 Gold
Stock Valuations
Adam Hamilton
Archives
May 7, 2004
FYI: The next essay from
Adam will be published on Sat May 15th
The last few years have probably been the most educational and
eye-opening for investors in the past seven decades. The spectacular
rise, ferocious crash, and devastating bust in general equities
have blessed us with rare front-row seats to witness timeless
financial-market truths in action, lifted right out of dusty
old history tomes.
One of the greatest lessons
learned from the bubble is that valuation is everything over
the long-term. Nothing is more important. If long-term investors
buy when stock valuations are historically
high, they are virtually guaranteed to lose money on their
investments, period.
The wisdom of buying at low
valuations and selling at high valuations forms the very foundational
basis of contrarian investing. Valuation Theory has been extensively
observed and tested for centuries and is the most ironclad and
rock-solid long-term law of the financial markets. Those who
ignore it do so only at their own peril.
While the Great Bear of recent
years has gradually taught general investors that valuations
matter, contrarians have known it all along. Interestingly however,
some of these same contrarians who wouldn't be caught dead buying
companies like General Electric and Microsoft at 30x+ earnings
are buying gold stocks. Unfortunately most gold stocks themselves
currently sport very high valuations, presenting a quandary for
contrarians.
If market history irrefutably
teaches that buying at high valuations is a fools' game, then
why are contrarians willing to buy gold stocks trading at 50x
to well over 100x earnings? Are the gold-stock owning contrarians
being played for fools? Are gold stocks themselves somehow exempt
from the timeless laws of valuation?
As a gold-stock owning contrarian
myself, I don't think contrarians buying gold stocks are degenerating
into starry-eyed slack-jawed conventional investors willing to
buy at any price. At the same time, I am certain that gold stocks
are not exempt from the ironclad financial-market laws of valuation.
So can a gold stock trading
at a conventional bubble valuation above 28x earnings actually
be a good contrarian investment? Yes! This certainly sounds like
a glaring contradiction at first, but the magic of the commodities
markets makes it possible. To understand why, we have to first
contrast conventional and commodities-based businesses.
In any business, a company
sells its product for a profit. The company can increase its
profits by raising the price of its product, increasing the sales
volume of its product, or by lowering the cost of its product.
In today's brutally competitive global economy, often the only
way that most mature companies can grow their profits is by lowering
their costs.
For a conventional business,
raising prices is a very difficult proposition. The higher a
product is priced, the more competition it draws as other companies
around the world seek to carve out a piece of the profits pie.
For example, LCD televisions are expensive now, but their profit
margins are so large that high-tech companies all over Asia are
jumping into the game to manufacture LCD TVs. As these new factories
come online, LCD TV prices and profits will plunge dramatically
in the next couple years.
Increasing sales volume is
also very challenging, as higher sales in mature industries primarily
come from cannibalizing market share away from other companies.
For example, there is a finite market for new computers. If Dell
continues to increase its market share, other companies will
lose. Every marginal computer that Dell sells will be one less
for HP or Gateway to sell. Dell's impressive growth is carved
directly out of its competitors' profits.
Thus lowering costs is often
the only viable option to grow profits in mature industries.
Lowering costs is the primary driver behind outsourcing. If your
company is manufacturing anything in the States, and paying high
American wages, it is just impossible to compete with a factory
in Asia paying Asian wages. Lowering costs can only go so far
though, as the cost of a product will never go to zero no matter
how cheap labor and materials become in some far-off corner of
the world.
Because it is so difficult
for big mature companies in conventional businesses to grow their
profits, high
valuations are seldom justified. A company trading at 30x
earnings today will take a whopping 30 years to earn back the
price investors paid for it if its profits do not grow. And since
it is so difficult to raise prices or increase sales in mature
industries, and since cost cutting can only go so far, earnings
growth in large companies is rarely high enough to justify stellar
valuations.
Now most of the time, commodities-based
businesses feel these same pressures. They have no control over
their selling prices since the free markets set commodities prices.
They constantly strive to lower their costs of production by
becoming more efficient. And they slowly grow their profits by
increasing their sales through higher production. But commodities
producers have one key advantage that blows normal companies
out of the water.
While the prices of normal
products like LCD TVs and computers are never likely to enter
a bull market and go significantly higher, commodities prices
do witness periodic
bull markets. The net effect of these bull markets on the
profits of commodity-producing companies is nothing short of
phenomenal. Commodities bulls enable profit growth in mature
companies that is utterly breathtaking, far beyond anything else
witnessed in the conventional markets!
