For many investors, myself included, the gold price has previously seemed out of touch with reality. In fact, I warned six months ago that gold could be 'the next to fall'.
Yes, I understand the arguments about quantitative easing and the perceived relative safety of physical assets, but saying gold is worth 'more than it was previously' is different from being able to fundamentally assess how much it was actually worth yesterday, and therefore how much it's worth today.
Knowing that training helps you run faster isn't the same as knowing whether it can help you run the 100 metres in 10 seconds.
Gold – and gold miners – on the nose
But the recent 20% fall in the gold price has taken some of the steam out of the market, and has also taken the shares of gold miners with it.
The gold miners' falls have been sustained. Indeed, the S&P/ASX All Ordinaries Gold sub-index has fallen consistently since mid-October 2012, to be off 44% in just six months, and a full 25% in the last month alone.
When you include dividends, the gold index has fallen just shy of 42% in the last five years, while the S&P/ASX 200 has gained 12.6%. That's an underperformance of almost 55%.
To the enterprising investor, that should at least mean taking a closer look. So often in the sharemarket, the babies are thrown out with the bathwater – both booms and busts tend to overshoot on the upside and downside. Rarely is the good news as great as many imagine, or the bad news so terrible.
Which leaves us with the question – with carnage in the gold sector, is now the right time to be scooping up the miners of the yellow, shiny metal?
Bargain prices or a value trap?
The hardest part of making an investment case for miners in general, and gold miners in particular, is understanding the cash flows that will come from their businesses.
As the past couple of months have shown, unlike Coca-Cola Amatil (ASX: CCL), Telstra (ASX: TLS) or Wesfarmers (ASX: WES) there's no way to reliably predict the sale price of a miner's product. Of course, some of them do hedge their production, but even those hedges have a limited life.
And if you can't determine the revenue a company is likely to make, the profit numbers become similarly challenging. Lower revenues with the same cost base means profits fall faster than sales. On the flipside, any price increases translate to profits quickly, too.
The other challenge for investors is in estimating what a company will do with those profits, when they arrive. A gold mine is a finite asset – once the gold is removed, the company either has to close up shop and give the cash to investors, or find another place to start digging.
Managers rarely like to put themselves out of a job (and to be fair, most investors in gold mines want the company to find more gold), so the latter option is almost always the one they choose.
Knowing when to buy
Given those criteria, here's how to think about buying gold miners:
You want to buy when the price has fallen to around the point at which it is almost unprofitable to mine for more gold – when the price equals the costs. At that point, new mine expansion is unlikely, keeping supply in check, and the odds of a subsequent price increase significantly outweigh the chances of a sustained price fall. (A fall is possible, of course, but unlikely to be much further or for a sustained period).
You also want to make sure you're investing in a company with competent and shareholder friendly management. This is a dangerous industry to be in when the CEO or Board of Directors are more intent on empire-building than on looking after the interests of shareholders. One poor decision – such as paying too much or buying a sub-economic mine – can be responsible for permanently destroying shareholder wealth.
Foolish takeaway
In short, we're not yet at the point where the gold price is around the cost of extraction, but we're not all that far off. Another $200 fall in the price of gold would be the point at which I'd be getting very interested (assuming share prices kept pace). Of course, that point may never come – in which case there are plenty of other fish in the investment sea.
Remember, we only ever have to buy something when the odds are in our favour – there's no penalty for patiently waiting.
Savvy investors are now seeking growth in smaller companies. Discover two stellar small-cap opportunities now, in our brand-new research report, "2 Small Cap Superstars" — simply click here to download your FREE copy.
More reading
The Motley Fool's purpose is to help the world invest, better. Click here now for your free subscription to Take Stock, The Motley Fool's free investing newsletter. Packed with stock ideas and investing advice, it is essential reading for anyone looking to build and grow their wealth in the years ahead. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson. Motley Fool investment advisor Scott Phillips owns shares in Woolworths and Telstra.
