Editor's note: Investing in gold stocks under the right conditions is one of the best ways to make a fortune in the markets.
It looks like "the right conditions" are setting up in the gold sector today. In the last two years, gold stocks fell around 60%. Now, several S&A analysts believe the stocks are putting in a bottom. And that opens up a big investing opportunity…
In today's edition of our weekend Masters Series – an interview excerpted from his latest book Right on the Money – contrarian speculator and our friend Doug Casey discusses the importance of picking the right gold stock. Gold stocks are extremely volatile, he says. But some offer the potential for "10, 100, or even 1,000 times returns on your money."
Louis James – chief metals and mining analyst at Casey Research – conducted this interview on September 30, 2009, when gold stocks were rebounding from their post-crash lows. But Doug's thoughts are just as timely today as they were then.
By Doug Casey, chairman, Casey Research
Louis: If one of the reasons to own gold is that it's real – it's not paper, it's not simultaneously someone else's liability – why own gold stocks?
Doug: Leverage. Gold stocks are problematic as investments. That's true of all resource stocks, especially stocks in exploration companies, as opposed to producers. If you want to make a proper investment, the way to do that is to follow the dictates of Graham and Dodd, using the method Warren Buffett has proven to be so successful over many years.
Unfortunately, resource stocks in general and metals-exploration stocks in particular just don't lend themselves to such methodologies. They are another class of security entirely.
Louis: "Security" may not be the right word. As I was reading the latest edition of Graham and Dodd's classic book on securities analysis, I realized that their minimum criteria for investment wouldn't even apply to the gold majors. The business is just too volatile. You can't apply standard metrics.
Doug: It's just impossible. For one thing, they cannot grow consistently because their assets are always depleting. Nor can they predict what their rate of exploration success is going to be.
Louis: Right. As an asset, a mine is something that gets used up, as you dig it up and sell it off.
Doug: Exactly. And the underlying commodity prices can fluctuate wildly for all sorts of reasons. Mining stocks – and resource stocks in general – have to be viewed as speculations, as opposed to investments.
But that can be a good thing. For example, many of the best speculations have a political element to them. Governments are constantly creating distortions in the market, causing misallocations of capital. Whenever possible, the speculator tries to find out what these distortions are because their consequences are predictable. They result in trends you can bet on. It's like the government is guaranteeing your success because you can almost always count on the government to do the wrong thing.
The classic example, not just coincidentally, concerns gold. The U.S. government suppressed its price for decades, while creating huge numbers of dollars before it exploded upward in 1971. Speculators that understood some basic economics positioned themselves accordingly.
As applied to metals stocks, governments are constantly distorting the monetary situation. And gold in particular, being the market's alternative to government money, is always affected by that. So gold stocks are really a way to short government – or go long on government stupidity, as it were.
The bad news is that governments act chaotically, spastically. The beast jerks to the tugs on its strings held by its various puppeteers. So it's hard to predict price movements in the short term. You can only bet on the end results of chronic government monetary stupidity.
The good news is that, for that very same reason, these stocks are extremely volatile. That makes it possible, from time to time, to get not just doubles or triples, but 10-baggers, 20-baggers, and even 100-to-1 shots in these mining stocks.
That kind of upside makes up for the fact that these stocks are lousy investments and that you will lose money on most of them, if you hold them long enough. Most are best described as burning matches.
Louis: One of our mantras: Volatility can be your best friend.
Doug: Yes, volatility can be your best friend, as long as your timing is reasonable. I don't mean timing tops and bottoms. No one can do that. I mean spotting the trend and betting on it when others are not, so you can buy low to later sell high. If you chase momentum and excitement, if you run with the crowd, buying when others are buying, you're guaranteed to lose. You have to be a contrarian. In this business, you're either a contrarian or roadkill. When everyone is talking about these stocks on TV, you know the masses are interested, and that means they've gone to a level at which you should be a seller and not a buyer.
That makes it more a game of playing the psychology of the market than doing securities analysis.
I'm not sure how many thousands of gold-mining stocks there are in the world today. I'd guess about 3,000. But most of them are junk. If they have any gold, it's mainly in the words written on the stock certificates. So in addition to knowing when to buy and when to sell, your choice of individual stocks has to be intelligent, too.
Remember, most mining companies are burning matches.
Louis: All they do is spend money.
Doug: Exactly. That's because most mining companies are really exploration companies. They are looking for viable deposits, which is like looking for a needle in a haystack. Finding gold is one thing. Finding an economical deposit of gold is something else entirely.
