Prospects are shiny for these 4 gold miners

This group could see longer-term price gains of 50% or more.

By TheStockAdvisors May 24, 2012 12:46PM
Image: Gold Bars (© Stockbyte/SuperStock)By Adrian Day, Global Analyst

The gap between gold bullion and the stocks of companies that produce the stuff has widened. In fact, in the past nine months, the gap between gold stocks' valuation relative to bullion has fallen almost 30%.

In our view, the senior gold stocks are now "amazingly cheap," and we are recommending a package of four stocks as a way to participate in the eventual share price recovery. Here's a look at Freeport Copper & Gold (FCX), Barrick Gold (ABX), Newmont Mining (NEM) and Yamana Gold (AUY).

There are many reasons for this: Costs have gone up; miners have lagged fiscal discipline (overpaying for acquisitions and issuing too many dilutive shares); investors are buying gold for protection not profit (and hence are drawn to bullion); and the gold ETFs make buying gold easy.

This undervaluation continues even as some of the reasons for stocks lagging have diminished; costs increases have slowed, while miners are displaying better fiscal discipline and increasing dividends.

How low can they go? Now gold stock valuations are, by many metrics, at their lowest levels for this entire bull market, and indeed, lower even than during the 1990s bear market.

Astonishingly, the XAU (an index of senior gold and silver mines) is fundamentally cheaper than the broad market, and I can’t remember another time when this was so.

The XAU index is trading at a price-to-earnings ratio of under 10 and yielding almost 2%, cheaper than the allegedly cheap S&P Index, setting up a tremendous opportunity for steeled contrarians.

Other significant declines in gold stocks during this bull market -- 25% in 2002, 12% in 2005, and 34% in 2008 -- have been followed by rallies in which the stocks more than doubled (102%, 114% and 256% respectively, as per the XAU; small cap stocks did even better).

Of course, one does not know when the decline will end; the lower prices may linger for the next couple of months, summer being a frequent low point for the year.

And there are risks: Gold itself may decline further; the broad stock market may collapse, taking gold stocks with it; and political risk may step up.

Notwithstanding these risks, the gold stocks are now undervalued enough, and the potential large enough, to want to buy.

We are buying a package of senior miners as a play on the sector recovery; if you are already exposed to this sector, you could ladder in over the next couple of months, or perhaps sell puts to generate income (but perhaps miss owning the stocks).

Freeport Copper & Gold, a top-flight company, is the largest publicly traded copper company, with a super strong balance sheet (11% debt to assets, and most debt long term).

The stock is selling at less than 8 times earnings and yielding almost 4% (more if you include the bonus dividends which are not infrequent). Buy under $32.

Barrick Gold, the world's No. 1 gold miner, has operations in most of the world, though it has spun off its African mines, trading at under 8 times earnings, 1½ times book, strong balance sheet, and yielding over 2%. Buy under $37.

Newmont Mining, the No. 2 gold miner, trades at 9 times earnings, with good balance sheet, and a yield -- following a new dividend policy tied to gold -- of over 3%.

With almost 100 million ounces in reserves, it has a huge land ownership that gives it lots of long-term exploration potential. Buy up to $45.50.

Yamana Gold is a fast-growth company focused on Latin America, with a strong pipeline ahead, trading at 12 times estimated earnings; with a strong balance sheet (just 4% debt to assets), and trading at a low 1.3 times book. Limit $13.45.

Each of these companies has its own risks: a slowdown in China's copper demand, new Argentinian "local-content" rules (for Barrick and Yamana), higher government-mandated costs for Newmont's erstwhile next major project in Peru, and so on.

But we suspect that buying these stocks now at these prices could offer potential of 50% or more over the next 18 months.

We would put the first three in our "conservative" category (conservative within the context of mining companies), and Yamana in the mid-risk section.

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