Heralded as "the best of today's best," Gold Stock Analyst author and publisher John Doody's Top 10 portfolio is up 61% through the end of July. In this exclusive interview with The Gold Report, Doody talks about misperceptions about a summer slump, his Market Cap metric, and select producers or near producers he thinks are well positioned to thrive in the current environment.
The Gold Report: John, gold didn't hit its traditional summer slump, so what are we expecting gold to do here for the second half of the year?
John Doody: In the first place, I think it's a misconception that gold has a summer slump. We ran a study in the July mid-month update, where we looked at the charts for gold in each of the eight years so far in this bull market, which began in 2001. Gold never hit its low in the summer. Its lows have always been early in the year or the second half. Maybe one way people think about summer being a slump period is that typically the strongest time for gold has been the second half of the year. In six out of the eight years of this bull market, the high was hit in the last four months, from September through December.
Now, having said that about gold, it doesn't mean the gold stocks can't go into a slump because, if we learned anything in the 2008 financial crisis about the relationship of gold and gold stocks, we learned that they're not tied together. Gold ended up for 2008, but gold stocks ended down and our Top 10 were down. We did better than the averages; we did better than the S&P, which is to say we were down less, but we were still down for the year. There is a disconnect. When buyers go away for all stocks, they go away for gold stocks too, seemingly regardless of what gold is doing. I didn't look at how the stocks fared in summer, but there's no question that gold itself, the metal, does not have a summer slump. It might have a flatness, but gold has never hit its low for the year in the summer in this bull market.
TGR: It's interesting you mentioned the gold stocks may go into a slump, because when we go back and we look at GSA's market cap per-ounce data, as of the end of June, gold stocks were discounted 10% relative to the gold price. But July was a good month and that discount closed to just 1% based on your data.
JD: All stocks trade based on investor enthusiasm. Gold stocks are a derivative of gold, so how the investors value the stocks waxes and wanes based upon a lot of factors and some of it is just technical aspects of what's going on in the stock market itself and has nothing to do with gold.
But, just because we see gold stocks as being fairly valued now doesn't mean much for investors because in this bull market there's been a number of times that the stocks have been undervalued or overvalued, in our estimation. The largest overvaluation was in February 2006 when gold was around $550 an ounce. We saw the stocks overvalued by 24% then.
At some point I think they are going to go too far overvalued due to investor enthusiasm. This is such a small segment of the total market that when people want to jump in, there are not enough stocks to buy. It can't accommodate an onslaught of investors and that will drive the stocks to an overvalued situation. Gold going over $1,000, in my opinion, will be the driver because when people see it finally achieving that milepost—assuming it does it for more than a day—will be the signal that brings general investors into the sector. The generalist isn't going to be the first guy to the party and, in this case, it certainly won't have been because this bull market began at $256 back in April 2001. So it will take a four times increase to $1,000 to get the general investor in, but he'll come. There's no question about it in my mind. The whole universe of gold stocks is going to benefit. Of course, we think our Top 10 stocks will to do the best.
TGR: If gold doesn't get out of this trading range, which it's been in for at least a year and a half—in the $900s—would you still expect the gold stocks to become overvalued? Or does gold need to get above $1,000 for gold stocks to really become overvalued?
JD: The price of a stock today is effectively a summary of what investors see in its future. I think gold doesn't have to get over $1,000 itself, but the picture has to become even clearer than it is. It's crystal clear to me that gold is going a lot higher because all you have to do is look at the U.S. fiscal and monetary policy. That's the impetus. But in the short run, we don't see the confirmation. Maybe it's going to take a couple of months of higher inflation and or a falling dollar to signal the future to investors. The stocks were undervalued for a long time and, while we've traded in this range for a while, our Top 10 portfolio is up 61% through the end of July and every one of the Top 10 stocks is up in this first week of August, so I assume we're now up 65% or 70% for the year.
