Tech Stocks vs. Gold Stocks

Scott Wright, Zeal LLC
[Adam Hamilton's partner]
Sep 2, 2005

Stock investing at the turn of the millennium has taken on quite a different look. Technology has simplified the process of investing and widened the scope of the everyday investor. High-tech tools such as online trading have drawn investors into the convenience and perceived reality of "New Economy" investing.

The tech boom of the 1990s into early 2000 gleamed with investor confidence in this New Economy before its abrupt and overdue halt in March 2000, bringing an end to a 17-year secular bull market in general equities. Since the burst of the tech bubble it has become readily apparent that we are in the beginning stages of a secular bear market in general equities.

From its high of 5048 in March 2000, the tech-heavy NASDAQ retreated by 78% to an interim extreme low in October 2002. While many investors have seemingly forgotten the massive evaporation of capital that affected so many people during that time, it has not stopped them from rallying the NASDAQ to 4+ year highs earlier this month.

NASDAQ valuations today still sit in bubble territory, yet this renewed tech hype has won over investors and media alike allowing everyone from shoe-shiners to corporate drones to once again talk tech.

So does this mean we are in line for another massive tech rally? Absolutely not! Every bear market experiences bear market rallies, and historically those poor souls that get caught up in them and believe them to be new beginnings usually end up sacrificing their hard-earned capital to the tech abyss.

Over the course of history, for bulls and bears alike, the financial markets have punished the ignorant and rewarded the prudent. Investors who consistently make money in the financial markets are unbiased in their investment strategies and focus on the fundamentals of every market sector. If the general stock markets appear to be in a long-term downtrend, there is usually some other venue that has or will catch wind in its sail and outperform them.

That venue today is the Great Commodities Bull of the 00's. Commodities, like the stock market, have a history of running in large cycles over time. Commodities cycles tend to run inverse to the stock markets and were beaten down in the 1990s as stocks soared into bubble territory, but their comeback has begun. As shown by the recent rise in the popular CRB Commodities Index, commodities are on the rise again and appear to be in the early stages of a secular bull market.

Oil, gold and silver have spearheaded this commodities run for stock investors. Stocks of companies that produce such commodities have performed spectacularly since the inception of this bull. And there has been no better way for investors and speculators to capitalize on it than to invest directly in gold stocks.

As you can see on the chart below, gold stocks have been carving quite an impressive uptrend since the beginning of 2001. Gold stock performance is measured on this chart by the venerable HUI, which is a popular gold-stock index comprised of a basket of unhedged gold-producing companies.

The infamous NASDAQ, which is our best measure of tech stocks, has been far less impressive than the HUI over this same period of time. After the massive twelve month bleed-off from its high in early 2000, the NASDAQ has entrenched itself in an unimpressive sideways trading pattern for the last 4+ years.

If history repeats itself, as it usually does, the NASDAQ is at best doomed to a long-term sideways trading range. Since valuations and sentiment are still enormously high though, I expect it to continue its bleed-off to the negative. On the flip side, commodities are expected to continue their secular uptrend as the fundamentals of the world economy dictate.

This chart alone speaks magnitudes in our tech stock versus gold stock discussion, but though these trends are blatantly apparent, the bull run in gold stocks has remained relatively unknown in greater investing circles. You will rarely hear CNBC talk about the HUI or gold stock performance but instead you will hear useless drivel about the daily noise of the NASDAQ as well as the latest and greatest tech stock.

I suppose this lack of mainstream exposure is one reason why many investors suffer in stock bear markets. Manipulation theories aside, the media usually covers large venues, regardless of performance. Case in point, the total market capitalization of all the stocks in the HUI combined is barely one-sixth of that of Microsoft alone.

Therefore not only does it take a prudent investor to search out the not-so-mainstream opportunities that exist in today's markets, but growing doses of education from those players within the smaller venues to grow awareness of those markets.

To this day gold stock investors and speculators remain black sheep among their peers. Most of my acquaintances think I am nuts for being a gold investor. Even so, the numbers speak for themselves and simply cannot be ignored.

