Gold Stock Valuations 7
Source: Adam Hamilton, Zeal Research (3/25/11)
"Gold stock investors face a critical question. . ."
Valuations are the fundamental heart of stock market investing. Ultimately, investors invest because we want to share in the future profits a business earns. Valuations express how much investors are paying for each dollar of future profits. A dollar is a dollar—it is totally fungible. So, naturally, shrewd investors want to pay as little as possible for each dollar of future profits. Valuations are measured by the classic price-to-earnings (P/E) ratio.
P/E ratios quantify how much each dollar of profits currently costs in the marketplace. They are calculated by dividing the prevailing share price of any stock by its latest annual earnings per share. If a stock is selling for $10 and earning $1 per share a year, its P/E ratio is 10x (10 times earnings). If it is bid up to $20 and its earnings don't rise, its P/E grows to 20x. Paying $10 for $1 of future profits is way better than paying $20.
In the gold stock realm, miners' long-term profitability is driven by the price of gold. As long as gold's secular bull drives this metal higher faster than mining costs are rising, gold stock profitability grows. And over the past decade, this has indeed been the case. My business partner Scott Wright did some fascinating research late last summer quantifying aggregate gold mining profit margins over the past decade.
All stock market fundamentals ultimately boil down to valuations, how much investors are being asked to pay for future profit streams. So if gold stocks have a fundamental problem today, it will be evident in their valuations. Since individual-stock valuations can vary radically from company to company and quarter to quarter, it is best to aggregate many stocks' valuations to do sector-wide analysis.
This is accomplished by taking a sector's leading stock index, looking at individual-stock valuations for each component company and averaging them. Gold stocks' flagship index is the HUI, now known as the "NYSE Arca Gold BUGS Index." BUGS stands for "Basket of Unhedged gold stocks." Today the HUI has 16 component stocks, which are mostly gold miners but also include a handful of primary silver stocks to confuse everyone.
There are a couple ways to average the valuations of each component stock in an index to get a sector-wide read on valuations. The obvious one is a simple average, but I've always preferred a market-capitalization-weighted average in my valuation work.
Larger companies with bigger market caps (total value in the marketplace, share price multiplied by shares outstanding) are much more important to investors than smaller ones. Imagine you have two HUI stocks, one worth $50b trading at 15x earnings and one worth $5b trading at 70x earnings. This leads to a simple average approaching 43x, but this is skewed and misleading based on these miners' relative importance to investors. A MCWA approach yields a much more representative (and realistic) sector P/E of 20x.
While this chart of monthly HUI valuations highlights MCWA P/Es (dark blue) since they better represent gold stocks' relative proportions of investors' capital, the simple average P/Es (light blue) are also rendered for reference. Are gold stocks becoming too expensive for their earnings streams, impairing their fundamental outlook? Is this why gold stocks have been consolidating since early December?
The short answer is no, gold stock fundamentals continue to look great. Note that the blue sector P/E line is gradually trending lower on balance. If you filter out the spikes to look at this trend's center mass, gold stocks are as good of fundamental deals today as they were in early 2009 emerging out of the stock panic. Investors haven't been spurning gold stocks in recent months due to their fundamentals, which continue to slowly improve.
So, why do we see big spikes in gold stocks' collective P/E ratios from time to time? Because the HUI is such a small index. With just 16 component companies, a sharp surge in the P/E ratio of just one due to quarterly operational challenges can skew this whole index. Not even market-cap weighting can eliminate this effect. Over the years, I've done a lot of valuation work with the headline S&P 500, as well. And with 500 stocks to average, any one's P/E ratio volatility is irrelevant with no noticeable impact.
Thanks to gold's powerful secular bull, earnings have generally risen faster than gold stock prices, which are gradually driving down valuations. There are many examples of this on the chart. Back in late 2007 the HUI started surging in a major upleg. By mid-2008, it was much higher yet its aggregate P/E ratio remained near similar levels to where they were when that upleg launched. While gold stocks' prices were higher, they didn't get more expensive fundamentally.
