Gold is traditionally seen in some quarters as a safe haven in times of geopolitical volatility. I think the reality is a bit more complicated than that but with the gold price recently hitting all-time highs, clearing the yellow metal has been attracting a lot of buyers.
The London market includes multiple gold miners including various penny shares. Given that the gold price has been surging, ought I to add some of these penny shares to my portfolio or perhaps soaring former penny stocks?
The economics of gold – and gold mining
Before digging into specifics, let me discuss how the gold business works. As a precious metal with finite availability, the gold market is cyclical.
When demand is high, for example because nervous investors seek a store of value, money piles in. As demand increasingly outstrips supply, the price rises.
At some point the market tops and sellers outnumber buyers. The price then starts falling and eventually (maybe many years later) reaches a bottom, when the process starts all over again.
Crucially though, it is not obvious that the market is at a bottom or a top at the time – that only becomes clear in retrospect.
Mining is initially highly speculative and capital intensive. Miners spend lots of money prospecting and sometimes building mines. That can be money down the drain. But a viable mine can produce great rewards.
The marginal production cost can be low, so surging sale prices can feed almost directly to the bottom line. In other words, profits can soar when prices are high.
Investing in miners is not for the faint-hearted
In investment terms, prospecting can be high-risk, high-reward. That is the case with many prospecting penny shares. They want to raise money to fund a single prospective project. The potential rewards could be high — but there is a big concentration of risk.
The industry economics still apply to giant diversified miners like BHP. Fixed costs can be high, prospecting is costly and metals are a cyclical market, meaning potentially big swings in sale prices over time.
Crucially though, they have far less concentration risk than the typical mining penny share.
Two that have soared!
That explains why I have no plans to invest in gold-focused shares that sell for pennies, including Serabi Gold (LSE: SRB) and Metals Exploration.
A year ago, both were penny shares with market capitalisations of under £100m. While they still trade for pennies, those two shares have soared 164% and 116% respectively in 12 months, giving each a nine-figure market-cap. That shows what a soaring gold price can do.
Serabi’s profits have jumped accordingly. Full-year figures are not yet available, but its gold output last year was up 13%. Add to that higher production a very strong gold price and the profit uplift should be substantial.
If gold prices stay high, this year could be even better, as Serabi expects to ramp up production significantly again.
But whereas Metals Exploration has at least some geographic diversification, Serabi is all-in on one market (Brazil). Both companies focus on one metal: gold.
Even aside from the risk of the gold market turning into a downward phase of its cycle, that level of concentration is still far too risky for me.
