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Gold Stock Valuations

Adam Hamilton
May 7, 2004

FYI: The next essay from Adam will be published on Sat May 15th

The last few years have probably been the most educational and eye-opening for investors in the past seven decades. The spectacular rise, ferocious crash, and devastating bust in general equities have blessed us with rare front-row seats to witness timeless financial-market truths in action, lifted right out of dusty old history tomes.

One of the greatest lessons learned from the bubble is that valuation is everything over the long-term. Nothing is more important. If long-term investors buy when stock valuations are historically high, they are virtually guaranteed to lose money on their investments, period.

The wisdom of buying at low valuations and selling at high valuations forms the very foundational basis of contrarian investing. Valuation Theory has been extensively observed and tested for centuries and is the most ironclad and rock-solid long-term law of the financial markets. Those who ignore it do so only at their own peril.

While the Great Bear of recent years has gradually taught general investors that valuations matter, contrarians have known it all along. Interestingly however, some of these same contrarians who wouldn't be caught dead buying companies like General Electric and Microsoft at 30x+ earnings are buying gold stocks. Unfortunately most gold stocks themselves currently sport very high valuations, presenting a quandary for contrarians.

If market history irrefutably teaches that buying at high valuations is a fools' game, then why are contrarians willing to buy gold stocks trading at 50x to well over 100x earnings? Are the gold-stock owning contrarians being played for fools? Are gold stocks themselves somehow exempt from the timeless laws of valuation?

As a gold-stock owning contrarian myself, I don't think contrarians buying gold stocks are degenerating into starry-eyed slack-jawed conventional investors willing to buy at any price. At the same time, I am certain that gold stocks are not exempt from the ironclad financial-market laws of valuation.

So can a gold stock trading at a conventional bubble valuation above 28x earnings actually be a good contrarian investment? Yes! This certainly sounds like a glaring contradiction at first, but the magic of the commodities markets makes it possible. To understand why, we have to first contrast conventional and commodities-based businesses.

In any business, a company sells its product for a profit. The company can increase its profits by raising the price of its product, increasing the sales volume of its product, or by lowering the cost of its product. In today's brutally competitive global economy, often the only way that most mature companies can grow their profits is by lowering their costs.

For a conventional business, raising prices is a very difficult proposition. The higher a product is priced, the more competition it draws as other companies around the world seek to carve out a piece of the profits pie. For example, LCD televisions are expensive now, but their profit margins are so large that high-tech companies all over Asia are jumping into the game to manufacture LCD TVs. As these new factories come online, LCD TV prices and profits will plunge dramatically in the next couple years.

Increasing sales volume is also very challenging, as higher sales in mature industries primarily come from cannibalizing market share away from other companies. For example, there is a finite market for new computers. If Dell continues to increase its market share, other companies will lose. Every marginal computer that Dell sells will be one less for HP or Gateway to sell. Dell's impressive growth is carved directly out of its competitors' profits.

Thus lowering costs is often the only viable option to grow profits in mature industries. Lowering costs is the primary driver behind outsourcing. If your company is manufacturing anything in the States, and paying high American wages, it is just impossible to compete with a factory in Asia paying Asian wages. Lowering costs can only go so far though, as the cost of a product will never go to zero no matter how cheap labor and materials become in some far-off corner of the world.

Because it is so difficult for big mature companies in conventional businesses to grow their profits, high valuations are seldom justified. A company trading at 30x earnings today will take a whopping 30 years to earn back the price investors paid for it if its profits do not grow. And since it is so difficult to raise prices or increase sales in mature industries, and since cost cutting can only go so far, earnings growth in large companies is rarely high enough to justify stellar valuations.

Now most of the time, commodities-based businesses feel these same pressures. They have no control over their selling prices since the free markets set commodities prices. They constantly strive to lower their costs of production by becoming more efficient. And they slowly grow their profits by increasing their sales through higher production. But commodities producers have one key advantage that blows normal companies out of the water.

While the prices of normal products like LCD TVs and computers are never likely to enter a bull market and go significantly higher, commodities prices do witness periodic bull markets. The net effect of these bull markets on the profits of commodity-producing companies is nothing short of phenomenal. Commodities bulls enable profit growth in mature companies that is utterly breathtaking, far beyond anything else witnessed in the conventional markets!

