We have invested 2% of the assets of BL-Global Flexible in gold mining companies, with an objective of gradually raising this to 5%.

I’ve written on many occasions that buying gold is speculation not investment. This statement is due to the fact that gold has no intrinsic value and cannot be valued whereas the intrinsic value of a share can be assessed based on the underlying company’s assets, shareholders’ equity, current and future profits, current and future dividends etc.

So why invest in gold mines? After all, if it’s impossible to value the product they sell, it follows that it must also be impossible to value the companies.

First, speculation can be a good idea, provided you are aware that you are speculating. Two conditions are necessary for the price of gold to rise:

• a scary economic and financial environment which causes investors to seek a safe haven and
• the conviction among investors that gold represents such a safe haven

The first condition seems undoubtedly to be met while at the present time there is no sign that the second is not.

So, if we start from the hypothesis that the price of gold is likely to at least remain at its current level (~1,800 $/ounce), an investment in gold mines could be considered a form of rational speculation. While gold mining share prices generally exaggerate movements in the price of gold (up or down), this time they have lagged behind. This can be seen in the following graph, where the gold miners index is divided by the price of gold. A drop in the ratio means that the miners have underperformed the metal, and a rise that they have outperformed.

There are a number of potential reasons for the miners’ underperformance against the actual metal:

• doubts concerning the sustainability of the rise in the price of gold
• increase in production costs especially due to higher energy prices and wages
• the fact that in recent years the rise in the price of gold has not been reflected in the results of a number of gold mining companies
• concerns over the use of surplus cash flow (in the past, mining companies have not always been very disciplined in this respect)
• the increase in capital spending announced by a number of companies and uncertainties over the return on these investments
• the emergence of paper securities (index tracker funds) aimed at replicating the performance of the price of gold.

The valuation of gold mining companies has consequently decreased considerably in recent years. According to various experts, the share prices of these companies currently discount a price of gold of around 1,300 $/ounce. Based on the current price, this would give our rational speculator a security margin of some 25%.

In addition, the stock market performance of gold companies since mid-August has been encouraging. Since then, they have decorrelated from the stock market, finally following the price of gold more closely.

In terms of individual stocks, there is generally a distinction between established producers (Tier 1), intermediate producers (Tier 2) and junior producers (Tier 3). In terms of investment, the latter are obviously by far the most risky. The Market Vectors Junior Gold Miners tracker fund represents a way of holding a diversified investment in this segment.

For their part, established or intermediate producers can be differentiated on the basis of their production costs, current and future reserves, and valuation. We have purchased Goldcorp, Gold Fields, African Barrick Gold and Newmont Mining. The latter has a unique dividend policy, directly related to the price of gold. Note that there is also a tracker fund for the 30 biggest gold mining companies: Market Vectors Gold Miners.