Gold Stocks Are a Compelling Buy – Here Are 3 Reasons Why

A strong stomach and a tremendous amount of patience are  required for gold stock investors these days, as…gold stocks are historically twice as volatile as U.S. stocks. I believe the drivers for the yellow metal remain  intact, however, so for investors who can tolerate the ups and downs, gold stocks are a compelling buy. Here are three reasons:

So writes Frank Holmes (www.usfunds.com) in edited excerpts from his original article* entitled Three Reasons to Buy Gold Equities Today.

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Holmes goes on to say in further edited excerpts:

[As I said,] gold stocks are a compelling buy. Here are three reasons why:

1. Gold Companies are Cheap

According to research from RBC Capital Markets, Tier I and  Tier II producers are inexpensive on historical measures. Based on a  price-to-earnings basis, RBC finds that shares are currently trading not far from the recent trough valuations observed during the 2008 global financial crisis and, on a price-to-cash-flow basis, gold stocks are trading at bargain basement prices.

The chart below shows that average annual cash flow multiples for North American Tier I gold companies have fallen to lows we haven’t seen in years. Since January 2000, forward price-to-cash-flow multiples have climbed as high as 26 times. This year, we see multiples at the high end  that are less than half of that. On the low end, today’s price-to-cash-flow of 6.5 times  hasn’t been seen since 2001.

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Tier I and Tier II companies “offer investors an attractive entry point from an absolute valuation perspective with respect to the broader  market,” says RBC.

2. Gold companies are  increasing their dividends

With the Federal  Reserve suppressing interest rates, investors have had to adapt and reallocate  investments to generate more income and that’s where gold  companies come in…In response to  shareholders’ desire to get paid while they wait for capital appreciation, gold  companies have rolled out dividend programs and increased payouts…Over the past 15 years, the world’s top 20 gold companies have increased their dividends at a compound annual growth rate of 16 percent. By comparison, gold only rose 12  percent annually.

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Not only are gold companies increasing their payouts, the  yields offer a tremendous income value to investors compared to government  bonds today. Whereas investors receive a 1.5% yield on a 10-year  Treasury, the stocks in the Philadelphia Stock Exchange Gold and Silver Index  (XAU) are paying a full percentage point more! This is a significant change from the past: In April 2008,  the Treasury yield was nearly 3 percent more than the dividend yield of the  XAU.

In addition, the yields of gold stocks have been climbing  over the past year while the 10-year Treasury remains low.

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3. Enhanced returns  in a diversified portfolio

We have long advocated a conservative weighting of 5% to 10% in gold and gold stocks because of the inherent volatility you are  seeing today but, despite the extreme moves, there’s a way to use gold stocks to enhance your portfolio’s returns without adding risk.

Take a look at the  efficient frontier chart below, which creates an optimal portfolio allocation  between gold stocks and the S&P 500, ranging from a 100 percent allocation to U.S. stocks and no allocation to gold stocks, and gradually increasing the share of gold stocks while decreasing the allocation to U.S. equities.

The blue dot shows that from  September 1971 through March 2013, the S&P 500 averaged a decent annual return of 10.34% but, had an investor had a portfolio consisting of 85% S&P 500 stocks and 15% in gold stocks which was rebalanced annually, his portfolio return would have been 10.96% (i.e. 0.62% more) with no additional risk.

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Although 0.62% doesn’t seem like much, it adds up over time. Assuming the same average annual  returns since 1971 and annual rebalancing every year, a portfolio with a 15% allocation in gold  stocks would be worth have appreciated 26.46% more than a portfolio solely invested in the S&P 500 while adding virtually zero risk!

(Editor’s Note: The author’s views and conclusions in the above article are unaltered and no personal comments have been included to maintain the integrity of the original post. Furthermore, the views, conclusions and any recommendations offered in this article are not to be construed as an endorsement of such by the editor.)

*http://www.usfunds.com/media/files/pdfs/investor-alert/_2013/2013-05-10/Investor_Alert_05-10-2013.pdf

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