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April 07, 2006

Gold Stock Valuations 2
by Adam Hamilton

With gold challenging $600 this week and the HUI achieving new all-time highs, gold stocks are on a lot of investors' minds. I have certainly been pondering them too while enjoying their latest dazzling upleg.

A few weeks ago I wrote an essay on commodities bull portfolio design, how both investors and speculators can build custom stock portfolios that minimize their risks while maximizing their chance to reap enormous profits over the course of this commodities bull. This essay was an introduction to our April newsletter, which discussed dozens of elite commodities-producing stocks that fit into the various layers of my pyramid portfolio model.

After two solid weeks of reading 10-K and 10-Q reports that a broad array of commodities producers recently filed with the SEC, something about gold stocks struck me between the eyes like a sledgehammer. As I was searching for awesome opportunities my research took me into all major sectors running from precious metals to base metals to energy. Thus I had the chance to compare gold stocks with other commodities producers.

Unfortunately every single gold stock I looked at was trading at a high to extremely high valuation, if it was even managing to earn profits at all even with today's surging gold prices. I found this disturbing on multiple fronts.

First, for long-term investors there is nothing more important than valuation, the price at which a stock is purchased relative to its earnings power. While buying high is sometimes rewarded with a higher selling price later, especially in a powerful secular bull market, the ultimate odds of success when buying high are far worse than those when investors buy at low valuations. Market wisdom admonishes us to buy low and sell high, not buy high and hope to sell to a greater fool.

Second, since gold is up 130% bull to date shouldn't gold stocks be expected to be earning massive profits? Most of the gold companies that investors and speculators salivate over today were around in the lean years of sub-$300 gold in the early 2000s. Back then they had to have their costs under control in order to survive and they should have kept those costs managed so they could thrive with the surging gold price.

The primary reason commodities-producing stocks are awesome investments during a commodities bull is that profits usually grow far faster than their underlying commodities prices rise, their leverage is immense. Four years ago I wrote about gold-stock leverage and back then I was awestruck by gold stocks' potential to multiply their profits tremendously. If gold stocks aren't now exhibiting this leverage, is there something wrong with them?

The problem of low gold-stock profits relative to their soaring stock prices is nothing new. Gold stock valuations have been high for this entire bull. Two years ago I wrote an essay on this phenomenon, but up until that point gold stock valuations were generally contracting. Thus at the time my thesis was that higher gold prices would lead to much higher profits which would drive down the stellar gold stock valuations.

Unfortunately the last two years have proven me very wrong. Gold producers, for whatever reasons, can't seem to manage to mine their gold at respectable profits despite today's higher gold prices. If, like me, you have a big chunk of your investment capital deployed in gold stocks, this is a critical issue to address. While I don't have the answers yet, I am writing this essay to delve into the gold stock valuation issues we face today.

I think the most logical place to start is with a chart update from my original gold stock valuations essay. Since historical stock valuation data is difficult if not impossible to find, I used Newmont Mining as a proxy for gold stocks as a whole. NEM is the world's premier major gold producer and has been a long-time favorite of gold investors. Up until recently, when competitors' mergers created a larger gold miner, NEM was the largest gold producer on earth.

The only reason we have this NEM valuation and market capitalization data is because NEM has been an S&P 500 component for this entire gold stock bull. At the end of every month we collect and crunch valuation data for every S&P 500 company in order to calculate the multiples at which the general stock markets are trading. This valuation data is published in our newsletter and charted in a private area on our website for our subscribers. Thankfully this exercise left us with all the necessary NEM data.

Newmont is definitely the most important player in the gold-mining world. This week it alone accounted for 28% of the HUI and 19% of the XAU by market capitalization. The blue line above is Newmont's closing stock price, which is up a very impressive 377% bull to date. Compare this performance since 2000 of this elite blue-chip gold with the sideways trading or plunges in elite blue-chip general stocks over this same period of time and you can readily see why gold stocks are so loved today among contrarians. They are making us rich.

On an interesting sidenote, check out the yellow market capitalization line above. This shows the total outstanding NEM shares multiplied by its stock price, or the total value the markets assigned to this company. Starting near $2.5b it has grown an incredible 1067% to nearly $27.5b recently. Why did its total market value growth dwarf its stock-price gains? A dirty word, dilution.

Like all big companies NEM constantly issues new shares for various things ranging from paying for acquisitions to paying stock compensation for its management. Over time this dilutes existing shareholders. If total shares outstanding grow by 10%, for example, your stake is worth 10% less even though you still hold the same number of shares.

