Digging for opportunities in gold

(Fortune Magazine) -- Having lived through bubbles in technology stocks and real estate, many investors have grown nervous lately about gold. Its price quadrupled in the past decade to a record $1,227 an ounce in December, before falling back near $1,100. Hedge fund legend George Soros, for example, recently warned that "the ultimate asset bubble is gold." Others, by contrast, cling to it as the ultimate safe haven in a period of wrenching economic uncertainty.

Bubble or refuge? Fortune turned to Mark Johnson, manager of the USAA Precious Metals and Minerals Fund (USAGX), for insight. Johnson's $1.5 billion fund invests in mining companies -- 80% in diggers of gold, with another 15% divided among silver and platinum miners, and the rest in cash -- and returned an annualized 24.4% for the 10 years ended Dec. 31, 2009. Lipper recently crowned it the best-performing mutual fund of the decade in any category.

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Fund manager Mark Johnson

There's still plenty of reason to like gold, argues Johnson, 59, who has run the fund since 1993 (with Dan Denbow as co-manager since 2008). "Think of gold as homeowners insurance," Johnson says. "The question when you own a home isn't whether you carry insurance. It's how much you have. If you really believe we're in a [gold] bubble, have minimal exposure." But he doesn't think calamity is looming.

With prices already above $1,000, what makes you think they might go higher?

The real driving factor will be when the Fed starts to rein in inflation, an intermediate-term concern. Gold doesn't like a rising-interest-rate environment because currencies strengthen when rates rise and inflation is controlled. I think the central bank won't raise rates until at least 2011 because it's most concerned with unemployment and financial instability. The economy must be strong before the Fed actually responds with a tightening policy, and unemployment hasn't even peaked yet. Over the long term our structural deficits will keep gold prices high.

While those factors are important, they don't sound as if they'll create a spike in gold prices. They're already well known.

You want to own the sector, but at this point you don't jump in with both feet. Look, is gold a great investment at this particular point in time -- at $1,085 as we speak? Probably not. But it's a good investment. With the S&P now at 1100, that's not exactly a giveaway. And bond yields are very low and prices will fall as the Fed tightens. You're hard-put to find any great investments right now. Now more than ever you also want gold as a hedge.

Even if we are not in a bubble, couldn't we still encounter a correction, given how high prices are?

We're probably close to the end of a correction. We're down more than $100 from the all-time high we saw in December. I have a hard time seeing gold go below $1,000. But if I had to call a floor, I'd say it could be $800 an ounce, given that most mining projects on the drawing boards don't work unless gold is at $800 or more. And I will say that it's a long and painful way from $1,100 to $800.

If investors shouldn't jump in with both feet, what should they do?

Invest in defensive companies that can do well regardless of what gold prices are doing. In any commodity -- whether gold, oil, copper, or forest products -- in the long run only the low-cost producers with strong balance sheets and good management survive. They will survive even when gold prices plummet.

We also own stocks that can grow production and reserves because they will do very well in up markets. And whether gold prices are up or down, valuation matters. You don't want to identify the perfect company and then overpay. The median multiple for the companies we track is 19.7 times estimated 2010 earnings and 10 times cash flow. Our model uses a gold price of $1,050.

What names do you like?

We have increased our stake in Newmont Mining (NEM, Fortune 500) because the stock is very inexpensive (a P/E of 12) relative to the group. It seems to have some projects under way that could create modest growth, including development of the Boddington mine in Australia and beginning construction on a new mine in Ghana. Because the stock is so cheap, investors should be rewarded if the company delivers any growth, though it has historically had problems there.

We also like Royal Gold (RGLD). It owns royalties on mine production rather than the underlying mines. Consequently, on an after-tax basis, about 69% of the revenue translates to cash flow.

And it's not as exposed as other companies to moves in commodity prices, which are a big factor in the industry. For example, for an open-pit miner, about a third of its costs are related to oil. If oil goes through the roof, the mine's costs go up. Royal Gold just gets a royalty on the revenue stream of a mine, and its costs don't change.

The company also has no obligations for future capital costs, so it doesn't move up or down with gold prices as much as most mining stocks. The downside is, if gold takes off, Royal Gold will lag other mining stocks. But from a risk standpoint, it's the ultimate defensive stock. The cost of production is basically zero.

One more-expensive name we have is Randgold Resources (GOLD), which has a very strong growth profile. At a P/E of 33, you're definitely paying for the growth. But production is anticipated to grow dramatically in 2010, from 455,000 attributable ounces to 1 million ounces by 2013. It's also a low-cost producer, and has long mine lives and good management. For all intents and purposes its balance sheet is debt-free.

Why not just buy physical gold?

You can get better leverage by buying the mining stocks. They move twice as much as the underlying gold price, but that's true whether they're moving up or down. So be careful. Make sure that you have defensive names like Royal Gold. Buying the physical metal is also tax-disadvantaged because it is treated as a collectible by the IRS, which is taxed at 28% no matter how long you own it. Stocks are taxed at the capital gains rate.

Your fund fell more than 50% in one three-month period in 2008. Could that happen again in 2010?

Actually, from peak to trough we were down 70% from March to October in 2008. But you would need a radical change in the economic paradigm similar to what you saw that year. It looked as if the capital markets were collapsing. In the panic, people had to sell gold positions to cover margin calls, since gold is fairly liquid. And in that case, yes, we would certainly see the values of everything, including gold, go down.