How to Pick a Gold Stock

A trend of declining unit costs would be ideal, but lately the opposite has been happening across the industry.

How Good Is Management?

Foster says a company's leadership should have a suitable background in mining and know how to deliver on their promises.

"Start with the next quarter and see if management's results are in line with its guidance," he says. "If they miss expectations, then that might be a stock you don't want to own." He adds that firms should theoretically always meet their guidance, but "mining is a risky business."

Vahid Fathi, a gold stock analyst at Morningstar in Chicago, says a useful way to determine whether management has created shareholder value is to look at its return on assets.

A 6% ROA should be a minimum for good miners, he explains. "It's low, but given gold's role as a diversifier and a hedge against inflation, it's enough," he says. Return on assets is calculated by dividing average assets for the year into the annual net income.

Still, he says that's a baseline case for a firm with multiple operating mines that are located in friendly countries. The rate should be increased for single-mine firms or those doing business in risky locales, so it's a good idea to brush up on your politics.

Some companies who work cooperatively with foreign states do better than others, and as with many things, experience helps.

"Having a decades-long track record is great as it means that the company is doing the right thing," says Peter Zeihan, director of global analysis for Austin-based Stratfor, a business intelligence consulting firm. "North America is certainly the safest region."

Takeover Targets

Stocks that appear likely to get gobbled up by major producers are another good way to profit, but investors need to be judicious.

For a takeover to work, the output of the acquired firm needs to be large enough to make an impact on the firm doing the buying, says Jim Vail, portfolio manager at the (LEXMX Quote)ING Global Natural Resources fund in New York.

In other words, buying a two-bit firm with tiny output likely isn't worth the hassle for a large player like AngloGold Ashanti(AU Quote), whereas a larger midtier target might be worthwhile.

"If you look at Meridian Gold(MDG Quote), which is being taken over by Yamana Gold(AUY Quote) then the combined entity will likely produce approximately 2 million ounces a year by 2012," Vail says. That's the reason his fund owns Yamana.