(Reprinted with permission from the May 2 edition of the Gold Mining Stock Report
.)

Gold shares have been brutalized in recent sessions, at the same time that gold has been a relative rock. The disconnect between gold and gold shares has been widening since December of ’03, and has been especially pronounced in recent weeks, prompting some to question the authenticity of bullion’s relative strength, others to question manipulation in the share markets, and, no doubt, many others to question why they own these so-called leveraged proxies for gold. Let’s consider a few of the reasons that might explain the gap between the shares and the metal:

1. An ounce of gold is an ounce of gold, but a gold share is many different things. It may represent a producer of the product, a company looking to discover or grow the product, or it may be stymied-in innumerable ways-in its pursuit of the discovery or production of the product. Don’t confuse bullion’s standard issue product for the wildly mixed bag that is the universe of gold stocks. One is a simple investment decision, the other is fraught with a broad range of risks, most of them subjective, and all of them vastly more complicated than buying an ounce of gold.

2. For most companies that attain production, gold mining at today’s gold price-$429-is a marginal business for all but a handful of companies. Despite the underlying product being priced just 5% shy of a 16-year high, about which there was much publicity a mere five months ago, most companies mining the product are not coining money, but rather, they are losing money or making it in negligible quantities. Last week’s earnings disappointments from Placer and industry leader Newmont are but two examples of a widespread phenomenon: at current prices, gold mining is a lousy business. The world’s largest gold producer, South Africa, has seen its gold industry evolve from having the lowest production costs to the highest; in the current rand challenged environment, profitability is all but precluded, and mine shutdowns have been announced with increasing frequency in recent weeks. Challenging economics will eventually help the gold price, but in the meantime, it won’t be the economic attractiveness of the sector that will result in investors rushing to participate in the gold mining business.

3. Gold stocks are stocks, and with too many instances of gold stocks being treated as stocks during previous declines in the broader market, the recent erosion of the broader market has not been the sort of catalyst one would expect to result in a flood of new money into gold shares. (Quite the contrary. It has contributed to even the true believers heading for the exits.) If such a flood of new money did materialize, there’s reason to think that it might be met by waves of new paper created by so many companies. In a market where new demand is likely to await the higher gold prices that will deliver it, the explosion of paper supply is making it increasingly more difficult to move these markets.

Apart from being stocks and occasionally being subjected to the same treatment as those in the broader market, rather than seeing something sinister that’s exclusive to the universe of gold stocks, the examples of oil and base metals have also shown the stocks to be imperfect mirrors of the underlying commodity’s performance. The disconnect between $50 oil and a universe of oil stocks that seem to be factoring in something more on the order of $30 oil has been well documented. Closer to home, the performance of base metals vs. base metals stocks also reflects underperformance by the shares. Phelps Dodge’s quarterly earnings this past week provided another example: earnings were twice that of a year earlier, but in a market that’s looking forward rather than back, PD was down 14% on the week. Clearly, today’s stock market is focused on an economic slowdown, not on copper at $1.51/lb. Uranium? Same thing: last week uranium prices continued their relentless advance, gaining another $0.50/lb, to $24/lb., the sixth straight week of gains in the spot price. Uranium stocks, meanwhile, continued to digest the gains that have significantly outrun the uranium price.

4. We pointed it out back in early March, and the seasonality of end-of-quarter, brokerage year-end, and in April, the unfortunate necessity of paying taxes, always seems to weigh on the resource markets during this period. With a global slowdown looming and the broader stock market in sharp decline, the pressure of some to raise money for taxes had an exaggerated effect in some markets. This may sound far-fetched to some of you, but I speak to a number of brokers who had clients with this problem. It’s much more a Canadian phenomenon than a U.S. issue, but given the amount of optimism that is so common throughout the sector, many who thought they would be raising money at higher prices find themselves with no choice but raise money even though prices were much lower than they had forecast. And shares of all stripes in the resource sector were the worse for it.

REASONS TO BELIEVE

The preceding discussion might leave some of you with the view that I see little hope and almost no reasons to own gold stocks. Quite the contrary. I mention this list of variables because I think they lend perspective to the ongoing, and recently much more pronounced, disconnect between the performance of gold and gold stocks. In the universe of gold producers, winning has meant losing least: the HUI and XAU indexes are down 17% and 16%, respectively, since the year began, and stocks such as Barrick Gold (down 7%), Newmont, even after last week’s washout (down 14%) Glamis (down 14%), and Goldcorp (down 14%) are the bright spots on this end of the market. (In Goldcorp’s defense, this is after consummation of the Wheaton River acquisition, without which the performance would have been much better.) If you want this discussion to get ugly, consider Harmony (down 32%) or Durban Deep (down 55%). On the producer end of the gold stock food chain, there’s no shortage of ugly numbers to consider.

