Excerpt from “An Insider’s Guide to the Mining Sector: An in-depth study of gold and mining shares”– by Michael Coulson

To order a copy of An Insider’s Guide to the Mining Sector, please click here: http://www.harriman-house.com/book/view/66/investing/michael-coulson/an-insiders-guide-to-the-mining-sector/

Investing in gold

Our main concern in this book is to steer investors through the mining share market, and the gold share sector has always offered an encouraging number of choices. However, investors in particular have in the past dabbled in physical gold whether by buying gold coins such as Krugerrands and Sovereigns, or gold in bar form, so a brief mention here is appropriate.

Physical gold

One of the characteristics of gold that makes it an investment vehicle is the fact that it is high value for low weight, as people fleeing revolution with only one (strong) suitcase have found to their advantage. It is also very easy to store as it is very dense, consequently its weight is compacted into a small dimension. So a 400oz bar measuring, in ‘old money’, around 7x3x3 inches, is worth $340,000 (at $850/oz). If you carried the same amount of wealth in the form of copper you would need to plan for a substantial lorry to carry the 50 tonnes or so – not much good if you’re in a hurry to catch the last plane out of Saigon, for example.

Gold broadly can be bought for physical delivery or for storage in a secure warehouse. There are a number of specialist gold and gold coin dealers who will take small orders, although the bullion banks are after wealthy customers only. In the UK in the 70s the clearing banks dealt in gold coins in small numbers for their customers but this service has largely been discontinued. The other method of dealing in gold is through holding certified gold. In essence that means that specific gold bars are not allocated to a buyer, but he receives a certificate stating the amount of gold that constitutes the liability of the bank (usually one of the bullion banks) to him.

Gold exchange traded funds

In 2003 the World Gold Council launched a gold investment product, the now named Lyxor Gold Bullion Securities (code: GBS), which is listed on the London Stock Exchange and provides investors with an easy and cheap way of investing in gold. The security is backed by a fixed amount of gold on the basis of around one tenth of an oz per share. The gold exists physically in allocated form and is thus the property of the gold fund shareholders, although initially there was some debate as to how physical the gold was in the hands of the Fund’s custodians. Dealing costs are relatively low at 0.4% per trade. The shares are listed in the Financial Times under Exchange Traded Commodities and appear to trade at a slight premium to the underlying gold value. The fund of gold was valued at around £1.3 billion in June 2008, and daily volume in value is usually over £3 million. ETF Securities also has a gold ETC fund (code: PHAU).

There are also other gold funds in the form of exchange traded funds available in other markets, the biggest in the world is the SPDR(R) Gold Shares (GLD) (invested in bullion not gold shares) in the US. There are also bullion funds in Australia and Canada and in other centres, but any prospective investor needs to look at the structure of the fund as not all of them hold physical gold, some may simply be paper promises based, of course, on gold price movements but not actually backed by gold.

Gold derivatives

Investors in gold can also spice up their exposure by using the derivatives market to obtain greater reward from gold price changes. One route is the purchase of options giving the investor the right to buy (or sell) at a fixed price at some time in the future. The investor puts down a relatively small amount of money to secure the option and if he has bet correctly can enjoy a return far greater than an investment directly in gold itself. Using the options market is, however, very much taking the paper gold route, and there must always be the concern that the counterparty may not be able to honour his side of the trade in extreme circumstances. Although in most cases the option would trade on an exchange and the exchange should guarantee the contract.

There is quite a philosophical divide on the customer side in the gold investment world.

• Some potential investors buy because they think gold is cheap and they will make money. They do not intend to hold their gold for ever, and are simply looking for a decent turn on their purchase price. They tend, therefore, to buy gold in certified form which is cheaper than buying specifically allocated gold. It also simplifies the process of buying and selling because a book entry is all that is needed to complete the deal.

• For others, dealing in gold has a much more mystical significance and they not only want to deal in physical gold they also want to take delivery and store it themselves. Taking delivery can literally mean having it delivered to the buyer who then holds it in a safe or secretes it in a secure place; more normally such a buyer will probably put it in a personal bank deposit box. When buying coins it is usual to take personal delivery, and there are also small, low weight gold bars or wafers which are mostly purchased for personal keeping.

A matter of trust

The other key point to make about gold is that many investors buy the metal because they no longer trust their government, trust the international financial system, or trust more conventional forms of investment including bank deposits. This latter issue galvanised Japanese citizens to cash in their bank deposits, when government insurance of such deposits was materially scaled down in 2002. In place of their deposits, which under the regime of negligible interest rates were providing little income, many Japanese bought gold bars and coins and took delivery. The withdrawal of government insurance cover came at a time of rising concern about the solvency of Japanese banks, and gold seemed like a solid alternative.

Investor scepticism about government attitudes to gold is rooted in the past and one example will suffice. In the 30s, as the US government of Franklin Roosevelt grappled with the Depression, it was decided to use gold as a means of bolstering prices at a time of chronic deflation, in particular farm produce prices. To this end the price of gold was raised to $35/oz in 1934. Before that, in 1933, Roosevelt controversially through the Emergency Banking Act ordered all gold, gold coins and gold certificates held by US citizens to be handed in to the Federal Reserve in exchange for paper dollars or dollar deposits.

There are various estimates of how much gold actually was surrendered, but any gold known to the authorities, like gold certificates and gold held to customer accounts in banks, would have been automatically handed over. US citizens only recovered the right to own gold in 1975, but in the interim many had clearly bought it and stored it overseas, as the price of gold, strong ahead of the lifting of the ban, fell sharply afterwards as demand failed to materialise.

Gold, then, has an important role as a safe haven investment and though many governments these days claim to have little or no interest in it, sceptical supporters of gold believe that if financial chaos was to return then the view of governments could easily change. So to avoid the danger of a Roosevelt-style enforced confiscation of gold, the best thing to do is store your gold yourself. You then have the choice whether to comply with government dictum or not. Of course what you would be doing would be unlawful and there might well be records that could trace the gold purchase back to you. Also, if at some time you wanted to sell your gold it would have to be done unofficially with the likely consequence that a discount to the market price would have to be accepted.

To order a copy of An Insider’s Guide to the Mining Sector, please click here: http://www.harriman-house.com/book/view/66/investing/michael-coulson/an-insiders-guide-to-the-mining-sector/

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