Four Things to Look Out for When Buying Gold Stocks

Yesterday we showed you a chart for the Market Vectors Gold Miners ETF [NYSE: GDX].

It was an ugly looking chart for anyone who had bought the ETF.

Today we’ll show you another chart…an even uglier chart.

But like yesterday’s chart it’s giving you a clue.

It’s showing that despite the tremendous returns from Australian stocks over the past six months, there is still plenty of value among some of the market’s most beaten-down stocks…

Yesterday afternoon we asked Doc Cowie if there are any other charts he follows. He showed us this one:

Market Vectors Junior Gold Miners ETF
Click here to enlarge

 

Source: Google Finance

 

It’s the Market Vectors Junior Gold Miners ETF [NYSE: GDXJ]. This ETF only goes back to late 2009. Things started off pretty well for the ETF as markets and the gold price rallied hard in 2010.

But since then things haven’t been so great. The ETF has more than halved since the 2010 peak.

Of course like all falling investments it hasn’t gone down in a straight line. As you can see on the chart there have been many false dawns (or ‘false breaks’ as Slipstream Trader Murray Dawes calls them).

Each time these falls have sucked in investors, believing that the market is about to turn and gains are on the way. But now the ETF is at its lowest point since its creation.

As we mentioned last week in Scoops Lane (the premium weekly eletter available to Port Phillip Publishing’s paid subscribers), we haven’t tipped a gold stock since November 2010. We ended up taking a 14.7% loss on that stock, which in hindsight was a good exit point as it fell much further after that. It turns out that was near the top of the market for gold stocks.

But now, based on what the Doc tells us, and what we can see in the price action on the charts, gold stocks look super attractive again.

So what is it about gold stocks that attract the Doc…and what does he look for when he chooses a stock?

What to Look For in a Gold Stock
 

Well, the first part is easy. Worldwide, central bank meddling and the devaluation of currencies have driven investors to seek security.

Part of that involves buying gold and silver.

And it’s not just mom-and-pop investors or gold bugs. The biggest buyers are the developing nations’ central banks, such as China’s, India’s, and Russia’s.

Each has actively bolstered their gold holdings. That said, China hasn’t released official gold holding number since 2009, so no one know for sure just how much gold the Peoples’ Bank of China owns.

As for what to look for in gold stocks, the Doc has a few key criteria. Chief among them are:

  • Low cost of production
  • High grade deposit
  • Country risk
  • Management

He also adds in cash. But he says this is less important for companies that already produce gold and generate cash flows. That’s because those companies are less likely to need to raise cash from investors or lenders.

What you need to be careful of are the perennial capital raisers. That is, the companies that frequently need cash injections from shareholders and which always claim to be one step away from making it to the big time…yet never get there.

Boy, have we learned that the hard way over the years…

Margins Up, Yet Gold Stocks Down
 

But it’s the first criteria – low cost of production – that has the Doc perplexed at the moment. On Tuesday he showed you the following chart:

Senior Gold Producers Cash Costs and Margin

 

Source: Tocqueville Monitor 2012 Q4

Despite the near-record high gold price, gold miners’ cash costs have haven’t kept pace. For instance, in 2002 when the gold price was about USD$350 an ounce, cash costs were about USD$150 an ounce (a $200 margin).

Roll forward to the third quarter of 2012 and even though gold was USD$1,650, cash costs were only about USD$650 an ounce…for a USD$1,000 margin.

Now, measuring the cash costs of a project isn’t perfect. It doesn’t take into account all the exploration costs and construction capital for a mine or the company. But it’s still a valid measure for comparing costs against other companies and against prior years.

So with widening cash margins, it makes no sense that gold explorers and gold producers have fared so poorly over the past year. Or does it?

In our view, the big handbrake for gold mining stocks has been an unstable and unpredictable global market. Because gold miners need so much capital it means they have to raise cash from shareholders or from lenders.

And as you saw during 2008, capital can quickly dry up. So it’s reasonable to expect that with so much negativity around the market investors haven’t forgotten recent history.

But maybe that’s about to change. Yes, the global economy isn’t any better than it was five years ago. Arguably it’s worse, given the trillions of dollars printed by central banks. But with the blue-chip S&P/ASX 200 index bashing through 5,000 points we see some of the gloom lifting from investors – even if it’s only temporary.

There’s No Longer Shame in Buying Shares
 

A big reason why shares have done so well – and could continue to do so – is that it’s no longer embarrassing to admit you buy shares!

If you told anyone two years ago that you buy shares they would have shook their head and sucked in. They would have warned you that share investing is a mugs game – ‘Don’t you know the world is in turmoil?’

It was hard to argue that when shares were mostly going down or sideways. But now share investors have a comeback line. They can point to the profits in their trading account.

And once investors build up some confidence our bet is this will filter down through the market – from blue-chip to mid-cap to small-cap. The latter two are where most of the gold explorers and small producers sit.

This may sound like a crazy reason to buy shares, but you should never underestimate the power of positive attitudes when it comes to investing.

Cheers,
Kris

From the Port Phillip Publishing Library

Special Report: How to Hunt Down 2013’s Biggest Stock Market Winners
Money Morning: Why You Shouldn’t Fall in Love With Beautiful Bank Yields

Pursuit of Happiness: Put the Future on Hold, Plan for Today First


Money Morning is Australia’s most outspoken financial news service. Your Money Morning editorial team are not afraid to tell it like it is. From calling out politicians to taking on the housing industry, our aim is to cut through the hype and BS to help you make sense of the stories that make a difference to your wealth. Whether you agree with us or not, you’ll find our common-sense, thought provoking arguments well worth a read.

Money Morning Australia is published by Port Phillip Publishing, an independent financial publisher based in Melbourne, Australia. As an Australian financial services license holder we are subject to the regulations and laws of Corporations Act and Financial Services Act.


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