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 deeper into gold stocks than almost any other research
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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.
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