The case for gold stocks

October 29, 2010, 2:56 PM UTC

Is it time to buy gold stocks?

Prominent gold fans are saying yes, reasoning that shares of miners haven’t kept pace this year with the rise in the price of gold. The gold price is up 23% for 2010, compared with a 20% rise in the NYSE Arca Gold Bugs index, which tracks the shares gold producers such as Goldcorp and Barrick .

Will the gold stocks close the gap?

But that gap closed this week, thanks to a rally sparked by a shiny earnings report at Goldcorp, the biggest miner of Canadian gold. And while next week’s planned launch of QE2 certainly won’t tempt anyone to dump their gold holdings, shares of the gold miners may for now be an even better way to hedge against the excesses of reflation-minded central bankers.

“Despite the buzz you’ve heard about gold and silver over the last two months, the stocks haven’t caught up,” write Eric Sprott and David Franklin of gold-pushing Sprott Asset Management in Toronto. “We expect that to change over the next two quarters as investors realize how much stronger gold producers’ earnings will be at $1,350 gold.”

Exhibit A for that case came Thursday, when Goldcorp surged 5% and Barrick rose 3% following the announcement by Vancouver-based Goldcorp that profit quadrupled from a year ago, thanks to cost-cutting and rising gold prices. The firm said its cash profit margin surged to a record $979 an ounce in the third quarter, prompting it to double its dividend payout.

The strong results produced by Goldcorp suggest to gold bulls that the shares of gold miners — and exchange-traded funds that track various baskets of those securities — could be the best way to benefit from the next dozen-odd rounds of currency devaluation. The Federal Reserve is expected to announce next Wednesday that it is preparing for another round of large scale asset purchases, and the Bank of Japan said Thursday it would move up its own meeting, presumably to announce actions that might ease upward pressure on the yen.

Sprott points to the lagging prices of the Market Vectors Gold Miners exchange-traded fund and the Gold Bugs — which, by the way, stands for “basket of unhedged gold stocks.” Both track the performances of big miners — a group whose gains seem likely only to expand as long as the gold price stays where it is, let alone post a further rise.

“These are companies that can process an ounce of gold for $800 and sell it for $1,300, with virtually no sales risk,” Sprott and Franklin write. “What other investment sector can boast that kind of margin in this environment?”

Yet as appealing as plunking down a few bucks for a gold ETF might seem, not everyone sees this as the way to play the gold craze. Tom Winmill, who manages the $118 million Midas fund, says the index-minded strategy underlying most ETF investments “was totally discredited during the 2008 bust,” because the diversification such approaches supposedly achieve proved worthless in a major crisis.

He says investors should focus on individual companies with strong resource bases and quality management teams, just as he does at Midas. The fund has returned 144% since Halloween of 2008, he says, compared with a 79% gain for the SPDR Gold Trust (GLD), which tracks the spot gold price. Its top holdings include Australia’s Newcrest Mining and Barrick.

That said, just about everyone agrees higher gold prices, should they be here to stay, will line the pockets of the better miners’ shareholders. The Midas fund’s recent gains, Winmill says in accord with Sprott, “may reflect only the operating leverage of the miners to the rise in the gold price” — which is to say, the shares are rising because the profits are getting bigger.

Characteristically, Sprott — who was warning last year that the United States is a “Ponzi scheme,” beating Pimco’s Bill Gross to that punch by 10 months — says that trend is only getting started.

“If you haven’t participated in gold’s recent rise, don’t fret, because the fun has only just begun,” Sprott and Franklin write. “At $1,300 gold, these companies literally have a license to print money.”