After the stock panic, the HUI regained its early 2008 highs by late 2009. Even though this index was trading at the same levels, its valuations were much lower. Gold was rising so rapidly that gold stock earnings climbed faster than gold stock share prices. By mid-2010, despite the HUI being near all-time highs again, its valuations still fell to levels approaching those dark days in late 2008 near stock-panic lows.
After last year's usual summer doldrums, the HUI started powering higher in a major upleg that peaked in early December 2010. Yet despite this big run higher, the HUI valuations didn't climb materially. Thanks to the strong concurrent gold rally, profits for mining gold were growing almost as fast as gold stock share prices were being bid higher. And over the last few years gold stocks' collective dividend yield, an alternative measure of valuation, has been gradually rising (meaning they are getting cheaper).
So, there is definitely no problem in gold stock valuations! Buying the HUI basket of gold stocks today shows prices for future earnings streams similar to lower to what investors paid in early 2007, late 2008, early 2009 and mid-2010. And these are vastly lower than what investors were paying in the early years, when elite world-class gold miners sold for crazy valuations exceeding 100x earnings. When gold was so beaten down in the early 2000s, it wasn't very profitable to mine.
Even better, gold stock valuations are almost certain to improve considerably from today's already-reasonable levels. In the third quarter of 2010, gold prices averaged $1228. In the fourth quarter, they shot up 11.6% to $1370. And so far in this nearly over first quarter of 2011, they have edged even higher to $1383. Gold has never traded higher in any quarter in history, so the miners pulling it out of the ground ought to report record Q1 profits, as well. These numbers should be released in late April or early May.
Record gold mining profits combined with the sideways-drifting HUI will drive down valuations, making gold stocks look even cheaper fundamentally. So with gold prices remaining so strong, valuations are certainly not a concern at all for gold stocks. Their recent troubling high consolidation is not fundamentally driven; something else has to be the cause. Before we consider another explanation, it's useful to look at an alternative proxy for gold stock valuation.
Strategically, the gold mining business model is very simple. Dig up gold, sell it at prevailing market prices and profit. The higher the gold prices, the higher the profits. And in all stock market sectors, share prices ultimately follow profits. So since gold drives the profits of gold miners, it ultimately drives their stock prices as well. Thus, an alternative valuation proxy for gold stocks is looking at them relative to the price of gold. This is best expressed through the HUI:Gold ratio.
This HGR is exactly what it sounds like, dividing the daily close in the HUI gold stock index by the daily close in the price of gold. Over time, this ratio quantifies the relationship between gold prices and gold stock levels. While comparing the HUI to gold certainly isn't a classic valuation measure, this ratio still functions like one. It reveals when gold stock prices are likely too high or too low relative to gold, their primary driver.
For five years prior to 2008's once-in-a-lifetime stock panic, the HGR generally traded in a solid secular range between 0.46x to 0.56x. Its pre-panic average between mid-2003 and mid-2008 was 0.511x. In other words, the HUI tended to trade at about half of prevailing gold prices. When this ratio rises, gold stocks are outperforming gold. And when it falls, gold is outperforming gold stocks. This latter phenomenon typically happens during corrections, when the far-riskier gold stocks fall much faster than gold itself.
While gold was certainly weak during the stock panic, gold stocks were just obliterated. Between July and October 2008, the HUI plummeted a mindboggling 67.7%! Though this was crazy oversold and totally irrational even considering panic gold prices, this epic anomaly shattered the HGR's long-established secular trend. By the time the HUI bottomed, gold stocks were trading at levels relative to gold last seen in April 2001 at the very dawn of today's secular gold bull!
Naturally, gold stocks rallied rapidly out of those ludicrous lows and since they powered higher far faster than gold the HGR surged too in a fast initial recovery. But in late 2009, this HGR reversion stalled out. Though the HUI kept right on rallying, gold started surging so fast that the HUI merely paced it. Ever since then, this same thing has happened. Gold stocks have only been rallying enough to match gold's gains. They need to leverage their metal to drive the HGR back up into its pre-panic secular trading range.
Prior to the stock panic, the HUI usually traded between 0.46x to 0.56x the price of gold. But since late 2009, the HGR has languished in a much-lower range between 0.35x and 0.42x. Compared to pre-panic precedent, this makes gold stocks actually look seriously undervalued today. Gold stock investors face a critical question. Is this lower post-panic range the new secular norm? Or will the HGR regain its pre-panic range?
