Gold-Stock Valuations 9
Adam Hamilton March 15, 2013 2899 Words
Gold miners have to be the most hated sector in the markets these days. At best they’ve been forgotten as the hyper-complacent general stock markets continue to inexplicably levitate. At worst they’re utterly despised. But the breathtaking bearishness choking them has left gold stocks incredibly cheap relative to their profits. This is a dream come true for battle-hardened contrarians who really want to buy low.
Valuations are the fundamental heart of stock investing, ultimately driving the vast majority of long-term performance. Investors buy stocks because they want stakes in companies’ future profits streams. The less they pay for each dollar of future profits, the better their ultimate returns. Valuations measure how much profits cost today. The price of future profits is also a direct function of prevailing stock prices.
The leading valuation metric has always been the classic price-to-earnings ratio, which is simple in both concept and calculation. Any company’s current stock price is simply divided by its latest annual earnings per share, yielding its P/E ratio. This expresses how much investors are currently being asked to pay for each dollar of earnings. Naturally the lower the better, smart investors buy earnings cheap.
A company with a P/E of 30x is said to be trading at “thirty times earnings”. Investors buying this stock have to pay $30 for each $1 of profits. But all dollars are fungible, right? A dollar of earnings in stock XYZ is no better or worse than a dollar in stock ABC. So why not look for stocks with lower P/E ratios, like 20x or 10x? Why pay more for profits than you have to? Paying too much radically lowers future returns.
Thus over time investors naturally gravitate to stocks with higher profits that happen to be languishing at lower prices. This contrarian strategy yields the most bang for your buck, the highest long-term returns on your invested capital. And you’d be hard-pressed to find a sector that is a better fundamental bargain today than the gold stocks. Extreme bearish sentiment has forced them to deep discounts to their profits.
And considering gold stocks’ amazing bull-to-date performance, it is really surprising they are so loathed today. Between November 2000 and September 2011, the flagship HUI gold-stock index rocketed an astonishing 1664% higher! Over that same decade-plus span, the general stock markets as measured by the S&P 500 fell 14% and gold itself merely rallied 603%. Gold stocks are unparalleled proven performers.
Yet since that bull-to-date peak, they’ve been consolidating and correcting. As of last week, the HUI had fallen 46% over 18 months. That certainly wasn’t the first consolidation in gold stocks’ secular bull, and wasn’t even close to being the biggest correction. Yet it was enough to sour investors on this sector in an overwhelming way. But while sentiment drove stock prices lower, gold miners’ profits continued to grow.
This mounting fundamental disconnect has exploded in recent weeks, leaving gold-stock prices drifting in some dark fantasyland totally divorced from reality. For contrarian investors who like to buy their profits cheap to maximize their future returns, this anomaly has created an extraordinary buying opportunity. This is readily apparent in the gold-stock valuations as measured by the elite components of the HUI.
On every month’s final trading day, we compute the market-capitalization-weighted-average P/E ratio of all the HUI’s component stocks. The resulting valuations charted over time are very valuable in helping us understand when to buy gold stocks low when they are cheap, and later sell them high when they get expensive. The latest read after February’s brutal 10.1% HUI selloff on the recent gold capitulation is amazing.
This first chart shows the raw HUI itself in red, its MCWA P/E ratio in dark blue, its simple-average P/E ratio in light blue, and its dividend yield (another classic valuation measure) in yellow. Unfortunately some bad data in early 2012 infiltrated our last iteration of this research, which has since been corrected by our data provider. So the HUI’s P/E ratios between February and May 2012 have been revised higher.
Gold stocks have never been cheaper in fundamental terms in their entire secular bull than they were at the end of February when we last calculated the HUI’s aggregate P/E ratio! Weighted by their market capitalizations, its component companies had an average P/E ratio of just 13.1x earnings. And their MCWA dividend yield soared to 2.1%. These are major new secular-bull lows and highs respectively.
The best gold miners in the world saw their stocks selling at prices where each dollar of profits only cost $13 in stock price to purchase. This is incredible from multiple perspectives. The last time gold stocks achieved significant popularity in early 2008, investors were eagerly paying over $40 for each dollar of profits. While they loved gold stocks then over 40x earnings, they hate them now at just a third the price!
Even at the nadir of 2008’s brutal stock panic, the scariest market event of our lifetimes, the lowest the HUI P/E ratio fell was 15.7x. So to see it plunge considerably lower to 13.1x at the end of February 2013 with no extreme fear was unbelievable. Gold stocks, almost certainly the entire markets’ best-performing sector of the past decade, were pummeled to their cheapest valuations of their entire secular bull.
