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Gold-Mining Profits Fallacy

Adam Hamilton
Archives
Oct 18, 2013

Gold miners' stocks have been brutalized this year, leaving them bleeding in the gutter as the most hated sector in all the markets. Plunging prices always lead to fear and excessive bearishness, unsustainable anomalous extremes that investors desperately try to rationalize as righteous. Today the bears' primary rationalization against gold miners is the notion they can't earn any profits, which is a complete fallacy.

Stock prices have always been the result of an endless tug-of-war between fundamentals and sentiment. Fundamentals measure how much any stock is worth based on its underlying company's earning power. Naturally this only changes slowly, so stock prices would be very stable and gradual if fundamentals were their sole driver. Imagine a price chart with a largely-straight line, trending modestly higher or lower.

But sentiment, traders' collective greed and fear, endlessly forces stock prices above and below their slowly-evolving fundamental reality. Visualize a sine wave oscillating around that core fundamentally-determined price line. Buying buoys prices higher than fundamentals warrant, spawning greed which feeds on itself. And fear hammers prices below that line, sparking fear which becomes a vicious circle.

At the greedy crests of this price sine wave, traders are optimistic, complacent, and even euphoric. Rather than acknowledge that prices are indeed high after a powerful upleg, the ideal time to sell, they attempt to rationalize those high prices as being the new norm. They latch on to any theses that argue the high prices are actually fundamentally-righteous, no matter how weak or tenuous those ideas happen to be.

The opposite happens at the fearful troughs of these price sine waves, traders are pessimistic, scared, and even despairing. But instead of realizing prices are very low after a wicked correction, the best time to buy, they instead wrongly assume those low prices are fundamentally-righteous. So they desperately look for any bearish theories that rationalize their fears, that justify their overwhelming desire to sell low.

That's what is going on in gold stocks today. At worst in late June, the flagship HUI gold-stock index had plummeted a gut-wrenching 53.4% in 2013 alone! And this year's carnage cascaded after a 16-month correction where this gold-stock index had already lost 30.0%. Such extreme price weakness ignited epic and universal fear, and the longer these low prices persisted the more investors tried to rationalize them.

The word rationalize means "to devise self-satisfying but incorrect reasons for one's behavior". And that is exactly what happens at price extremes. Investors know intellectually that they have to buy low then sell high to multiply their wealth in the markets, but this simple concept is so hard to execute. It requires fighting your own heart, overpowering and ignoring your own greed and fear to buy and sell when you least want to.

Today gold stocks as measured by the HUI are still down an astounding 51.4% year-to-date, and 66.0% in the 25 months since the HUI's all-time record high. Gold stocks have never been cheaper relative to gold, the metal that drives their profits and hence ultimately stock prices. The HUI now languishes at levels it first hit fully a decade ago when gold and silver were merely trading near $385 and $5.25, vastly lower than today's prices!

Yet rather than acknowledging these simple absolute truths and agreeing gold-stock prices are far too low today, that the popular fear plaguing this sector is wildly overdone, the great majority of investors are trying to rationalize these gold-stock levels as the new norm. They lack the necessary contrarian courage to buy low, to fight their own fear. So they create and traffic in theories that attempt to justify their own bearishness.

Chief among them today is the widespread notion that gold miners can't earn any profits. I get dozens of e-mails a week explaining to me why the gold stocks are doomed to fall much lower because they simply can't earn sufficient money where gold is today. After having spent 14 years studying the markets full-time and trading gold stocks, the sheer popularity of this notion blows my mind. It is completely and utterly false!

Investors desperately want to believe their own fears are justified, that they are not fools for selling low or refusing to buy low. So they troll the internet until they find someone even more irrationally bearish than them, and then parrot his ideas. They can't be bothered with investigating these theses themselves, instead they just blindly accept them as gospel truth because they are emotionally in line with their own bearish biases.

But the cold, hard data is crystal-clear, gold miners can and are making huge profits even in this year's horrendous gold environment. This is readily evident in elite gold miners' price-to-earnings ratios. We've been building gold-mining databases for over a decade now at Zeal, and have extensive earnings data. At the end of every month for example, we record the P/Es of all the major gold miners in the HUI index.

Its 16 component stocks include the biggest and best globally-diversified gold miners on the planet, which account for well over a third of total worldwide mined supply. If gold miners indeed weren't earning money, it would quickly show up in their individual P/E ratios. Yet even in the midst of 2013's incredibly-anomalous gold plunge, the gold miners are still showing their best profitability of their entire secular bull!

This first chart looks at two different measures of gold-stock P/E ratios, taken and averaged monthly from the HUI component companies. The light-blue line is the simple average of each gold miner's trailing-twelve-month P/E ratio. The dark-blue line weights these P/E ratios by the market capitalizations of each company, which in most cases is a more accurate representation of an index's underlying valuation.

