Why You Should Own Gold Stocks

Gold stocks generally outperform the metal by a 2-to-1 ratio over time. That's because every $1 increase in gold prices goes straight to profits. What's more, the gold still in the ground becomes even more valuable.

But the shares of gold mining stocks have suffered lately, mainly hurt by higher energy and exploration costs.

Gold bullion has risen to $1,670 from $1,531 since the beginning of 2012 - a 9% gain. Meanwhile, the Gold BUGS Index (NYSE: HUI) of gold stocks dropped a whopping 23.5%.

In fact, the stocks of the large gold miners have become nearly as undervalued as they were during the worst of the financial crisis.

What gives?

Fact is, gold shares can be traded and go up or down like any other stock.

And with investors increasingly skittish about stocks - outflows from mutual funds totaled $546 billion from 2008-11, according to the Investment Company Institute -

But even though gold stocks have underperformed since 2006, they have significantly outperformed the metal since 2001.

From 2001 through today, physical gold has appreciated by 475%. However, gold stocks have posted gains of 755%.

That's the kind of leverage you can get only by betting on mining stocks.

If gold-stock fundamentals return to normal, gold miners' stock prices will be driven significantly higher by prevailing gold prices.

But there's good reason to believe gold prices could jump significantly higher from here, making now the perfect time to jump in.

Gold Prices Set For a Rally

There are a number of reasons to be bullish on gold, S&P Capital IQ analyst Leo Larkin wrote in a recent analysis.

Mining production is likely to remain relatively stagnant in coming years.

And volatility among the world's currencies combined with the growth of the M-2 money supply in the U.S. will likely spur global government demand for gold as a reserve asset.

"Gold needs to rise only 15% to trade at a new high. We believe that this is in the cards for 2013," John Hathaway, manager of the Tocqueville Gold Fund (MUTF: TGLDX), told the The Globe & Mail.

Hathaway is one of the better-regarded money managers in the space - his fund is up more than 18% annually over the past decade.

If gold trades consistently above the $2,000-an-ounce level, mining shares could run up by 60% to 90%, Hathaway said, noting the miners are trading near historical lows in terms of earnings, cash flow and sales.

In fact, any breakout past the previous high of $1,901 would raise earnings and valuations - a tremendous one-two punch that could ignite the sector in 2013.

Opportunities like these come along only rarely in a bull market. The last time was four years ago when there was a lot more risk.

However, not all boats are likely to rise with the tide.

How to Go Big on Gold Stocks

While there's money to be made betting on junior exploration companies, they're not for the faint of heart.

That's why most investors should limit the field to big miners that can spread their risk by diversifying their revenue stream over many mines around the globe.

Shares of the world's second-largest producer, Newmont Mining Corp. (NYSE: NEM), for example, are selling for about five times earnings before interest, taxes, depreciation and amortization.

Newmont's profit went from $4.7 billion to almost $6.4 billion from 2009 to 2011. The stock also has a 3% dividend, uniquely tied to the price of gold, so as the price of gold goes up, so will the dividend.

Another large-cap miner, Goldcorp Inc. (NYSE: GG), is the fastest-growing, lowest-cost senior gold producer and pays a dividend of 60 cents, yielding 1.7%.

With operations spread from Canada to Argentina and a market cap of $29 billion, the company shows good growth and potential for capital appreciation.

GG expects annual gold production to reach4.2 millionounces by 2016, an increase of 70% over the next five years.

The company has only $770 million in debt and operating margins exceed 40%, giving GC excellent leverage to the price of gold.

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