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(LUIS ENRIQUE ASCUI)
(LUIS ENRIQUE ASCUI)

Fabrice Taylor

Mining for quality shares backed by gold Add to ...

It's hard to have a relationship with gold. You give it love, it gives you mood swings. You try to communicate, it sits there in cold silence.

Still, it's worth working through those differences, in my view. Being a simple person, I have a simple view on the prospects for gold and, more importantly, gold shares: Whatever appears to be making gold prices go up isn't going away any time soon.

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Gold bullion has done very well, gold shares not as well. In theory, gold shares should do better than the metal when the price rises. That hasn't really happened, but when the companies start cranking out profits that investors find sustainable, gold stocks will go up.

First, the background: gold is going up, one would reason, because money is suspect in Greece, Spain, Ireland, the United States, Japan, and even Canada, where we pretend to be better than anyone while we rack up enormous deficits and household debt. There's so much debt and so little that can be done about it that we're left with two choices: not pay it back or print more money to pay it back.

You can't count on economic growth to fix the problem. Will the Greeks suddenly start working harder? Will the Japanese stop being in denial about their demographic and debt problems? Will U.S. politicians abruptly stop using the public purse to buy votes from either the rich or special interests?

Obviously not. If anything, the debt crisis, at least 30 years in the making, has only revealed how weak and ineffective the "first-world" political system is. No one wants to address the burning problems. Europe seems to be most adept at producing politicians and bureaucrats. Wall Street still runs America. Japan is shrinking toward oblivion.

So, money is not going to get more valuable - it's going to get more abundant. Investors are lemmings, it's true, so when gold goes up as it has, thanks in large part to the gold-holding exchange-traded funds, it's easy and probably wise to assume some froth.

But are investors dumb? Faced with a choice between, say, a government bond paying next to nothing (or paying a lot, but with great odds of default), are they suckers for buying gold?

The U.S. debt-ceiling "crisis" will pass, just as the Greek crisis passed. But the debt remains, and, in fact, grows faster than the economy almost everywhere.

Gold prices will undoubtedly whipsaw. As mentioned earlier, it's a moody thing. But does it make sense that gold will plummet? I doubt it; and if you do, too, you have to think gold shares are attractive, at least some of them.

Take New Gold Inc. as an example. At current gold and copper prices , according to analysts, the company could produce cash flow of between $2.60 and $3 a share in five years. Using an average historical multiple of 15 times, for big producers, yields a stock price between $39 and $45 a share.

Where's the stock today? About $10. Investors clearly aren't interested in producers or they're skeptical about the gold price. And some caution is warranted. Mining gold is a tough business, notwithstanding every yahoo who claims to have the mother lode and a mine plan.

If you like smaller plays, there's Wesdome Gold Mines Ltd. , with a mine in Quebec and another in Ontario. The company pays a (modest) dividend and has bought back stock - unheard of in the business.

Wesdome needs to find reserves, but higher gold prices help as more rock becomes economical, and it's in very good areas for new discoveries. Again, the stock seems neglected at six times earnings, notwithstanding its challenges.

But investors always go where the cash is eventually, and at some point the market will take note of the cash that quality - and I can't stress that word enough - gold companies are producing and bid up those shares aggressively.

I think this is true of producers and also of high-quality explorers. They are, of course, considerably riskier, but gold production is falling. The industry needs new deposits, and anyone who finds a quality one will likely get snapped up. In fact, New Gold bought one earlier this year.

So, don't dump gold; make the relationship work by buying some quality shares that are backed by yellow metal, just like money used to be.

 

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