In late June 2006, we highlighted a peculiar situation.

It was a situation where the price of gold had risen 32% to $583 per ounce in the previous twelve months, but three interesting small-cap gold stocks were selling for the same prices they were when gold was trading around $430 an ounce.

We presented our readers with three stocks: a small-cap, a mid-cap, and a large-cap. Buyers of shares of the small-cap and the mid-cap only had to wait two months before they were up 30.5% and 45.3%, respectively. The large-cap, coincidentally, was actually down half a percent for the same period.

The stocks that performed so well were IAMGOLD Corp. (IAG: NYSE), which is now the tenth largest gold company in the world, and Kinross Gold (KGC: NYSE), the eighth largest.

These situations for quick profits don’t happen very often, but when they do we need to jump on them.

Well, there is a very real chance that the gold bull market is poised to continue. Even if you only look at it from a chart perspective, much of 2006 saw gold trading sideways with higher trends now looking likely.

But no matter what you believe about gold’s immediate future, there are some things you need to know before you go out and buy a gold stock. The four that I’m about to highlight are critical:

• Evaluate the Level of Sales and Earnings: Many risky exploration companies exist in the marketplace today that have no real sales or profitability. They may have been clever enough to attract lots of cash in the hopes of making a large discovery, though. Unless your risk tolerance is extremely high, you’ll want to own the companies that are actually generating cash flow from selling gold.
• Examine the Company’s Reserves: The amount of gold a company has is measured by its reserve level. The higher the reserve, the more gold that can be translated into sales and earnings. It’s important to pay close attention to a company’s proven and probable reserves numbers. This will clue you into the possible amount of gold the company can reasonably expect to extract and turn into a product for sale.
• Location: It’s important in real estate, and it’s important in gold investing. Well, it’s not so much the location per se, but the politics that control it. It’s better to pay a slight premium for gold in a politically stable area than to risk having a dictator seize your company’s mine, leaving your investment worthless. Obviously, gold plays in North America are among the safest in which you can place your money from a political perspective.
• Funding: It’s important to look for gold companies that are able to self-fund their operations. That is, they are generating positive operating cash flows, and hopefully positive free cash flow as well. A gold company might have to tap the equity and debt markets from time to time to fund major new projects, but we don’t want to invest in companies turning over sofa cushions to stay alive.

We already have small-cap gold plays in Small-Cap Strategy Report, and you can rest assured that we will be examining all future gold additions with those four criteria above, as should you.

Until next time,

Craig Walters
February 22, 2007

Craig Walters

Craig Walters spent years entrenched in the investment industry doing what he loves best: performing financial research on scores of small-cap companies. Craig was formerly an equity analyst and Systems Director for Ferris, Baker Watts.

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