Have a look at the following article written by Georges Lequime  who works for Earth Resource Investment group and is co-manager on the Earth Gold fund.  In the following piece he tells us how even though gold equities are at this time being shunned by mainstream investors he points out there are reports of 90-95% of conference delegates convinced that gold prices will increase in 2011 and 2012 (as they have for the past 11 years) and do so with small risk fears.

Please read on to get a clearer picture of Mr. Lequime's rationale and judgements in this excellent editorial.

Gold focus: Why gold equities are in their best shape since 2008

by Georges Lequime on Jan 20, 2011 at 12:38

True to character, the gold market has been behaving rather emotively as we enter 2011. Over the past couple of weeks, we have witnessed sentiment moving from boom to gloom, with many commentators now suggesting profits should be taken at this juncture and cash allocated to other sectors of the market. Many investors have indeed shifted their bets to industrial metals like copper and palladium that are grabbing most of the headlines.

But we see gold equities at a very intriguing point right now, possibly generating the best returns for investors over the next two to three years.

Why?

First of all, gold equities are still shunned by mainstream investors in what is a supposed to be a bull market (many even call it a bubble!). While we constantly see reports of 90-95% of delegates at conferences believing that the gold price will be higher at year end 2011 and in 2012, we also sense a great fear of a short-term correction prevailing in the market, which is causing investors to step back, especially with a number of other sectors offering similar returns without the same apparent risks.

Secondly, we are seeing many genuine value opportunities in the sector from the combination of improving fundamentals (higher commodity prices, improved margins and profitability, earning and cash flow upgrades) and equities trading at all time low multiples. 

Despite the reported “collapse” in the gold price over the past couple of weeks, where gold dropped to US$1,355 per ounce (only US$70 off its all time high), gold is trading at a very healthy price. The gold price today is still 11% higher than the average spot price in 2010 and 23% higher than Q1 2010. Even with high working cost inflation at mining operations around the world (due to the mining of lower grade material, currency rates against the US dollar and higher fuel and reagent prices), record profit margins are being reported quarter after quarter.

Interestingly though, record profits do not necessary equal record returns. Over the past five years, investors would have made little or no money investing in the world’s largest gold producers despite their profits surging 2-300%.  If you bought Newmont Mining in 2006 (when the gold price averaged US$604.27 per ounce) for $57.62 per share, your return to today would be -3.6%. The same is true for returns on investing in AngloGold Ashanti (-10.9%), and Gold Fields Limited (-35.6%) over the same time period. Although you would have made money investing in Barrick Gold (+37.6%), Kinross Gold (+17.4%) and Goldcorp (+8.1%), among the larger capitalisation names, these are hardly the kind of returns that you are going to tell your grandchildren about.

Fundamentally, we argue that the physical gold market remains very sound.  

Physical demand has and will continue to be strong, particularly in the emerging markets with a high historic affinity for gold – China and India. Investment demand across the globe continues to reach new highs as sovereign debt and currency concerns intensify. Large US pension funds are grossly underweight gold and looking to invest. Central Banks in the Western World are increasingly hesitant to sell their gold while the Central Banks in China and India are looking for opportunities to accumulate gold on weakness.

On the supply side, global gold supply is muted with a small growth in primary supply in 2010 offset by lower scrap sales. Even if we assume that all the current gold projects are commissioned, primary gold supply is set to decline materially from 2014 onwards. Average cost of production for the industry reached $1000 per ounce in 2010 and continues to rise by 10-11% per annum creating a solid floor to the gold price going forward.   

So what is happening right now?

Hedge funds and speculators alike are liquidating gold positions to take advantage of the spike in copper and bulk commodity prices as well as the rally in the oil price, especially given the M&A activities in these sectors. Generalist fund managers, who have largely missed out on the gold price rally since 2000, are wary of any pullback in the gold price, especially with it near its all time high, as well as being equally seduced by the excitement surrounding industrial commodities and oil. This leaves the gold equities with little support in this market and an opportunity for the astute investor. While the gold price could fall further in the short-term, dragging down gold mining shares with it, in our opinion, the risk-reward has not been so favourably stacked for investments in gold equities since the capitulation that we saw in the sector in late 2008, which intrigues us enormously.