Gold Series Part II: How To Own Gold?

We have established gold’s critical role as the backbone of monetary systems. Hopefully there is an understanding at this point that your personal assets should likewise be backed by something real. The logical question remains, how should one acquire this misunderstood asset?

In order to properly own gold an allocation of physical bullion, exchange-traded bullion, large, medium and small mining companies and exploration stocks must be achieved. Capital should be placed in a manner that balances the gold-rush excitement of exploration-stage companies with the boring stability of physical metal.

Physical Gold 15%-

It is common to see physical gold in the form of jewelry or as an accent on luxury items. This same gold can be melted down and sold at many Cash for Gold type stores today. Once scrap is melted, purified and combined with other gold it takes the form of investment-grade bullion. An assay process determines the purity of the gold and is detailed in a certificate presented to the owner. This form of gold is one of the most efficient means of storing wealth. The largest bar available is a 400oz Good Delivery bar which many have seen pictured in Hollywood movies. More practical 1,000gram, 10oz, 100gram and 1oz bars are also available. This section of our gold portfolio provides stability and real wealth acting as a form of insurance against governmental abuse of the fiat currency you call money.

Exchange-Traded Bullion 15%-

While this section of our portfolio has striking similarities to that of our physical holdings, there is one glaring difference: we don’t physically possess the asset. This creates a need to carefully chose the entity in which we place our faith. We do however need this holding, as lugging our physical metal to the bullion broker in the event of a sale is not always practical.

Your stock broker will reluctantly suggest a position in the most popular ETF which you will politely decline to purchase. Gold is traded in contract form on futures exchanges around the world. It is common for this fund to hold a great deal of futures contracts, or paper gold, in addition to unaudited physical holdings. It is critical for us to be sure that the fund we purchase has actual, physical, audited metal held in private, secure vaults.

Large Mining Companies 30%-

Companies positioned in the business of mining seek out pieces of land with definable mineral deposits. These deposits are studied to determine how much of the desired mineral exists and what the cost of extraction will be. Typically a tiny exploration company will first purchase the prospective land. Once surface samples indicate there could be an economic deposit they will sell the asset to a small mining firm. The small, or junior, firm will develop an economic assessment of the asset and if favorable will sell the project to a large firm. This large firm will operate the mine in a financially predictable fashion.

The reason we intend to own these large firms is that they have acquired deposits at a discount to the gold price over time. For example, when gold was $1,250/oz they might have purchased a development stage mine paying $700/oz for proven reserves. They intended on operating that mine at a cost of $300/oz over a 15 year period. As year one of that period commences they are selling mined product at $1,550/oz. Rising labor and fuel costs have caused operating expenses to rise by say 10% to $330/oz but the increase in revenue far surpasses this amount. As these companies release quarterly earnings detailing this revenue growth the market will be surprised. Remember, the research your stock broker provides you with is very helpful in studying what happened yesterday. You must think for yourself in order to profit from what will happen tomorrow.

Gold Nugget

Mid-Tier Producers 15%-

While large mining companies offer financial and operational stability, mid-tier firms deliver more direct exposure to a rising gold price. In this sector we want to seek out firms that will produce 100,000-400,000 ounces of gold per annum. At this level they have taken the business risk of building a processing facility and are attempting to produce product from start to finish. Usually management has determined that this makes sense based on market conditions and the quality of the company’s mineral assets.

Concerns in this sector are two-fold. With respect to operations these firms can be hit hard by rising costs or turbulent capital markets. Also, the larger firms have a more pronounced ability to lobby local foreign governments and protect their mineral rights in the event that geopolitical risks take hold. While these risks are true concerns, they do not keep us out of this sector. We will mitigate them by spreading our capital over a minimum of three mid-tier holdings.

Prospect Generators 20%-

We have established a firm base in our portfolio using physical metal holdings as our foundation. Next we added operating exposure to a rising gold price which will translate into increased earnings. The final portion of our portfolio should focus on speculative positions as we hope to benefit from windfalls created by new mineral discoveries.

Throughout history men have risked everything as they were sucked into an irresistible gold rush. Capital seems to chase the dream of discovering a giant gold deposit in hopes that the ensuing windfall will change one’s life forever. Unfortunately this is rarely the outcome.

In current times this gold rush takes the form of penny stock solicitations, rumors, message board activity and slick salesmanship. Mark Twain famously said, “A mine is a hole in the ground with a liar standing next to it.” How do we benefit from mineral discoveries while avoiding being swindled? The answer lies in the business model espoused by prospect generators.

These firms attempt to acquire a large number of initial land claims in areas where previous discoveries have been made or geological signs show hints of rich deposits. It is critical to choose firms that are managed by experienced industry veterans with a track records of success. Also, we want to pay close attention to share structure, favoring firms that show conservative share issuance along with a closely held float. Finally, we need to have some understanding of the region where our money will be spent.

This model is currently the most effective way to gain exposure to the Yukon gold rush which is in progress. In a very short due diligence period it is possible to see that there are a handful of companies that seem to know just where to look in the region. Capital is flowing swiftly into the area and unfortunately much of it will be lost. By sticking with the winners we have a greater chance of being part of a large discovery.

Explorers 5%-

It is impossible to fully eradicate the dream of making that big discovery and being part of a stock that soars from $0.25 to $50.00. While this certainly does happen we must be disciplined enough to keep these dreams contained in a small portion of our portfolio.

By following the same due diligence standards employed in our search for prospect generators, people, share structure and region, we should be able to find a handful of small exploration companies that have a chance to make it big. No more than 2% of our gold related capital should ever be wagered on any one single pick in this sector.
We are in a period of rising gold prices driven by political mismanagement and poor decision making. It appears that this trend is firmly in place and far from finished. Our goal is to invest in the sector in a way that allows us to profit from this economic reality. If capital is properly placed it is possible to benefit greatly as the price of gold continues to rise.

See also: Gold Series Part 1: Why do People Buy Gold?

By Edwin B. Tucker

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Trading involves substantial risk of loss and is not suitable for all individuals. Past Performance is not indicative of future results.