3 Ways to Profit from Precious Metals Mining

Gold and silver have appreciated about 30% and 130%, respectively, in the past year. Given the returns, a pullback or correction in precious metals-related stocks would not be surprising. However, should the rally in precious metals continue to have legs, I have three mining stocks that can deliver big gains for investors.

Precious metals prices are driven by a variety of factors. About 10-15 years ago, when gold hovered around the lows of $250-$300/oz, prices were driven to a large extent by central banks, which were selling the yellow metal, and the hedging programs of the large gold-mining companies. Very little of gold's price fluctuations had to do with investment demand. Importantly, while there were geopolitical and financial concerns at the time, the problems did not appear particularly daunting.

Fast-forward to today and the situation is much different.

There are multiple revolutions in the Middle East, three military conflicts involving the United States, the major world economies carry enormous debt burdens and exchange-traded funds (ETFs) that have sparked investment demand for precious metals worldwide. The combination of uncertainty and the ability of retail investors to efficiently invest in metals may give the rally in precious metals legs for some time to come. If this is the case, there are three stocks that can help drive investor returns.

1. First, Newmont Mining (NYSE: NEM) can be viewed as an "investment grade" holding. As the only gold miner in the S&P 500 and a market capitalization of more than $28 billion, Newmont is a conservative approach to investing in the sector. The hedging program means the company is not levered to the price of gold, but will participate in price increases. Further, with a new policy that increases the dividend$0.05 for every $100 rise in the company's average realized gold sales price of the previous quarter. In a way, this represents a natural hedge against inflationwith participation in upside movement in the metal's price.

2. Silver Wheaton (NYSE: SLW) contrasts sharply with Newmont Mining. Silver Wheaton is not a mining stock per se, but rather a silver-streaming company. The company contracts to acquire silver at fixed prices from mines that produce the metal as a byproduct to their main mining activities. For investors, the business model has two significant implications. First, because the company does not mine silver, there is no exploration risk. Secondly, with silver acquired at fixed contractual rates, earnings are highly sensitive to the street price of silver. This provides a lot of leverage in the stock when the price of silver moves either up or down.

3. Lastly, the CMP Gold Trust (CMP-UN.TO) is a fund trades on the Toronto and on the pink sheets in the United States. CMP offers investors the ability to buy a portfolio of mostly junior explorers at a steep discount of about 30%. The discount to net asset value (NAV) and the portfolio approach to investing mitigate some of the substantial risks associated with investing in small mining companies. The discount also helps compensate for the very heavy hedge-fund like fees charged by management.

The profit opportunities with smaller mining companies can be substantial. Valuations often increase along with the price of metals, just like the large miners, but more dramatically. Additionally, smaller companies are frequently exploration-driven. New deposit discoveries and resulting buyouts from larger firms looking to build reserves are key drivers of the stock prices. These events give small mining stocks the characteristics of catalyst-driven special situations. Simply put, this means that investors in CMP can potentially profit irrespective of the price direction of gold if companies in the portfolio make discoveries and are purchased by larger players.

Action to take --> Precious metals and companies that mine them may still offer attractive returns going forward, despite the strong rally. That said, it always important for investors to pay attention to the risks posed by any stock or fund. Each of the three mining-related securities above offers a different risk/reward profile, from the more stable Newmont to the levered price action of Silver Wheaton and event-driven CMP.