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Gold Stock Valuations 3

Adam Hamilton
Oct 20, 2006

With gold stocks looking up again lately following their rather typical consolidation since their May tops, traders are getting excited about the tantalizing prospects of this bull's next major upleg launching. But although the gold-stock technicals are certainly looking increasingly bullish, a vexing fundamental issue remains.

Gold stocks remain extremely expensive relative to the profits they are earning. Despite the amazing year gold is enjoying, the profits of gold miners remain very low relative to their stock prices. When their valuations are analyzed with any classic metric including price-to-earnings ratios and dividend yields, the inevitable conclusion reached is that gold stocks are simply chronically overvalued today.

This unpleasant truth has the potential to seriously undermine the ongoing gold-stock bull on multiple fronts. For investors like me who have been riding this bull higher since its early days in 2000, the fact that gold-stock valuations remain very high threatens to negate our entire original thesis for investing in this particular sector. What was this foundational thesis?

Six years ago this month, gold was languishing in the $260s and calls for it to continue sliding under $200 abounded. Sentiment was horrifically ugly. Traders remained so enamored with general stocks following their mighty multi-decade bull that gold-stock investors were considered irrational at best and crazy at worst. We were buying into a contracting and long-neglected "old economy" sector full of companies hemorrhaging money like crazy. At those dismal gold prices it was nearly impossible to earn a profit mining it.

So why buy gold stocks in late 2000? Gold had been falling for decades on balance and it was increasingly looking like its secular bear was ready to give up its ghost and yield to a new secular bull. Gold's fundamentals were stunningly bullish and gold stocks looked like a fantastic way to multiply gold's gains. And interestingly this idea has proven true. Bull to date gold was up 183% at best compared to 996% at best for the HUI gold-stock index. Thus gold stocks have leveraged gold's gains by 5.4x or so over the past six years.

The reason a brave few contrarians believed such a profitable gold-stock outcome was possible six years ago way before anyone else was due to the prospect of rapidly rising gold-mining profits. If the gold price was due to rise, then gold miners' innate operating leverage would seriously multiply those gold gains. This would lead to gold-stock profits rising at rates much higher than either the gold price or the stock prices. As this happened, gold-stock valuations would fall attracting in an ever-wider pool of investors to drive gold stocks higher.

While this has indeed happened to a great extent, gold-stock valuations have not fallen as far yet as I had originally expected. And this leads us to the next front where these pricey gold stocks could undermine this bull's progress, the new-investment front. Value investors want to buy extremely profitable companies at low valuations to ride the increasingly well-known secular commodities bull. If gold stocks are not very profitable and remain expensive, they won't attract in as much new capital as they should.

Unfortunately this problem is unique to gold and silver miners. Other major commodities producers, including base-metals miners and oil and gas drillers, are earning gargantuan levels of profits even compared to their relentlessly climbing stock prices. Outside of gold and silver, most other metals and energy producers are great fundamental bargains today trading at low P/Es. Why on earth would a value investor want to buy a gold miner trading at 50x earnings when he can buy a copper miner trading at 8x earnings?

And we really need these value investors to jump onboard to form the backbone of the Stage Two investment-driven third of this secular commodities bull. Relative to contrarian investors, the pool of capital commanded by value investors is very large. Value investors also bridge the gap between true contrarians and true mainstreamers. Contrarians, then value players, then mainstreamers, in this order, drive great bulls higher by subsequently following each other in.

It is the value guys who flood in near the early middle stage of bull markets and pave the way for the even larger pool of mainstream capital later. But value investors need value to deploy their capital, and they cannot find it in precious metals miners today. Gold-stock valuations remain far too high, near NASDAQ-2000-like levels in some cases. Without the usual contrarian-to-value-to-mainstream capital evolution in gold-stock investing, this bull will only reach a fraction of its ultimate potential.

So with today's persistently high gold-stock valuations threatening to negate the thesis of this bull's original contrarian investors as well as drive new value investors into other commodities stocks with far superior valuations, this is a critical issue to understand. There is nothing that concerns me more in commodities stocks today than the inability of gold and silver miners to earn big profits relative to their stock prices.

Since my last essay on this unpopular topic written six months ago, there have been some developments of note to discuss. Today gold-stock valuations are thankfully once again moving in the right direction, I now understand why this valuation problem is occurring, and there are ways investors can position themselves into the most fundamentally attractive gold stocks that are likely to become undervalued years before the rest.

