 Gold Stock Valuations
4
Adam Hamilton
Archives
May 18, 2007
This week the International
Monetary Fund, which has long commanded the world's third largest
official holding of gold bullion, once again made some noise
about selling 400 tonnes of its gold. Such a sale would represent
about an eighth of the IMF's total holdings, and as usual such
tidings spooked the markets.
So far in its secular bull,
gold has climbed 181% higher since April 2001. Interestingly,
the IMF has been periodically announcing that it is considering
gold bullion sales over the majority of this entire six-year
span. The recurring threat of IMF gold sales is just another
brick in the great wall of worries that gold has handily overcome.
The old market aphorism that
"all bull markets climb a wall of worries" couldn't
be more true for gold and gold stocks. Whether it is IMF sales,
other central-bank machinations, allegedly declining investment
demand, or whatever, a myriad of worries plaguing every step
of the way higher has been par for the course in this bull.
For every dollar higher that
gold has climbed since $257, countless worries argued against
its progress. And the same remains true today. Yet the hardcore
contrarians know that fear is nothing to fear, indeed it is bullish.
The real time to worry in a bull market is when no one else is
worrying, when widespread euphoria reigns. And gold is about
as far from euphoria today as the east is from the west.
So this week as skittish gold-stock
investors panicked for the umpteenth time this year, doing their
best Chicken Little imitations despite gold remaining encouragingly
strong in the mid-$600s, I was looking at gold-stock fundamentals.
While you certainly wouldn't know it thanks to some of the worst
gold-stock sentiment yet seen in this bull, today's gold stock
fundamentals are actually the best we've seen so far.
Fundamentals are crucial for
stock investment because they ultimately drive stock prices.
While sentiment-driven trading dominates over the short term
and can batter stocks all over the place temporarily, in the
end fundamentals will dictate their fate. Operating profits are
the primary fundamental statistic of interest, and all throughout
stock-market history all over the world stock prices eventually
follow their underlying profits.
Contrarian investors like Warren
Buffett know this well, seeking to buy companies that are trading
at low stock prices relative to their earnings. Buying low P/E
stocks in growing businesses is one of the surest ways to achieve
great long-term success in the stock markets because stock prices
will rise to reflect high earnings sooner or later.
But unfortunately for the contrarian-oriented
gold-stock investors, gold stocks have never been cheap relative
to their earnings in this bull market. Even though the HUI unhedged
gold-stock index has soared nearly 1000% higher since late 2000
and earned fortunes for early investors, we never had a chance
to buy in cheap. In fact, during those ugly bottoming months
in late 2000 and early 2001, gold miners were barely earning
any profits at all.
While time has indeed proven
it to be the correct strategy in hindsight, why did anyone buy
gold stocks in the early 2000s at valuations higher than the
bubbly tech stocks? Because during secular commodities bulls
the inherent profits leverage in mining commodities leads to
profits rising much faster than stock prices. Thus a gold stock
purchased in 2000 at 150x earnings could have seen its price
go 10x higher since then yet simultaneously have seen its P/E
ratio plunge to 25x due to stellar profits growth.
This thesis that had to be
taken on faith six or seven years ago is proving true in reality
today, and it is very exciting to see! Even over this past year,
when gold has been largely flat, tremendous progress has been
made in gold stock valuations. While gold stocks aren't yet cheap
in a classic contrarian sense, they are certainly trending in
this direction.
Unfortunately valuation data
is little-analyzed because it is so hard to find. Very few analysts
bother tracking it, especially in a relatively obscure sector
like gold stocks, on an ongoing basis. Although I don't have
historical valuation data on all the gold stocks in the major
gold-stock indexes, I do have monthly valuation data for one
key elite blue-chip gold stock over this entire bull to date.
It is as good of representative as any for its sector.
This stock is Newmont Mining,
which was the world's largest gold miner for much of this bull
market. It was the biggest and most liquid gold stock for years
and dominated the HUI in terms of weight. Today it is the world's
second-largest gold producer and largest unhedged gold miner.
We only happen to have NEM valuation data because it is an S&P
500 component, and we've long tracked general stock-market valuations
every month.
