The 7 'Golden Rules' of Picking a Gold Stock

Gold is flirting with $1,000 an ounce right now and there are many supply, demand, psychological and monetary reasons for this. Commodities in general have been moving in a near vertical fashion for the last 3 to 6 months and, even though there most certainly is aggressive speculation contributing to this latest move, the underlying fundamentals and macro economic reasons for a continuation of this move are present.

When gold was at $650 an ounce in August of 2007, the Bears were calling for a collapse to the high $400’s as the run to $650 was ‘over-extended’. This did not happen. Why not? Gold was the world’s first currency and it may very well be the last. The old saying that ‘Money does not grow on trees’ is absolutely wrong. Paper money, or fiat currency, is printed on paper and therefore literally does grow on trees. If this paper money falls off the trees faster than we dig up the gold, the amount of paper you trade for gold increases. In 2007 Australia increased its money supply by 20.7%, Brazil +17%, Canada +12.9%, China +18.5%, The Euro +12.3%, Hong Kong +31.5%, India +21.5% and the USA +15.8% - a 47 year high. Thats a whole lot more paper falling off those trees.

As the hot market these days are commodities, and assuming the commodity you are looking to get into is gold, I have come up with the following ‘Seven Golden Rules’ to help guide you towards picking the right gold stock;

1) Location, Location, Location

Where are they digging for the gold? I learned the value of this lesson back in 2006 when I was invested in Ivanhoe Mines (NYSE: IVN). The fundamentals, valuation and chart all looked good to me and I thought I had a winner, so I bought in. The stock moved up nicely and all was happy and joyous, until the Government of Mongolia decided that the proper rate of taxation on the foreign owned miner needed to be raised to as much as 70% of profits. The stock plummeted and I learned to pay attention to Rule #1.

2) He Who Has the Army Makes the Rules

Crystallex International (AMEX: KRY), a Venezuelan mining concern has great potential and spiked on good news in April of 2006. I got in, made good money and got out after just a few days. A few days after that Populist President and Socialist Hugo Chavez started making noise about nationalizing the mine. I barely avoided this nightmare of the boogeyman stealing my gold, and sold my position near all time highs at $6.10. At last look the stock was trading below $2.50 while gold has been going nowhere but up. KRY has made those that still own it cry.

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3) How Deep Does a Gold-Digger Dig if a Gold-Digger Does Dig Gold?

This is all about the costs per ounce of gold mined. As gold can be found lying on the ground or three miles deep, the amount of digging that needs to be done determines the cost of each ounce of gold mined. The largest gold mines in the world are in South Africa and run as deep as two to three miles down. These mines need to be air-conditioned, elevator accessed and it gets very expensive to lug one of the heaviest metals in the earth, as well as a lot of dirt and rock, up to the surface. Also, copper is usually found in geologic formations that produce gold. If a large amount of copper is found along with the gold, the copper is also sold thereby increasing the profit of the Gold-digger. All that glitters is not gold, but if it is a little duller in shine and makes for good plumbing, even more profit flows from the mine.

4) Hedge Hogs

A few years ago most all the gold mining companies started unwinding and buying in all their future hedging contracts. As I would think the people that knew the most about the gold industry would be those working in the gold industry, this was the strongest signal that a run in the price of gold was coming. Most of the miners out there are no longer hedged or hedged only in small amounts, so this rule is least important at this point in time. Avoid the more hedged companies. If you start to see companies increasing their hedging this could be an early signal the top in the price of gold is near. If the miners stay 'naked' as far as futures contracts are concerned, gold is going higher.

5) As Long as There is Life There is Hope

Mines can die out and be dug dry. The quarterly and yearly statements of mining companies contain legally defined estimates of ‘proven’ and ‘probable’ reserves. As gold is basically money in the ground, the more of it they have found, and/or think they have found, the more money they are worth now in potential dollars and in the future in actual profit dollars. In this respect the gold companies are very similar to oil companies. Northgate Minerals (AMEX: NXG) has a great P/E to growth ratio and when compared to other mining companies looks fantastic fundamentally. The problem with this company is that they only have 3 mines. In other words, they only have so much gold. The gold is there and they will dig out some every year, but if a currently mined vein runs dry, and they have to start a different dig to get to another vein that could mean less gold production that quarter and an earnings miss. We hate earnings misses right? The only way this type of company makes more money is if the price of gold goes up, otherwise their earnings will top out and that means no more growth other than that attributed to the possible growth in the price of gold. I owned this mine for awhile on fundamentals alone, finally sold it, and it is still going sideways, and sideways, and sideways…

6) Variety is the Spice of Life

Having multiple mines diversifies a company across the risks of a mine running dry, caving in, electricity supply disruptions, flooding, environmental concerns, etc… The more mines the better. See Rule 5 and NXG.

