All That Glitters Is Not Gold (But Sometimes It Is)

Grigoris is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Gold is possibly the most "love-it-or-hate-it" investment asset. It's supposed to be a great hedge against inflation, and it seems like the perfect asset for those who want to preserve their wealth. On the flip side, it is very difficult to estimate its fair value with a minimum degree of certainty.

Over the past nine months, gold has been trapped in bear-market territory, mainly because of increased optimism for an economic recovery in the U.S. and fears that the Fed may taper bond buying. “Safe haven” assets have, pretty much, lost their charm while investors' appetite for equity funds has been stronger than ever fueling an almost unprecedented rally in the U.S. stock market.

The recent slump in gold has sparked a lot of controversy within the investment community. Goldman Sachs has turned bearish on gold warning investors that a rebound during 2013 is highly unlikely. On the other hand, notable hedge fund manager, John Paulson, increased his bets on the precious metal, despite having experienced severe losses in his gold funds.

So, is gold at $1,300 a bargain?

Fundamentals are still strong

The single most important determinant of gold's price is the monetary policy employed by major central banks around the globe. The U.S. and Japan are expanding their monetary base rapidly. Despite rumors to the contrary, the Fed is unlikely to slow down its purchases this year. Last week, Ben Bernanke reassured the markets that the Fed will not change its monetary policy at least until significant improvement in the labor market has been achieved.

The Fed's persistence to flood the world with paper money generates uncertainty that weighs on the value of the dollar, and forces investors to seek a place to hedge their exposure in the greenback.

Therefore, the main reason that pushed the price of gold down, over the past months, the possibility of the Fed implementing an exit strategy sooner than the market had anticipated, is not on the table, at least for now.

Furthermore, we should also take into consideration the central banks’ specific actions regarding buying and selling gold. Central banks need gold to balance their position effectively. The USA, Germany, France and Italy hold more than 60% of their national foreign exchange reserves in gold. However, China’s respective share is around 2%. So, if China's central bank decides that it needs more, the price of gold could skyrocket.

Gold vs Treasuries

Such a move could have significant implications for the treasuries market as well. China is the largest foreign holder of U.S. debt, and it's not unreasonable to think that it might want to reduce its exposure to treasuries in favor of gold. I recently recommended shorting U.S. treasuries using the appropriate ETFs. This move turned out to be quite profitable for those who followed it. Despite the recent appreciation of these ETFs, I still believe TBF has significant upside potential.

Miners: a better bet than gold?

So far this year, gold miners have underperformed SPDR Gold Shares (NYSEMKT: GLD) - the most popular gold ETF. So, what lies behind this poor performance? The precious metal's drop has put a lot of pressure on miners to write down asset values. Furthermore, many of these companies have already undertaken projects, which might not look so lucrative in light of the lower metal price environment.

For instance, Barrick Gold's (NYSE: ABX) Pascua-Lama project in Argentina/Chile. This project was expected to produce 800,000-850,000 ounces in the first five years of operations. However, the slump in gold and silver prices forced the company to cut capital expenditures and reduce the total cost of the project. Furthermore, the project has been temporarily blocked by the Chilean government due to environmental violations. The company has warned shareholders that it might abandon the project if the production does not begin before the end of this year. So, how likely is this scenario?

If you ask me, I think i's highly unlikely. Pascua-Lama will be one of the cheapest resources of gold when completed and the company has already invested a lot in it. Also, the project is of paramount importance for Chile too, as the Chilean president Sebastian Pinera has many times stated in the past.

August 1 will be an important day for the stock as Barrick announces it second quarter earnings. A total of $10 billion in writedowns is expected associated with Pascua Lama, overpaid acquisitions and overvalued assets. Although Barrick is trading at rock-bottom levels, I believe that fears for Pascu-Lama project being shutdown are overplayed. The stock has a lot of upside, if confidence for its completion returns and gold market bounces back.

Newmont (NYSE: NEM) is a similar story. The company has made a significant investment in a single project. The company has made a deal with the government of Suriname to implement the Merian gold project. Production will not start before 2015, and is estimated to be around 400,000 ounces per year. This project considerably increases Newmont’s operating leverage and consequently, a rising gold price would be great news for the company.

Valuation multiples are all very attractive. The stock is trading at low multiples compared to the industry. Newmont has a P/E of 8.5 and a P/S close to 1.5, while the company's debt to equity ratio stands at 0.22, significantly lower than its major peers'. Moreover, the company has a dividend policy directly linked to the price of gold. Dividend yield is about 5% with gold's price close to $1300, making Newmont an attractive option for income investors.

The Foolish bottom line

The total cost of gold mining is estimated to be around $1,150 per ounce. Obviously, miners would be unwilling to sell a commodity that costs more to mine than to sell. So, which could be the outcome, if gold goes below the $1,150 mark?

Supply could be seriously hurt triggering a rise in price. Based on that, and taking also into account that QE will remain in place, owning gold seems the most wise way to protect your wealth.

At the moment, gold mining companies might be a smart investment choice as their shares have experienced a whopping downtrend driven by gold's recent slump. Barick and Newmont are well-positioned to benefit from a potential turnaround in the gold market. 

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Grigoris Vlassis has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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