 The Soft Underbelly of Mining Stocks
Todd Stein & Steven McIntyre
The Texas Hedge Report
April 25, 2006
Courtesy of www.texashedge.com
For most of this month, the
physical prices of gold and silver have been rising nearly every
day, yet the mining stocks have been stagnating and in some cases
falling. What gives? Over the last 3 months, the operational
leverage that mining stocks are supposed to provide has not been
seen.
To take a step back, let us
reiterate that long term we are extremely bullish on the prices
of gold and silver. They are the only two currencies in the world
that are not someone else's liability. In a world of fiat money
chaos and destruction, the long-standing monetary stability and
finite supply of both gold and silver will be increasingly desired
by investors around the globe. This latest leg of the precious
metal bull market rally that began in 2000-2001 has taken gold
to $630 an ounce and silver to over $13. In recent days, the
rally has corrected twice, but for long-term investors, we think
the U.S. Dollar's imminent and unrelenting weakness will be the
catalyst for much higher prices on both metals over time.
If one is bullish on the precious
metals, the question then becomes how best to play their upcoming
appreciation? Is it stocks, futures, options on futures, or simply
owning the metal itself through ETFs or physical storage? Since
we first became bullish on the metals in the late 90s, we have
played higher precious metal prices through long-term ownership
(we are not smart enough to trade in and out) of both mining
stocks and some physical ownership of the metals. Mining stocks
we felt had greater upside, but also greater downside than the
physical. We wanted to own the metal stocks of established miners
as we were partial to the operational leverage they provided
to investors. A 1% increase in the price of gold for instance;
often times meant a 2% or greater increase in net earnings for
these mining companies. Junior miners were and still are too
speculative for our blood - though certain juniors may offer
spectacular returns, many others will go up in smoke.
To date, followers of this
strategy have been rewarded pretty handsomely. While gold is
up about 150% off its sub-$250 low and silver has tripled off
its 4 buck low, many mining stocks are up 7 or 8 times off their
lows. In most cases, owning the mining stocks to date has produced
far better returns. However, over the last 3 months, the physical
prices of both gold and silver have done far better than the
mining stocks. Gold has tacked on nearly $100 to its price
and silver has jumped even more percentage-wise recently, yet
many components of the XAU and HUI haven't budged or are barely
up in the same time frame.
We think the reason for this
divergence is several fold. First, the gold and silver stocks
may have gotten a bit ahead of themselves as the underlying earnings
of the companies need to play catch-up with their stock prices.
Secondly, a lot of the miners have shot themselves in the foot
with higher than expected cash costs due to oil and production
shortfalls that have limited to some extent the EPS growth achieved
with higher physical prices to gold and silver. Third, places
like Latin America with recent left-leaning presidential elections
in Bolivia and Peru have turned increasingly hostile towards
producers. The growth of Hugo Chavez type dictators in Latin
America could conceivably be beneficial to the actual metal prices
as supply is reduced, but negative towards the foreign miners
that occupy Latin American mines that now run the risk of higher
taxes or perhaps even nationalization. Fourth, many mining companies
are (in our opinion) extremely poorly run - perhaps more so than
any other industry we follow. Most mining companies seek to grow
their production profile at any cost. This means issuing a great
deal of heavily dilutive shares annually to "build the business".
Coeur d'Alene (ticker: CDE) , for example, has seen its share
count grow about 30% per annum from 1997 thru 2005 - providing
a constant headwind to shareholder returns. Coeur has further
diluted shareholders by over 10% since the start of 2006! As
one could imagine, Coeur's silver production hasn't grown anywhere
near 30% per annum over the last decade, which means that shareholder
dilution in terms of falling metal production on a per share
basis has been real. This is not to single out Coeur alone (we
have no position in the name), as nearly every mining company
has perpetrated this offense on shareholders.
Lastly, the reason that has
perhaps been the greatest contributor to mining underperformance
of late is skepticism. Gold and silver are going up and a great
deal of the crowd is anticipating a large pullback. Like in the
oil complex a few years ago, higher highs in the price of the
commodity are met with a great deal of disbelief by a young Wall
Street crowd that was in diapers the last time commodities really
performed well. In many cases it took over a year of oil and
natural gas going straight up along with the earnings of many
producers before Wall Street came to the realization that higher
prices were here to stay and began to bid up what had become
very cheap oil and gas stocks. Some sort of replay in the gold
and silver sector is always a possibility. Slowly climbing a
wall of worry over ever higher precious metal prices would allow
miner P/Es to become more reasonable and provide a more solid
fundamental base for sustained share price increases.
We do think the last 5 years
or so of outperformance by the mining stocks over the physical
has shifted some of the relative value to physical ownership
at this point, but if market trends continue where physical outperforms
the shares, the relative value will again revert back to the
miners. Also, keep in mind that with any company (whether it
is Coca Cola or a gold and silver miner) the ultimate
intrinsic value can never be more than the present value of future
free cash flow (net earnings) streams to shareholders. Many mining
stocks still make us shiver when we look at their trailing P/Es.
Others prefer to look at reserves and resources in the ground
and the cost to extract those ounces combined with the market
cap per ounce to determine whether gold and silver is cheap on
a relative basis to the physical. Knowing relative value of the
mining stocks versus physical is important, but you should always
be most concerned about absolute values. To get comfortable with
a miner's absolute value, you have to ultimately believe that
a long-term sustainable metal price causes your company to generate
free cash flow and earnings per share - which equates into fair
value for the mining stock well above its current price in the
market.
April 25, 2006
Todd Stein & Steven McIntyre
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Todd Stein
& Steven McIntyre
email: admin@texashedge.com
For more information, go to http://www.texashedge.com.
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