This first chart shows Newmont's
price-to-earnings ratio superimposed over its market capitalization
since this gold-stock bull began. I've seen this same pattern
in many other gold and commodities stocks. They entered their
bulls with pitiful low values in the marketplace and meager earnings
which drove ridiculously high P/Es. Yet as their values climbed
and multiplied many times over, their valuations still fell on
balance.
Investing in a secular bull
sector where stock prices rise dramatically but still become
better values over time is the best of all possible worlds. Gold
stocks in today's bull market are going to be a textbook case
of this relatively rare phenomenon that will be studied for decades
to come.
Newmont was a beaten-and-left-for-dead
little company back in late 2000 with a trivial little $2.3b
market cap. Meanwhile it was trading between 125x to 160x earnings,
valuations higher than most of the tech darlings at the top of
their own bubble. It took a maverick contrarian to buy the world's
biggest gold miner back then when its prospects looked so bleak
and its fundamentals so atrocious.
But this is the magic of a
secular commodities bull. Unlike almost everything manufactured,
commodities are very difficult to wrest from the bowels of the
earth so their supplies cannot respond rapidly to price signals.
Prices can trend higher for a couple decades before supply and
demand imbalances are totally rectified. So if you believed gold
was on the cusp of a major bull market six years ago, buying
battered-down gold miners was not a difficult decision.
Since those early dark-yet-opportunity-filled
days, Newmont's market capitalization has soared 1067% higher!
Now I have to note that NEM issued stock to make acquisitions
during this time, so shareholders have not reaped this entire
market-cap gain. But the raw stock-price gains have been excellent
too, 388% trough to peak. Outside of the commodities-stock realm,
I think you'd be hard-pressed to find a sector-leading stock
that performed so well over a seven-year period where general
stocks were largely dead flat.
Now typically when a stock's
value multiplies nearly 12x higher over just a matter of years,
its valuation will rise too. In the initial six-to-seven years
of the general-stock secular bull in the 1980s, for example,
valuations roughly tripled. Yet Newmont Mining is not trading
at bubblicious 480x earnings levels today. If it was, even the
most rabid gold bulls would shy away from buying it.
Despite its huge gains in market
capitalization and stock price, Newmont's price-to-earnings ratio
has contracted by a radical 85% since early 2000! Today it is
only trading near 28x earnings, not too far above the S&P
500's 20x levels today. This illustrates the marvelous profits
leverage inherent in mining scarce commodities. In a rising commodities-price
market, usually mining profits growth will far outpace mining
stock-price appreciation. Despite huge stock-price gains, valuations
decline over time.
Now admittedly this 1067% market-cap
growth and 85% P/E decline are from best-case points for each
series of data. But even if we ignore the best case and just
look at the bull to date today, this trend is still immensely
powerful. As of now NEM's market cap has risen 722% since late
2000 yet its valuation has still fallen 85% despite this gain.
There is no doubt the initial gold-stock-bull valuation thesis
was wildly correct.
Although I only have comprehensive
historical valuation data for Newmont, in recent years we have
started collecting broader gold-stock valuation data. The trend
towards gold stocks earning far higher profits that drive valuations
down while their stock prices simultaneously climb is accelerating
tremendously with today's higher gold prices. The mid-$600s that
spooked the milquetoasts this week have been a great boon for
gold miners over this past year.
These next two tables show
valuations and market capitalizations for all of the elite gold
and silver stocks of the flagship HUI and XAU gold-stock indexes.
Stocks that are common between both indexes, and there are many,
are highlighted in yellow. In addition the XOI oil-stock index
metrics are included for comparison's sake. The first table shows
valuations early last April, when I wrote the second iteration
of this thread of research, and the second table shows valuations
this week.
Between these relatively close
(in a secular sense) points in time, the profits growth in the
elite blue-chip gold miners has been staggering. Gold stock fundamentals
have never been better in this bull market, there is no doubt
about it.
Carefully examine the HUI and
XAU component valuations in both tables and marvel at how gold
stocks' earnings are rapidly growing into their prices. And realize
that the HUI was only 6.5% lower the day the second table was
made compared to the day of the first. With the HUI essentially
flat, the profits growth in the elite gold miners is all the
more stunning. This is incredibly bullish fundamental news.
