Lower Gold Crash Risks with Mining

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

The price of gold has been on a meteoric rise. Since 2002, the price of gold has risen by approximately 446%. Gold is often seen as an inflation hedge and with the current global economic problems (e.g. Europe mired in a debt crisis and the US fighting a large deficit), there are legitimate reasons to consider buying gold. However, the large past increases in the price of gold cast doubt on the amount of protection the metal can provide at current levels. The following chart, from 2002 to 2012, compares the rise of the US Consumer Price Index (CPI) to the rise of the price of gold.

<img src="http://media.ycharts.com/charts/fd2f4b5e6cc6634f31401d939f7f0e25.png" />

Gold Price in US Dollars data by YCharts

As shown, in the past 10 years, the US CPI has risen by 27.5%, far from the 445.6% rise in gold. Since gold is a hard asset, when the purchasing power of fiat money declines (through inflation), the price of gold should rise (because fiat money is used to purchase gold). However, the rise in the price of gold has clearly outpaced inflation. Gold’s large climb is mainly the result of a shift in the supply and demand curve for gold. There are three main sources of demand for gold: investment, technology, and jewelry. The five year average demand distribution (from Q1 2007 to Q4 2011) is 32.7%, 12%, and 55.3% for investment, technology, and jewelry, respectively. Since 2003, investment has been the largest driver of rising demand. From 2007 to 2011, investment demand increased by 534% (World Gold Council). In other words, investors turned to gold out of fear or speculation. As a result, gold’s current high price makes it a risky investment.

However, this risk can be tempered by investing in gold mining companies. Gold mining companies are benefiting greatly from higher gold prices. While the companies’ profits are inflated due to the current gold bubble, the difference is that companies keep their profits. Gold mining companies that are run by intelligent managers have been piling up the profits on their balance sheets. Everything else being equal, the best gold mining company to buy is the one with the largest gold reserves. Barrick Gold Corp (NYSE: ABX) is the world’s largest gold producer and has the largest gold reserves. On December 31, 2011, the company had estimated total global proven and probable gold reserves of 140 million ounces.  The following table compares the company’s reserves to the other top producers in the industry.

<table> <tbody> <tr> <td>Gold</td> <td>2011 Proven and Probable Reserves (million ounces)</td> <td>2011 Production (million ounces)</td> <td>2011 Reserve Life Reserve/Production (years)</td> </tr> <tr> <td>Barrick Gold</td> <td>140</td> <td>7.7</td> <td>18.2</td> </tr> <tr> <td><strong>AngloGold Ashanti</strong> <span class="ticker" data-id="206836">(NYSE: <a href="http://caps.fool.com/Ticker/AU.aspx">AU</a>)</span></td> <td>75.7</td> <td>4.3</td> <td>17.6</td> </tr> <tr> <td><strong>Gold Fields</strong> <span class="ticker" data-id="203703">(NYSE: <a href="http://caps.fool.com/Ticker/GFI.aspx">GFI</a>)</span></td> <td>77.6</td> <td>3.7</td> <td>21.0</td> </tr> <tr> <td><strong>Freeport-McMoRan Copper & Gold</strong> <span class="ticker" data-id="203558">(NYSE: <a href="http://caps.fool.com/Ticker/FCX.aspx">FCX</a>)</span></td> <td>46.1</td> <td>1.4</td> <td>32.9</td> </tr> <tr> <td><strong>Harmony Gold Mining</strong> <span class="ticker" data-id="207147">(NYSE: <a href="http://caps.fool.com/Ticker/HMY.aspx">HMY</a>)</span></td> <td>39.1</td> <td>1.3</td> <td>30.1</td> </tr> </tbody> </table>

As shown, Barrick Gold’s gold reserves dwarf the other companies. Due to its high production levels, the company’s reserve life is shorter than some of its competitors. Freeport and Harmony have reserve lives of around 30 years. It should be noted that reserve life estimates are rough estimates because there are many factors involved. For example, if the price of gold continues to rise, more expensive mines can be developed, which would increase a company’s total reserves. The reverse can happen.

Currently, Barrick Gold has a PE ratio of 10.5. In comparison, AngloGold Ashanti, Gold Fields, Freeport-McMoRan, and Harmony Gold have PE ratios of 9.9, 9.1, 12.5, and 13.2, respectively. The gold industry has an average PE ratio of 21.2 (Yahoo Finance). In addition, as shown in the following chart, with the exception of Freeport, the companies' stock prices have significantly lagged the price of gold.

<img src="http://media.ycharts.com/charts/aace9dcc2b4fc113057d2b205b5aa49d.png" />

ABX data by YCharts

Since 2002, Barrick Gold has piled profits onto its balance sheet. In 2002, Barrick Gold had a tangible book value per share of $6.69. In its most recent quarter, its tangible book value share was $15.08. In comparison, AngloGold, Gold Fields, Freeport-McMoRan, and Harmony Gold have tangible book value per share of $14.05, $7.39, $17.72, and $9.00, respectively. When taking into account their large reserves, their tangible book values, and low PEs relative to the industry, it is clear that these companies are good investments. In the case of Harmony Gold, the company has a larger tangible book value per share than stock price. This means that investors who buy the stock at this level are really getting the earnings power of the business for free. However, Barrick Gold is the most compelling investment because of the company’s significantly larger gold reserves.

The biggest risk to investing in Barrick Gold is the high price of gold. If the price of gold comes crashing down, Barrick Gold’s profits will crash. However, 43% of the company’s current stock price is covered by the company’s tangible book value per share. This limits the downside risk. The benefits of investing in Barrick Gold are the large profits the company continues to make due to the high price of gold and the protection gold provides against a potential crash in the value of the US dollar (i.e. high inflation). By having the largest gold reserves and a PE below the industry average, investing in Barrick Gold is a great way to get the benefits of investing in gold while lowering the downside risk.

Alvin has no positions in the stocks mentioned above. The Motley Fool owns shares of Freeport-McMoRan Copper & Gold. 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.If you have questions about this post or the Fool’s blog network, click here for information.

blog comments powered by Disqus