Gold as insurance

I have, on occasions, been described as a gold bug. It is fair to say that I usually own a few gold shares and that from time to time I also speculate in the metal itself. However, I believe that I am reasonably objective about gold, although I have to admit that it fascinates me.

Gold is, of course, a commodity, but it has a particular attraction as a store of value, especially when world currencies are in turmoil. Most countries have large deficits, so their governments are often tempted to print even more money. Inflation is rampant in many emerging economies, where a large number of people buy gold as a way of saving. Gold cannot be printed; it is universally accepted; it is no one else's liability and it is likely to remain in very short supply.

The scarcity of gold hardly needs emphasising. The metal is so dense that the world's production each year could be stored in the living room of an average house and all the world's gold could be stored under the Eiffel Tower. The market capitalisation of all the world's gold mines is no more than the combined capitalisation of BT and Glaxo. A minor change in sentiment could therefore trigger a powerful rise in the gold price and in gold shares.

Sceptics argue that gold is just like other commodities. They say that it is absurd to devote so much time and effort to extracting yellow metal from the earth with a view to burying it again under Indian and Chinese mattresses.

The supply and demand statistics are published each year in comprehensive detail by Gold Fields Mineral Services. In 1992, for example, mine production was 2,217 tonnes and old scrap gold yielded a further 453 tonnes, giving an estimated total supply of 2670.

The demand for fabrication was 3,107 tonnes and a further 288 tonnes was used up by the hoarding of gold bars, making total demand 3,395 tonnes. The excess of demand over supply was therefore 725 tonnes. It has been increasing rapidly; in 1990 it was 187 tonnes followed by 476 tonnes in 1991.

To meet the extra demand, central bank sales have also risen dramatically from 184 tonnes in 1990 to 568 tonnes in 1992. This high level of official sales seems unlikely to continue. The main sellers were the Belgians and the Dutch, who reduced their reserves to bring them more in line with the general European level of about 40 per cent. When Helmut Schlesinger was president of the Bundesbank he argued that gold was a core holding for central banks. Edouard Balladur, France's Prime Minister, has similar views and the Governor of the Bank of England recently made it clear that Britain would not be selling its gold.

That leaves only the Americans with 8,144 tonnes, worth about dollars 100bn. They own more than anyone else, but although dollars 100bn sounds a lot it is small beer in relation to the thousand billion or more dollars traded every day in the world's currency markets.

The Federal Reserve tried selling gold in the Seventies, but that was not a great success. This time around it is less likely to sell any, so it is difficult to see how the rising demand will be met, unless the gold price increases substantially. This is especially the case if the Far Eastern and Indian economies continue to expand rapidly. There is also the prospect (many would say probability) that in a year or so inflation will rear its head again in the west. A further joker in the pack is the world's largest producer, South Africa, which is likely to experience more civil unrest.

If gold does take off again, the move could be explosive, so a small investment could yield a very substantial return. I therefore believe that it makes sense to allocate about 5-10 per cent of a total portfolio's value to gold shares as a kind of insurance policy.

You then have to decide on where to invest. One of the reasons Julian Baring, the great gold guru, favours South Africa is that each ounce of gold in the ground can be bought so cheaply there compared with America and Australia. However, the political risk of South Africa and the comparatively high cost of production of many of its deep mines have to be considered when weighing up relative values.

If there was a civil war in South Africa, the gold price would soar and gold mining shares in America and Australia would be the main beneficiaries. In those circumstances, South African gold shares could have a very tough time.

I have been investing in marginal gold mines in South Africa. The high cost of production and consequent low profit margin makes them very sensitive to a rise or fall in the gold price. They, therefore, exaggerate any movement either way and need watching very carefully indeed.

More recently, to add geographical balance to my gold portfolio, I have been looking at Australian mines. However, for the average investor, who wants an insurance policy in gold, I would recommend beginning with an investment of no more than 5 per cent of total portfolio value in a geographically well-spread unit trust. Your stockbroker should be able to advise on the best ones for this purpose.

The author is an active investor who may hold any shares he recommends in this column. Shares can go down as well as up. Mr Slater has agreed not to deal in a share within six weeks before and after any mention in this column.