In part two of our series on gold; Amanda Morrall talks to Socrates Fund Management Charles Drace about some considerations for investors adding gold to their portfolio

By Amanda Morrall

Last week, in part one of our series on gold Socrates Fund Management director Charles Drace and I discussed some fundamentals around gold and why Drace is predicting it'll hit US$7,000 an ounce at the peak of its cycle. Today, in part two, Drace talks about some more practical considerations for gold investors. This an abbreviated transcript of the full video interview above.

Q) Gold is considered a good hedge against inflation. Why?

A) Because historically it has always worked. Certainly we haven't had inflation like we've had in the past but it's always worked as a hedge against inflation because gold tends to go up faster than inflation while bank accounts, treasury bills, bonds and even stocks tend to go up slower than inflation. At the end of 1970-1980 , inflation was over 15% per annum but the average over that period was 7.7% Treasury bills were the same as inflation, bonds were less, stock were 1.5% less, property was almost 2.5% better but gold was four times better. When inflation was 7.7% gold went up 31.6% so it was a massive increase during that period. Silver went up too, more than tripled and diamonds not as good but 15% better. So historically it's always worked. (For more historical  charts see www.kitco.com here).

Q) What happens if we enter a period of deflation for a long time as some experts are forecasting now?

A) I think we're going to have inflation and deflation at the same time. The things that will get inflated are the ones that are more difficult to produce. Oil until recently was going to inflate but now that America is producing more from fracking it's put a lid on it. It's still a lot more expensive to fill your car now than it was a few years ago. We'll experience more food (inflation) with droughts in Russia and the Ukraine and the U.S. But things that are easy to make, like the iPhone, things like that will get cheaper. And the other things that we put in our houses will get cheaper but our houses themselves will be more expensive.

Q) What's your response to criticism that gold is not a good investment because it does not produce any income?

A) I don't think it matters if it doesn't produce interest. Interest, generally speaking, is always less than the capital gain during market cycles and most people buy stocks for capital gain. When stock markets aren't doing too well they'll orient themselves back to income producing stocks but they're still hoping for capital gain. So its capital gain that's the most important for investors. When we look at the cycles for gold, the capital gain is so tremendous, who cares about the income. The argument that it doesn't have income is probably made mostly by people who don't understand gold or who have their own barrel to push, be that the stock market or a fund management company that specialises in the stock market.

Q) What about tax on capital gains?

A) It's a difficult area because in theory we aren't supposed to have capital gains on a long-term investment. So if you held your gold for a long time you should be able to keep the proceeds without tax. I suspect the person who goes in and out of the gold market will be seen as a trader. I am not a tax expert so I'm not giving advice on this. If anyone wants to clarify that, they need to consult with a tax expert.

Q) You've said gold is undersold in New Zealand. Do you still believe that to be the case?

A) There's a growing interest but there's still a real reluctance to put money in. This gold boom is 11 years old and I'm not aware of any other fund manager coming up with another product in New Zealand. I think it's pretty typical. I used to watch fund managers in Australia come out with new products in the '90s and they might come out with a technological product or an Asian product and I used to buy options for a falling market in those areas because generally you have fund managers coming into these areas when they're at the top of the market. So I wouldn't be surprised if it's not another five to 10 years before we see a lot of gold products on the market in New Zealand.

Q) Storage of physical gold is seen as a deterrent for some investors? Is this something you come up against.

A) We buy the mining stocks but we buy bullion too. We buy principally through two fund managers in Canada. One has a very long reputation and stores their gold through the Bank of Canada. Another stores their gold through the Swiss Cantonal Bank. It's stored in the  Swiss national vaults. A lot of people do like to hold gold. The good thing about gold is that if your house burns down and if you have a bunch of liquid gold it's still gold. On the other hand, during the Christchurch earthquakes a lot of people weren't able to get into their houses, so storing it yourself can be a risk.

Q) What about investing in mining stocks?

A) Mining stocks run in a totally different cycle. They tend to follow the price of gold but they're really volatile. You really have to have a long-term view. Or if you're really good, you're a trader. As an example of that mining stocks on average lost between 60 - 80 % in 2008 so just a big decimation. Sharemarkets lost about 50% and gold lost about 10% then they took off in 2009 and 2010 they were looking brilliant then they turned around back in the winter of 2011 and now they're lower  than they were before the 2008 crash. So we've had no joy there. It hasn't been any good for our fund and for the last couple of years we haven't held (mining stocks) it because we haven't seen any point in it. Having said that, when gold takes off the mining stocks outperform. Going back a few years when we bought gold at $600 an ounce, it cost $400 an ounce to get out of the ground, now it costs $600 an ounce to get out of the ground but it's worth $1,700 an ounce. That's what you find with the mining shares. We're in a flat cycle but it could be broken in the next year or so and I expect we'll see the mining stocks go back up again.

Q) What are your short-term and long-term outlooks?

A) I'm relatively confident it will start to pick up in 2013. Going longer, I see the economic situation getting worse because of the massive debt and Government's inability to deal with it. Bullion banks won't be able to short it as it starts to climb, central banks will be buying it, inflation and all those barriers will come away because the debt has climbed and we haven't done anything about the economic situations that make it worse. We've borrowed more money to feed into it. In Greece, Spain and America we're making the debt worse, that would argue for gold as a safety. Then we have the other dynamics, they're (Central banks) are printing trillions of dollars around the world to push the currency down. The IMF and BRIC (Brazil, Russia, India and China) countries have been talking about having some kind of a tradable currency to replace the U.S. dollar because the U.S. government with all their printing will devalue their dollar and that will hurt all the exporting countries because they're all priced in dollars.The discussion is around having 15-25% of this new trading currency in gold, - the best way to think about it is as a trade weighted asset. When I said a few years ago $5,000 an ounce gold, now I'm thinking closer to US$7,500 an ounce because things have got worse and these new dynamics will bode well for gold prices.

For more news and analysis, on precious metals, see interest.co.nz's gold section here.

------------------------------------------------------------------------------------------

You can find detailed, up-to-date pricing for gold coins, bars/bullion, and gold scrap, all in both NZ$ and US$, here »

------------------------------------------------------------------------------------------