Gold Stocks: 2 Ways To Size Up Investment Buys

By Dr. Steve Sjuggerud, Chairman, Investment U
Tuesday, September 20, 2005: Issue #470

Gold hit a new 17-year high yesterday, at close to $470 an ounce.

I first wrote about gold in the June 2002 issue of my newsletter, True Wealth, with the headline “The Single Best Way to Cash In on the Only Asset that Soars When Fear Rises.” Since then, the price of gold has risen by 40%, beating just about every asset class you can think of in that time period.

While I recommended gold in June 2002, I did NOT recommend gold stocks… at the time, I decided they were not the best way to go. It’s been more than three years now… are gold stocks attractive now?

Today we’ll take a look at two quick ways to size up gold stocks, so we know if they’re buys now for your investment portfolio. For perspective, before we get to the two quick ways, we’ll start with a look back at why I said gold should rise, and why I think it will keep rising…

Why I First Recommended Gold in 2002

I consider gold to be “catastrophe insurance.” And back in 2002, catastrophe insurance was cheap. What I said back then is turning out to be exactly right, and it holds true today:

For the masses to pile into gold, they need to believe that we are at war. They need to believe that our nation is at risk. They need to believe that the dollar is going to fall and that inflation is going to appear. And most important, they need to believe that the men at the controls are no longer in control. Or at least, these are the things that have caused gold to move in the past.

It will be hard to convince investors of these things. Investors haven’t worried about any of these things for many years now - if they’ve ever worried about them… Funny how times change… 1980 wasn’t that long ago…

In January of 1980, nobody trusted anybody in government to man the controls. Gold hit $850 an ounce. After a decade of dumb ideas from our political leaders (including Nixon’s price controls), the Vietnam War, and the OPEC oil embargo, we were stuck with drastic inflation, high unemployment, and no signs of economic growth…

Inflation was considered a permanent condition. It got so bad, singer-comedienne Bette Midler demanded that payment for her $600,000 European tour be paid in South African gold coins, NOT in U.S. dollars!”

It’s amazing that all of these things are coming back out now… even price controls! Price controls were a disaster back then, yet talk about price controls on fuel is back. It’s crazy.

Gold’s Resurgence: Better Late than Never

I’ve said “buy gold” for the last three-and-a-half years. I haven’t backed off. And I’m still not backing off.

Reading the news today, people are just now finally deciding to get into gold. What took them so long? Quoting a story on Bloomberg yesterday:

“A lot of people see some risk in the current financial system, and they’re diversifying into gold to protect their assets,” said Bart Kitner, president of Montreal-based Kitco Precious Metals, Inc., an online bullion and gold-coin dealer. “We’re getting a lot of new customers.” Kitco’s 15 customer representatives have had to take shorter breaks to field phone calls and Internet orders that have doubled in the past three days, Kitner said. The most popular products are the American Eagle coin, the Canadian Maple Leaf coin, and pure gold bars, he said.

Apparently, “hot” money is just now moving in, too… Again from Bloomberg:

“There’s just a lot of hot money that had been in the oil market looking for the action, and gold is where it’s at now,” said David Solin, a partner at Foreign Exchange Analytics in Essex, Connecticut.

Based on this new record high in gold, the major gold stocks are finally catching up to the price of gold again, as the chart below shows (the price of gold is in red, everything else is a major gold stock):

Gold is up 40% since mid-2002. Yet gold stocks haven’t kept up with this growth. So is it time to buy these stocks? Are they cheap? The answer is yes… but not resoundingly so…

What To Look for in Gold Stocks: Assets and Cash Flow

I like to inspect two things:

• Assets (gold reserves in the ground)
• Cash Flow

Looking at the gold reserves first, I point you to my “idiot’s guide” to gold stocks… it’s basically a look at each company’s gold in the ground, minus debt.

Current Gold Price	463	463	463	463	463
- cash costs / oz.	235	225	273	275	330
= gross value / oz.	228	238	190	188	133
* reserves (mn oz.)	92	89	84	60	76
= Gross gold value ($mn)	21,046	21,170	15,897	11,247	10,025
- Long term debt	1,795	2,154	1,371	992	643
= Net gold value	19,251	19,016	14,526	10,255	9,382
Gold value per share	43.14	35.56	54.93	23.49	19.06
Share price	46.06	28.76	43.20	16.83	13.67
Discount / premium	7%	-19%	-21%	-28%	-28%

When you look at this table, and see the share price discounts to the gold reserves at the bottom, you might think that gold stocks are cheap. But you really only want to pay a big discount, as it’ll take many years to get that gold out of the ground. Some of these discounts are decent. With the exception of Newmont, they might be worth a speculation, as long as you use a trailing stop.

It’s the same when it comes to Cash Flow… There is some opportunity here…

History Repeating?

A few years ago, U.S. Funds CEO Frank Holmes (http://www.usfunds.com) showed me an interesting chart… It showed how major gold stocks traditionally peak out at 30 times forward cash flow when the price of gold goes above $400 an ounce. Well… we’re safely above $400 an ounce now, and that peak may turn out to be higher this time around. I hunted around on my computer, and found the old chart:

According to Merrill Lynch, the Tier I North American gold companies currently only trade at 15 times forward cash flow. And that number is based on a gold price of $435 an ounce. If history repeats, that means there’s still a good amount of upside potential in the major gold stocks (not including Newmont). Maybe even room for a double.

(The math I did here is not that hard. You can find all the current numbers I used above at the company’s websites, or on Yahoo!Finance…)

Conclusions on Gold Stocks

In short, I do think gold stocks will go up from here. Cash flows will no doubt increase. We may have 50% upside.

While the gold stocks are somewhat attractive, I still prefer pre-1933 Mint State U.S. gold coins instead

These coins are still at their smallest premiums to their melt value in their recorded history. You make money both as the price of gold goes up, AND as the “collector’s premium” goes up. The first has happened, the second has not. But I believe it’s coming. That is a story for another day, though…

Based on what I consider the two important pieces, the GOLD IN THE GROUND and the PRICE-TO-CASH FLOW, gold stocks are cheap enough to warrant speculating. If you use something like a 15% trailing stop, your downside risk is limited, and you could make 50% or more in a year here… The risk to reward is good.

Me? I’m still buying coins over gold stocks…

Good investing,

Steve

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