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Holding gold
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March 2, 2000: 8:52 a.m. ET
It's been out of favor for a mighty long time. So when is Au good for you?
By Staff Writer Alex Frew McMillan
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NEW YORK (CNNfn) - With interest rates rising, an oil-price boom and the market at scary highs, cautious investors who remember the '70s might find their minds wandering to safe, reassuring gold.
Forgotten what it is? Who could blame you?
The only safe and reassuring thing about gold recently was that investing in it would lose you money. Old-timers might keep 2 percent of their wealth in bullion but the rest of the world steered clear. And it was a wise move.
"As long as people are comfortable with financial assets and they've done well, they ignored gold," said Jean-Marie Eveillard, portfolio manager of the First Eagle SoGen Gold Fund. "And they've been right to ignore gold for quite a while."
But if inflation picks up, governments back themselves into a corner and economic chaos breaks lose, gold will be an asset to remember. Eveillard has often considered closing his fund. He decided to keep it open after the Long-Term Capital Management debacle.
"Maybe the world was more fragile than it appeared to be," he recalled thinking. If a financial crisis like that ever gets further out of control, "maybe it [his fund] is a cheap insurance fund."
An out-of-favor asset gets a boost
Central banks around the world, which collectively hold around 30,000 tons of gold, have depressed its price by selling consistently in recent years. Gold had also been depressed because gold mining companies have tended to hedge by selling gold "forward," ahead of its production.
The strategy makes sense if they fear the price will fall -- and who could blame them, having lived through two decades of precedent. But they sold at a discount by hedging. Finally, the mines started to realize their hedging and apparent lack of confidence was contributing to gold's decline.
Gold has recently received a double boost. Last September, the European central banks announced they would restrict their gold sales to 2,000 tons over the next five years. That removed uncertainty about how much gold could flood the market. And governments are showing they still have a place in their vaults for it, to back their currencies.
Then, earlier this year, major gold producers such as Placer Dome (PDG: Research, Estimates), Anglogold (AU: Research, Estimates), Gold Fields (GOLD: Research, Estimates) and Barrick Gold (ABX: Research, Estimates) announced that they were scrapping or scaling down their hedging activity.
Those two effects have helped boost the price of gold. There's now a third driver -- when another commodity such as oil starts skyrocketing, other commodities often rise in sympathy. Gold hit a four-month high in February.
Handling gold for inflation insurance
What's the best time and way to use gold as an investment? Gold is famous as a hedge against rising interest rates and, more specifically, inflation. But after a run in it in the '70s, it's still not much of an asset to get excited about.
Bill Martin, portfolio manager of the American Century Global Gold Fund, agrees with Eveillard that gold is best used as "insurance," particularly against inflation. But even when interest rates are rising, gold doesn't always benefit. Gold proves its mettle when the nominal interest rate set by the Federal Reserve is very close or even below the rate of inflation.
Even though the nominal rate of inflation is rising now, inflation is very low, around 2 percent, so that's not the case now. The best time for gold is when "real" interest rates, interest rates minus inflation, are around zero. Only if Alan Greenspan lets the economy escape his grasp will that happen.
"It really should be a very small holding," Martin said, comprising perhaps 3 percent to 5 percent of assets for people who are trying to maintain their wealth. Perhaps its best use is for older people who are more worried about preventing their assets from depreciating rather than trying to grow them.
Bullion is for the birds
Financial planners and other experts are not so sure it belongs in a portfolio at all. "If somebody is super-wealthy and wants to be super-safe, owning some gold is fine for them," said Don Boegel, a certified financial planner in the Minneapolis suburb of Plymouth, Minn. But for normal people, he doesn't see the use. Even for the super-cautious, "I personally don't think they'll see a significant rate of return on it," he said.
The last time he recommended owning gold was in the mid-'80s, after high inflation and poor stock-market returns spooked investors in the '70s. "I'd always have a piece of it there," usually less than 5 percent and never more than 10 percent of a portfolio, Boegel said.
Boegel suspects the inflation of the mid-'70s may never happen again. "It's been years since I encouraged people to own gold," he said. He now tells his clients to look for other kinds of assets that tend to perform well under inflation, such as real estate. Real estate investment trusts, which pay hefty dividends, make a lot more sense than gold, he said.
For people who are leery of real estate but worried about inflation, looking for hard assets as a result, other commodities may prove the answer.
"If we were in a super-inflationary period, like some suggest [we're in], it would be better to have a tanker of oil in your backyard, or a bushel of wheat," said Robert Stein, president and senior economist of Stockbrokers.com. Unlike wheat or oil, almost every ounce of gold produced remains in supply, he pointed out.
A composite commodity mutual fund may be the best answer for people looking for an inflation hedge, since it minimizes exposure to one particular commodity. Gold makes the headlines every now, as it did with its highs in February and in October. But because gold has basically been on hard times for so long, a short-term peak "is really a meaningless statistic for me," Stein said. "It's really coming from such a basement price."
Raising the standard with gold stocks
Investing in gold stocks is less conservative, but that defeats the "insurance" value of investing directly in bullion. They see greater gains than the metal if gold increases in value thanks to their leverage.
Think of it this way: A gold mine spends $300 to produce an ounce of gold. It sells it at $325 for a profit of $25. If the price of gold rises to $350, the mine's profit increases 100 percent to $50. But the price of gold has only increased 7.7 percent. Of course, the downside is equally severe when the gold price moves against manufacturers.
Gold, which closed at $293 an ounce on Wednesday, has increased 11.5 percent since its 20-year low last summer. So gold experts would normally expect gold stocks to rise between 28 percent and 35 percent as a result. Instead they have declined around 6 percent since then.
Martin explained that investors are worried that gold-mining companies have overhedged their positions, even though they have now scaled the program down. If they're overhedged, if gold increases significantly in value, they stand to lose more money through covering hedge positions they've sold than they stand to gain in the increase itself.
Martin thinks the concern is overdone. "This seems like a safe entry point for gold shares," he said.
When discretionary money flows into gold stocks, it tends to move only into the big-cap companies, where it is easy to get back out again. Gold producers Barrick Gold (ABX: Research, Estimates), Anglogold (AU: Research, Estimates), Newmont Mining (NEM: Research, Estimates), Placer Dome (PDG: Research, Estimates) and Freeport McMoran Copper & Gold (FCX: Research, Estimates) all have market caps of more than $2 billion, and are the biggest components of the Philadelphia Stock Exchange's Gold and Silver Index. Anglo American (AAUK: Research, Estimates), which trades in London and via American depositary receipts, is the biggest gold company in the world.
But Martin thinks mid-cap gold stocks are particularly undervalued, because they have suffered from both the unpopularity of gold as an asset, and because of the market's penchant for large-cap names. Companies such as Agnico-Eagle Mines (AEM: Research, Estimates), Meridian Gold (MDG: Research, Estimates) and Goldcorp (GG: Research, Estimates) are all "undervalued with good growth potential," he said.
They rise after their big-cap peers, and right now they're the cheapest and have the most leverage, Martin continued. But they will be less liquid and tougher to sell. Small-cap gold stocks are too risky and too tough to sell for individual investors, gold experts say.
Gold stocks still need something to get them moving, though. Many asset classes and out-of-favor sectors have idled while a narrow slice of the market captures most investors' attention.
"Things can be undervalued for a very long time, as we've seen," Martin said. "You need a catalyst. And that's hard to predict for gold." 
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