The Slo-Mo Gold Rush

Believe it or not -- like it or not -- gold stocks are momentum plays.

The group was sagging a bit at midday as the broader equity market rebounded from Monday's undressing. But as reported last night, the Philadelphia Stock Exchange Gold & Silver Index hit a 52-week high yesterday as did a number of individual stocks, including Newmont Mining (NEM), Goldcorp (GG), Glamis Gold (GLG), Agnico Eagle Mines (AEM) and Freeport McMoran Copper & Gold (FCX).

Predictably, Wall Street is starting to wake up to a group that was an also-ran -- if not an outright laughingstock -- for much of the 1990s.

Today, Goldman Sachs raised its rating on Toronto-based small-cap TVX Gold (TVX) to market outperformer from market performer, while Morgan Stanley Dean Witter initiated coverage on South African giant Gold Fields (GOLD) with an overweight recommendation and a $13 price target.

There are some fundamental reasons for the recent advance in gold shares, as discussed last month. But it does seem that every time Wall Street gets excited about the group, it suffers a setback. Even those who believe in the group's long-term fundamentals concede that a retreat is a real possibility short term, more especially if the broader equity market is going to embark on a spring fling.

"It's a common concern, [and] short term, I see digestion" of recent gains, said Frank Holmes, chief investment office at U.S. Global Investors in San Antonio. "But long term, I'm very constructive."

U.S. Global Investors offers the $30 million (USERX)Gold Shares fund, which is up 46.6% year to date after rising 11.1% in 2001, and the $50 million (UNWPX)World Gold fund, which is up 40.2% so far in 2002 after rising 7.5% last year.

Several fundamental factors underscore Holmes' optimism about gold's long-term prospects, including:

Most money managers remain underweight in the sector, and nongold funds are starting to buy shares because of the group's performance. "It's a portfolio reallocation," Holmes said;

The return of deficit spending by the U.S. government and the Bank of China's expressed desire to diversify its holdings and own more euros. Both are likely to put downward pressure on the dollar, which generally benefits gold;

Gold buying in Japan;

Demand outstripping supply while gold-mining firms, most notably Barrick Gold (ABX), are reducing their hedging -- the selling of future production for fixed prices.

Finally, Holmes noted that for all the price appreciation of gold shares, investor interest remains low -- which is understandable given the group's performance in the 20-plus years prior to 2001. He recalled being at a recent conference at which 500 people showed up for a breakout with U.S Global's mid-cap growth manager Art Bonnel, but only a handful came to talk about gold.

"We've found there's still doubt and skepticism," he said.

Citing these "driving factors," Holmes expects the price of gold to resume and sustain a rally above $300 an ounce. At midday, the price of gold was down 0.3% to $296.80 in COMEX trading.

Still Bullish After All These Gains

The direction of bullion is "the critical factor" for gold stocks, followed by the company's individual "growth profile" and whether it hedges production, he said.

U.S. Global does have a long position in Barrick, historically one of the industry's biggest hedgers, but has spent the past year shifting into nonhedgers such as Newmont Mining.

Currently, Holmes is bullish on smaller players he believes are undervalued and that may be targets for acquisitive industry giants such as Barrick and Newmont, as well as Australian miners BHP Billiton (BHP) and Rio Tinto (RTP).

Among his favorites potential targets are Northgate Exploration (NGEX), which trades on the Toronto Stock Exchange, and Freeport McMoran Copper & Gold.

Northgate is in the process of a debt restructuring that will clean up its balance sheet, and it's currently trading at a price-to-cash flow of 2 vs. over 20 for Glamis, Holmes noted. U.S. Global is long Glamis, but has recently been "rolling out of Glamis and into Northgate" as the former has climbed more than 200% in the past year.

Freeport, meanwhile, trades at a discount to the group because of the political risk in Indonesia, where its biggest mines are located. But "someone is going to take it out," he said, suggesting the political risk would be worth taking for a big company with the majority of assets in North America or Australia.

Holmes also expressed optimism about Harmony Gold Mines (HGMCY), which is benefiting from weakness in the South African rand now that most of its holders aren't exposed to the firm's local currency.

Should gold and related stock continue to retreat near term, it would probably invigorate the skeptics once again. But that may be the best thing for what remains an undiscovered and unloved sector.

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