In response to a request to list my favorite gold mining stocks, I decided to go one step further and to give an overview of my approach to precious metals investing. While I do list my favorite companies, I also discuss the current state of the precious metals markets and my broader precious metals investing strategy.

I will discuss all four of the so-called precious metals.

• Gold ((Au))
• Silver ((Ag))
• Platinum ((Pt))
• Palladium ((Pd))

The Fundamental Overview: Why Invest In Precious Metals?

Precious metals are valuable insofar as they are a convenient store of value. In addition to their industrial applications, they have monetary value. While this fact has been lost among the masses, who believe that U.S. dollars or other fiat currencies are stores of value, the fact remains that if we look at precious metal prices over the long run and smooth out the shorter-term volatility, then we can observe that their purchasing power remains constant over long periods of time.

This cannot be said about fiat currencies, which are subject to central bank intervention and manipulation. As central banks buy and sell bonds in the market, they have an incredible impact on the purchasing power of fiat currencies. True, this impact isn’t always obvious or immediate, but by changing the size of the monetary base and by controlling short-term interest rates, central banks can determine to a fairly large extent the capacity and incentive for banks to lend money and inflate the broader measures of the money supply. Thus, the value of fiat currencies is largely a function of politics, psychology, and a particular interpretation of statistical data.

People often make a similar argument for gold, and it is true that gold is an asset whose price is driven by psychology. However, there is a physical component—gold cannot be created or destroyed in the way that fiat money can. Consequently, so long as there is demand for a physical store of value, there will be demand for gold, and negative sentiment can only drive the price down so far before the physical reality of the supply/demand fundamentals force the downtrend to cease.

Silver, platinum, and palladium are different insofar as their demand is largely driven by industry. Historically, however, silver has been used regularly for money. It was only 50 years ago that silver was the most common component of American dimes and quarters. In fact, the Hebrew word Kesef was used to mean both silver and money in the Torah .

Platinum and palladium are a little different. These two metals are valuable for their extreme scarcity, coupled with their industrial uses and the fact that they cannot be substituted in essential products such as catalytic converters in automobiles. Nevertheless, people collect these metals, most notably platinum, in the form of jewelry and coins. While they haven’t been used as money in any significant way, their monetary potential is similar to that of gold’s insofar as they have monetary qualities (fungibility, durability, divisibility) and in their convenience stemming from the fact that a small amount of platinum or palladium is extremely valuable.

Why Buy Precious Metals (GOLD)?

The decision to buy a specific precious metal over others should come from an analysis of the fundamentals of each metal, which I discuss presently. However the decision to buy precious metals is an anti-investment decision—it is a decision not to deploy capital into any interest or capital-returning assets such as stocks, bonds, or real estate.

Let us look at gold in particular. If we look at the time frame when the gold price floated freely, we see that there are essentially three periods of time where we can make the following broad observations:

1. 1968-1980: Gold is a good investment, stocks, bonds, and real estate are bad investments.
2. 1980-1999: Stocks bonds, and real estate are good investments, and gold is a bad investment.
3. 1999-present: Gold is a good investment, and stocks, bonds, and real estate are bad investments.

Obviously, these are not clear-cut delineations. For instance, gold peaked in 1980, but gold stocks peaked and the stock market bottomed in 1982. Also, real estate continued to go higher after 1999. Furthermore, stocks and bonds are higher today than they were in 1999 (although they are lower priced in gold). But broadly speaking, gold has been a winner when the returns of interest and dividend-bearing assets have been mediocre, and it has been a loser when the returns of interest and dividend bearing assets have been strong.

If this basic observation guides your investing strategy, you can come out a real winner in the long run. If you had held the Dow Jones Industrial Average from 1968 to the present day, you would have made 6% on your money per year on average. If you had held gold, you would have made 8%. However, if you had held gold from 1968, traded it for the Dow Jones in 1980, and then traded back to gold in 1999, you would have made nearly 19% on your money!