I bring this up for a couple of reasons. The first is that we have been doing well to be focused much farther down the food chain. We’ve been paying attention to a fairly narrow list of companies, story stocks if you will, and if you’ve been a disciplined buyer, the worst case is that you may be down a few percentage points on this year’s purchases. Bitterroot and VRB are the likely names that fall into this category, but for many, these stocks and others merely represent dead money, not losers. Orezone and Almaden are others that fall into the same category, but inasmuch as I feel both offer substantial upside, I am willing to be patient with these companies. Crystallex, Virginia, and Viceroy should be clear winners for all concerned, and stocks such as Kilgore, AfriOre, and Bravo are all up well over 100% from where they began the year. I’m not going to belabor the point too much, because there are many other stocks we’re following that have not fared nearly so well. I raise the issue, however, because these are the stocks we’ve been buying, and they have fared much better than the market. Defining Nevsun as a low-risk buy at $3 is probably my most glaring mistake of the year-to-date, but given the mispricing of that company and the value play it represents-to say nothing of the frequent use of the word patient in conjunction with any mention of Nevsun-it’s a mistake I can live with. If Nevsun’s license-to-print-money Bisha deposit is not eventually going to see a higher value attached to it, I suspect it means that it’s going to be exceedingly difficult to make money anywhere in this sector.

Lest you think I’ve gone Pollyanna on you, I am acutely aware of how bleak the market is. I own many, many stocks that either don’t trade or are trading by appointment only. When possible, I’ll always sell such stocks to buy something about which I feel more strongly-and that describes many of the stocks mentioned in the previous paragraph. While the initial discussion of the disconnect between gold was focused on reasons to help understand why shares are not mirroring the price action in gold, an event that is neither limited to gold and has happened before, let’s review a few reasons why I think this situation will not last:

    1. As many commentators have pointed out, gold is beginning to show signs of performing as an alternative currency. It has broken out in terms of euros and yen, and has shown strength even on days when the US dollar has been strong. If the dollar can be said to be overowned and overvalued, gold is underowned and, thanks in large part to the mobilization of central bank gold, gold is undervalued.

    2. Market washouts such as the one experienced last week smack of climactic events, in short, a good time to be buying, and a bad time to be selling. The market can go lower, but from where I sit, a washout such as that experienced in Newmont last week is the kind of throw-in-the-towel event investors want to see before spending new money. Beyond Newmont, the spread between gold and gold stocks is approaching historical extremes, extremes that suggest gold must decline a great deal-or, my interpretation, that gold stocks are approaching extreme undervaluations.

    3. The challenging economics of gold mining are an explanation to account for the lack of participation in the sector, but over time, the same economics are extremely positive for the gold price. Gold production is beginning to show significant declines, most notably in South Africa, but the challenges to new production anywhere remain high. Barrick Gold chairman Peter Munk, speaking at last week’s annual meeting and echoing a recent theme in these pages, summed it up: “When you do have an ore body discovery, in half the countries today you cannot get them permitted. And when you do get them permitted, the time it takes is four or five times longer than it used to be and the costs are increasingly making the average mine nonviable.”

An example of one such cost was exemplified by last month’s award of the Goldman Environmental Prize, one of whose recipients was Ms. Stephanie Roth. Roth, the most visible opponent of Gabriel Resources’ Rosia Montana gold project, had this to say upon receipt of her award: “Gabriel Resources and Newmont [Ed: the latter a 10% shareholder in Gabriel] are modern-day vampires; who in the name of progress aim to bleed Rosia Montana to death. Their lust for gold has already given rise to flagrant and crying injustices. I refuse to accept this and I refuse to stay silent about this.” And, she might have added, she refuses to accept the will of the local people, who last year re-elected the local mayor by a near 90% majority, a mayor who ran on a platform that favored development of the Rosia Montana gold project. The will of the people, it would appear, takes a backseat to self-appointed vampire-slayers.

CONCLUSIONS

The recent strength in gold and the first indication of gold’s strength in currencies other than the dollar are positive signs that gold may begin to lead the shares to higher levels. That said, the past pace of share issuances, the challenging economics facing the sector, and broader questions about the stock market and deteriorating economic backdrop, argue for continuing to maintain a highly selective approach to the sector. While longer term fundamentals point to higher gold prices, the near-term future of the broader stock market and the dollar are likely to be the chief determinants of upside potential for gold producers. In such an environment, purchases should be confined to periods of weakness in gold, to widespread liquidation such as was witnessed last week, and to special situations that hold out the potential to perform counter to the larger trends of the marketplace. Such an approach has worked well thus far this year, but that observation is also fully mindful of the more challenging environment prevailing today. Pick your spots with care and keep some powder dry.

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Robert Bishop is the editor and publisher of the highly acclaimed Gold Mining Stock Report, a monthly newsletter specializing in emerging gold mining companies and other special situations in the resource sector. Gold Mining Stock Report has been published since 1983, and is regarded as one of the most authoritative and independent sources of information in this field. Bishop’s recommendations have consistently outperformed the averages of the senior gold mining companies and his subscribers have profited greatly from early exposure to the Northwest Territories diamond rush and the discovery of nickel at Voiseys Bay.

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