In the chart above we see the technical advantage gold stocks have shown over tech stocks, but what I would like to provide is a fundamental case as to why the technical trends we see above will continue and why gold stocks will bring more value to investors than tech stocks as this commodities bull gallops forward.

In addition to Long Valuation Waves, there are a myriad of strategic reasons why we are in a secular gold bull and why the stock markets are in a secular bear. Reasons such as commodities demand, the US dollar bear, gold fundamentals, interest rates, etc provide a macro view of what we are faced with today. It's not too late to jump on the commodities bandwagon! These reasons alone provide case enough for what we have witnessed in the last five years and what we will most likely experience for the next 10+ years.

Instead of repainting the strategic picture summarized above and waving in front of you the past performance our chart provides, we will take a tactical look at tech stocks versus gold stocks. We will look at several different facets of business and finance at the corporate level and compare and contrast the average technology stock to the average gold stock.

In comparing tech stocks against gold stocks, they must first be defined in the context I will be using. When I refer to a gold stock, this is a mining company that actually pulls gold from the earth and sells it on the open market. Tech stocks can be loosely defined as companies, whether internet, telecom, hardware, software, etc that claim cutting-edge technology, services or concepts which they market as necessity or convenience and as the wave of the future.

At a glance, it is easy for a tech investor to look at the fundamentals of some gold stocks and think to himself, "These gold stocks are just as risky as my tech stocks, in fact, the valuations are not very impressive." Well, at a glance, they may have a point. Interestingly, half of the stocks that currently make up the HUI do not have positive earnings.

Tech pumpers I know insist there is no fundamental difference between their investments and speculations and mine. As you can imagine, I couldn't disagree more and this mindset is not only dangerous but couldn't be farther from the truth. We must dig a little deeper to discover the true make-up of these types of companies.

The Product: Gold is the Ancient Metal of Kings. Gold is gold, has always been gold and will always be gold. Gold was as rare and precious 6000 years ago as it is today. Gold will never be replaced with a better gold, gold will never be artificially fabricated and gold will always be in demand. The product gold stocks provide is alluring, everlasting and continually desired.

Technology on the other hand is a whole different ballgame than gold. Please don't take me the wrong way, as I am not anti-technology. I love technology and think it is a wonderful thing. I have a cellular phone, a wireless computer network in my house and live on the internet. And if it weren't for Al Gore and his internet revolution, it would be infinitely harder to communicate with the global populace.

To generalize the different areas of technology, we will use widgets as the blanket product our tech companies provide. This product can be physical, a service or a concept, so we'll have to keep an open mind for our widgets.

Technology does have countless benefits, but it quickly becomes outdated. Widgets will always be replaced by cheaper, smaller, faster and more efficient widgets. When old widgets are replaced, their lifespans are drastically decreased and they eventually become obsolete. If the company that produces these widgets is not the company that produces the next-generation widget, then it too will become obsolete.

In order for something to become obsolete, that means it actually had to be useful at some point. Interestingly, some widgets are not always useful and have never proven market or cost effectiveness. Even though some tech companies are publicly traded with billion-dollar-plus market capitalizations, their widgets may have never been implemented on an accurately measurable scale in order to prove their viability.

As I mentioned above, some widgets are conceived in concept and sold to investors without truly being tested in the marketplace. If that's the case, is the product truly a widget? I'm sure you remember well the dot-com craze not too long ago. Internet companies were so popular that stock investors bid up any company that boasted a creative web address. All that was needed was a little code and a catchy tune for them to be billion-dollar companies.

Thousands of companies sucked in trillions of dollars of investor capital to no avail during the tech bubble. If you wanted to ride the tech rocket, it was truly a crapshoot choosing which companies to invest in that would actually survive. Most of these companies had promising and ambitious business plans, but ended up not being viable in the marketplace.

Notorious flops such as Pets.com, eToys, Internet Capital Group, Webvan, WebTV, Rhythms and thousands more turned out to be busts. You would think the lessons learned by investors five short years ago would translate into more rigorous testing and resolve before throwing capital at tech stocks again, but that's not appearing to be the case. Even today there are hundreds of high-flying tech companies publicly traded in which their widgets are shady at best.

Gold miners have one main product, gold, which will never become obsolete and will always be in demand. If the market for gold is not hot, the miner may not have as high of a profit margin, but the gold will still be in demand and will sell.

