Its price can be volatile, but gold is good to keep in your portfolio in any market condition

by Ken Chernin

The equity markets are looking better compared to six months ago, but caution is still warranted. When we look for positives in the markets they seem to be driven primarily by forecasts; the facts presented by actual economic data are still somewhat grim.

Unemployment continues to rise, there are few (if any) signs of improving consumer confidence, the residential housing markets are still in turmoil, and now commercial real estate has taken the front seat for potential catalysts to sink us further into the recession.

In these uncertain times, diversification within a portfolio is of the utmost importance. Simply put, diversification is not putting all of your eggs in one basket. At the most elementary level it entails holding numerous stocks in your portfolio, but it should also include spreading exposure over different sectors of the economy because different points within the economic cycle impact sectors in different ways.

The three best-known asset classes are equities, fixed income, and cash, but there are other investment vehicles that can help reduce a portfolio's downside exposure. For instance, allocating a proportion of your portfolio to gold may help mitigate market risk.

Historically, gold prices have not been strongly correlated with the overall equity markets (10-year correlation with the S&P/TSX Composite is .3277). The reason for this is that factors that have an adverse impact on the overall equity markets, such as inflation and financial-market turmoil, often benefit gold prices.

From the end of August 2008 until late July 2009, gold prices increased by about 12%, as opposed to the S&P/TSX Composite Index, which declined by 27.5% during the same period. But investors shouldn't mistake reduced portfolio risk with reduced volatility-gold prices are volatile, although typically less so than the S&P/TSX Composite.

Ways to invest in gold
Investors seeking exposure to gold have four basic options: buy physical gold; invest in exchange traded funds (ETF), which replicate the price changes in gold; buy options and futures; or invest in a gold-mining company.

Investing in gold-mining companies can afford greater leverage relative to a direct investment in gold because the companies' profits and cash flows tend to rise disproportionate to the increase in the commodity. In addition to the stronger cash flows derived in the short run from higher gold prices, the value of companies' proved and probable reserves also increase.

Since the end of August 2008, the S&P/TSX Global Gold Index increased by 9.3%—outperforming the S&P/TSX Composite by roughly 51%—but about four percentage points lower than the increase in gold prices. This likely reflects company-specific risks such as operational and financial risk. Also, companies often hedge their output so they may not fully benefit from uptakes in gold prices in the short run.

Atlantic Canadian gold-mining companies
Here in Atlantic Canada we have approximately 30 mining companies that are either purely focused on gold or have gold properties. There is only one gold mine in operation in Atlantic Canada; it is in Newfoundland and operated by Anaconda Mining Inc. (TSX-ANX). There are no producing gold mines in the region. Acadian Mining (TSX-ADA) is focused on bringing its Beaver Dam property in Nova Scotia into production after the rapid decline in lead and zinc prices resulted in the closure of its Scotia Mine.

Two other Nova Scotia-based mining companies have producing mines in other countries. Gammon Gold Inc. (TSX-GAM) owns and operates two mines in Mexico-the Ocampo mine in Chihuahua State and the El Cubo mine in Guanajuato State. Etruscan Resources Inc. (TSX-EET) produces gold from its Youga Gold Project in Burkina Faso, West Africa. Etruscan's stock price came under considerable pressure when power-supply issues resulted in lower-than-expected production, and the company didn't produce sufficient quantities of gold to satisfy a hedge.

Then we have gold-mining exploration companies such as Nayarit Gold Inc. (TSX.V-NYG) and Linear Gold (TSX-LRR), which don't have producing gold mines but are in the process of developing their properties. Nayarit has acquired 110,000 hectares of prospective mineral concessions in the State of Nayarit, Mexico, since the company was founded in 2005.

An initial NI 43-101 resource estimate on the Animas/Del Norte zone is scheduled for release in the next two months (you can find research on Nayarit Gold at www.jenningscapital.com). Linear Gold is in the process of acquiring the Goldfields project in Saskatchewan.

It has a total resource of more than one million ounces with reserves of 601,007 ounces of gold stated in a National Instrument 43-101 resource estimate. Although exposure to gold by owning common shares of a gold-mining company can afford great leverage to up-tics in gold prices, it also comes with company-specific uncertainties such as operational and financial risk. Investors are cautioned to scrutinize a company's financial health, paying particular attention to leverage and cash flows.

Ken Chernin is a Halifax-based equity research analyst with Jennings Capital Inc. You can contact him at ken.chernin@jenningscapital.com to receive a copy of Jennings Capital research on Nayarit Gold Inc.