Why miners are the cheapest way to buy gold

A popular myth says that The Wonderful Wizard of Oz is a parable about the folly of putting your faith in gold. Try telling that to the investors who've been following the yellow brick road to safety of late. Or join them with our top gold stock tips.

One popular myth about The Wonderful Wizard of Oz is that it's a parable about the gold standard. Apparently, author L. Frank Baum wanted to bring his feelings about money reform to the masses believing that banks (the Wicked Witch of the East) and big-city financiers (the Wicked Witch of the West) had manipulated the gold-backed currency to such an extent that they had put the US economy in peril.

According to this reading, Dorothy's journey is about the folly of putting your faith in gold. But tell that to the hordes of investors who have followed the yellow-brick road to safety in recent weeks the spot price of gold has jumped to a 28-year high of $746 an ounce and JP Morgan Chase and Fortis are forecasting that it will hit $850 by the end of the year. Private investors now hold more gold in exchange-traded funds than the Japanese central bank has in its vaults. In much the same way that oil producers broke out once oil was holding steady at $50 a barrel, it looks like gold stocks are poised for some serious gains in the year ahead. With the gold price on the up and miners at their cheapest since 2003, gold stocks have become "the most attractive sector on earth", Tradewinds Global Investors' David Iben tells Bloomberg.

Logic dictates that gold miners should already be benefiting from a rising gold price. If the price is rising faster than the cost of mining an ounce of gold, gold miners' margins should get a lift. Yet gold producers' share prices have not reflected the gains of the metal itself. According to Evy Hambro, mining fund manager at BlackRock Merrill Lynch, this is down to how the industry responded when the gold price was languishing between $250 and $300 an ounce in 2000/2001, when miners cut production to focus on high-grade veins in order to cut costs.

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As the gold price has risen, they have returned to mining the full spectrum of grades, says Daniel O'Sullivan in Investors Chronicle. However, this means their operating costs have picked up again, which has eaten into profits particularly as the cost of everything from labour to machinery to truck tyres has rocketed, as the resources industry races to mine as much material as possible to feed the infrastructure boom in emerging markets. The cost of building a mine has also increased 50% over the past five years, which is a significant hurdle to expanding production. But rising costs can only swallow so much of the increasing sales price for gold, and Hambro now reckons most of the gains in the gold price should be feeding "straight through to company profits".

The good news is the gold price is likely to keep rising. Supply isn't keeping up with demand apart from the high costs of opening new mines, the other problem is that the places where gold is being found, such as Venezuela, are not exactly hospitable to foreign miners. Meanwhile, demand continues to rocket: global demand for gold jewellery reached a record $14.5bn, up 37% on last year on the back of newly wealthy Chinese and Indian consumers. "I'm quite comfortable talking about $1,200 an ounce for gold in the next 24 months," says Ian Cockerill, chief executive of Gold Fields, the world's fourth-largest producer. But even if gold remains at its current level, the prospects for gold miners look bright. If Baum were writing The Wizard of Oz today, Dorothy would be clicking golden, rather than ruby, heels.

Two glittering prospects in the gold sector

Of the bigger gold mining plays, South African miner Gold Fields (NYSE:GFI) looks a good bet, John Hathaway of Toqueville Asset Management tells Barron's. The stock price has stumbled after a failed takeover bid for Harmony Gold, but the company hasn't done anything towarrant the write down, says Hathaway. South Africa remains the world's most important gold-producing country, controlling 40% of global reserves, and Gold Fields has a solid footing in the market, recently announcing it would invest $1.2bn until the end of 2008 to grow production. The company's shares trade at a discount to its peers on a forward p/e of 19.4 and carry a price-to-earnings ratio of 0.9 which implies that earnings growth will come cheaply.

A smaller but potentially more rewarding play on gold miners is US Gold (AMEX:UXG). The firm is a junior gold explorer, managed by Rob McEwen, who turned Goldcorp into one of the world's premier mining companies. It's at an early stage of development, but has large land holdings in Nevada, which sit between two very lucrative trends in the area. It is certainly a speculative play, as it is nowhere near production yet. But as high-risk plays in the sector go, "US Gold would be my top choice", Curtis Hesler of investment newsletter Professional Timing Service tells Forbes.

Eoin came to MoneyWeek in 2006 having graduated with a MLitt in economics from Trinity College, Dublin. He taught economic history for two years at Trinity, while researching a thesis on how herd behaviour destroys financial markets.