John Doody doesn't run off chasing down Indiana Jones' lost gold mines in Peru. He focuses on producers or near-producers whose reserves have been verified as economic to produce. A former professor and the author of the Gold Stock Analyst, Doody has been lying in wait for the market to reach bottom, at which point he'll be ready to deploy the one-third of his portfolio he's been holding in cash into his top 10 stocks. In this exclusive interview with The Gold Report, Doody shares the metrics he uses to nail down those companies.

The Gold Report: After a couple of big pushes up last year to $1,900/ounce (oz), the gold price has been bouncing around $1,600/oz. You've pointed to a lack of investor enthusiasm for the stall. Do you see that changing any time in the near future?

John Doody: In this now 11-year bull market, gold actually ran up to several tops before the most recent one of $1,895/oz in August 2011. In 2006, it topped out at $725/oz and it was 27 months before it moved higher. Then in 2008, it topped out at $1,011/oz, and it took 26 months to go higher. Running up and settling back is typical of any market that gets overenthusiastic. We're in the same basic formation.

What drives the gold price is still the major factor in this market: real interest rates. The U.S. real rate of return (risk free Treasuries minus inflation) is negative, and ultimately, that number will come to the fore and drive the gold price higher. Unfortunately, it drives everybody crazy that the economics and the gold price aren't linked like Siamese twins, nor are the stock prices and gold price. That's why investors need guidance and help. If they were linked, people wouldn't need to buy a newsletter.

TGR: Very true. How high could gold go?

JD: Predicting gold's future price is a fool's errand because nobody really knows. You can say what the gold price would have to be for the gold at Fort Knox to fully back the U.S. currency, which is around $9,000/oz. Maybe that's the high end of the range. When people talk that number though, I'm always willing to agree with the caveat of, "Well, in whose lifetime?"

I'd be very comfortable seeing gold above $2,000/oz this year, but it's partly a function of the macroeconomic environment, what Federal Reserve Chairman Ben Bernanke does to get us out of our economic funk and what the Europeans do to solve their currency crisis.

I'm pretty happy being on the side for higher gold. The smart money is there. All the people whose names we all recognize as intelligent money managers have their bets on a higher gold price. The last thing one wants to do is get tied into some time frame, though, because it is often easier to spot value than it is to pick the time frame at which that value will be recognized.

That said, I should tell you what I've been telling my subscribers since the middle of last year. We have been in what we call our one-third portfolio position where we're one-third cash, one-third gold and one-third the Gold Stock Analyst (GSA) Top 10. We know that gold is less volatile than the gold stocks, but we also know that the GSA Top 10 is by far and away the best performing stock portfolio in the gold universe. We know we're going to catch the bottom with our one-third in the Top 10.

"Predicting gold's future price is a fool's errand because nobody really knows."

We're down about 6% this year, which is a lot better than the indexes. We're down 6.3% for the GSA Top 10. The Philadelphia Stock Exchange Gold and Silver Sector Index (XAU:NASDAQ) is down 16.5%, the AMEX Gold BUGS Index (HUI:NYSE) is down 17.9% and the Market Vectors Junior Miners ETF (GDXJ:NYSE.A), which is the index of junior gold miners, is down 22.2%.

Our intent is to catch the bottom—we're already in the right stocks—and spend the one-third cash that we are holding when we're fully convinced that the bottom is here. Even if we're 10% off, it's OK. We'll double down with that one-third cash and go two-thirds into the GSA Top 10.

The last time we did this, the GSA Top 10 gained almost 300% in the two years beginning in January 2009. Gold was up 61% and the XAU was up 83%.

TGR: Let's talk about some of your success. You have stressed that good stock picking can beat the indices. What are some of the factors you use to create your Top 10 list?

JD: Yes, it can. For years, we've proven it. We focus on a unique sector of the stock market that doesn't lend itself to Indiana Jones' lost gold mines in Peru stories that other guys focus on. We focus on 60 gold mining stocks that have data, are either in production and have reserves and current production or a feasibility study that shows that a site is economic and is in the process of raising the money to build it or is in the middle of construction. This is a market segment in which the stocks are generally larger. In the Top 10, the smallest has a market cap of $200 million (M), with the largest at $11 billion (B).

Unless you know how the whole industry is valued, you don't know what's undervalued and overvalued. We know how the market values the average ounce of production and the average ounce of reserves. Then we can take an individual stock and look at that versus the averages and say, "Well, gee, this stock is really high versus the average so maybe we don't want to own it, or it's really low versus the average."

How come? Maybe it's being overlooked. Maybe it doesn't have any sponsorship. Maybe it doesn't do any financing so the brokers aren't interested in it. The brokers are still all whores and there's no such thing as a Chinese wall. They cover companies that are going to do deals just as other newsletter guys cover companies that pay them. We're totally 100% subscriber supported. We do objective analysis.

