Gold
Stock Valuations 2
Adam Hamilton
Archives
Apr 7, 2006
With gold challenging $600 this week and the HUI achieving new
all-time highs, gold stocks are on a lot of investors' minds.
I have certainly been pondering them too while enjoying their
latest dazzling upleg.
A few weeks ago I wrote an
essay on commodities
bull portfolio design, how both investors and speculators
can build custom stock portfolios that minimize their risks while
maximizing their chance to reap enormous profits over the course
of this commodities bull. This essay was an introduction to our
April newsletter,
which discussed dozens of elite commodities-producing stocks
that fit into the various layers of my pyramid portfolio model.
After two solid weeks of reading
10-K and 10-Q reports that a broad array of commodities producers
recently filed with the SEC, something about gold stocks struck
me between the eyes like a sledgehammer. As I was searching for
awesome opportunities my research took me into all major sectors
running from precious metals to base metals to energy. Thus I
had the chance to compare gold stocks with other commodities
producers.
Unfortunately every single
gold stock I looked at was trading at a high to extremely high
valuation, if it was even managing to earn profits at all even
with today's surging gold prices. I found this disturbing on
multiple fronts.
First, for long-term investors
there is nothing more important than valuation,
the price at which a stock is purchased relative to its earnings
power. While buying high is sometimes rewarded with a higher
selling price later, especially in a powerful secular bull market,
the ultimate odds of success when buying high are far worse than
those when investors buy at low valuations. Market wisdom admonishes
us to buy low and sell high, not buy high and hope to sell to
a greater fool.
Second, since gold is up 130%
bull to date shouldn't gold stocks be expected to be earning
massive profits? Most of the gold companies that investors and
speculators salivate over today were around in the lean years
of sub-$300 gold in the early 2000s. Back then they had to have
their costs under control in order to survive and they should
have kept those costs managed so they could thrive with the surging
gold price.
The primary reason commodities-producing
stocks are awesome investments during a commodities bull is that
profits usually grow far faster than their underlying commodities
prices rise, their leverage
is immense. Four years ago I wrote about gold-stock
leverage and back then I was awestruck by gold stocks' potential
to multiply their profits tremendously. If gold stocks aren't
now exhibiting this leverage, is there something wrong with them?
The problem of low gold-stock
profits relative to their soaring stock prices is nothing new.
Gold stock valuations have been high for this entire bull. Two
years ago I wrote an essay on this phenomenon, but up until that
point gold stock valuations were generally contracting.
Thus at the time my thesis was that higher gold prices would
lead to much higher profits which would drive down the stellar
gold stock valuations.
Unfortunately the last two
years have proven me very wrong. Gold producers, for whatever
reasons, can't seem to manage to mine their gold at respectable
profits despite today's higher gold prices. If, like me, you
have a big chunk of your investment capital deployed in gold
stocks, this is a critical issue to address. While I don't have
the answers yet, I am writing this essay to delve into the gold
stock valuation issues we face today.
I think the most logical place
to start is with a chart update from my original gold
stock valuations essay. Since historical stock valuation
data is difficult if not impossible to find, I used Newmont Mining
as a proxy for gold stocks as a whole. NEM is the world's premier
major gold producer and has been a long-time favorite of gold
investors. Up until recently, when competitors' mergers created
a larger gold miner, NEM was the largest gold producer on earth.
The only reason we have this
NEM valuation and market capitalization data is because NEM has
been an S&P 500 component for this entire gold stock bull.
At the end of every month we collect and crunch valuation data
for every S&P 500 company in order to calculate the multiples
at which the general stock markets are trading. This valuation
data is published in our newsletter and charted in a private
area on our website for our subscribers. Thankfully this exercise
left us with all the necessary NEM data.
Newmont is definitely the most
important player in the gold-mining world. This week it alone
accounted for 28% of the HUI and 19% of the XAU by market capitalization.