First, an update of our gold-stock valuations chart is in order. In this chart I compare the price-to-earnings ratio and market capitalization of flagship gold miner Newmont Mining to its stock price since this gold-stock bull launched in late 2000.

While I would far prefer to have comprehensive historical valuation information available for a wide array of gold stocks rather than just one, Newmont Mining acts as a suitable valuation proxy for gold stocks as a whole. It is the world's second largest gold producer and largest unhedged gold miner, an elite blue-chip representative for this sector. Since NEM is an S&P 500 component, we have gathered data on it at the end of each month since 2000 for our general-stock-market valuation-tracking research.

Apparently largely due to the gold-stock consolidation since May, over the last six months NEM's valuation is finally contracting again. This is wonderful to see especially after the two previous years where its P/E ratio was expanding, or it was getting more expensive in valuation terms. The lower gold-stock valuations go, the higher the odds they will attract in the crucial value-investor capital necessary in this stage of the bull.

While the stubbornly high gold-stock valuations remain a vexing problem, this chart always encourages me as we have made much progress. Despite Newmont's market capitalization being bid up 1067% at best in this bull market so far, its valuation has contracted a whopping 81% at best so far. Less than six years ago Newmont Mining was only worth $2.3b and trading at 160x earnings. Today it is worth around $19.0b at 34x earnings. Thus it has gotten much larger and much cheaper just as the original gold-stock bull thesis predicted.

Although Newmont's earnings haven't risen as fast as its stock price in recent years, they have certainly risen with the gold bull. This is readily apparent when looking at the valuations at its major interim lows since 2003. In March 2003 NEM was around $24 a share and trading at 83x earnings, definitely radically overvalued. To understand this in context, realize that the elite NASDAQ 100 tech stocks had an average P/E of 50x earnings back in late 2000 when the NASDAQ was still trading in the 3000 range.

But at Newmont's next interim low in May 2004 its stock price had risen to $37 or so while its P/E had fallen under 31x earnings. So over a period of about 14 months, from major interim low to major interim low, Newmont Mining had about a 54% gain in its stock price along with a 63% contraction in its valuation. This is tremendous progress that lines up with the original gold-bull thesis of profits rising way faster than stock prices.

After this episode, unfortunately Newmont's valuation started expanding again. It was near the end of this two-year expansion when I wrote my last essay on gold-stock valuations. During this period Newmont's stock price was rising faster on balance than its earnings, leading to higher P/E ratios. This troubling countertrend move in valuations ultimately led to Newmont peaking above 60x earnings at $62 per share last February.

While there were some Newmont-specific issues happening in this time frame, such as production declining at its mature mines before its new mines were fully online, Newmont was pretty representative of the entire gold-mining sector. The powerful gold-stock upleg straddling 2005 and 2006 led to stock-price advances easily outpacing higher profits driven by the rallying gold price. Until their May tops, gold-stock prices were looking more mania-like by the week and causing increasing concern amongst level-headed contrarians.

Interestingly though, even during this manic surge valuations were still modestly contracting when measured on the same interim-low-to-interim-low basis. At its $35 stock-price interim low in May 2005, Newmont was trading near 37.4x earnings. And at its subsequent interim low near $41 we just witnessed over the last week or two, NEM was trading around 34.9x earnings. Thus even though its stock price rose about 17% trough to trough, its P/E ratio contracted 7%. Progress was still made even though it was masked and modest.

The following table shows that Newmont is not an anomaly and is representative of the gold-stock sector as a whole. These columns show the valuations and capitalizations of all of the component companies of the leading HUI and XAU gold-stock indexes. Since they have many common components between the two of them, these are highlighted in yellow. In the third column the XOI oil-stock index is included for comparison purposes.

Back in April the last time I worked on this analytical thread, the HUI had an average P/E of 78.2x earnings, a market cap of $86b, and 7 of its 15 components had no earnings at all. Today this has improved a great deal in some ways. Now the HUI is only trading at 28.8x earnings, a massive 63% improvement in about six months! And today "only" 6 of its 15 components can't manage to earn any profits at all these days.

Now the initial temptation is to assume that the reason the HUI's valuations have contracted so dramatically is because of its consolidation since May. Although stock prices have corrected significantly, the decline in market cap or the total value of HUI stocks on the exchanges has only fallen by 15% since my last essay. So only around one-quarter of the HUI's improved valuations can be directly attributable to the fall in stock prices.

