Investors: May All Your Days Be Gold (GLD, SLV, GDX, UUP, AUY)

Elliott Gue: Gold is money. For centuries, the yellow metal has been viewed as a store of wealth and a store of value that has largely maintained its purchasing power over time. Unlike fiat currencies such as the US dollar (NYSEARCA:UUP) or the euro, gold (NYSEARCA:GLD) cannot be created out of thin air.

Many investors regard gold as a hedge against inflation and the falling value of the US dollar. And gold certainly does perform both of those tasks. For example, as US inflation soared from the early 1970s through the early 1980s, the S&P 500 marched in place and the value of government bonds was eroded by persistent double-digit inflation. But gold acted as a safe-haven, surging from a fixed level of USD35 per ounce in 1971 to highs of about USD800 per ounce in 1980. On an inflation-adjusted basis, those 1980 highs equate to about USD3,000 an ounce in today’s dollars.

But gold can also act as a hedge against a deflationary spiral. The Great Recession of 2007-09 was the worst economic downturn since the 1930s. The credit market bubble burst and for the first time in years household debt began to decline as a percentage of gross domestic product (GDP). This deleveraging cycle is inherently deflationary. But gold acted as a safe haven amid the crisis, rallying from about USD840 per ounce at the end of 2007 to over USD1,200 per ounce in December 2008.

The dollar has generally been weak against most major foreign currencies since early 2009. From its March 2009 highs of 89.10, the US dollar index dropped to less than 73 in April of this year. That decline certainly contributed to the doubling in the value of gold over the same time period.

But too many investors forget that gold isn’t just a hedge against the value of the dollar, but also a store of value that can act as a hedge against the value of all paper currencies. The ongoing European credit crisis demonstrates that the euro common currency is far from perfect in its current form. It’s likely that the European Central Bank, like its US counterpart, will be forced to print money in an effort to stem the risk of credit contagion emanating from fiscally troubled nations such as Italy and Greece. Gold is not only an alternative to the dollar, but to other flawed currencies such as the euro and yen.

The bottom line: All investors should consider holding at least a portion of their assets in gold. Given the uptrend in gold prices over the past few years, a conservative target for the yellow metal is a retest of its inflation-adjusted 1980 highs of about USD3,000 per ounce. And if the financial crisis deepens further, you’ll be glad to have some exposure to this safe-haven asset class.

One of the age-old debates in the markets is whether it’s better to own gold bullion or shares in gold mining companies. The best answer to that question is that it’s wise to hold a bit of both.

Over the long-term, the NYSE Arca Gold BUGS index (also known as the AMEX Gold BUGS index or the HUI) is more than 90 percent correlated to the price of bullion, meaning that gold mining stocks (NYSEARCA:GDX) and the yellow metal tend to move in the same direction. But there have been some significant swings and divergences over the long term. For example, gold mining stocks massively outperformed gold bullion from late 2000 through late 2003 and significantly underperformed in 2008 at the heart of the financial crisis.

During extreme market sell-offs such as those we experienced in late 2008, gold mining stocks can get pummeled alongside the broader stock market, even when the value of gold (NYSEARCA:IAU) rises. There are a number of reasons for this ostensible paradox. For starters, investors often are forced to sell off all stocks to raise capital, regardless of fundamentals. Another factor: In 2008, some mining firms relied on borrowed money to finance expansion, only to find that the credit market freeze brought project financing to a halt. See my graph below for a closer look.

Source: Bloomberg

This chart shows the ratio between the price of the AMEX Gold BUGS index and the price of gold bullion. A rising line suggests that gold mining shares are broadly outperforming gold.

As you can see, there are only two periods since the mid-1990s in which gold mining stocks have been this cheap relative to gold prices: the late 1990s and the height of the 2008 financial crisis. I’ve already explained the reason for the weakness in these stocks in 2008. The late-1990s weakness in gold stocks can be explained by the fact that gold prices traded under USD300 per ounce, a level at which most gold mining firms can’t mine the metal profitably.

If the relationship between these two indexes were to simply return to the long-term average, there’s at least 30 percent of upside for gold mining stocks as a group. The current market provides us with an outstanding opportunity to accumulate shares of high-quality, growing producers.

Here’s a look at a mid-tier and producer with even more leverage to the yellow metal and strong production growth potential.