While we mere mortals can't know the future, I suspect the HGR will eventually regain its pre-panic range. And if silver's recent performance is any indicator, this catch-up surge might not take very long once it launches. Late last summer when silver was languishing near $18, my research showed a big autumn silver rally was imminent. Silver was poised to surge dramatically. And if you check out that essay, back then the Silver:Gold ratio chart looked nearly identical to this HGR one! The SGR had stagnated, consolidating at post-panic levels relative to gold that were way under its pre-panic ones.
Yet once investors started flooding back into silver, this metal soared and rapidly undid the remaining SGR damage from the stock panic. This happened in the space of about seven months, not much time at all in the grand scheme of secular bulls. The fortunes of anything can turn quickly when capital starts pouring into it. And the resulting surge radically changes psychology. It is ironic that many of the silver zealots who think this metal is so cheap today at $37 avoided it like the plague at $18 late last summer!
Gold stocks today seem to have the same problem silver had last summer. Investors weren't interested yet. 2008's stock panic was so unbelievably brutal that it largely scared individual investors out of the financial markets entirely. As more time passes and those painful memories fade, more and more individuals are gradually returning to the markets. When they get excited about something, like silver, they can drive massive moves in short periods of time. Sooner or later, they'll rediscover gold stocks too.
Prior to the stock panic, gold stocks were one of the most-popular destinations for contrarian-oriented individual investors. As gold relentlessly marched higher for its own intrinsic fundamental reasons, investors bought gold stocks to leverage their metal's upside. Individuals, both directly and through mutual funds, were the largest constituency by far for gold stock investment. So naturally when they fled during the stock-panic scare, gold stock prices cratered.
As the HUI has nearly quadrupled since its panic low, obviously some capital has indeed returned to gold stocks. But most hasn't. Individuals trickling back into the markets were first enamored with gold when fear remained high after the panic. Then last autumn as their comfort grew they flooded into far-riskier silver, which leverages underlying moves in gold. As their risk tolerance continues to rise and silver gains are moderate like gold's have, the next logical destination for capital is these undervalued gold stocks.
Like silver, this sector is vanishingly small compared to the greater pool of stock market capital. At the end of last month, the elite gold stocks of the HUI had a collective market capitalization of $233b. Meanwhile the elite S&P 500 minus its single gold stock had a market cap of $12,349b. With gold stocks weighing in at less than 2% of the broader stock markets' market capitalization, it wouldn't take much of a shift to sentiment favoring gold stocks to drive a massive rally in this tiny sector.
Like silver, gold stocks often consolidate listlessly for a long time before suddenly soaring. We've seen this drift-surge pattern many times in this secular bull. Traders always have to be ready for the next gold stock surge, so we are constantly researching to find the best high-potential gold stocks to buy when the technical timing is right. Buying opportunities driven by corrections are often fleeting, so we have to know which stocks we want to own before those narrow windows arrive in which we can buy them relatively low.
Just this week, we finished our latest deep-research project on junior gold stocks. Starting with the universe of around 500 junior golds trading in the US and Canada, we gradually whittled this list down to our dozen fundamental favorites. They are each profiled in depth in our fascinating new 26-page report. If you are interested in high-potential junior golds, you'll love this report. Hot off the presses, this fruit of 3 months of expert labor is available on our website for just $95 ($75 for subscribers). Buy yours today!
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The bottom line is gold stock valuations are not the reason this sector has been lethargically consolidating lately. In traditional price-to-earnings terms, gold stock valuations are still gradually declining. Gold price gains are driving profits that are rising faster than gold stock prices, leaving this sector relatively cheap fundamentally. And compared directly with gold prices, gold stocks are very undervalued today relative to their own bull-to-date precedent.
The problem with gold stocks is not valuations, but rather the lack of individual investor interest. But as gold's gains moderate, its miners will come back into vogue. They are starting to spin off such large profits at prevailing gold prices that they are getting harder and harder to resist fundamentally. And since gold stocks remain such a small sector, it won't take much capital shifting into them to drive big gains.
Adam Hamilton, CPA
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