Why Gold Producers are Underperforming the Bullion, and What to do About It

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

While gold has attracted many risk-averse investors, gold producers, strangely enough haven't seen a commensurate rise in value. Although this may tempt you into buying whatever gold producer you can find on the Street, careful screening is always recommended. I encouraging backing a variety of emerging players and those that will drive high volumes to offset any fears about gold depreciation.

Goldcorp (NYSE: GG)

According to Goldcorp's CEO, Chuck Jeannes, gold producers largely have themselves to blame for underperforming the rise in the bullion. He argues that the operational missteps of a few companies have caused general investor aversion to the sector. This is disappointing, because Goldcorp has actually delivered stellar results--outperforming earnings expectations by 20% in the third quarter--and been, ironically, overshadowed by the weakness of competitors. The industry has been challenged by cost overruns and expansionary delays.

That Goldcorp would be "overshadowed" by competitor weakness is odd. Of course, it should be seen as a strength going forward. However, investors, like Jeannes, said tend to group "gold stocks" into one big basket and, unfortunately, don't take the time to sift out the differences. Barrick (NYSE: ABX) saw net income plummet 55% in the third quarter. This poor performance recently caused Goldcorp to become the most valuable gold producer by market cap for a short period of time. Both stocks have still plummeted a great deal over the last 12 months: 26.5% for Goldcorp and 36.6% for Barrick.

However, Goldcrop itself hasn't been without falls. From operational delays in Red Lake and Penasquito to rising cost pressures, the downside has looked bleak for some time. Red Lake was said to have hit lower ore grades and moving slower than forecasted. But this has changed dramatically in the recent quarter now that we have seen higher grade ore realizations and greater production.

For Barrick, however, the story has become much worse. Gold discovery rates have been declining despite exploration spend rising to a record-setting $8 billion. According to the company's CEO, it is taking "at least twice as long" to find large deposits than it did decades ago. This has been a wet blanket to investors who have had to come to terms with old mines not being replaced as fast as they were in the past.

Yamana Gold (NYSE: AUY)

And what about the smaller producers? In my view, they are potential buyout targets. The environment for takeover activity has been very, very strong given how hard it has been for the majors to get a good ROI on exploration activity. Yamana Gold has actually risen 13% this year, and this is a good reflection of a relatively strong outlook. Past performance actually has been pretty poor (a 21.7% miss in 2Q12 and a 3.9% miss in 1Q12), but company's are ultimately valued on the future, and the future looks bright for Yamana.

RBC Capital Markets and Barclays are both calling Yamana a $25 stock. It currently trades at less than $19, so that represents around a 30% premium. Low debt, $400 million in cash, and growing margins make Yamana an easy deal to finance. Diversification in silver, copper, zinc, and molybdenum would also help reduce uncertainty for an acquirer. The exploration budget has increased by almost 300% in just four short years, but the strong financial status indicates cash flow has been able to cover the added aggression.

Production in 2012 is expected to come out to between around 1.2-1.3 million ounces with the Mexican Mercedes mine driving much of the growth. When production ramps up in Santa Luz and Ernesto Pau-a-Pique in 2013, these mines will become the lead value drivers. Then, in 2014, production, which has been started for around 1.7 million ounces, will come primarily from existing mines in politically stable regions. As a matter of policy, Yamana only secures development interests when they have the property rights indicating protection against nationalization. Thus, from a risk/reward standpoint, Yamana offers ideal security with a potential takeover target premium that is not being factored in. I encourage investing in the company alongside a major producer, like Goldcorp.

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