My Secret for Picking Consistent Winners in Gold Stocks

Want to know the secret to a 669% gain in gold stocks? I’ll tell you in a second, but first, some background…

If you don’t know what gold stocks are, they’re pretty straightforward.

Gold stocks consist of the gold miners, the companies that actually pull the yellow stuff out of the ground. I prefer gold stocks to bullion for a couple of reasons.

For one, many miners pay regular dividends — whereas, to paraphrase Warren Buffett, gold bars just sit there and look at you.

But more important — gold stocks offer considerable leverage over owning physical bullion. As the price of gold increases, production becomes more profitable, justifying a higher stock price for gold stocks.

That’s not to mention that when gold prices increase, the miner’s reserves also become more profitable. Because miners often have reserves equal to 10 times their production rate, it’s easy to extrapolate the total profit increase from a rise in the price of gold.

But, that said, this is the part where most investors mess up.

See, novice investors tend to think that if gold is poised for a big move, then any gold-mining stock will take you along for the ride.

But that simply isn’t the case.

Take shares of Novagold Resources (AMEX: NG) and Buenaventura Mining (NYSE: BVN) for example. In that past five years, Novagold has lost 10% of their value during a gold bull market. Meanwhile by comparison, Buenaventura Mining has advanced 207% — and it sells the exact same metal.

Clearly, there are some attributes that separate the pedigreed thoroughbreds from the rest of the field. Specifically, there are five main criteria I use to evaluate a prospective metals company: extraction costs (the lower the better); production rates (preferably rising); reserve base (ditto); areas of operation (be cautious of geopolitical trouble spots), and hedging (ideally none in a rising market). But today, I want to look at one of the most important — extraction costs.

See, commodity producers brings their wares to market for the same price. If gold is fetching $1,700 an ounce, then you’re going to sell it for $1,700 an ounce.

Therefore, it stands to reason that the biggest gains will go to the producers that can dig it up the cheapest. The leaner and more efficient the company, the more cash it pockets for every ounce sold.

Take Canadian precious metals miner North American Palladium (NYSE: PAL) for example. It extracted 2,976 ounces of gold from its Sleeping Giant site last quarter. That gold production brought in $5.6 million in revenue.

But unfortunately, the cash costs (on-site operating expenses per unit of output) were $1,869 an ounce. This means the gold cost $5.6 million ($1,869 times 2,976) to produce. In other words, the gold mine operated at the breakeven point.

At the other end of the spectrum is Goldcorp (NYSE: GG), which is sitting atop some of the highest-grade mines on the planet. At the prolific Red Lake site in Ontario, each metric ton of raw ore relinquishes about 68 grams (2.4 ounces) of gold — that’s 10 times the 6.7 grams/ton of Sleeping Giant.

Goldcorp can currently get an ounce of gold from the ground to the market for $553. But this doesn’t include copper, silver and other metals that are found in the company’s mines. After you include the sales proceeds from these by-products (standard practice in the industry), the cash costs fall to just $185 per ounce.

In 2011, the company had an average sales price of $1,516 per ounce and netted $1,331 per ounce in profits, for a sky-high margin of nearly 88%.

It’s no accident that Goldcorp, which has some of the lowest costs and strongest operating leverage in the industry, has delivered the biggest gains for stockholders — 669% in the past decade, versus 294% for its peer group and just 27% for the Dow Jones Industrial Average.

This isn’t a difficult concept, and it doesn’t just apply to gold stocks. All other things being equal, if a commodity sells for $100 per pound, then you’re better off with a low-cost producer that can retrieve it for $60 per pound than a competitor who must spend $70.

Risks to Consider: But keep in mind, costs can change dramatically from year to year or even quarter to quarter. So it’s important to understand what’s driving the cost advantages. Maybe it’s favorable geology, superior extraction techniques or vertical integration (mining is energy intensive, so some companies actually generate their own power).

Whatever it may be though, any cost advantage/disadvantage is sure to affect the company’s profit margins. And you can bet that anything affecting how much money the company is making will be reflected in its stock price.

Action to Take –> So if you’re shopping for gold stocks, or any commodity producer for that matter, make sure to focus solely on those with the lowest extraction/production costs. The cheaper a company gets its product to the market, the more money it and its shareholders are going to make.