Uptrend intact as industry leaders innovate for gold

A commitment to more transparency about gold holdings by central banks and product innovation in the industry is making it easier for investors to access the gold market and protect their portfolios through further diversification, according to Graham Birch, manager of the Merrill Lynch Gold & General Fund.

Two important factors in the past few years have improved liquidity and depth of the gold market. In 1999, the first five-year Central Bank Selling Agreement (CBSA) introduced a mechanism to indicate how much gold the central banks involved were likely to sell over the period. The voluntary agreement, which includes most European central banks, has just been renewed for a further five years. This time round, sales volume was restricted to 500 tonnes per year, which was less than expected.

"Originally, the central banks involved felt that their actions in selling gold were damaging the market," says Birch. "Announcing the limit of what they would sell each year brought a degree of transparency about their activity and helped reduce any fear about what they were doing. The first CBSA was quite effective and has helped turn the gold market round. The renewal is a positive factor for the sector."

Then, at the end of last year, the World Gold Council launched the World Bullion Securities Exchange Traded Fund on the London Stock Exchange. This innovative structure allows investors to buy gold bullion through shares in the fund, as each share is backed by 1/10th oz of bullion.

"That solved a lot of the problems investors had about how to buy gold bullion," comments Birch. "Although it is too early to say exactly how much impact this new security will have, the early signs are encouraging and there is a possibility that it will encourage greater use of gold as an asset class."

Such supportive factors are partly reflected in the evident recovery in investment demand. The gold price reached an eight-year intraday high of $430/oz in January this year, even though it has since given back some of those gains, standing at around $380/oz currently.

Birch puts the more recent slide down to the rebound in the US dollar. "Gold and other commodities are priced in dollars, so when the dollar clawed back some lost ground, it adversely affected gold and swamped other underlying factors that have been, and continue to be, quite supportive," he says.

The longstanding investment appeal of commodities in general, and gold in particular, is as a safe haven and bulwark against inflationary pressures.

"Higher commodity prices suggest that inflationary pressures are building in the global economy," Birch notes.

"It is a long time since we had any serious inflationary pressures and many investors have perhaps forgotten how to structure their portfolios for a more inflationary world. We expect a generally uptrending market, with some setbacks, but it will be interesting to see if gold responds to an increase in anxiety about these pressures."

In today's sophisticated financial markets, there are several alternatives to buying gold to fend off inflationary pressures. Why is gold still in demand?

"Obviously, there are other ways of dealing with inflationary pressures," says Birch. "But most of them will cost quite a lot of money. You can buy protection or other clever things from investment banks but the attraction of gold, and especially gold bullion, is that it is very simple. Once you buy it, there is nothing further to pay, no annual management fees or complex pricing structure."

Birch calls it "one of the most boring assets you can own", which for investors trying to navigate difficult global markets, is a considerable plus.

"Gold is anonymous," he adds. "It has a physical presence, so it doesn't have to be securitised and there is no default risk. Even a government bond has a small risk via the currency, which may become debased due to deflationary pressures. Gold is one of the few financial market assets that is not a liability against someone else's balance sheet."

The market is experiencing rising investment demand plus a boost from mining companies buying back their price protection hedges. Rather than downside protection, which is now looking expensive, shareholders of gold mining companies would rather have exposure to higher prices.

"That is supportive of the market because when you repurchase the price of the protection programme, it is the same as actually buying gold, and we expect that trend to continue through this year," says Birch.

Merrill Lynch Investment Managers' £395.3m Gold & General Fund, launched in 1988, is aimed mostly at UK professional investors, although there are also a number of private investors who have had holdings for some time. However, gold shares are typically three times as volatile as gold bullion itself so a 10% shift in the gold price can prompt a 30% move in gold share prices, and the fund.

"That's great when gold prices are going up but it's very painful when they are coming down," admits Birch. "It's not an investment that suits everyone."

Most professional investors, such as life and pension funds, still have no commodity or gold holdings in their portfolios. Others may already be holding up to 2.5% of their portfolios in gold, says Birch.

"What we find is that these institutions are the same ones looking at other alternative assets, like hedge funds," he adds. "They are bright and alert and realise it is no longer good enough to be invested solely in the UK equity market. There is protection and performance in diversification."

Birch agrees there is a certain element of timing to a successful investment in gold and gold shares.

"For people looking at a one-to-two-year investment period, it is certainly important to get the timing right," he says. "It is probably better to buy the fund after a fall and wait for the rebound. But for those who can take a longer term view, we have shown it is possible to get a reasonable return."

The two areas of the gold market Birch finds most interesting at the moment are China and Russia. Both, until recently, have been very difficult to invest in. "But both are big gold producers - fourth and fifth largest respectively in the world," he points out. "The global stock market in gold shares has been opening up a bit so we have been putting more money in both markets and we are pleased at how they are performing."

China has been liberalising its gold market over the past year, culminating in the floatation of three key companies: Shandong Gold, Zhongjin Gold and Fujian Ziijn, all of which are held by the fund.

The industry is very fragmented and these three companies are expected to be at the forefront of imminent consolidation and modernisation in the industry.

South Africa has been a weak market in the past few months, due mainly to the unusually strong rand and a domestic political agenda to change mining and ownership laws. "That has undermined sentiment but both factors have largely run their course, so this is a market due for improvement," says Birch.

With a global macroeconomic backdrop of increasingly volatile and difficult markets, there are opportunities to buy certain shares cheaply but this demands considerable stockpicking skill. "We don't have a target level for gold and we cannot always be chasing a rising gold price," explains Birch. "So we have to look very hard at the investment arithmetic."

Buying gold shares is essentially buying gold that has not yet been mined, so the asset manager has to calculate what profits will finally be generated by extracting the gold that is in the ground. The starting point is to look at the reserves and resources the target company has. "If the company's market capitalisation is too high in relation to the future profits, the share is obviously less attractive," Birch notes.

He tries to build a portfolio where each stock offers something slightly different in terms of risk profile so that, "if gold drops, we live to fight another day, but if it does well, you get some extra lift".

A company like Placer Dome, a major North American gold producer, has strong cashflow and earnings, while South Africa's Harmony is highly sensitive to changes in the gold price and provides gearing to an improving gold market.

After recent meetings with the executives of the principal investments in the fund, Birch says he is "extremely comfortable" with his holdings. The 'general' part of the fund consists of holdings in platinum, silver or diamond companies. He tends to sell these shares first if he needs to meet redemptions. "Essentially, as the gold price drops, the fund becomes even more concentrated on gold, so you are sure to get the maximum benefit from the rebound," he says.

Birch is cautious about predicting new highs for the gold price but is convinced investors will start to pay more attention to gold, rather than less. "The global capital markets today are an extremely difficult place to implement a long-term investment strategy and the world is not exactly improving in political terms," he says.

"The factors that drove the gold price higher in 2003 have not gone away and we expect the investment climate to remain favourable, especially in view of the better earnings performance gold mining companies are likely to display over the next six months."

key points

Gold is a natural hedge against inflation.

Recent dollar rise has depressed price of gold.

Many institutions are still underweight gold.

Factors supporting gold price remain intact.