How to Buy Gold for Only $159 an Ounce

Wednesday, December 8, 2010 - 7:00am

by Tom Taulli

Since reaching a multi-decade low of $251.70 in August 1999, gold has been a top performing investment. Even during the 2008 financial crisis, it was only one of the few assets that increased in value (up +5.8%).

While top-notch investors like John Paulson are still bullish, gold still appears to be overheated. It certainly would be nice to be able to buy gold at, say, $800 or even $900 an ounce, but it's not possible to find such opportunities.

Or could it? OK, it does sound as fanciful as alchemy. But there is a clever way to buy gold at a discount. In fact, it's even possible to get it at a discount to the 1999 low.

How? You can buy stocks of miners. Take Gold Fields Ltd. (NYSE: GFI). The company has mines in far-off places like South Africa, Ghana, Australia and Peru. The total reserves of the company come to about 78.9 million ounces of gold.

Yet the market value for Gold Fields is roughly $13 billion. In other words, if you bought all the shares, you would be getting the gold deposits at about $164.77 per ounce ($13 billion / 78.9 million = $167.77 per ounce).

This is not an anomaly. Here's a list of other top miners:

Why the gap between Gold Fields' cost per ounce and the other miners? There are several key reasons. For example, it will take many years to extract the gold. Thus, the value of this future cash flow is lower. Also, there are risks of extracting the gold. After all, Gold Fields is not the only mining company with operations in dicey countries.

Despite all this, an investor is still getting a nice deal on the overall value of the deposits. Although, just like any investment, this should not be the only factor.

In light of the spikes in gold prices, it makes sense to find a company that is accelerating its production and is also trading a low valuation. An example is Yamana Gold (NYSE: AUY). Based in Canada, the company has properties relatively stable countries like Brazil, Argentina, Chile, Mexico and Colombia.

According to the latest earnings report, revenue spiked +36% to $454 million in the quarter, and mine operating earnings were up +48% to $201.2 million. Production has been increasing steadily and the positive trend should continue. Keep in mind that the company will see new mines come online in 2012 and 2013.

Yamana also has a low cost structure. The company has a cash expense of $104 per gold equivalent ounce (GEO). As a result, Yamana has been producing substantial cash flow.

Action to Take --> There are certainly strong forces propelling the price for gold. With the debt explosion -- especially with the Federal Reserve's easy money policy -- there are legitimate fears that inflation will eventually come roaring back. [For more on why gold could go higher, check out my recent piece, "Why Gold Could Go Even Higher"]

If so, investors will seek an alternative to the dollar. Traditionally, this has been gold.

Moreover, central banks and institutional investors are already buying up gold, and there is much room for more. (Keep in mind that China has less than 2% of its reserves in gold.)

But as with any investment, there needs to be caution. Gold has had a big run-up and it will inevitably have corrections. Just look back to the 1970s, when gold shot up 23-fold. During this period, there were severe painful price drops.

Yet, there are a variety of solid gold mining companies, like Yamana, which are selling at compelling valuations when compared to the current price of gold., The company's shares are even reasonable using the traditional price to earnings (P/E) ratio, at 28 times earnings. And more importantly, the company has mines in fairly stable jurisdictions and is likely to see growing production over the long haul.

Tom Taulli does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.