The Basics of Gold Stock Investing

The Basics of Gold Stock Investing: The Difference Between Being Up 100%, Vs. Just A Little

By Dr. Steve Sjuggerud, Advisory Panelist, Investment U
Monday, April 28, 2003: Issue #234

Somehow, the U.S. has ended up with two major gold-stock indexes. But unlike the Dow Jones Industrial Average and the S&P 500 Index, which have shown similar returns on the overall stock market for nearly 80 years, the gold indexes just can’t seem to agree… One is up about 100% since the beginning of 2002, while the other is up only 20%. What’s going on, and why should we even care?

The explanation of the strange behavior of the two gold-stock indexes is your introduction to the market for gold stocks, where you can make a bundle or lose it all, depending on whether you make the right moves…

We should care about gold because there are few industries out there as hated as gold mining right now… and this means that when the turn in mining stocks finally does come, the rewards could be truly extraordinary. Now is not the time to buy gold-mining stocks, but the time is getting close. Once we see the “important” gold-mining index start an undeniable uptrend, it will be time to buy…

But which gold index is the “important” one?

The two major U.S. indexes are the “XAU” Index and the “Gold BUGS Index.” Each is distinguished by the stocks that make up the respective indexes.

The XAU is actually the Philadelphia Stock Exchange Gold and Silver Stock Index. It’s a way to take the pulse of generic mining stocks. It has been around since 1983, and it’s the industry standard.

The Gold BUGS index is NOT an index of generic mining stocks. It is specifically a gold index, and will specifically contain only “non-hedged” gold mining companies - those that are fully exposed to the price of gold, for better or worse. And this is where the important difference between the two indexes lies…

The Impact Of Hedging On Gold-Mining Companies

The largest two stocks in the XAU Index are Barrick Gold and AngloGold. Yes, these are two of the world’s largest gold-mining companies. But they also significantly “hedge” their bets - putting themselves in a position where a significant increase in the price of gold above a certain price may not necessarily benefit their business. Barrick has hedged about $6 billion of future gold production at $341 an ounce. AngloGold has 9 million ounces hedged - closer to $3 billion.

Hedging may be a prudent BUSINESS decision… In short, hedging has helped smooth out the losses for Barrick in a down gold market. Barrick states, “Between 1991 and 2002, Barrick’s forward sales program [its hedging] allowed the company to secure an average premium of $67 per ounce on the 32.6 million ounces of gold we sold, generating additional revenue of $2.2 billion. Barrick’s forward-sales program eliminates one of the biggest risk factors facing our business [the price of gold]. By managing this risk, Barrick can expand its asset base, increase its mineral reserves and production, and, most importantly, generate predictable returns for our gold sales.”

Unfortunately, when the market is roaring higher, a hedging program will also smooth the profits out in an up market - meaning the gold companies that have hedged their bets will not make nearly as much money as those that aren’t hedged.

As an investor looking to get the most bang for your buck out of gold, hedged gold stocks like Barrick and Anglogold are not your best choices. Yet these two stocks make up about 45% of the XAU Index - the inferior index. I consider the Amex Gold BUGS index (symbol ^HUI) a much better index to track…

What To Look For When Gold’s Day Comes…

The Amex Gold BUGS Index (the “BUGS” part actually is an acronym for Basket of Unhedged Gold Stocks) is much younger than the XAU Index, having started in 1996. It is a better gauge for how gold shares are acting in relation to the price of gold. The two major stocks in this index are Newmont Mining (NEM) and Goldcorp (GG).

When you consider the fact that Newmont, the world’s #1 gold miner, only has a market value of $1.3 billion, you can see that the world of gold-mining is incredibly tiny. If you added up the value of every gold mining stock on the planet (roughly 2,000 companies), it would only come up to about half of what the tech stock Cisco trades for…

When gold’s day comes, an unhedged gold stock like Newmont could do extraordinarily well. Remember, the company is only valued at $1.3 billion. But get this: It has $419 million in cash! So the value of “the business” is closer to a tiny $880 million. This is a company with gold reserves of 87 million ounces - with a current value of nearly $30 billion dollars! Using Newmont as an example, the downside should be limited, due to its gold hoard in the ground. Yet the upside potential could be huge.

You can use the standard analysis tools to analyze gold companies, as long as you compliment it with some analysis of their gold… With gold companies, you must also consider the cost per ounce of production and the gold reserves themselves. Cash costs of production at Newmont, for example, are expected to be around $200 an ounce in 2003. So gold, at $335, is nicely profitable. Reserves, again, are 87 million ounces.

The websites of Newmont, Barrick and AngloGold spell out all the details in their “analyst” and “investor relations” sections, including their hedging activity, their reserves, their costs per ounce, etc. As you might guess, it’s www.newmont.com, www.barrick.com, and www.anglogold.com, respectively.

Before investing in gold stocks, start with these three websites to get your feet wet and gain an understanding of their businesses. Then, when the time is right - when we see a clear uptrend in the Amex Gold BUGS Index - you may want to consider investing in an unhedged gold producer, like Newmont, Goldcorp, Kinross or another member of the Gold BUGS index.

Good investing,

Steve

Today’s Investment U Crib Sheet

I would not recommend investing in JUNIOR mining stocks for most people. It’s more risk than you need to take. You don’t want to put your faith in the success of exploration. For nearly all people it’s best to start with a major company as your first investment.
Before investing in any mining company, you may want to do some more reading… A good book on gold is The Power of Gold by Peter Bernstein. An okay book on mining is Mining Explained by James Whyte. A decent book on what can go wrong is Bre-X: The Inside Story by Diane Francis (this one could even be a movie!). If you only have time to read two of these, I’d recommend The Power of Gold and Bre-X.