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Gold Mining Stocks and the Gold Mining Sector

Screenshot 2015-07-22 17.12.31Not surprisingly, the profits of companies that produce gold is largely a function of the price of gold. Investing in these companies can provide similar benefits to buying physical gold with the added liquidity of stocks and the potential to earn dividends. However, the business of mining gold is extremely complicated and risky. Only if you are willing to diligently do your homework and can afford to take some risk, should you consider betting even a small amount of your retirement portfolio on a mining company. Because of the high fixed costs and huge capital requirements, mining stocks tend to be more volatile than the metals they produce.

Any single gold mining company will add a great deal of firm-specific risk to your investment portfolio. This can be avoided by buying into an index fund that invests in many gold mining companies or a mutual fund that strategically invests in the gold mining sector. These options are discussed in the next section and are more appropriate for most RRSPs. However, even if you choose to invest in a fund rather than picking stocks, do not skip this section. It is important to understand the industry dynamics and know the major players before investing.

Over the past seven or eight years gold miners have struggled and the stocks have taken a beating. They have under performed the broader stock market and physical gold. Many mines are becoming depleted, the cost of extracting gold is growing and production declining. There is much uncertainty around how much gold is actually left in the ground.

However, gold stocks appear relatively cheap in today’s market and institutional investors are starting to show renewed interest, which always drives stock prices higher. Companies have been forced to cut costs and the industry has consolidated. If the price of gold accelerates, mining companies could start to see big profits even with lower levels of production.

There are three types of companies that are involved in the production of gold: exploration, development and production. Explorers and developers find and develop the mines and are often small operations and very risky investments. Production companies are large, multi-national corporations that take gold out of the ground.

Because of the tax laws governing RRSP accounts, highly speculative investments are better kept elsewhere. Capital losses in your RRSP are not tax deductible. Stick with the large gold miners that operate on multiple continents. They have more diverse income streams and are much less risky than the small exploration and development companies.

The graph below shows the return on physical gold (GLD), the return on an index of gold miners that largely represents the big production companies (GDX), and the return on an index of smaller exploration and development companies (GDXJ). It illustrates how stock funds are basically a leveraged play on gold and smaller companies are more leveraged than large companies. All these investments move in the same direction with varying degrees of volatility.

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What to Look for in Mining Stocks

Political, social and environmental problems can pose major risks for gold miners, especially those that operate in less developed regions of the world.  Although production costs are likely lower in less stable countries, unexpected strife can mean mining operations must be suddenly stopped or postponed. Look for companies that invest in the communities around their mines and make an effort to operate in an environmentally and socially responsible way.

It is also important to consider the geological variables that mining companies are dealing with. The quality of the ore or rock that contains gold can vary drastically. Look for oxide ore and open pit mines, not underground mines, as extraction is cheaper.

When analyzing potential investments in mining companies, consider what they have in the pipeline. How old are the mines? What is their expected productive life? What political and environmental risks surround each mine? How much new exploration are they pursuing?

Annual revenues for gold producers can fluctuate drastically and be hard to predict. Gold producers can, and should hedge their profits against falling gold prices by trading gold futures. Although this means less upside when the price of gold rises, it reduces the risk of bankruptcy or the need to halt operations when the price of gold falls. Look for companies that do not have drastic variation in profits from year to year.

Gold miners must report their total cost per ounce of production – this is probably the most vital statistic to consider. The ability to maintain a low cost structure, well below the price of gold, is critical. It is also worth considering whether they have they been able to maintain low costs without compromising their environmental and ethical reputation. Look for a strong management team that is personally invested in the company.

Gold Companies

Since there are no longer limits to the amount of foreign investments Canadians can include in their RRSP, it might be beneficial to add foreign gold companies to your portfolio. This could add even more diversification. However, some of the world’s largest gold mining companies are based here in Canada. The following companies are some of the largest gold producers and relatively safe gold stocks to consider adding to your RRSP.

Barrick Gold Corp (ABX), based in Toronto, is the world’s largest miner of gold.  They mined nearly 6.25 million ounces in 2014 and operate mines in Chile, Australia, Argentina, the United States, Peru and Canada. They focus largely on cash flow and keeping costs down and are able to pay regular dividends.

Newmont Mining (NEM) is a U.S. company based in Colorado. It is the world’s second largest gold producer, extracting 4.85 million ounces in 2014. They operate mines in Africa, Asia, Australia, New Zealand, Canada and the Americas. They are also involved in exploration and copper mining. Year-to-date, Newmont has outperformed its peers and has been upgraded by multiple analysts.

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Other mulit-national gold producers include Goldcorp Inc (GG), AngloGold Ashanti (AU) and Eldorado Goldcorp (ELD). AngloGold Ashanti is the number three producer, extracting 4.4 million ounces in 2014. They are headquartered in South Africa and operate mines in 10 different countries. Goldcorp is a huge global producer, headquartered in Vancouver, with mines in throughout North, Central and South America. Eldorado Gold Corp, is another Canadian gold-producer/explorer with mines in Europe, Asia and the Americas.

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