Gold Bulls Should Stay Away from Gold Stocks

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"The trouble is gold stocks aren't just a simple leveraged play on the gold price."

In light of the recent stories of hedge funds piling into gold and gold related plays, I am still shaking my head over the fact that investors were buying gold stocks instead of gold and other inflation hedge vehicles.

The trouble is gold stocks aren't just a simple leveraged play on the gold price.

As I pointed out before, a gold company could be simplistically thought of as a call option on the price of gold, with the strike price being the cost of production. My analysis also showed that most senior gold producers were raising production costs by mining lower grades of ore. Gold mining shares consequently did not perform as expected because of earnings disappointment.

Moreover, as the gold price has risen from about $260/oz. in 2000 to over $1,000/oz. seen this year, the leverage of gold stocks to gold has diminished as a result of the rise.

Once you throw in other considerations such as political, operational and developmental risk, are gold stocks really worthwhile investment vehicles? More importantly, if commodity inflation does surface with a vengeance, then we will likely see negative surprises in the form of increased mining costs stemming from rising material and energy prices, which will squeeze gold mining margins.

Of course, it depends on why you are buying gold. If the gold holding is a hedge against disaster, then some physical gold in the form of coins and bullion may be better choices.

If you are looking for a pure inflation hedge, then perhaps inflation-linked bonds, gold ETFs like GLD, or a closed end fund like Central Fund of Canada (CEF), could be your vehicle.

If you are looking for a leveraged play on gold, then you may want to look at silver (the metal, not the silver stocks), which is traditionally thought of as a leveraged play on gold. Another alternative could be the purchase of long-dated options on gold bullion for investors.

Buy gold stocks? The fact is they are overly erratic and unpredictable vehicles as to be effective leveraged plays on gold bullion.

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