Gold-mining companies are the perfect example of this amazing profits leverage inherent in commodities companies.

In normal stable gold-price environments, gold miners face the same pressures as conventional businesses. Prices are out of their control, they can only cut costs so far, and most profits growth comes out of increased production. Increasing production means bringing new mines online, a capital-intensive and slow process that takes years to complete.

Thus, if the gold price is flat and not expected to rise in the future, buying gold stocks at bubble valuations over 28x earnings is as foolish as buying tech stocks at bubble valuations. There is no way that earnings will grow fast enough to justify excessive valuations so gold-stock prices are doomed to collapse to return their valuations to historical norms.

A bull market in gold, however, changes everything!

In a bull market, gold producers receive a windfall as the price they receive for their product climbs. This fantastic event is something almost never witnessed in conventional mature non-commodities-producing businesses. As the gold price rises and increases gold miners' profit margins, both their production costs and production levels remain roughly the same. The net result is profits multiplying fast enough to defy imagination.

Our first graph this week attempts to illustrate this phenomenon. It plots the profits per ounce earned by a gold-mining company as the gold price climbs higher. For this example we are assuming a cost of production of $400 per ounce. The rising gold price is shown on the horizontal axis and the profits per ounce earned on $400-cost gold are shown by the black line on the left axis.

The rainbow-colored lines, slaved to the right axis, illustrate the ratio of the increase in the gold miner's profits to the increase in the price of gold itself, at different production costs. A ratio of 2x, for example, means that a gold miner's operating profits are growing at twice the percentage rate as the increase in the price of gold itself. Since gold is currently near $400 today, $400 is our baseline for gold percentage gains in this graph.

Now this graph looks a bit odd, like some child went wild with crayons, but it is easy to understand and very important. If you can grasp these key concepts, you will be able to understand why contrarians are willing to buy gold stocks at high valuations in a gold bull and still earn enormous profits on their investments.

In this example, our mining company can chisel gold out of the bowels of the Earth at an average cost of $400 per ounce. These costs include the heavy equipment necessary to mine, the labor to get to the gold, the fuel and supplies, the depreciation of the enormous up-front capital investments to sink the shafts, all the administrative salaries, basically all the costs involved in running a gold-mining operation. Gold mining sure isn't cheap or easy!

With a $400 cost, our company isn't doing well today with gold trading under $400. It is operating at a loss. If we expected $400 gold to persist into the foreseeable future, then investing in this company would be a foolish decision. There is no sense buying any stock only able to sell its product at or below cost. But if the gold price is expected to march higher in a gold bull, then this $400-cost company is an ideal investment.

Once the gold bull pushes the gold price to $425, our company is suddenly able to earn a $25 per ounce profit. It is not much, and depending upon the company's share price it may have a very high price-to-earnings ratio at $425 gold. Yet, even if it is trading at 100x earnings, this is right where contrarian investors want to buy it, when it starts showing profits in an ongoing gold bull.

Once gold gets to $450, our miner has now doubled its profits per ounce with zero additional effort. Its costs are the same, its production is the same, but the free markets are generously enabling it to sell its product at a higher price. While gold itself is only up 12.5% from $400, our miner's profits have doubled to $50 per ounce mined as gold went from $425 to $450. The profits leverage of an unhedged gold miner to the price of gold is simply magnificent!

The red line above, tied to the right axis, illustrates the enormous profits leverage for a company able to mine gold at $400 per ounce. Point 1, the first white circle above, shows the profits leverage curve at the $450 level we just discussed. Gold is up 12.5% from $400, but our miner's profits are up 100%. This 100% increase in profits divided by the 12.5% increase in gold yields a profits leverage ratio of 8x at this point. Our miner's profits are soaring at 8x the rate of the price of gold!

And it gets even better as gold keeps meandering higher in its bull market. At $500 gold, our company is able to sell every ounce of gold it pulls at a $100 profit. While gold is up 25% from $400, our miner's profits are up 300% from the $425 gold days when it was just squeaking by. A 300% profits increase divided by a 25% gold increase yields a profits leverage ratio of 12x, labeled as Point 2 in the graph above.

Since the profits leverage ratio multiplies the fastest right after a gold miner becomes profitable, due to the easy percentage gains from small numbers, this ratio gradually moderates at a higher gold price. It is still pretty extraordinary however!