Dilution is to a stock exactly what inflation is to fiat-money supplies. The more shares issued the more the value of your own stake erodes. Dilution is a little-watched but hugely expensive cost we investors must bear. And while NEM is by no means bad in this regard compared to other large companies like tech stocks, this chart really illustrates how issuing more stock can decimate gains over time. Two-thirds of NEM's total gain in market value over the past five years has been lost to investors due to it issuing so much new stock.

Back to the task at hand, the reason I updated this chart was to see the red line, which is NEM's price-to-earnings ratio plotted on a monthly basis since the genesis of this gold-stock bull in November 2000. This trend was very favorable for several years but then about two years ago it reversed to an unfavorable direction. For two years now my thesis that gold stock valuations would contract has been disturbingly incorrect, despite gold soaring about 50% from $400 to $600.

It all started back in November 2000, when NEM was trading at 126x earnings. To put this into perspective, during that same month Cisco Systems, the most notorious bubble stock of the tech mania, was still trading at 134x earnings! Thus contrarian investors like me who wouldn't touch the radically overvalued tech stocks with a ten-foot pole believed gold stocks offered a stunning opportunity despite their similar valuations.

Why? Unlike the tech giants, the gold stocks had a product that was just ending a multi-decade bear and likely to enter a secular bull. While Cisco may not be able to sell all the routers it manufactures if someone else makes a better one, gold miners have a guaranteed global market to sell every ounce they can wrest from the bowels of the earth. And if they could survive just above $250, they would thrive and their profits explode as gold started climbing higher into its first secular bull in decades. Gold stock valuations were destined to contract dramatically.

Since gold bottomed about six months after gold stocks in April 2001, NEM's valuation ballooned to 160x in early 2001 as its ability to earn profits was stretched. But soon its valuation started contracting. While I wasn't really looking at gold stock P/Es back then and didn't notice at the time, NEM's valuation broadcasts then went black. The stretch from early 2001 to mid-2002 in this chart without data is a long period of time when NEM lost money.

The world's largest gold miner started earning money again by mid-2002. It wasn't a lot of money, the company was still trading at a stellar 82x earnings, but it was still far lower than its valuation top at 160x. Because gold rose from roughly $255 to $315 over this period, NEM cut its valuation in half even while its stock price more than doubled. Its profits were growing far faster than its stock price which is how things ought to be in a secular gold bull.

Over the next couple years into mid-2004, this favorable trend continued. NEM's stock price powered higher to a once unimaginable $50 but all the while its profits were growing much faster so its valuation continued contracting. By early 2004 its valuation had contracted 81% to 31x earnings. While still overvalued, this progress was tremendous and the downtrend was perfect. I was glad to see this when I wrote my original essay two years ago.

But soon after this something happened which does not please me. NEM, and indeed gold stocks in general, started to see their profits slip or at least rise slower than their stock prices. Valuations started expanding again, and this from levels that were high to start with compared to stock-market history. If this trend was only a month long I wouldn't care at all, but after two consecutive years of expanding gold stock valuations I have to be concerned.

During NEM's latest massive upleg from $35 to over $60 in this past year, the company's valuation soared from 37x to 75x earnings! I knew its valuation was high, but gold stocks rise with gold and gold was blasting its way higher into bull-to-date virgin territory so I bought and recommended extensive NEM call options trades. Our realized profits on these NEM calls ran from 100% to over 700% with an average realized gain of 206% over 11 separate trades.

The reason I highlight our latest NEM calls campaign is to show how bullish I have been on this company, in terms of risking my own capital as well as my reputation by recommending these trades to our subscribers. I have been a huge NEM fan for many years and I will continue to be. It remains the best major gold miner on earth and the bluest-chip gold. So I am approaching its continuing high valuations not as a hostile critic, but as a long-time friend who is concerned.

At this point in our journey an obvious question emerges. What if NEM's stellar valuation is due to company-specific issues? What if NEM really does not represent gold mining as a whole despite its leadership position? This thesis is easy enough to check. All we have to do is look at all the elite blue-chip gold stocks that comprise the flagship gold stock indexes, the HUI and XAU. These are like the NASDAQ 100 of the gold stock world.

This table shows the P/E ratio and market capitalization for every HUI and XAU component as of this past Wednesday. Stocks that are highlighted in yellow indicate companies that are components in both indexes. There is a lot of overlap here as there really aren't that many larger gold miners around. For a comparison I will develop a little later, the XOI oil stock index is also included. Unfortunately this HUI and XAU data shows the gold stock overvaluation is sector systemic and not NEM's issue alone.

OK, if you fancy yourself a contrarian value investor at heart who happens to love the vast potential of gold stocks in this ongoing commodities bull, this table is going to feel like a swift kick in the teeth with steel-toed boots. If I wasn't a battle-hardened speculator I probably would have cried when I first saw it. Nevertheless this data is very real and can be verified in minutes. The entire gold stock sector is radically expensive!