Because of their epic past performance, high volatility, and vast upside potential, gold stocks usually trade at a large premium to general stocks. The S&P 500 (SPX) has literally zero chance of doubling in a major upleg in just 6 to 12 months. But gold stocks have achieved this feat many times during their secular bull. So investors traditionally pay higher prices for their earnings in return for the huge upside.
But as the HUI languished at 13.1x earnings at the end of February, the SPX was trading at 20.0x earnings. Gold stocks were a third cheaper than general stocks, something that has never happened before in this bull and probably ever. The HUI gold stocks were yielding 2.1% in dividends, nearly matching the SPX’s 2.2%. The degree of this unprecedented anomaly is stunning, it defies all belief.
To highlight the absurdity of recent gold-stock price levels, the HUI hit a 43-month low early this month. The last time it was lower was August 2009, as you can see above in this chart. Where were gold and silver, the metals that drive gold miners’ profits, back then? At $933 and $14! As the HUI revisited those levels in early March, gold and silver prices were 69% and 105% higher. Does this make any sense?
Of course not! Excitable traders didn’t dump gold stocks in recent months for fundamental reasons, but emotional ones. The gold miners kept on earning large profits with high prevailing gold prices, yet weak-willed investors and speculators got caught up in the irrational bearishness and sold and sold. I can’t understand why anyone wants to sell low, it guarantees failure. But countless traders do it anyway.
Of course gold’s capitulation last month galvanized the fear that has been scaring skittish capital out of beaten-down gold stocks. If you want to get up to speed on that capitulation and the unfortunate sequence of news and sentiment that drove it, I discussed it in depth in our latest monthly newsletter. But the end result is gold stocks now trading at their lowest valuations by far of their entire secular bull.
Whenever any sector has suffered a long downtrend, traders extrapolate it continuing indefinitely. So they seek out rationalizations, theories that apparently justify their own bearishness. They have a deep emotional need to convince themselves they weren’t fools to dump gold stocks low when they were incredibly cheap fundamentally. So they have to believe gold stocks are doomed to head even lower.
Provocatively these HUI valuations decisively torpedo several leading bearish rationalizations against gold stocks these days. The most prevalent one asserts gold miners simply can’t earn money in this environment, their costs are too high thanks to perpetually-rising energy, labor, and materials prices. But the HUI’s dirt-cheap aggregate MCWA P/E ratio of 13.1x totally refutes that oft-cited bearish thesis.
Gold stocks have never earned more relative to their stock prices, despite gold’s own secular bull consolidating since its last major surge in the summer of 2011. And the acid test of these earnings is dividends. While earnings can be somewhat managed between quarters, dividends require hard cash in the bank to pay. The necessary treasuries to afford big dividends can only be built through consistently strong earnings.
Fed by strong profits, gold-stock dividend yields have surged dramatically during gold’s consolidation. A related bearish rationalization claims gold miners have really mismanaged their capital in recent years. Yet if that was the case, then they wouldn’t have high earnings and couldn’t pay hefty dividends. Fundamentally this sector has never been healthier, the miners’ operations are generally doing fine.
Another bearish rationalization claims gold stocks can’t rally because of extreme dilution. They often issue new shares to buy out other gold miners in order to get their hands on increasingly scarce gold projects. But if dilution was indeed excessive, it would show up immediately in P/E ratios. They use earnings per share, so the record-low valuations of the gold stocks today already take every issued share into account.
Despite dilution, gold-stock fundamentals have been improving on balance for over 5 years running now. Note above that the HUI’s MCWA P/E ratio has a definite downtrend. As gold miners’ profits grow with the higher prevailing gold prices, their valuations drop despite higher HUI levels. While the HUI near 500 in early 2008 traded around 40x earnings, much higher above 625 in mid-2011 it was merely trading near 21x.
And 43 months ago the last time gold-stock prices were at recent levels, the HUI’s P/E ratio was near 31x. That is way higher than the 13x it is trading at today! Gold stocks are getting considerably cheaper as gold’s secular bull marches higher. They are simply earning a ton of money as a sector despite all the erroneous bearish rationalizations that falsely declare otherwise. Their valuation progress is ironclad.
The most important driver of gold-mining profits by far is the price of gold. It takes about a decade to bring a new gold mine online, and the average operating costs of that mine are largely determined up front in the planning stage. No matter how high energy or labor costs go over a mine’s operating life, the great majority of the costs were fixed on construction. So higher gold prices directly translate into higher profits.
If a miner can wrest this rare metal from the bowels of the earth for $800 per ounce, and gold is trading at $1500, it earns a healthy $700-per-ounce profit. But the inherent profits leverage boosts these profits far faster than gold rises since costs are essentially fixed. If gold rallies 33% to $2000, the profit of this operation soars 71% to $1200. Higher gold prices drive potent non-linear earnings growth for miners.
