Reg Howe examines the gold cause''s options

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By Thom Calandra
CBS.MarketWatch.com
Thursday, June 13, 2002

Here's the question of the year: When the investing public,
already headed for the exits, runs screaming from the U.S.
stock market, how will gold mining stocks, and gold, benefit?

Gold mining stocks, the best performing stock market group
this year, have a life of their own. Since September, the
mining equities actually have risen ahead of the spot gold
price.

Gold mining stocks, thanks to the weak stock market,
nuclear war threats, and reduced forward-selling by miners,
are juiced well beyond the pricing models of professional
analysts. The Wall Street and Toronto mining analysts
almost all use operating cash flows, profit margins, and the
level of proven bullion reserves a company has in the
ground as their touchstones for value.

"Should a gold stock trade at 10 times earnings, 50 times
earnings, 60 times earnings? Nobody knows the answer
to that," says Victor Flores, senior mining analyst at HSBC
in Toronto and New York. Indeed, gold mining stocks in
some cases -- Gold Fields Ltd., Barrick Gold -- are selling
for hundreds of times their profit for the past four quarters.

A big chunk of the soaring prices of gold mining stocks is
tied to what the grizzled bullion veterans call "the option
premium." Investors during gold rallies anticipate a far
higher price for the gold a miner sells and thus are willing
to pay more for a gold stock than any financial planner
can counsel.

Thus, companies that mine rich resources at low cash
costs, like Canadian producer Goldcorp, are expected to
trade at extremely high multiples to earnings and cash flow.

Goldcorp, its shares trading at 17 or so times cash flow,
enjoys easy pickings from one of the world's richest gold
deposits, the Red Lake Mine in northwestern Ontario.
Production costs for pulling one ounce from the ground are
among the world's lowest at $120 an ounce. That's a lot of
profit margin if gold's price adds to its $320-an-ounce price
in the next six months . . . or six days.

Another golden rule for gold-company investors is pretty
simple. The more a miner has in the ground, the fatter the
premium gets. "Big mining companies are concerned with
the size of ore bodies, ones that give them a long marketing
cycle so they will hit high points in the (gold price)," explains
hedge fund manager Rick Sacks of Phoenix Advisory Co.
in Chicago. Sacks is a big believer in Crystallex
International (KRY), which is awaiting a Venezuela ruling
on Las Cristinas, a gold project with 8 million or more
ounces of the precious metal in the ground.

For those on Wall Street and Main Street who are wary of
gold companies, and there are many who won't touch the
stuff, the miners' soaring stock prices are even more
reason to snub the equities. Rafe Resendes at research
firm Applied Finance Group Ltd. in Chicago computes
three-year cash flow margins for many companies, then
determines the sales growth those companies will need
to justify their stock prices.

Newmont Mining, world's largest miner, has a three-year
median sales growth of 6.5 percent and a three-year
median cash-flow (EBITDA) margin of almost 34 percent.
Newmont's sales will need to rise 35 percent a year to
justify the current stock price, Resendes reckons.

Tiny Richmont Mines (RIC) has the easiest road to travel,
by these computations. With three-year median sales
growth down 6 percent and a three-year median profit
margin of 28 percent, Richmont need only boost sales by
14.8 percent to satisfy this pricing model.

"Obviously, should margins go up, the required sales will
go down," says Resendes, who uses the model as a
starting point, sizing up whether a stock is basically cheap,
expensive, or somewhere in between . "These (gold)
companies looked reasonably priced at half their current
levels, but very expensive here in terms of what they must
deliver," he says.

But -- back to the safe-haven question of the year: What will
happen to gold stocks when investors, drained by 2 1/2
years of Nasdaq and blue-chip losses, throw in their
red-ink stained towels? And they will, rest assured of that.

"The Elliott Wavers are predicting the market will soon
drop like an elevator with its wire cut, down to [post] 9-11
levels and possibly below," David Ward, an investor from
the U.K, sums up for me. "If true, that will scare the investing
public witless. What will happen to the gold price then?
And what price gold as the market recovers?"

Ward notices that "over the last couple of days, as the Dow
has toyed with 9,500, the Nasdaq Composite with 1,500, and
the S&P 500 Index with 1,000, there seems to be a growing
correlation between the price of certain high-beta gold
stocks, like Durban Deep, and the stock market movement.
Could market jitters be driving the price of gold stocks more
and more, rather than the price of gold?"

If you're comfortable with gold and gold equities, as I am,
you can add that to the option premium of a gold-mining
stock, sit back and enjoy the fireworks.