Of course, we all like to be a little more active in our investing, and we don’t want to view things in black and white, but I think a good starting point for investing, given this observation, is to ask whether now is a good time to own stocks/bonds/real estate, or whether its a good time to own gold and precious metals. That is to say, do you want to be invested or anti-invested?

While I own assets in both categories, I believe that this is still a precious metals era, even if we have seen a significant correction. Recall that in the 1970’s gold bull market, there was a cyclical decline that is larger than the decline we have seen thus far in gold.

But the reason I believe that gold and precious metals are superior investments to interest-bearing assets is based on valuations. It is pretty much the consensus view that bonds are overvalued, and historically treasury yields should be 4%-6% higher. Stocks, however, are still generally liked by investors despite the fact that by historical metrics they are significantly overvalued. Furthermore, stocks did not hit a valuation in 2009 that would signify a bottom in the market. Typically, stocks bottom at a P/E ratio of 5-10. Now the market’s P/E is around 23, and we hit a low of 15 in 2009.

Gold, on the other hand, is undervalued and it didn’t come close to hitting a point of overvaluation in September, 2011. Historically, gold has peaked when the value of America’s gold exceeds the size of the monetary base, and it has been good value when America’s gold is valued at less than 25% of the monetary base. As the following chart shows, gold is a screaming buy.

In fact, the value of America’s gold is just over 9% of the current monetary base, which means that by this metric, gold offers better value than it did in 1971 at $35/ounce, and in 1999 at $255/ounce.

Why Buy Silver, Platinum, and Palladium?

My reasons for buying all of these metals (aka the white metals) are qualitatively more or less the same, although I am much more bullish on the silver price. Basically, the industrial demand for all of these metals is rising as more technologies employ them. But from a strictly monetary perspective, the prices of the white metals relative to their respective supply fundamentals suggests to me that platinum and palladium should trade at substantial premiums to gold, and that silver should trade at a much larger fraction of the gold price.

In addition to the fact that the white metals are consumed in industry while gold is not, we find that platinum and palladium production pales in comparison to gold production—16 ounces of gold are produced for every ounce of platinum and palladium produced. This means that without considering industrial demand, and even if we only assume that monetary demand is 20% of gold’s monetary demand, platinum and palladium should trade at more than three times the gold price.

Silver production is only about 9 times greater than gold production. Assuming no industrial production and 50% of the monetary demand for silver, the silver price should be about 1/18th that of gold, not 1/65th.

The fact that most of the white metal supply goes towards industry implies that these ratios can favor the white metals even more relative to gold. Consequently, the bullish case for the white metals is a fortiori vis-a-vis the bullish case for gold.

Price Targets

Assuming a flat monetary base and that the value of America’s gold peaks at 100% of the monetary base, gold should trade to $13,000/ounce. Based on the above ratios, which again, do not take industrial demand into consideration, platinum and palladium should trade to around $40,000/ounce each and silver should trade to about $720/ounce.

These appear to be outlandish given current prices, but they are conservative for the following reasons:

• The monetary base is increasing at about $800 billion annually.
• In the past, gold has peaked at valuations that made it so the value of America’s gold exceeded the monetary base by 25% or more.
• The gold peaks reached in the 1930s and in 1980 occurred at a time before Eastern countries began to heavily accumulate them. This should drive the gold price higher than what we have seen in the past.
• As I have emphasized, these figures do not take into consideration the industrial demand for the white metals. Silver, in particular, will be a major beneficiary. The fact that silver is consumed while gold isn’t means that actually, despite the fact that gold trades at a 65-fold premium, silver is actually rarer than gold, and could trade at a higher price!
• Given silver’s history as money, particularly as the poor man’s gold, I think its monetary demand is going to rise substantially higher than 50% of that for gold.
• The supply of platinum and palladium in particular is at risk, as these metals are mined primarily in South Africa and Russia, which are high-risk mining jurisdictions (especially South Africa). This means that there can be a supply shock if a geopolitical or labor problem arises, and this can send the prices of these metals soaring.