Gold-mining companies are the
perfect example of this amazing profits leverage inherent in
commodities companies.
In normal stable gold-price
environments, gold miners face the same pressures as conventional
businesses. Prices are out of their control, they can only cut
costs so far, and most profits growth comes out of increased
production. Increasing production means bringing new mines online,
a capital-intensive and slow process that takes years to complete.
Thus, if the gold price is
flat and not expected to rise in the future, buying gold stocks
at bubble valuations over 28x earnings is as foolish as buying
tech stocks at bubble valuations. There is no way that earnings
will grow fast enough to justify excessive valuations so gold-stock
prices are doomed to collapse to return their valuations to historical
norms.
A bull market in gold, however,
changes everything!
In a bull market, gold producers
receive a windfall as the price they receive for their product
climbs. This fantastic event is something almost never witnessed
in conventional mature non-commodities-producing businesses.
As the gold price rises and increases gold miners' profit margins,
both their production costs and production levels remain roughly
the same. The net result is profits multiplying fast enough to
defy imagination.
Our first graph this week attempts
to illustrate this phenomenon. It plots the profits per ounce
earned by a gold-mining company as the gold price climbs higher.
For this example we are assuming a cost of production of $400
per ounce. The rising gold price is shown on the horizontal axis
and the profits per ounce earned on $400-cost gold are shown
by the black line on the left axis.
The rainbow-colored lines,
slaved to the right axis, illustrate the ratio of the increase
in the gold miner's profits to the increase in the price of gold
itself, at different production costs. A ratio of 2x, for example,
means that a gold miner's operating profits are growing at twice
the percentage rate as the increase in the price of gold itself.
Since gold is currently near $400 today, $400 is our baseline
for gold percentage gains in this graph.
Now this graph looks a bit
odd, like some child went wild with crayons, but it is easy to
understand and very important. If you can grasp these key concepts,
you will be able to understand why contrarians are willing to
buy gold stocks at high valuations in a gold bull and still earn
enormous profits on their investments.
In this example, our mining
company can chisel gold out of the bowels of the Earth at an
average cost of $400 per ounce. These costs include the heavy
equipment necessary to mine, the labor to get to the gold, the
fuel and supplies, the depreciation of the enormous up-front
capital investments to sink the shafts, all the administrative
salaries, basically all the costs involved in running a gold-mining
operation. Gold mining sure isn't cheap or easy!
With a $400 cost, our company
isn't doing well today with gold trading under $400. It is operating
at a loss. If we expected $400 gold to persist into the foreseeable
future, then investing in this company would be a foolish decision.
There is no sense buying any stock only able to sell its product
at or below cost. But if the gold price is expected to march
higher in a gold
bull, then this $400-cost company is an ideal investment.
Once the gold bull pushes the
gold price to $425, our company is suddenly able to earn a $25
per ounce profit. It is not much, and depending upon the company's
share price it may have a very high price-to-earnings ratio at
$425 gold. Yet, even if it is trading at 100x earnings, this
is right where contrarian investors want to buy it, when it starts
showing profits in an ongoing gold bull.
Once gold gets to $450, our
miner has now doubled its profits per ounce with zero additional
effort. Its costs are the same, its production is the same, but
the free markets are generously enabling it to sell its product
at a higher price. While gold itself is only up 12.5% from $400,
our miner's profits have doubled to $50 per ounce mined as gold
went from $425 to $450. The profits leverage of an unhedged gold
miner to the price of gold is simply magnificent!
The red line above, tied to
the right axis, illustrates the enormous profits leverage for
a company able to mine gold at $400 per ounce. Point 1, the first
white circle above, shows the profits leverage curve at the $450
level we just discussed. Gold is up 12.5% from $400, but our
miner's profits are up 100%. This 100% increase in profits divided
by the 12.5% increase in gold yields a profits leverage ratio
of 8x at this point. Our miner's profits are soaring at 8x the
rate of the price of gold!
And it gets even better as
gold keeps meandering higher in its bull market. At $500 gold,
our company is able to sell every ounce of gold it pulls at a
$100 profit. While gold is up 25% from $400, our miner's profits
are up 300% from the $425 gold days when it was just squeaking
by. A 300% profits increase divided by a 25% gold increase yields
a profits leverage ratio of 12x, labeled as Point 2 in the graph
above.
