Best Gold Stock as a Hedge Against Inflation

Most economists expect inflation to accelerate. Gold stocks are often used as a hedge against rising prices, but not all are tightly correlated with bullion prices.
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BOSTON (TheStreet) -- The price of gold has retreated since it reached a record $1,200 an ounce in December. Now, as the economy is showing signs of life, concern about inflation is rising, suggesting gold stocks will start to glitter again.

But not all gold stocks are the same.

Randgold Resources

(GOLD) - Get Report

may be the best option to cash in on the return of the gold bull. Two other companies, mentioned later, are poor proxies for bullion.

Gold won't be helped by a weak dollar this time around, as Greece's debt woes have investors flocking to the U.S. currency from the euro. Bullion will increase almost solely due to inflation expectations. While economists have widely varying forecasts for inflation, the consensus is that it will be substantial.

The Federal Reserve has its work cut out for itself in trying to ward off inflation. The Obama administration has injected billions of dollars in stimulus and bailout packages.

Now that money needs to be slowly drained. Otherwise, prices could spike, leading to faster inflation and short-circuiting the economic revival. Hence, gold as a hedge against inflation.

Preservation of value, however, doesn't cause a massive increase in the price of gold. Inflation hasn't been high enough to push gold to $1,200 an ounce.

Speculation also has been driving the price. Investors expect the price of gold to spike when inflation becomes real and they bid up the spot price of gold in anticipation.

Many would like to get in on this speculation, but that must be done carefully.

As the above graph shows, Randgold's share price has followed the price of gold very closely over the past five years. The tight correlation suggests that investing in Randgold is an excellent proxy for the precious metal.

The same can't be said for other gold stocks.

Barrick Gold

(ABX)

and

Goldcorp

(GG)

have much lower correlations to the price of gold, making them poor alternatives for this gold-investment strategy.

It turns out that the price of gold accounts for 92.5% of the price movement in Randgold -- nearly a perfect match between the two assets. Buying Barrick or Goldcorp could leave an investor out in the cold if gold makes another push toward $1,200 an ounce and beyond.

Randgold, on the other hand, has almost no correlation with the stock market, so it serves as a tool for diversification. As the following chart shows, there's hardly any link between the

S&P 500 Index

and the price of Randgold. Barrick and Goldcorp are correlated almost equally to the price of gold and the stock market.

Stocks are often considered mild inflation hedges, since they have variable cash flows, unlike fixed-income securities. But for a stock to really hedge against inflation, a company needs to be able to pass its cost increases on to customers. Most companies are unable to do this to a high degree.

Gold is mechanical in its protection of investors from inflation. Randgold is a solid option for investors looking to get into gold as part of a standard stock portfolio. Barrick and Goldcorp don't offer the same correlation, so consider those two only if their business prospects are appealing.

-- Reported by David MacDougall in Boston.

Prior to joining TheStreet Ratings, David MacDougall was an analyst at Cambridge Associates, an investment consulting firm, where he worked with private equity and venture capital funds. He graduated cum laude from Northeastern University with a bachelor's degree in finance and is a Level III CFA candidate.