Greenspan and bullion dealer panic over gold


By Don Luskin
Special to
May 18, 2001
Originally posted at

I wrote Thursday that we had taken a position in a couple
of gold stocks: Newmont Mining and Homestake Mining. It's
been more than 20 years since I've traded gold stocks;
doing it again took me back to my earliest days of trading
in the 1970s.

Back in the early '70s, you bought gold stocks because of
their dividend yields. For a while there, some of them had
absurd yields, topping 20 percent in some cases -- especially
the small-cap South African stocks. I remember having to
learn to pronounce company names like Blyvooruitzicht and
Bloemfontein and thinking I was pretty sophisticated.

When inflation got out of control from 1977 to 1982 and gold
hit $850 an ounce, these stocks went absolutely nuts. They
ended up being the Internet stocks of the hyperinflation era.
They were trading toys par excellence. And those dividends?
What dividends? Fuggedaboudit!

But now gold languishes near 22-year lows. As exciting as
last week's breakout could be for its implications about the
global economy's health, it isn't even visible on the
long-term gold chart.

As for gold stocks, they aren't yield plays anymore. And
they're certainly not trading toys -- at least not until now.
That could all be changing. So here are a few basic pointers
for thinking about gold stocks, just in case you get the urge
to play.

On one level, gold stocks are like any other stocks, and
gold companies are like any other companies. They have
earnings. They have assets. They have management. All
normal rules of analysis apply. But there are some very
important differences in how investors and traders need to
think about gold stocks.

The most urgent difference is that gold companies are
asset plays. Their most fundamental valuation criterion is
the value of their gold reserves, or their "rocks in the box."
Think of it as their inventory -- but while inventory is bad
for Cisco, it's good for gold companies because it means
value. However, it also means risk, as the value of the
inventory fluctuates every moment with gold's market

Every gold company has its own way of dealing with the
inventory risk. Some hedge the risk, and some don't.
Some lever it up. This turns out to be the most important
difference between one gold company and another,
especially if you're looking for gold stocks that will
outperform in an environment with a rising gold price.

Producers who hedge generally sell gold forward as a
way of locking in a known price for their product, the
same way farmers can hedge by selling their crops in
the futures markets. Hedging allows producers to
cushion themselves against a falling gold price -- not
a bad thing over the past 20 years, considering that
it's fallen so far that many unhedged gold companies
actually operate at a loss. According to Merrill Lynch,
hedging accounted for 120 percent of the industry's
fiscal year 2000 operating profit -- meaning that without
hedging, this industry would have lost a lot of money
last year. The cost, of course, is that hedged
companies also hedge their upside.

Barrick Gold is one of the most heavily hedged gold
producers. In fact, the company actually added to its
hedge book in the most recent quarter, selling gold
forward at an average price of $270 per ounce.
Analysts estimate that Barrick has between 27 and
39 percent of its total reserves sold forward, a huge
number for a gold company. Gold Fields, in contrast,
is completely unhedged, as it closed its hedge book
Feb. 16.

But better even than unhedged companies are those
that are levered, those that have structured their
balance sheets and their hedge books so that their
value will rise and fall more, in percentage terms, than
the price of gold itself. Morgan Stanley's gold analysts
do a particularly good job of looking at the relationship
between the gold price and the net asset value of a
gold producer. They say that Newmont and Homestake
are among the most highly levered of the large-scale
producers. According to Morgan, for every 10 percent
increase in the price of gold, Newmont's net asset value
should appreciate by 47 percent and Homestake's
should appreciate by 27 percent.

Some smaller companies are even more levered. For
example, Morgan estimates that Kinross Gold's net
asset value should increase by 400 percent or more
for every 10 percent uptick in gold.

Also, every gold company has its own cost function
for getting its gold out of the ground. Some are efficient
(and more profitable at low gold prices), and others are
inefficient (and only profitable at higher gold prices). A
gold company's leverage can increase or decrease
depending on where the gold price stands in relation to
its profitability. A company that is on the borderline of
profitability, based on the current gold price, is in the
sweet spot of leverage. With the gold price slightly
lower, it can simply shutter its operations and sit on
its inventory like King Midas. But as the gold price
rises, it can light up its operations and cash in.

According to a conversation I had Thursday with
Morgan gold analyst Michael Durose, the average
gold company starts making money on the
incremental hunk of gold brought out of the ground
using incremental capacity at a gold price of about
$240 to $270 per ounce. And that's just the level
from which the price of gold is now breaking out to
the upside. No wonder all of the gold stocks have
made such spectacular moves over the past couple
of months.

All that's required to keep the action going in gold
stocks is for the price of gold to keep going up. It's
that simple. But for that to happen, the Federal
Reserve is going to have to keep supplying the
economy with the liquidity it needs to reverse the
deflationary spiral of the past four years. It will be
great for gold stocks -- and it just so happens it
will also save the world.

Are you listening, Alan?

* * *

Don Luskin is president and CEO of
and a portfolio manager of OpenFund, an aggressive
growth fund investing in the New Economy. OpenFund
strives to be fully invested, expecting to be at
least 90 percent invested under most market
conditions. At time of publication, OpenFund was
long Homestake Mining and Newmont Mining, although
holdings can change at any time.