Check out the generally high
P/E ratios as well as all the blank spaces, which indicate no
earnings. Last April when folks were getting euphoric about gold,
gold-stock fundamentals were certainly nothing to write home
about. Now compare these mediocre results to this week's impressive
metrics.
While the gold stocks aren't
yet classical contrarian bargains like the unloved oil stocks,
they are getting a lot closer. Between the HUI and XAU, they
contain 20 elite gold miners. A year ago, fully 50% of these
companies couldn't earn any profits. Today this number has dropped
to 10%. Also a year ago, of the half of the stocks earning profits,
60% had P/Es over 50x earnings. Today only 17% of the profitable
companies sport such crazy P/Es.
Over the past year, the simple-average
P/E of the HUI has plunged 62% despite just a 6.5% decline in
the HUI itself. While the headline XAU only fell 7.3% between
these two data points, its own simple-average P/E has fallen
50%. These are stunning improvements in valuations over such
a relatively short period of time. They prove that the gold miners
are finally starting to earn some real profits in this gold bull.
Since simple-average P/E calculations
for stock indexes are easily skewed by extreme outliers, I have
long preferred to compute composite index P/Es by using market-capitalization
weightings. This way a tiny company with a crazy P/E cannot influence
the overall index P/E anywhere near as greatly as it would in
the conventional simple-average approach. The market-capitalization
weighted-average P/Es of the HUI and XAU show similar dramatically
positive results.
Last year, the HUI had a MCWA
P/E of 35.2x. Today it has fallen to 23.2x, a 34% decline! Provocatively
this compares very favorably to the S&P 500's 20.3x and NASDAQ's
32.5x current MCWA P/E ratios. It is incredible to realize that
gold stocks as a sector are a much better fundamental bargain
today than tech stocks! Who would even have entertained such
a heresy a year or two ago?
The XAU's MCWA P/E has fallen
30% to 22.6x, which is again competitive with other sectors of
the general stock markets. As a gold-stock investor and speculator
over this entire bull I can scarcely believe my eyes, but finally
after believing in a controversial thesis for years with little
confirmation gold stocks' earnings are really growing into their
stock prices. Gold stock valuations are finally reasonable!
There are a couple more specific
observations of interest on these tables. First, note how small
the gold miners generally are in market-cap terms today despite
the HUI's nearly 1000% run higher since late 2000. Together all
20 of these elite gold stocks are only worth $149b today. To
see how small this is compared to other sectors, check out the
massive oil stocks' market caps. The combined market cap of the
13 XOI companies is almost 12x larger than that of the 20 HUI/XAU
companies.
These tiny gold-stock market
caps, despite us being seven years into their bull market, show
how far we still have to run in a secular sense. They also show
how fast gold stocks will move when more mainstream investors
get interested in their fortunes. The smaller a sector is in
terms of its market-cap footprint, the faster and higher it will
go if a given amount of capital bids on it. There is still not
much room in the entire gold-stock sector for serious capital,
so mainstreamers will face a bidding war when they catch on to
the gold bull.
Second, note that the HUI and
XAU both contain Freeport McMoRan Copper & Gold, FCX. At
$27b, FCX alone represents 26% of the market cap of the HUI and
19% of the market cap of the XAU, both indexes' largest component.
Since FCX mines vast amounts of the dazzlingly profitable copper,
its P/E is considerably lower than most of the other gold and
silver miners. Thus FCX's copper production is still skewing
the HUI and XAU P/Es lower.
>From a pure P/E-analysis-over-time
standpoint, this is not a problem. Since FCX has been in the
gold-stock indexes in the past its effect is fairly comparable
across the years. Its recent acquisition of Phelps Dodge may
change this in the future though by altering its gold/copper
mix, making it more copper-heavy. Regardless, in simple P/E terms
where FCX's low P/E is weighted equally with all other component
companies to minimize its influence, the HUI and XAU still show
remarkable price-to-earnings ratio contraction over the last
year or so.
Three or four years ago before
the base metals bulls started getting exciting, it used to bother
me that a major copper producer (that is also a major gold producer)
was "tainting" the purity of the gold-stock indexes.
No more. Today's emerging gold-mining method of choice is digging
big open pits to process low-grade ore. It is usually much cheaper
than digging shaft mines, and much easier to find low-grade deposits
than the rare high-grade ones.
