 Your Gold Mining Stocks - The Moment of Truth
Kenneth J. Gerbino
Archives
Kenneth J.
Gerbino & Company
March 20, 2006
Although I believe we are in
a multi-year bull market in metals. This past month witnessed
the worst gold mining share retreat in 23 months. February was
a very bad month for the mining stocks, the XAU (Philadelphia
Gold and Silver Index) was down 13.4% and gold was also down.
So far in March, there has been more downside pressure as well
and now the miners are holding their own in a nervous market.
I recently spent four days
in Florida at the Bank of Montreal Nesbitt Burns Institutional
Mining Conference and met with dozens of managements of large
and small mining companies. Two of the themes were 1) continued
demand for base metal and 2) the precious metal companies are
all using much lower metal prices for cash flow projections and
engineering studies. They are being conservative since production
decisions involving billions of dollars are many times at stake.
For the novice gold mining investor, which includes many billion
dollar hedge fund managers, seeing cash flow projections based
on $400 gold can paint a conservative future as well as present
a high cash flow multiple to the current price. This is actually
favorable to the long term gold bugs as it can help keep a lid
on an explosion in prices which would make buying these stocks
even more of a volatile proposition.
At my firm we are analyzing
our mining stocks using $400 gold, $6 silver, $1.00 copper, and
50 cents zinc for our spreadsheets. These prices are well below
current prices (gold $535, silver $10, copper $2.20, and zinc
$1.00). If we can see a double in a stock over a three year period
with metal prices substantially lower, then we know we have a
winner. These stocks will do even better if the metal prices
stay anywhere near current levels or go higher.
Over the next five years I
expect metals prices to stay well above their long term averages
but I have learned the hard way that it pays to take some money
off the table once in awhile when markets get too hot.
There are going to be ups and
downs but by avoiding overvalued or fundamentally flawed mining
companies one should do better in down cycles and this should
allow you to take advantage of what looks like a positive long
term trend in the metals market. Most importantly, always remember
that your gold and silver investments are a powerful insurance
policy against a world gone mad in a political and economic sense.
Don't Forget the Base Metal Stocks
We still have a long way to
go in this mining stock bull market, because all the mining stocks
together represent less than 1% of the S&P 500 Index. Therefore
we still have the luxury of buying value at relatively good prices
because Wall Street does not generally follow many of the base
or precious metal stocks. You are ahead of the crowd.
In almost every other industry,
when prices go up the makers of those goods build more factories
and hire more people and produce as much product as they can
ship out the door. New companies and people show up and pour
lots of money into that industry to try and take advantage of
the obvious shortages or price boom. In the mining industry it
takes 5-10 years to build a mine... and that presumes you have
found an economic mineral deposit. So when metal prices go up
there is no fast business response available.
We are in an era where India
and China need 5-6 times more raw materials than Europe
and the U.S. did during the 30 years of booming economic expansion
after WWII. However, the inventories of metals in the world's
major warehouses (Comex, London Metal Exchange and Shanghai)
are down by more than 80% in the last three years and all the
easy mineral deposits found near surface over the last century
have been mostly consumed. Minerals and metals are becoming more
scarce.
Consequently an acute supply
squeeze will surely occur in the coming years. This means historic
valuations of mining stocks based on global economic cyclicality
is no longer valid. Growth from Asia and India changes the entire
landscape of raw materials from a cyclical business to a growth
business - and there is precedent for this; the 1950's and 60's,
where old names such as Kennecott Copper, Reynolds Metals, St.
Joseph Minerals and International Nickel experienced two decades
of strong non-cyclical growth.
The above makes this investment
thesis a unique opportunity and the mining sector could, again,
become the long term darling of Wall Street.
Mining companies should now
enter an era of sustained growth. Growth stocks sell for 20-30
times earnings. Base metal mining stocks in the last three decades
usually sold for only 3-7 times earnings because of the constant
ups and downs of the world's economy (cyclicality). This is
all changing right now. Although we own plenty of gold and
silver companies for our clients we are also invested in producers
of copper, nickel, platinum, zinc and lead deposits and I recommend
the same for you. These companies will experience higher valuation
multiples of cash flow by Wall Street because they are enjoying
very strong profit margins and sustained growth.
Even slow growth from India
and China make these stocks big time growth companies that have
huge asset values already in the ground and because no one can
ramp up any supply in the short or medium term to meet demand,
pricing power will be strong. Also these mineral deposits like
everything else in the world become more valuable as inflation
continues to move forward year after year.
The mining sector, up until
2002, had 20 years of lower prices, layoffs, and abnormally low
investments in new mines and exploration. Consequently the mining
companies were totally unprepared for the huge increase in global
demand for basic metals in the last three years. They are now
5-7 years away from catching up. Shortages are here and now and
they could get worse.