In addition, one of the HUI components has changed since then. The index's custodians kicked out Glamis Gold and added Yamana Gold. Since the latter is less than half the size of the former in market-cap terms, the HUI's decline in market cap is even overstated at 15%. Thus at least three-quarters of the impressive valuation contractions in gold stocks over the past six months is attributable to rising earnings. This is exactly what we want to see and is very encouraging!

The XAU gold-stock index, which is about 55% larger than the HUI in market-cap terms since it also includes companies that are major hedgers, shows a similar phenomenon. Back in April the XAU had an average P/E of 74x, a market cap of $124b, and 7 of 16 components losing money. Today its average valuation has fallen by 50% while its market cap only contracted by 9% and now "only" 6 of 16 have no profits. So the XAU has a similar three-quarters of its valuation improvement attributable to rising profits and not correcting stock prices.

Then happy days are here again, we are back on track and out of the woods, right? Not yet I fear. While gold stocks have had excellent relative improvements in their valuations over the last six months, in absolute terms they remain very overvalued. Realize that any time the general stock markets trade above 28x earnings it is considered a bubble, a speculative mania like the NASDAQ in 2000. This week the HUI was trading at 28.8x and the XAU at 37.2x, both still in classical bubble territory.

The absolute expensiveness of the gold stocks is readily apparent when they are compared to the XOI oil-stock index in the right column above. Not only are the elite major oil stocks now averaging P/E ratios of just 9x earnings, which is very cheap in light of stock-market history, but all of them are earning profits. This is vastly different from the gold stocks on the left, which are either trading at high P/Es or even worse not earning any profits at all despite today's high gold prices.

So why are gold and silver stocks trading at sky-high prices relative to their earnings while other commodities producers are already at the deeply undervalued levels necessary to attract in legions of value investors? The answer is two-pronged and the blame lies evenly at the feet of both gold-stock investors and gold-mining companies.

On the investor side, we contrarians have become so enthusiastic about gold stocks over the last six years that we have dumped a relatively large amount of capital into a relatively small sector. Early on in this gold-stock bull every publicly-traded gold stock in the US added together was worth much less than one of the big technology stocks. So it didn't take a lot of capital in relative terms to drive this small sector up by an order of magnitude.

Even today gold stocks remain small. The average HUI or XAU stock above has a market cap of under $6b, really chump change within the context of the broader markets. And these stocks are the elite of the gold-mining world, the bluest of the blue chips. Meanwhile the average XOI oil stock has a market cap of $123b, 22x larger than the average gold miner! If X amount of capital flows into a $6b company it will rise much more than the same X amount flowing into a $123b company.

So the primary reason that gold stocks remain so overvalued today is that we investors have driven them up too fast. The enemy is us. Even though the overall pool of pure contrarian capital is not large compared to the general markets, it was huge compared to the tiny and shriveled-up gold-stock sector back in 2000 that was trading at market capitalizations of about one-tenth of today's. Gold-stock prices were bid higher far faster than their earnings could leverage the rising price of gold.

The secondary reason lies with the gold miners themselves. While investors want to maximize profits since it is profits that ultimately drive stock prices over the long term, miners want to maximize mine life. Although these two goals are generally congruent, sometimes pursuing mine life over profits leads to much slower profit growth than is possible. Mine managers pursue this goal by targeting different grades of ore depending on how the gold price is faring.

Even in gold mines, there is not a lot of gold relative to waste rock trapping it. So this rock, or ore, is mined and processed. It is run through a series of mechanical and chemical processes that ultimately extract the gold from the plain rock. But these processes, including mills which grind up the ore into small pieces, have a fixed capacity. Every day a given mine's mill can only process so many tons of rock regardless of how much gold is contained in the rock.

So when gold prices are low, mine managers target the best high-grade ore and run it through their mills. Since this rock has more gold per ton, each day they produce a lot of gold. They hate to burn through high-grade ore at low prices, but sometimes it is necessary to ensure there is enough cashflow to meet the ongoing costs of running their mine and paying their people and suppliers. High-grading keeps mines in business in tough times like the lean gold years surrounding 2000.

But when gold prices are high, mine managers save the high-grade ore for future lean times and they mine low-grade ore. Even though there is less gold per ton of rock, the gold price is still high enough to cover expenses and earn a modest profit. So low-grade ore is mined and run through the fixed-capacity mills, yielding fewer ounces per day at high gold prices than the high-grade ore yielded at low gold prices. The more low-grade ore a miner can process, the longer its mine will last and the greater the ultimate amount of gold it will recover.