The companies out there that do make good widgets are few and far between, and bottom line, most are currently well overvalued. It's hard enough to discover these good tech companies, and even harder yet to find them at a reasonable valuation for investment purposes.

Leverage: The main product for gold miners will never change. They will mine gold until the economics or ore viability of their deposits say otherwise. In order for a gold miner to make money on the gold they pull from the ground, their expenses per ounce must be cheaper than the price at which they sell that ounce for on the open market.

As stated previously the demand for gold will always exist, but the price miners are able to sell it for is at the mercy of the markets. Gold miners historically have not done the gold industry any favors with their lack of marketing, but you almost can't blame them as many consider marketing a hopeless cost because of their perceived lack of control over the market price of gold.

When it comes to making money, gold miners' profits are highly leveraged to the price of gold as it trades in the futures markets. Each company's cost per ounce stays relatively fixed (variables such as labor, location, ore quality and more can change expenses at the individual mine level). For example, miner XYZ is able to produce its gold at an average expense of $300 per ounce. But what XYZ can sell it for on the open market varies depending on the daily price fluctuation of gold assuming XYZ is unhedged (if a miner is hedged the selling price is already set independent of where the market is).

To put it simply, if gold is trading at $350 per ounce, XYZ can realize a $50 profit per ounce sold. But if gold is trading at $500 per ounce, it can realize a $200 profit per ounce sold. This difference can be directly added to bottom-line profits because its costs of producing that ounce of gold remain the same. In a gold bull market, gold miners are leveraged to make some serious profits as the price of gold continues to rise, as in this case XYZ's profits quadrupled on a modest 40% increase in gold.

For many technology companies, there is no guarantee that their widget is even viable in the market place. If it is or can be viable, its required scalability may end up hurting it. But a small gold miner can have just as good of a profit margin as a large gold miner.

Many tech companies require a large volume of sales of their widgets in order to realize a profit. Smaller widget makers usually have a tough time breaking into the marketplace. If widget-producing companies cannot meet sales forecasts, they will not make money, and will eventually go out of business. And in order to ramp up sales, widgets are mass-produced, pre-ordered, stuck in inventory and may never be sold whereas gold miners can easily sell every ounce they liberate.

Competition: One of the benefits of free-market economies is competition. Naturally, all like-widgets are not produced and sold by the same company. This forces widget makers to compete for the sale of their widgets. Competition among widget makers is fierce and expensive, and the weak and inefficient will not survive.

Competition amongst gold miners is not the typical market competition you would imagine. Their main competition is not necessarily with each other, but in their internal business efficiencies and trying to attract shareholder capital. All gold miners produce and sell the same perfectly fungible product and there is no competitive advantage to their finished product. Simply put, a refined ounce of gold is a refined ounce of gold.

Unhedged gold miners sell their gold based on futures prices the commodities markets set. Because of the limited supply of gold available globally, these miners need not worry about undercutting the miner next door, they just sell at the current market price.

Attracting shareholder capital to a gold-mining stock is multifaceted. First, in a gold bull market, most gold mining companies will be bid up as the underlying commodity rises in price. But the exceptional ones need to boast alluring qualities that stand out from the rest. With the final product being the same amongst competition, cost management and resources are looked at next by investors.

Simply put, those companies that are able to produce their gold cheaper than the others have a profit advantage and will be rewarded in the financial markets. Investors also favor those companies that have solid resource portfolios. Miners that have good mine-lives on existing mines and good mineable deposits for future mining have a superior advantage in attracting capital.

Tech companies on the other hand compete directly with competitors for a limited market share of their widgets. They need to be very cognizant of their pricing or they will either not be able to generate new sales or will lose existing sales to their competitors. Many times competitors may undercut the price of their product and initiate a price war that will not only kill the bottom-line profits of various companies but will bring them to their knees when it comes to future viability.

In order to stay ahead of the competition, most tech companies employ a massive sales force and have very large marketing expenses. This is one of many reasons why valuations are so out-of-whack for these companies. Competition in a weaker economy will unfortunately break many tech companies as they find fewer and fewer buyers for their widgets.

