This article appeared in the June 2010 ASX Investor Update email newsletter. To subscribe to this newsletter please register with the MyASX section or visit the About MyASX page for past editions and more details.

Learn how to pick the best gold shares - and avoid the traps.

Photo of Allan Trench By Allan Trench, author

From a supply-side perspective, gold is one of the simpler commodities on the Periodic Table to understand. Gold processing is generally straightforward, and project capital costs are modest when compared to the likes of iron ore, coal, nickel and even copper. Gold producers usually produce final metal - not some intermediate opaque product - and only small quantities of metal at that, measured in ounces more often than tonnes.

As a result, there are fewer infrastructure issues for investors to comprehend in gold than for other metals, at least when it comes to getting gold to market.

There is no lack of choice in the gold sector either. Investors have plenty of gold companies to choose from, with more than 100 listed on ASX. Making comparisons between junior gold companies to inform investment decisions should therefore be relatively easy.

(Editor's note: Investors can also use other ASX-listed products, such as Exchange Traded Commodities, or Commodity Warrants, to gain pure exposure to the gold price and trade their view.)

Of course, successful investment is never that simple, in gold or elsewhere. There are many pitfalls to avoid. Here are 10 personal tips - the result of 20 years' hands-on experience in the sector - to help investors looking to make significant capital gains from gold exploration companies and emerging gold miners.

The tips cover issues that will help your thinking when approaching investment decisions in gold and complement the more general 10 top mining share tips published previously in ASX Investor Update.

1.  Consider every gold company to be unique

The above introduction to gold mining clearly over-simplifies the reality. The first step in approaching the sector is to realise that all gold companies, however small, are different. Gold companies differ in geographic and geological focus, in the stage of their development, in their financing and, of course, in the quality of their mining and people assets.

2.  Understand that gold is where you find it

Even the best qualified and most experienced geologists have yet to develop X-Ray vision. It is hard to know exactly how prospective certain gold leases are, especially at an early stage of development before JORC compliant resources have been discovered and estimations completed. Early-stage exploration is high risk; allocate your investment capital accordingly.

3. High grades trump low grades, but not always

In general, the higher the metal value per tonne of rock being mined, the higher the operating margin at a gold mine. There are 31.1 grams in an ounce. A typical mine grade of 2 grams per tonne means the average gold company is mining rock with an intrinsic value of $85 per tonne. A higher-grade mine delivering 5 grams per tonne is mining rock worth more than $200 per tonne. Typically, however, a higher-grade mine will move more barren, worthless rock, to access the high-grade ore, so margins are not proportional to the grade of deposit.

4. Treat high-grade gold as a relative term

Gold is never uniformly distributed in a rock, even within a gold mine. There are areas within a mine that can be very rich in gold, and other areas, only metres away, where gold grades are significantly lower. So exploration drilling is always likely to return a few sporadic high-grade gold hits within rocks which, for the most part, contain little gold. Even very low-grade gold deposits contain high-grade gold occurrences. So investors must differentiate between grades from drill-hits (where companies emphasise high grades) and resource and reserve grades (which will more closely approximate a future mine grade).

5. Look to the cash flow statement, not to cash costs

The gold industry reports cash costs of production to the market; companies in most other commodities do not. Variations exist as to where companies place their full costs of production, some costs being placed into categories other than cash costs. In this light, accounting systems offer investors a better measure of true costs in a gold company. Make sure cash flows from operating activities are positive, and are sufficient to cover the investment costs that ensure the future of operations. Both categories are clear in a company's cash flow statement.

6. Gold price hedging is neither good nor bad

Some investors will seek out unhedged gold companies over hedged ones, especially when prices are rising. The opposite is true when interest rates rise (allowing companies to lock in higher future gold prices) and/or upon a gold price fall. Hedging is merely a choice, both for the company and for the investor. Never believe anyone who says hedging is either good or bad: it is a case-dependent decision to manage investment risk. Of course companies (and investors) do make poor investment decisions. I once supervised a Masters' thesis which, among other things, studied how companies with different hedge commitments responded to changing gold price: both sets of companies responded equally to gold price movements.

7. Check US dollar and Australian dollar gold prices

Share prices of Australian gold companies can often respond more to US dollar movements in the gold price than to the movements in the Australian dollar price. For local producers, the latter price in Australian currency is the more pertinent metric. Look for occasions when the US-dollar gold price has fallen (driving weaker gold sentiment) but the Australian-dollar price has risen (when the Australian dollar has weakened more in relative terms than has the US-dollar gold price). Such occasions can create buying opportunities to acquire local gold shares cheaply.

8. Following fashion is a choice in gold investment

Fashion is alive and well in gold investment. I do not refer to gold jewellery but to trends in gold investment that favour some companies over others at different times. Investors have a choice whether to be fashionable go against the prevailing trend (awaiting a change in taste). In 2010, West African gold companies are very much in fashion (attracting high valuations). In Australia, which as a whole trails Africa in the gold fashion stakes, Victoria is most akin to selecting a mullet toupee at the hair salon, a consequence of the poor track record of recent gold projects in that state.

9. Size matters

Junior gold companies that are able to raise the perception of their exploration upside and/or their actual production levels to achieve a higher market capitalisation, then benefit from the increased investment interest of professional fund managers. Companies that grow beyond $100 million in capitalisation benefit from this effect.

10. Look for exceptions to the rules

The largest value opportunities in gold often lie in finding the exceptions to the rules. For example, the low-grade mine that is able to deliver low production costs; the recycled gold asset that performs this time around but failed previously - or perhaps the Victorian gold mine that changes the performance trend of modern gold producers in that state.

One thing is certain, that emerging gold companies will continue to seek investment capital from market participants. I hope these 10 checkpoints will assist your investment choices in this exciting sector.

About the author

Allan Trench is Adjunct Professor of Mineral Economics at the Western Australian School of Mines, the Independent Chairman of ASX-listed Venturex Resources and Navigator Resources, and a Director of Pioneer Resources. He is the author of several books on investment and business management, including the Insider's Guide series published by Wrightbooks-Wiley.

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