How to Pick Gold Stocks

Investors should buy gold, Cramer said during Wednesday’s Mad Money. The market’s just too volatile a place to be without this classic hedge.

Cramer, of course, knows that the price of gold is declining, having dropped to $950 from an intraday high of just over $1000. But that actually plays into his strategy. Until Treasury Secretary Geithner delivers a real solution for our bank and housing problems, the market madness will continue. And gold, always a great protection in these situations, will become more and more attractive.

Europe is also in trouble – even worse than the U.S. – as is the euro, and that, too, should push even more buyers to this precious metal. The catch here, though, gold tends to snap back from a bottom rather quickly. Cramer thinks the price per ounce could drop to $900 or a bit lower, giving people a 10% discount, so investors have to be ready to take advantage of that move.

How? The SPDR Gold Shares exchange-traded fund is the most attractive way, Cramer said, because it directly tracks the price of gold. He recommended buying GLD in stages: a quarter of a position at $90 to $91, the next quarter at $88, then another at $85 and the last at $82. The fund might not drop that far, but regardless, investors will still get a good chance to build a position.

People who don’t trust paper might want the real thing, so gold bullion is an option. Bullion tends to be an investment for the wealthy, though, because they can afford to buy it in bulk. Those with less money might purchase gold coins instead, through the U.S. Mint’s American Eagle program.

Cramer likes the gold stocks, too. The key, though, is to pick the right one, and that process is different than valuing other equities. While regular stocks are rated by low price-to-earnings multiples, good dividends and cheap share prices relative to the sector, gold stocks have their own metrics. In this case, investors want to know production growth, cash costs, the sensitivity of a company’s earnings to changes in gold prices and the price-to-net-asset value. According to these standards, Eldorado looks to be the best gold stock, though Cramer’s a big fan of Agnico-Eagle Mining.

AEM has the top production growth in the industry – 344% – which is one of the reasons Cramer likes the stock so much. Yamana’s a distant second with 56%, and Eldorado’s fourth with 27%. Still, that’s a decent number and nothing to scoff at.

EGO is the leader when it comes to cash costs, spending just $286 per ounce. This is important because production growth doesn’t matter if a company isn’t making money on its gold. And even at these lower prices, EGO’s still making money. The closest competitor here is Goldcorp at $397 per ounce, then Yamana at $411 and AEM last with $483. But Cramer still feels confident about Agnico because its costs are coming down, he said. Plus, AEM’s share price had dropped to $49 from $83. EGO’s only $1.50 from its high of $9.52.

Next investors need to know how sensitive these companies’ earnings are to gold prices. The earnings-per-share sensitivity of a company is the percent change in earnings for a 10% change in the price of gold. The less sensitive a company is, the better able it is to withstand volatility. EGO is only 20.4% sensitive, while AEM is second with 22.4%.

The price-to-net-asset value will tell whether or not a gold stock is cheap. Think of it as the sector’s P/E ratio. On this basis, AEM is the most expensive with a 1.55 multiple, EGO’s a bit cheaper with 1.12, and Newmont is the cheapest at 0.83. But Cramer recommended paying up for quality, so it makes sense to shell out some dough for AEM or EGO.

AEM might be Cramer’s favorite growth stock – because of that monstrous production growth – but according to these measures Eldorado is the one to buy. He recommended picking up EGO in stages as gold works its way down to $900 an ounce.

Questions for Cramer?

Questions, comments, suggestions for the Mad Money website?