Many investors focused on tumbling equity markets have failed to appreciate the value of miners producing gold at less than half the price they can sell it at in the open market.

One man who has seen this profit opportunity is hedge fund manager John Paulson, widely seen as a canny investor, who made billions of dollars betting against subprime mortgages in 2007.

The company he runs, U.S. fund firm Paulson & Co, last week made a surprise move to buy an 11.3 percent stake in South Africa’s AngloGold Ashanti for around $1.3 billion.

“If a mine produces gold at $300-$400 an ounce you can effectively get long at a deep discount to spot prices,” said David Linsley, a partner at Sirius Investment Management.

Spot gold hit a record high of $1,030.80 an ounce in March 2008 and last month it rose above $1,000. Since then it has slipped to $935 on receding worries about the financial crisis and profit taking by short-term investors.

Further falls are possible, but levels between $250 and $400 seen in the years preceding the September 2001 attacks on U.S. cities are unlikely, as investors fearing inflation and wealth erosion are expected to stick with gold for a long time.

“Gold is a strange thing, the only reliable monetary thing in 3,500 years, all the rest sooner or later become rubbish,” said Markus Bachmann, fund manager at Craton Capital. “Gold companies are no more than money factories.”

Of course there are risks associated with investing in gold producers — mines could flood, workers could strike, research reports could be wrong and debt financing may dry up.

“Those who cannot assess the company specific risks of gold miners or those who cannot accept a potentially significant loss in the short run, should avoid gold equities,” said Adam Taylor, analyst at Liongate Capital Management.

PRIVATE VS PUBLIC

Bachmann cited a well-known ratio — the gold price divided by the Philadelphia gold and silver index of major mining companies — used by many fund managers to work out whether gold miners are cheap or expensive.

The average of the ratio historically is just above four — any reading above suggests gold miners are cheap.

Since last September when Lehman Brothers collapsed and investors at last understood the full scale of the financial crisis facing the world economy, the ratio has stayed above six.

At the end of October 2008 it was around nine as gold spiked and equities collapsed, dragging down gold miners.

“The ratio has been quite a reliable indicator in the past,” Bachmann said. “Believe me in an environment of competitive devaluations gold will be one of the few things to hold up.”

Earlier this month the Swiss National Bank intervened in currency markets to weaken the Swiss franc, deliberately undermining one of the world’s safest currencies. Quietly or openly, other countries will follow, fund managers said.

That would leave gold as the alternative currency, adding to upward pressures and widening the gap against production costs.

“Gold miners may have total costs of around $550 per ounce, or lower in some instances, … and so should be profitable as long as gold prices remain above that level,” Taylor said.

Investors could buy exchanged-listed gold-back commodity funds such as the SPDR Gold Trust, the world’s largest gold-backed exchange-traded fund. SPDR’s holdings rose to a record 1,124.99 tonnes on March 24.

“Physical gold gives direct exposure to the price of gold without any risks,” Taylor said. “But for this convenience a fund must pay … transport, storage and insurance.”

An alternative is for investors to buy into small unlisted gold producers with strong management and proven resources.

“If I take a significant stake in a gold mining company, I would prefer it was a private vehicle than a public one,” Linsley said.

“You are better off with a stake in a private operation because you are not subject to the whims of stock market sentiment.” (Editing by Sue Thomas)

 

(c) Copyright Thomson Reuters 2009.