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Feeling Contrarian? Try Mining Dulled Gold Miners

AP

Gold mining stocks have lost their luster over the past 18 months as a stronger dollar and falling commodity prices have investors fleeing the resources sectors.

Gold prices have corrected by more than a fifth this year, and the Market Vectors Gold Miners Index ETF is down nearly 45 percent. Gold miners Barrick Gold and Newmont Mining are down 53 percent and 36 percent, respectively, year to date.

But with sentiment toward the group turning increasingly bearish, contrarian investors may find something to like in the beaten-down group.

"Gold miners are as hated as anything I've seen," said Arnold Espe, USAA's VP of mutual fund portfolios.

Indeed, after money poured into gold on fears of what central bank easing will mean down the road for inflation, investors since the beginning of the year have been moving into other investment opportunities as they position for better U.S. economic growth ahead.

According to Bank of America Merrill Lynch's June global fund manager survey, investors' allocation to commodities fell to the lowest level on record, with 32 percent underweight.

(Read More: How Gold And Silver Bears May Actually Help Silver)

One reason gold and gold miners have been abandoned has been the prospects that quantitative easing will eventually be coming to an end in the United States.

(Read More: Taper Tipoff? Bernanke Hints Easing End Is Nearing)

"One way or another, the U.S. is getting toward the end of its liquidity cycle. And that is supporting U.S. yields and it's supporting the U.S. dollar, and that's going to be a headwind for the gold price and all commodity prices going forward," Erik Wytenus, head of foreign exchange and commodities at JP Morgan Private Bank, told CNBC.

But while there may be headwinds, Espe expects the precious metal to benefit from ongoing global "monetary debasement" as central banks like the Bank of Japan print money in hopes of stoking inflation and reducing the value of their currencies and as developed countries continue to run large budget deficits.

Gold Miners Can Still Shine

Amidst the overly bearish sentiment, many investors may be overlooking the benefits of owning the gold mining stocks as part of a diversified portfolio given improving company fundamentals and their operating leverage to gold prices, fund managers say.

"Miners are making money," said Rachel Benepe, manager of the $2.4 billion First Eagle Gold Fund. "The negative bias has taken over and investors are ignoring the fundamentals."

She added that given where the gold price is, if you told gold miners that gold would be where they are today a few years ago, they'd be "over the moon."

(Read More: 3 Gold Mining Stock Bargains)

Benepe and Dan Denbow, manager of the $1.1 billion USAA Precious Metals and Minerals Fund, note that miners' capital spending has peaked and operating expenses are starting to fall after the large increases in labor costs and capital budgets during the rapid growth in the mining industry over the past five years.

"Costs have abated," Denbow said. "That should lead to better earnings and better returns."

Benepe echoed those comments, saying that across the global mining sector big miners like BHP Billiton and Rio Tinto and gold miners are reducing capital expenditures to improve cash flow. "World miners today are focused on maximizing free cash flow," she said.

And better free cash flow could lead to higher dividends down the line. "Owning the gold miners is like owning gold with a yield because the miners can provide a dividend," Benepe added.

Denbow sees this trend playing out at Goldcorp, his fund's top holding as of the end of May. As the company completes some of its mining projects, Goldcorp has "large capacity to generate free cash flow going forward and the ability to increase the dividend."

Those miners that operate in places like Canada and Australia may also benefit modestly in the second half of the year from a weakening Aussie Dollar and Canadian Loonie.

Alamos Gold, Newmont Mining, Eldorado Gold and Yamana Gold rounded out the top five holdings of the USAA gold fund as of the end of May.

While not getting into specific names, Benepe likes companies that "produce" gold as opposed to the more speculative junior miners that focus on exploration.

As of the end of March, First Eagle Gold Fund's top five gold miner holdings were Agnico-Eagle Mines, Goldcorp, Randgold Resources, Newcrest Mining and Barrick Gold.

You Can Have Too Much Gold

The fundamental case for gold miners may look appealing, but investors shouldn't jump headlong into the group—especially given all the recent volatility.

In asset allocation, USAA advocates a 3.5 percent weighting, which represents an overweight position. "Investors need to have some of it for portfolio diversification benefits," Denbow said. But because of the volatility in gold prices, precious metals should only be a small portion of the portfolio.

First Eagle's diversified portfolios have an allocation to gold in the 5 percent to 10 percent range given its benefits as a potential hedge.

"The reality is where we are with the world, people are fleeing the space and missing the opportunity in the gold miners," Benepe said.

By CNBC's Justin Menza. Follow him on Twitter @JustinMenza.

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