5 Reasons to Buy Gold Stocks

I've long regarded gold as the province of people who store large quantities of dried food in their basements and entertain ideas of moving to the mountains with their shotguns. Now, I'm changing my mind.

Here are five reasons I think gold-mining stocks are a good investment for a soupçon of your money -- say, 2% or 3%.

1. Gold stocks are cheap compared with the metal itself. Consider two exchange-traded funds: SPDR Gold Shares (symbol GLD), which owns gold bullion and tracks its price, and Market Vectors Gold Miners (GDX), which invests in the shares of 30 of the largest gold- and silver-mining companies. Their prices moved more or less in tandem from the launch of the Market Vectors ETF in mid 2006 until mid 2008.

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But as the financial crisis unfolded, gold bullion dipped in price while the mining shares crashed. SPDR Gold Shares lost 7% in the third quarter of 2008, while Market Vectors plunged 30%.

Some of this is no surprise. At the end of the day, gold-mining stocks are still stocks. So their prices should correlate more with stock prices than gold bullion does. But ultimately, gold-mining shares move with the price of gold just as coal miners prosper with rising coal prices. Consequently, gold-mining shares don’t move closely with the overall stock market.

The gold miners made up a little of the lost ground during the bull market in stocks that began March 9, 2009. But the gap again widened substantially starting last January. So far this year through October 10, the price of physical gold has gained 14%, while the Market Vectors ETF has lost 7.5%.

Better still for prospective investors, both physical gold and gold-mining stocks sold off sharply in September. SPDR Gold Shares lost 11.1%, and Market Vectors fell 12.1%.

How cheap are the stocks? At $47.85, Barrick Gold Corporation (ABX), the world’s largest gold miner, trades at 13 times the company’s earnings over the past 12 months. That’s not all that low for such a capital-intensive business. But it’s Barrick’s lowest price-earnings ratio in at least ten years. And the story is much the same for other gold miners. In other words, rising gold prices are ramping up miners’ profits even as share prices fall.

2. Miners are a leveraged play on gold. On average, gold-mining companies are producing gold at about $850 an ounce these days. They sell it for $1,641 an ounce, or a profit of $791. So if gold goes up in price by $200 an ounce, it adds about 25% to the miners’ bottom lines. That’s leverage.

Of course, leverage works in reverse when the price of gold tumbles. And leverage is why the Market Vectors mining ETF is more than twice as volatile as SPDR Gold Shares. But it also means you don’t need to invest as much in gold-mining shares as you would in bullion to make money when gold rises.

3. Gold provides protection against a flood of paper money. Anemic economic growth of the type that most of the developed world is experiencing today isn’t good for gold. What is good for gold are the things governments do to stimulate economies during hard times. The Federal Reserve has turned on the printing presses in an effort to entice businesses and investors to borrow, produce and consume. Rising risks of a recession in Europe are spurring similar actions abroad.

Gold was used as money before the invention of paper currencies. When central bankers are doing everything they can to inflate their nations’ economies, gold can provide a cushion. And it often moves inversely to stock and bond prices.

4. Gold miners don’t appear to be in a bubble. Over the past five years through October 10, SPDR Gold Shares appreciated by an annualized 23.5%. Market Vectors Miners returned an annualized 11.2% over the same period. Gains in the miners’ stocks don’t strike me as excessive (by contrast, Standard & Poor’s 500-stock index lost an annualized 0.4% over the period).

Barrick Gold has a market value (share price times number of shares outstanding) of $47.8 billion. Only a handful of other miners boast stock-market values of more than $10 billion. Most of the players in this industry are still small potatoes.

Demand for gold has increased with the rise of emerging markets. Many people in these countries buy gold jewelry as a store of wealth, rather than trusting banks.

Surprisingly, Robert Cohen, manager of Dynamic Gold and Precious Metals (DWGOX), says the amount of gold being mined and refined isn’t increasing rapidly. From the time of discovery, it takes about seven years to produce gold, Cohen says. It’s a laborious process.

I don’t want to downplay the risks in gold. When I started investing in 1982, everything I read recommended putting 5% of your assets into gold -- usually gold coins. On a nominal basis (that is, not adjusted for inflation), gold peaked in 1980 at $875 an ounce, then did a belly flop for two decades. It bottomed at $252.80 an ounce in 1999, before beginning the climb that took the metal to nearly $2,000 an ounce in early September (it closed at $1,676 on October 10). My point is that once before gold stagnated for many years after a period of scintillating performance. It could happen again.

5. Good companies can (usually) find ways to make money. I don’t expect gold miners to be profitable if we enter another 20-year period like the one that started in 1980. But if gold prices are flat, or even if they fall slightly, well-run companies can find ways to boost their profits. In a gold bear market, marginal producers should go out of business, leaving the field to more profitable enterprises.

As far as investing in gold, Market Vectors is a decent ETF, with annual expenses of 0.53%. But Dynamic Gold and Precious Metals looks like a better bet. Its Canadian cousin has returned an annualized 16.8% in Canadian dollars over the past five years through October 7 (the U.S. fund is only two years old), far outpacing Market Vectors’ returns.

Steven T. Goldberg (bio) is an investment adviser in the Washington, D.C. area.