Why do you own gold?
Is it the fear of the unknown?
Perhaps it’s simply the love of the yellow metal.
Whatever the reason, precious metals are cyclical. Gold has been a commodity for over 7,000 years. Sometimes it has performed well, and sometimes not so much.
If you’re holding gold and gold stocks as a hedge against instability in the financial system, you need to know that some gold stocks hold up better during a crisis than others. Today, I’ll explain which.
But how does the gold sector look today?
After a poor five years, the last couple months have been great for the yellow metal. But compared to earlier in the year, that ‘warm and fuzzy’ feeling towards gold is evident.
Euphoria normally happens near the peak. That means gold stocks could be in for a bit of a tough time in the months ahead.
That doesn’t mean you should panic and sell everything. The best speculative gold stocks can still skyrocket. It happened during the 2008 financial meltdown, and I believe it will happen again.
Winding back the clock…
The 2008 financial meltdown seems like a distant memory. Yet it’s hard to forget that some of the world’s largest banks collapsed.
85-year old investment bank Bear Stearns nearly went under in March 2008. It was saved by JP Morgan Chase at the 72nd hour. The investment bank paid $2.00 for each Bear Stearns share — a price far below its former 52-week high of $133.20 per share.
Lehman Brothers, the world’s third largest investment bank, didn’t survive. It filed for bankruptcy protection on 15 September, 2008. The filing remains the largest bankruptcy filing in US history.
It was an extremely scary and uncertain period of time.
Gold — the hedge against uncertainty — collapsed by about 34% during the crisis.
The world’s biggest gold stocks fared worse than the yellow metal. The ‘HUI’, a global major gold index, nosedived by more than 71%. This is shown in the chart below:
Source: Sunshine Profits
[Click to enlarge]
The gold miners are leveraged to the gold price. They tend to outperform the yellow metal during the good times, and underperform during the bad. Yet, despite the carnage that seemingly hit across the sector, not all gold stocks collapsed.
A golden diamond in the rough
In October 2007, Aurelian Resources — a penny stock at the time — released a 13.7 million ounce resource estimate for its gold deposit. The share price jumped from US$6.00 to US$10 per share. This was near the top of the bull market.
When the 2008 financial crisis hit, the share price went sideways. The company ignored the broader macro environment.
But it wasn’t always smooth sailing…
In early 2008, Aurelian’s share price dived to about $5.00. Ecuador’s government, where its gold deposit is located, suspended mining across the country.
The share price traded around that level for a few months. Billion-dollar gold company Kinross Gold Corp. [NYSE:KGC] saw a bargain. It offered Aurelian shareholders $8.20 in late July 2008.
The deal valued the Aurelian at a 64% premium to the prior trading price. The deal went through when gold stocks were in freefall.
Aurelian Resources, like most speculative stocks, reacted to fundamental events. The junior miner found gold. A LOT of gold. And it managed to handily shrug off the financial meltdown hammering most stocks across the rest of the world.
Speculative gold stocks are the way forward
If another financial crisis hits in the months ahead, similar to 2008, the best speculative gold stocks can still outperform. These small companies don’t care about macroeconomics. They react to company events.
Speculative mining companies aim to create value. If they’re successful, then you don’t just get exposure to gold. You get exposure to the additional value created by finding and developing mines.
If the company uncovers a multi-million ounce deposit, you stand to make a lot of money. That’s called ‘organic’ growth — growing from the inside out.
Gold producers and developers, on the other hand, tend to grow by acquisitions rather than organically. These companies generally need to acquire assets, or take over speculative companies that have unearthed a major deposit, to grow.
Large companies are more mature businesses with proven deposits. And of course these deposits don’t last forever. The market values their assets based on the free cash flow potential, and other risks. They are also valued on their balance sheets. That exposes them to macro risk.
If another financial meltdown hits, which I believe is inevitable, back the smaller gold players. The large companies, the producers and developers, could get hit hard again, like they did during the 2008 financial storm.
Speculative gold stocks have the potential to make you enormous profits, regardless of what happens to the gold price.
To find out more, go here.
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Editor’s Note: This article was originally published in Money Morning.