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May 18, 2007

Gold Stock Valuations 4
by Adam Hamilton

This week the International Monetary Fund, which has long commanded the world's third largest official holding of gold bullion, once again made some noise about selling 400 tonnes of its gold. Such a sale would represent about an eighth of the IMF's total holdings, and as usual such tidings spooked the markets.

So far in its secular bull, gold has climbed 181% higher since April 2001. Interestingly, the IMF has been periodically announcing that it is considering gold bullion sales over the majority of this entire six-year span. The recurring threat of IMF gold sales is just another brick in the great wall of worries that gold has handily overcome.

The old market aphorism that "all bull markets climb a wall of worries" couldn't be more true for gold and gold stocks. Whether it is IMF sales, other central-bank machinations, allegedly declining investment demand, or whatever, a myriad of worries plaguing every step of the way higher has been par for the course in this bull.

For every dollar higher that gold has climbed since $257, countless worries argued against its progress. And the same remains true today. Yet the hardcore contrarians know that fear is nothing to fear, indeed it is bullish. The real time to worry in a bull market is when no one else is worrying, when widespread euphoria reigns. And gold is about as far from euphoria today as the east is from the west.

So this week as skittish gold-stock investors panicked for the umpteenth time this year, doing their best Chicken Little imitations despite gold remaining encouragingly strong in the mid-$600s, I was looking at gold-stock fundamentals. While you certainly wouldn't know it thanks to some of the worst gold-stock sentiment yet seen in this bull, today's gold stock fundamentals are actually the best we've seen so far.

Fundamentals are crucial for stock investment because they ultimately drive stock prices. While sentiment-driven trading dominates over the short term and can batter stocks all over the place temporarily, in the end fundamentals will dictate their fate. Operating profits are the primary fundamental statistic of interest, and all throughout stock-market history all over the world stock prices eventually follow their underlying profits.

Contrarian investors like Warren Buffett know this well, seeking to buy companies that are trading at low stock prices relative to their earnings. Buying low P/E stocks in growing businesses is one of the surest ways to achieve great long-term success in the stock markets because stock prices will rise to reflect high earnings sooner or later.

But unfortunately for the contrarian-oriented gold-stock investors, gold stocks have never been cheap relative to their earnings in this bull market. Even though the HUI unhedged gold-stock index has soared nearly 1000% higher since late 2000 and earned fortunes for early investors, we never had a chance to buy in cheap. In fact, during those ugly bottoming months in late 2000 and early 2001, gold miners were barely earning any profits at all.

While time has indeed proven it to be the correct strategy in hindsight, why did anyone buy gold stocks in the early 2000s at valuations higher than the bubbly tech stocks? Because during secular commodities bulls the inherent profits leverage in mining commodities leads to profits rising much faster than stock prices. Thus a gold stock purchased in 2000 at 150x earnings could have seen its price go 10x higher since then yet simultaneously have seen its P/E ratio plunge to 25x due to stellar profits growth.

This thesis that had to be taken on faith six or seven years ago is proving true in reality today, and it is very exciting to see! Even over this past year, when gold has been largely flat, tremendous progress has been made in gold stock valuations. While gold stocks aren't yet cheap in a classic contrarian sense, they are certainly trending in this direction.

Unfortunately valuation data is little-analyzed because it is so hard to find. Very few analysts bother tracking it, especially in a relatively obscure sector like gold stocks, on an ongoing basis. Although I don't have historical valuation data on all the gold stocks in the major gold-stock indexes, I do have monthly valuation data for one key elite blue-chip gold stock over this entire bull to date. It is as good of representative as any for its sector.

This stock is Newmont Mining, which was the world's largest gold miner for much of this bull market. It was the biggest and most liquid gold stock for years and dominated the HUI in terms of weight. Today it is the world's second-largest gold producer and largest unhedged gold miner. We only happen to have NEM valuation data because it is an S&P 500 component, and we've long tracked general stock-market valuations every month.