The blue line above is Newmont's closing stock price, which is
up a very impressive 377% bull to date. Compare this performance
since 2000 of this elite blue-chip gold with the sideways trading
or plunges in elite blue-chip general stocks over this same period
of time and you can readily see why gold stocks are so loved
today among contrarians. They are making us rich.
On an interesting sidenote,
check out the yellow market capitalization line above. This shows
the total outstanding NEM shares multiplied by its stock price,
or the total value the markets assigned to this company. Starting
near $2.5b it has grown an incredible 1067% to nearly $27.5b
recently. Why did its total market value growth dwarf its stock-price
gains? A dirty word, dilution.
Like all big companies NEM
constantly issues new shares for various things ranging from
paying for acquisitions to paying stock compensation for its
management. Over time this dilutes existing shareholders. If
total shares outstanding grow by 10%, for example, your stake
is worth 10% less even though you still hold the same number
of shares.
Dilution is to a stock exactly
what inflation
is to fiat-money supplies. The more shares issued the more the
value of your own stake erodes. Dilution is a little-watched
but hugely expensive cost we investors must bear. And while NEM
is by no means bad in this regard compared to other large companies
like tech stocks, this chart really illustrates how issuing more
stock can decimate gains over time. Two-thirds of NEM's total
gain in market value over the past five years has been lost to
investors due to it issuing so much new stock.
Back to the task at hand, the
reason I updated this chart was to see the red line, which is
NEM's price-to-earnings ratio plotted on a monthly basis since
the genesis of this gold-stock bull in November 2000. This trend
was very favorable for several years but then about two years
ago it reversed to an unfavorable direction. For two years now
my thesis that gold stock valuations would contract has been
disturbingly incorrect, despite gold soaring about 50% from $400
to $600.
It all started back in November
2000, when NEM was trading at 126x earnings. To put this into
perspective, during that same month Cisco Systems, the most notorious
bubble stock of the tech mania, was still trading at 134x earnings!
Thus contrarian investors like me who wouldn't
touch the radically overvalued tech stocks with a ten-foot
pole believed gold stocks offered a stunning opportunity despite
their similar valuations.
Why? Unlike the tech giants,
the gold stocks had a product that was just ending a multi-decade
bear and likely to enter a secular bull. While Cisco may not
be able to sell all the routers it manufactures if someone else
makes a better one, gold miners have a guaranteed global market
to sell every ounce they can wrest from the bowels of the earth.
And if they could survive just above $250, they would thrive
and their profits explode as gold started climbing higher into
its first secular bull in decades. Gold stock valuations were
destined to contract dramatically.
Since gold bottomed about six
months after gold stocks in April 2001, NEM's valuation ballooned
to 160x in early 2001 as its ability to earn profits was stretched.
But soon its valuation started contracting. While I wasn't really
looking at gold stock P/Es back then and didn't notice at the
time, NEM's valuation broadcasts then went black. The stretch
from early 2001 to mid-2002 in this chart without data is a long
period of time when NEM lost money.
The world's largest gold miner
started earning money again by mid-2002. It wasn't a lot of money,
the company was still trading at a stellar 82x earnings, but
it was still far lower than its valuation top at 160x. Because
gold rose from roughly $255 to $315 over this period, NEM cut
its valuation in half even while its stock price more than doubled.
Its profits were growing far faster than its stock price which
is how things ought to be in a secular gold bull.
Over the next couple years
into mid-2004, this favorable trend continued. NEM's stock price
powered higher to a once unimaginable $50 but all the while its
profits were growing much faster so its valuation continued contracting.
By early 2004 its valuation had contracted 81% to 31x earnings.
While still overvalued, this progress was tremendous and the
downtrend was perfect. I was glad to see this when I wrote my
original essay two years ago.