Virtually all the time in these
types of open-pit deposits, byproduct metals exist. Thus most
gold miners in the world today have byproduct metals that they
mine in conjunction with their gold at most of their operating
mines. Pulling other metals along with gold is part of the game
now. These byproduct metals, thanks to raging bull markets driven
by insatiable Asian demand, can greatly contribute to overall
gold-mining profits.
While FCX certainly has the
largest proportion of byproduct-to-gold production in terms of
revenues realized, many of the other elite gold miners also have
significant byproduct production too. Since this is the reality
today and it is really helping gold miners' overall valuations
drop, I don't believe the concept of 100% gold-mining purity
is relevant for the HUI and XAU anymore. Yes, their index components
should be primary gold miners, but they don't have to be 100%
gold.
Byproduct revenue is wonderful
and it should be embraced, not scorned. At Zeal we consider any
byproduct revenue to be a big plus when we pick our stocks to
buy. It enables companies to develop lower-grade gold deposits
that would not be economical at today's gold prices without their
byproduct revenue. So operations like FCX's are ultimately very
bullish for gold-stock valuations and prices.
The vast progress made in gold-stock
valuations over the past year is incredibly encouraging regardless
of its causes. It confirms and verifies the once-controversial
thesis that guided the earliest investors in this bull market
six years ago. We were willing to buy gold stocks at ridiculous
valuations back then not because they were fundamental bargains
at the time, but because they would turn out to be fundamental
bargains as the gold bull marched higher. There is no disputing
this now.
And I think this trend is even
more relevant today than it was six years ago. The higher the
gold price goes, and it is very likely to continue much higher
due to its stellar fundamentals, the greater the profits for
the gold miners will grow. And as they've done in the past six
years, overall these profits will probably multiply faster than
stock prices due to the tremendous profits leverage inherent
in this business.
This means that not only are
gold stocks highly likely to continue appreciating on balance,
but they will get cheaper and cheaper like the oil and base-metals
stocks. These lower valuations are crucial in a bull market as
they open the door for much broader investor participation.
Early on, only brave or foolish
contrarians buy in. They believe in a secular bull before anyone
can see it and they bear huge risks. Since the contrarian pool
of capital is so small in the grand scheme of things, they can
only drive up a sector so far. Eventually value investors realize
the early contrarians were right, and they notice that the sector's
P/E ratios are favorably low. So they start to buy into the attractively-valued
stocks and drive them much higher than the contrarians could
have alone.
Then ultimately the mainstream
investors follow the early contrarians and later value investors
in. The mainstreamers collectively control gargantuan amounts
of capital that can drive a sector stratospheric, but they won't
buy in until late in the game when momentum compels them to.
Without the value investors buying in first, which wouldn't happen
without low valuations, the momentum necessary to seduce in the
mainstreamers near the end of the bull would never exist in the
first place.
So if the gold stocks' lower-valuation
trend continues in the coming year, they will become even cheaper
relative to the general stock markets. These low valuations will
attract in new investors and a much larger pool of value capital
than the contrarians could ever hope to control. If this scenario
plays out as it ought to, obviously now is a great time to buy
while general sentiment remains so irrationally pessimistic.
At Zeal we have traded these
gold and gold-stock bulls since they began, and have been blessed
with outstanding realized profits over the years. We buy gold
stocks when others are scared, like today, and sell them when
others are euphoric, like last May. If you are willing to fight
the thundering herd and take a contrarian chance on earning big
profits in the likely approaching major gold-stock upleg, please
subscribe to our acclaimed newsletter today. Periodic weakness
offers excellent buying opportunities.
The bottom line is gold stock
valuations are really looking excellent today, the best we have
seen in this entire bull market. More elite gold stocks are profitable
than ever before and they have lower valuations as individuals
and a sector than ever before. From an earnings-fundamental perspective
at least, there has never been a more attractive time to add
long gold-stock positions than today.
As usual the psychological
wall of worries is drowning out these truly important fundamental
developments, but sentiment can't trump fundamentals for long.
Sooner or later traders will realize $650 gold is very profitable
for miners and they will rush in to buy. Profits are always the
ultimate long-term driver of stock prices.
Adam Hamilton, CPA
May 18, 2007
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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