What to Look for Before Putting Money Into Another Gold Stock

By Matt Badiali, editor, S&A Resource Report (Daily Wealth | Original Link)

Gold-stock investors are bitterly disappointed.

It makes little sense that an entire industry – or even an individual company – could perform worse than the stuff it makes for any significant period of time. After all, if your labor isn’t adding any value, something’s wrong…

But like I showed you last week, that’s exactly what’s happened to gold stocks. Since 2002, the gold price has risen 446%, while the benchmark index of gold-mining stocks – the NYSE Arca Gold BUGS Index (“HUI”) – is up just 344%. And gold bullion has outperformed mining companies by a ratio of 5-to-1 since January 2010.

A lot of gold-stock investors have made much less money than they hoped to. But if you understand why… there’s no reason you shouldn’t make plenty of money in this sector over the coming years.

As I showed you in my previous essay, most miners sacrificed profits for growth. One of the worst offenders was Canadian gold miner Agnico-Eagle. But it was far from the only one.

Today, I’ll show you what the other big gold miners got themselves into… and what I’m looking for before I put my money into another gold stock…

Mining companies can grow their reserves in one of two ways. They can go out in the field and find a big new deposit. Or they can go buy someone else’s. It’s obviously a lot easier and faster to go out and buy what you want.

At a conference my publisher Stansberry & Associates held last month in Sea Island, Georgia… Morgan Poliquin – CEO of the small exploration company Almaden Minerals – laid out a series of statistics showing just how badly major gold miners managed their businesses.

Morgan is not only a successful junior mining executive, he’s also a PhD mining engineer. And his key point was that in a mad dash, these companies loaded their balance sheets with assets… no matter how profitable those assets might be one day…

Reserves in the ground is a figure the market uses to value these companies. The more reserves you have, the higher the market price. As you can see in the table below, companies employed huge capital budgets from 2005 to 2011 to grow reserves…

Remember… from 2005 to today, the price of gold averaged about $1,000 per ounce. So these companies were willing to spend colossal sums for new reserves.

But if we look at how those dollars translated into gold production… the money wasn’t well-spent…

It gets worse: A lot of investors are skeptical that the gold price could rise much further from its high of more than $1,900 an ounce… and that made all that reserve growth the gold companies were buying a lot less appealing to investors.

As the price of gold has ebbed over the past year… the giant, low-grade projects that cost billions of dollars to build were no longer economic to develop.

The mining firms have begun writing down the asset values. In addition to Agnico-Eagle’s $604 million write-down of Meadowbank in the Nunavut region in far northeastern Canada… we’ve seen Kinross Gold write off $2.7 billion on its Tasiast project in the African nation of Mauritania… and Newmont Mining write off $1.6 billion on its Hope Bay project, also in Nunavut.

Today, though, things could be turning around… Many gold miners are making high-profile management changes. Over the summer, Norton Gold Fields, Kinross, and Barrick Gold all changed CEOs.

I’m looking for companies that will focus on disciplined capital allocation – companies that will only spend a dollar when it can expect a reasonable rate of return.

That’s something the industry as a whole hasn’t done in a long time. And that’s why this decade has been so disappointing for gold-stock investors.

But once we bring a “business mentality” back to gold mining, gold-stock investors should see the returns they deserve.

Good investing,

Matt Badiali

Further Reading:

Last week, Matt told DailyWealth readers about the dangers of gold miners sacrificing profits for growth. “The companies’ primary focus wasn’t running profitable mines… but tapping as much of that investment capital as possible,” he writes. “Whether a mining project could ever turn a profit mattered less than simply jacking up reserve numbers.” Find out what that meant for shareholders – and get the full story – here.