Gold Stocks Are A Minefield, Pun Intended

by: Alberto Savrieno

Two pieces of news came out in recent weeks that indicate the global currency may have escalated to a new level. One is that Japan has become openly determined to devalue the yen intensely in an attempt to artificially stimulate its exports. Aside from the fact that this hasn't worked in a sustained way for decades, it has lowered the Japanese standard of living for just as long. Here's an excerpt from "The Case for Gold," Congress' 1982 Gold Commission minority report, coauthored by Ron Paul and Lewis Lehrman:

The only effect of internal inflation now is a drop in the currency exchange rate, a currency falling in value. But in each country there are special interests who desire just that. These include domestic businessmen who can't compete with better-made or lower-cost products of other lands. If these inefficient firms' goods are priced in a currency becoming cheaper, consumers of stronger-currency countries can more easily buy those goods. But the reverse of this is that goods from those stronger currency countries, priced as they are in currencies rising in value, become more expensive for the consumers of the nation whose currency is falling. Their living standards thus fall as they are forced to subsidize inefficient domestic producers. (Page 137)

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The second development, which is even more indicative of a serious escalation, comes from a BBC news report. They report that the German Central Bank has decided to move 56% of its total national gold reserves of 3,396 tons from storage at the Fed (45%) and the Bank of France (11%), back home to Deutschland. At today's gold prices, that's over $39B worth of gold. When that much physical wealth - not digital computer currency - moves across countries between central banks, it's time to ask why. My guess is that the Bundesbank may be having second thoughts about the euro, the dollar, or both, and want their gold home. And when central banks themselves start doubting their own currencies, the ice is thin indeed.

The easiest way to play this is to buy junk silver, bury it in your backyard and forget about it. But we've all heard that one before. Instead, I'd like to discuss something far more interesting and challenging from an investing, rather than a hoarding point of view.

Gold stocks have been an enigma for years

Gold stocks, since gold started really breaking out around 2006-2007, have been an enigma for most investors. They have not broken out together with gold, and in fact have gone down over the last 5 years as a sector while gold prices have gone way up. I have yet to see a cogent, convincing argument as to why this has been the case. Here's my shot at one and what to do about it.

Jim Rogers, a known hard money enthusiast and precious metals investor, made clear in quite a few interviews why he does not invest in miners but instead holds the metal itself. He uses the example of Enron and natural gas to make his point. Enron was a natural gas company at a time when natural gas prices were soaring, yet Enron investors didn't exactly make money on Enron stock, quite the opposite in fact. Whereas commodity companies can go to zero, the commodity itself cannot. Yes, concedes Rogers, if you pick the right ones, you'll make a lot more money in gold stocks rather than gold itself or commodity ETF's like GLD, IAU, or PHYS. But he'd rather just play it safe.

We'll come back to Rogers in a minute. As for a theory of why the whole sector hasn't moved since '06, there are some miners that have not managed the increased cost of mining well, and others that have. Given that, shouldn't the ones with increased earnings have gone up, and the others down? Take, for example, the case of Goldcorp (GG) vs. Newmont (NEM). Back in 2006, Newmont Mining raked in close to $800M. Gold was trading at around $600, and Newmont's mining costs per ounce were $477 (page 25, previous link), giving them a profit margin of $123 per ounce of gold mined. In 2011 gold traded at an average $1570 an ounce, and Newmont's mining costs per ounce were $752 (page 33). A wider profit margin, but still Newmont only netted a mere $366M. Why? Because one of their mining projects at Hope Bay fell apart and cost them $2.1B. Newmont's stock price has not moved significantly since 2004.

As for Goldcorp, success has been spectacular. In 2006, they earned $408M. In 2011, they earned $1.57B. That's almost quadruple the earnings with only a 2.6x increase in the price of gold over the time period. And still, amazingly enough, Goldcorp has not moved at all from its 2006 highs of $38.

