How to Pick a Gold Stock

"An absolutely pure play gold company is really rare," says Shanquan Li, portfolio manager of (OPGSX Quote)Oppenheimer Gold & Special Minerals fund in New York. When gold is mined, byproduct metals are also produced and sold for additional revenue.

When total revenue from gold is upward of 80%, that's probably sufficient to warrant the inclusion of a stock in a gold-only allocation, Li says.

Understanding Hedging and Output

Hedging is something investors don't want to see. It means that all or a portion of a miner's future output will not fluctuate in line with the price of gold because the prices are locked in. But that works against the reason many people want to own gold stocks.

"Most investors want to participate when gold soars," says Li.

It is worth noting, however, that banks sometimes insist that development projects hedge a future portion of their production as a condition of a loan. Financially solid firms like Barrick Gold(ABX Quote) and Newmont Mining(NEM Quote) can sometimes avoid such loan covenants.

When you've found an unhedged gold miner, study its growth in reserves and production, says Joe Foster, portfolio manager at the (INIVX Quote)Van Eck Intl Investors Gold fund in New York.

"Companies that can achieve growth have always commanded a premium," says Foster. "It's truer today, because it's harder to find growth."

In some sense, a miner is the value of the gold ore in the ground. So as that metal gets extracted, it needs to be replaced with new reserves. Between them, Newmont and Barrick will need to replace about 15 million ounces mined a year, or more than one-fifth of the annual output of all gold mines across the globe, just to renew depleted reserves.

Barrick's emphasis on forward-looking growth -- say, 10 to 15 years down the road -- has made it a better bet than rival Newmont, Foster says.

The other basic measure by which all gold miners are judged is cost per ounce of gold sold. Newmont recently reported third-quarter costs of $388 an ounce, up from $318 an ounce in the same period a year earlier.