Gold stocks languish in a
sentiment wasteland these days, left for dead by everyone but a small
contrarian remnant. So naturally bears abound, their arguments dominated by
the idea that gold miners’ costs are so high that they can’t make
money anymore. Provocatively though, this notion is totally wrong. As
gold-stock valuations reveal, gold miners are earning profits hand-over-fist
at today’s gold levels.
Valuations are the fundamental heart of stock investing, ultimately driving the vast
majority of long-term performance. Investors buy stocks because they want a
stake in companies’ future profits streams. The less they pay for each
dollar of future profits, the better their ultimate returns. And the price of
future profits is a direct function of prevailing stock prices. Valuations
measure how much profits cost.
The classic
price-to-earnings ratio has always been the
leading valuation metric. P/E ratios are simple in both concept and
calculation. Any company’s stock price is divided by its latest annual
profits per share, yielding the amount that investors are being asked to pay
for each dollar of earnings. The resulting ratios are often expressed as
“times earnings”. A stock with a P/E of 30.0 is said to be at
“thirty times earnings”.
In this case investors
must pay $30 for each $1 of yearly profits. But what if they could buy $1 of
earnings for just $20 or even $10 elsewhere? Every dollar is fungible, right?
A dollar an investor makes in stock XYZ is no better or worse than a dollar
made in ABC. So over time investors naturally gravitate to sectors with lower
P/E ratios. Investing is about paying the lowest-possible price for the
highest-possible profits.
Sectors with low P/E
ratios attract value investors seeking to do exactly that. And traditionally
gold stocks are certainly not a value realm. For most of their secular bull,
they had high valuations. Investors were paying a premium for the earnings
the gold miners could spin off. Why? They believed that gold’s bullish
fundamentals would force the metal
higher, greatly increasing gold miners’ earning power.
And that indeed ended up
being one of the best bets of the last
decade. While gold’s secular bull propelled it 638% higher at best
between 2001 and 2011, the flagship HUI gold-stock index blasted an
astounding 1664% higher at best by last September! This performance is epic,
as over the same secular span the benchmark S&P 500 actually fell 14%. The gold stocks have
leveraged gold by 2.6x so far.
With gold stocks
exploding nearly 18x
higher during a secular bear where the stock markets were flat, they should be
the most popular sector on the planet today. But their recent serious
correction of 41% over 8 months as measured by the HUI has totally
obliterated bullish sentiment. The bears have tried to rationalize these
losses as the new normal (as opposed to a temporary selloff) by attacking
earnings.
They claim gold stocks
are doomed to drift even lower indefinitely because the rising costs of gold
mining are rapidly eroding profits. And the lower the earnings gold stocks as
a sector can generate, the lower their stock prices should be as investors
refuse to overpay for future profits streams. Thankfully because earnings are
one of the most important and widely-followed stock metrics, this idea is easy
to investigate.
At Zeal we’ve been
tracking and analyzing gold-stock earnings for over a decade now. I wrote the
original essay in this series way back in May
2004. While P/E ratios are
calculated on an individual-stock basis, they can be aggregated to give
valuation reads on entire sectors. The best way to do this is to pick a major
stock index and calculate a weighted average of the individual P/Es of all its component stocks.
In late 2006 we started
doing this for the HUI. At the end of every month we record each HUI
component’s stock price, P/E ratio, dividend yield, and market
capitalization. We feed this all into a giant spreadsheet that computes a
bunch of stuff including the HUI’s market-capitalization-weighted-average
P/E. That is a mouthful, but weighting index component P/Es
by market caps is essential for precision.
Say you had a
hypothetical index of two gold stocks. One has a P/E of 90 and the other a
P/E of 10, so their simple-average P/E would be 50. But what if the expensive
former stock has a market capitalization of $3b while the cheaper latter one
is worth $30b? Investors have 10x more capital at risk in it, so it should be
weighted accordingly. Their MCWA P/E is 17x, a
superior reflection of underlying reality.
This first chart
documents the HUI component stocks’ MCWA P/E ratio, simple-average P/E
ratio, and dividend yield at the end of every month since 2007. If the
bears’ thesis is right, that gold miners’
profits are shrinking as higher costs eat up operating cashflow,
it would absolutely show up in these valuation metrics. Lower earnings would
yield higher P/Es, but the exact opposite is true! The bears are wrong.
