Revenge of the Goldbugs

The threat of war, faltering economic growth, a drooping dollar--those are tough conditions for most investors, but they're the perfect climate for goldbugs. And Graham Birch, who manages Merrill Lynch & Co.'s World Gold Fund, has taken full advantage. His fund jumped 78.3% in the 12 months ended Sept. 30. That made it the best performer of the 500 offshore funds in BusinessWeek's annual survey.

The reason is simple: Nervous investors have lost faith in stocks and, with interest rates so low, bonds, as well. So, many are putting their cash into tangible assets such as real estate and gold. "It's almost a horrible thing to say, but what's bad for the rest of the market is good for gold," says Birch. "Bullion just sits there and makes you feel good."

Birch doesn't spend his days counting ingots, however. The 42-year-old Brit, who holds a doctorate in geology and manages the fund out of London with two colleagues, is more interested in the companies that mine and sell gold. His fund is more than 85% invested in gold-mining shares, with the rest in companies that dig for other precious metals such as platinum and silver. He also dabbles in diamond mining.

That makes for a volatile performance because gold shares typically rise--or fall--by three to five times the ups and downs in the price of gold, Birch says. The operating costs at a typical gold-mining company average about $210 an ounce, while the price of gold now hovers around $300. The cost of extraction remains the same whatever the gold price, so changes in that $90 margin pack a big punch. "If the price of gold rises by 10% from current levels, we'd be making a 33% [added] profit," he says. "But you can make and lose money quite quickly."

Of course, Birch has seen gold rallies before in his nearly 20 years in the money-management business--first as an analyst and for the past decade as a fund manager--and each time, they fizzled. In 1993, for instance, gold had a phenomenal year as hedge-fund managers stampeded into the market. But the boom was short-lived, Birch recalls. After all, who wanted to play it safe when big money could be made buying shares in almost anything during the booming '90s?

Now, after hibernating in a long bull market until the end of 1999, the goldbugs are back. And with the unrelenting storm of bad news, safe havens are in style. "There are a lot of different factors helping the price of gold now," says Birch. "I'm confident we might have a fairly prolonged period of pro-gold sentiment."

Gold may be a safe haven, but the same can't always be said of Birch's fund. Many of the companies it invests in operate in the world's riskiest markets, such as South America and Africa. Birch tries to mute the risk by investing only in established companies with good earnings prospects and a strong cash flow, shunning speculative exploration companies. Moreover, his currency risk is reduced because gold is priced in dollars. So companies benefit when their home currency depreciates against the greenback. "We aim to deliver attractive returns regardless of what the gold price does," Birch says. "But gold companies are no different from any other business: You need to thoroughly analyze a company's cash flow, dividends, and expected returns."

Birch always cautions investors that a gold fund such as his shouldn't form the core of their portfolios. Instead, it should be used to diversify and spread the risk as part of a broader investment strategy. "I always tell clients, `If you have a small amount of money in our fund, you don't mind losing some of it, since [if gold is out of favor], it means your other investments must be making money."' Certainly, the difficult times of the past three years have underscored the value of this age-old investment.

By Kerry Capell in London

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