Panning for Gold Among Miners

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"In the past five years, it made more sense to buy the type of gold that hurts if it falls on your head. . ."

Now that the Federal Reserve has pulled the tarpaulin off its shiny new printing press, gold has jumped again.

Not all investors stash coins or buy shares in bullion-backed exchange traded funds. Others, such as hedge fund manager John Paulson, just take a stake in a miner. Which is better?

In the past five years, it made more sense to buy the type of gold that hurts if it falls on your head: Spot metal tripled in price, while global gold mining stocks rose just over one-third. That is odd. Consider, for example, a company producing gold at a cost of $400 an ounce. The price doubles from $500 to $1,000. Even if costs rise 50%, unit profit should quadruple, and the share price should soar.

In part, gold mining stocks suffered as investors broadened their appetite for all commodities. ETFs have also cannibalized investors' cash, although the impact may be overstated. The collective value of the largest gold ETFs is around $47 billion, according to the World Gold Council. That's equivalent to 30% of the market capitalization of the NYSE Arca Gold Miners index. Actual inflows over time to ETFs, however, would have been at lower prices than today.

Mining stocks also face structural problems. They intrinsically carry exploration and political risk. Legacy hedging programs damp realized prices for their output.

Meanwhile, gold's popularity stems mainly from fears of inflation and financial meltdown. The former should, eventually, erode miners' margins. Malfunctioning credit markets hamper project financing. That tarnishes one advantage miners have over gold: They can grow through exploration, while the metal itself pays no dividends and doesn't breed.

HSBC pegs this year's cost at $749, suggesting good profit growth and stock performance in the near term, especially as the sector was hit hard in last year's market crossfire.

As with any stock, however, investors still favoring gold miners over the metal should pick carefully. Low cost producers in resource rich areas are best. And ideally, they should have other levers to pull to increase value.

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