TGR: If we're expecting a pullback in the general market, would we also expect a pullback in gold shares, presenting an opportunity to buy them in an undervalued situation?
JD: It depends what gold does. I think we're in a long cycle. I like to compare the gold price to the S&P 500. The S&P is a good proxy for the U.S. economy, with the stock prices reflecting the economic strength or lack of it. We go through 15- to 18-year cycles, where one is above the other. (See a chart of these cycles on our website's homepage.)
In the '70s to mid-'80s, gold was above the S&P. Then they switched and the S&P was above gold until late last year. Now we're into what I call an area of uncertainty, where they're sort of trading places on a daily or monthly basis. The S&P is around 1,000 and gold is around $965, so they're very close. Earlier in the year, gold was at $940 and S&P was at 900. So, we're in one of these areas of uncertainty, where we're trying to get the future direction. This can run for a year or two before it really becomes clear and I think that going forward the inflation and dollar devaluation theme is going to drive gold higher. And I also think that, in general, the lack of earnings growth is going to send the S&P lower.
The S&P has basically recovered from a terrible setback and so this is sort of a rebound rally. But pretty soon people have to start inquiring about the underlying strength in the economy. You cannot have a strong U.S. economy with 10% unemployment. It just cannot happen. The consumer is too important—70% of GDP—and if 10% are out of work, that psychologically weighs on the other 90%. They may have jobs, but they don't feel so good. There's an old joke, a recession is when your neighbor is out of work; a depression is when you're out of work. Well, the neighbors are all out of work now and that has a psychological impact.
TGR: You said earlier that the performance of your Top 10 is now 61% through July 31. Did you anticipate that level of return in the first six months?
JD: Nobody has a crystal ball. I expect gold to trade above $1,000 before the end of the year, but timing is the hardest thing to predict in this market. I knew we were way undervalued in the beginning of the year. One of our philosophies is to have 10 significant gold stocks. We don't cover any explorers, only producers or near-producers. People are always saying, well, what's your favorite stock and I usually counter that with, well, who's your favorite child? You don't know which stock will catch fire and that's why you have 10. In January I didn't know that Northgate Minerals Corp. (TSX:NGX) (NYSE.A:NXG) was going to triple to where it is now. Another Top 10, Golden Star Resources Ltd. (TSX:GSC), is almost up 200%. But the worst performer of the Top 10 has actually lost money. It's down around 15% in 2009. But last year it was the industry's biggest gainer. The stocks go through cycles and that's why you have 10 to make sure you're going to get some of the big winners.
TGR: Has most of the appreciation for the Top 10 for this year been realized?
JD: No, there's plenty to go. We continually reassess and raise our targets as goals are hit. Or, we lower them. We took a dollar off the target of one stock recently, but others have been raised in 2009 based upon things happening—mines coming into production, their future being clearer, higher gold price or a change in the gold-silver ratio, whatever. There are adjustments that you make as you go along to change your target. And when companies reach their target like Franco Nevada Corp. (FNV.TO) did earlier this year, we took them off—not because we have anything against Franco; it's a great company. We expect at some point we'll put it back on. But, our target was $27 and it reached it. That's what you do. Otherwise, what's the point in having a target?
TGR: You select your Top 10 based on three major criteria: market cap per ounce of proven and probable reserves, market cap per ounce of production and operating cash flow multiples, all compared each other and industry averages. That sounds like a pretty straightforward way of seeing who's over-performing or under-performing based on those metrics. But there's got to be some other things you're looking at to select the Top 10.
JD: The overall premise is you're buying ounces of gold. When you buy a share of company stock, you're buying ounces of production, ounces of reserves, or the money it's making on the ounces it mines. That's what operating cash flow is—the difference between gold price and the company's cash cost per ounce times the number of ounces that it produces. I'm from New England and thrifty by nature. Since all ounces are the same, I want to buy those that are the cheapest. We search for values not yet recognized by Mr. Market. That's why we've been able to do well even in a flat gold price environment.