Price-to-earnings ratios are the core valuation metric for the entire stock markets, and naturally lower is cheaper. Investors buying stocks trading at 10x earnings, which means their current stock price is 10 times its profits earned in the last four quarters, have vastly higher odds of seeing their stocks rally than if they buy at 30x earnings. The cheaper this valuation multiple, the better the deal any stock price offers.

In both simple-average and market-capitalization-weighted-average terms, the gold-stock valuations have been trending lower throughout the HUI's entire monster 1664% 10.8-year-long secular bull. And today both measures are as low as they've ever been since at least November 2000 when this gold-stock bull was born in fear and despair. Gold-stock prices have never been cheaper relative to their underlying profits!

With fear and despair again rampant in gold stocks today, every day I get e-mails telling me gold miners can't earn enough anymore. That bearish rationalization is incredibly popular, yet complete crap. People tell me gold mining is now too expensive and gold prices are too low, so therefore it is wise to remain very bearish when everyone else is after the second 70%ish mega-correction of this secular gold-stock bull.

I always wonder if these people have no web browsers. Can't they spend an hour on Yahoo! Finance to look at major gold miners' earnings for themselves before they parrot some fool perma-bear's self-serving falsehoods? I suspect many of these same investors were euphoric and bullish in March 2008 and September 2011, when the HUI was carving major interim highs. They offer some damning comparisons.

At the end of March 2008 in which the HUI hit 515, a whopping 139% higher than today's levels, its elite component gold miners had simple-average and MCWA P/E ratios of 38.2x and 34.8x earnings. And since these stocks had been rallying and prices were high, investors eagerly rushed to buy. At the HUI's latest September 2011 peak when it was 194% higher, these valuation metrics were 29.4x and 21.1x.

Now remember higher valuations mean lower earnings relative to prevailing stock prices. At the end of June 2013 after this year's gold-stock plunge, the HUI components' aggregate P/E ratios were merely 17.9x and 11.3x, secular-bull lows even exceeding the extremes of 2008's hyper-fearful stock panic. If gold miners indeed couldn't earn money today, their P/E ratios would be very high instead of exceedingly low!

In about half the feedback I get parroting these silly bearish rationalizations, the writers cite energy prices. They tell me gold mining isn't profitable today because energy is so expensive, and gold mining is usually very energy-intensive. In late June 2013, oil was around $97 per barrel. Back in March 2008 and September 2011 at the last major HUI highs, it was near $109 and $89. Gold stocks still soared despite high oil!

There's another key valuation metric to consider as well, dividend yields. Dividends are the acid test of earnings, companies can't pay them unless they really are earning the necessary profits to cover them. Note above that gold-stock dividend yields (yellow) have never been higher than they were this year, surging above 3% in June as the HUI slammed into its lows. High dividends are a sign of financial strength.

Provocatively there is indeed a problem with gold-miner earnings today, but it isn't them not making money. In the second quarter of 2013, the unprecedented combination of ultra-rare futures forced liquidations and a mass exodus out of the flagship GLD gold ETF hammered gold down 22.8%. This was the worst quarter for gold in something like a century, an extraordinarily-anomalous once-in-a-hundred-year disaster.

Many major gold miners responded to this in the most conservative way possible, they assumed those quarter-end $1200ish gold prices were the new norm and aggressively wrote down their gold projects accordingly. These billions and billions of dollars of non-cash writeoffs have zero impact on operating profitability, but they will totally overwhelm and wipe out most accounting profits until they roll off trailing twelve-month earnings.

I happen to be a Certified Public Accountant, I started my career after college auditing mining companies for an elite Big Six firm. Personally I think these massive gold-project writeoffs were not reasonable at all. Markets nearly always mean revert dramatically out of extremes, and indeed after falling 22.8% in Q2 gold rebounded 7.8% in Q3. Odds are gold will continue climbing out of that once-in-a-century fear super-storm.

So if I had been advising these gold miners, I'd have told them to look at trailing-twelve-month average gold prices before making write-down decisions. As of the end of Q2 when gold languished just above $1200, its average price over the past year was still 30% higher at $1604. Gold's year-to-date average today is $1446. So the assumption that gold would trade at or below $1200 forevermore was very poor.

Thanks to these massive Q2 non-cash writeoffs, many gold miners today show no accounting profits. And they won't for another year. But at the operating-earnings level, they are still very profitable and spinning off tons of cash. If the writeoffs bother you, remember that they only happened after Q2. Even if you ignore all P/E and dividend-yield data after Q2, gold stocks were still hugely profitable in 2013 before that.

And I mean hugely. For many years now my business partner Scott Wright has been doing deep research into the underlying profitability of elite HUI gold miners from another perspective. He's constructed an awesome database of gold-mining costs and margins, which he last wrote about in a May essay. This incredible chart highlights the massive growth in gold-mining profitability before 2013's stunning anomaly hit.

