Two questions we’ve heard a lot lately are “Why haven’t the stocks kept pace with the metal?” and “What’s the right amount of gold for my portfolio?”

PART 1: Gold Bullion Versus Gold Mining Stocks

The recent disparity in performance between gold bullion and gold mining stocks is largely down to concern about higher costs to extract and refine the metal. Compare those fears with conditions in 2009 and 2010, when gold mining stocks did very well as the price of gold bullion surged, while changes in production costs were comparatively tame. This meant better top-line revenue and margin figures, making for attractive stock performance.

How Changes in Gold Prices Relate to Gold Company Profits

Here’s a quick, back-of-the-napkin example of how changes in gold’s price relate to gold company profits using approximate values and costs as of late April 2011. Say the price of gold increases from $1,000 to $1,500 an ounce, with a total production cost of around $750. So while the price of gold has increased by 50%, mining company profit margins went from $250 an ounce ($1,000 price minus $750 production cost) to $750 ($1,500 minus $750)—an increase of three times.

As a result of this relationship, gold company stocks are typically highly levered to changes in the price of the underlying metal. Over a complete pricing cycle, a 1% change in gold has typically provided a 2–3% change in the price of gold company stocks. Of course, it’s also true that this leverage works to the downside, so investors have to be prepared for some potentially sharp volatility to both the up- and downside.

Growth of $10,000: This chart displays the typical relationship between the price of gold bullion and gold company stocks over time. Since the depths of the financial crisis, an investment in the precious metal has doubled, while the value of an investment in gold mining stocks (as measured by an index of leading precious metals miners around the world) has increased about three times.

 

Production Costs Key

But it should also be obvious from this example that rising production costs have a very real effect on the profit margin math. It is no coincidence then that worry about higher input costs has been weighing on gold shares of late. Production costs for gold companies are largely a function of labor and energy (oil and electricity) costs, all of which vary with the age, quality, and type of mine in question. Let’s start with labor costs. Huge demand for gold has meant a significant increase in gold production and exploration operations, putting a premium on experienced mining project engineers and workers. That scarcity premium has translated into rapidly rising wages in the mining industry, and higher costs for gold miners.

Energy prices are another key input to production costs, so much so that changes in the average cost to produce gold have closely tracked changes in oil prices going back to 1990, according to analysts at RBC Capital Markets. Oil costs are forecast to rise faster than the price of gold bullion in 2011, which has some investors worried about profit margins.

Fears of Cost Increases Overdone

We do not expect margin compression in 2011; instead, we believe worry about shrinking profit margins and rising costs is overdone for several reasons. First, we think companies have done a fairly good job controlling costs and learning the lessons of the last major surge in oil prices in the mid- to late-2000s. As proof, we can cite a recent report by gold mining-industry leader Barrick, which forecast flat to lower production costs over the next five years. Second, importantly for active investors in gold company stocks, this concern does not account for the ability of individual companies to generate operational efficiencies and margin improvement regardless of what average production costs do.

For example, Newmont Mining, another leading gold producer, argued for likely margin improvement in its business going forward even allowing for output costs rising by an estimated 17% in 2011 on average. Similarly, exposure to rising oil prices relates to the type of mine in question, with deep underground operations being more energy intensive than other types of operations. Again, active investors can manage their exposure to these effects through individual security selection. Finally, gold miners also generate “byproducts” of their mining operations—silver, copper, and other metals. Prices for these byproducts have also surged along with gold. Sale of these “byproduct credits,” as they are known in the industry, are a further offset to rising costs.

Rising Dividend Payouts Also Positive

It’s also worth pointing out that many gold companies have initiated or increased dividend payments in 2010 and so far in 2011. Dividend payouts provide an additional advantage that bullion does not, and give a boost to total returns for investors in the mining company stocks. It’s worth mentioning here that there is no guarantee those dividend payouts will continue at the same level in the future.

Gold Company Stocks Look Attractively Valued

Because gold shares have lagged the performance of the metal in recent months, the stocks of gold producers now look comparatively attractive relative to the value of their metal in the ground, according to some market analysts. A key metric for valuing gold companies is their stock price relative to their net asset value, or P/NAV, where NAV equals the total value of the company’s estimated gold reserves in the ground for a given gold price, discount rate, and production cost.

Recent analysis focused on the senior gold-producing companies shows that these shares traded for much of the last decade at a modest market value premium of about 1.3 to 1.5 times their net asset value. That P/NAV ratio dipped below 1 only once in that period, at the very height of the financial crisis in late 2008. But the failure of the stocks of gold miners to keep up with recent surge in the price of the metal means this ratio is again below 1.

PART 2: Gold’s Role in a Diversified Portfolio  

The key consideration for gold investors is not so much the price of the metal, but what is gold’s role and allocation in your overall portfolio. Because gold benefits from safe-haven demand in times of political and economic uncertainty, and it has unique properties as an alternative currency, the precious metal has a low correlation to the performance of stocks and bonds. That is, gold has tended to do well when stocks and bonds struggle, and vice versa. These characteristics mean gold is well suited to diversify a larger portfolio against inflation or market uncertainty.

From a short-term, market-timing perspective, it’s hard to advocate buying gold—or any other asset, for that matter—after a huge run-up. But from a long-term, portfolio diversification point of view, it can make sense to have an allocation to gold because it tends to do well when other asset classes struggle. Of course, diversification does not ensure a profit or protect against a loss in a declining market.

For younger investors/those in the wealth accumulation phase:  It’s important to remember why you are investing in gold—it’s meant to be a small allocation in a much larger, diversified portfolio, not a core portfolio holding. For this reason, a number of analysts suggest that a modest 3–5% allocation to gold or gold stocks could be a hedge against a downturn in financial markets related to inflation risk or other economic or political uncertainty.

For older investors/those in the wealth preservation phase:  Here, too, investors must consider the high degree of volatility and risk inherent in gold investing, and allocate only a comparatively modest portion of their overall portfolio to gold. Analysts typically suggest a 5–10% allocation to gold may be appropriate for investors in the wealth preservation phase of their financial lives. This higher allocation is because you are more vulnerable to the effects of inflation (or a market sell-off as a result of financial uncertainty or calamity) the closer you are to retirement—your balance is at its highest level, and you won’t be making any more contributions to offset losses.

American Century Investments^® offers a wide variety of stock, bond and asset allocation funds. Visit americancentury.com for more information: U.S Investment Professionals

The NYSE Arca Gold Miners Index represents the largest cross-section of precious metals mining companies exploring, developing, and mining gold and silver around the world

Due to the limited focus of gold funds, they may experience greater volatility than funds with a broader investment strategy. They are not intended to serve as a complete investment program by themselves.

Gold stocks generally are considered speculative because of their high share price volatility, and the fund’s share price may be affected by this volatility. Fluctuations in the price of gold will likely impact the performance of gold companies. These fluctuations may be severe and may result from, among other things, unpredictable international monetary and political policies, concentration of the source of gold supply in a limited number of countries, and other economic conditions affecting the supply and demand for gold. Many investors believe gold investments hedge against inflation, currency devaluations and general stock market declines, but there is no guarantee that these historical inverse relationships will continue.

The opinions expressed are those of American Century Investments and are no guarantee of the future performance of any American Century Investments portfolio. This information is not intended to serve as investment advice; it is for educational purposes only. Statements regarding specific holdings represent personal views and compensation has not been received in connection with such views.

You should consider a fund’s investment objectives, risks, and charges and expenses carefully before you invest. The fund’s prospectus or summary prospectus contains this and other information about the fund, and should be read carefully before investing. Investments are subject to market risk.

 

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