Gold Mutuals Make Bullion Look Tepid

The excitement over gold this spring is wild enough. But gold bullion’s price rise is piker stuff compared to the gains in gold mining stocks.

While bullion futures on the New York Commodity Exchange have jumped from $332.80 an ounce at year’s end to $378.30 now, a nearly 14% rise, the average gold mining stock mutual fund is up 56%.

In fact, the gold funds are on track to post their biggest half-year advance since the second half of 1982, when the average fund zoomed 111%, says fund tracker Lipper Analytical in Summit, N.J.

The mining stocks historically have done an excellent job of foreshadowing the metal’s price moves, and that was certainly true this year. The stocks’ rally began in the first quarter, while virtually all of bullion’s gains have come since March 31.

Because the mining stocks are perhaps the simplest way to own gold, especially through mutual funds, their price moves tend to be exaggerated on both the upside and the downside. In other words, owning gold funds is like owning gold bullion on steroids.

So after a 56% leap, how bullish do you have to be on gold to buy a mining fund today?

There’s a strong argument that both the metal itself and the stocks still have momentum in their favor. Remember that for the last five years, investors have used every excuse imaginable to sell gold. Now, say gold’s fans, the reverse is true--investors are overwhelmed with very good reasons to buy.

To name a few: inflation’s apparent revival from a 3% annual rate to the 4% to 5% range, the sinking U.S. dollar and soaring Chinese demand for jewelry.

And precisely because so many investors have been caught short by gold’s surge, the sheer force of cash trying to enter the gold market may assure that this move lasts at least through year-end if not longer.

“I think this is just the first step of a long-term rally,” says Lucille Palermo, manager of the Van Eck Gold/Resources fund in New York.

The frenzy over the mining stocks is a major reason why gold bulls believe that bullion’s rise is for real this time.

From 1988 through ‘92, a period of mostly declining U.S. interest rates and declining inflation, bullion slumped from just under $500 an ounce to about $330. But while there were numerous gold rallies within that downtrend, the mining stocks had only one significant rally, which was during the second half of 1989.

With the stocks’ surge this year, many gold fund managers believe the market is forecasting a near-term bullion price of $400 to $415 an ounce. That would be about a 6% to 10% gain from the current price.

The mining stocks rise so much faster than the metal’s price because of the great earnings leverage the companies enjoy. For most miners, the per-ounce cost of getting gold out of the ground is fairly constant. So each $1 increase in the price of the metal is essentially gravy for the companies.

To illustrate that leverage, consider what happened to San Francisco-based Homestake Mining in 1987. Gold jumped from about $350 an ounce in mid-1986 to about $450 by mid-1987, almost a 30% rise. But the windfall to Homestake from that price rise was far greater: The firm’s operating earnings rocketed 130%, from 23 cents a share in 1986 to 53 cents in 1987.

Thus, if investors simply become convinced that gold is more likely to rise than fall in price over the next few years, the mining stocks will again be perceived as growth companies--potentially luring many new buyers.

Still, fund buyers today should realize they aren’t getting bargains in the stocks. One of the premier mining firms, Toronto-based American Barrick Resources, trades at $22.875 a share on the New York Stock Exchange, up 48% from year-end. At the current price, you’re paying 30 times the 75 cents a share Barrick may earn in 1993 if gold settles near $400.

Dan Leonard, who manages the Financial-Invesco Gold stock fund in Denver, figures that only about half the 43 mining companies in his $280-million portfolio are currently profitable.

“These stocks really don’t trade on the basis of earnings,” Leonard argues. “They trade based on their gold reserves” in the ground, which rise and fall in value with the metal’s price.

To buy a gold fund today, you obviously have to be bullish on the metal. But you don’t have to believe that inflation will roar soon, many fund managers say.

While rising inflation is traditionally what drives investors into gold as a way of preserving money’s purchasing power, gold’s fans say the metal is advancing for more basic reasons:

* The Fear Factor. Not fear of Armageddon, but uncertainty over the next cycle in the world economy, says Sy Harding, whose Sy Harding Investor Forecasts newsletter in Palm Coast, Fla., turned bullish on gold in December.

For the last three years, the global trend has been toward lower interest rates and-or controlled disinflation, Harding notes. Now the United States, Japan and most other developed nations except Germany are trying to spur growth.

Investors don’t know if that will revive inflation--but they do know the game is changing, with uncertain consequences, Harding says. So for safety’s sake, more investors are turning to gold.

* The Undervaluation Factor. There is a powerful argument that gold, as an asset, is too cheap and has been for some time. Money should eventually flow to undervalued assets.

The Van Eck fund’s Palermo figures that the bare-bones cost of finding and producing an ounce of gold is $375: $30 for exploration, $60 for mine construction, $240 for processing, $35 for financing and $10 for overhead. In theory, the market price of gold should at least reflect that economic cost plus some emotional premium.

Overlaying the price fundamentals is a bullish supply-demand situation, Palermo adds. While miners have had little incentive to boost gold production since 1990, bullion demand has been rising, especially in China, where an increasingly well-off population craves gold jewelry both for ornamentation and as a hedge against spiraling inflation.

The World Gold Council estimates that China could account for 25% of 1993 world gold purchases.

More important, says Palermo, is that many of the “desperation” sellers of gold in recent years have been exhausted--including the Kuwaitis, Eastern European and Russian central banks and cash-needy Japanese investors. With any asset, when the sellers finally dry up, even a slight rise in demand can boost prices sharply.

Despite all of the positives for gold, however, “in the end, this is an investment that depends heavily on emotion,” notes Don Phillips, a principal at mutual fund tracker Morningstar Inc. in Chicago. “To say that you can predict the price of gold better than someone else is to say you can predict human emotions better than someone else.”

That’s why an investment in gold or gold funds today should make up no more than 10% of your total assets, most experts say. And you should own gold for one reason alone: as a hedge against trouble in stocks and bonds because of inflation or other unforeseen problems.

The gold funds make it easy to get that hedge--if you can stand their volatility.

Of course, if you’re drawn to gold because you fear the end of civilization, you belong in gold coins, not gold funds.

Or maybe not. If you fear the end of the world, says Victor Flores, manager of the United Services Gold Shares fund in San Antonio, “forget bullion--buy an Uzi.”

Gold Stock Funds: On Fire Again Gold stock mutual funds are on track to post their strongest six-month period since 1982. A look at the average gold fund’s total return each half-year since 1979. First half, 1993: +55.7%* * Through May 27 Source: Lipper Analytical Services