Get Ready – Here Come the Gold Stocks!

By David Galland
Managing Director, Casey Research

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.

To learn about the International Speculator and how you can try it free of risk with an unhesitant three-month, 100% money-back guarantee, click here now.


The new credit crunch is here. It just arrived. And unfortunately, this time it's even worse than what we saw in mid-August of 2007.

That means it's really bad now, as mid-August 2007 was downright terrible...

Back then, the U.S. banking system nearly seized up... Big banks decided they just wouldn't lend money – regardless of credit quality or the interest rate they could charge. Even worse, they called in loans they had already made... even the rock solid, AAA loans. So the market prices for bundles of super-safe loans crashed.

The crazy part was, these super-safe loans were fine. The recent history of the share price of Thornburg Mortgage tells the story... Thornburg crashed in August of 2007. Then it nearly doubled. Now, in a sign of the return of the credit crunch, it crashed again yesterday, to new lows.

I am shocked. Thornburg hardly takes any credit risk, and hardly has any loan losses. It makes safe home loans to rich people. And it buys AAA-rated bundles of loans.

When the credit crunch hit back in August, panicked investment banks that lent Thornburg money demanded their collateral back immediately.

The company was forced to sell $22 billion worth of good-quality mortgages at a loss, to satisfy panicked creditors. The total loss was $1.1 billion on those mortgages. These were good loans! But the investment banks forced the company to sell at any price, demanding their collateral back immediately.

At a conference in late 2007, the CEO of Thornburg explained how the company survived it all... The worst financial market storm it had faced in its 15 years. And he explained how it fortified its defenses after that crisis. It has become more conservative, by dramatically reducing its leverage. The CEO said the company "can withstand a shock three times worse than the August storm."

As the August crisis passed and banks came to their senses, shares of Thornburg nearly doubled to $14 by last month. As recently as Thursday of last week, the CEO of Thornburg said on Bloomberg that the company will be profitable in the first quarter (now), and for the balance of 2008.

Then bang... The investment banks started demanding their collateral back again, at any price. Once again, Thornburg is forced to sell high-quality assets, at a fire-sale price.

What's going on? The credit crunch that clobbered Thornburg in the first place has returned. Surprisingly – and unfortunately – it's worse than before. When I say it's worse, I mean that prices on bundles of quality mortgages are lower today than they were in August of 2007. And the "spreads" between the interest rates they pay and safe Treasury bonds are higher. It's worse!

I can't believe myself. While I think businesses like this should be fine once the storm passes, we can't know right now if they'll even survive the storm. Mortgage companies and banks – which have both leverage and exposure to real estate – are in a purgatory right now.

While those with leverage and real estate exposure will suffer, I expect one group will do well... the Business Development Companies (BDCs). By charter, these companies can't have more debt than equity. And they usually don't have much exposure to real estate.

Since banks are afraid to lend, BDCs have more opportunity – and they can charge a higher rate of interest.

I wrote about BDCs last week. They're incredibly cheap. And they're positioned as the best risk-to-reward bet you can make right now.

The new credit crisis is here. The best way to participate is to buy the companies that can finance America... yet have no leverage or real estate exposure. That's the BDCs!

Check 'em out, if you haven't already.

Good investing,

Steve

"This article is reprinted here with permission from DailyWealth at http://www.dailywealth.com"

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