Gold-stock P/E ratios
today are actually the lowest they’ve been in this entire secular bull! Our latest read at the end of May
saw the HUI sport an incredible MCWA P/E ratio of only 12.0x earnings. This
is amazingly cheap for gold stocks as this chart shows, way below even
stock-panic levels. Gold miners are actually earning enormous profits now relative to their stock prices. They are
value investments today!
Zooming way out, the
general stock markets meander in great third-of-a-century cycles I call Long Valuation
Waves. At the crests of these
waves just before major secular bears (like in early 2000), stocks tend to
trade above 28x earnings. By the troughs about 17 years later,
general-stock-market P/E ratios have fallen near 7x earnings. The long-term
average of the broad-market P/E ratio is around 14x.
So in an absolute sense,
gold stocks (which traditionally have high P/Es
like growth stocks) are now trading on the cheap side. At the end of last
month, the broad S&P 500 MCWA P/E was running at 17.8x.
I never thought I’d see the day, but gold stocks are far cheaper than
the stock markets as a whole! A dollar of gold-stock profits costs investors
$12, but the same dollar is going for $18 in the general markets.
As recently as early
2008, which was before that epic once-in-a-century
stock panic, investors were happily paying 40x earnings for gold stocks.
While certainly expensive, the idea was that as gold powered higher gold
miners’ profits would rise and their valuations would fall. And indeed
this has been the case for most of this secular bull, as the downtrend shown
above in the HUI’s MCWA P/E reveals.
By the time the HUI fully
recovered from its brutal stock-panic losses in late 2009, its P/E ratio had
been cut in half. Even though gold
stocks were trading at similar levels to early 2008, their profits had
effectively doubled so their valuations were much lower. And by summer 2011
as gold stocks powered to new all-time highs, their valuations shrunk lower
still. Gold miners’ profits just keep on growing.
And this is not just
relative to stock prices, which valuations measure. It is also true in an
absolute sense as my business partner Scott Wright’s ground-breaking research shows. Between 2007 and 2011, average profits at
nearly two dozen of the world’s largest gold miners (representing
almost half of global mined production) soared dramatically from $354 per
ounce to an astounding $915 per ounce!
Even though mining costs
are rising rather sharply as the bears gleefully latch on to, profits and
even profit margins are rising faster. The strong ongoing secular bull market
in gold is more than offsetting the growing challenges of wresting this
scarce metal from the bowels of the earth. Gold mining has become so
profitable that the gold miners are even dramatically ramping
their dividend payments to investors.
The yellow line above
shows the MCWA dividend yield of
the HUI component stocks. It is multiplied by ten so it can use the same P/E
axis, so 15 means 1.5%. Notice that gold miners have been raising their
dividends consistently for a couple years now. This along with the sharp
capitulation plunge in this sector’s latest correction has led the
HUI’s dividend yield to surge. It is now way up above 1.8%!
Dividend yields are
another valuation metric that works the opposite of P/E ratios, high is cheap
and low is expensive. For most of 2012, the HUI’s dividend yield has
actually been higher than it was during that extreme stock-panic anomaly in
late 2008! Dividends are the ultimate acid test of earnings, because
companies can’t pay them unless they are earning way more than
necessary to cover these cash outflows.
So gold-stock dividend
yields are way above panic extremes while gold-stock price-to-earnings ratios
are way below. By both of these standard valuation metrics, gold stocks are
now as cheap as they’ve been for their entire decade-plus secular bull.
This unloved and forgotten sector has seen its stock prices beaten so low
that it is now a value play today, something literally unheard of in the
gold-stock world.
When the bears assert that
gold stocks’ earnings are falling, realize they are either lying or too
lazy to do the research themselves. We’ve spent nearly a decade
building extensive databases of gold-stock earnings, and their trend is
crystal-clear as this chart shows. Gold stocks’ brutal correction since
September’s latest peak was a sentiment thing, driven by fear. It had
nothing to do with fundamentals.
Traditionally in this
series of essays on gold-stock valuations, I’ve included an alternative
valuation measure to buttress the case argued by P/E ratios and dividend
yields. It looks at the HUI relative to the gold price, which ultimately
drives gold-stock profitability as a whole. As I discussed this HUI/Gold
Ratio in depth in another thread of research last
week, I won’t dig in
deep today. But it is
important to consider.
