2 Gold Stocks to Buy, 1 to Avoid

David is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Given how weak the economy has been against expectations, it should not be surprising that gold (commonly viewed as a hedge against macro tail risks) has been on a dramatic rise over the last six months. From quantitative easing to fiscal stimulus packages, the Government has increasingly raised fears about inflation. However, investing in gold stocks based on just the expected rise in basic materials is very risky as the economy is technically moving towards a full recovery. Accordingly, I recommend backing gold producers that are undervalued based more on volumes with a margin of safety if the precious metal depreciates.

Barrick Gold (NYSE: ABX): Still an Undervalued, Top Name Gold Producer

As much as gold has been on the rise, Barrick has relatively underperformed. While Kinross and Goldcorp have gone up 31.8% and 41.6%, respectively, over the last three months, Barrick has returned "only" 12.9%. This may still be nearly 600 bps better than the return of the S&P 500 over the same time period, but it's noticeably under that of peers. Some of the reason stems from a poor decision in 2011 to gain exposure to gold through the $7.3 billion takeover of Equinox Minerals. By diluting the relative holding of gold by opening a large stake in copper (to say nothing about political risks), Barrick missed out on much of the rise experienced during the poor job reports.

However, Barrick has the largest economic moat out of all of the gold producers. And the management turnover has suggested that a major change is in order. The new management, for example, has addressed rising input costs at Pascua-Lama by increasing production at Pueblo Viejo. They have guided for upwards of 675,000 ounces of gold from Pueblo Viejo in 4Q12 alone. Media sources have also argued that it will be difficult to secure an attractive price for selling African Barrick Gold, which I believe has set the bar low for outperformance. And while the company's average cash costs are high, Barrick still has a leading EBIT margin of nearly 50%. When pessimism is predominantly factored into the stock, the result is the market value below intrinsic value.

Kinross Gold (NYSE: KGC): A "Buy" Over Goldcorp (NYSE: GG)

Kinross is another compelling "buy." While it has lost $2.07 per share over the twelve trailing months, Kinross is heading for a sharp turnaround. Analysts expect EPS of $1.05 next year and a 10% annual earnings growth rate over the next five years. Assuming the company meets expectations, 2016 EPS will come out to $1.40. At a multiple of 15x, this translates to a future stock value of $21.

Discounting backwards by 10%, the intrinsic value of the stock comes out to $13.04, or around a 30% margin of safety. Given that the stock is currently 8% cheaper than book value and the price target is $12.12, I believe there is much more reward than risk in the stock right now.

Goldcorp, on the other hand, is quite expensive at a respective 26.5x and 15.6x past and forward earnings. The premium is largely due to the company's impressive 39.2% annual EPS growth rate over the past five years and minimum debt load. However, there are simply too many risks that are being overshadowed by expected production at Eleonore and Cochenour. One major risk is the precipitous 2Q12 drop in earnings, which was due to poor volumes at Penasquito and Red Lake. This 45% drop in earnings for 3Q12 was so bad, however, that management had to revise gold guidance to as low as 2.35 million ounces versus 2.6 million ounces originally. I thus recommend staying out until greater visibility emerges.

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