Gold Diggers To Avoid

How much is gold worth?

The simple answer is nobody really knows. For instance, at the turn of the Millennium you could have bought an ounce of gold for $255. But the same quantity of gold will set you back $680 today.

Now you would think that rising gold prices is good news for investors in gold mines. That's generally the case, but not in every instance. For example, Randgold Resources (LSE: RRS), which is one of the stock market's biggest gold producers, has seen profits rise with surging gold prices. Consequently, investors in the African miner have benefited from the huge boost in profits that rising gold prices has provided. The shares have risen three-fold in five years, valuing the company at £962m.

Peter Hambro (LSE: POG) and Avocet Mining (LSE: AVM) are other companies that have gained from demand for gold. In 2001, Peter Hambro, which digs for gold in Russia, reported profits of £5m. But its bottom-line is expected to swell to £12m next year. Meanwhile, Avocet, which pans for the yellow metal in Malaysia, was loss-making in 2001. It is now expected to post a profit of £9m this year, rising to £24m in 2007.

But Highland Gold Mining (LSE: HGM), which mines for gold in Russia, has seen its profits go into reverse. In 2002 it reported profits of £12m but it fell into a loss of £9m last year. It seems that production delays and increased costs were to blame for its woes.

Cost of production is indeed something to consider carefully when investing in gold miners. For instance, inflation can be rife in some parts of Africa, which has meant that some companies have had trouble keeping their costs down. It is also worth bearing in mind that gold is priced in dollars, but mining firms have to pay costs, such as wages, in local currencies.

Another thing to consider is that a miner's profit can often be beyond the control of management. For example, if you own a share in a gold miner where the costs of production is $400 per ounce and the price of gold is $600, the mine's profit will be $200 an ounce. So, a 10% rise in the gold price to $660 per ounce will push the margin up to $260 an ounce -- this is actually a 30% increase in the mine's profitability, and may result in a 30% increase in the share price.

However, a 10% fall in the gold price to $540 will cut the margin to $140. In this case the profits will drop 30%, and may potentially result in a 30% decrease in the share price!

To avoid the volatility in profits, many miners will enter into contracts to sell gold at predetermined prices in the future. This is known as hedging and will help to reduce the exposure of many gold miners to short-term price fluctuations. However, the downside is that it also reduces potential returns when the gold price is rising.

Now there are two main schools of thought with regards to investing in gold miners. Some investors prefer the industry heavyweights such as Anglo American (LSE: AAL), which generates 9% of its turnover from gold. Others like to speculate on gold explorers that have unproven reserves. The advantage here is that the shares can rise very quickly on discovering a rich deposit. For instance shares in Shanta Gold (LSE: SHG) surged three-fold after it identified a "geological anomaly".

But as I see it neither option is especially attractive right now. After all gold mining is a commodity industry, and it can be very difficult for any miners to establish a competitive advantage, if at all. And with gold exhibiting all the signs of being in a bubble, the bursting of gold profits may be only a pin-prick away.

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