But, yes, you're right, we do look at other factors. We look at cash cost per ounce. What's the trend? Where are the mines located? What's the pipeline of the company look like? What new mines are coming online? Gold stock investors are like every other investor; they like growth and they like to see growth in the pipeline. So, to the extent that it's defined and you can see the mines being built or at the feasibility stage with the prospect of being built, all this is important in selection for the Top 10.
TGR: Do you find that there are certain factors about mining companies or gold companies, specifically, that the market consistently undervalues?
JD: The market does go through phases and, as the market assesses some segments as being fully valued, they start looking down the food chain, as it's called, and last to come along are the explorers. So the other sectors have to get up to full value and then maybe the explorers can catch fire.
The problem is picking an explorer because there's so many of them and so little data. We only analyze companies that have data and I recognize that explorers can give opportunities for some 10 baggers, but they also give a lot of opportunities for zero gain. I'm pretty happy hitting singles and doubles and triples. Over time our approach might get boring because we don't get a 10 bagger very often, but our Top 10 approach has beaten every gold index and every gold fund. There's a reason why other newsletters don't publish their portfolio results on an annual and an ongoing basis, and that's because they're not very good, in part due to recommending far too many stocks
TGR: Can you share with us some insights on some of your Top 10 companies and how they're doing?
JD: I'll talk about a few but I don't want to give away the whole store. Otherwise, why would anybody subscribe?
TGR: Back to Franco Nevada Corp.—they hit your target; you're resting on them for a while.
JD: Yes, hit the target, and we pulled back. The target was $27; it's pulled back to $24 or $25. As I said, there's nothing wrong with that company. There are two things we're waiting for. One is either the stock will pull back further or second, they'll spend some money. They've got $480 million in cash and I expect that they'll use that to buy a pretty good royalty. That may be the incentive to put it back in the Top 10. We'll see.
Another company we can talk about is Royal Gold Inc. (Nasdaq:RGLD), which was the best performer of 2008 in the whole gold arena, up 60%. It was Top 10 then and it's still a Top 10. Royal has come back around 15% and, basically, it's catching its breath. One of the biggest projects in gold mining is coming on line throughout this year and next and that's Goldcorp's (TSX:G) (NYSE:GG) Peñasquito mine. Royal Gold has a 2% royalty on that, which is like a 2% sales tax. So of the billion dollar a year in revenues the mine will generate, Royal's going to get 2%, or $20 million a year. There's about 40 million shares outstanding so that's about 50 cents a share right there, in addition to other good royalties.
We think the market's just waiting for Penasquito to come online, which is going to be a continuing process through 2010. It's starting up now, but at a low non-commercial stage. The mine is going to be key to the valuation of two other stocks in the Top 10, Goldcorp and Silver Wheaton. It's Goldcorp's mine, so they're going to get a bounce out of this when the market sees it's running properly. And Silver Wheaton Corp. (NYSE:SLW), which owns 25% of the silver output. That gives Silver Wheaton 7 or 8 million ounces a year, for which they pay four bucks an ounce
So I think this mine is really important to three stocks. There's nothing complicated about it. It's in Mexico in a place I've been to. Isn't worth staying there as a tourist, but it was great to see. It's in the middle of nowhere and I think it's going to be a great mine.
Another company we can talk about is Golden Star Resources Ltd., which is one that was really hurt in 2008. The stock ran from the $4 range down to about a buck because it had a lot of trouble operating efficiently in Ghana. They have a three or four mine, two-mill complex that was bringing on-line a BIOX treatment system that Gold Fields Ltd. (NYSE:GFI)(JSE:GFI) also uses in Ghana, but it took a while for Golden Star to get it right. Part of it was a manufacturer's problem with the equipment, but I think they've got it right now. Also Ghana had a big drought last year, where power had to come from diesel at 20 cents per KW. The drought's now over and Ghana government just cut the power cost by more than half to about 8 cents/KW, which cuts the cash cost by about $45/ounce.