This first chart shows Newmont's price-to-earnings ratio superimposed over its market capitalization since this gold-stock bull began. I've seen this same pattern in many other gold and commodities stocks. They entered their bulls with pitiful low values in the marketplace and meager earnings which drove ridiculously high P/Es. Yet as their values climbed and multiplied many times over, their valuations still fell on balance.

Investing in a secular bull sector where stock prices rise dramatically but still become better values over time is the best of all possible worlds. Gold stocks in today's bull market are going to be a textbook case of this relatively rare phenomenon that will be studied for decades to come.

Newmont was a beaten-and-left-for-dead little company back in late 2000 with a trivial little $2.3b market cap. Meanwhile it was trading between 125x to 160x earnings, valuations higher than most of the tech darlings at the top of their own bubble. It took a maverick contrarian to buy the world's biggest gold miner back then when its prospects looked so bleak and its fundamentals so atrocious.

But this is the magic of a secular commodities bull. Unlike almost everything manufactured, commodities are very difficult to wrest from the bowels of the earth so their supplies cannot respond rapidly to price signals. Prices can trend higher for a couple decades before supply and demand imbalances are totally rectified. So if you believed gold was on the cusp of a major bull market six years ago, buying battered-down gold miners was not a difficult decision.

Since those early dark-yet-opportunity-filled days, Newmont's market capitalization has soared 1067% higher! Now I have to note that NEM issued stock to make acquisitions during this time, so shareholders have not reaped this entire market-cap gain. But the raw stock-price gains have been excellent too, 388% trough to peak. Outside of the commodities-stock realm, I think you'd be hard-pressed to find a sector-leading stock that performed so well over a seven-year period where general stocks were largely dead flat.

Now typically when a stock's value multiplies nearly 12x higher over just a matter of years, its valuation will rise too. In the initial six-to-seven years of the general-stock secular bull in the 1980s, for example, valuations roughly tripled. Yet Newmont Mining is not trading at bubblicious 480x earnings levels today. If it was, even the most rabid gold bulls would shy away from buying it.

Despite its huge gains in market capitalization and stock price, Newmont's price-to-earnings ratio has contracted by a radical 85% since early 2000! Today it is only trading near 28x earnings, not too far above the S&P 500's 20x levels today. This illustrates the marvelous profits leverage inherent in mining scarce commodities. In a rising commodities-price market, usually mining profits growth will far outpace mining stock-price appreciation. Despite huge stock-price gains, valuations decline over time.

Now admittedly this 1067% market-cap growth and 85% P/E decline are from best-case points for each series of data. But even if we ignore the best case and just look at the bull to date today, this trend is still immensely powerful. As of now NEM's market cap has risen 722% since late 2000 yet its valuation has still fallen 85% despite this gain. There is no doubt the initial gold-stock-bull valuation thesis was wildly correct.

Although I only have comprehensive historical valuation data for Newmont, in recent years we have started collecting broader gold-stock valuation data. The trend towards gold stocks earning far higher profits that drive valuations down while their stock prices simultaneously climb is accelerating tremendously with today's higher gold prices. The mid-$600s that spooked the milquetoasts this week have been a great boon for gold miners over this past year.

These next two tables show valuations and market capitalizations for all of the elite gold and silver stocks of the flagship HUI and XAU gold-stock indexes. Stocks that are common between both indexes, and there are many, are highlighted in yellow. In addition the XOI oil-stock index metrics are included for comparison's sake. The first table shows valuations early last April, when I wrote the second iteration of this thread of research, and the second table shows valuations this week.

Between these relatively close (in a secular sense) points in time, the profits growth in the elite blue-chip gold miners has been staggering. Gold stock fundamentals have never been better in this bull market, there is no doubt about it.

Carefully examine the HUI and XAU component valuations in both tables and marvel at how gold stocks' earnings are rapidly growing into their prices. And realize that the HUI was only 6.5% lower the day the second table was made compared to the day of the first. With the HUI essentially flat, the profits growth in the elite gold miners is all the more stunning. This is incredibly bullish fundamental news.

