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Betting on a Gold Upswing

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

Gold's 30% fall over the past six months has pushed nearly all investor sentiment to the negative side of the trade. Meanwhile, there has been no slowdown in money printing or debt raising and the long-term fundamental trends point toward a recovery in gold prices.

As a value investor, I tend to shy away from macro investing, but I also love to take positions that are contrary to the market -- when just about everyone thinks the same thing (usually without actually researching the point) they're usually wrong. 

This article focuses on three ways investors can profit from a potential upswing in gold prices. I do not wish to get myself bogged down in arguments over whether gold will recover, so we will move forward on the assumption that it will.

Buy gold

This is the most straightforward way to invest in gold. My favorite ETF in the space is the Central Fund of Canada (NYSEMKT: CEF). The Central Fund is a closed-end fund that currently has a 53.5% allocation in gold bullion and a 45.6% allocation in Silver bullion. Because it is a closed-end fund, the fund does not accept new inflows of AUM and trades on an exchange like a stock would.

Buying or selling pressure on the fund will push it either to a premium (from buying pressure) or discount (selling) to its Net Asset Value. Currently, it trades for a 2.7% discount to NAV, in the time I have followed the fund, it has mostly cycled between a 10% discount and premium. Upward momentum in the gold price will likely drive buying pressure and allow investors to hold the fund at a premium, earning a higher return than they would by simply holding the two precious metals.  

The most popular ETF is the SPDR Gold Trust (NYSEMKT: GLD). The fund has over $60 billion invested in gold. Some investors have a problem with its prospectus, which gives the fund managers the right to use futures to mimic the gold price instead of investing in physical gold, but I have not seen any real problems with its tracking ability.

Also, because of its size, the Gold Trust has a plethora of options available. I prefer to bet long-term when I use options, currently, the Jan. 15 $125 calls (the fund’s price is around one tenth of the gold price) are trading for $13. If, for example, gold started to rise quickly again over the next year and a half and trade up to $1,800/oz, investors would make 423% ((180-125)/13) on their investment on a 50% rise in gold.

Buy gold miners

An alternative to investing in physical gold funds is to invest in gold miners. The potential multiple expansion and inherent operating leverage in miners could allow investors to amplify their returns over the price of gold.

To illustrate these two factors, I will use a mythical mining company: Gold Bugs United (GBUN). Gold Bugs mines one million ounces of gold per year. Currently, it trades for six times earnings and spends $500/oz on average to extract gold. As shown in the following table, the company would trade at a market cap of $4.2 billion.

Assuming the price of gold rises to $1,800/oz over the next two years, and as a result, miners trade up to a 12x earnings multiple, Gold Bugs will almost quadruple on a 50% rise in the gold price.

This example assumed no change in ounces mined or the cost of extraction for Gold Bugs. The following table shows the potential market value assuming changes in these variables.

This is where the Market Vectors Gold Miners ETF (NYSEMKT: GDX) comes in. The Gold Miners ETF is an index that owns shares in the biggest gold mining companies. By only holding the biggest stocks, it is able to ferret out the ones with bad management or not enough diversification. It also allows a few of the companies to miss a quarter or year’s earnings and not kill returns.

The problem with miners is the gold mining is an inherently inefficient business. Most miners go out of business early. Even the ones that manage to stay around for a while do it through serial acquisitions and tend to miss quarterly or annual earnings often. It is tremendously difficult to pick one or two gold miners and know if their six mines on five continents will continue producing the same amount of gold or if the extraction costs will stay steady.

Though I like the Gold Miners ETF, due to the macro headwinds for gold and the potential operating leverage and multiple expansion, as a value investor, the average PE in the fund of just 10x is also appealing. At $24.29/unit right now, if the companies in the fund increase EPS by 25% and the multiple rises to 15x, the price would increase to $42.56, a  75% gain. I think this is easily doable in the next year to year and a half if the gold price recovers. 

Junior miners

Juniors are the penny stocks (literally) of the industry. Many of the juniors have just one mine that is still in the exploration stage -- that is it hasn’t even been mined yet. Some of the juniors will fail because environmental concerns are too heavy, some will fail because they simply cannot control their costs, and more will fail because there was never any gold on the land they purchased to begin with. In the end, more than 80% of junior mining companies fail.

Of course, the ones that do not fail tend to go up a few thousand percent in just a few months. More when the price of gold is rising. This is what makes the Market Vectors Junior Gold Miners ETF (NYSEMKT: GDXJ) convenient. The Junior Gold Miners ETF currently holds 77 junior gold miners. Though many of these will likely fail, the collective beta relative to the gold price is fairly high, so as the price of gold rises, the portfolio will rise even faster. Eventually, a few will hit on great mines, rise ten or so thousand percent, and move the portfolio as well.

Like the two aforementioned securities, the Junior Miners ETF has Jan. 15 options available. I would probably only look to invest in options here due to the binary nature of the possible returns (either go up a lot or go down to zero). If you’re going to lose most of your investment on the downside either way, you may as well have the added leverage in the options.

Conclusion

It is far from certain whether or not gold will recover soon if at all, but intelligent investors constantly look for ways increase their returns. Shown here are a few easy ways to get leveraged returns to the price of gold. Setting aside a small amount of ones portfolio to speculate on a gold recovery may be well worth the risk.

Gold has outshined the stock market with strong returns since 2000, but more recently has given way to big declines. The Motley Fool's new free report, "The Best Way to Play Gold Right Now," dissects the recent volatility and provides a guide for gold investing. Click here to read the full report today!


Mike Price, MSF 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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