All over the world, mine managers have been taking advantage of high gold prices to mine marginal low-grade ore that wasn't even remotely economical six years ago. Because of this low-grading, gold-mining profits across this sector have not been anywhere near as high as they could have been. As an investor I have mixed feelings about this. I want profits maximized (mine the best high-grade ore at high gold prices) but I also want reserves prudently managed (low-grade ore at high prices) for long mine lives.

So I believe a combination of a relatively large amount of capital flowing into a relatively small sector coupled with mine-management techniques to mine the most marginal ore at the prices where it becomes profitable have led to today's high gold-stock valuations. Although vexing, I still suspect gold-stock investing will prove very profitable in the decade to come and investors can capitalize on this.

While gold-stock valuations are absolutely high today by any measure, they are still trending in the right direction, lower. Several key factors lead me to believe they will continue moving this way, that gold-mining profits will rise faster than gold-stock prices on balance in the coming years.

As the secular gold bull continues powering higher, the gold price will eventually get to a level where even marginal low-grade ore is very profitable to mine. The mine managers I have talked with believe there is a limit to low-grading. There is probably some small amount of gold per ton of rock where mine managers don't want to mess with it even if gold is trading at thousands of dollars per ounce. So they won't keep milling progressively worse ore into infinity as gold moves higher. The economics will swing back in favor of profits.

And interestingly low-grading itself, since it leads to lower short-term gold production industry wide, will contribute to higher gold prices in the future since it acts to constrain overall gold supplies coming onto the market.

Another important thing to consider is how small the gold bull has been compared to other commodities bulls. Gold is only up about 180% bull to date, which doesn't sound too bad. But since late 1998 oil is up a whopping 580% or so, more than triple the gains of gold! So odds are a big part of the reason why oil stocks are so massively more profitable than gold stocks is because their underlying commodity has run much higher giving their profits leverage more room to kick in. When gold's gains eventually reach the levels of today's gains in energy and the base metals, I suspect gold-stock valuations will fall quite low like the energy and base-metals producers today.

Finally, many gold deposits are found with other marketable minerals. These other minerals are sold as byproducts and their revenues are used to offset gold-mining costs and increase profitability. The best example today is copper. Major gold deposits sometimes include sizable copper reserves. Copper prices have risen so tremendously, on the order of three times as much as gold, that it is incredibly profitable to mine. Therefore gold miners pulling copper as a byproduct are usually far more profitable than their peers.

A case in point in the table above is Freeport McMoRan, FCX. It was trading at just 9.4x earnings this week, down in the oil-stock range of low valuations. The reason why it is the only elite gold stock above that looks like a great buy today is because it mines a huge amount of copper in addition to its gold. This byproduct contributes to incredible profits and makes FCX one of the few gold miners attractive to value investors. Thus any gold miner with a profitable byproduct metal should see its valuation contract far faster than a pure gold miner.

You investors and speculators can definitely use this phenomenon to your advantage. If you want to buy gold stocks today near their latest major interim lows, you can look for gold miners that have relatively low valuations due to their base-metals byproducts. Their low P/Es will make them look much more attractive to value investors and hence greatly increase their odds of soaring in the next major gold-stock upleg.

We have been following this strategy ourselves at Zeal lately. One of our seven new trades recommended this month in our October Zeal Intelligence newsletter to capitalize on the commodities weakness is a small hybrid gold/copper producer with tremendous potential. Another is a small copper miner that is working on a project that will also make it a smaller intermediate gold producer in the coming years. It is not too late to buy these high-potential companies at excellent prices so please subscribe today!

And we are continuing to look for great gold miners with superior profits to their peers due to their byproduct metals mined to recommend in the future. Companies like these are lower risk with high potential and they provide excellent diversification for portfolios of gold stocks largely composed of pure gold miners with high valuations.

The bottom line is gold-stock valuations do remain absolutely high today, despite their tremendous relative improvement over the last six years. This is due to a combination of a relatively large amount of capital bidding up the small gold-stock sector and gold miners themselves mining lower-grade ore at high gold prices to maximize their mine lives.

Despite these high valuations, the trend is moving in the right direction. Not only are pure gold miners getting more profitable which is gradually driving down their valuations, but hybrid gold miners are proving great bargains today. And as gold's bull-market gains continue higher and eventually approach those already seen in oil and copper, mining gold should only get more profitable on balance.

Adam Hamilton, CPA

October 20, 2006

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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