Golden rules of investing in gold shares

By Ian Lyall for MailOnline
Updated: 04:40 EDT, 19 October 2010

Each week, the Daily Mail's Investment Extra column spies out opportunities to make money. This week: Gold mining shares

What do QE2, India and Goldman Sachs have in common? The answer is each has played a part in driving the already sky-high price of gold to record levels.

The threat of a second bout of quantitative easing in the US - which is flooding the economy with newlyminted dollars to kickstart growth - has prompted large international and sovereign investors to switch some of the greenback into gold. Demand from the emerging middle classes on the sub-continent and China continues unabated.

›› Latest gold price charts

Goldman Sachs was a bit of a red herring. The Wall Street broker-dealer this week predicted that the gold price would hit $1,650 an ounce in the next 12 months.

But so sensitive is the market to these things, that the price of bullion rose on the back of the forecast. It is currently trading at $1,377 an ounce, within a whisker of its all-time high.

The obvious ways private investors can gain exposure to the rising price of the yellow metal are via jewellery, coins and exchange-traded gold funds. And there's another method - buying shares in the companies that produce the stuff.

The discussion on Investment Extra tips starts today, online. Have your say on these stocks on our sister website at thisismoney.co.uk/extra

'While the current frenzy for gold has brought with it anecdotal evidence of panic buying, the more practical way of gaining exposure is via the mining sector and gold stocks within it,' says Andrew Gibson, the head of research at City trading house Galvan.

'Mining costs are a relatively stable part of the equation, so a 10% or 20% rise in the underlying price of gold can have a disproportionately greater effect on the upside for profits of these companies and therefore the share price valuations.'

A 43% rise in the mining sector partly reflects this new gold rush. And there have been some stand out stars - Mariana Resources is up 466% and Shanta Gold is ahead 366%.

But there are also some undiscovered and undervalued golden nuggets out there if you look hard enough. However you need to follow some strict guidelines when making your choice.

Carrying out what the professionals call due diligence is part of the process. So look through the regulatory filings and examine with a sceptic's eye the claims a firm is making. It is all very well having a potentially massive resource base, but if it is buried several kilometres underground there's a problem - not least the massive costs of getting the gold out of the ground.

Remember, miners will often issue shares to develop projects, so be prepared to see your investment watered down. John Meyer, respected mining analyst at City research firm Fairfax, adds a few more pointers. Key for him is the company's potential to carry on building the gold resource (what's in the ground) and reserves (what it is able to extract).

Look also for companies with projects that are high margin, with low capital costs, he adds. But above all the management must pass muster.

'If there's no dirt under the fingernails then there's no dirt and that's not a good sign,' Meyer says. 'For us at Fairfax, there are a series of dos and don'ts in the mining sector. We don't finance people with gold Rolex watches, leather jackets or shiny suits.

'We don't finance shoes with tassels or men with man bags. These are the golden rules for mining analysts and woe betide anyone who breaks them.'

Meyer cites Petropavlovsk (formerly Peter Hambro Mining) as a low cost, high margin producer. He reckons Medusa Mining has the management to become a top notch gold company, while Shanta has the capacity to build out its resource base.

There's another group of miners that is also of interest. This is made up of so-called junior or smaller diggers that are producing significant amounts of gold, but that also have some very exciting exploration projects.

Into that category falls Cluff Gold and Pan-African Resources, which are my picks. Both are profitable and generating the cash that will fund their exploration ambitions. HAVE YOUR SAY ON INVESTMENT EXTRA'S TIPS

The discussion on Investment Extra tips starts today, online. Have your say on these stocks on our sister website at thisismoney.co.uk/extra

Top performers (price rise so far this year): Marianna Resources (+466%), Solomon Gold (+316%), Shanta Gold (+229%), Conroy (+151%), Condor Resources (+131%)