NEW YORK (KWR) If you invested in gold during the 1990s, it was clearly an exercise in frustration. However, the tide turned in the early 2000’s as long depressed metals prices came roaring back. Gold is becoming one of the new “hot” ideas for the general investing public, though dedicated gold investors have long been positioned to take advantage of the improved pricing environment. Where is gold going? While there is likely to be some continuing consolidation occurring over the near term, we see gold continuing to rise over coming years as a number of key factors favor an upward sloping price projection. Although we are not so bold to predict that gold will go over $500 an ounce over the coming year and would not be surprised to see a continuing consolidation over the short term, it still has room to go and constitutes a sound investment opportunity.

Depending upon ones investment orientation, the performance of precious metals over the past few years has either been surprising or the natural byproduct of the excessive worldwide fiscal and monetary stimulation caused by U.S. Federal Reserve Board policy. Furthermore, a higher degree of political risk, directly linked to the new cold war of the 21st century – terrorism, societal upheaval related to the globalization of markets -- and resistance to that process – as well as a falling out of the former major Cold War allies over the Iraq war have contributed to the greater degree of market uncertainty that favors precious metals. To this we add the decline of the dollar and extremely low interest rates, all of which enhance the value of gold as a storehouse of value. As a result, both the unhedged Gold Bugs (^HUI) and hedged Gold/Silver Index (^XAU) have substantially outperformed the Dow Jones, Nasdaq and S&P Index over the past two years.

As readers of numerous analytical reports we are actively aware of the current debate as to whether gold remains in a “multi-year secular bullish trend” or whether the current consolidation seen since gold hit multi-year highs late last year will now enter into a full-blown correction. The answer is over the short term no one really knows for sure, but we think the question itself misses the point.

In addition to all the fundamental reasons often used to create a bullish case for gold, we believe one of the key reasons that gold-related shares will continue their upward projection is that overall equity supply trends will lead to a further appreciation over time. Yes, recent reports indicate that the Toronto Stock Exchange and Venture Exchange was home to nearly 1,600 mining equity financings worth $4.18 billion in 2003, with a worldwide deal flow of almost $10 billion. However, with all the talk seen in recent months from investors and the financial media, the entire capitalization of the entire gold and silver market as of late November, according to Mineweb, totaled only $120 billion.

To provide a simple comparison, General Electric and Microsoft have market capitalizations exceeding $300 billion, and Wal-Mart and Intel both exceed $200 billion. Coca Cola registers about $120 billion, roughly the same size as the entire market for all gold and silver companies.

Coca Cola is admittedly a large company with over 56,000 employees. However, as present trends continue and investors around the world increasingly turn to hard assets as a safe haven and store of value, it is hard to see how demand for precious metals and related equities will not continue.

It may be true that gold and precious metal shares are overbought at the present time, (a situation not helped by the central bank of Germany’s recent decision to sell their gold reserves) and that the sector is gaining a lot more attention within the financial media. In addition a lot of the present volatility might be attributed to aggressive hedge funds seeking to gain quick profits by bidding up or down prices. Despite all of this, however, most retail investors have minimal gold exposure and have not yet begun to focus on metals at the present time. Even if one looks at the major copper and nickel companies, such as Phelps Dodge and Inco, which have also appreciated strongly over the past year, the actual investment is relatively small. While both of these firms have developed loyal followings, together they are not as large as Newmont Mining, the largest gold mining company. Newmont has a market cap slightly over $17 billion as opposed to Phelps Dodge ($6.8 billion) and Inco ($7.1). To provide a point of comparison, Eastman Kodak has a market cap of $8.6 billion.

Most metals-oriented conferences and events – while attracting more attention in years past – still do not attract anywhere near the interest of more mainstream investments. At one presentation held last week highlighting a Canadian gold exploration company here in New York for retail and small institutional investors, there were little more than a dozen people in attendance. From the questions it was clear most could not even distinguish between exploration and mining companies. That seems hardly the sign of a market top, when all people with a possible interest are invested. Even precious metals-oriented mutual funds are relatively small. Cursory research reveals none of these funds have net assets exceeding $1 billion. The bottom line is that the small investor – who helps create a bubble of rising prices and expectations – has yet to be fully engaged.

Many analysts reject the supply argument noted above on the grounds that ultimately equities are valued based on earnings and gold and precious metals companies have not delivered in that regard. There is certainly some truth to this line of thinking, however, we would argue given the nature of the mining process, all increases in the price of the underlying metal above extraction and administrative costs will fall to the bottom line. As a result, a sustained increase in metals prices will likely lead to dramatic upside surprises in the profitability of mining companies. It is also important to note that many mining companies – in gold and otherwise – have considerably reduced their inventories. There is a less supply than in the past, while demand is on the rise for gold as well as copper, nickel, zinc and many other commodities.

Furthermore, given the sparse investment into new mining properties that has taken place over the past two decades, we could begin to see an upturn in the M&A environment within the sector as major producers seek to acquire properties that can help to boost their reserves.

On the other hand, higher prices for gold has also led to an increasing number of secondary financings. After a $1 billion financing last November, Newmont Mining, the world's largest gold producer, filed with regulators last week to raise up to $200 million for a possible acquisition and to sell up to another $1 billion in debt and stock. While we still believe the aggregate amount is still small compared to the demand that will arise over the next few years, many analysts point to the dilutions and added supply that will result as evidence that the move in precious metals has past.

This may indeed be true over the short term, and there may indeed be better entry opportunities in the near future – however, the basic fundamentals, which include, but are not limited to, a declining dollar, highly simulative central banking policy in the U.S. and many other economies, stronger long-term growth in China, India and other developing countries, as well as the relatively low level of investment and equity supply following an almost two decade bear market in the commodity sector -- all point to continuing appreciation over time. While we do not necessarily see gold going over $500 in the near term, and would not be surprised to see a continuation of the current consolidation,  it has room to run and the potential to surprise on the upside, especially if – and ultimately when -- greater uncertainty begins to creeps back again into equity markets

© 2004 Keith W. Rabin
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