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Investing in a commodity different from the buying shares of its producer

Rising demand for gold as a safe haven asset has made many investors consider shares of gold mining companies

August 26, 2020 / 10:36 AM IST

Stocks of gold and silver miners the world over are in focus, especially after Warren Buffett bought shares of Barrick Gold – a gold mining company. Buffett’s Berkshire Hathaway bought 20.9 million shares of Barrick Gold worth US$ 565 million. This purchase comes as a shock to Buffett’s followers, as the value investor was always apprehensive about investing in gold.

Rising demand for gold as a safe haven asset has made many investors consider shares of gold mining companies and funds investing in the shares of gold mining companies.

Some investors buy a commodity such as gold to benefit from the appreciation of its price. Commodity prices are primarily determined by demand for and supply of that commodity. Demand and supply for a commodity depend on many factors and to that extent investors are exposed to risk. When you invest in a company that produces or mines that commodity to benefit from the stock price appreciation on the back of rising prices of its product, however, you are exposed to many other risks.

Stock market phase: Buyers of equity shares gain when markets rise. Though some sectors may profit in bearish markets, overall returns typically remain modest, even if underlying fundamentals of that sector are getting better. When you are buying a stock or equity mutual fund to benefit from a boom in commodity prices, you cannot ignore the sentiment in the equity market.

Government policies: Commodities are produced and consumed globally, but companies producing them may have country and region specific operations. Government may change policies pertaining to mining, labour laws and employee benefits. Such changes generally curb the mining activities in some regions or inflate costs of such operations. Such adverse changes may push up the prices of that commodity, as the expected supply of that commodity goes down. But it also tends to affect the earnings of the company and leaves you poorer if you are a shareholder.

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Company financials: Two companies producing the same commodity need not be identical. Their balance sheets and accounting practices may differ from each other. The failure to grasp the nitty-gritty can materially impact your returns.

Corporate governance: Investors the world over are getting more and more sensitized to a listed company’s response to environmental, social and governance factors, more popularly known as ESG. Analysts and institutional investors give utmost importance to a company’s adherence to ESG policies. Gold-mining companies are watched closely by ESG monitors since its main activity is mining. A low ESG score can hurt the share prices even if the underlying commodity does well.

Event risk: Unforeseen events such as epidemics, floods and earthquakes can impact the operations of individual companies. But that does not generally impact the entire commodity market. In such a situation the company in question may get affected.

There are many such risks specific to company, country, region which cannot be factored into the investing decisions by individual investors. When you invest in thematic equity funds that buy equity shares of such companies spread across the world, you are taking an additional risk compared to risk you take when you are investing in the commodity in question.

When Berkshire Hathaway invests in a volatile asset such as the stock of a gold mining company, the allocation is a fraction of the large investment book it has. Diversification helps contain risks. Investors must also take this factor into account when they contemplate getting into such avenues.
Nikhil Walavalkar
first published: Aug 26, 2020 10:36 am

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