Just make sure you do your
homework when buying mining stocks and remember there are a lot
mining stock "experts" on the internet that are not
as well versed as you might think. There are now hundreds. Back
in the early 70's when my friend Doug Casey and I were buying
moose pasture at the beginning of our careers there were some
very good advisers around. Now, it's a different story. Mining
is a tough business. Be a tough investor and work hard at it
and you will be better off. But be careful of what you read from
the new wave of "experts".
The Best Sector on Wall Street
There are three phenomena converging
right now that offer you a unique opportunity. 1) Prices are
going up for gold, silver, copper, nickel, zinc, lead, uranium,
and the platinum group. 2) Supply will be constrained for 5-7
years. 3) Warehouses are almost empty. The combination of higher
prices and a growth aspect means that many properly evaluated
mining stocks could have enormous moves to the upside.
The U.S. dollar will also continue
to face tremendous pressure. Chinese and Japanese exporters will
take more of their earnings in their local currency and this
will be a huge strain on the dollar value vis a vis these currencies.
If the dollar is going to trend down, anything denominated in
dollars will be priced higher and that certainly includes gold
and silver - the only liquid tangible assets with a globally
standard value.
There is no better sector on
Wall Street than the mining companies in my opinion. Take advantage
of the above data and being in the right place at the right time.
Most likely we have a 5-10 year major bull market coming in the
metals. There will be some nasty corrections... but no one ever
said it would be easy.
Up and Down Influences
The U.S. current account and
budget deficits hit records in the latest reporting period. This
combined with U.S. interest rates at less competitive levels
internationally (compared to a year ago) and the fact foreign
central banks may start to rebalance their reserves away from
dollars, could bring on a period of dollar weakness. This should
have a positive effect on gold which will help balance the "sticker
shock" of gold jewelry buyers reacting to a 25-year high
in the price of gold.
Along with the above trends,
the gold market still has other factors that should positively
affect the demand side of the equation and the price level. These
are:
- Oil exporting nations recycling
huge dollar surpluses outside of the dollar
- Continued strong Mideast gold
buying
- Mine production forecasted
to be flat to slightly down for 2006
- High energy prices creating
a more inflation prone environment
- Political tensions regarding
the Iranian nuclear situation and Iraq
- Higher than expected Chinese
GDP growth
- ETFs taking more and more
gold off the market as large international institutions now have
a vehicle to own bullion.
The downside influences are:
1) the possibility of jewelry demand being stagnant or declining
due to new higher price levels, 2) large hedge funds, active
in the metals market could create some profit taking sell-offs
and 3) normal price pullbacks from the last six months rise.
The latest Bank for International
Settlements report on derivatives states a combined total global
amount of $328 trillion. This is $100 trillion larger than 2003.
Just to give you something to compare this number to; The U.S
is the largest economy in the world, accounting for 25% of the
worlds GDP at $12 trillion. According to the BIS there is a 25.2
times leverage factor of derivative value versus the money backing
the transactions. This enormous leverage is so high and these
market amounts so large that even a mild economic shock could
have tremendous repercussions that could possibly bring down
some large financial institutions. Having gold and silver investments
in the current climate is mandatory for anyone's nest egg.
Silver Should do Well
The supply/demand fundamentals
on silver are even more positive than gold. Silver is also the
poor mans' gold and there are billions of poor people
in India and Asia, many who manage to save. Therefore, silver
should have very strong demand going forward.
With a new ETF in silver most
likely coming to market, many market players have bought in anticipation
of this event and this might be somewhat anticlimactic. But,
if the gold ETFs have bought $6 billion of inventory in less
than a year, then the approximate 250 million ounces of silver
inventory in various warehouses may not be enough to handle the
demand.
Zinc is my favorite base metal
because it will be in supply deficit for the next three years,
has few substitutes and in most applications, higher prices do
not diminish demand. For example a car uses about $17 worth of
zinc. If zinc tripled in price, it would mean only a 2/10th of
1% percentage increase to a $20,000 car. However, the impact
on a zinc mine of a few pennies per pound is substantial.
I would be cautious here and
be patient as well. $600 gold may look good but will it last.
A move to $600 sounds great but are you prepared for a normal
correction back to $500 from there? I would suggest having a
core portfolio that you hang on to as your insurance portfolio
(this should not include any exploration stocks since they have
zero gold) and another where you intelligently make good investments
in quality, properly valued companies but don't take losses if
the trades go against you and only buy on dips.
Currently a price decline back to $460 is very possible and a
run up to $600 is also possible. No one can predict this. Your
only protection in the coming environment is to stay with real
good merchandise and don't be afraid to take some off the table
on run ups.
Good luck.
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Mar 17, 2006
Kenneth J. Gerbino
Archives Kenneth J. Gerbino & Company
Investment Management
9595 Wilshire Boulevard, Suite 303
Beverly Hills, California 90212
Telephone (310) 550-6304
Fax (310) 550-0814
E-Mail: kjgco@att.net
Website: www.kengerbino.com Copyright ©2004-2016 Kenneth J. Gerbino & Company. All Rights Reserved.
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