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How To Diversify Your Gold Mining Portfolio

Gold mining stock expert shares his views...

JOHN DOODY, an economics professor for almost two decades, became interested in gold and Gold Mining stocks due to an innate distrust of politicians. In order to serve those that elected them, politicians always try to get nine slices out of an eight-slice pizza. How do they do this? They debase the currency via inflationary economic policies. 

Success with his method of finding undervalued gold mining stocks led Doody to leave teaching and start the Gold Stock Analyst newsletter late in 1994. The newsletter covers only Gold Mining producers or near-producers that have an independent feasibility study validating their reserves are economical to produce

In this interview with The Gold Report he reveals what diversifying your gold portfolio really means. 

The Gold Report: What are some of your strategies for picking stellar Gold Mining stocks and limiting risk?

John Doody: We cover 70 mining and royalty stocks. In the selection process, we reduce it to our top 10. It's an ideal number because if one stock falls by 50% in value, it only affects your portfolio by 5% total. If a couple of stocks double or triple, they can really pull up the whole portfolio. 

If someone argues for investing in 8 or 12 stocks, we wouldn't argue with that. But I see too many people at gold shows who have one or two and think they are diversified. They aren't. Too many others have 20 or more, which is too many to follow and too many to have outstanding portfolio returns.

Our premise is that the market is inefficient and doesn't value all 70 stocks we cover appropriately all the time. Since an ounce is an ounce is an ounce, GSA's metrics can show which companies are undervalued and which ones are overvalued. These are our market capitalization per ounce numbers, market capitalization meaning shares times price. What's the market capitalization of an ounce of reserves? What's the market capitalization of an ounce of production? That's the initial filter. 

We look at a whole range of factors and ask the big questions. Is it a producer or is it just getting started? Where are the mines located? Are they in politically safe areas or are they risky locations? Are they open-pit mines primarily or underground mines? What's the cost to produce an ounce? What's the operating cash flow from the mines?

We only look at producers or near-producers. No exploration stocks, because there is no data. Some of these exploration companies do mature and get our coverage later on.

We build our Top 10 portfolio based upon integrating all of these factors and don't get over-weighted in one sector or the other. For example, we have one silver stock in the portfolio. And, I've always felt silver is a derivative of gold. As gold goes up, silver will come along. But our real focus is on gold. 

TGR: Of those Top 10 stocks, how many of those projects have you visited?


John Doody: About half. A lot of them have a whole bunch of projects, but others only have one. 

TGR: Is it correct that you lean more toward mid-tier producers than you do near-term producers?

John Doody: Yes. We want data to analyze. With our track record of an average 43% gain per year over the last 10 years, we don't have to go down the risk spectrum into exploration stories. When analyzing 70 stocks, we find undervalued situations. By looking at companies that are in production, we eliminate the risk of drill holes coming up dry or running into a permit problem that you didn't expect, or some type of environmental issue. 

TGR: Are you talking to managers of these companies on a fairly frequent basis?

John Doody: We're on all the analyst calls of the Top 10 companies, as well as others we're following. We're always looking in the bullpen for who could be the next for the Top 10.

TGR: Mexico's Central Bank bought 100 tons or about US$4.6B worth of gold in February and March. Do you believe this will trigger another round of gold buying by Central Banks?

John Doody: We have had ongoing buying. Russia bought at the same time. 

TGR: Is this part of a growing trend?

John Doody: I think so. Everyone, including Central Banks wants to get away from the Dollar because it is sinking. There's not going to be any change in interest rate policy until after the next election, in my opinion. President Obama wants to get reelected and the last thing he needs is higher interest rates, which would worsen the unemployment situation. 

I think Chairman Bernanke, who's an expert on The Great Depression, knows that the Fed screwed up in the last Great Depression when it started raising rates in the mid-1930s and tightening the credit standards for bank loans. That had the effect of slowing down the economy, causing a double dip. Bernanke's not going to do anything to jeopardize this recovery. 

A true recovery requires a lot more than one data point so the recent good US job report hasn't turned the tide for the Dollar. Countries are looking to diversify reserves. The big one is China. What will China do? China is already the largest consumer and producer of gold. It produced approximately 11 million ounces (Moz.) from its own mines last year and had to import another 8 Moz. to fill demand. 