Economic Resiliency: After the NASDAQ crash in early 2000 and before the Federal Reserve created the housing bubble, America was in the midst of a mini-recession. During these tough times businesses and individuals alike pulled back on their expenditures. Before the Fed rescue took full force, many high-flying tech companies either went completely out of business or were forced to file for bankruptcy protection causing investors to lose massive amounts of capital.

The Fed housing bubble buffered what could have been a domino effect and will only keep the economy artificially afloat for so long. When recessionary forces start to unfold once again, the resiliency of many tech companies will be tested. How will your tech company withstand increased curbs on spending? How will your tech company withstand large decreases in investor capital that are relied upon to boost its stock price?

Now obviously gold stocks will perform better in a gold bull market, but even when prices are down gold miners are resilient. Gold miners tend to stick around through the doldrums of their commodity's economic cycles. Many tech companies on the other hand have serious trouble weathering minor economic blips yet alone a full-fledged recession.

If the Long Valuation Waves do continue to dictate the future of the stock markets and most likely the state of the economy, where do you want to have your hard-earned capital? Take a look at the true fundamentals of some of these companies. Yes, at first glance, a speculative gold stock may have the outward appearance of a speculative tech stock, but dig a little deeper.

Gold miners may not currently be in the green because they are aggressively ramping up the development and production of their gold reserves to take advantage of this continuing gold bull. Infrastructure and construction costs that go into a gold mine are enormous. Huge capital expenditures are involved in bringing these mines to life. But when they are brought into production and the gold starts to flow, their enormous profits will quickly pay off the mine infrastructure costs.

Whereas gold demand is far outpacing its mined supply right now, most tech companies need to create demand for their widgets, and much of the demand for tech does not lie in necessity. When gold mines go live, their product will sell. When tech companies create infrastructure and a product line, there is no guarantee it will sell, especially in a down-trending market.

I have acquaintances in the tech world in which the companies they work for or used to work for threw away billions of dollars on New Economy physical infrastructure that will never be fully utilized. Stocks for some of those companies are somehow still around and trading on the NASDAQ with enormous market caps, but bankruptcy may be just around the corner for them.

Tech-stock earnings and valuations the last seven or so years have seemed like the bald-headed step children of fundamentals. For far too long have countless tech companies been trading upwards without earnings, near-term or long-term projected earnings or insanely high multiples if they are actually making money.

As the economy tightens and as the commodities bull progresses, the cost of doing business will rise. Every individual and business will be affected by the rise in costs of the natural resources it takes to build, transport and run every widget produced. This will naturally reduce discretionary income and expenditures on the individual and corporate level. Will tech companies be able to withstand pressures of this sort?

Continue to keep in mind the strategic reasons listed above for the fundamental advance of the commodities bull. Supply and demand are a major strategic reason why commodities are hot, and this funnels down to the individual company level as well.

At Zeal our research team continually monitors the status of the markets. The subscriber section of our website has updated Long Valuation Wave charts as well as many other cutting-edge charts that track the status of this gold bull.

With the wind catching sail in this commodities bull, we are continually looking for investment opportunities that have a high probability for success in today's markets. When the timing looks right, we recommend stocks to our Zeal Intelligence and Zeal Speculator newsletter clients that should be positioned to enjoy the highest leverage to this continuing commodities bull. Please subscribe today if you would like to join us in these exciting times.

The bottom line is don't be fooled by the summer tech rally and renewed tech hype. We are in the midst of one of the greatest commodities bulls in history. In unison with this commodities bull, probabilities are highly in favor of a continued secular bear market for general equities.

No matter what may be happening in the markets, there are always opportunities to make money. Gold stocks are so leveraged to the commodity they produce that if you are positioned well, you may reap legendary gains going forward.

You can take the popular road and risk your hard-earned capital in non-resilient tech stocks, or you can ride this commodities bull in the stocks of the companies that produce them. A century-old parable that is often quoted by mainstream commodities-hater Jim Cramer is very appropriate for today's stock investing, "Bulls make money, Bears make money, but Pigs get slaughtered!"

Scott Wright
[Adam Hamilton's partner]
Sep 2, 2005

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