Gold Stocks: Too Much Speculative Risk for My Taste

Includes: ABX, AU, GFI, GG, HMY, KGC, NEM
by: Stuart J. Shaw, CFA

I've structured my portfolio over the last several years with a healthy complement of natural resource stocks. I purchased leading companies with solid fundamentals in the oil, natural gas, base metals and timber industries. The investment themes surrounding my holdings are: (1) "Peak oil" is here or will be soon; (2) The robust growth of the Chinese and Indian economies will continue for many years; and, (3) Trees, well, they just keep growing. I do not own gold or gold stocks. The price of gold has been hitting new highs so I thought I would take another look.

Briefly, the principle variables influencing the price of gold are:

  1. Because gold is priced in U.S. dollars, its price is inversely correlated with the value of the dollar relative to other currencies. A depreciating dollar makes gold more attractive to foreign investors since it takes less of their currency to buy a given amount of gold in dollars. Likewise, a strengthening dollar makes gold less attractive to foreign investors.
  2. Investors turn to gold during times of political and economic upheaval because gold is an accepted currency in and of itself. The value of paper currency depends on the confidence holders have in the government and economy that the currency represents. Those that favor owning gold cite the large budget and current account deficits in the U.S., inflation and the declining value of the dollar. Some hardened gold bugs go so far as to predict the collapse of the U.S. economy. Since year-end 2002, the dollar has depreciated 40% against the Euro and 14% against the Yen. The Consumer Price Index ranged from +2.3% in 2003 to +3.4% in 2005, and came in at +2.9% in 2007. The price of gold is up 180%.

Owning the yellow metal itself is not right for me. I want to invest in stocks of companies that can grow and pay me dividends. Gold cannot do that. So I focused my research on gold stocks.

Gold stocks performed well in the last five years along with the price of gold. The Phlx Gold Silver Index (mostly gold stocks) is up 164%, as compared with 55% for the S&P 500. Are gold stocks a good investment? I used the Company Stock Risk Profile and Fast Track to find out.

I put together a group of seven gold stocks:

  • Kinross Gold (NYSE:KGC)
  • Goldcorp (NYSE:GG)
  • Harmony Gold (NYSE:HMY)
  • Gold Fields (NYSE:GFI)
  • AngloGold Ashanti (NYSE:AU)
  • Barrick Gold (NYSE:ABX)
  • Newmont Mining (NYSE:NEM)

I started my research with the Company Stock Risk Profile Fast Track. None of the companies passed my rule of failing no more than 3 of the 10 variables which would make it worthwhile for me to go forward with more extensive research.

Here's the real surprise. Free cash flow was negative at five companies. All seven companies reported earnings that disappointed at least once in the last four quarters, and analysts were lowering earnings estimates at five. I expected these companies to be money machines given that the price of gold has been well above the cost of extraction.

But I wanted to find out more about the leading companies in the industry: Barrick and Newmont Mining, the first and second largest gold producers. After putting both stocks through the entire Company Stock Risk Profile research process, I'm still not interested based on their Risk Profile ratings, free cash flows and valuations.

Barrick's rating was Medium Risk, having failed 23 of the 50 categories. Barrick's free cash flow, while positive, dropped from $1.0 billion in 2006 to $686 million last year. The stock failed 7 of the 12 valuation categories.

While Newmont Mining came within the range of a Medium Risk rating, the stock failed 29 of the 50 categories. Newmont's free cash flow was negative in both 2006 and 2007 at $408 million and $1.1 billion, respectively. The stock failed 8 of the 12 valuation categories.

Because gold is a volatile commodity, I want a Low Risk Profile rating incorporating solid company fundamentals and value before considering a gold stock for my portfolio. Otherwise, buying gold and gold stocks becomes solely a speculative bet on forecasting inflation, the dollar and world events. That's not the way I invest.

Disclosure: None