how try to price that in? In the near term, there is less to push the price of gold up except another natural disaster or geopolitical risk. In our view, a significant amount of risk has been priced into most commodities already. The price of gold will remain volatile but, absent any unexpected shocks, directionally we feel it should remain range bound in 2011.

Consider these risks before investing: Commodities involve risks of changes in market, political, regulatory, and natural conditions.
International investing involves certain risks, such as currency fluctuations, economic instability, and political developments. Additional risks may be associated with emerging-market securities, including illiquidity and volatility. The use of derivatives involves special risks and may result in losses. Growth stocks may be more susceptible to earnings disappointments, and value stocks may fail to rebound. The use of short selling may result in losses if the securities appreciate in value. The fund’s non-diversified status, which means the fund may invest in fewer issues, can increase the fund’s vulnerability to common economic forces and may result in greater losses and volatility.

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