Way back in late
2000, only the very hardest-core contrarians even considered
investing in gold stocks. This sector was all but obliterated after
a multi-decade bear in gold. Its flagship HUI gold-stock index was
languishing in the 40s, while the headline S&P 500 still traded in
the 1400s. Most investors didn?t even know the tiny gold-mining
sector even existed.
Those few willing
to deploy capital into such a wasteland needed to have very good
reasons for making such seemingly hopeless bets. One of the
arguments we used to buy gold stocks back then was as a counterpoint
to the newly-born secular stock bear. Since general stocks were
likely doomed to poor performance for over a decade to come due to
their excessive
valuations, why not buy gold stocks?
Time has clearly
vindicated us early contrarians in this decision. From its 2000
close to its worst levels a few weeks ago, the S&P 500 fell 48.8%.
Meanwhile over this exact same span, which is actually quite
unfavorable for the HUI, it still soared 573.2%! Emerging from
utter despair, gold stocks have indeed become one of the
best-performing sectors of this entire decade.
While excessive
general-stock valuations certainly weren?t the only, or even the
primary, reason to buy gold stocks when no one else wanted to, this
thesis still generated a lot of controversy in the early 2000s.
Astute investors rightfully pointed out that the valuations on the
gold stocks were often higher than those of the tech-stock
bubble we were betting against. Was a gold stock trading at 150x
earnings a better investment than a tech stock ?merely? trading at
75x?
Many called us
hypocrites, as we were railing about the imploding tech-stock bubble
(an unsustainable valuation anomaly) yet simultaneously buying gold
stocks with little or no earnings of their own. But we weren?t
ignoring the ludicrous gold-stock valuations, we were anticipating
their future earnings potential. As the expected secular gold
bull gradually gained steam, we expected gold-mining earnings to
grow at a faster pace than gold-stock prices climbed. This would
gradually collapse their high P/E ratios.
Since I was not
only deploying my own capital in the battered-down gold stocks, but
advancing this gold-stock-valuation-contraction thesis publicly, I
started a thread of research on gold-stock valuations. I needed to
understand if this was indeed happening as expected. As gold-stock
prices marched higher since the early 2000s, was their earnings
growth indeed outpacing their stock-price gains? Were their early
outrageous valuations indeed contracting?
Initially in this
research, we used the world?s largest gold miner (Newmont Mining at
the time) as a proxy for this sector as a whole. Newmont, then and
now, was the only primary gold miner included in the S&P 500. We
were doing a ton of general-stock-market
valuation work
so we had monthly valuation data on every S&P 500 component
including Newmont. Here is a chart of this data from
the 4th essay
of this series.
Newmont Mining,
the world?s premier gold miner over most of this span, was indeed
following the model. It traded as high as 160x earnings in
late 2000 when it could barely eke out any profits in the brutal
$260s gold environment. And then it was unprofitable for the next
year and a half, so it had no P/E. But when it started producing
profitably again in mid-2002, its P/E had been cut in half to 80x.
And since then, NEM?s valuation has continued to gradually contract
on balance.
While I don?t want
to spend too much time on this old chart today, the key point is
Newmont?s market capitalization soared 1067% at best while its P/E
ratio simultaneously fell 85%. You need to have
breathtaking earnings growth to support a greater-than 5/6ths
plunge in a company?s valuation at the same time its market cap
multiplies by an order of magnitude. The thesis was unfolding as I
had expected!
While this
research proved that gold-stock earnings growth was far-outpacing
stock-price appreciation, so valuations were becoming more
reasonable, I was never quite comfortable with it. It is never
optimal to use one stock as a proxy for an entire sector. There are
too many company-specific developments that affect its earnings and
stock price that don?t affect its peers?, which dilutes its
representative usefulness.
In Newmont?s case,
it issued great quantities of new stock to expand. Barrick Gold
usurped its place as the world?s largest gold miner. NEM has also
faced serious operational challenges over the last couple years,
hurting profits. While I am still satisfied with my long-term
investment in Newmont I made in March 2002, it has fallen out of
favor among gold-stock investors in recent years. I have no doubt
this perception will reverse, they usually do, but it still
highlights the danger of using any single company as a sector proxy.
So back in late
2006, at Zeal we started collecting valuation data for the entire
HUI. The HUI is not only the world?s flagship gold-stock index, but
its 15 component companies vary greatly by size, operations,
locations of mines, and a myriad of other factors. Thus the HUI is
a superior and diversified representation of this sector,
unlike any single company. Last month my business partner Scott
Wright wrote a fantastic essay briefly surveying each of the HUI?s
component
companies. Read it if you?d like to better understand this
index?s impressive fundamental breadth.
Unfortunately
building a new dataset takes time. For an obscure sector like gold
stocks, most of this data can only be secured in real-time the day
it happens. After that it is lost forever. Data companies only
tend to save data there is considerable demand for, so to the best
of my knowledge you can?t even buy historical HUI valuation data.
No one cares even now, despite this being one of this decade?s
best-performing sectors. Which suggests this gold-stock stealth
bull has a long way higher to run yet!
