As gold stocks continue to
power higher in their usual spring rally, they are starting to attract
investors’ attention again. This includes some value investors, a group
that is always concerned with valuations. Unfortunately, valuation
analysis of gold stocks is fairly rare. But I’ve been researching this
thread for over 6 years
now, and this week is a great time for an update.
Valuation is exceedingly
important for stock investing in general. It measures how cheap or expensive
individual stocks happen to be, greatly enhancing investors’ ability to
buy low and sell high. Valuation is expressed in terms of price-to-earnings
ratios. It shows where a stock happens to be trading relative
to the underlying earnings per share that company can generate
for investors. The more profits a company can spin off relative to any stock
price, the cheaper the stock and the greater the odds it will be bid higher.
General-stock-market
valuations drive the massive overarching 34-year Long Valuation Waves,
a 17-year secular bull followed by a 17-year secular bear. They effectively
provide a strategic roadmap for prudent investors, highlighting the best
times to buy (and not to buy) stocks. By monitoring valuations and
integrating them into buy-and-sell timing, value investors like Warren
Buffett achieve great long-term success.
While these valuation
concepts do apply to gold stocks, this small sector has a much looser
relationship with valuations than the broader stock markets. This is actually
the case with many sectors, valuations don’t directly scale down from
the markets as a whole to affect all sectors the same way. While gold
stocks will probably never meet the classic definition of value investing
(low P/Es), this doesn’t mean they aren’t great buys.
Since late 2000 the flagship
HUI gold-stock index is up a staggering 1331% at best! And remember this is
over a decade when the general stock markets traded flat to
lower, making gold stocks’ massive gains even more
impressive. But back when we started buying and recommending elite gold
stocks to our subscribers almost a decade ago, their valuations looked terrible.
Most were losing money due to bear-market gold prices, while a few managed to
eke out embarrassingly tiny profits.
Near the beginning of this
mighty bull, the world’s largest gold miner (Newmont back then) was
trading with a P/E between
130x to 160x! This was comparable with the bubblicious tech stocks at
that time, leading many value investors to shake their heads at us early
contrarians betting on gold stocks. Yet by the end of last month, this
same company was trading at 21x earnings at a stock price that had multiplied
over 4x higher.
Despite the enormous
bull-market gains in most gold stocks, as a group their valuations have
dropped dramatically from the early days. Why? As I predicted many years
ago, their profits have climbed much faster than their stock prices. Gold
stocks’ profits leverage
to rising gold prices has always been extraordinary. During secular gold bulls,
few investments manage to outperform the gold stocks.
While the epic volatility
generated by the once-in-a-century stock panic and the markets’
subsequent rebound has distorted gold stocks’ declining secular valuation
trend in recent years, it is still apparent. Contrary to many value
investors’ expectations, the higher the gold price goes the cheaper
gold stocks as a group get. This first chart, the index valuation of the HUI
gold-stock index, drives home this crucial point.
At the end of every month, at
Zeal we crunch the numbers to compute the HUI valuation. Each HUI component
stock’s individual P/E ratio feeds into this index’s. A couple
P/Es are rendered below, a simple average in light blue and a market-capitalization
weighted average in dark blue. In a small index like the HUI (16
components today), weighting by market-cap is very important to avoid
distortions. The MCWA P/E ratio is usually much more representative of
what is really happening in gold-stock valuations.
It’s easy to understand
why. Imagine two gold stocks, a world-class major worth $20b trading at 30x
earnings and a smaller intermediate worth $5b trading at 60x earnings. A
simple average yields an “index” P/E ratio of 45x, but obviously
this is very distorted by the smaller company. If you weight these companies
by their market capitalizations, their MCWA P/E is 36x which is much more
representative of their aggregate reality. Outliers that happen to be small
have far less influence on the overall average.
Before we get into the
details, note the strategic gold-stock valuation trend. The dotted blue line
is the mathematical linear-best-fit line of the monthly MCWA HUI P/E ratio.
And despite all the panic-induced volatility and chaos, it is still
trending lower. So just like we’ve witnessed for the great
majority of this gold-stock bull, gold stocks continue to get cheaper on
balance even as their stock prices rally higher.
Back in the first half of
2007 the HUI averaged around 335 with an index P/E around 25x. Then as gold
surged in late 2007, the gold stocks followed it higher as usual. The
gold price is gold stocks’ primary driver of course, as it determines
their ultimate profitability and hence future stock prices. Initially in that
late-2007 surge, HUI valuations shot up with the index itself. But as
quarterly earnings results started to arrive reflecting the higher gold
prices, valuations dropped in early 2008.