The blue bars are the average annual gold price, while the red show average cash costs of HUI component companies. Hold that thought on cash-cost objections, I'll get there. The yellow bars show the gross-margin percentages for the HUI gold miners, while the yellow numbers show the average cash profit per ounce of gold mined. This data should shatter any doubt that gold miners can weather 2013's epic fear maelstrom.

Last year, the HUI gold miners that produce over a third of the world's mined gold supply averaged $950 per ounce cash profit! Their gross margins have hovered in the 50% to 60% range continuously since 2006. There are very few industries in the world that have such high gross margins, the profitability of mining gold has been extraordinary. And this provides a fortress-like buffer to survive this year's gold plunge.

Mining costs have indeed been rising, but one thing the bears forever fail to mention is much of this is by design. The higher the gold price climbs, the more gold miners can focus on lower-grade ore to increase their production. When the ratio of gold to waste rock is lower, the price to extract each ounce naturally climbs. Gold miners chose to pursue lower-grade projects, which drove much of their rising mining costs.

Over the past four years, average cash costs of the elite HUI gold miners have grown 13.8% annually on average. So apply a similar increase to 2012's average cash cost of $719, and you get a 2013 projected cash cost of $818 per ounce on trend. Odds are cash costs will actually come in lower, since gold miners can modify mining plans in many cases to target higher-grade ore to compensate for a gold-price downturn.

The average gold price this year is $1446, implying still-massive gross margins of $628 per ounce at costs rising on trend. This is still much bigger than all but the last several years of this secular gold-stock bull! If gold plummets like the bears forecast and averages just $1000 in the fourth quarter of this year, the full-year average gold price will still be $1342. Even that hyper-bearish case would leave gross margins of $524 per ounce!

Of course cash costs are out of vogue today in favor of "all-in sustaining costs", the full costs of producing gold including exploration and bringing new mines online. Indeed they are much higher, rumored to be around $1100 to $1200 globally although no one knows since not all gold miners report them and the ones that do measure them differently. But all-in sustaining costs are not very relevant to gold miners weathering 2013.

When times are tough and a major pricing anomaly has to be survived, all that matters is immediate cashflow. While gold miners have to slow exploration for new deposits and construction of new mines when gold prices are weak, the costs of their existing mines are already sunk. As long as their cash costs are below prevailing gold prices, they can keep running these mines to pay the bills until gold inevitably recovers.

Consider all-in sustaining costs versus cash costs at an individual-person level. If someone gets laid off, their income drops, all that matters until they get another job is cash costs. They have to pay ongoing bills, but they usually don't have to replace their appliances or cars or buy a new house until their situation normalizes. Gold miners weather adversity just like individuals do, by delaying major purchases to pay bills.

And there is no doubt gold prices will continue recovering. The extreme forces that drove the second quarter's once-in-a-century gold plunge were unsustainable and self-limiting, they are already slowing and reversing. The wild extremes in both gold-futures long and short positions held by American traders are mean reverting, and the epic mass exodus out of the GLD gold ETF driven by the levitating US stock markets has petered out.

Gold investment demand will return even in the United States as the full magnitude of the Fed's massive QE3 inflation campaign gradually becomes more apparent. Thanks to the Washington budget fight and Obama's appointment of a new uber-dovish Fed chairman, QE3 is going to continue creating money out of thin air to monetize US Treasuries for many months to come. Gold will absolutely return to favor again.

Will you be ready? If you listen to the bears and their endless rationalizations of why it is smart to stay bearish at wildly-anomalous lows after extreme price declines, you probably think gold and gold stocks are going to fall forever. That's a terrible mistake. All markets are cyclical, both prices and sentiment ebb and flow. The extreme fear plaguing precious metals can't last, the sentiment pendulum will swing the other way.

At Zeal we're going to multiply our fortunes as gold and gold stocks mean revert back up to far higher fundamentally-normal levels. We continue to detail our specific trades in our newsletters, where we own elite gold and silver producers trading as cheaply as 5x earnings! Many of these great miners are so oversold and loathed that their prices ought to easily at least quadruple. Their coming gains are likely to be gigantic.

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The bottom line is the dominant bearish gold-stock rationalization today that gold miners can't earn money is totally false. Contrary to the assertions by shameless perma-bears, the gold miners continue to earn big operating profits even with 2013's anomalously-low gold prices. These stocks have never been cheaper relative to their underlying earnings (or gold) in their entire secular bull, they are screaming bargains.

Even at $1200 gold, the ongoing cash spun off from the great majority of existing gold mines is massive. Though the miners have prudently slowed non-critical expenses like exploration and mine construction, they can easily ramp these back up as gold recovers. And it will, with miners emerging from survival mode leaner and stronger. The deeply-oversold universally-loathed gold stocks are perfectly set to soar.

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Oct 18, 2013
Adam Hamilton, CPA

Thoughts, comments, or flames? Fire away at zelotes@zealllc.com. Due to my staggering and perpetually increasing e-mail load, I regret that I am not able to respond to comments personally. I will read all messages though and really appreciate your feedback!

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