Check out the generally high P/E ratios as well as all the blank spaces, which indicate no earnings. Last April when folks were getting euphoric about gold, gold-stock fundamentals were certainly nothing to write home about. Now compare these mediocre results to this week's impressive metrics.

While the gold stocks aren't yet classical contrarian bargains like the unloved oil stocks, they are getting a lot closer. Between the HUI and XAU, they contain 20 elite gold miners. A year ago, fully 50% of these companies couldn't earn any profits. Today this number has dropped to 10%. Also a year ago, of the half of the stocks earning profits, 60% had P/Es over 50x earnings. Today only 17% of the profitable companies sport such crazy P/Es.

Over the past year, the simple-average P/E of the HUI has plunged 62% despite just a 6.5% decline in the HUI itself. While the headline XAU only fell 7.3% between these two data points, its own simple-average P/E has fallen 50%. These are stunning improvements in valuations over such a relatively short period of time. They prove that the gold miners are finally starting to earn some real profits in this gold bull.

Since simple-average P/E calculations for stock indexes are easily skewed by extreme outliers, I have long preferred to compute composite index P/Es by using market-capitalization weightings. This way a tiny company with a crazy P/E cannot influence the overall index P/E anywhere near as greatly as it would in the conventional simple-average approach. The market-capitalization weighted-average P/Es of the HUI and XAU show similar dramatically positive results.

Last year, the HUI had a MCWA P/E of 35.2x. Today it has fallen to 23.2x, a 34% decline! Provocatively this compares very favorably to the S&P 500's 20.3x and NASDAQ's 32.5x current MCWA P/E ratios. It is incredible to realize that gold stocks as a sector are a much better fundamental bargain today than tech stocks! Who would even have entertained such a heresy a year or two ago?

The XAU's MCWA P/E has fallen 30% to 22.6x, which is again competitive with other sectors of the general stock markets. As a gold-stock investor and speculator over this entire bull I can scarcely believe my eyes, but finally after believing in a controversial thesis for years with little confirmation gold stocks' earnings are really growing into their stock prices. Gold stock valuations are finally reasonable!

There are a couple more specific observations of interest on these tables. First, note how small the gold miners generally are in market-cap terms today despite the HUI's nearly 1000% run higher since late 2000. Together all 20 of these elite gold stocks are only worth $149b today. To see how small this is compared to other sectors, check out the massive oil stocks' market caps. The combined market cap of the 13 XOI companies is almost 12x larger than that of the 20 HUI/XAU companies.

These tiny gold-stock market caps, despite us being seven years into their bull market, show how far we still have to run in a secular sense. They also show how fast gold stocks will move when more mainstream investors get interested in their fortunes. The smaller a sector is in terms of its market-cap footprint, the faster and higher it will go if a given amount of capital bids on it. There is still not much room in the entire gold-stock sector for serious capital, so mainstreamers will face a bidding war when they catch on to the gold bull.

Second, note that the HUI and XAU both contain Freeport McMoRan Copper & Gold, FCX. At $27b, FCX alone represents 26% of the market cap of the HUI and 19% of the market cap of the XAU, both indexes' largest component. Since FCX mines vast amounts of the dazzlingly profitable copper, its P/E is considerably lower than most of the other gold and silver miners. Thus FCX's copper production is still skewing the HUI and XAU P/Es lower.

From a pure P/E-analysis-over-time standpoint, this is not a problem. Since FCX has been in the gold-stock indexes in the past its effect is fairly comparable across the years. Its recent acquisition of Phelps Dodge may change this in the future though by altering its gold/copper mix, making it more copper-heavy. Regardless, in simple P/E terms where FCX's low P/E is weighted equally with all other component companies to minimize its influence, the HUI and XAU still show remarkable price-to-earnings ratio contraction over the last year or so.

Three or four years ago before the base metals bulls started getting exciting, it used to bother me that a major copper producer (that is also a major gold producer) was "tainting" the purity of the gold-stock indexes. No more. Today's emerging gold-mining method of choice is digging big open pits to process low-grade ore. It is usually much cheaper than digging shaft mines, and much easier to find low-grade deposits than the rare high-grade ones.