Point 3 on the red curve above is noted at $600 gold. At this point the gold bull has pushed gold 50% higher than it was at $400, yet our miner's profits have increased to $200 per ounce, or 8x as high as they were at $425. This 700% increase in profits yields a profits leverage ratio of 14x, very impressive for a mere 50% increase in the gold price!

The red profits leverage line is plotted based on a $400 cost of production, but five other higher costs are drawn above in different colors. These illustrate the profits leverage multipliers of a higher-cost gold miner compared to the same percentage increase in gold from $400. We added these lines because it is really important to point out that this leverage exists throughout the whole spectrum of a gold bull, not just the early years when the gold price first exceeds production costs.

It is interesting, however, that the slope of subsequent profits leverage curves moderate. A gold company producing gold at $500 per ounce has a smaller, but still enormous, profits leverage multiplier compared to a gold company producing gold for $425 per ounce. While this multiplier is highest for companies just moving into profitability, it certainly does not disappear later on at higher gold prices and costs of production.

Amazingly, a single company can even witness its profits leverage soar on multiple curves throughout a gold bull, multiplying its profits even more dramatically. This is due to the peculiar nature of gold-bearing ore bodies. At one part of a mine, gold may be economically mineable at $400. As soon as gold heads north of $400 and the gold company believes it will stay higher, they can start mining this gold at $400 per ounce and watch their profits head up the red curve.

But at this very same mine, the other end of this ore body may have gold that costs $450 to mine. Naturally it is silly to mine gold for $450 when the gold price is $400, so the mining company does nothing. But once gold crosses $450 and heads higher suddenly a company can add additional production at $450 that was previously uneconomical. This extra production at $450 rides the yellow curve higher and adds to a company's overall profits leverage.

Between the powerful profits leverage curves as gold rises, the ability to bring on new production as rising prices make previously uneconomical ore bodies profitable, and the compounding nature of these subsequent leverage curves, the ultimate profits growth in gold miners during gold bulls can be staggering.

During a gold bull a gold miner's selling prices rise, its costs remain stable, and its production either remains stable or expands as well if it can mine previously unprofitable ore. The net result is profits that literally explode higher in even the most mature and largest of the unhedged mining companies.

While most mature companies in conventional industries have zero hopes of seeing their profits multiply by 10x or more in the space of a few short years, such events are common for gold miners during a major bull market in gold. This immense profits leverage rapidly nullifies extreme valuations in gold stocks. A contrarian can buy a gold stock trading at 100x earnings in the early stages of a gold bull, watch his stock price soar, and still end up with a vastly higher stock at a far lower P/E ratio.

While this concept is pretty simple, it is still difficult for a lot of hardcore contrarians to swallow. The idea of buying anything at stellar valuations is so foreign to the whole realm of contrarian thought that it just gives some contrarians a nasty headache. To prove that this theory actually works in the real world, however, all we have to do is look at Newmont Mining in this gold bull to date.

Newmont (NEM) is the General Electric of the gold-stock world. It is the world's best and biggest unhedged gold miner. NEM utterly dominates the blue-chip gold-stock indices, accounting for 27% of the market capitalization of the XAU and 16% of the HUI. This monster, also listed in the venerable S&P 500, expects to mine a phenomenal 7m+ ounces of gold in 2004.

I have long been a fan of Newmont, first recommending it to my clients as a long-term investment in early 2002. It remains an anchor in our long-term gold-stock portfolio today. As outlined in the latest issue of our Zeal Intelligence newsletter for our subscribers, I am also now recommending specific call options on NEM as I expect it to soar higher in the next major gold upleg.

As this second graph shows, even the largest unhedged gold mining companies like Newmont are witnessing soaring profits and plummeting valuations in this young gold bull. The blue line tracks the daily stock price of NEM since 2000, when the bull market in gold stocks began. The red and yellow lines tied to the right axis show monthly data, highlighting NEM's collapsing P/E ratio and its soaring market capitalization.

When can a contrarian buy an elite stock in a mature industry trading at 160x earnings, earn huge profits during a Great Bear market, and still be holding the stock today at far lower valuations? In a bull market in gold! Long live the commodities!

