Over the last couple of months, gold investors have worried about the underperformance of their gold stocks relative to bullion itself. No doubt, the best answer so far has come from Nick Barisheff’s “Bullion or Mining Stocks: Do you Have the Right Mix”. Barisheff provides a superb investment analysis based on portfolio theory. He concludes that physical bullion is the “superior” investment.

In this article, on the basis of fundamental analysis I conclude that gold bullion is the safer investment than gold stocks. The problem seems that too many advisors in the gold and silver community emphasize heavily gold stocks, especially as a “leveraged” exposure to the metal itself. While there is a grain of truth, this is fundamentally misleading. Once we account for risk, this seems even incorrect. In a sense, I reach the same conclusion as Barisheff, although my approach is entirely different.

Admittedly, many of the top experts in the gold and silver area stress the importance of holding the physical metal. They call for a non-leveraged position in gold, usually called a “core” position. Clearly, this is a minority in the field. Ted Butler, Dave Morgan, Jim Rogers, and Jim Puplava come to mind.

However, my observation is that most gold analysts pay bullion a lip service. They usually mention it in a sentence or two. Then they quickly move on to discuss “undervalued” junior gold mining stocks with terrific upside potential. Recommending stocks creates excitement. Recommending bullion is dull. A stock analyst doesn’t get paid for recommending bullion; instead he gets fired. 

I have never found anyone anywhere in the literature to provide a meaningful comprehensive list of all major risks associated with gold stocks. Barisheff mentions quite a few of them in a sentence without elaborating them. I believe that if investors understood those risks better, they will be able to better construct their own portfolios. My thesis is simple – bullion is safe, while stocks are riskier. Let me outline for you a dozen of reasons.

1.    Intensive Research. Stock investing requires intensive research. For gold stocks, it also requires understanding a wide range of mining concepts. Advanced technical knowledge is essential. Are you willing to plow through hundreds of quarterly and annual reports and figure out what is in the ground and at what cost? Is it cheap or expensive to mine?

2.    Forward Hedging. Many mining companies learned to hedge against falling prices during the 20-year gold bear market. Hedging in a bear market enhanced their returns. However, hedging in a bull market surrenders earnings potential; it may result in lower profits or even losses. It is true, many companies have already unwound their hedges, but you should make sure this is the case for your stocks. Just read Jason Hommel’s recent revelations about Barrick’s presumably unwound hedges!

3.    Naked Short Selling. Understanding naked short selling is a must. It has nefarious effects. You should know how it works and how to detect it. It occurs when hedge funds and others short a stock without borrowing it in the first place. It is illegal. For them it is very profitable. For you, it will mean huge losses. It is hard to prove. It is hard to prosecute. The small investor is practically helpless. So, you should be alert. It may never hurt you, but it could today, or tomorrow, or at any point in the future. You can do very little about this risk. 

4.   Government Expropriation. Populist governments love it. It does happen only in limited jurisdictions, but it happens. When it does, the government takes the company’s property. Your company loses it. Your stock takes a hit. You cannot avoid this risk.

5.    Government Contract Renegotiation. When governments see a very profitable company or industry, they reach to grab part of its wealth. They may resort to expropriation, but this means running a company. Management requires skill and effort. Governments do not have them, so it is a lot easier to take more of what others have already produced. Increasing royalties is quick and easy. The government simply re-negotiated the contract. The investor cannot avoid this risk.

6.       Punitive Government Taxation. Yet another means for a greedy government to grab more. It simply raises the profits tax. It gets more, while investors get less. It frames it in terms of “Windfall Profit Tax” or some other similar euphemism. The investor cannot avoid this risk. 

7.       Mining Risk. Mining is risky. Acts of God tangle even the best-laid plans. Quakes or floods could set back a mine months or years behind. Repairing damages could be costly. Revenue could be lost. Mine problems could badly affect the bottom line and the stock. The investor cannot avoid this risk. 

8.    Management Risk. This risk is present in every company. Typical are management fraud and incompetence. Many other examples are possible. Moreover, in mining it may take additional forms complicated by the nature of the industry. The risk is always present for any company stock. However, there is no such risk for bullion.

9.   Stock Overdilutions. Investment bankers or lenders play these games. They profit handsomely from them. When bankers extend a loan, they keep an option to convert their debt to equity. When they sell new stock, they keep some stock warrants for themselves and for their best clients. The result in both cases is the same – a rise in the amount of outstanding shares, known as stock dilution. This lowers earnings per share. It increases selling pressure on the stock, as investment bankers decide to sell and cash out. Overdilution often occurs in small exploration or junior mining companies in need of cash. Their management is mostly made of honest geologists and mining engineers; however, Wall Street can easily fool them with glib talk and financial mumbo-jumbo. With physical bullion, such a risk does not exist.

10.  Resource Leverage. Gold analysts tout this one the most. If the price of the commodity goes up by 10%, then earnings go up a multiple of that, say 30%. Yes, this is true, but the risk on the downside also multiplies. If the commodity goes down a little, your stock will likely go down a lot. Leverage cuts both ways! More importantly, leverage multiplies risk!

11.  Rising Production Costs. In inflationary times, commodity prices rise. Of course, that is why investors love to invest in them. However, production costs must rise too. Mining and energy companies have been constantly struggling over the last 3-4 years with rapidly rising cost. Even worse, for many of them, cost prices rose faster than revenue prices. Essentially, rising costs have been “eating” a big chunk of margins and of the profits. 

12.  Price Suppression. This is an especially serious problem for “political” commodities like gold and oil, where governments have the habit of jawboning and manipulating the commodity price. Lower prices benefit consumers and politicians, but hurt investors. One cannot avoid this risk.

Thus, bullion is safer than stocks.

If stocks are riskier, then is it worth taking the risk? Diligent students of the gold bull market of the 1970s suggest that this is not the case. Jim Rogers in his book Hot Commodities presents empirical evidence that stocks of commodity producers did not in general keep up with the commodity itself. Marc Faber provides similar evidence in his book Tomorrow’s Gold. 

What about a well-diversified portfolio of gold stocks? Actually, such a well-diversified portfolio will provide a broad exposure to all of the above risks. While portfolio theory suggest that its expected return should be higher than that of gold bullion, it may likely deliver lower returns for higher risks, not exactly the right way of investing.

I claim that gold bullion is safer than gold stocks. However, I do not suggest that investors avoid gold stocks. Neither do I suggest that they are the worse choice. The case for stocks is strong and undeniable. Their higher risk profile offers a higher expected return. However, no one should expect that the higher expected return should materialize in higher actual return, just like the higher expected return on subprime mortgages did not actually materialize in higher returns when compared to prime mortgages. 

During the 1970s, many gold stocks indeed outperformed the metal 5-10 times or more. With gold stocks, the solution undoubtedly is better stock picking. My investment advice is as follows:

ADVICE 1. Investors should keep a bulk of their portfolio in bullion.

ADVICE 2. Investors should carefully pick their stock pickers.

© 2008 Krassimir Petrov, Ph.D.
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