7) Knowledge is Power

Finding gold, mining gold and operating a company that is basically a hole in the ground is a surprisingly complicated operation. Proven and experienced management with a long track record of beating their earnings number is as important here as in any other industry. As the price of gold heads higher companies across the globe are digging and digging more furiously for it. This has created a serious shortage of qualified and experienced professionals in geology, metallurgy, exploration and logistics. Experienced management teams who know the top professionals and know the value of retaining this brain power will build, retain and operate better teams.

Once you find a company that conforms to these Seven Golden Rules, you can then move on to evaluating them like any other stock according to their relative valuations, growth potential and chart patterns. So put your Levi's on, grab a pan, a donkey and act cranky and go strike gold!

After watching many segments about the history of gold strikes in the United States, it was hillarious to find out how many miners struck gold, walked into town and the nearest saloon, plopped down a nugget for some whiskey and subsequently got shot or claim jumped about 15 minutes later. I am pretty sure that if you find a good gold company and tell a friend or two about it, you are not going to get shot or mugged. Happy Hunting!

Comments

[KEITHBS]

Great approach to gold miners.

[User 51324]

Thank you for these insights.
So what companies fit your criteria.

[ritr54]

Northgate has a negative cash cost to mine its gold courtesy of copper extracted. When Young Davidson comes on line it will have 4 productive mines and about 15+ years of mining life. (And mines have a way of extending their lives). The company also has a nice cash reserve and is in safe locations politically (Canada and Australia). The only thing not to like is their copper is hedged 2nd half of 2009 thru 1st half 2010 @ $2.50 a lb.

[Kentipuss]

To be pedantic, it is "all that glisters is not gold."
Seriously, a good article and worth taking to heart. Gissome names, please.

[eric hart]

Goldcorp fits your seven rules nicely. I own GG.

[curious cat]

enjoyed your article, but our "paper" money is actually printed on linen, which is why you can wash and dry it and how it manages to stay in circulation so long and why you hear the word "threads" when someone is referring to it's composition.

[OJO Zafado]

I wouldn't give two dollars for a fifty guilder note! Alot of people who travel around the world thought they were saving enough of the local currency to pay a cab fare or buy a newspaper the next time they were in that country. But many found themselves stranded with defunct banknotes not easily redeemed or even worthless. It is not just the Euro thing. A ten pound note printed in 1979 with Florence Nightingale printed on the back side is not worth nearly $20. As with a defunct Guilder note it is not worth $2. A beautifully minted one ounce silver bullion coin minted in 1979 that would have cost $4.00 plus sales tax, shipping and even contained the premium of the minting, would now be worth $18. You could have bought 4 of them for that 1979 10 Pound note. Today you could cut that $4.00 silver coin into pieces of eight and still get nearly $2 for each piece selling or trading it as scrap. In 1979 you could have also bought 5 gals of gas for $4. Five gallons of gasoline now costs $17. Isn't that remarkable that with an ounce of silver you can still buy approximately the same amont of gas as you could buy 30 years ago. The currencies are just paper! The ETFs however are not! KOL, UHN,GLD,SLV,CUT,NLR,DB... you name it and there is an ETF for it. There are a few that have not come to pass Platinum? for instance ...yet. This is a fundamental change in how currencies printed on paper will be percieved into the future. The author is correct to point out the world inflation that we the United States created by exporting all of our printing press dollars all over the world to supply the shelves of Walmart and the refineries of Exxon-Mobil. Now we pull up to the pump and feel gsoline has quadrupled in price but it really hasn't in terms of a true measure of valuation. Most of our current difficulties in this vein are just due to the election of the most ineffective leadership the nation has ever seen. Americans are mezmerized by the TV sound bites of O'Reilly and bored by reality. In hind sight we see that the FEd has put our economy on a rollercoaster and seems bent on continuing the process. When interviewed by Congress the Dollar Slayer freely discusses the negative impact of uncontrolled deficit spending far into the future. He then steadfastly refuses to comment on tax policy. More tax cuts and more spending of paper checks now electronically deposited not backed by anything more than more tax cuts and more spending. America now believes in this as a solution like some new found religion. You need no physical anything to support faith. The Barbarians are at the gate and they are us. They are also known as baby boomers.