Just as the abstract gold-stock profits leverage discussion above predicts, as gold marches higher the valuations on gold stocks collapse. Gold behemoth Newmont soared from around $13 in late 2000 to $50 late last year, a magnificent 285% gain during the worst stock market environment since the Great Depression. Investors in Newmont were richly rewarded.

Yet, way back in late 2000 and early 2001 when NEM and gold stocks were bottoming, the valuations on these stocks looked almost as outrageous as the NASDAQ tech bubble! The red line above highlights NEM's P/E. The best time to buy, amazingly enough, was when NEM was trading at the ridiculous level of 130x to 160x its meager gold-bottom earnings!

At the time, gold was in the process of bottoming and was approaching $250 in early 2001. Needless to say, it was very difficult for gold miners to earn profits in this brutal environment. They either had tiny profits which made their valuations look huge, or they actually lost money. In NEM's case, it did both. While it had minuscule profits in late 2000, the 18-month gap above with no red data highlights a period of time when NEM was losing money and therefore had no P/E ratio.

Yet, as the gold price marched higher, gradually NEM's profits leverage multiplier kicked in. Even though its stock price was relentlessly rising, its valuations started to fall. By mid-2002, its earnings were back and its P/E was cut in half even though its stock price was twice as high as the late 2000 bottoming days. Of course 80x earnings was still obnoxiously high, but contrarians knew that as the gold bull powered higher NEM's earnings would only balloon ever larger.

As its valuations fell for most of 2003 and 2004 while its stock soared, today NEM is trading a bit above 30x earnings. Yes, this is still overvalued from a classic contrarian standpoint, but as the gold bull continues NEM's earnings will grow rapidly right along with it. Almost regardless of how high its stock price trades, its P/E is likely to continue to shrink as its earnings multiply.

In the real world of today's gold bull, the world's biggest and best unhedged miner witnessed a massive 285% bull-to-date gain in its stock price. Its market capitalization, the yellow line, soared by 702% from just over $2b in 2000 to over $18b in 2004. Yet, its valuation collapsed by 81% from trading at 160x earnings when the gold bull began to just over 30x earnings today. Wow.

These amazing results are due to the profits leverage multiplier of gold mines in a gold bull market. And if a massive market leader like Newmont can witness this phenomenon even at its vast scale, imagine how much more powerful the leverage is for smaller gold-mining companies. Generally the larger a company the more difficult it is for the markets to bid its share price higher, so NEM really is the most conservative example possible to illustrate the valuation wonders inherent in a major gold bull.

So, during a gold bull market, contrarians can buy gold stocks at valuations that seem irrational and still earn huge profits. A rising gold price grows profits far faster than most gold-stock prices can rise, shrinking valuations. Because of the powerful nature of the gold-miner profits leverage multiplier, contrarians can even ignore gold-stock valuations altogether if the gold price is expected to head significantly higher, like today.

The primary caveat I have regarding gold stocks is to please realize that this profits leverage applies only to unhedged miners. Avoid hedgers in a gold bull like the black death!

Hedged miners have already locked in a future selling price for their gold, so even if the gold bull continues higher they cannot sell their gold at higher prices. Their contractual obligations keep them from participating in the gold bull and their share prices suffer accordingly. If you would like more background on this crucial distinction, please check out my "Gold Stock Investing 101" essay of a couple years ago.

As I have advised my subscribers in recent newsletters, high gold-stock valuations are no reason to avoid buying unhedged gold stocks during a gold bull. Gold miner profits usually multiply far faster than gold share prices and valuations are reduced over time even as stocks power higher.

In the latest May issue of our monthly Zeal Intelligence newsletter just published, I even outlined my six favorite gold and silver stocks for the next major upleg in gold. Subscribe today or be left behind when the current fantastic buying opportunities evaporate.

As contrarians have always known, valuations do matter. But in the peculiar situation of a major commodities bull market, P/Es of commodities-producing companies plummet as their profits soar. High valuations are very common at major commodities bottoms since the producing companies are barely getting by, but once commodities prices recover their earnings and stock prices soar at the very same time their valuations collapse.

Don't let high valuations scare you away from investing in commodities producers during a commodities bull.

May 7, 2004
Adam Hamilton, CPA
email: zelotes@zealllc.com

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