Five things to watch before you invest in gold stocks

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Gold has been a store of value for an age. Prized for its beauty and non-corrosive elements, gold is an investment that, despite its volatile price, is typically viewed as a defensive investment.

In an environment of high global debt levels, the potential for a geopolitical melt-down, and high asset prices, many share investors have sought the safety of gold stocks in their portfolio to introduce a hedge against a possible catastrophe. One key mistake that many investors make when investing in gold stocks is believing that it is the same as holding the physical commodity. It is true that in the short-term, the share price will be governed by the change in the price of gold. However, over the long-term, investors must realise that they are actually investing in a business, one that generates sales, pays expenses, makes profits and is exposed to management and operational risk.

So, what should you look for when investing in gold or mining businesses? The answer is multifaceted. Here are the basic principles to determine whether your gold stock is a quality business.

Financial health: Gold explorers not yet cashflow positive are not safe investments. They carry elevated risks and should only be considered by speculators and/or those with unique insights into the company. Unless the company is fundamentally sound, particularly from a cash flow perspective, it is at risk of failing or needing to raise more capital. This could dilute the interests of existing shareholders.

Reserve size: It stands to reason that a key part of assessing a gold miner is knowing the amount of gold their mines sit on. Investors should keep an eye out for the size of reserves and the estimated mine life. This information can often be sourced from the company or your research provider. Look for reserve upgrades, which will give additional comfort that reserves can be replenished. Remember that once the commodity has come out of the ground, it’s gone. Therefore, reserve upgrades from continued exploration activity at existing or new sites are important for a gold miner’s long-term viability.

Production profile: When it comes to commodity businesses, one outcome the company can control is the amount it produces. For all mining stocks this is monitored quarterly and announced on the ASX. Ideally, an increasing production profile should support underlying earnings growth. The stronger the ramp up, the more it will be able to absorb short-term commodity price volatility.

Cost management: In the same way the level of production can be controlled to a degree, so too is the cost of extraction. The All-In Sustaining Costs (AISC) of a mining business is usually declared every quarter. Investors can see whether the cost of mining the gold is being done efficiently and sustainably. The higher the cost to extract the mineral, the more susceptible the business is to commodity price movements.

Gold price: Last but not least is the price of the underlying commodity itself. This can have a huge impact on the earnings of the company and can often overshadow the quality of the business. Neither companies nor investors can control the price of any commodity. Rather, they simply need to adapt. There will be times when the gold price falls to levels where many mines become unprofitable and vice versa. The price of gold can jump so much that even the poor-quality producers are making money. Many ASX-listed gold miners are domiciled in Australia so changes in the Australian dollar versus the US dollar will ultimately impact the profitability of the business. In general, and assuming economic conditions remain constant, a rising AUD/USD tends to dampen the profitability of an Australian gold producer. Look for the quarterly updates to understand gold price movements in the appropriate currency.

Published Tuesday, 15 August 2017 | Financial Review

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