Gold’s hit record highs – and these former penny shares have soared over 115%!

After gold recently hit record highs, it may be no surprise that two former penny shares focused on the yellow metal have soared. Will our writer invest?

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Gold is traditionally seen in some quarters as a safe haven in times of geopolitical volatility. I think the reality is a bit more complicated than that but with the gold price recently hitting all-time highs, clearing the yellow metal has been attracting a lot of buyers.

The London market includes multiple gold miners including various penny shares. Given that the gold price has been surging, ought I to add some of these penny shares to my portfolio or perhaps soaring former penny stocks?

The economics of gold – and gold mining

Before digging into specifics, let me discuss how the gold business works. As a precious metal with finite availability, the gold market is cyclical.

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When demand is high, for example because nervous investors seek a store of value, money piles in. As demand increasingly outstrips supply, the price rises.

At some point the market tops and sellers outnumber buyers. The price then starts falling and eventually (maybe many years later) reaches a bottom, when the process starts all over again.

Crucially though, it is not obvious that the market is at a bottom or a top at the time – that only becomes clear in retrospect.

Mining is initially highly speculative and capital intensive. Miners spend lots of money prospecting and sometimes building mines. That can be money down the drain. But a viable mine can produce great rewards.

The marginal production cost can be low, so surging sale prices can feed almost directly to the bottom line. In other words, profits can soar when prices are high.

Investing in miners is not for the faint-hearted

In investment terms, prospecting can be high-risk, high-reward. That is the case with many prospecting penny shares. They want to raise money to fund a single prospective project. The potential rewards could be high — but there is a big concentration of risk.

The industry economics still apply to giant diversified miners like BHP. Fixed costs can be high, prospecting is costly and metals are a cyclical market, meaning potentially big swings in sale prices over time.

Crucially though, they have far less concentration risk than the typical mining penny share.

Two that have soared!

That explains why I have no plans to invest in gold-focused shares that sell for pennies, including Serabi Gold (LSE: SRB) and Metals Exploration.

Created with Highcharts 11.4.3Metals Exploration Plc PriceZoom1M3M6MYTD1Y5Y10YALLwww.fool.co.uk

A year ago, both were penny shares with market capitalisations of under £100m. While they still trade for pennies, those two shares have soared 164% and 116% respectively in 12 months, giving each a nine-figure market-cap. That shows what a soaring gold price can do.

Serabi’s profits have jumped accordingly. Full-year figures are not yet available, but its gold output last year was up 13%. Add to that higher production a very strong gold price and the profit uplift should be substantial.

If gold prices stay high, this year could be even better, as Serabi expects to ramp up production significantly again.

Created with Highcharts 11.4.3Serabi Gold Plc PriceZoom1M3M6MYTD1Y5Y10YALLwww.fool.co.uk

But whereas Metals Exploration has at least some geographic diversification, Serabi is all-in on one market (Brazil). Both companies focus on one metal: gold.

Even aside from the risk of the gold market turning into a downward phase of its cycle, that level of concentration is still far too risky for me.

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Should you invest, the value of your investment may rise or fall and your capital is at risk. Before investing, your individual circumstances should be assessed. Consider taking independent financial advice.

C Ruane has no position in any of the shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.

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