Since the profits leverage
ratio multiplies the fastest right after a gold miner becomes
profitable, due to the easy percentage gains from small numbers,
this ratio gradually moderates at a higher gold price. It is
still pretty extraordinary however!
Point 3 on the red curve above
is noted at $600 gold. At this point the gold bull has pushed
gold 50% higher than it was at $400, yet our miner's profits
have increased to $200 per ounce, or 8x as high as they were
at $425. This 700% increase in profits yields a profits leverage
ratio of 14x, very impressive for a mere 50% increase in the
gold price!
The red profits leverage line
is plotted based on a $400 cost of production, but five other
higher costs are drawn above in different colors. These illustrate
the profits leverage multipliers of a higher-cost gold miner
compared to the same percentage increase in gold from $400. We
added these lines because it is really important to point out
that this leverage exists throughout the whole spectrum of a
gold bull, not just the early years when the gold price first
exceeds production costs.
It is interesting, however,
that the slope of subsequent profits leverage curves moderate.
A gold company producing gold at $500 per ounce has a smaller,
but still enormous, profits leverage multiplier compared to a
gold company producing gold for $425 per ounce. While this multiplier
is highest for companies just moving into profitability, it certainly
does not disappear later on at higher gold prices and costs of
production.
Amazingly, a single company
can even witness its profits leverage soar on multiple curves
throughout a gold bull, multiplying its profits even more dramatically.
This is due to the peculiar nature of gold-bearing ore bodies.
At one part of a mine, gold may be economically mineable at $400.
As soon as gold heads north of $400 and the gold company believes
it will stay higher, they can start mining this gold at $400
per ounce and watch their profits head up the red curve.
But at this very same mine,
the other end of this ore body may have gold that costs $450
to mine. Naturally it is silly to mine gold for $450 when the
gold price is $400, so the mining company does nothing. But once
gold crosses $450 and heads higher suddenly a company can add
additional production at $450 that was previously uneconomical.
This extra production at $450 rides the yellow curve higher and
adds to a company's overall profits leverage.
Between the powerful profits
leverage curves as gold rises, the ability to bring on new production
as rising prices make previously uneconomical ore bodies profitable,
and the compounding nature of these subsequent leverage curves,
the ultimate profits growth in gold miners during gold bulls
can be staggering.
During a gold bull a gold miner's
selling prices rise, its costs remain stable, and its production
either remains stable or expands as well if it can mine previously
unprofitable ore. The net result is profits that literally explode
higher in even the most mature and largest of the unhedged mining
companies.
While most mature companies
in conventional industries have zero hopes of seeing their profits
multiply by 10x or more in the space of a few short years, such
events are common for gold miners during a major bull market
in gold. This immense profits leverage rapidly nullifies extreme
valuations in gold stocks. A contrarian can buy a gold stock
trading at 100x earnings in the early stages of a gold bull,
watch his stock price soar, and still end up with a vastly higher
stock at a far lower P/E ratio.
While this concept is pretty
simple, it is still difficult for a lot of hardcore contrarians
to swallow. The idea of buying anything at stellar valuations
is so foreign to the whole realm of contrarian thought that it
just gives some contrarians a nasty headache. To prove that this
theory actually works in the real world, however, all we have
to do is look at Newmont Mining in this gold bull to date.
Newmont (NEM) is the General
Electric of the gold-stock world. It is the world's best and
biggest unhedged gold miner. NEM utterly dominates the blue-chip
gold-stock indices, accounting for 27% of the market capitalization
of the XAU and 16% of the HUI. This monster, also listed in the
venerable S&P 500, expects to mine a phenomenal 7m+ ounces
of gold in 2004.
I have long been a fan of Newmont,
first recommending it to my clients as a long-term investment
in early 2002. It remains an anchor in our long-term gold-stock
portfolio today. As outlined in the latest issue of our Zeal
Intelligence newsletter for our subscribers,
I am also now recommending specific call options on NEM as I
expect it to soar higher in the next major gold upleg.
As this second graph shows,
even the largest unhedged gold mining companies like Newmont
are witnessing soaring profits and plummeting valuations in this
young gold bull. The blue line tracks the daily stock price of
NEM since 2000, when the bull market in gold stocks began. The
red and yellow lines tied to the right axis show monthly data,
highlighting NEM's collapsing P/E ratio and its soaring market
capitalization.
When can a contrarian buy an
elite stock in a mature industry trading at 160x earnings, earn
huge profits during a Great Bear market, and still be holding
the stock today at far lower valuations? In a bull market in
gold! Long live the commodities!
