Why Gold's Gleam Isn't Likely to Dim


The S&P Gold index has surged 52% this year through Nov. 14, vs. a 19% rise in the broader S&P 500-stock index. And in the last few days, the price of gold has rallied -- hitting roughly $398 on Nov. 18 -- as the U.S. dollar fell amid a spate of news, including potential trade wars with China, falling foreign investment in U.S. Treasuries, and lingering worries about the mutual-fund scandals.

As long as the dollar stays weak, and the Federal Reserve holds interest rates at low levels, gold should keep its luster, says Mark Johnson, portfolio manager of the USAA Precious Metals & Minerals Fund (USAGF). He figures its price could reach $435 next year. Even with the recent gains, Johnson thinks investors should own gold assets to lessen overall risk (see BW Online, 10/29/03, "Beyond Some Bumps for Gold").

BusinessWeek Online's Karyn McCormack recently spoke to Johnson about the sector's status today and what he sees tomorrow. Edited excerpts of their conversation follow:

Q: What's your outlook for gold?

A: Fairly positive, based largely on our expectations that we'll probably see continued weakness in the U.S. dollar related to the twin deficits -- namely the current-account deficit and the large federal budget deficit, which in aggregate are going to be pretty close to 10% of gross domestic product.

Q: What else is pushing the price of gold higher? Is it a supply-and-demand situation as well?

A: No, I think it's mostly the currency. And the recent action of the bond market, over the summer especially, kind of indicates that there might be higher inflation expectations going forward. And, of course, the Federal Reserve is committed to keeping interest rates low for the foreseeable future. So that basically means that the real interest rate -- which is already negative -- went even more negative. So that's positive for gold as well.

Q: What about the recent strong economic data, which has some people talking about the Fed raising rates sooner rather than later?

A: I think gold did surprisingly well in the face of the employment data. You would expect that, given that data and the productivity and GDP data, that the economy would be getting quite a bit better, which would argue for stronger stock prices for the general market, which would be negative for gold.

And it should also argue for a stronger U.S. currency, which would also be negative for gold. But gold did quite well this past summer, despite higher long-term interest rates, perhaps reflecting increased inflation assumptions by the bond market.

Q: And this is because of the currency, the current-account deficit, and the budget deficit?

A: Well, I think at this point, the gold market is looking past the recent data and saying, "Wow! The Fed really has committed to keeping rates low." And, in fact, Greenspan reiterated that commitment. And so, as long as they're keeping the rates low, I think it's still on a bull market for gold.

Q: Tell us why your fund is outperforming its peers and the broader market.

A: Through Oct. 31, the fund was up 55.1% year-to-date. The Lipper Gold Fund Index was up 40.6%. The fund's three-year annualized performance is 58.2%. And the Lipper Gold Fund Index is 46.2%. We would have been No. 3 out of 34 funds for that period. I think we're outperforming because of stock selection, plus the fact that we have it fully invested throughout this whole period. And we stuck pretty much to our precious-metals charter. So we're running about 80% gold and the balance in other precious metals, such as platinum and diamonds.

Q: Have platinum and silver and the other metals run up with gold?

A: Silver has definitely lagged. We don't have any significant silver exposure. For platinum, it depends on what time period you want to use for whether it has lagged or outperformed. Platinum is close to its all-time high of $763.50 on Oct. 30. It's at $762.50 right now [on Nov. 10]. [It traded at $771.50 as of Nov. 18.] And in diamonds, Aber Diamonds (T.ABZ) has done quite well. That's [traded in] Toronto. It's basically at its all-time high as well.

Q: What are some of your largest holdings, or your favorite stocks?

A: Our largest holding, in terms of U.S.-listed securities, is Glamis Gold (GLG). And that's also one of our favorite stocks at this time. It's a very high-quality company with a debt-free balance sheet, no zero hedging, low cost of production. It also has excellent management, a diverse mine base, and a very good growth profile because of two new mines that they're going to be building, plus expansion of a third mine.

So it's not a particularly cheap stock at these levels. But I think those other characteristics, especially the growth profile, will drive it higher over the next few years.

Q: Besides the price of gold, what's driving these companies' operations? Are they finding new mines?

A: What will drive these stocks higher, or particular stocks higher, is to the extent that they can grow production. Unless you're growing production, all you've got, basically, is a play on a commodity. So we think the trick is to identify the quality companies with growth profiles, and that's why I like Glamis.

Q: How do you figure out how good their properties are?

A: Well, [through] published feasibility studies, and I have a fairly decent idea of what the costs of production are going to be in a given operation. And so you want to focus on those companies that are likely to have costs of productions below $200 an ounce.... That way, if gold falls back, you're still making money.

Q: Is that their breakeven mark, their cost of production?

A: Well, the average mine out there right now is about $210 to $220 cash cost [the cost to produce an ounce of gold]. That excludes depreciation. So if you can buy companies that can produce below that level, then you're pretty secure. It's unlikely that gold would drop that far down, simply because too many mines would have to shut production.

Q: Where is gold right now? How far has it come?

A: As we speak [Nov. 10], it is $386.25 [as of Nov. 18, it closed at $398.45]. At yearend, the spot price of gold was $348.05. The beginning of the [gold] bull market was April 1, 2001, [and] the price of gold at that time was about $257 an ounce. The catalyst for the beginning of the bull market was, if you recall, when the Fed started dramatically...to cut interest rates about every month. And that's what got the market rolling, because the gold market, basically, likes low interest rates.

Q: And the stock market crashed, too.

A: Yeah, the stock market crash definitely helped, because it's negatively correlated with the S&P, no question about it. And then, of course, you had the weakening dollar. So you had a lot of things come together at the same time to get this bull market going.

Q: And you think it will continue?

A: Yeah, I think so. I think the first ringing of the bell will be when the Fed starts to raise interest rates. That's the first signal that, gee, we better start rethinking the bull-market thesis for gold. But until then, it's pretty much a bull market.

Q: Are there any other holdings that you particularly like? Any undervalued stocks?

A: If you want a contrarian play, more of a cheaper stock, then I suppose you could look at Barrick Gold (ABX). That stock has seriously lagged over the last couple of years. Nonetheless...[Barrick has] a very good balance sheet. It has an identifiable growth profile. It's not as good as Glamis, but it's better than most of the other senior producers.

The other one I'd rank second or third...is Newmont Mining (NEM). It probably has the best management in the business. Excellent balance sheet, great assets compared to Barrick.... But, consequently, it's not as cheap a stock. And the growth profile is probably not as good as Barrick's, but it's still pretty good.

Q: How should investors look at gold?

A: The key thing to remember about gold, and gold-mining stocks in particular, is that they're inversely correlated with the stock market and other financial assets. And, as a consequence, even though gold is inherently volatile itself, its inclusion in a portfolio, at a fairly low level even, will reduce overall portfolio volatility. And hence reduce overall portfolio risk for the investor. It's an effective insurance policy.

Q: It probably can't hurt having one gold fund or metal fund in your portfolio.

A: Sure. We certainly would. You know, those who even had a 4% commitment to gold, say, two-and-a-half years ago -- even if the rest of their money was in the S&P 500 or whatever -- they at least had something to help cushion that rather brutal experience.


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