John Paulson almost single-handedly made gold “cool” again on Wall Street.
The man who made billions betting against subprime debt put the spotlight on gold when his firm revealed in May 2009 that he was betting on gold in a big way.
Since then gold has climbed 45% and major gold stocks (as tracked by the Market Vectors Gold Miners ETF – NYSE:GDX) have climbed more than 70%.
Paulson’s largest gains in gold, however, have come from using a unique strategy which reduces risk, increases gains, and you can use to truly maximize the gold bull market.
Investing in “Impaired” Gold Stocks
When Paulson made his move into gold, he bought mostly gold and gold stocks. His funds took large positions in the SPDR Gold Shares ETF (GLD), the Market Vectors Gold Miners ETF, and individual gold miners including Gold Fields (GFI), Kinross Gold (KGC), and AngloGold Ashanti (AU).
But he also took a large stake (18% of the company) in a gold company that made was poised to outpace all of those all with much less risk. That company was Gabriel Resources (GBU).
Gabriel Resources shares have far outpaced everything he bought. Gabriel shares have climbed from around $2 per share to more than $7 since then. That 233% move more than three times the return of the major gold stocks.
More importantly, Paulson’s Gabriel investment shows a strategy you can use to truly capitalize on the gold bull market.
You see, Gabriel is what we call an “impaired” gold company.
It has a massive gold deposit. Its Rosia Montana deposit in Romania contains an estimated 14.6 million ounces of gold. The deposit has been mined on and off for more than 1900 years (the Romans were the first to mine it around 100 A.D.).
But it had a few problems too.
The Wall Street Journal reported in June 2009:
Gabriel’s main asset: a majority stake in a large Romanian gold mine. The problem: That mine produces no gold.
Environmentalists have long been hot under the collar, worried about potential cyanide poisoning. Their protests have helped block Gabriel’s decade-long efforts to open a modern mine at the site, known as Rosia Montana. Yet as gold fever continues to rage, the hedge funds appear to be banking on yellow trumping green.
Gabriel was impaired and the whole world new it. Efforts to open the mine have been going on for over a decade. And there was little chance when gold was between $700 and $900 per ounce to entice the local government to change course anytime soon.
That’s why the company was so cheap.
It had a market cap of $700 million at the time of Paulson’s investment. That’s works out to about $48 per-ounce-in-the-ground of gold. Most miners are valued at between $100 and $300 per-ounce-in-the ground depending on factors like mining costs, reserve base, production growth and many other factors.
Most of the world wrote Gabriel off completely. The basic thinking went: Sure it has a lot of gold, but it may never be mined.
StockChase.com, a web site which tracks “expert” comments on stocks, showed how hated the stock was. Only one of the 19 most recent comments on Gabriel said “buy.”
“Crazy” Moves Pay Off Big
Paulson, however, saw something different than the herd.
Although it seemed incredibly risky, the risk was actually very low. The bearishness was so strong it would have been tough for Gabriel shares to fall much further. There was always the sheer size of the deposit and the value of the gold in the ground to help put a floor in Gabriel shares.
The upside, when something is so out of favor, was maximized. Remember, when a stock is lowest and no one is willing to buy it, the upside potential is greatest.
Paulson saw it and bought big. He bought 18% of the Gabriel’s outstanding shares.
At the time it was “crazy.”
From a tactical perspective, however, it was a brilliant move.
Finding the Extremes
Gabriel turned out to be a classic “extreme” in the markets that one of the great speculators of this generation capitalized on.
As the gold bull market continues, we expect to find many more of these opportunities. After all, in the mining world everything that can go wrong will go wrong. The smaller gold companies with market values between a few hundred million and a few billion dollars and have their futures tied to just one or two mines, they will run into occasional speed bumps.
That’s all why we’re still focused on gold as one of the top asset classes to hold onto this decade and the best ways to play it.
All the fundamentals are in place for a record run in gold prices. And since the “hot money” hedge funds have come and gone since Paulson made took his first big stake in gold and gold stocks, we knew there were big things to come.
In May 2009 when the whole world noted Paulson’s gold bets we noted:
We all see the opportunity in gold though. Everything is there. We have the pending devaluation of the dollar. We have a very small gold market relative to the investment capital sitting on the sidelines. We have China quietly announcing it is going to buy a lot more gold…
It’s all there. And now Paulson is betting big too.
This run seems inevitable at this point. There is, however, one very big consideration a lot of folks following Paulson’s lead are forgetting. And that’s time.
You see, Paulson is good – really good. But a lot of investors are good at finding opportunities. The difference with Paulson is he’s patient and disciplined enough to maximize an opportunity. Just take a look at his bet against the subprime debt.
According to Pensions & Investments magazine, “Convinced that subprime mortgages would falter, [Paulson] did extensive research, hired staff with necessary expertise and in April 2005 began making a big bet, using credit default swaps to short the asset class.”
Think about that for a second. Paulson began betting against subprime mortgages in 2005. That was well before the housing market peaked and nearly two years before subprime markets started to falter in 2007.
He was right, but he was early. He stuck to his bet even though the housing market continued to do well. Eventually, it paid off.
Now we’re expecting the big payoff to come in gold.
We’re waiting for it. We know it will take some time to play out. And if history is any example, it will take just long enough for most investors to get bored and frustrated (or both) to move onto greener pastures just as the real boom begins.
While we’re waiting, “impaired” gold stocks will allow us to tie up less capital, reduce risk, and increase our eventual profits exponentially.
Chief Investment Strategist, Q1 Publishing
About the author:
My name is Ben C. and I am 2nd year MBA candidate at the Anderson School of Business at the University of California- Los Angeles. I have a BS in Economics from the Wharton School of Business at the University of Pennsylvania. Before coming to Anderson I worked as a generalist equity research analyst for Right Wall Capital, a long-short equity hedge fund located in New York City. Prior to working at Right Wall I worked as an analyst at Blue Ram Capital, another long-short equity hedge fund located in Rye Brook, NY. This past summer, I worked for West Coast Asset Management as a research analyst. West Coast, which was co-founded by Kinko’s founder Paul Orfalea, is run by well-known value investors Lance Helfert and Atticus Lowe.