 Gold Mining
Stocks: In Ground Value vs. Market Value
Kenneth J.
Gerbino
Archives
Kenneth J.
Gerbino & Company
Nov 1, 2006
Before I go into the discussion
of the title of this article I want to first cover some other
important points about gold and the gold share market.
The ratio of the mining stocks
(XAU) to the gold price is currently in undervalued territory
as the graph below shows (the higher the ratio the more undervalued
shares are at current gold values). The pullback in the gold
mining sector in September was overdone and a substantial rally
looks like it is underway.
Developmental Companies - Best Bang
for the Buck
Companies developing
mines should experience strong share price increases as they
approach production even with lower metal prices. Gold is approximately
$600 an ounce. Many companies use $325-350 as a guide to take
a mine into production profitably. Gold at $425-450 would make
these mines extremely profitable and $500 gold and above hugely
profitable. Therefore investments in developing mining companies
usually have solid 1-2 year upside potential even if metal prices
decline. One has to have patience with these future producers,
but the upside is usually worth the wait.
Driving The Gold Price
The fundamentals for higher
gold prices are tied to basic economic scenarios. Strong economic
growth increases jewelry demand and the past robust housing market
increased commodity demand in general which helped gold. Currently
the global economy is doing better than expected and will for
the time being help the mining industry and gold consumption.
But the housing market slowing down in the U.S. and consumers
being overextended and cutting back on their buying habits will
slow down the economy. A severe recession is also possible because
of the high debt levels in this economic cycle. A slow down in
the U.S. slows down a percentage of the world's economy. Therefore
oil demand, commodity demand and even jewelry demand will suffer
to varying degrees.
But there are four points that
are not in the above equation:
- Any slow down should be accompanied
by inflation. Recessions with inflation in the past (1974, 1980)
saw gold hit the highest levels in history! Consider these facts:
a) huge long term global money supply increases, b) commodity
prices 200% higher than just four years ago, c) intermediate
and crude goods inflation in the U.S., according to The Department
of Labor has averaged 10.2% annually in the last two and half
years. This will soon show up in producer prices and consumer
prices. This leads to only one conclusion. It is only a matter
of time before consumer prices start to increase sharply. Inflation
is already baked into the cake and all the jawboning by politicians
and economists and financial journalists will not change these
facts and the past inflationary effects they have always had,
including higher gold prices.
.
- Increased gold demand based
on new middle class buyers is global. Slow downs in China from
10% growth to 2% will not stop this trend.
.
- Money supply increases for
six important countries in the last year allow one to envision
even more gold and silver demand: China +15%, India +20.3%, U.K.
+10.8%, Russia +42.5%, France +7.5% Brazil +16.8%. These are
printing presses out of control and many of these citizens will
be gold and silver buyers to protect against this currency depreciation.
.
- The dollar is also vulnerable.
We just experienced the largest quarterly trade deficit in history
and sooner or later the Chinese and Japanese central banks will
have to sell and stop buying U.S. Treasuries which finance our
budget deficits. If foreigners do not buy our debt with their
money then the Federal Reserve would be forced to buy. When
the Fed buys Treasuries it creates new money. More money
issued depreciates the dollar. With inflation already in the
mix, a slowing U.S. economy, and international money flows out
of the U.S., the dollar is vulnerable. This is bullish for gold.
The powers that be, if faced
with inflation, would have to no choice regarding interest rates
as rates must go up with inflation. Rates at very high levels
would bring on a severe stock and bond market retrenchment. This
is what happened in 1974 and 1981. The Fed would then once again
have to come to the rescue. This would mean printing as much
money as is needed to make the nightmare end. We would then go
through the next economic cycle but gold would stay at a much
higher range for that cycle.
Oil and Gold
Oil pulling back affected the
gold market. Linking the price of oil and gold is half correct
because one is energy and the other is money but both are also
commodities so the linking does have some truth to it. For those
looking at this relationship from a commodity standpoint, I give
the following stats from the respected Energy Information Agency
(EIA). The U.S. consumes 3 gallons of oil per day per person.
China consumes .2 gallons per day per person. This is 15 times
less per person in a country with 4 times the population. Doing
the math shows a staggering 60x long-term demand ratio that may
take decades but is now underway as China's economy advances
toward becoming like the U.S. This ratio will also apply to many
other commodities in the years ahead.
