By David Sterman

As European and U.S. central bankers ponder stimulus measures to jumpstart their flagging economies, investors seeking inflation protection have turned to gold--Friday's closing price of $1,740 an ounce was up roughly 12% since late June and was its highest settlement price since February.

Yet even as gold prices try for the $2,000 mark (after reaching $1,900 last summer and then pulling back) gold miners are missing out on the party. A wide range of gold mining stocks are far from their peaks, failing to ride the coattails of the underlying commodity.

"It's at the point where gold mining stocks are trading at discounts to gold not seen in the past 30 years," says Adrian Day, portfolio manager of Day Asset Management. He notes that gold miners have historically traded at around three or four times book value, but now trade on average at 1.4 times book value. 

What went wrong? Simply put, profits at gold miners have not been up to snuff this year. "You've seen costs rising in terms of both labor and the energy needed to extract gold," says Brandon Rakszawski, product manager at Van Eck Global Funds.

And lagging profits are leading to some industry turmoil. Both Barrick Gold and Kinross Gold, two of the industry's largest domestic gold miners, have replaced their CEOs this summer as company directors seek to shift focus. "The boards are realizing that large capital spending plans need to be throttled back to put more of a focus on profitability," Rakszawki says.

The move to slow the supply of new gold could be quite helpful for miners because demand for gold keeps rising. "Central banks in Russia and elsewhere have become heavy buyers of gold after being big sellers in the 1980s and 1990s," says Leo Larkin, who follows gold miner ETFs for S&P Capital IQ. The key takeaway: Strong demand, less supply and a better grip on costs provides a nice backdrop both for gold and gold miners.

Ways To Play
There are a number of ETF options for investors looking at this space. Van Eck, for example, offers both the Market Vectors Gold Miners Index ETF (GDX) and the Market Vectors Junior Gold Miners ETF (GDXJ). The former focuses on big miners such as Barrick Gold and Goldcorp; the latter focuses on development-stage mining companies.

It's a crucial distinction. Large miners are fairly mature and already generate prodigious streams of cash flow, so investors are able to value these stocks using traditional profit metrics. The smaller miners, in contrast, typically consume cash as they get their mines up and running. So investors are left to assess the real estate value of those mines and try to anticipate what future cash flows might look like.

Why take a chance on junior gold miners if they are absorbing ongoing losses? Because investors tend to discount their value while mine development gets underway, and if the mines turn out to have a mother lode of gold then the company's stock can soar.

That said, the junior miner fund carries more risk. S&P's Larkin notes that the GDXJ "could be especially vulnerable to a downturn in the gold price," but adds that "it would be expected to outperform GDX in a rapidly rising gold price environment"

With almost every mining stock in the red this year, the various gold mining ETFs have lagged the overall market. But the focus on bigger miners has brought at least a bit more stability: The Market Vectors Gold Miners Index ETF has shed 24% in the past year against a 35% drop in the Market Vectors Junior Gold Miners ETF. As noted earlier, miners are now taking steps to boost profitability and look to earn back those recently incurred losses. GDX's net expense ratio is 0.52% and GDXJ's is 0.54%.

Beyond Miners
The current valuations for gold mining stocks appear to offer solid value when compared to gold itself, but investors who prefer gleaning exposure directly from the gilded metal and have several choices. You can mimic the price of action of gold bullion by buying the iShares Gold Trust (IAU), which carries a very reasonable 0.25% expense ratio. 

The most popular gold ETF is the SPDR Gold Shares Trust (GLD), which trades a hefty 12.8 million shares a day. Each share represents roughly 1/10th of an ounce of gold. Frankly, each ETF hold similar appeal as they move in lockstep. Both fund are up around 7% over the past three months, and have gained almost 40% over the past two years.

GLD's expense ratio is 15 basis points higher than that of IAU, which could be the differentiator for investors trying to decide which of these two funds to invest in.

If you're really bullish on gold, the PowerShares DB Gold Double Long ETN (DGP) is one way to express your enthisiasm. It is a leveraged (2X) fund based on the price of gold, helping it post solid gains during this summer's gold rally.

Yet you should look at this fund only if you anticipate a solid move in gold, as the fairly high 0.75% expense ratio will eat into returns. As you might expect, this fund has quite well in a period of rising gold prices. The ETF is up nearly 15% over the past three months and up a hefty 70% over the past two years.

If you firmly expect a pullback after this summer's gains, the PowerShares DB Gold Double Short ETN (DZZ) is a leveraged way to play on your pessimism. Of course, surging gold prices have led this fund to perform poorly ever since it launched in February 2008. Its shares began trading at $25 back then and now trade for less than $5. (Its odiferous 0.75% expense ratio has added insult to injury).

But for investors who believe gold is ripe for a pullback if inflation fears fail to materialize, this lagging fund could start to post robust upside.


David Sterman has worked as an investment analyst for nearly two decades. He was a senior analyst covering European banks at Smith Barney and was research director for Jesup & Lamont Securities. He also served as managing editor at and research director at Individual Investor magazine.