Get Ready – Here Come the Gold Stocks!

In a gold bull market, you'd expect the profits on gold stocks to be a multiple of those to be had from just owning gold bullion.

That leverage comes from simple arithmetic: Once a gold producer covers its production costs, each 1% rise in the price of gold can translate into a 5%, 10%, or even richer improvement in the bottom line. For Barrick, the world's largest gold producer with 125 million ounces in proven and probable reserves, even a $1 increase in the price of gold can mean big money.

And so we see that between January 2002 and last week, gold stocks gained 612%. So far, so good.

Yet, gold stocks have stalled in recent months; between August 1, 2007, and February 21, 2008, gold rose 42%, but gold stocks were up just 37%.

What's going on? Is it that, in their concern over the broader equity markets, people have forgotten gold stocks are associated with gold? Or is something else at work here?

The answer is "something else."

While there are several reasons why gold stocks are lagging, the true explanation reaches much farther into the past. It's that the managements of the gold producers have only recently escaped the state of fear they operated under during gold's 20-year bear market.

As recently as 2002, gold was trading at $280. Against that number was a production cost (called "cash costs") of around $250 per ounce for a typical company. That cost figure is about as low as the number could go.

As gold began its upward move in 2002, it did so in an industry still in mothballs and still run by managers whose primary skills were cost cutting and frugality. Managers of gold companies were skeptical of gold's rise, cautious of hiring new employees, and hesitant to build new mines.

Once the turning point came – when management finally realized the bull market was for real – the industry scrambled to catch up... which meant hiring and training lots of people, buying or refurbishing the equipment needed to reestablish production, upgrading facilities, and building expensive new mills.

The rebuilding of the gold mining industry really only began over the past few years. As would be expected, the costs associated with the rebuild sent big hits to the bottom line, resulting in ugly financial metrics that repel institutional investors.

At Casey Research, we believe now that the biggest costs related to restarting their industry are behind them, the big gold companies are poised to take off. The proof should come in rapidly improving profit margins... which we're already seeing in the quarterly reports now being released.

Just last week, Goldcorp announced fourth-quarter profit nearly quadrupled over the same quarter the year before. Kinross Gold announced that it, too, had a record quarter. Meanwhile, Barrick reported that net profit for 2007 was 28% ahead of 2006. Barrick is also feeling sufficiently flush (and optimistic) that it's buying out Rio Tinto's 40% interest in the Cortez Hills joint venture for $1.7 billion in cash.

It won't be long before other investors see the improving bottom lines of the big gold companies. The investment herd is coming, and it's coming soon. So how do we profit?

First and foremost, you want to be moving into the established producing companies right now. All of the big producers I just mentioned should do well.

Secondly, you should seriously consider buying several of the higher-quality junior exploration stocks. These are the companies that find the gold and partner up with large producers to build and operate the mines.

History has proven that, absent an exciting discovery story, the big gold stocks must get in gear before investor sentiment can reach the critical mass needed to ignite the "juniors."

History also shows that as profitable as the big gold companies are in a bull market, returns on the juniors can blow those away. During the big gold stock bull market in the mid-1990s, for instance, Cartaway Resources gained over 25,000%. Arequipa Resources gained 5,692%. The list of thousand-percent winners goes on an on.

The missing element of the recent gold rally has been that, until recently, the majors didn't have enough free cash to make those acquisitions. That is about to change. As the cash flows I mentioned above enter the coffers of the majors, we expect those companies to go on a spending spree. This means big buyout premiums for junior explorers.

I will also say that I have never been more bullish than I am now on the gold mining sector as a whole, especially well-run exploration companies.

Regards,

David Galland

David Galland is the managing director of Casey Research, publishers of Doug Casey's monthly International Speculator advisory. For more than 27 years, Doug Casey and the Casey Research team have provided investors with unbiased research on investments with the potential to provide double- and triple-digit returns by tapping into evolving economic and investment trends ahead of the crowd.

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