And even if you do find an economical deposit of gold, it's exceptionally difficult to make money mining it. Most of your capital costs are upfront. The regulatory environment today is onerous in the extreme. Labor costs are far above what they used to be. It's a really tough business.
Louis: If someone describes a new business venture to you, saying, "Oh, it'll be a gold mine!" Do you run away?
Doug: Almost. And it's odd because, historically, gold mining used to be an excellent business. For example, take the Homestake Mine in Deadwood, South Dakota, which was discovered in 1876, at just about the time of Custer's Last Stand, actually. When they first raised capital for that, their dividend structure was something like 100% of the initial share price, paid per month. That was driven by the extraordinary discovery. Even though the technology was very primitive and inefficient in those days, labor costs were low. You didn't have to worry about environmental problems. There were no taxes on whatever you earned. You didn't have to pay mountains of money to lawyers. Today, you probably pay your lawyers more than you pay your geologists and engineers.
So the business has changed immensely over time. It's perverse because with the improvements in technology, gold mining should have become more economical, not less. The farther back you go in history, the higher the grade you'd have to mine in order to make it worthwhile. If we go back to ancient history, a mineable deposit probably had to be at least an ounce of gold per ton to be viable.
Today, you can mine deposits that run as low as a hundredth of an ounce (0.3 grams per ton). It's possible to go even lower, but you need very cooperative ore. And that trend toward lower grades becoming economical is going to continue.
For thousands of years, people have been looking for gold in the most obscure and bizarre places all over the world. That's because of the 92 naturally occurring elements in the periodic table, gold was probably the first metal that man discovered and made use of. The reason for that is simple: Gold is the most inert of the metals.
Louis: Because it doesn't react easily and form compounds, you can find the pure metal in nature.
Doug: Right. You can find it in its pure form, and it doesn't degrade and it doesn't rust. In fact, of all the elements, gold is not only the most inert, it's also the most ductile and the most malleable. Other than silver, it's the best conductor of both heat and electricity, and the most reflective. In today's world, that makes it a high-tech metal. New uses are found for it weekly. It has many uses besides its primary one as money and its secondary use as jewelry. But it was probably also man's first metal.
But for that same reason, all the high-grade, easy-to-find gold deposits have already been found. There have to be a few left to be discovered. But by and large, we're going to larger-volume, lower-grade, "no-see-um"-type deposits at this point. Gold mining is no longer a business in which, like in the movie The Treasure of the Sierra Madre, you can get a couple of guys, some picks and mules, and go out and find the mother lode. Unfortunately, now, it's usually a large-scale, industrial earth-moving operation next to a chemical plant.
Louis: They operate on very slender margins, and they can be rendered unprofitable by a slight shift in government regulations or taxes. So we want to own these companies... why?
Doug: You want them strictly as speculative vehicles that offer the potential for 10, 100, or even 1,000 times returns on your money. Getting 1,000 times your money is extraordinary, of course. You have to buy at the bottom and sell at the top. But people have done it. It has happened not just once or twice, but a number of times that individual stocks have moved by that much.
That's the good news. The bad news is that these things fluctuate down even more dramatically than they fluctuate up. They are burning matches that can actually go to zero. And when they go down, they usually drop at least twice as fast as they went up.
Louis: That's true, but as bad as a total loss is, you can only lose 100%. But there's no such limit to the upside. A 100% gain is only a double, and we do much better than that for subscribers numerous times per year.
Doug: And as shareholders in everything from Enron to AIG to Lehman Brothers, and many more, have found out: Even the biggest, most solid companies can go to zero.
Louis: So what you're telling me is that the answer to "Why gold?" is really quite different to the answer to "Why gold stocks?" These are in completely different classes, bought for completely different reasons.
Doug: Yes. You buy gold, the metal, because you're prudent. It's for safety, liquidity, insurance. The gold stocks, even though they explore for or mine gold, are at the polar opposite of the investment spectrum. You buy those for extreme volatility and the chance it creates for spectacular gains. It's rather paradoxical, actually.
Editor's note: Doug believes the steep correction in gold stocks over the last few years is presenting us with a once-in-a-lifetime opportunity – to get in at the bottom of a bull market and ride it all the way to the top. Speculators could make staggering gains.
On Wednesday, February 5, Doug will be speaking with several seasoned resource investors and speculators – including Porter Stansberry – about the turning tides of the precious-metals market. They'll discuss the "unmistakable signs" that the gold sector is bottoming. And they promise to tell you all you need to know to lay the foundation for life-changing gains. Sign up for the free online event here.