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3 Top Gold Stocks to Consider Buying Now, and 1 to Avoid

Reuben Gregg Brewer, The Motley Fool

There are different ways to invest in gold, and the method you choose to get exposure to this precious metal really depends on the role you want it to play in your portfolio. The big benefit of including gold (and its precious metal companion silver) in your asset mix is that it is a store of wealth and, thus, it can provide material diversification benefits. And, in my opinion, the best way to get that exposure is via Royal Gold, Inc (NASDAQ: RGLD), Wheaton Precious Metals Corp (NYSE: WPM), and Franco-Nevada Corp (NYSE: FNV).

But whatever you do, think carefully before you gamble with some of the high-risk investments Wall Street has conjured up in this space.

Gold: The big picture

If you want to get a feel for why having some precious metals exposure is so important, look back at Great Recession. The S&P 500 Index fell precipitously during that difficult time, but the price of gold rose. That was a rough time to be an investor, to be sure, but if you owned a little gold there would have been at least one bright spot in your portfolio. It's that tendency for gold to do well when the world appears to be falling apart that makes the metal so desirable.

A woman with her arms around stacks of gold bars

Image source: Getty Images

Precious metals go up like this because they are viewed as a store of wealth. They are real assets that will be around long after the fiat currencies of the world disappear. Thus gold can be a safe haven in a turbulent investing sea -- which is why many like to own gold bullion, stashing coins and ingots in their homes and bank safe deposit boxes. This is a wonderful choice if you are worried that the global financial order could end, but it isn't the most efficient way to get gold exposure in your portfolio.

A better option for most is to buy a gold-linked exchange traded fund (ETF), like iShares Gold Trust. The only assets of this ETF are gold bullion, so it's like buying gold directly, but without the dealer markups for buying and selling or the storage issues. You'll pay a 0.25% expense ratio to own it, but that's probably worth the cost for the ease it provides.

Another way to go, however, is to buy a gold miner like giant Barrick Gold or relatively small Yamana Gold (NYSE: AUY). Miners, in general, tend to have a little bit of leverage to the price of gold on the upside and downside. That said, there are reasons to like large, established miners, and reasons to prefer smaller miners. For one thing, a large miner is likely to have a more predictable production outlook and cost structure, often producing at the lower end of the cost curve.

Smaller miners, meanwhile, often need high prices to turn a profit because of their relatively high costs. That means that small miners can outperform when gold is rising since higher prices can be the difference between making money and bleeding red ink. Also, smaller miners like Yamana are often more leveraged to production growth via new mines and expansion projects.

The key here, however, is that mining is a business, which adds another variable to the equation beyond just gold prices. Mining costs tend to rise as a mine ages, and sometimes investments in new mines don't pan out as well as projected.

Bar charts depicting Yamana Gold's production projections, showing increasing production over the next few years

Yamana Gold's production forecast, showing the growth it expects after new mines come online. Image source: Yamana Gold

There's more than one way to go here, too. You can buy a Barrick or Yamana, or you can buy an ETF that invests in miners. For example, VanEck Vectors Gold Miners ETF tracks the broad gold mining sector, with a lot of weight on larger companies. VanEck Vectors Junior Gold Miners ETF, meanwhile, has a specific focus on smaller miners.

ETFs are a great way to get exposure to a broad basket of miners if you don't want to try to pick out one or two that you think will excel. That said, the one thing you really want to avoid, unless you are a market timer, is buying an ETF leveraged to gold miners, like Direxion Daily Gold Miners Index Bull 3X Shares (NYSEMKT: NUGT). This fund is structured to go up (or down) three times that of its benchmark, the NYSE Arca Gold Miners Index. This ETF has a sister fund that moves three times in the opposite direction of the index as well. But precious metals miners are already prone to swift and volatile price swings; adding leverage to that mix is a dangerous tactic that most, if not all, investors should avoid.

The better way to play gold

Which brings us to the third, and perhaps best, way to invest in gold: streaming companies. Royal Gold, Franco-Nevada, and Wheaton Precious Metals all fall into this category. They provide cash up front to miners for the right to buy gold and silver at reduced rates in the future. To put a dollar figure on that, Wheaton pays around $400 an ounce for gold and $4 an ounce for silver, well below the spot price of either precious metal. These low costs lock in wide margins in both good years and bad. Miners often watch their margins dip deep into the red when gold and silver prices are weak.

A visual depiction of the streaming process

A quick overview of how streaming works. Image source: Wheaton Precious Metals

Weak commodity prices will hit this trio on the top and bottom lines as well, but there's a silver lining to the streaming model here. Miners are most likely to ink streaming deals when they're struggling, because alternative financing options, like banks and capital markets, are likely to be less disabled when gold is in the doldrums. So Royal Gold, Franco-Nevada, and Wheaton all have something of a countercyclical element to their businesses since they can use precious metals downturns to build for the future.

Then there's the issue of diversification. A miner normally only owns a small collection of projects. But streaming companies are more like specialty finance companies that get paid in gold and silver, so they tend to have a portfolio of streaming deals in various stages of the mine lifecycle. For example, Franco-Nevada has over 340 investments, with a collection of 47 active mines, 40 in development, and 173 in the exploration stage. (Rounding out the total are its 80 investments in oil and natural gas drilling projects, adding a little more diversification to the picture.) Franco-Nevada is easily the most diversified of this trio.

A world map showing the 340 investments in Franco Nevada's portfolo

Franco-Nevada's portfolio of investments. Image source: Franco Nevada Corp

The high margins offered by streaming has also allowed Franco-Nevada and Royal Gold to amass impressive dividend records, with annual increases for 10 years and 16 years, respectively. I don't know of any gold or silver miner with a record to match either of these streamers, a fact that dividend investors should note in particular. And while Wheaton's dividend is variable, it's tied to the company's performance. That means the dividend will generally go up when gold prices are high (when the broader market may be slumping) and down in bad years for gold. So an investment in Wheaton can give you a little dividend diversification, too. Franco-Nevada, Royal Gold, and Wheaton, with yields of around 1.1%, 1.2%, and 1.7%, respectively, won't get you rich on dividends, but their dividends are still an important reason to like each of them.

A bar graph of Royal Gold's increasing dividend with a line graph of the gold price, showing the precious metal's volatility, over it

Royal Gold's dividend compared to the price of gold. Image source: Royal Gold

The best part of all of this, however, is that Royal Gold, Wheaton, and Franco-Nevada never take on the headache and risk of operating a mine. Their investment is limited to the money they have contractually agreed to provide the miner. Add that to the wide margins and this gives them very consistent businesses with, generally speaking, highly visible performance goals. They have historically been reliable performers in what has historically been a volatile market.

You can buy what you want, but...

At the end of the day, you should buy the gold investment that makes the most sense to you. However, when it comes to owning the physical commodity, mining stocks, or streaming companies, I think the best option for most investors will be Royal Gold, Franco-Nevada, or Wheaton. That said, you'll need to do a deeper dive on each to figure out which one you like best. What you should probably avoid, however, is buying a leveraged ETF like Direxion Daily Gold Miners Index Bull 3X Shares. That'll just make an often volatile investment even more volatile -- and why bother with that when you can benefit from streaming companies that actually pull key risks out of the investment equation?

More From The Motley Fool

Reuben Gregg Brewer has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.

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