The Myth of Risk in the Gold Mining Sector

Myth: Gold investments are risky.

Fact: some gold investments are extremely risky. But not all of them…

For the record, I need to point out my own gold thesis: I buy physical gold for an entirely different reason than I invest or speculate in the gold mining sector. And even within the gold mining sector there's a rather significant continuum of risk (and reward) from majors like Barrick (NYSE: ABX) (the world’s largest gold miner) down to thinly traded, boiler-room junior gold mining companies that trade on the pink sheets or on the Toronto exchange.

You should think of these three different types of gold assets in entirely different ways – though I know most investors lazily categorize “gold investments” as a single asset class with equal risks and rewards. But that’s not a very useful or profitable way to look at these vastly different assets.

Regular gold bullion is for safety, and security – insuring you against fiat currency crisis. I wouldn’t even call it an investment. Do you call cash under your mattress an investment? No – and gold is the same way.

Consider it a cash position without any central-banker, counterparty risk. In other words, you don’t have to worry that Ben Bernanke will inflate gold supply and devalue your gold holdings – but you do have to worry that he’ll inflate dollar supply and devalue your dollar holdings. That’s what I mean by “counterparty.” Gold doesn’t have a counterparty!

Gold majors – and even mid-cap gold miners – are relatively safe plays that can (and should) be analyzed like any other large or mid-cap company – on fundamentals, growth, earnings, debt, cash flow, etc.

After all, if a company is slated to grow earnings by 10% a year for the next 12 quarters, and it's selling for less than 10 times earnings, and carries no debt, then it's a conservative play regardless of what sector it's in.

And that’s the space we’re in now for gold majors. There are many large and mid-cap gold companies that are selling for dirt cheap valuations – and that are also planning on increasing gold production.

Even if gold drops in price, many of these companies will still grow their profits. And though these companies tend to rise and fall on news from the gold market, or from the market in general, the same can be said for any mid- or large-cap company in the stock market. It’s just a matter of paying the right price for these companies.

But the third group of “investments” in the gold sector is entirely different. You can’t analyze junior miners the same way you would a Barrick Gold – just like it would be foolish to analyze a tiny oil exploration company the same as you would Exxon Mobil (NYSE: XOM).

Unlike gold majors, these junior miners probably don’t make sense to buy at any price. Most of them are completely worthless. The overwhelming majority of them go bust – never mine an ounce, never earn a dime.

They’re lottery tickets – with slightly better odds. Whereas you might only have a 1 in a million chance at winning the lottery, you can actually increase your odds of success in the junior space to 1 in 50 or possibly 1 in 10 if you have the right information.

But it’s tricky. Most investors should probably stay away from junior gold miners and focus on bullion and gold majors at the right prices.

Fortunately, I think now is the perfect time to add to or to start a position in both bullion and gold majors. The sector has rallied strongly in the past month – and typically these reversals are the best times to buy the sector as a whole.

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