Despite a much higher HUI,
valuations fell back down to similar levels seen in mid-2007 before the gold
surge. Even though the HUI was consolidating high in 2008 prior to the
stock panic, gold-stock valuations were shrinking rapidly on big profits
growth. Then like many speculative sectors, gold stocks were
utterly crushed in the panic. The HUI lost 71% between March and
October 2008, brutal! Meanwhile the HUI’s P/E fell by a similar
66%, which showed gold stocks as a group maintained consistent earnings
despite the huge panic disruptions.
Between its
ridiculously-silly stock-panic lows and December 2009, the HUI rocketed 237%
higher in one of the best sector recoveries in the entire stock markets. Yet
over this span its MCWA P/E climbed from 15.7x at the depths of panic despair
to merely 21.3x in December 2009. This trivial 36% increase in the face of a
237% stock-price rally clearly reveals how fast gold-stock earnings surged
since the panic days. Earnings growth nearly paced stock-price appreciation,
leaving gold stocks still cheap despite their gigantic price gains.
Traditional value investors
tend to avoid gold stocks like the Black Death when they see individual-stock
P/Es running 30x, 40x, or 50x. And there is no doubt that compared to the
conventional stock-market metric of 7x being dirt-cheap these gold-stock
valuations are very expensive. But general-stock valuation standards
don’t translate directly into gold-stock terms. No matter how high
gold-stock P/Es are, over time as gold’s bull powers higher these
valuations still tend to contract making gold stocks cheaper.
After nearing panic lows
again in late 2009 as the HUI corrected with gold, valuations have rocketed
higher in 2010. This recent spike looks troubling, but even it isn’t enough
to shift the best-fit trend away from down. As I dug into the
individual-stock valuation data underneath the HUI’s, it quickly became
apparent that this is an isolated anomaly. I fully expect it to fade away in
the coming quarters.
P/E ratios are based on
accounting profits, and all kinds of non-cash charges flow through accounting
profits from time to time. Big non-cash charges for things such as byproduct
hedging, tax adjustments, or currency fluctuations occasionally eat up most
of the operating profits of some unfortunate gold miner. And if that company
is big enough, especially within the small population of the HUI, it really
distorts this index’s P/E.
Provocatively the culprit
behind this recent gold-stock valuation spike is none other than Goldcorp,
the most-widely-loved major gold miner. At the end of January it was trading
at 21.9x earnings, right in line with the HUI at 22.8x. And by the end of
February GG’s P/E rose modestly to 24.4x driven by the gold-stock recovery
from the HUI’s preceding correction. This jibed with the broader HUI at
26.6x.
But by the end of March,
Goldcorp’s P/E blasted up to 113.8x on its Q4’09 profits!
This catapulted the entire HUI’s P/E up to 36.8x. Without Goldcorp, the
HUI’s P/E actually would have fallen 8% that month instead of
rising 38%! GG has a huge influence because it is the
market-darling major gold miner. It has the second-largest market
capitalization of all the world’s gold miners, up at $27b by the end of
March. This single company represented 15.8% of the entire HUI’s market
cap then, hence its big outsized influence.
So what happened to
GG’s profits? Between Q4’08 and Q4’09 they plunged 93%!
This was driven by a non-cash foreign-exchange loss on a revaluation of
future income-tax liabilities, and losses on securities. On an operating
basis, GG’s profits actually climbed 116% year-over-year. But for
the purposes of this essay, why Goldcorp’s accounting profits (used to
calculate P/Es) fell is irrelevant.
The key point here is a large
company in a small index can drive wild volatility in the index’s
market-capitalization-weighted-average P/E ratio. This is why gold-stock
valuations should mostly be considered from a long-term-trend perspective, as
time smoothes out all the quarter-to-quarter noise. With just 16 component
companies the HUI is particularly susceptible to this chaos, which is the
primary reason I try to avoid analyzing gold-stock valuations more often than
once a year or so.
If the HUI had 500 components
like the S&P 500, this extreme volatility wouldn’t exist. The
larger the population of any given index, the less the influence any
individual component company has on it. This is even true for the larger
components. Of course there aren’t very many intermediate and major
gold miners in the world, so the HUI’s custodians don’t have the
option of including a large index population.
