There weren’t many investments that did worse than gold stocks last year. Yes, bonds were flat. And emerging markets were off. But gold stocks really hit the skids, down 35% in 2013… and down roughly 60% from their highs a couple years ago.

Time to bail out? No, just the opposite. Here’s why.

Gold stocks are down primarily because gold is down. The metal peaked at $1,923 in April 2011.

[ad#Google Adsense 336×280-IA]Since then the price has fallen 38% to $1,200.

But the chart on gold stocks bears an uncanny resemblance to a drunk falling down a flight of stairs.

As a group, gold shares are down 65% from the 2011 high.

Am I betting that gold is about to perk up?

No. I don’t know what gold is going to do.

And neither does anyone else.

As I’ve said before, this is a near-impossible asset to value. Gold accrues no interest. It generates no earnings. It pays no dividends. It provides no rental income. That means you can’t use standard valuation tools like yield-to-maturity, projected cash flow or price-to-earnings ratios.

However, you can look at gold shares on the basis of earnings, yield and book value.

And I like what I see.

Yes, gold could perk up unexpectedly. But you should buy gold shares even if it doesn’t. Because gold shares are about as cheap relative to the price of gold as they have ever been. Take a look at the current gap between gold and gold shares:

Gold shares are at a historically cheap 15 times trailing earnings. And a good way to play this is with the Market Vectors Gold Miners Fund (NYSE: GDX). This is an exchange-traded fund (ETF) with significant advantages over open-ended funds:

  • It has a lower expense ratio compared to mutual funds.
  • It can be traded continually throughout the trading day.
  • It is linked to an index as opposed to being actively managed. (So you don’t have to worry about the fund manager underperforming his benchmark.)
  • The shares are tax-efficient with only a 5% annual turnover.
  • You can use trailing stops, something that is not possible with open-end mutual funds.
  • And unlike, say, the Vanguard or American Century gold funds, it will not close to new investors.

Market Vectors is linked to the AMEX Gold Miners Index (NYSE: GDM). It owns all of the world’s leading gold and silver mining companies. That means you can capture the performance of the entire sector with a single, well-diversified investment.

Diverse Holdings

The top 10 holdings include Barrick Gold, Goldcorp, Newmont, Silver Wheaton, Yamana Gold, Newcrest Mining, Franco-Nevada, Randgold, Kinross Gold and Anglogold Ashanti.

The annual expense ratio is 0.5%. Shares can be margined. And there are call options available for traders who prefer to play the sector more aggressively.

Expectations are low but I believe these mining companies are likely to report better than expected earnings in the months ahead. While gold has declined, they have been paring down costs and ramping up production.

As you may know, gold stocks are a good inflation hedge. But they also move independently of both the stock and bond markets, as we saw last year. Gold-related investments have a near-zero correlation with other assets.

It won’t take a lot of money flowing into gold stocks to get them moving higher again. The total market capitalization of the world’s top 15 gold companies is less than the market cap of Exxon Mobil.

Blue chip gold stocks are cheap and unloved right now. They are a fine inflation hedge and a great portfolio diversifier. And while they were big losers in 2013, that could change dramatically in the months ahead.

Good investing,

Alex

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Source: Investment U