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
Zealllc.com
Mai
18, 2007
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