Gold vs. Gold Stocks: Which Is a Better Investment?

11/28/2011 12:01 am EST

Focus: COMMODITIES

Mark Skousen

Editor, Forecasts & Strategies, High-Income Alert

Gold and silver, the precious metals, have proven to be superior inflation hedges since we went off the gold standard in 1971. I prove this in a chart in the new 4th edition of my book Economics of a Pure Gold Standard.

Precious metals have risen sharply in the past ten years, ever since the terrorist attacks in 2001. Wars, crises, and inflation are bullish for gold and silver.

What about the mining companies that produce and sell precious metals? It turns out that they are much more volatile than the underlying metals, and don't always move together.

What gives? Top mining analysts point to five possible reasons

1. The introduction of the gold ETF (GLD) has made it easier for investors to invest in pure gold. Before GLD was available, investors had to buy physical gold through coin dealers or foreign banks.

2. Gold equities anticipated the run up in gold prices five years ago, and the metal had to "catch up" to expectations already built into the equity markets.

3. Mining companies have disappointed investors; they have failed to perform in increasing free cash flow and profitability, relative to the rapid rises in commodity prices.

4. The mining industry has gone through its own version of inflation, through share dilution. Market capitalization has risen much faster than share prices, as companies have resorted to issuing new stock to raise capital. (We're seeing this share dilution especially in the "rare earth" and "uranium" stocks in the past few years.)

5. Up to 90% of all junior mining companies--all heavily diluted--are "no good," according to Rick Rule and other mining experts, and investors are heavily discounted their value.

Why the Gold Market Is About to Change

While the competition with gold and silver ETFs will continue, mining companies are now inexpensive relative to bullion and investors will be rewarded accordingly.

The reasons why mining stocks may do better in the next few years:

  • After a 10-year bull market, good managers have finally returned to the mining sector.
  • Top mining companies are finally generating dramatically higher profit margins. Free cash flow is now "gushing" and will double in the next year as huge capital investments by the majors have paid off.
  • Expect enormous consolidation as majors start buying up smaller producers, at startling premiums to current market prices.
New discoveries are expected as ten years of new exploration is paying off, and the gains accruing to successful exploration efforts can be explosive.

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