Like our famous
general-stock-market valuation data (charted on our website for
subscribers), we have been compiling the HUI valuation data at the
end of every month. We look at the P/E ratios and dividend yields
of each individual HUI component in order to compute these key
valuation metrics for this index as a whole. We do both simple
averages of these metrics as well as market-capitalization-weighted
averages.
I have long
thought this MCWA approach is superior for valuation work. Imagine
an index of 2 stocks. One trades at a P/E ratio of 100x while the
other is sporting a 10x multiple. Their simple average is 55x
earnings. But if one company is way bigger than the other, this
number is skewed. If the 10x company is worth $20b, but the 100x
company only has a $1b market cap, then the larger company should
have proportionally more influence than the smaller one. After all,
investors have much more capital at stake in it!
So by weighting
valuation metrics by the market capitalizations of individual index
components, I believe we get a much sounder view of gold-stock
valuations over the long term. And since the HUI is such a small
index, just 15 stocks compared to the S&P 500?s 500 stocks, this
MCWA approach also helps reduce the overall valuation impact of the
sometimes wildly-fluctuating earnings results of the smaller gold
miners.
After more than 2
years of painstakingly collecting HUI valuation data each month,
here is the first chart of it. I?ve been excited to see this for a
long time. As we continue to add to this dataset going forward, it
will allow for superior gold-stock-valuation analysis. And you
really could not ask for a wilder period of time in HUI terms to
analyze from a valuation perspective. This sector has been
crazy-volatile.
After hitting an
all-time high in March 2008, a staggering 1331% run from the HUI?s
bear low of November 2000, this index was ultimately driven to
plunge 70.6% by October 2008 in the stock panic. Since those dismal
lows, its initial recovery has already surged 120.5% higher by this
week. While gold stock valuations are gradually contracting, this
is still an extremely volatile sector not for the faint of heart.
But despite this
short span of time, and the
once-in-a-lifetime stock panic that drove such wild anomalies,
there are still some interesting HUI valuation observations. For
example, in the first two quarters of 2007 the HUI averaged 335 on
close and its MCWA P/E (all P/Es I use from now on will be MCWA,
although both it and simple are shown in this chart) averaged 25.3x
earnings. 25x is really quite reasonable.
Mainstream stock
investors usually have no problem paying 20x to 30x earnings for
stocks with outstanding potential for profits growth. And the gold
stocks certainly have this due to the
secular gold
bull and their impressive
profits
leverage inherent with higher gold prices. To see the elite
gold stocks of the HUI trading in the mid-20s in P/E ratio terms is
incredible, it totally vindicates those of us who bought at far
higher valuations yet far lower stock prices in the early 2000s.
In Q3 2007, the
HUI started powering higher in another upleg. Valuations initially
shot up with stock prices, as earnings are always slower to change
than stock prices and they are only reported quarterly for any given
stock. But gradually the higher gold prices translated into higher
earnings as expected, dropping gold-stock valuations. By the end of
Q1 2008 the HUI was near the 450s compared to the 400s at the end of
Q3 2007. Yet its valuations remained at similar levels, gold stocks
were growing earnings.
During the first
half of 2008 (before the bond and stock panics started), the HUI
averaged 443 on close. It generally consolidated sideways over this
span while the general stock markets ground lower in a
strengthening
bear. Yet despite gold-stock prices remaining high, the HUI
valuation shrunk considerably. Trading at 46.6x earnings in
January, by July the HUI?s P/E had contracted to 30.7x. This is a
microcosm episode of the secular trend of outsized earnings growth
evident in Newmont in the first chart.
Of course the
stock panic (and the preceding bond panic which
indirectly hit
gold and hence gold stocks) in the second half of last year cast
all the financial markets into unbelievable disarray. The
gold-stock investors, once so brave, panicked too. By late October
thanks to the HUI?s plunge, it was trading at an incredible 15.7x
earnings! To give you an idea of how cheap this is, the S&P 500 was
trading at 13.9x right then. Gold stocks were almost as cheap in
pure valuation terms as the general stock markets!
Such events almost
never happen in high-potential speculative sectors, so the bargains
in gold stocks were obviously immense. In late October we started
aggressively buying gold stocks and silver stocks and recommended
our subscription
newsletter subscribers do the same. We not only added
short-term trades, but our first long-term investments in gold
stocks in years. As of this week, our new long-term investments in
this sector are up an average of 91.6% since late October.
Since then, the
HUI has recovered back up to early-2007 levels and the latest
valuation read we computed at the end of February is running at
25.7x earnings. While this is reasonable, I don?t expect this
situation to persist. Odds are high that HUI valuations will fall
considerably soon after Q1 earnings are reported. This will make
gold stocks even more attractive to investors than they are today.
Back in Q1 2007
when the HUI last traded consistently at today?s levels, gold
averaged $649 on close. But so far in Q1 2009 it is averaging $909,
40.0% higher! So gold miners are going to have much higher revenue
this quarter, and thus far higher profits, than they did back in
early 2007. Further magnifying this effect, the average oil price
this quarter is running 26.6% cheaper than it did back then. Thus
many of gold miners? big energy costs of mining will be lower this
quarter, resulting in even higher operating profits.