Virtually all the time in these types of open-pit deposits, byproduct metals exist. Thus most gold miners in the world today have byproduct metals that they mine in conjunction with their gold at most of their operating mines. Pulling other metals along with gold is part of the game now. These byproduct metals, thanks to raging bull markets driven by insatiable Asian demand, can greatly contribute to overall gold-mining profits.

While FCX certainly has the largest proportion of byproduct-to-gold production in terms of revenues realized, many of the other elite gold miners also have significant byproduct production too. Since this is the reality today and it is really helping gold miners' overall valuations drop, I don't believe the concept of 100% gold-mining purity is relevant for the HUI and XAU anymore. Yes, their index components should be primary gold miners, but they don't have to be 100% gold.

Byproduct revenue is wonderful and it should be embraced, not scorned. At Zeal we consider any byproduct revenue to be a big plus when we pick our stocks to buy. It enables companies to develop lower-grade gold deposits that would not be economical at today's gold prices without their byproduct revenue. So operations like FCX's are ultimately very bullish for gold-stock valuations and prices.

The vast progress made in gold-stock valuations over the past year is incredibly encouraging regardless of its causes. It confirms and verifies the once-controversial thesis that guided the earliest investors in this bull market six years ago. We were willing to buy gold stocks at ridiculous valuations back then not because they were fundamental bargains at the time, but because they would turn out to be fundamental bargains as the gold bull marched higher. There is no disputing this now.

And I think this trend is even more relevant today than it was six years ago. The higher the gold price goes, and it is very likely to continue much higher due to its stellar fundamentals, the greater the profits for the gold miners will grow. And as they've done in the past six years, overall these profits will probably multiply faster than stock prices due to the tremendous profits leverage inherent in this business.

This means that not only are gold stocks highly likely to continue appreciating on balance, but they will get cheaper and cheaper like the oil and base-metals stocks. These lower valuations are crucial in a bull market as they open the door for much broader investor participation.

Early on, only brave or foolish contrarians buy in. They believe in a secular bull before anyone can see it and they bear huge risks. Since the contrarian pool of capital is so small in the grand scheme of things, they can only drive up a sector so far. Eventually value investors realize the early contrarians were right, and they notice that the sector's P/E ratios are favorably low. So they start to buy into the attractively-valued stocks and drive them much higher than the contrarians could have alone.

Then ultimately the mainstream investors follow the early contrarians and later value investors in. The mainstreamers collectively control gargantuan amounts of capital that can drive a sector stratospheric, but they won't buy in until late in the game when momentum compels them to. Without the value investors buying in first, which wouldn't happen without low valuations, the momentum necessary to seduce in the mainstreamers near the end of the bull would never exist in the first place.

So if the gold stocks' lower-valuation trend continues in the coming year, they will become even cheaper relative to the general stock markets. These low valuations will attract in new investors and a much larger pool of value capital than the contrarians could ever hope to control. If this scenario plays out as it ought to, obviously now is a great time to buy while general sentiment remains so irrationally pessimistic.

At Zeal we have traded these gold and gold-stock bulls since they began, and have been blessed with outstanding realized profits over the years. We buy gold stocks when others are scared, like today, and sell them when others are euphoric, like last May. If you are willing to fight the thundering herd and take a contrarian chance on earning big profits in the likely approaching major gold-stock upleg, please subscribe to our acclaimed newsletter today. Periodic weakness offers excellent buying opportunities.

The bottom line is gold stock valuations are really looking excellent today, the best we have seen in this entire bull market. More elite gold stocks are profitable than ever before and they have lower valuations as individuals and a sector than ever before. From an earnings-fundamental perspective at least, there has never been a more attractive time to add long gold-stock positions than today.

As usual the psychological wall of worries is drowning out these truly important fundamental developments, but sentiment can't trump fundamentals for long. Sooner or later traders will realize $650 gold is very profitable for miners and they will rush in to buy. Profits are always the ultimate long-term driver of stock prices.

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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