More to Gold Miners Than Falling Knives

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Precious metal stocks have sorely underperformed the U.S. equity markets over the last year or so. GLD, which tracks the price of physical gold, had negative returns of 5 percent over the last year.

The decline has been even stronger in the last six months, during which the fund lost more than 10%. Reasons behind this fall are not difficult to track; with the equities boom in major markets across the world, investors are spoilt for investment choices and have often managed higher return from other asset classes.

The impact of this fall in gold prices has been severe on gold mining firms too, as stock prices of most companies are substantially off their highs seen in 2010. To some extent, inconsistent accounting practices employed by smaller companies which earned the sector a bad name are also responsible. As such, many analysts feel the days of depressed valuations are not likely to be over in a hurry, but trying to choose winners is more like catching a falling knife.

Not all is lost

Given this background, it is no wonder that stock prices in the sector are low, but what is going almost unnoticed by a large part of the market, is the gradual recovery in gold demand. In recent months, central banks of South Korea, Russia, and Kazakhstan turned into net buyers of the metal.

While bank of Korea termed the development a part of its long-term diversification strategy, purchases by Russia and Kazakhstan deserve special mention for being net buyers for the fourth consecutive month in January. Gold buying by central banks is a routine task, but the sheer size of their purchases allows them to affect gold prices substantially.

For example, Bank of Korea boosted its gold reserves by 20 metric tons in one go to close its February tally at 104.4 metric tons. This buying is a bullish indicator for gold stocks, which, by the virtue of being at the receiving end for many months, are looking attractively priced.

Stocks to consider

Royal Gold (NASDAQ: RGLD) is one such player which is currently trading at levels last seen in May 2012. At the current price of around $68, the stock is available at a premium of just 18.5 percent from its 52-week low and a forward P/E of 26. Against this price, the company has a cash hoard of $10.6 per share. Book value of $36.2 per share and a very small debt on the balance sheet are other factors which make this stock worthy of consideration.

Despite the headwinds, Royal Gold has managed to turn in excellent performance in recent quarters, with revenue and profit rising 16% in the most recent one. It is also worth noting that UBS and MLV & Co. have a "Buy" rating on the stock, with a target price of $90 and $92 respectively.

Quite similar is the case with Allied Nevada (NYSEMKT: ANV), which has been hitting new yearly lows so far this year, and has lost more than half of its market capitalization during the last six months.

Although quarterly revenue more than doubled, it was the poor show at net levels which dragged the stock. Notwithstanding the revenue growth, profit during the latest quarter dropped to $16.1 million from $18.2 million a year ago.

There was a substantial time lag between mining activity and revenue growth for Allied Nevada Gold this year, as nearly 72% of its total 2012 output was mined in the second-half of the year, and a large portion of this output is yet to be recovered from the leach pads due to extremely cold and wet weather conditions in December.

This presents an opportunity as delayed sale, coupled with prospects of higher commodity prices, is expected to lead to better financial performance in the coming quarters.

A smaller player worth noting

Golden Star Resources (NYSEMKT: GSS) is the smallest of the pack with a market capitalization of just $435 million. Like other industry players, it has been trending down in recent months, although the severity has been somewhat less in this case.

Being one of the smaller players in the industry, Golden Star is not covered by many analysts, but its financial performance has been on a mend after swinging to a loss in September quarter. For the December quarter, the company reported a 26% growth in revenue to $149 million, while profit jumped by a similar factor to $9.1 million.

In comparison to this decent show, the stock price is heavily discounted with a forward price earnings multiple of just 5.2 times. Golden Star's market price of $1.65 is dangerously close to the book value of $1.67, even though debt levels are not arduously high.

The takeaway

Overall, gold mining stocks appear to be oversold and under-owned, while demand is gradually improving. Analysts believe the yellow metal, which has historically served as an effective hedge against risk and inflation, will see more demand from investors in the second-half of the year, which is when a recovery in gold stocks can also be expected.

Jacob Wolinsky has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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