Out of the 15 stocks that comprise the venerable HUI, the blue-chip golds, fully 7 are losing money today despite gold challenging $600! Isn't this strange? And of the remaining 8 that can somehow manage to mine gold at a profit today, their average P/E ratio is a staggering 78x, even higher than NEM's. If you don't feel sick enough yet, FCX is a primary copper miner which is the only reason its P/E is under fair value. If FCX is excluded, the average profitable HUI gold producer's P/E soars to 87x! Ouch.

And the larger XAU, which includes more big gold miners since it accepts hedgers, isn't looking much better. 7 of its 16 components are losing money in today's awesome gold and silver environments too. The remaining 9 companies are averaging a wickedly high P/E of 74x earnings. And if the same primary copper miner that is also found in the HUI is excluded, the average XAU P/E rockets to 82x. This is systemic.

As I examined this table in stunned silence this week, another irony leapt out at me. You folks who have been around this bull awhile certainly remember Barrick Gold, ABX, the notorious mega hedger. Four or five years ago this company was the evil empire among hardcore pro-gold investors. Many people including me spoke out against ABX's irrational hedging program which was hindering the gold bull's progress. There was a time not too long ago when this company couldn't have been more loathed even if it was sacrificing babies to Molech.

Interestingly out of all the world's largest gold miners, ABX now has the lowest valuation at 39x earnings. This is still high, but it is only about half of the average these days. ABX has been reforming itself and reducing hedges in recent years, but it is still not viewed favorably by the lion's share of gold investors due to its past deeds. It struck me as ironic that the black sheep of the gold major world now has the lowest valuation. Will wonders never cease?

Now all these gold stock overvaluations could at least be rationalized if similar phenomena were being witnessed in other major commodities stock sectors. But this isn't the case. The XOI oil stock valuation data in this chart shows that major oil stocks have average P/Es that are dirt cheap, around 9x earnings. Oil stock profits have climbed far faster than oil stock prices so oil stocks are unbelievably good deals today. Oil stocks are doing what gold stocks should have done in the past couple years.

While hardcore students of history and money will always understand how unique and important gold is, it will be difficult for the gold stock world to capture the attention of mainstream investors if its valuations remain higher than tech stocks. Value investors especially, who control enormous pools of capital, are going to want to buy the fundamentally cheap energy or base metals producers as opposed to the fundamentally expensive gold producers.

Scott and I have been discussing and pondering this gold stock valuation anomaly relative to other commodities stocks sectors and have some ideas. While I'm certainly not convinced that any of these adequately explain why gold stocks are extremely expensive while oil stocks are ridiculously cheap, I share them to hopefully advance research and debate on this crucial issue.

The first clue may lie in the nature of the respective bulls. Gold is only up 130% bull to date, which is one of the poorest performances of any major commodity in this broader bull. Meanwhile oil is up 300% since 2001, it has quadrupled. And in real terms, gold remains only about 27% of the way to its all-time inflation-adjusted highs of $2200 per ounce. Meanwhile oil is about 70% of the way to its own all-time real highs just under $100 per barrel.

These very different bull profiles have left gold stocks with a far smaller gain to profit from than other commodities producers like the oil stocks. While the gold bull is chronologically older than most of the other major commodities, in terms of distance traveled higher it remains young. Perhaps when gold has ultimately quadrupled to over $1000 gold stock valuations will fall under fair value just as the oil stocks' valuations have. The higher a commodity price moves, the more amazing its producers' profits leverage becomes.

And in some ways gold is harder to mine than oil is to pump, which contributes to gold miners' higher relative costs. For example, a major oilfield can last for decades while a major gold mine will often be depleted in only one decade. Thus gold miners must always be exploring for and developing new mines, an extremely expensive process. Scott recently calculated that the elite HUI gold miners only have reserves equivalent to about 17 years of production. I suspect, on average, that oil stocks have reserves running several times farther out in time.

And while oilfield construction is largely finished once the primary wells are sunk and the pumps and pipelines built, gold miners have to keep digging and constructing their mines for their entire useful lives. Most gold mines today are giant holes in the ground where a vast amount of rock must be blasted, hauled, and crushed to extract a relatively tiny amount of gold.

While I am not an engineer, I suspect the ratio of capital-required-to-revenue-generated for gold mining is higher than that of oil pumping. And the gold companies are utterly tiny compared to the oil companies, so the gold companies have to spread these costs out over far smaller operations and they do not enjoy the enormous economies of scale that the giant oil companies command. If you look at the market caps in this table, there are only a handful of gold stocks that even come close to the size of the smallest elite oil stocks.

