Four Gold Stocks for Your Radar Screen

Gold, beautiful and much sought after, has evoked a wide range of emotions among humans since it was discovered more than 5,000 years ago. On the one hand, gold bugs believe gold is the only true store of value and is a great inflation hedge. The other extreme might be typified by Warren Buffett, arguably the greatest investor of our time, who said the following about gold in 1998--"It gets dug out of the ground in Africa, or someplace. Then we melt it down, dig another hole, bury it again and pay people to stand around guarding it. It has no utility. Anyone watching from Mars would be scratching their head."

Fortunately here at Morningstar, our stock valuation approach lets us sidestep this philosophical debate and value gold stocks the way we value all of our stocks: as a piece of the underlying business. Consistent with our long-term approach to investing, we analyze two aspects of a company--its valuation and its attractiveness. In regards to valuation, we apply the discounted cash flow (DCF) method to value a gold miner. As for attractiveness, we look for companies that have sustainable competitive advantages and thus deliver superior returns on invested capital (ROICs) over the long term.

Attractiveness
In general, gold-mining is an unattractive industry for several reasons. First, gold is a commodity, so mining companies cannot differentiate their product. Second, gold is primarily used for jewelry, which means that demand for gold highly elastic--meaning that demand is very sensitive to price. Even a small increase in price of gold will affect demand, so producers have little pricing power. Third, annual production of gold only accounts for about 60% of the annual supply--the rest comes from old gold scrap and the sale of gold by central banks. With any increase in the price of gold, supply from recycled gold increases, thus dampening the price. Because of all these factors, gold producers tend to have little control over the price of their product.

Adding to the unattractiveness of the industry are the costs of extracting gold from the ground. As more gold is mined, less is left in the ground. Costs of extracting gold have therefore increased as mines get deeper In addition, rising input costs (steel, oil, electricity are important inputs in gold mining process), rising labor costs and labor shortages plague the industry, and make healthy contributions to year-over-year cost increases. As a result margins are squeezed and profitability suffers.

It is no wonder then that most gold producers do not have an economic moat around their business. This is manifested in the profitability measures--ROICs at most gold companies fall short of their cost of capital.

Valuation
When valuing gold-mining companies using our DCF model, one of the most important inputs is the price that producers will realize for their output in the next five years. Since we believe in a long-term value-oriented investment approach, we attempt to project a "normalized" gold price--a price that is reflective of the whole cycle in gold, rather than the current market conditions.

To calculate a normalized gold price, we studied trends in gold price, inflation, the Consumer Price Index (CPI), oil prices, silver prices, and the prices of other commodities. Our conclusion is that the price of gold is most closely related to CPI and inflation. This is not surprising, since numerous studies have shown that gold has retained its purchasing power through the ups and downs of economic cycles over the last 200 years.

As a starting point, we analyzed the historical ratio of gold prices to CPI. While this ratio has been volatile, it has exhibited a mean reverting behavior. By our calculation, the long-term average for this ratio is 2.66, and we assume that gold prices will revert to this ratio.

Based on this methodology we arrive at a normalized long-term price for gold, which is $434/oz. We assume a 3% growth in gold price each year, in tandem with inflation. We also assumed that each gold producer will realize this price for the unhedged portion of its production.

Given this assumption of mean-reversion, our price projections will tend to be lower than market expectations during a bull market in gold, and vice versa during a bear market. Gold stock prices have typically followed gold prices. Therefore, in a bull market for gold, gold mining stocks will tend get 1-star Morningstar Ratings if they exhibit typical behavior. When the cycle turns and gold prices sink, and there is a corresponding drop in gold stock prices, quite a few stocks will tend to get 5-star ratings. Needless to say, most gold stocks in our coverage universe earn 1-star ratings at this time.

Shining stars
Even though the industry in general faces gloomy prospects, we think there are a few stocks that should be on investors' radar screens. These stocks have historically earned well in excess of their cost of capital and have respectable reserves.

Goldcorp .
Goldcorp has enjoyed enviably low extraction costs because its Red Lake Mine in Ontario has 2 ounces of gold per ton of ore as opposed to the 0.01-1.3 ounces found in the mines owned by larger North American companies like  Newmont (NEM),  Placer Dome , and  Barrick (ABX). Low extraction costs translate into healthy cash flows, higher margins, and higher returns on invested capital. Goldcorp's average ROIC is an impressive 30% since 2001, which is outstanding in the gold mining industry. Under new CEO Ian Telfer, Goldcorp has set its sights on using the cash generated by operations to acquire its way into the 2 million-ounce-per-year category. We expect to see a lot of action and growth here, though we would keep a close watch on acquisition prices.

Freeport McMoRan (FCX)
Freeport-McMoRan Copper & Gold stands head and shoulders above its mining peers because of its flagship Grasberg mine in Indonesia. The mine boasts the largest single gold reserve and the second-largest copper reserve in the world. Like Goldcorp, Freeport also enjoys enviable margins, and ROICs have topped its cost of capital even in 2003/2004--years adversely affected by a landslide.

Royal Gold (RGLD)
Royal Gold is a cross between a bank and gold company. As a holder of gold royalties, Royal Gold has exposure to gold price movements, but is insulated from mining costs. This great position results in awesome returns by gold-mining standards.

 Barrick (ABX)
Barrick does not earn its cost of capital currently. But we will still keep this company on our radar screen because of its disciplined approach to exploration and development. By keeping a constant exploration budget going during the late 1990s, Barrick has lined up an admirable queue of projects that will provide significant growth in the coming years unlike the gold mining industry in general. Although the company's partially hedged output will restrict its ability to capture the value of increasing spot gold prices, we think Barrick is one of the better gold stocks in our mining universe.

Conclusion
Despite their solid fundamentals, all of these stocks in our opinion are currently overvalued based on our assumptions about the long-run price of gold. Of course, different gold-price assumptions will result in different opinions. For example, if we assume a normalized gold price of about $600 per ounce, Barrick, Freeport, and Goldcorp would be attractive at their current valuations.