Real Value versus Market Value
Mining stocks are notorious
for fluctuating far out of the price range of what a reasonable
value should be. Because of this, investors have a difficult
time making correct investment decisions. The correct valuation
method is to take the estimated resource and figure out only
how many ounces or pounds of minerals or metals will be able
to be recovered. Next, apply a conservative future price to these
metals and then estimate how much capital and how much mining
cost will be needed to dig the metals out of the ground, crush
and grind the rock and then process the crushed rock or powder
and then extract the metal. You have to figure how much debt
and how many millions of new shares must be sold to finance this
whole procedure. After all this you will be left with a multi
- year future cash flow from the project. Discount this future
value back to present time and then you will have a good idea
of what the projects(s) or company is worth.
A reasonable value can be estimated
for many companies. Also future upside can come from higher metal
values and future discoveries and additions to their reserve
base. On the downside is lower metal prices, permitting and engineering
problems and political (country) risk. But if you are already
using $375 to $425 gold as a future price to determine future
profits and you come up with a stock that should be valued at
$15 (at $400 gold in the future) and the stock is trading at
$5, then you probably have a winner. The ideal company shows
that recoverable value in the ground will eventually translate
into value in the market even if gold trades well under $600
in the future. In these types of analyses, a lower gold price
in the end will not even matter. Gold going down to $400 is a
non factor to an undervalued project that will make plenty
of money at the $400 gold in the future. Even a crash in the
gold price for non producing developmental companies can
be offset by substantial profits from the business of
mining the metal. This does not apply to producers. Producers
will be affected by the current gold price. That is why when
owning producers try and own some with future projects in the
pipeline.
The mining sector is not alone
in these illogical pricings by the stock market. Northern Trust
a major financial institution with over $620 billion under management
had this to say about net asset values in real estate and various
closed end mutual funds.
"As with closed-end
funds, it is one of the enduring mysteries of academic finance
how REIT share prices can be so volatile and can pull so far
away from their net asset value (NAV) when this value is firmly
grounded in hard assets"
Gold stock investors can certainly
relate to the above. Therefore don't despair when your stocks
are being sold off by uninformed or scared or fast buck traders
and investors. If you know for sure that the company already
has found the minerals and the engineering studies by the company
or an outside company are positive, then you should be able to
know what the company will be worth in a few years. That number
should be more valid than the short term market value.
Your success in investing in
companies is making sure the cash flow from all the hype and
hoopla in the future years will support a higher share value.
10 million ounces in the ground is meaningless if it is too low
grade or too expensive to mine. A company that will have to sell
a lot of stock and dilute the value of existing shareholders
if it is overpriced already, has nowhere to go but down
even as they become a successful mining company. If they are
already overpriced you better know it.
Mining insiders and people
that study the engineering reports and can make the many calculations
that are necessary to figure all this out are the ones most likely
selling when you are buying or buying when you are selling.
The key to this business is
to find companies that have already found the goods in the ground
and are developing quality and large projects. I am always comfortable
with a three year time frame to production and at least a 3x
return using much lower metal prices and a reasonable multiple
of cash flow. Even if a lot goes wrong - and it usually does
- there is plenty of room for capital gains.
I will be speaking at the New
Orleans Investment Conference [Nov 15-19. 2006] and
encourage you to attend. My speech title is My Four Favorite
Mining Companies that also have $100 million Cash in the Bank.
These stocks should be in everyone's portfolio. They are what
I consider the premier holdings for the next decade. They are
in my opinion "estate builders". My handout at the
conference detailing these stocks could be worth the entire trip.
Also this great Conference has plenty of world class speakers
that are not at other hard money conferences. I hope to see you
there. You can register here.
For other articles on gold
and the economy please visit our website at: www.kengerbino.com.
Ken Gerbino
Archives Kenneth J. Gerbino & Company
Investment Management
9595 Wilshire Boulevard, Suite 303
Beverly Hills, California 90212
Telephone (310) 550-6304
Fax (310) 550-0814
E-Mail: kjgco@att.net
Website: www.kengerbino.com Copyright ©2004-2016 Kenneth J. Gerbino & Company. All Rights Reserved.
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