There are likely sentimental and technical reasons why gold stocks are priced so high compared to other commodities stocks too. The gold bull has been running the longest in time and hence has had many years to win over investors. These investors only have a handful of gold stocks from which to choose so their prices have all been driven way higher into overvalued territory by the flood of capital.

Despite this, the gold stock sector remains very small. The entire HUI was only worth $86b this week. For comparison Google alone was trading at a $122b market cap! Since gold stocks are such a tiny sector it doesn't take a lot of capital to generate fast price surges. The less a company or sector is worth, the higher and faster its price can be multiplied by new investors. The XOI, by comparison, was worth a gargantuan $1404b. Since oil stocks are so huge they haven't been driven as high as gold stocks relative to earnings.

And lest you fear I am making the case that oil stocks ought to replace gold stocks, which is not true, consider the following chart. The XOI is only up 178% bull to date, over the past 36 months. Meanwhile the HUI is up 867% over the last 64 months. Gold stocks have run far higher and farther than oil stocks which should explain some of their high valuations. Gold stock investors have been far more richly rewarded than oil stock investors.

There's really not a lot to add to the story this chart so clearly tells. The gold stock bull is vastly larger and nearly twice as old as the oil stock bull. And despite all of these fantastic gains, the entire gold stock sector remains smaller than most of the major individual companies in the oil or tech sectors. Thus a given amount of investor capital pouring into gold stocks in the future will generate much greater gains than the same amount of capital entering larger sectors.

So this issue of gold stock overvaluation, while critical for commodities-stock investors, remains complex and multi-faceted in its implications. A gold stock investor buying a major gold stock at 70x earnings is accepting far higher risks than an oil stock investor buying a major oil stock at 10x earnings. The higher the valuation of a company, the greater the downside price risk it faces if its primary commodity corrects.

But at the same time, with this much higher risk comes much higher potential rewards. Smaller companies like the golds are much easier to drive higher and multiply than larger companies like the oils. In addition, profits leverage on future commodity price increases is greater the lower profits currently are. Since the golds are all unprofitable or barely profitable today, they have enormous potential to see huge profit increases as gold continues higher.

This principle is easily illustrated with two hypothetical gold companies. Company A is only earning $1 of profits today per ounce of gold mined and has a ridiculously high P/E. Company B, on the other hand, is earning $100 per ounce mined and has a low P/E. While Company B is a safer investment, Company A has much higher potential due to the mechanics of profits leverage. If gold rises $100 per ounce, Company A's profits skyrocket from $1 to $100, a 100x gain. Meanwhile Company B's profits just double from $100 to $200. Thinner margins today always mean higher profits leverage potential in the future.

So what's the bottom line? Gold stock valuations remain disturbingly high, far beyond any other major commodities sector. This means gold stocks are far riskier investments than cheap energy or base metals stocks. Thus even hardcore gold stock investors ought to seriously consider diversifying into other major commodity producing stocks with low valuations. Gold and silver are great, but oil, gas, uranium, copper, zinc, nickel, lead, molybdenum, and other commodities are also making great gains and their producers' stocks are thriving.

In our current Zeal Intelligence monthly newsletter just published, I discussed dozens of elite commodities stocks for long-term investors. It is prudent to have commodities-stock exposure covering a wide array of specific commodities rather than having all of your precious long-term capital at risk in a single commodity.

Please subscribe today and build your own custom commodities-bull portfolio! First-time electronic-edition subscribers will receive a complimentary copy of this issue, your paid subscription will start in May.

While gold stock valuations are at disturbing levels, I still believe their earnings can soar as gold's bull continues higher and starts to catch the gains of other major commodities. Gold is totally unique among all commodities, the ultimate safe investment, and global demand for it should continue to climb along with this general commodities bull. No other commodity in history has been so favored by investors and no other commodity even approaches gold's ideal investment properties.

And only one small group of companies can produce this gold. Regardless of their valuations, gold stocks control the world's fresh-mined gold supply and investors will continue to buy them. While they would be more comfortable and less risky to buy at low valuations like the rest of the commodities stocks, even at today's levels they have great long-term promise since there is no other source for new gold.

Adam Hamilton, CPA
Zeal LLC.com

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Mr. Hamilton, a private investor and contrarian analyst, publishes Zeal Intelligence, an in-depth monthly strategic and tactical analysis of markets, geopolitics, economics, finance, and investing delivered from an explicitly pro-free market and laissez faire perspective. Please visit www.ZealLLC.com for more information, www.zealllc.com/samples.htm for a free sample, and www.zealllc.com/subscribe.htm to subscribe.

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