Golden Star will report earnings next week and I think we're going to see a good bump up in the stock, which has had a good run so far, but I think it's got further to go.
I like mining situations, where a company is significant in a certain area because that makes them a plum that has appeal to a bigger mining company and Golden Star has about 400,000 ounces a year in production from about 4 million ounces of reserves. All the mines are within a 50-mile radius. And that kind of production, once they get their cash costs in line, is an easy pick off for somebody that's already in Ghana, somebody like Newmont Mining Corp. (NYSE:NEM) or Gold Fields. So we've had a good run with Golden Star, but there's more to go. We had a $3 target, but I'm sure as we get closer and after the quarter results are announced, we may well be raising that target.
Another company that has the same kind of cluster concept is European Goldfields Ltd. (TSX:EGU) (AIM:EGU), which has an existing base metals and silver mine in Greece and two gold mines it wants to build on the same general property, Skouries and Olympias, for a total 400,000 ounces a year. And it also has a mine that's a former operating site in Romania, where it's in permits to reopen at a much higher production rate, approximately 160,000 ounces per year. The company issued a press release today that it had received a key approval for the final Greek permit. Greece, because it's got such a long history, has a very strong archeological review process and they want to make sure that whatever you're doing won't harm any ancient ruins. Neither of the two mines the company wants to build has any historical archeological issues; that was confirmed by getting this last approval.
Investors should be aware that European is 20% owned by Greece's largest engineering contracting firm, Aktor, which is a $3 billion conglomerate. Aktor built everything in Greece of significance, from the road system to subway system in Athens to some of the Olympic stadiums for the Olympics. The chairman of the board of European Goldfields is the President of Aktor—and last winter he went into the market and bought shares to double his holdings to almost 10% of European.
Another company, Minefinders Corporation (NYSE.A:MFN) (TSX:MFL), is bringing online a silver-gold deposit, Dolores, in northern New Mexico. This is a world-class project that's got almost 5 million ounces of reserves and when they're fully up and running, they'll be at about 175,000 ounces a year, gold and silver as a gold equivalent, and with a pretty good cash cost. I think this is an easy takeover target. Yamana Gold Inc. (NYSE:AUY) is a likely buyer because it's building another mine about 150 miles away and Yamana likes to have clusters of mines, as all miners do, so that you can have a common top management and you get good quality guys who are used to running significant sized operations. So I think Minefinders is ultimately a takeover target, as is European Goldfields. It's the same kind of thing. European has a cluster of mines that makes it attractive to a Newmont or a Gold Fields or a lot of other people.
TGR: John, we appreciate your insights. Any last comments you have for our readers, who are investors in gold?
JD: Well, if they don't subscribe, they're missing an opportunity.
TGR: Sixty-one percent, at least. Thanks again for your time. We appreciate it.
DISCLOSURE: John Doody
I personally and/or my family own shares in all the companies mentioned in this interview. I personally and/or my family am not paid by the any of the companies mentioned in this interview. GSA is entirely subscriber supported.
John Doody brings a unique perspective to gold stock analysis. With a BA in Economics from Columbia and an MBA in Finance from Boston University, where he also did his Ph.D.-Economics course work, Doody has no formal "rock” studies beyond "Introductory Geology" at Columbia University's School of Mines.
An Economics Professor for almost two decades, Doody became interested in gold due to an innate distrust of politicians. In order to serve those that elected them, politicians always try to get nine slices out of an eight slice pizza. How do they do this? They debase the currency via inflationary economic policies. Success with his method of finding undervalued gold mining stocks led Doody to leave teaching and start the Gold Stock Analyst newsletter late in 1994. The newsletter covers only producers or near-producers that have an independent feasibility study validating their reserves are economical to produce.
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