Just as the abstract gold-stock
profits leverage discussion above predicts, as gold marches higher
the valuations on gold stocks collapse. Gold behemoth Newmont
soared from around $13 in late 2000 to $50 late last year, a
magnificent 285% gain during the worst stock market environment
since the Great Depression. Investors in Newmont were richly
rewarded.
Yet, way back in late 2000
and early 2001 when NEM and gold stocks were bottoming, the valuations
on these stocks looked almost as outrageous as the NASDAQ tech
bubble! The red line above highlights NEM's P/E. The best time
to buy, amazingly enough, was when NEM was trading at the ridiculous
level of 130x to 160x its meager gold-bottom earnings!
At the time, gold was in the
process of bottoming and was approaching $250 in early 2001.
Needless to say, it was very difficult for gold miners to earn
profits in this brutal environment. They either had tiny profits
which made their valuations look huge, or they actually lost
money. In NEM's case, it did both. While it had minuscule profits
in late 2000, the 18-month gap above with no red data highlights
a period of time when NEM was losing money and therefore had
no P/E ratio.
Yet, as the gold price marched
higher, gradually NEM's profits leverage multiplier kicked in.
Even though its stock price was relentlessly rising, its valuations
started to fall. By mid-2002, its earnings were back and its
P/E was cut in half even though its stock price was twice as
high as the late 2000 bottoming days. Of course 80x earnings
was still obnoxiously high, but contrarians knew that as the
gold bull powered higher NEM's earnings would only balloon ever
larger.
As its valuations fell for
most of 2003 and 2004 while its stock soared, today NEM is trading
a bit above 30x earnings. Yes, this is still overvalued from
a classic contrarian standpoint, but as the gold bull continues
NEM's earnings will grow rapidly right along with it. Almost
regardless of how high its stock price trades, its P/E is likely
to continue to shrink as its earnings multiply.
In the real world of today's
gold bull, the world's biggest and best unhedged miner witnessed
a massive 285% bull-to-date gain in its stock price. Its market
capitalization, the yellow line, soared by 702% from just over
$2b in 2000 to over $18b in 2004. Yet, its valuation collapsed
by 81% from trading at 160x earnings when the gold bull began
to just over 30x earnings today. Wow.
These amazing results are due
to the profits leverage multiplier of gold mines in a gold bull
market. And if a massive market leader like Newmont can witness
this phenomenon even at its vast scale, imagine how much more
powerful the leverage is for smaller gold-mining companies. Generally
the larger a company the more difficult it is for the markets
to bid its share price higher, so NEM really is the most conservative
example possible to illustrate the valuation wonders inherent
in a major gold bull.
So, during a gold bull market,
contrarians can buy gold stocks at valuations that seem irrational
and still earn huge profits. A rising gold price grows profits
far faster than most gold-stock prices can rise, shrinking valuations.
Because of the powerful nature of the gold-miner profits leverage
multiplier, contrarians can even ignore gold-stock valuations
altogether if the gold price is expected to head significantly
higher, like today.
The primary caveat I have regarding
gold stocks is to please realize that this profits leverage applies
only to unhedged miners. Avoid hedgers in a gold bull like the
black death!
Hedged miners have already
locked in a future selling price for their gold, so even if the
gold bull continues higher they cannot sell their gold at higher
prices. Their contractual obligations keep them from participating
in the gold bull and their share prices suffer accordingly. If
you would like more background on this crucial distinction, please
check out my "Gold
Stock Investing 101" essay of a couple years ago.
As I have advised my subscribers
in recent newsletters, high gold-stock valuations are no reason
to avoid buying unhedged gold stocks during a gold bull. Gold
miner profits usually multiply far faster than gold share prices
and valuations are reduced over time even as stocks power higher.
In the latest May issue of
our monthly Zeal
Intelligence newsletter just published, I even outlined my
six favorite gold and silver stocks for the next major upleg
in gold. Subscribe
today or be left behind when the current fantastic buying
opportunities evaporate.
As contrarians have always
known, valuations do matter. But in the peculiar situation of
a major commodities bull market, P/Es of commodities-producing
companies plummet as their profits soar. High valuations are
very common at major commodities bottoms since the producing
companies are barely getting by, but once commodities prices
recover their earnings and stock prices soar at the very same
time their valuations collapse.
Don't let high valuations scare
you away from investing in commodities producers during a commodities
bull.
May 7, 2004
Adam Hamilton, CPA
email:
zelotes@zealllc.com
Archives
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