India's pretty much in the same boat, but doesn't have any gold mines. Everything has to be imported. The issue in both nations, as in the US and Europe, is the real interest rate. Both China and India currently have real interest rates of negative 3% to 4%. China and India are not well banked, so their people save their money in gold. 

The real interest rate is the risk-free return from short-term Treasuries or savings deposits, adjusted for inflation. When the real interest rate is negative, as in the 1970s and 2000s, cash loses purchasing power. That's what drives gold. It can protect against purchasing power loss. That's the single most important factor. Everything else is just noise.

TGR: With Spot Gold about US$1,500/oz., why are the stock prices of the major gold producers continuing to languish?

John Doody: It's due to a variety of factors. Two majors are in South Africa and run the risk of their mines being totally nationalized. I don't want that risk. I assume other people don't want it either. We've seen both companies trying to diversify out of South Africa. But they have to get permission from the South African Central Bank to do much. That means they're not going to be able to split the companies into a South African part and a non-South African part.

The second reason is that gold producers have had rising cash costs, although some of it's not their fault. Canada's a great place to have a mine, but the Canadian Dollar has been very strong. When you translate your Canadian Dollar cash cost back into US Dollars, cash costs are higher than before. A lot of the mines are struggling with rising cash costs, which puts a greater emphasis on byproducts, but most Canadian mines don't have the luxury of a copper byproduct.

And, the third reason is growth. There hasn't been demonstrated growth from a number of the majors. The growth companies have been the next tier down. So, when you get to 7 Moz./year it's really tough. In order to produce 7 Moz., you’ve got to find 10 Moz. of new reserves due to recovery losses. That's basically two world-class mines a year. It's not sustainable. You can get growth as you go down to the smaller companies because of the smaller scale. I think that's what investors are seeking. 

I look for a combination of growth and yield. I want the company to do something that competes against the Gold ETF (or exchange-traded fund), which is a barren asset with no yield. Dividends open up a whole new class of investors to gold. Pension funds typically cannot buy a stock that doesn't have a dividend. Increasingly, the miners are coming to the realization that they need to pay a dividend.

TGR: Is that really providing the best return for investors?

John Doody: I think dividends are increasingly important to investors. A dividend-paying gold miner tends to trade at a price that gives a 1% yield, in a range from .5% to 1.5%. That's a growth stock yield found with tech stocks. That kind of yield is pretty attractive. 

TGR: The Gold Price recently dropped by US$100/oz. to under $1,500/oz. Is this a sentiment-driven drop or is something else at play?

John Doody: First of all, the drop is trivial. The US$100/oz. is a big number, but is 5.8% a big drop? No. That's the same as a $10.00 stock's price falling $0.58. Insignificant. Since the bull market low in October 2008, we've had five Gold Price drops of greater than 5.8%, from 8.5% to 14.7%. Bull market pullbacks are normal and many would say healthy. The underlying force driving Gold Price is the real interest rate. It's what's driving this market. People are trying to protect their wealth whether it's here, China or India. 

Actually, if there was a relation or single cause of the $100 drop, I think it was the European Central Bank (ECB) deciding not to raise rates a couple of days ago. Everybody thought the euro was going to get a rate bump up, and all the hedge funds had bought euro in advance to profit. Then when ECB said it wasn't going to raise interest rates because the economy was too weak, everybody pulled out of the euro and went back to the Dollar. Gold and the Dollar are negatively correlated, so when one rises, the other usually falls. 

TGR: How big a drop in the Gold Price would cause you concern?

John Doody: In order to get to its 50-day moving average, a key technical benchmark, it would have to fall to around US$1,340. From the US$1,560 high; it would have to fall by US$230, but it didn't fall half of that. Other people say a bear market begins when you fall 20%. That would mean it would have to fall more than 300 points. 

TGR: Any parting wisdom for gold investors?

John Doody: I think we touched on the two key things. One is diversification across different sectors of the gold market. Owning 10 exploration stocks is not diversification and you've got to be in politically safe areas. 

The other part is the macroeconomic picture. What's driving gold? It's the real interest rate. Focus on that. If risk-free returns are negative after inflation (and it's now negative worldwide), then you've got the driver around the world for higher Gold Prices. The gold market prices may be set in London and Chicago, but the demand — the end buyer — is all around the world. Half of them are in Asia and lots are in the Middle East. A smaller percentage than one might expect is comprised of end buyers in the US and Europe. 

TGR: Thank you for your time.

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