So unlike most
other sectors in the stock markets that are looking at slow earnings
in this first post-panic quarter, gold miners are likely to announce
excellent profits. This should garner a lot of attention and
increase investor interest in this high-potential sector. And since
gold?s own future looks so dazzlingly bullish for
many fundamental
reasons, this trend should only accelerate. I fully expect the
next update on this thread of research to show HUI profits growing
nicely on balance.
In addition, many
of the world?s biggest and best gold miners have been gradually
transitioning from old to new mines over the last few years. This
drove much higher costs (hence lower profits) for miners on a couple
fronts. First, as old mines are depleted their costs are spread
over fewer ounces of gold. Second, as new mines are brought online,
their initial production gradually ramps up which results in costs
spread over fewer ounces as well. So when the old mines are fully
retired and the new ones fully up to speed, this industry?s profits
should increase markedly.
Conventional
valuation analysis like this is critically important for all
long-term stock investors to study. After all, it was looking at
market P/E ratios that warned contrarians way back
in 2000 and 2001
that a devastating secular stock bear had been born. And
with the stock markets likely to trade sideways
for 17 years
after 2000, alternative investments
like commodities
were the place to be. Valuation analysis has made fortunes for us
and our subscribers, and I will always keep studying it.
But as I?ve
pondered the specific case of gold-stock valuations in recent years,
I?m gradually becoming convinced an unconventional approach is more
useful than the classic P/E ratio approach. Rather than looking at
earnings themselves, why not look at the one thing that drives
gold-stock earnings? The price of gold, of course! Thus the
HUI/Gold Ratio, the HUI index level divided by the gold price, has
proven much more useful for gold-stock trading decisions than P/E
ratio analysis.
It was
this HGR chart,
not the low P/E ratios, that led me to aggressively buy and
recommend gold stocks in late October when most traders and analysts
were running for the exits in terror. In the 5 years prior to the
stock panic, the HGR had traded in a tight secular range between
0.46x and 0.56x. Note above that each time after the HGR neared or
pierced support of 0.46x, tradable HUI rallies soon emerged. Some
of these were very large and massively profitable.
Traders buying
gold stocks whenever the HGR neared its support, and tightening
stops when it neared resistance, were rewarded with outstandingly
profitable gold-stock investments and speculations. And there is a
real fundamental basis for this relationship since gold-stock prices
are ultimately driven by mining profits, which in turn are
ultimately driven by the price of gold. Gold stocks? innate ability
to leverage a gold bull is the very reason people invest in them in
the first place.
The HGR?s 5-year
pre-panic average was 0.511x, meaning the HUI averaged just over
half the price of gold. To think of this in valuation terms,
this 0.5x number is essentially ?fair value?. When the HUI was
trading well over it gold stocks were getting ahead of themselves,
temporarily overbought. But when the HUI fell well under it, they
were lagging gold and not yet reflecting their true earnings
potential.
And then 2008?s
epic stock panic arrived, shattering this secular trading range like
it did so many other longstanding relationships. Both gold and the
HUI fell in the heart of the panic as the fear bubble climaxed, but
the HUI plunged faster and farther than gold. This meant gold
outperformed the HUI, which of course drove the HGR lower. You can
see the resulting deep anomaly on this chart, as the HGR was driven
to unthinkably low levels in the depths of the panic.
It was this absurd
HGR that led me to buy gold stocks in late October. The HUI was
trading at the same place it was when gold was in the $350s, yet
gold?s worst close of the entire panic was over twice as
high. Even if gold had never recovered, it made no sense at all
for gold stocks to be discounting $350 gold when the metal itself
was in the low $700s. The HGR proved a much more powerful valuation
proxy than classical valuation analysis!
So while I am
excited to see how the true HUI P/E ratio valuations play out in the
coming years, I think that looking at the HUI?s levels relative to
its primary driver gold also has great ?valuation? merit. Odds are
the HUI will gradually return to its historical relationship with
gold, which means gold-stock prices are far too cheap even today.
Eventually they will reflect today?s gold price, since it
drives their profits.
At Zeal we?ll
continue our decade-long quest to really understand gold stocks, and
what drives them, at a deep level. Knowledge is power, and as
always in the financial markets the biggest profits over the long
term will accrue to those who are the most diligent in seeking
understanding. Yet you can share in the valuable fruits of our
research for an infinitesimal fraction of the costs we bear.
Subscribe today
to our acclaimed
monthly newsletter!
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The bottom line is
gold-stock valuations are indeed gradually contracting on balance,
just as we contrarians expected back in the early 2000s. The
secular gold bull is driving such large profits increases for the
gold-mining sector that valuations have plunged despite radically
higher gold-stock prices. As gold powers higher, this trend should
continue. Gold stocks? future earnings potential in a gold bull is
vast.
In addition gold
stocks are not only reasonable today in P/E terms, but very cheap
relative to prevailing gold prices. Sooner or later this residual
stock-panic discount will totally vanish. Ultimately over the long
term, all stock prices gravitate to their underlying companies?
earnings. And since the gold price controls the gold miners? future
profits, their stocks will continue to follow and leverage gold as
always.
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