But soon after this something
happened which does not please me. NEM, and indeed gold stocks
in general, started to see their profits slip or at least rise
slower than their stock prices. Valuations started expanding
again, and this from levels that were high to start with compared
to stock-market history. If this trend was only a month long
I wouldn't care at all, but after two consecutive years of expanding
gold stock valuations I have to be concerned.
During NEM's latest massive
upleg from $35 to over $60 in this past year, the company's valuation
soared from 37x to 75x earnings! I knew its valuation was high,
but gold stocks rise with gold and gold was blasting its way
higher into bull-to-date virgin territory so I bought and recommended
extensive NEM call options trades. Our realized profits on these
NEM calls ran from 100% to over 700% with an average realized
gain of 206% over 11 separate trades.
The reason I highlight our
latest NEM calls campaign is to show how bullish I have been
on this company, in terms of risking my own capital as well as
my reputation by recommending these trades to our subscribers.
I have been a huge NEM fan for many years and I will continue
to be. It remains the best major gold miner on earth and the
bluest-chip gold. So I am approaching its continuing high valuations
not as a hostile critic, but as a long-time friend who is concerned.
At this point in our journey
an obvious question emerges. What if NEM's stellar valuation
is due to company-specific issues? What if NEM really does not
represent gold mining as a whole despite its leadership position?
This thesis is easy enough to check. All we have to do is look
at all the elite blue-chip gold stocks that comprise the flagship
gold stock indexes, the HUI and XAU. These are like the NASDAQ
100 of the gold stock world.
This table shows the P/E ratio
and market capitalization for every HUI and XAU component as
of this past Wednesday. Stocks that are highlighted in yellow
indicate companies that are components in both indexes. There
is a lot of overlap here as there really aren't that many larger
gold miners around. For a comparison I will develop a little
later, the XOI oil stock index is also included. Unfortunately
this HUI and XAU data shows the gold stock overvaluation is sector
systemic and not NEM's issue alone.
OK, if you fancy yourself a
contrarian value investor at heart who happens to love the vast
potential of gold stocks in this ongoing commodities bull, this
table is going to feel like a swift kick in the teeth with steel-toed
boots. If I wasn't a battle-hardened speculator I probably would
have cried when I first saw it. Nevertheless this data is very
real and can be verified in minutes. The entire gold stock sector
is radically expensive!
Out of the 15 stocks that comprise
the venerable HUI, the blue-chip golds, fully 7 are losing money
today despite gold challenging $600! Isn't this strange? And
of the remaining 8 that can somehow manage to mine gold at a
profit today, their average P/E ratio is a staggering 78x, even
higher than NEM's. If you don't feel sick enough yet, FCX is
a primary copper miner which is the only reason its P/E is under
fair value. If FCX is excluded, the average profitable HUI gold
producer's P/E soars to 87x! Ouch.
And the larger XAU, which includes
more big gold miners since it accepts hedgers, isn't looking
much better. 7 of its 16 components are losing money in today's
awesome gold and silver environments too. The remaining 9 companies
are averaging a wickedly high P/E of 74x earnings. And if the
same primary copper miner that is also found in the HUI is excluded,
the average XAU P/E rockets to 82x. This is systemic.
As I examined this table in
stunned silence this week, another irony leapt out at me. You
folks who have been around this bull awhile certainly remember
Barrick Gold, ABX, the notorious mega hedger. Four or five years
ago this company was the evil empire among hardcore pro-gold
investors. Many people including me spoke out against ABX's irrational
hedging program which was hindering the gold bull's progress.
There was a time not too long ago when this company couldn't
have been more loathed even if it was sacrificing babies to Molech.
Interestingly out of all the
world's largest gold miners, ABX now has the lowest valuation
at 39x earnings. This is still high, but it is only about half
of the average these days. ABX has been reforming itself and
reducing hedges in recent years, but it is still not viewed favorably
by the lion's share of gold investors due to its past deeds.
It struck me as ironic that the black sheep of the gold major
world now has the lowest valuation. Will wonders never cease?