Then we take a look at how the market is capitalizing an ounce of a company's Proven and Probable reserves, and an ounce of their production. We incorporate the mine's profitability by looking at the operating cash flow from the mine and what the ratio of market cap to operating cash flow is.

The average ounce of production among our 60 stocks, as of July 30, is valued at $5,332 by "Mr. Market." The average cash flow multiple is 5.2, in other words, the market capitalization divided by the profitability of the mines. The average ounce of Proven and Probable reserves is valued at $247.

TGR: Which number would you say is the most important one?

JD: All three. The operating cash flow multiple tells you how the company is doing now based upon its production and cash costs versus the market. The reserves represent how the market is valuing the future production, because companies typically have 10 times or more of current production in their reserves. Current production tells how a company is doing now versus its competition. All three of those are important metrics.

TGR: Are those numbers lower than they were, say, three years ago?

JD: The average operating cash flow ratio since October 2008, which was the market low, has been 8.7x. Now at 5.2x, Mr. Market is not rewarding the gold miners for the profits that they're earning.

We're seeing this in the executive suites. Companies are doing pretty well in terms of profits, but the stock prices are doing very poorly. Aaron Regent, the head of Barrick Gold Corp. (ABX:TSX; ABX:NYSE), got fired. The head of Kinross Gold Corp. (K:TSX; KGC:NYSE), Ty Burt, just got fired. There is a lot of executive turnover because boards are unhappy with the stock prices. They're looking for people who can lead them to higher stock prices.

TGR: Sounds as if there is a lot of room for upside there.

JD: A tremendous amount.

TGR: Are you buying and selling a lot in that third that you have invested in stocks, or are you holding?

JD: We make changes in the Top 10, but we're not a trading letter. We look for situations that can double based upon the analyses that we do. This year we've made two sells and one buy. We're currently holding 10% in cash in that Top 10 as well as one-third cash in the overall portfolio.

TGR: Because you're waiting for that bottom.

JD: We're waiting for that opportunity. We've been doing that for a year now.

TGR: You recently launched a new Silver Stock Analyst newsletter. The silver price is down by about 40% for the year. Why are you doing this now?

JD: Silver is gold on steroids. It's extremely volatile, much more volatile than gold. In the October 2008 crash, silver fell 54% from its July 15 high, and gold fell 28% from its July 15 high. On the other side, from January 2009, when the market finally got some footing back, until June 15, 2012, silver gained 158% whereas gold gained 87%.

TGR: So, there's more downside and upside.

JD: The macroeconomic stage is set for gold to go higher, and that should mean that silver should do even better. I've told people to put 5–20% of their money into silver stocks. We're doing essentially the same fundamental analyses with silver that we do for gold stocks. We look for production and reserves, at who's cheap and who's not cheap. We don't look at exploration plays. We don't know anything about some stock in Peru that's drilling holes. Those juniors are basically just lottery tickets. We analyze 25 primary silver producers in the Silver Stock Analyst. From those, we pick what we call our "Fave 5."

"The macroeconomic stage is set for gold to go higher, and that should mean that silver should do even better."

TGR: It's been a challenge for gold and silver juniors this last year to access capital. Do you see that changing?

JD: Not until there's enough investor enthusiasm to attract new people into the market and it filters down to the juniors.

TGR: With all the bargains out there right now, do you foresee a lot of mergers and acquisitions for the rest of this year?

JD: We talk to companies. We know what they're looking at. We identified in advance for subscribers an acquisition that New Gold Inc. (NGD:TSX; NGD:NYSE.A) made two years ago, in which it bought Richfield Ventures Corp. (RVC:TSX.V). We knew what New Gold was looking for and we told subscribers. We never covered Richfield as a Top 10, but we told them as sort of a bonus that we thought that New Gold would buy it. The stock was around $6.60, and New Gold took it out six weeks later at $10.

New Gold is in the market for another company because it has flat production. The market hates flat production. It wants to see gold miners increase production every year. New Gold has a flat period of production coming up from 2014 to 2017 of about 500,000 ounces (500 Koz)/year. After that, in 2018, the British Columbia-based Blackwater deposit, which has about 10 million ounces, is going to kick in along with El Morro in Chile. It's going to buy something to fill that hole. We've made some speculations about what that could be in our newsletter.

If you're talking to the companies, you can see that they're all looking. Primero Mining Corp. (PPP:NYSE; P:TSX) made a bid for Northgate Minerals Corp. (NGX:TSX; NGX:NYSE.A) and got trumped by AuRico Gold Inc. (AUQ:TSX; AUQ:NYSE). It is in the market, and we have some ideas who it might buy.

