Time to Buy Junior Gold Stocks

As an analyst, I'm not only interested in how high gold might go over the next year. My suspicion is that it will go much higher than $1800.

But I can't build a stable financial model and a strong case to buy gold mining stocks around suspicion.

What I can build a case around however are the facts in the ground, right now.

And right now, it is clear that gold stocks have been lagging strength in the price of gold. Normally we expect gold stocks to outpace gains made in the underlying metal by a significant margin. Yet today many gold stocks are underperforming.

Take a look at this chart which compares the Junior Gold Mine ETF (NYSE: GDX), a basket of junior gold stocks, with the price of gold since the beginning of 2011.

Over this period gold has outperformed juniors by 35 percent.

This divergence isn't all that rare to be honest. Gold and mining stocks don't correlate perfectly. But over time the performance of the best mining stocks reigns supreme, hands down.

So when I see the gap above, I know it's time to add junior gold stocks to my portfolio.

There are only two things that will close this gap; junior gold stocks need to rise or the price of gold needs to fall. I think gold could pull back, in fact I hope it does because that would open the window once again to buy the underlying metal (which I'm not a buyer of here).

But I'd be very surprised if we see gold below $1500. That's right around the current 200-day moving average, which over the last two years hasn't been broken.

So rather than put money to work betting on a drop in the price of gold (would you place this trade based on the steady trend higher for gold?) I'd rather be a buyer of the underperforming gold mining stocks.

And the biggest potential gains will be found in the junior gold stocks - more specifically those that have huge gold reserves that the market is deeply discounting, or emerging gold producers that are on the cusp of generating revenues.

These two types of companies are, in my opinion, the best value right now.

We can do better than buying a basket like the GDX pictured above by focusing on individual gold companies that are trading at substantial discounts to the value of the gold they have in the ground.

The nice thing about buying these companies now is that we don't need gold to stay at $1800, or even $1500 an ounce to be undervalued - although my models do show that buying the right gold miners with the underlying metal at these prices is almost a no-brainer.

When I plug a gold price below $1500 into my model and still find junior gold companies that are undervalued, there is an extra margin of safety. Naturally there are a host of reasons why these stocks could be undervalued, and that's where the follow on research begins, but starting with a 'too cheap to stay that way' valuation is always a plus.

This week, and over the next couple of weeks, I'd recommend looking into junior gold mining companies. Track those that are emerging producers, and be on the lookout for companies with large quantities of proven reserves that are heavily discounted.

One metric that is extremely useful is to calculate a miner's enterprise value per ounce of gold reserve - or what I call EVPO. A company's enterprise value is easily sourced from most financial websites, and almost all publicly traded gold companies will list their ounces of reserves on their website. So with a little digging, you can come up with a table of EVPOs for any mining company you want.

We have to use enterprise value instead of something like a price to earnings ratio (PE ratio) to value these small companies for the simple reason that many don't have earnings at all. And that's okay - it's just a fact of life for early stage junior mining companies. They have a long development stage before they get a single ounce of gold out of the ground and bring it to market - so we have to analyze them based on what they may or may not have in the ground.

And there are a few basic rules to help us do so.

There are three categories of gold reserves, in decreasing order of confidence. Typically, we give a higher valuation for greater confidence reserves in the 'proven and probable' category. Next down is the 'measured and indicated' category. The lowest, and least certain, category is 'inferred'.

For instance, for our small cap subscription service I recently recommended a company that the market is valuing at less than $10 per ounce of 'measured and indicated' and 'inferred' resources. I calculated this EVPO by dividing the company's enterprise value by the ounces of gold in these categories.

Many gold juniors trade with EVPOs above $100, or even $200 per ounce of gold. So to me, $10 is a downright steal.

This company is just one example - I've seen others as well with similarly cheap EVPO ratios.

It will be at least 2 years before this company goes into production, but it has a mammoth reserve that the market has yet to assign any real value to, based upon the company's EVPO.

I believe it is only a matter of time before the market wakes up to this company's, and other emerging producers', potential.

And given the divergence in the price of gold and the performance of junior gold mining stocks, the upside potential for this group is well worth the investment. As always, start with valuation as a jumping off point, and dig a little deeper into a company's story to figure out why its stock is trading at a discount.