With annual production of about 1.1 million gold equivalent ounces (GEO) in 2011, Yamana Gold (NYSE:AUY) is considered a mid-tier producer. Although headquartered in Canada, the company’s six operating mines are located in three countries: Chile accounts for half of production, Brazil makes up 30 percent of GEOs and Argentina chips in the remaining 20 percent of output. Roughly 80 percent of total GEO output is gold; because many gold deposits occur naturally with silver (NYSEARCA:SLV), the remaining 20 percent of output is silver.

Yamana is in the early stages of a major phase of output growth that will raise total GEO production by roughly 60 percent to about 1.7 million ounces by 2014–one of the fastest growth rates of any precious metals mining firm in our Global Investment Strategist coverage universe.

The company’s largest mine is its 100 percent owned El Penon gold and silver mine located in northern Chile. In 2011, Yamana expects to produce 420,000 to 440,000 GEOs from the project, roughly in line with last year’s output of about 428,000. The mine has been in commercial production since 2000, but Yamana expanded its processing plant there in 2010 and has discovered several additional high-grade ore deposits, including the large Pampa Augusta Victoria vein that should result in modest production growth over the next few years. In the third quarter, for example, production from this mine was up 15 percent year over year.

The Gualcamayo open-pit gold mine in northwest Argentina produced 135,000 ounces of gold in 2010 and should produce 150,000 to 170,000 ounces in 2011. The most exciting development for Yamana at this facility is the potential to develop the QDD Lower West deposit–an underground project located adjacent to the mine’s existing production operations that will boost overall mine output to about 190,000 ounces by 2013.

The firm’s third-largest mine is Jacobina in northeast Brazil, expected to produce 120,000 to 135,000 ounces of gold in 2011, compared to 122,000 ounces last year. The firm has identified some higher-grade ore deposits at this mining project, including the Lagartixa trend, which was discovered in 2009. These discoveries should result in modest production growth over the next few years and has allowed the firm to upgrade its reserve and mine life estimates at the project.

Although the performance of its existing mines has been solid, the real output growth will come from new mine operations scheduled to start up over the next two years. The news on that front is particularly encouraging. The company’s new Mercedes mine in Sonora, Mexico produced its first gold in November 2011, well ahead of management’s target start date of mid-2012. The mine is now expected to reach commercial production by the second quarter of 2012 and ramp up to an impressive 130,000 GEOs per year by 2013. In addition, in February 2012, Yamana expects to update its reserve estimates; management is likely to announce a significant increase in those estimates at that time, another upside catalyst for the stock.

Yamana also has three new mines in Brazil currently under construction. Santa Luz is expected to produce about 100,000 ounces per annum by mid-2013; Ernesto/Pau-a-Pique is expected to produce similar quantities within roughly the same time period; and Pilar is slated to produce 120,000 ounces per year by the second half of 2013. Given management’s success in executing projects and mine expansions on time, the firm appears well on target to meet its production targets over the next few years.

Even as Yamana ramps up production, the miner’s costs remain in check. The co-product cash cost of production for gold–a common industry measure of production costs–stands at USD456 per GEO on a year-to-date basis and management expects costs to remain in that range through 2014 as it ramps up output. With gold prices more than triple that level, Yamana remains a top growth stock pick for aggressive investors.

On a valuation basis, Yamana looks compelling–check out my chart below.

Source: Bloomberg

On a price-to-sales and price-to-earnings basis, Yamana trades at its lowest valuation levels in years, with the exception of a few brief weeks at the height of the financial crisis in 2008.

Written By Elliott Gue From Investing Daily

Elliott H. Gue is editor of Personal Finance, a one-stop source for market-beating investing advice. Mr. Gue scours the world for the best investments – whether it be growth stocks, bonds, Master Limited Partnerships or commodities – to build and protect your wealth no matter what the “market” does. Mr. Gue delivers in-depth insight and analysis that cuts through the noise and hype to reveal the truth about the economy, the market and your investments. Mr. Gue is also editor of The Energy Strategist, helping subscribers profit from oil and gas as well as leading-edge technologies like LNG, CNG, natural gas liquids and uranium stocks.

He has worked and lived in Europe for five years, where he completed a Master’s degree in Finance from the University of London, the highest-rated program in that field in the U.K. He also received his Bachelor’s of Science in Economics and Management degree from the University of London, graduating among the top 3 percent of his class. Mr. Gue was the first American student to ever complete a full degree at that business school.

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