Relative to the gold
price which drives their profits, gold stocks were recently bludgeoned back
down to 2008’s stock-panic levels. But such extreme undervaluations
couldn’t persist then and they won’t persist today. Gold stocks
need to and will rebound sharply to reflect today’s prevailing gold
prices. Even if gold goes nowhere, the HUI would have to nearly double just to regain its 5-year pre-panic HGR average!
So this nontraditional
valuation metric of the HUI/Gold Ratio totally agrees with what the classic
P/E ratios and dividend yields are screaming. The gold stocks are dirt-cheap
today, radically undervalued relative to the profits that gold mining is
spinning off. Sooner or later this gold-stock pricing anomaly is going to
catch the attention of value investors, and capital will flood in to buy this
sector’s future profits cheap.
If you can buy a dollar
of annual future profits in elite gold stocks for $12 today, why pay $18 for
the same dollar in the general stock markets? The earnings stream of gold
stocks is a third cheaper, which is
unheard of for this sector that traditionally trades at high valuations.
Prudent investors want the biggest bang for their hard-earned dollars, the
best value, and gold stocks are offering that in spades these days.
Like the rest of the
markets, sentiment flows and ebbs in the gold stocks. Sometimes investors
love them and bid them up to dizzying heights as greed reigns. But then the
great sentiment pendulum starts swinging towards the opposite extreme of
fear. And gold stocks are crushed to ridiculous unsustainable lows like we
saw last month. Realize neither excessive greed nor
excessive fear can persist for long.
And once sentiment
inevitably shifts, it won’t take much capital to drive massive gains in
this tiny sector. As of the end of last month, the total market
capitalization of all the HUI’s component stocks was under $182b.
Meanwhile the biggest stocks of the general markets as measured by the
S&P 500 were worth $12,394b. Worth less than 1.5% of the broader markets,
the small gold-stock sector can easily rocket.
The only real threat to
this bullish gold-stock thesis is the price of gold, but for a wide variety
of reasons its secular bull is likely to continue gradually powering higher.
And the higher the gold price, the higher the gold stocks will ultimately be
bid. The goofy Federal Reserve continues inflating the narrow and broad money supplies in the US like
there is no tomorrow, and fiat-money inflation is
gold’s best friend.
The Fed’s latest
data shows it has grown the broad MZM money supply by an absolute 8.3% over
this past year! Meanwhile the global gold supply grows by a fraction of that
from new mining, on the order of 1% annually over the long term. With
relatively more dollars available to chase relatively fewer ounces of gold,
it’s hard to imagine gold’s secular bull giving up its ghost
anytime soon. Couple this with extreme uncertainty heading into
November’s critical US elections, and gold should thrive in the months
ahead.
So today’s
beaten-down gold stocks are an incredible fundamental bargain. They are
super-cheap relative to their earnings, dividends, and the price of gold
which drives their performance. We’ve never seen such a confluence of
extreme undervaluation in this entire secular bull, so speculators and
investors strong enough to fight the crowd and buy low have one of the best
buying ops of this bull today.
And among the gold
stocks, none have been hammered harder and lower than the junior golds. Their upside potential vastly exceeds that of the
HUI’s major miners. We are constantly researching this realm, which
includes many hundreds of
publicly-traded stocks. The great majority are junk, doomed to fail. But the
rare winners will prove wildly successful and earn vast fortunes for the
investors who buy in early.
We just finished our
latest deep-research project on this front last week. We gradually whittled
hundreds of these companies down to our dozen fundamental favorites, which we
profiled in depth in a fascinating new 27-page report. It is now for sale for just $95 ($75 for subscribers),
a fantastic deal for hundreds of hours of expert world-class research. Buy yours today, and get deployed before junior golds
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The bottom line is
gold-stock valuations are incredibly low today. In fact, they have never been
lower throughout this entire decade-plus secular bull. Despite all the
bearishness and pessimism out there, gold miners are practically minting
money at today’s high prevailing gold prices. Profits are very high
both absolutely and relatively, and high dividend yields irrefutably confirm
these high cashflows.
So it is not fundamentals
that have been plaguing gold stocks, but psychology. Traders are scared
because gold stocks have corrected sharply. This always happens after major
selloffs. But this very fear paves the way for massive uplegs
as sentiment slowly swings to the opposite greed extreme. As that shift
accelerates, gold miners’ high profits will attract in more and more investors
as gold-stock prices surge.
Adam Hamilton,
CPA
June 23, 2012
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