Investors value gold for many reasons. Some see the yellow metal as protection against economic collapse. These investors tend to accumulate physical gold as coins or bars believing they will be able to use their gold to prosper under extremely adverse economic or social conditions. Other investors believe the financial system will continue to function in the future, but acknowledge gold tends to rise under adverse conditions and maintain positions in the metal through investment accounts owning ETFs, futures or gold mining stocks. Some investors simply view gold as a trading vehicle to be bought in up trends and sold in down trends.
Of course, it is possible to directly trade gold. This can be done with coins, ETFs or futures. Coins are collectibles and can have tax consequences that are different than investments in stocks. Many investors are surprised to learn popular ETFs that back their shares with physical holdings of precious metals face taxes at the higher rate for collectibles. This includes SPDR Gold Shares (NYSE: GLD). Futures carry their own tax consequences and risks and many individual investors avoid these markets.
Publicly-traded stocks of gold miners offer an indirect way to invest in gold. Mining companies are taxed at the same rate as stocks, which is lower than the rate for gains in GLD or other ETFs. In addition to offering tax benefits, gold miners also offer the benefit of leverage. An example might be the best way to explain the leverage miners offer.
Let’s assume it costs a miner about $800 an ounce to produce gold and they mine 1 million ounces a year. If gold is at $1,000 an ounce, the company should generate a profit of about $200 an ounce or $200 million. This is a simplified example so we will assume the company has no other costs and no additional revenue. If the price of gold increase by 30%, to $1,300 an ounce, assuming the costs of production stayed the same, the miner’s profits would increase to $500 an ounce or $500 million for the company, an increase of 150%. The miner is leveraged, in this example, 5 to 1, and benefits immensely from higher gold prices. Even smaller gains in the price of gold have a large impact on earnings. A 1% increase in gold prices (to $1,010 an ounce) results in a 5% jump in the earnings of this hypothetical mining company.
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Remember, there is no free lunch in the stock market. Leverage can help increase investment returns on the upside but can cause significant losses on the downside. A 1% decline in the price of gold could result in a 5% drop in earnings for this gold miner and we would expect the stock price to reflect the diminished earnings potential of the company. A 20% decline in gold would push the miner from a profit to a loss.
This leverage makes gold miners an excellent way to invest in gold. Buying miners when gold prices are low can lead to large gains when the price of the metal recovers.
With gold in a recent pullback, now is the time to look for bargains in the mining sector. This week, we screened for miners that have positive cash flow and low prices, potentially the companies that could deliver big gains when gold turns back up. Four potential buys turned up in our research.
Jaguar Mining Inc (Nasdaq: JAGGF) is a Canadian-based mining company with operations in Brazil. One of the unique facts about JAGGF is that the company’s CEO lives in Brazil and works at the mine site. This is unusual since most company CEOs work out of the corporate headquarters. In this case, we have a hands-on CEO overseeing annual production of around 90,000 ounces. Cash costs of production are estimated to be $700 to $750 per ounce this year. At the current pace of production, JAGGF could be profitable as soon as next year. The company has approximately 4.4 million ounces in reserves, potentially worth more than $320 million in future profits.
This is a high-risk, low-priced stock trading at about $0.50 a share with low volume. It has the potential to deliver large gains, but is a risky investment and you should consider the risks as well the rewards when making an investment decision.
Golden Star Resources Ltd. (NYSE: GSS) has operations in Ghana, other West African nations and South America. Last year, production topped 175,000 ounces of gold and the company reported reserves of approximately 9.4 million ounces. Cash costs of production are estimated at about $900 per ounce. Analysts expect GSS to be profitable this year with earnings per share (EPS) of $0.04. Next year, EPS are expected to grow to $0.19 with earnings of $0.21 per share expected in 2018. At the current price, GSS is trading at about 4 times next year’s expected earnings.
Gold miners have historically traded with an above average price-to-earnings (P/E) ratio. Over the past five years, the industry’s P/E ratio averaged 27.2. To be conservative, we will estimate a P/E ratio of 17 which is just slightly above the long-term market average. With normalized earnings power of $0.20 per share and P/E ratio of 17, GSS could trade at $3.40, about 350% above the recent price.
McEwen Mining Inc. (NYSE: MUX) is focused on precious metals in Argentina, Mexico and the US. In 2016, the company is expected to produce 100,000 ounces of gold and 3 million ounces of silver. Analysts consider this to be equivalent to total production of 150,000 ounces of gold. Reserves are estimated at 7 million ounces of gold and 200 million ounces of silver. Cash costs of production are estimated at about $750 per ounce for gold and $8 per ounce for silver.
After a history of losses, MUX has been profitable over the past twelve months. For the full year, the company is expected to report EPS of $0.11. Next year, analysts forecast EPS of $0.13. Profits should increase along with the price of gold. Changes in the stock price of MUX have been highly correlated with changes in the price of gold recently.
As gold pulled back, MUX also retraced recent gains. Now, the price of both is near support and momentum, shown as the stochastics indicator at the bottom of the chart, appears to be completing bullish crossover.
Coeur Mining, Inc. (NYSE: CDE) has widely diversified operations with properties in Australia, Mexico, Ecuador, New Zealand, Argentina, Bolivia, Mexico and in the US with mines in Alaska and Nevada. This year, CDE is expected to produce about 16 million ounces of silver and 300,000 ounces of gold. Reserves are estimated at 5.2 million ounces of gold and 400 million pounces of silver. Cash costs of production are relatively high, estimated at about $900 per ounce for gold and $12 per ounce for silver.
CDE is expected to report EPS of $0.35 this year, $0.84 per share next year and $0.78 in 2018. Assuming average earnings of $0.80 per share and a P/E ratio of 17, CDE could trade at $13.60, more than 20% above the recent price. Higher gold and silver prices should boost profits and result in a higher stock price.
These are four low-priced stocks that should track the price of gold. All four have strong cash flow and stock prices that show a high correlation to gold prices.
Action to take: Consider a diversified investment in gold miners to benefit from higher prices in gold. Consider stops to protect against large losses and consider a trailing stop to take profits.