So as long as gold’s secular bull remains intact, there is no reason to sell gold stocks when they are earning so much money and trading at such cheap valuations. And gold’s core global supply-and-demand fundamentals are now as bullish as ever, buttressed by the powerful tailwinds of rampant money creation by the Fed and other major central banks worldwide. There is no fundamental reason to sell.
While gold itself is poised to head a lot higher in the near future thanks to some of the most bearish sentiment of its entire secular bull, even if it stalls at today’s prices for years gold stocks are still radically undervalued. This last chart is one of my favorites, looking at gold-stock prices relative to the price of gold. The HUI/Gold Ratio (HGR) shows how the miners are trading compared to their earnings’ primary driver.
The HGR is an alternative gold-stock valuation measure, offering a different perspective than the classic P/E ratios and dividend yields. For 5 full years before the epic anomaly of 2008’s once-in-a-lifetime stock panic, the HGR traded in a tight secular range between 0.46x and 0.56x. It averaged 0.511x, with the headline HUI trading at about half the prevailing gold price. Unfortunately the panic shattered that relationship.
Gold stocks plummeted far faster than gold itself was being sold in late 2008, driving the HGR down to levels not seen since gold’s secular bull was being born. This anomaly was extreme beyond belief and couldn’t last as I pounded the table on at the time. Much like today, the HUI was trading as if gold and silver were at $350 and $4.75 even though they were still 108% and 88% higher in the panic’s dark heart.
And indeed look what happened to the gold stocks out of those unsustainable valuation extremes. They started rocketing higher just after their moment of peak despair. Over the subsequent 34-month span, the HUI would blast 319% higher! The brave contrarians who could divorce themselves from their natural fear and buy cheap during the stock panic earned fortunes in the subsequent years’ gold-stock recovery.
But since gold’s secular bull stalled out and started consolidating high in the summer of 2011, gold stocks have again been losing ground relative to gold. The HGR has experienced a series of collapses as excessive and irrational fear blinds traders to the gold miners’ strong underlying fundamentals. The end result of this correction trend is the HGR has once again been battered back down to panic extremes.
This anomaly is readily evident in this chart. That crazy stock panic was the only other time in this entire secular bull that gold stocks’ price levels relative to gold were anywhere near what we are seeing today! Yet because this sector was so radically cheap fundamentally right when traders totally gave up on it, those low HGR levels couldn’t last long. The markets abhor extremes, and today’s won’t linger either.
Gold stocks as a sector are now as cheap relative to gold, and considerably cheaper in conventional price-to-earnings and dividend-yield terms, than they were in the black hole of 2008’s stock panic. Yet that very point of universal capitulation was a major, major low just before the HUI started powering higher in a monster upleg that would ultimately see it more than quadruple. Talk about a bullish omen!
There is no doubt we are on the verge of a similar massive reversal today. When a long correction in a fundamentally-cheap sector ends in an irrational capitulation, all the weak hands are frightened into running away. That leaves shares in strong hands, the calm and rational contrarians who understand fundamentals and really practice buying stocks low when their prices are cheap relative to earnings.
This makes gold stocks one of the highest-potential and even safest bets to make at a time when the general stock markets are experiencing a hyper-complacent topping. While most investors are foolishly buying expensive general stocks high while the SPX hits irrational and unsustainable 65-month highs, smart contrarians are buying cheap gold stocks low while the HUI is languishing near absurd 43-month lows.
At Zeal we are contrarians fighting the crowd, buying low when stocks are deeply out of favor and selling far higher later. The mainstream practice of buying high near multi-year highs is a fool’s errand, doomed to end in failure. During recent months when emotional traders were panicking out of gold stocks, we were painstakingly researching them to find the best ones with the most fantastic fundamental prospects.
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The bottom line is gold-stock valuations are incredibly low today. The flagship gold-stock index has just been battered to its lowest price-to-earnings ratios and highest dividend yields by far of this entire secular bull. Gold stocks have never been cheaper in both absolute and relative terms. Their stock prices are back at panic levels relative to the price of gold, and are way cheaper than general-stock valuations.
This extreme anomaly happened because excitable traders irrationally panicked in recent months. Yet their lack of emotional control is our gain. Gold stocks more than quadrupled after the last time sentiment grew so excessively bearish in the stock panic. The mean reversion out of this latest anomaly ought to be just as impressive. If you are a contrarian who can fight the mainstream herd and buy low, carpe diem!
Adam Hamilton, CPA March 15, 2013 Subscribe at www.zealllc.com/subscribe.htm