Yamana Gold Inc. (YRI:TSX; AUY:NYSE; YAU:LSE) made a pre-emptive cash bid for Extorre Gold Mines Ltd. (XG:TSX; XG:NYSE.A; E1R:FSE) in Argentina recently. That company was on other companies' radar screens, but Yamana had the synergies and we know it pre-empted another company.

We're going to see mostly cash bids. Companies have learned to be cautious about issuing shares, which is good for shareholders. If you can buy incremental production and not get dilution, that's very good for shareholders.

TGR: And these acquisitions can help both the share price of the acquirer and of the acquiree, right?

JD: Yes, particularly when it pays cash. Yamana paid maybe $400M in cash and it still had some $500M left over. It has a mine operating cash flow of more than $1B/year. This was not a major deal. It was a 200 Koz/year acquisition that will fit nicely into its portfolio of mines.

A couple of the stocks we have in the Top 10 are acquisition targets. They're either building a mine or are fully permitted to build. They're turn-key ready, and we expect they'll get acquired.

TGR: Royalty companies make up a good portion of your Top 10. Do you expect there to be more of these?

JD: Not so much more companies, but I do expect the existing ones to get bigger. The way that some of the explorers or want-to-become producers are getting financed is through the royalty companies. Banks will give you financing, but they want hedging. They want to be protected, but the royalty companies will take the risk. They have geologists on staff and they understand the nature of the deposit. They understand the nature of the processing.

"Right now, the numbers show, on average, the gold stock industry is 35% undervalued to where it should be at $1,600/oz gold."

In a sense, when "Miner A" sells a royalty to Franco-Nevada Corp. (FNV:TSX) or Royal Gold Inc. (RGL:TSX; RGLD:NASDAQ), it is hedging it because it is giving up either some portion of its production for a fixed price—that's called a stream—or it is giving up some portion of revenues, like a sales tax on revenues. It's giving up some of the upside. But the market doesn't penalize them the same way that it perceives a hedge being put on by a lender. Companies that need financing are predisposed to want to do a royalty deal as opposed to a bank deal.

TGR: Do you evaluate royalty companies the same way you do a miner?

JD: It's a little bit different. They have much bigger portfolios. The royalty portfolios for Franco and Royal are 20–30 mines. We look much more at how the market, in general, values them on a growth royalty per share basis, and we focus more on their dividend-paying abilities. We run a database of how the market has valued them in the past versus the gold price.

The gold stock sector generally trades between a 10% overvalued and a 10% undervalued range. That's normal. Right now, the numbers show, on average, the gold stock industry is 35% undervalued to where it should be at $1,600/oz gold. That's a screaming buy. The last time it was that undervalued was October 2008.

When the gold market gets lit, the Top 10 will take off. Last time, as I said earlier, we were up 285% in the two years following that market bottom. We beat gold and the XAU gold index by a factor of three or four times in that period of time. We can be cautious, but we're ready. We're primed.

TGR: When the market comes screaming back as you predict, will the large caps or the small caps come back first?

JD: The large caps because big money will be going in. The retail investors in small caps will have been killed unless they've been subscribers and following what we've told them to do. If they've been invested in the junior explorers, such as the Market Vectors Junior Miners that is down 22% for the year, they don't have any money.

It always starts with the big guys. As the big guys start getting fully valued and some enthusiasm comes back into the market, investors start getting greedy and start looking at the lottery ticket stocks. What can I buy for $1/share that might go to $5/share? That doesn't come first because the funds that are going to drive the gold stocks higher aren't interested in lottery tickets. They can't buy enough of them.

TGR: Thank you, John, for taking the time to talk to us today.

An economics professor for almost two decades, John Doody became interested in gold due to an innate distrust of politicians. Success with his method of finding undervalued gold mining stocks led Doody to leave teaching and start the Gold Stock Analyst newsletter in 1994. The newsletter covers only producers or near-producers whose reserves have been verified as economical to produce. It is believed to be the world's only newsletter to have independently audited results, the same as required of mutual funds by the Securities Exchange Commission.

Want to read more exclusive Gold Report interviews like this? Sign up for our free e-newsletter, and you'll learn when new articles have been published. To see a list of recent interviews with industry analysts and commentators, visit our Exclusive Interviews page.

Disclosure:

1) JT Long of The Gold Report conducted this interview. She personally and/or her family own shares of the following companies mentioned in this interview: None.
2) The following companies mentioned in the interview are sponsors of The Gold Report: Primero Mining Corp., Extorre Gold Mines Ltd. and Franco-Nevada Corp. Streetwise Reports does not accept stock in exchange for services. Interviews are edited for clarity.
3) John Doody: I personally and/or my family own shares in all of the companies mentioned in this interview. I personally and/or my family am paid by the following companies mentioned in this interview: None. I was not paid by Streetwise Reports for participating in this interview.