How could this be? Primarily, I believe, because the historic rise in gold prices in the last decade is not really an appreciation of the value of gold per se. It is rather a fear of the paper dollar. And those who fear the dollar, both individuals and central banks like the Bundesbank moving $100B worth of it away from the Fed, have a very different buying mentality than stock traders. If you look at a chart of NEM or GG or any given large cap gold miner over the last 7 years, what you'll see is a sharp rise in tandem with gold prices, followed by an even sharper fall with gold's price corrections. What results is a steadily rising gold price with a seesawing gold stock price that never breaks out. Below is a Google chart of GLD vs GG since May 2006 and you'll see exactly what I mean.

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When gold corrects, some sell, but the large portion of those who buy gold not to trade but because they do not want to hold dollars - they buy, and they do not let go. Let go into what? Dollars? That's why gold prices only retreat so far before support is hit. On the other hand, Newmont or Goldcorp investors are not buying gold. They're buying stocks denominated in dollars speculating on gold, but buying essentially dollars. When gold falls, they all sell back to the original support level, and the cycle starts anew.

Secondarily, I think at least part of the answer is ETFs. For as long as the gold mining ETF GDX has been around, the argument can be made that it has functioned as a sort of lowest common denominator and leveler of all gold stocks in it. For example, say Newmont comes out with some bad news about Hope Bay. Selling pressure in GDX starts building up, and affects Goldcorp's price as well. After all Goldcorp is a major component of GDX. People like to think of ETF's as reflective of the individual stocks they are composed of, but cash flows in and out of the ETF itself can themselves affect the price of these stocks the other way around.

The question now is what to do? The first thing to realize is that this widening between gold and gold stocks cannot persist forever. At some point people will realize that companies like Goldcorp are quadrupling their earnings with the same stock price as 7 years ago, and a sharp correction upward will quickly ensue. This will likely happen when gold starts to really tear away and chasers will flood liquidity into the oversold sector rather than chase gold itself, which by then will have left many in the dust.

The second thing is to follow Jim Rogers' advice and pick the best gold stocks out there. In dollar terms, you will definitely gain more than you would in a straight up investment in GLD. That means, in terms of the large cap miners, go for companies like Goldcorp over Newmont. It's easy to see which ones are skyrocketing in earnings and going nowhere in terms of capital growth. Those are the ones you want.

Don't ignore the juniors

But there are others crucial moves one can make with a small amount of capital. Keep in mind that Goldcorp used to be a junior miner trading at just over a dollar back in 2000. Those who bought it when it was just a junior can pretty much ignore everything in this essay, sit back, collect dividends, revel in their 30x plus capital gains and wait for gold to take off again. This in mind, the real spectacular gains will be made in the junior miners that succeed as the gold/gold stock ratio corrects to normal.

There are two candidates I find especially interesting. One is Brigus Gold (BRD), and the other is Southern USA Resources (OTC:SUSA). Brigus is a $218M junior miner that has gone from a loss of $3.6M to a net income of $14.1M in the span of 6 quarters. They have an accurate assessment of their mines and have hit production targets consistently since running net positive. They have also recently reported finding high grade gold in one of their Ontario mines. If they can pay down their fairly large debt racked up during exploration, their stock can really break out and ride the coming gold miners wave with some serious momentum.

As for SUSA, this is more speculative and a brand new stock just open for trading on the OTC. What I find intriguing about this company is its business strategy, which may be a bit quirky but may actually work. They have acquired old abandoned mining property in the epicenter of Alabama's 1830's gold rush, which was abandoned in 1849 with the rest of the 49ers to California. SUSA plans to reopen these mines for the first time in nearly 200 years in some cases, and start where their great grandparents left off, but with much better equipment and the ability to mine much wider and deeper than anyone did back then.

Who knows what they'll find there, but if they do, they'll have cut exploration costs to the bone by starting the race at midpoint. We'll know in the next quarter or two, as the mines are already there and waiting to be opened again.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

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