Is It Time to Load Up on Gold Stocks?

By almost any measure, gold stocks are undervalued. Should we load up?

After completing my research on this question, I’m convinced that as gold stock investors, we’re in the right place. See if you agree…

Let’s first get a handle on the degree of undervaluation. The more undervalued, the lower the buying risk. A fairly valued stock, on the other hand, requires added caution.

Gold accelerated higher in August and September, peaking around $1,900/ounce, while gold stocks lagged. Here’s a chart of the HUI-to-gold ratio (HGR). In a rising gold environment, a climbing HGR indicates that gold stocks are outperforming the metal; a falling HGR means they’re trailing gold.

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Today’s 0.32 HGR means gold stocks as a group have not been this cheap, relative to their underlying metal, since January 2010. And a lower ratio hasn’t been seen since February 2009, when it was recovering from the 2008 global meltdown.

I think there’s a more compelling situation that demonstrates the undervalued nature of gold stocks. It’s hard to read a mining company’s quarterly report these days without hearing about “growing margins.” The gold price has risen faster than operating costs across our industry, which has lifted profit margins of the better-run producers.

Higher margins are key to increasing earnings and cash flow, which in turn lead to rising stock prices. Have gold mining equities kept pace with ever-increasing margins?

(Click on image to enlarge)

Gold mining companies are earning record margins, averaging a whopping $1,268 per ounce last quarter. In both nominal dollars and percentage above costs, margins have never been this high for gold producers. Stock prices, however, have not responded in similar fashion.

This is a potentially significant point, because margins of this magnitude will be ignored only so long. When the broader investing community begins to take notice, investors will snap up these highly profitable stocks and push prices higher. The “catch-up” in gold stocks could be tremendous.

The conclusions from these data seem clear: Gold stocks, as a group, are undervalued. The incredible profit margins generated by our sector will attract investors – sooner or later. We also have data that indicate that picking the better stocks – like most of those in BIG GOLD – is more profitable than buying a gold stock fund.

We’re in the right place.

The question, of course, is timing. We don’t know when gold stocks will begin to catch up. And the data don’t suggest that they must rise right now nor that they’ve hit bottom. We’re convinced they’ll someday hit lofty levels, but for now we maintain the same refrain: keep one-third of assets in cash. This reduces risk and gives us a nice pile of funds to deploy during selloffs.

In the big picture, gold has ratcheted steadily higher throughout the rallies and corrections, a trend we’re confident will continue for some time. As the price sets new highs and margins remain robust, our sector will attract more attention. We must patiently stay the course until those new realities begin to set in.

Make sure you have exposure to gold stocks, but it’s not yet time to jump in yelling “Geronimo!”