Gold means different things to different investors. For some investors, gold is a hedge against disaster. This type of investor tends to believe economic disaster is imminent and may prefer holding physical gold. Other investors view gold as part of a long-term investment plan. These investors often point to studies showing an allocation to gold helps manage risk and volatility through diversification. These studies are often produced by an industry group known as the World Gold Council which notes, “Whether investors are based in the U.S., the U.K., continental Europe, or Japan, adding 2% to 10% in gold provides benefits that may not be easily replicated by a combination of traditional assets and commodities. In particular, our research shows that a 5% to 6% allocation to gold is ‘optimal’ for investors with a well-balanced medium-risk portfolio (a 60/40 portfolio allocation in equities, cash and bonds). When a portfolio also includes real estate, private equity and hedge funds, the optimal allocation for gold is closer to 4% in a medium-risk portfolio.”
While it can be difficult to argue with studies, there is no argument that this one, and similar studies, are funded by a group with a vested interest in demonstrating the importance of gold.
For some investors, gold is simply a trade. These investors tend to be unemotional and believe if the price of something is rising, it is a buy. When the price turns down, it is a sell. Using that idea, gold appears to be a buy now. The long-term chart below shows gold appears to have broken through resistance after forming a bottoming pattern. Momentum, shown as the stochastics indicator at the bottom of the chart, is overbought. On monthly charts, the stochastics indicator tends to become overbought and remain overbought for months at a time in up trends.
From a trading perspective, gold appears to be a buy. Unfortunately, gold is sometimes a market driven by emotions and the price of the metal move up or down suddenly, seemingly for no reason other than a reaction to breaking news. Of course upside surprises can be welcome news to any trader holding a long position, while downside surprises can result in large losses. To minimize the risk of a downside surprise in gold, traders can apply the principles of value investing to find low-risk trading opportunities.
Few gold miners are undervalued in the current market. Reviewing the ten largest holdings of the Market Vectors Gold Miners ETF (NYSE: GDX) we see that three of the stocks have triple-digit price-to-earnings (P/E) ratios, topped by Newmont Mining with a P/E ratio of 615. Two of the top ten holdings reported no earnings in the past twelve months.
We screened our database to find low-priced gold miners (those trading at less than $20 a share) and paying a dividend. We then selected the most promising candidates with the lowest price-to-book (P/B) ratios in the group.
To manage risk, we often turn to low-priced stocks since they are already at low prices and the dollar risk in these stocks is lower than it is in high-priced stocks. Low-priced stocks can also deliver large gains since it can take just a small amount of buying pressure to move the stock a significant amount. Dividends, even small ones, allow us to be paid while we wait for gains. In the gold mining industry, dividends are also an indication of management’s commitment to shareholders. This is an industry with high costs and some managers will spend as much as possible on exploration, in some cases hoping for a big payoff rather than prudently managing their resources and recognizing the value of shareholders. Dividend payments demonstrate management’s desire to balance growth and value. Low P/B ratios provide a means to identify the best trade candidates in an industry where earnings can be cyclical.
Based on these criteria, four gold stocks offer long-term investors a degree of safety and the chance to participate in the potential bull market in gold. In the long run, assuming gold continues to rise, these stocks could double. In the short term, each stock has the potential to deliver significant gains.
Yamana Gold, Inc. (NYSE: AUY) pays a dividend of just $0.02 a year but trades at just an 11% premium to its book value. In the chart below, the book value per share is shown as the solid blue line. In the last bull market, the stock peaked at a 50% premium to its book value. A similar move could push the price to $7.65.
Yamana has a diversified operation with gold, silver and copper properties throughout Brazil, Argentina, Canada, Chile and Mexico. In the most recent quarter, the company reported all-in sustaining costs (or AISC which is the most comprehensive measure of production costs) of $804 per ounce. With this cost structure, the company is expected to be profitable in each of the next three years.
Action to take: AUY is a buy at the current market price. Consider a stop at $4.15. The price target is $7.65.
Gold Fields Ltd. (NYSE: GFI) holds interests in eight operating mines with an annual gold production of approximately 2.16 million ounces. The company also produces copper. The stock offers a dividend yield of 1%.
GFI has a relatively high AISC of more than $1,000 an ounce but is profitable with prices at their current level. This year, analysts expect the company to report earnings per share (EPS) of $0.29 and $0.45 next year. GFI is priced at about a 45% premium to its book value and peaked at about 190% of book value in the last bull market. This implies a price target of $8.90 a share.
Action to take: GFI is a buy at the market price. The price target is $8.90. Consider a stop at $4.30.
Alamos Gold, Inc. (NYSE: AGI) has operations in the United States and Canada. AGI also explores for silver and other precious metals and holds interests in a portfolio of development stage projects in Mexico, Turkey, Canada, and the United States. The company expects to produce approximately 385,000 ounces of gold this year with an AISC of $975 an ounce. A small profit of $0.02 per share is expected this year. Next year, analysts expect EPS of $0.22. Based on the company’s book value, the price target is $11.35, more than 30% above the current price. The stock also pays a small dividend, yielding 0.2
Action to take: AGI is a buy at the market price. The price target is $11.35. Consider a stop at $7.30.
Goldcorp Inc. (NYSE: GG) operates the Red Lake, Porcupine, Musselwhite, and Éléonore mines in Canada, the Cerro Negro and Alumbrera mines in Argentina, the Marlin mine in Guatemala, the Peñasquito and Los Filos mines in Mexico, as well as the Pueblo Viejo mine in the Dominican Republic. The company has proven reserves of almost 20 million ounces and another 21 million ounces of reserves that could be mined if higher prices or advances in technology increases the expected profits of the projects.
GG reports an AISC of about $890 an ounce. Based on book value, the price target for GG is $23.34, a potential gain of 23%. The dividend yield of 0.5% could add to the total return of the trade.
Action to take: GG is a buy at the market price. The price target is $24.10. Consider a stop at $17.21.
These four stocks provide small amounts of income and allow for participation in what could be a bull market in gold. Given the emotional nature of the gold market, these could be among the safest investments in that sector.