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Before I go into the discussion of the title of this article I want to first cover some other important points about gold and the gold share market.
The ratio of the mining stocks (XAU) to the gold price is currently in undervalued territory as the graph below shows (the higher the ratio the more undervalued shares are at current gold values). The pullback in the gold mining sector in September was overdone and a substantial rally looks like it is underway.
Developmental Companies – Best Bang for the Buck
Companies developing mines should experience strong share price increases as they approach production even with lower metal prices. Gold is approximately $600 an ounce. Many companies use $325-350 as a guide to take a mine into production profitably. Gold at $425-450 would make these mines extremely profitable and $500 gold and above hugely profitable. Therefore investments in developing mining companies usually have solid 1-2 year upside potential even if metal prices decline. One has to have patience with these future producers, but the upside is usually worth the wait.
Driving The Gold Price
The fundamentals for higher gold prices are tied to basic economic scenarios. Strong economic growth increases jewelry demand and the past robust housing market increased commodity demand in general which helped gold. Currently the global economy is doing better than expected and will for the time being help the mining industry and gold consumption. But the housing market slowing down in the U.S. and consumers being overextended and cutting back on their buying habits will slow down the economy. A severe recession is also possible because of the high debt levels in this economic cycle. A slow down in the U.S. slows down a percentage of the world’s economy. Therefore oil demand, commodity demand and even jewelry demand will suffer to varying degrees.
But there are four points that are not in the above equation:
- Any slow down should be accompanied by inflation. Recessions with inflation in the past (1974, 1980) saw gold hit the highest levels in history! Consider these facts: a) huge long term global money supply increases, b) commodity prices 200% higher than just four years ago, c) intermediate and crude goods inflation in the U.S., according to The Department of Labor has averaged 10.2% annually in the last two and half years. This will soon show up in producer prices and consumer prices. This leads to only one conclusion. It is only a matter of time before consumer prices start to increase sharply. Inflation is already baked into the cake and all the jawboning by politicians and economists and financial journalists will not change these facts and the past inflationary effects they have always had, including higher gold prices.
- Increased gold demand based on new middle class buyers is global. Slow downs in China from 10% growth to 2% will not stop this trend.
- Money supply increases for six important countries in the last year allow one to envision even more gold and silver demand: China +15%, India +20.3%, U.K. +10.8%, Russia +42.5%, France +7.5% Brazil +16.8%. These are printing presses out of control and many of these citizens will be gold and silver buyers to protect against this currency depreciation.
- The dollar is also vulnerable. We just experienced the largest quarterly trade deficit in history and sooner or later the Chinese and Japanese central banks will have to sell and stop buying U.S. Treasuries which finance our budget deficits. If foreigners do not buy our debt with their money then the Federal Reserve would be forced to buy. When the Fed buys Treasuries it creates new money. More money issued depreciates the dollar. With inflation already in the mix, a slowing U.S. economy, and international money flows out of the U.S., the dollar is vulnerable. This is bullish for gold.
The powers that be, if faced with inflation, would have to no choice regarding interest rates as rates must go up with inflation. Rates at very high levels would bring on a severe stock and bond market retrenchment. This is what happened in 1974 and 1981. The Fed would then once again have to come to the rescue. This would mean printing as much money as is needed to make the nightmare end. We would then go through the next economic cycle but gold would stay at a much higher range for that cycle.
Oil and Gold
Oil pulling back affected the gold market. Linking the price of oil and gold is half correct because one is energy and the other is money but both are also commodities so the linking does have some truth to it. For those looking at this relationship from a commodity standpoint, I give the following stats from the respected Energy Information Agency (EIA). The U.S. consumes 3 gallons of oil per day per person. China consumes .2 gallons per day per person. This is 15 times less per person in a country with 4 times the population. Doing the math shows a staggering 60x long-term demand ratio that may take decades but is now underway as China’s economy advances toward becoming like the U.S. This ratio will also apply to many other commodities in the years ahead.
Real Value versus Market Value
Mining stocks are notorious for fluctuating far out of the price range of what a reasonable value should be. Because of this, investors have a difficult time making correct investment decisions. The correct valuation method is to take the estimated resource and figure out only how many ounces or pounds of minerals or metals will be able to be recovered. Next, apply a conservative future price to these metals and then estimate how much capital and how much mining cost will be needed to dig the metals out of the ground, crush and grind the rock and then process the crushed rock or powder and then extract the metal. You have to figure how much debt and how many millions of new shares must be sold to finance this whole procedure. After all this you will be left with a multi – year future cash flow from the project. Discount this future value back to present time and then you will have a good idea of what the projects(s) or company is worth.
A reasonable value can be estimated for many companies. Also future upside can come from higher metal values and future discoveries and additions to their reserve base. On the downside is lower metal prices, permitting and engineering problems and political (country) risk. But if you are already using $375 to $425 gold as a future price to determine future profits and you come up with a stock that should be valued at $15 (at $400 gold in the future) and the stock is trading at $5, then you probably have a winner. The ideal company shows that recoverable value in the ground will eventually translate into value in the market even if gold trades well under $600 in the future. In these types of analyses, a lower gold price in the end will not even matter. Gold going down to $400 is a non factor to an undervalued project that will make plenty of money at the $400 gold in the future. Even a crash in the gold price for non producing developmental companies can be offset by substantial profits from the business of mining the metal. This does not apply to producers. Producers will be affected by the current gold price. That is why when owning producers try and own some with future projects in the pipeline.
The mining sector is not alone in these illogical pricings by the stock market.
Northern Trust a major financial institution with over $620 billion under management had this to say about net asset values in real estate and various closed end mutual funds.
“As with closed-end funds, it is one of the enduring mysteries of academic finance how REIT share prices can be so volatile and can pull so far away from their net asset value (NAV) when this value is firmly grounded in hard assets”
Gold stock investors can certainly relate to the above. Therefore don’t despair when your stocks are being sold off by uninformed or scared or fast buck traders and investors. If you know for sure that the company already has found the minerals and the engineering studies by the company or an outside company are positive, then you should be able to know what the company will be worth in a few years. That number should be more valid than the short term market value.
Your success in investing in companies is making sure the cash flow from all the hype and hoopla in the future years will support a higher share value. 10 million ounces in the ground is meaningless if it is too low grade or too expensive to mine. A company that will have to sell a lot of stock and dilute the value of existing shareholders if it is overpriced already, has no where to go but down even as they become a successful mining company. If they are already overpriced you better know it.
Mining insiders and people that study the engineering reports and can make the many calculations that are necessary to figure all this out are the ones most likely selling when you are buying or buying when you are selling.
The key to this business is to find companies that have already found the goods in the ground and are developing quality and large projects. I am always comfortable with a three year time frame to production and at least a 3x return using much lower metal prices and a reasonable multiple of cash flow. Even if a lot goes wrong - and it usually does – there is plenty of room for capital gains.
I will be speaking at the New Orleans Investment Conference and encourage you to attend. My speech title is My Four Favorite Mining Companies that also have $100 million Cash in the Bank. These stocks should be in everyone’s portfolio. They are what I consider the premier holdings for the next decade. They are in my opinion “estate builders”. My handout at the conference detailing these stocks could be worth the entire trip. Also this great Conference has plenty of world class speakers that are not at other hard money conferences. I hope to see you there. You can register at:
www.neworleansinvestmentconference.com
For other articles on gold and the economy please visit our website at: www.kengerbino.com
Ken Gerbino
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