Now all these gold stock overvaluations
could at least be rationalized if similar phenomena were being
witnessed in other major commodities stock sectors. But this
isn't the case. The XOI oil stock valuation data in this chart
shows that major oil stocks have average P/Es that are dirt cheap,
around 9x earnings. Oil stock profits have climbed far faster
than oil stock prices so oil stocks are unbelievably good deals
today. Oil stocks are doing what gold stocks should have done
in the past couple years.
While hardcore students of
history and money will always understand how unique and important
gold is, it will be difficult for the gold stock world to capture
the attention of mainstream investors if its valuations remain
higher than tech stocks. Value investors especially, who control
enormous pools of capital, are going to want to buy the fundamentally
cheap energy or base metals producers as opposed to the fundamentally
expensive gold producers.
Scott and I have been discussing
and pondering this gold stock valuation anomaly relative to other
commodities stocks sectors and have some ideas. While I'm certainly
not convinced that any of these adequately explain why gold stocks
are extremely expensive while oil stocks are ridiculously cheap,
I share them to hopefully advance research and debate on this
crucial issue.
The first clue may lie in the
nature of the respective bulls. Gold is only up 130% bull to
date, which is one of the poorest performances of any major commodity
in this broader bull. Meanwhile oil is up 300% since 2001, it
has quadrupled.
And in real terms, gold remains only about 27% of the way to
its all-time inflation-adjusted highs of $2200
per ounce. Meanwhile oil is about 70% of the way to its own all-time
real highs just under $100
per barrel.
These very different bull profiles
have left gold stocks with a far smaller gain to profit from
than other commodities producers like the oil stocks. While the
gold bull is chronologically older than most of the other major
commodities, in terms of distance traveled higher it remains
young. Perhaps when gold has ultimately quadrupled to over $1000
gold stock valuations will fall under fair value just as the
oil stocks' valuations have. The higher a commodity price moves,
the more amazing its producers' profits leverage becomes.
And in some ways gold is harder
to mine than oil is to pump, which contributes to gold miners'
higher relative costs. For example, a major oilfield can last
for decades while a major gold mine will often be depleted in
only one decade. Thus gold miners must always be exploring for
and developing new mines, an extremely expensive process. Scott
recently calculated that the elite HUI gold miners only have
reserves equivalent to about 17
years of production. I suspect, on average, that oil stocks
have reserves running several times farther out in time.
And while oilfield construction
is largely finished once the primary wells are sunk and the pumps
and pipelines built, gold miners have to keep digging and constructing
their mines for their entire useful lives. Most gold mines today
are giant holes in the ground where a vast amount of rock must
be blasted, hauled, and crushed to extract a relatively tiny
amount of gold.
While I am not an engineer,
I suspect the ratio of capital-required-to-revenue-generated
for gold mining is higher than that of oil pumping. And the gold
companies are utterly tiny compared to the oil companies, so
the gold companies have to spread these costs out over far smaller
operations and they do not enjoy the enormous economies of scale
that the giant oil companies command. If you look at the market
caps in this table, there are only a handful of gold stocks that
even come close to the size of the smallest elite oil stocks.
There are likely sentimental
and technical reasons why gold stocks are priced so high compared
to other commodities stocks too. The gold bull has been running
the longest in time and hence has had many years to win over
investors. These investors only have a handful of gold stocks
from which to choose so their prices have all been driven way
higher into overvalued territory by the flood of capital.
Despite this, the gold stock
sector remains very small. The entire HUI was only worth $86b
this week. For comparison Google alone was trading at a $122b
market cap! Since gold stocks are such a tiny sector it doesn't
take a lot of capital to generate fast price surges. The less
a company or sector is worth, the higher and faster its price
can be multiplied by new investors. The XOI, by comparison, was
worth a gargantuan $1404b. Since oil stocks are so huge they
haven't been driven as high as gold stocks relative to earnings.
