Gold stocks are one of my favorite gold topics. I think the process of extracting gold from the ground is one of the most fascinating feats ever. I think it's even more fascinating how much money has been made and lost on shares of stock in gold mining companies. I personally made some great money on a gold mining stock a few years back however am now staying clear of gold stocks in general. The following article will explain some of my history with gold stocks and why I now highly favor holding gold bullion, gold exchange traded funds, and gold futures (if you want to take a riskier position with more leverage).
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The World Famous Desert Sun Mining
My first experience with gold stocks was roughly 4 years back when I noticed a small mining company in South America called Desert Sun Mining. At the time, Desert Sun Mining had fallen from a peak of roughly $2 to a low of $1. The huge decline in price despite any material problems with the company warranted a much closer look. At the time, Desert Sun Mining was a junior mining company. Junior mining companies are those small mining companies usually traded on the AMEX, Nasdaq small cap, OTCBB, or even pink sheets. I fell in love with Desert Sun Mining for a few reasons:
- Leverage: The name of the game in junior gold stock investing is leverage. Desert Sun Mining had recently resumed operations of a mine that was not profitable when gold was in the $200-$300 range. Because gold had rallied to heights not seen for many years, the company was able to profitably resume operation of their flagship mine. The reason there is huge leverage here is an unprofitable operation can quickly become extremely profitable in a gold bull market where the price of gold is rising rapidly. I was very intrigued by the fact that as gold continued to rise, the profit margins of Desert Sun Mining would go from negative to highly positive (that is some great leverage).
- Proven Management: Some of the folks running Desert Sun Mining came from Goldcorp, one of the most respected gold mining companies around. Gold Corp has emerged as one of the largest gold mining companies over the last 10 years due to great management. To leave Goldcorp for Desert Sun Mining, the executives must feel confident in the prospects of my junior play.
- Unhedged Operations: There are two types of gold mining companies, hedged and unhedged. Hedged mining companies hedge themselves against gold price fluctuations with options and futures strategies. They don't want to take on the risk of fluctuations in metal value. Unhedged companies, Goldcorp being one of the largest, do not hedge against metal fluctuations. As gold appreciates, they take full advantage of the spoils. With hedged miners, you are investing purely in the mining operation. With unhedged miners, you are investing in the mining operation and the price of gold appreciating. As a gold bug and bull, I cannot imagine myself investing in a hedged miner.
At the end of the day, my stock did well. It went from my low $1 range purchase price to several dollars before getting acquired by another gold mining company, Yamana. I sold prematurely in the $2 range but made a great double. I was very happy with my gains for sure. I was even happier that I recommended the stock to a close friend who took my advice and more than doubled his money.
Not All Gold Stock Stories Turn Out So Well
Desert Sun Mining is as good as it gets. It's a story of the right management, the right asset, and definitely the right time. Gold was at $500 back then and is at $800 now. I have been watching two other gold mining stocks but have fortunately not invested in them. (Actually, I was in one of them but then got out with a slight loss because I needed the cash for a large expense.) One of them recently had a cyanide leak in their main mine which has delayed mining operations and greatly hurt the stock price. The other had high hopes of a strategic partnership with an overseas company that did not pan out. The moral of the story: I probably got lucky with Desert Sun Mining and for every Desert Sun Mining there are several stocks that did not turn out as well.
So Why Do I Recommend Staying Away From Gold Stocks?
At this point, I feel there is a ton of upside left in gold. Gold is currently at $800 and I believe it should be worth at least several thousand per ounce. Why? It's quite simple: look at gold's past peak and then adjust it for inflation and we get into the thousands. Moreover, look at the current state of the economy and future of the US. Not so great (unless we get a radical change of fiscal policy, as advocated by someone like Ron Paul). While I definitely see gold going higher, the reason I don't like gold stocks can be summarized in a few bullets:
- The easy leverage is over. Gold has gone from the $200 range to $800s. Most operations that were borderline profitable have already witnessed huge price rallies (the leverage factor is now priced in). This reduces the leverage of gold appreciating but of course the appreciation will still help unhedged operations.
- The easy gold is gone. Gold miners are having to get more and more creative and are now mining pits that are less lucrative than the low hanging fruit of years past. Expenses of mining are not only increasing because the easy gold is gone but also because those that sell mining equipment are raising prices to capitalize on the bull market.
- The risks of problems is high. I like to think my success in Desert Sun Mining is all my pure analytical skill, but know there was some element of luck involved. For every large stock gain, there are several huge failures. I know gold is going to appreciate more and don't care to take the risk of losing my money in a market where my gains should be almost guaranteed.
What Alternatives Are There To Gold Stocks?
Here's the fun part. How can we capitalize on the large gold bull market while avoiding stocks? My main suggestions are gold bullion coins (either take personal delivery via your vault or safe deposit box or store in an allocated gold account), gold exchange traded funds such as GLD, and even gold futures. Gold futures are the perfect way to get the same volatility as a junior gold mining stock without taking on the above reasons I don't like gold stocks. Still want to own gold stocks? I don't blame you. There are still huge gains to be had and there are many companies out there and up and coming superstars that cannot be ignored. Do your research very carefully and take calculated risks. Even though I am biased towards the metal itself, I cannot deny the importance of a diversified gold portfolio (including unhedged stocks). Also, in the interest of playing devil's advocate, you just might see me writing "Why It's the Right Time To Buy Gold Mining Stocks" as one of my upcoming articles!
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