Gold or gold equities - which one to choose?

From a macroeconomic perspective, the case for gold and gold equities appears very strong. With US unemployment growing slower than expected and the manufacturing sector contracting nationally in August for the third time since July 2009, the Federal Reserve has launched a third quantitative easing programme – QE3 – to stimulate economic growth.

Gold bulls argue that quantitative easing increases the amount of dollars in circulation and hence will sooner or later dilute the dollar’s value. If the dollar is debased, the argument goes, investors will need an alternative reserve currency – gold.

With the presidential election only a couple of months away, the Federal Reserve had been holding back on QE3 – ostensibly so as not to seem like an undue influence on the ongoing presidential election campaign. However, with the US economy decelerating, Europe in formal recession and economic conditions continuing to deteriorate across emerging markets, another round of QE – aimed at further lowering long-term interest rates – had seemed a certainty.

Meanwhile, the election preparations – and their monetary implications – continue apace. The Republican and Democrat parties recently held their formal nominating conventions, where the loyal demonstrate their enthusiasm for the presidential candidates, Mitt Romney and Barack Obama, respectively. The electorate seems evenly divided at this stage, with the outcome truly 50/50 and the two represent a clear choice. Democrats are viewed as the tax and spend party and want to repeal all of the Bush-era tax cuts. They support social causes, favour spreading the wealth as dictated by the leviathan state and are pro-monetary stimulus. Republicans, once again regarded as the fiscally conservative party, have distanced themselves from the profligacy of the Bush era. They are more laissez-faire on regulatory matters and want to maintain the Bush tax cuts, while they have publicly stated that Ben Bernanke and his QE policies need to be replaced immediately.

For investors, an Obama victory in November may lead to debt-powered stimulus demands on an acquiescent Federal Reserve, historically a powerful boost to gold prices. Gold mining stocks can be a leveraged investment on gold price changes and an opportunity for equity funds. The old rule of thumb was that for every one per cent move in gold, gold stocks would move two to three per cent. However, in the past five years with the price of gold doubling, the XAU index of major gold stocks is essentially flat. Since most gold company stocks are trading close to their lows in terms of their valuation relative to bullion, we analysed them on a bottom-up basis to see if they could break this relationship.

Our findings are that capital expenditures and free cashflow are the two most important determinants for a gold mining company. Layered on that is the fact that political risk is very serious – the main driver, in fact, of any rise in the cost per ounce mined. Lastly, a gambling-type culture regarding acquisitions exists at many companies, increasing the risk of value being destroyed for shareholders. A company like Eldorado Gold would probably rank highly in terms of our view of it as a stock. It has risks, however, that make it nearly uninvestable, namely the fact its principal mines and revenue sources are in Greece and, if Greece exits the euro, one cannot rule out nationalisation risk.