ETF Teardown: The Best Gold Stocks

Noted for their simplicity and other advantages over mutual funds, exchange-traded funds have become a popular investing tool. ETFs hold a collection of stocks that share certain elements in common, so if investors want to capitalize on the rising popularity of gold, for example, they can turn to streetTRACKS Gold Shares (NYSE:GLD), which attempts to track the price of gold, or Market Vectors Gold Miners (AMEX:GDX), which invests in gold and silver mining stocks.

But because some ETFs invest in a number of stocks, investors get a broad diversity that also limits their upside. For an investor who was, say, really hip to gold-mining companies but cold on more diversified precious-metal plays, these ETFs wouldn't fit the bill.

Fear not, Fool -- in this edition of "ETF Teardown," we'll use some nifty tools to drill into the best of what the gold sector has to offer. To help, we'll use Motley Fool CAPS, our tool for screening and ranking stocks and stock pickers.

The power of tags
To help investors quickly locate great stocks, any of the 4,700 rated stocks that are profiled in CAPS can be "tagged" with a descriptor that groups the company with others sharing a certain quality.

Selecting the "Gold" tag in CAPS presents a list of 71 gold-related investments -- which includes the streetTRACKS and Market Vectors ETFs -- that trade on American exchanges. This particular collection of investments has done well in the past year, up 27.2% versus the S&P gain of 16.6%.

To get a sense of which companies the CAPS community thinks are the best opportunities in gold today -- and which they recommend staying away from -- we can sort this list by their CAPS star rank, denoted by one to five stars, with five being the best. Each of the individual companies can then be viewed for exactly who -- from Wall Street to Main Street -- is bullish or bearish on the company and why.

Getting down to the nitty-gritty
Here are a few of the five-star stocks our screen pulled up today.

With the recent increases in the price of gold over the past several years, it's not too hard to find a gold-related company that the CAPS community favors -- the average stock carries a four-star rating, and 16 of the 71 stocks included in this group have a five-star rating. And with Federal Reserve chief Ben Bernanke voicing concerns about the risk of inflation, it's no wonder interest in gold is high. Chiming in on the opportunities in gold and precious metals, investors are particularly vocal about Yamana Gold, as well as Northgate Minerals.

In the case of Yamana Gold, the Canadian company primarily mines gold but also now explores, mines, and refines copper. Since it operates mines in Brazil, Argentina, and Central America, costs to extract and transport ore are relatively low, and production margins remain high as a result. Many CAPS investors also cite confidence in management that has deep experience in Brazilian mining culture.

Despite all of the bullish sentiment, though, Yamana still poses significant risks. Most notably, while the company operates efficiently in mining gold and copper, profitability still eludes it. Several recent acquisitions and a huge three-way deal that Yamana currently proposes also add uncertainty. And since the company believes the price of gold will continue to rise, it leaves its production unhedged. That means Yamana will participate in all of the upside of gold price increases -- if the increases happen. But it also means there's no protection if Yamana is wrong. Still, more than 97% of CAPS investors are betting Yamana has it right and will outperform the market in the future.

Another Canadian miner producing gold and copper, Northgate Minerals, is smaller than Yamana Gold and has the bulk of its production coming from a few Canadian mines. The company wants to grow significantly larger, however, and management has already proved its capability on the balance sheet -- Northgate Minerals holds very little debt and has more than $300 million in cash and equivalents. Though production efficiency from its major mines has fluctuated lately, the company still reported $8.6 million in net earnings in the second quarter of 2007. Many CAPS investors like the company's financial position, as well as the defensive hedging it uses to help protect its production. Indeed, 261 out of 269 CAPS All-Stars think the company will outperform the S&P going forward.

You can lead a horse to water ...
Plucking individual stocks from a sector such as gold is, of course, a high-risk endeavor. Investors should always perform their own due diligence on companies rather than take a recommendation. After all, even the best stock pickers can be horribly wrong on a stock.

So, do you agree that a simple gold index is the best place to invest? Or are more diversified copper and gold miners a better play? Give your own opinion in Motley Fool CAPS.

Motley Fool Global Gains is another resource the Fool offers to help you find some of the greatest international investment opportunities. Check out the service free for 30 days to see which companies have made the cut.

Fool contributor Dave Mock loves doing the teardown part -- it's the put-back-together part he hates. He owns no shares of companies mentioned here. Dave is the author of The Qualcomm Equation. The Fool has a disclosure policy.