A Brief Primer on Choosing Gold Stocks

Includes: GDX, UXG
by: Moses Kim
Now that a generation of stock gains has been wiped out by the Big Bad Bear Market of 2008, investors are more skeptical than ever of bull market hype. Let's face it, in a bear market most stocks go down. Nonetheless, I believe there is a huge bull market brewing under the surface in gold stocks that will explode no matter what happens in the stock market.
Gold stocks are simple companies to understand as they produce one main asset- gold. The key is to understand what environment gold thrives in. Gold is widely considered a hedge against inflation, so obviously inflationary environments are something to look for. But, gold is also a great hedge against deflation. In fact, gold does better in a deflationary environment. The rationale behind this is simple: as prices deflate, production costs and expenses do too. During the deflationary Great Depression, gold stocks outperformed the Dow by many multiples. While the Dow was getting pummeled, the bellwether of gold stocks, Homesteak Mining, was trading at nearly 7 times 1929 prices.
So believe it or not, the much ballyhooed argument of deflation vs. inflation is immaterial. In the 2 great bull markets in gold in the 20th century, one was marked by inflation, and the other by deflation. The similarity? A dramatic downturn in the economy and collapsing confidence in the government. So if you believe we're in for a doozy of a depression, and you're losing trust in the government, you may want to look into diversifying into gold companies.
Now let's take a look at the different tranches of gold companies. There are the majors, which are established companies that produce millions of ounces annually. These are the most conservative gold stocks and they provide modest dividend income. Then you have the intermediates, which produce hundred of thousands of ounces annually. While still relatively conservative investments, you get slightly more upside with intermediates. At the bottom of the rung are juniors and exploration companies that are not yet in production, but hold the promise of striking gold and returning many multiples on invested capital. As you go down the ladder of gold companies, attendant risks rise, but so do the rewards.

As you dip your foot into gold stocks, here are some things to look for:

Management: Yes management counts. Pick a company with a proven leader at the helm. Rob McEwen, current CEO of U.S. Gold, is one CEO that comes to mind. Using innovative gold-locating strategies, McEwen helped turn the failing Goldcorp into a global giant.

Political risk: A gold mine is only as good as the political environment in which it is placed. The U.S., Canada, and Australia are solid choices (although recent developments in the U.S. have me worried). Venezuela is not.

Ounces in the ground: At the end of the day, it's all about the reserves of gold you have in the ground. Proven and probable reserves are the most accurate indicator of gold reserves. Measured and indicated ounces are less accurate, and inferred ounces even less accurate. Stick to the proven and probable reserve numbers if possible. As a basic valuation measure, look for companies with a market cap to proven and probable reserve ratio of no more than $300.
Depreciating currency in country of operation: Gold is denominated in dollars. Expenses are paid out in the local currency. If the local currency is depreciating against the dollar, expenses are effectively reduced. Currency depreciation often provides a windfall for gold companies, so don't underestimate this factor.

The easiest way to play the bull market in gold is by buying the Gold Miners ETF, GDX, which is a mixture of gold and silver stocks. More adventurous investors should look into a basket of intermediates and junior gold companies. In a properly diversified portfolio, one should see tremendous gains. The key to investing in gold is to consistently buy into weakness and hold on for the long haul. The shakeouts will be brutal, but the moonshot that's coming will be historic.

Disclosure: Long GDX and UXG