Given these figures, the case for investing in precious metals is extremely strong despite the negativity in the mainstream media. Of course, this doesn’t mean that the cyclical bear market can’t continue. While gold found support at a double bottom at $1,180/ounce, there is much stronger support that may have to be tested at around $1,000-$1,030/ounce. In fact, it may reach a capitulation point below $1,000/ounce to scare away the last of the speculative money before soaring higher.

Silver appears to have reached a bottom, having found major support in the $18.50-$20/ounce range. It may not race higher from here, but I would be surprised if it traded much lower than this range.

Platinum and palladium have very different charts. Platinum has traded much like the other base metals, despite the potential supply shock than can result from political turmoil in South Africa.

Palladium arguably has the most interesting chart of the four. It hasn’t even broken its 2000 peak of $1,100/ounce.

Furthermore. given its supply and its use-value, I think it should trade more in line with platinum, although at a small discount.

How I Invest In Precious Metals

In what follows, I discuss my precious metals investments. They mostly consist of coins and bars, although I have shares in several mining companies and royalty companies.

Essentially, I view precious metals as a risk-off trade, while at the same time I like to take risks when the reward is overwhelmingly compelling. Therefore, I take a barbell approach to investing. I own several relatively speculative mining companies and a lot of physical metal. At the same time, however, I do not own a lot of large mining companies or of the large, profitable, dividend-paying royalty companies. With this approach, I get to protect a good chunk of my portfolio, while at the same time I can get lucky with one of my smaller speculative stocks and vastly increase my wealth. As will become apparent, my favorite smaller mining companies have multi-bagger potential even before metal price appreciation.

Physical Metal

I think every portfolio needs to contain some physical precious metals. By this, I don’t mean SPDR Gold Trust shares (NYSEARCA:GLD ) or iShares Silver Trust shares (NYSEARCA:SLV ). I mean actual coins and bars that you can hold in your hand.

I outline the reason for this in an article I wrote back in March on the need for investors to diversify their counter-party exposure. While investors think of diversification by asset class (stocks, bonds, commodities, currencies), country, risk-level (i.e. beta), company size, and company sector, diversification means having some assets outside of the banking system all together. If this sounds overly paranoid, then consider that in Cypress last year, citizens could not access their deposits. Americans forget that they themselves could not access their financial assets on 9/11/2001. If something similar happens and you have some gold and silver coins, you will be better prepared than somebody with GLD shares or mining company shares.

How I Like To Own Physical Metal

I like to buy all sorts of physical metal items—coins and bars of various denominations issued by various mints. However, I do have certain tendencies.

First, I prefer small-denomination items to large-denomination items. This can be expensive. For instance, as I write this, the online bullion dealer Apmex is selling 1 ounce Gold American Eagles for about $1,300 vs. a spot price of $1,240. If I want 10 1/10 ounce Gold American Eagles, I’ll end up paying $1,420. This is steep, but it has its advantages.

1. First, if you ever have to trade your gold for consumables, an ounce of gold will have far too much value to purchase things such as food or basic clothing items. A tenth of an ounce is sort of like a $100 bill, and is far better suited for this purpose.
2. It is much more difficult and less economical to create a phony small coin than a phony large coin. Recall the tungsten-filled gold bar conspiracy from a few years ago. Regardless of its veracity, it is a possibility. Since smaller coins are more difficult to fill with tungsten, it follows that there is inherent relative safety in owning smaller coins.

In addition to preferring smaller coins, I like items that are widely recognized as authentic. This means I prefer to own coins that are made by some governments and bars made by the most widely-recognized dealers/refiners. These items will cost slightly more than bars minted by Joe’s Metal Refinery, but they are also far easier to transact in. The following is a list of the items that are most highly recognized.

Gold Coins

American Eagles