And lest you fear I am making
the case that oil stocks ought to replace gold stocks, which
is not true, consider the following chart. The XOI is only up
178% bull to date, over the past 36 months. Meanwhile the HUI
is up 867% over the last 64 months. Gold stocks have run far
higher and farther than oil stocks which should explain some
of their high valuations. Gold stock investors have been far
more richly rewarded than oil stock investors.
There's really not a lot to
add to the story this chart so clearly tells. The gold stock
bull is vastly larger and nearly twice as old as the oil stock
bull. And despite all of these fantastic gains, the entire gold
stock sector remains smaller than most of the major individual
companies in the oil or tech sectors. Thus a given amount of
investor capital pouring into gold stocks in the future will
generate much greater gains than the same amount of capital entering
larger sectors.
So this issue of gold stock
overvaluation, while critical for commodities-stock investors,
remains complex and multi-faceted in its implications. A gold
stock investor buying a major gold stock at 70x earnings is accepting
far higher risks than an oil stock investor buying a major oil
stock at 10x earnings. The higher the valuation of a company,
the greater the downside price risk it faces if its primary commodity
corrects.
But at the same time, with
this much higher risk comes much higher potential rewards. Smaller
companies like the golds are much easier to drive higher and
multiply than larger companies like the oils. In addition, profits
leverage on future commodity price increases is greater the lower
profits currently are. Since the golds are all unprofitable or
barely profitable today, they have enormous potential to see
huge profit increases as gold continues higher.
This principle is easily illustrated
with two hypothetical gold companies. Company A is only earning
$1 of profits today per ounce of gold mined and has a ridiculously
high P/E. Company B, on the other hand, is earning $100 per ounce
mined and has a low P/E. While Company B is a safer investment,
Company A has much higher potential due to the mechanics of profits
leverage. If gold rises $100 per ounce, Company A's profits skyrocket
from $1 to $100, a 100x gain. Meanwhile Company B's profits just
double from $100 to $200. Thinner margins today always mean higher
profits leverage potential in the future.
So what's the bottom line?
Gold stock valuations remain disturbingly high, far beyond any
other major commodities sector. This means gold stocks are far
riskier investments than cheap energy or base metals stocks.
Thus even hardcore gold stock investors ought to seriously consider
diversifying into other major commodity producing stocks with
low valuations. Gold and silver are great, but oil, gas, uranium,
copper, zinc, nickel, lead, molybdenum, and other commodities
are also making great gains and their producers' stocks are thriving.
In our current Zeal
Intelligence monthly newsletter just published, I discussed
dozens of elite commodities stocks for long-term investors. It
is prudent to have commodities-stock exposure covering a wide
array of specific commodities rather than having all of your
precious long-term capital at risk in a single commodity.
Please subscribe today and build your own custom commodities-bull portfolio!
First-time electronic-edition subscribers will receive a complimentary
copy of this issue, your paid subscription will start in May.
While gold stock valuations
are at disturbing levels, I still believe their earnings can
soar as gold's bull continues higher and starts to catch the
gains of other major commodities. Gold is totally unique among
all commodities, the ultimate safe investment, and global demand
for it should continue to climb along with this general commodities
bull. No other commodity in history has been so favored by investors
and no other commodity even approaches gold's ideal investment
properties.
And only one small group of
companies can produce this gold. Regardless of their valuations,
gold stocks control the world's fresh-mined gold supply and investors
will continue to buy them. While they would be more comfortable
and less risky to buy at low valuations like the rest of the
commodities stocks, even at today's levels they have great long-term
promise since there is no other source for new gold.
Adam Hamilton, CPA
April 7, 2006
Thoughts, comments, or flames? Fire away at zelotes@zealllc.com. Due to my staggering and perpetually increasing e-mail load, I regret that I am not able to respond to comments personally. I will read all messages though and really appreciate your feedback!
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