Building the perfect portfolio part II: Bargain hunting in the gold sector

Start with what’s cheap

At any one time within the investment universe you will find some assets that are overvalued (think technology stocks in early 2000), some assets that are fairly valued, and some that are undervalued.

When building a portfolio, it is my opinion that you should start by focusing on those asset classes that are undervalued, since these provide the biggest margin of safety and often the biggest upside potential. Of course there are some assets that are cheap for good, fundamental reasons so it’s important to go beyond price history in determining which assets to focus on.

Gold and gold stocks are undervalued

Yesterday I examined the uranium sector, but today I want to focus on another sector in which investor sentiment is negative and which I believe to be undervalued, and that’s gold.

The chart below shows the HUI:Gold ratio which indicates the performance of the gold shares relative to the price of gold itself. As we can see, the gold stocks, as represented by the HUI index, are now extremely undervalued versus the price of the actual metal.

A 3 Year Chart Of Gold vs. The HUI

Chart courtesy of Stockcharts.com

In an interview 22 April this year, John Hathaway, Chief Portfolio Manager for the Tocqueville Gold Fund, said “To me this is an excellent opportunity. I’ve been putting money to work in the sector, particularly in the gold stocks, which are as cheap as I’ve ever seen them.” He went on to say, “We are seeing values that I’ve never seen since I’ve been doing this for the last 13 years.”

The outlook for gold and gold stocks remains very bullish

I’ve talked about the outlook for gold and gold stocks before so I won’t go into it here. Suffice to say that the bull market remains intact, and still has a very long way to go. Within the next 3 to 5 years I see gold reaching a minimum of $3,000 to $5,000 an ounce at which point we are likely to enter phase three.

How to play gold

Physical gold (GoldMoney.com) – In my view every portfolio should contain some gold, and it’s vital that this is in physical, allocated form, and not an ETF (Exchange-Traded Fund). The purpose of owning gold is as insurance – portfolio insurance or wealth insurance. Gold is no one else’s liability, whereas a gold ETF is a ‘paper’ derivative of gold which is designed to reflect its performance. ETF investors are exposed (often unwittingly) to a host of risks from movements in the foreign exchange markets to there being multiple claims on the same metal – exactly the sort of risks you are trying to avoid when owning gold.

It’s for these reasons that I like GoldMoney.com, a company that stores physical gold (or silver) in allocated form in your name.

A Gold Fund (Black Rock Gold & General) – Once you have begun to accumulate physical metal you can then look at investing in the companies that produce it. I would begin by buying into a gold fund such as the excellent Black Rock Gold & General, the biggest gold fund available to UK investors. The fund invests in 50 to 80 high quality gold mining, commodity and precious metal related companies and it can also be held inside a Stocks and Shares (Maxi) ISA.

A little more than 50% of the fund is allocated to its top ten holdings which include large ‘blue chip’ names such as, Newcrest Mining, Goldcorp, Barrick and Kinross.

The fund, which is managed by Evy Hambro, has recently reduced its exposure to those companies that may be required to raise capital in order to develop their projects. It has also increased its holding of gold royalty companies, both of which are excellent strategic moves.

The fund’s impressive performance speaks for itself: £1,000 invested in the fund in an ISA in 1999 would now be worth £12,562 (as at 31 November 2011).

Individual gold stocks

We are now in phase two of this gold bull market, and because of that I believe the place to be is in the quality mid-size gold producers. With that in mind here are some of the companies I like.

Goldcorp (NYSE:GG) – The fastest-growing, lowest-cost senior gold producer, with operations and development projects in politically stable jurisdictions such as Canada, the United States, Mexico and Central and South America. The company has a history of growing its gold reserves (now around 64 million ounces), and thanks to new projects it expects to grow its production by around 70% between now and 2016 to 4.2 million ounces.

Royal Gold (NASDAQ:RGLD) – A gold royalty company which generates strong cash flow and high margins through its portfolio of over 190 producing, development, evaluation, and exploration stage royalties located in some of the world’s most prolific gold regions.

New Gold (NYSEAMEX:NGD) – An intermediate gold mining company with three producing assets and three significant development projects. The company has 7.9 million ounces of reserves and is forecasting production of between 405,000 and 445,000 ounces of gold in 2012.

Other gold stocks I like include Franco Nevada (NYSE:FNV), McEwen Mining (NYSE:MUX), and Pretium Resources (TSE:PVG).

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