NEW LOW OBSERVER

There are few times that we’ll actually recommend individual gold stocks because much of the available statistical data supports the view that gold stocks are inferior investments when compared to products like SPDR Gold Trust (GLD) or the iShares Silver Trust (SLV), let alone the peace of mind with ownership of the physical metals. The following are the three most prominent examples of when gold stocks didn’t make the grade.

First,  in the period from 1925 to 1932, a basket of gold stocks declined as much as  -64.81% when Homestake Mining is included in the index.  In a article titled “The Lessons of Homestake Mining in Gold Bull and Bear Markets,” we’ve outlined a majority of the reasons why Homestake did so well when other gold stocks didn’t. If we exclude Homestake Mining from the 1925-1932 period, gold stocks declined –76.47% in an equal-weighted gold stock index as reflected below.

Second, in the period from 1940 to 1960, although interest rates on the 10-year Treasury bond doubled from 2% to 4% and the 3-month Treasury bill increased nearly 800%, Barron’s Gold Stock Index was virtually unchanged in the same period of time.  Additionally, investors who feared “the coming inflation” and stayed out of general equities missed an inflation adjusted gain of  nearly 400% in the Dow Jones Industrial Average (DIA).

Third, in the middle of the raging gold bull market from 1971 to 1980, gold stocks routinely underperformed the price of gold.  In our articles on Seeking Alpha titled “A Strategy Is Needed for Lagging Gold Stocks” and “Why Gold Will Decline More Than the Markets,” we reviewed the instances where gold stocks routinely underperformed the price of gold or the stock market in general.  Worse still, Barron’s Gold Stock Index peaked in 1974 and declined -66% only to return to breakeven five years later, just before the blow-off stage in the gold bull market.  We can now add the selloff from July 2011 to April 2012 to the long list of severe underperformance of gold stocks, during a bull market in gold.

With the above facts in mind, it isn’t taken lightly that we would recommend gold stocks at this point.  However, a strategy is needed in order to outmaneuver the gold stock gremlins. In a recent Seeking Alpha instablog, we outlined the short and long-term gold stock price activity using our Gold Stock Indicator (found here) which is nearing a dual “buy” indication.

In our last article on gold stocks to consider, we used Edson Gould’s Altimeter highlighting Agnico-Eagle (AEM) and Gold Fields (GFI).  In this article we’re going to apply Gould’s Altimeter to Newmont Mining (NEM) and Barrick Gold Corp. (ABX). Gould’s Altimeter reflects the relative value of a stock based on the current dividend that is being paid.  Although Newmont Mining and Barrick Gold Corp. are near one year lows and have consistent dividend policies, Gould’s Altimeter sheds a completely different light on matters, leaving only one company a compelling investment opportunity after additional due diligence.

According to Yahoo!Finance, Newmont Mining engages “in the acquisition, exploration, and production of gold and copper properties. The company’s assets or operations are located in the United States, Australia, Peru, Indonesia, Ghana, New Zealand, and Mexico.”  There are a couple of fundamental attributes that are less than redeeming for Newmont Mining.  First, Newmont has a price to earnings ratio of 67.  This exceeds the norm for anyone who would buy a stock only if it had a p/e ratio of 20 or less.  The next issue is Newmont’s dividend which exceeds the trailing twelve months earnings by 91%.  This could be an issue down the road if earnings and the price of gold do not increase fast enough.

Considering these issues, Edson Gould’s Altimeter below suggests that, although the price of Newmont Mining (NEM) could decline from the current level, a purchase of the stock at or below $55 is considered a reasonable value.

The most impressive aspect of Edson Gould’s Altimeter for Newmont Mining is the period from 1996 to 2000 when the stock was in a clear downtrend during the entire time.  Despite this fact, the Altimeter gave clear indications of when Newmont was relatively “undervalued” (lowest trend line) and also overvalued (highest trend line).

The next stock is Barrick Gold Corp. (ABX).  According to Yahoo!Finance, Barrick Gold is involved in “…the production and sale of gold and copper. The company has a portfolio of 26 operating mines, and exploration and development projects located in North America, South America, the Australia Pacific region, and Africa.”  With Barrick’s earnings at $4.48 and a dividend of $0.60, the dividend payout ratio sits at a paltry 13.39% of earnings.

However, the reduction of the dividend near the middle of 2010 has had a major impact on how the Altimeter reflects Barrick’s relative value, which has played out in the movement in the stock price.  Had the dividend not been cut, Barrick would be characterized as though it were undervalued at the current price.  However, based on the Altimeter, Barrick is considered to be on a declining trend until the Altimeter falls below the 119 level.

In this instance, Newmont has the redeeming attributes that should carry the price much further than Barrick Gold Corp. based on the Altimeters above.

Note: As a word of warning, anyone compelled to invest in Newmont Mining should be mindful of the periods when the Altimeter declines by a wide margin from the lowest trend line (green).  This suggest that, in the short term, there is considerable downside risk.  However, the data in the chart for each period assumes that an investor were to buy at the moment the Altimeter first crosses below the lowest declining trend line.