While this conventional
valuation analysis does clearly show gold-stock valuations are shrinking
as their powerful secular bull powers higher, I increasingly prefer
alternative valuation measures. The combination of gold stocks’ big
earnings fluctuations as gold flows and ebbs, along with this index’s
small size, renders the HUI’s P/E much too volatile for any useful short-term
analysis.
Thus my favorite
“valuation” metric today for gold stocks is the HUI/Gold
Ratio. It isn’t influenced by volatile earnings and offers all
kinds of buying-and-selling signals that the conventional HUI valuations
never could. Naturally gold-stock prices are utterly dominated by gold,
as this metal’s fortunes drive their ultimate profits and hence stock
prices. The HGR nicely quantifies this relationship, and is effectively an
alternative measure of gold-stock valuations.
As I discussed the current
very-bullish HGR trends in much depth a couple months ago in another essay,
I’m not going to delve deeply into HGR analysis here. But from a pure
valuation perspective, the prevailing level of the HUI compared to prevailing
gold prices offers all kinds of unique insights. If you are looking to buy or
sell gold stocks, the HGR’s valuation read is vastly more useful than
conventional P/E-ratio analysis.
For 5 years prior to the
ultra-rare stock panic in late 2008, the HUI gold-stock index generally
traded in a tight band relative to the price of gold. This secular trading
range ran between support at 0.46x and resistance at 0.56x. The long-term
pre-panic HUI/Gold Ratio average was 0.511x. In other words, the HUI tended
to trade at just over half the price of gold at any given time. The
stock panic shattered this long-established relationship.
While gold faced plenty of
selling pressure during the panic, the gold stocks plummeted far faster and deeper
than their primary driver. Gold stocks are not only considered
highly-speculative by most investors, but gold-stock investors are often
easily spooked. There is such endless gold misinformation and disinformation
floating around the Internet that any serious selloff is quickly multiplied
psychologically into an end-of-the-world-type scare. Gold-stock investors are often
highly emotional.
By the time the dust settled
at the panic’s nadir, gold stocks had fallen as low relative to gold as
they had been in this entire secular gold bull! Of course this made no sense
at all, as gold miners’ earnings were still robust as the first chart
showed. This was an anomaly driven by a perfect storm of fear, and it created
the best buying opportunity of this entire secular bull. We bought gold
stocks aggressively near the panic lows and urged our subscribers to do the
same.
When prices are driven to
extremes by excessive greed or fear, they always mean-revert back towards
norms once those emotions abate. Gold stocks are no exception. As expected,
ever since the end of the stock panic the gold stocks have been gradually
normalizing relative to the gold price. In other words, their valuations
relative to gold have been rising on balance. But this doesn’t mean
they aren’t still cheap.
In HGR terms, the HUI
isn’t even close to climbing back up into the bottom of
its pre-panic trading range yet. It will almost certainly regain this
range though. The longer any relationship persists in the markets, the more
likely it is fundamentally-based. And to see gold stocks trade within a
well-defined range relative to gold for 5 long years before the panic’s
emotional anomaly is powerful evidence this relationship will resume. As gold-stock
investors scared out by the panic gradually return, the HGR will continue to
normalize.
So far more importantly than
the gold stocks’ P/E ratios, which are really pretty low relative to
their history in this bull, is where gold stocks are trading relative to the
gold price. And despite the strong gold-stock recovery since the panic,
gold stocks still remain very undervalued relative to gold.
Today’s HGR remains at low levels never seen for 5 years before the
panic. And despite periodic setbacks (sharp HUI corrections driven by gold
corrections), the gold stocks generally continue to advance relative to gold.
At Zeal we have always dug
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The bottom line is despite value
investors’ perceptions of gold stocks, they are really pretty cheap
today. In conventional valuation-analysis terms, they are in the lower end of
their bull-to-date range. And as gold stocks’ legendary profits
leverage amplifies gold’s gains, these valuations continue to decline
on balance despite much higher stock prices. And relative to gold itself,
gold stocks remain quite cheap.
After being pushed far too
low by the stock panic, gold stocks continue their march higher to normalize
with prevailing gold prices. This mean-reversion trade has already been
immensely profitable for 18 months now. And it should continue to prove
lucrative until the HUI’s pre-panic levels relative to gold are
regained. From both conventional and alternative metrics, today’s
gold-stock valuations are relatively low.
Adam Hamilton, CPA
Zealllc.com
April 23, 2010
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