By Adam Hamilton
Gold stocks languish in a sentiment wasteland these days, left for dead by everyone but a small contrarian remnant. So naturally bears abound, their arguments dominated by the idea that gold miners’ costs are so high that they can’t make money anymore. Provocatively though, this notion is totally wrong. As gold-stock valuations reveal, gold miners are earning profits hand-over-fist at today’s gold levels.
Valuations are the fundamental heart of stock investing, ultimately driving the vast majority of long-term performance. Investors buy stocks because they want a stake in companies’ future profits streams. The less they pay for each dollar of future profits, the better their ultimate returns. And the price of future profits is a direct function of prevailing stock prices. Valuations measure how much profits cost.
The classic price-to-earnings ratio has always been the leading valuation metric. P/E ratios are simple in both concept and calculation. Any company’s stock price is divided by its latest annual profits per share, yielding the amount that investors are being asked to pay for each dollar of earnings. The resulting ratios are often expressed as “times earnings”. A stock with a P/E of 30.0 is said to be at “thirty times earnings”.
In this case investors must pay $30 for each $1 of yearly profits. But what if they could buy $1 of earnings for just $20 or even $10 elsewhere? Every dollar is fungible, right? A dollar an investor makes in stock XYZ is no better or worse than a dollar made in ABC. So over time investors naturally gravitate to sectors with lower P/E ratios. Investing is about paying the lowest-possible price for the highest-possible profits.
Sectors with low P/E ratios attract value investors seeking to do exactly that. And traditionally gold stocks are certainly not a value realm. For most of their secular bull, they had high valuations. Investors were paying a premium for the earnings the gold miners could spin off. Why? They believed that gold’s bullish fundamentals would force the metal higher, greatly increasing gold miners’ earning power.
And that indeed ended up being one of the best bets of the last decade. While gold’s secular bull propelled it 638% higher at best between 2001 and 2011, the flagship HUI gold-stock index blasted an astounding 1664% higher at best by last September! This performance is epic, as over the same secular span the benchmark S&P 500 actually fell 14%. The gold stocks have leveraged gold by 2.6x so far.
With gold stocks exploding nearly 18x higher during a secular bear where the stock markets were flat, they should be the most popular sector on the planet today. But their recent serious correction of 41% over 8 months as measured by the HUI has totally obliterated bullish sentiment. The bears have tried to rationalize these losses as the new normal (as opposed to a temporary selloff) by attacking earnings.
They claim gold stocks are doomed to drift even lower indefinitely because the rising costs of gold mining are rapidly eroding profits. And the lower the earnings gold stocks as a sector can generate, the lower their stock prices should be as investors refuse to overpay for future profits streams. Thankfully because earnings are one of the most important and widely-followed stock metrics, this idea is easy to investigate.
At Zeal we’ve been tracking and analyzing gold-stock earnings for over a decade now. I wrote the original essay in this series way back in May 2004. While P/E ratios are calculated on an individual-stock basis, they can be aggregated to give valuation reads on entire sectors. The best way to do this is to pick a major stock index and calculate a weighted average of the individual P/Es of all its component stocks.
In late 2006 we started doing this for the HUI. At the end of every month we record each HUI component’s stock price, P/E ratio, dividend yield, and market capitalization. We feed this all into a giant spreadsheet that computes a bunch of stuff including the HUI’s market-capitalization-weighted-average P/E. That is a mouthful, but weighting index component P/Es by market caps is essential for precision.
Say you had a hypothetical index of two gold stocks. One has a P/E of 90 and the other a P/E of 10, so their simple-average P/E would be 50. But what if the expensive former stock has a market capitalization of $3b while the cheaper latter one is worth $30b? Investors have 10x more capital at risk in it, so it should be weighted accordingly. Their MCWA P/E is 17x, a superior reflection of underlying reality.
This first chart documents the HUI component stocks’ MCWA P/E ratio, simple-average P/E ratio, and dividend yield at the end of every month since 2007. If the bears’ thesis is right, that gold miners’ profits are shrinking as higher costs eat up operating cashflow, it would absolutely show up in these valuation metrics. Lower earnings would yield higher P/Es, but the exact opposite is true! The bears are wrong.
Gold-stock P/E ratios today are actually the lowest they’ve been in this entire secular bull! Our latest read at the end of May saw the HUI sport an incredible MCWA P/E ratio of only 12.0x earnings. This is amazingly cheap for gold stocks as this chart shows, way below even stock-panic levels. Gold miners are actually earning enormous profits now relative to their stock prices. They are value investments today!
Zooming way out, the general stock markets meander in great third-of-a-century cycles I call Long Valuation Waves. At the crests of these waves just before major secular bears (like in early 2000), stocks tend to trade above 28x earnings. By the troughs about 17 years later, general-stock-market P/E ratios have fallen near 7x earnings. The long-term average of the broad-market P/E ratio is around 14x.
So in an absolute sense, gold stocks (which traditionally have high P/Es like growth stocks) are now trading on the cheap side. At the end of last month, the broad S&P 500 MCWA P/E was running at 17.8x. I never thought I’d see the day, but gold stocks are far cheaper than the stock markets as a whole! A dollar of gold-stock profits costs investors $12, but the same dollar is going for $18 in the general markets.
As recently as early 2008, which was before that epic once-in-a-century stock panic, investors were happily paying 40x earnings for gold stocks. While certainly expensive, the idea was that as gold powered higher gold miners’ profits would rise and their valuations would fall. And indeed this has been the case for most of this secular bull, as the downtrend shown above in the HUI’s MCWA P/E reveals.
By the time the HUI fully recovered from its brutal stock-panic losses in late 2009, its P/E ratio had been cut in half. Even though gold stocks were trading at similar levels to early 2008, their profits had effectively doubled so their valuations were much lower. And by summer 2011 as gold stocks powered to new all-time highs, their valuations shrunk lower still. Gold miners’ profits just keep on growing.
And this is not just relative to stock prices, which valuations measure. It is also true in an absolute sense as my business partner Scott Wright’s ground-breaking research shows. Between 2007 and 2011, average profits at nearly two dozen of the world’s largest gold miners (representing almost half of global mined production) soared dramatically from $354 per ounce to an astounding $915 per ounce!
Even though mining costs are rising rather sharply as the bears gleefully latch on to, profits and even profit margins are rising faster. The strong ongoing secular bull market in gold is more than offsetting the growing challenges of wresting this scarce metal from the bowels of the earth. Gold mining has become so profitable that the gold miners are even dramatically ramping their dividend payments to investors.
The yellow line above shows the MCWA dividend yield of the HUI component stocks. It is multiplied by ten so it can use the same P/E axis, so 15 means 1.5%. Notice that gold miners have been raising their dividends consistently for a couple years now. This along with the sharp capitulation plunge in this sector’s latest correction has led the HUI’s dividend yield to surge. It is now way up above 1.8%!
Dividend yields are another valuation metric that works the opposite of P/E ratios, high is cheap and low is expensive. For most of 2012, the HUI’s dividend yield has actually been higher than it was during that extreme stock-panic anomaly in late 2008! Dividends are the ultimate acid test of earnings, because companies can’t pay them unless they are earning way more than necessary to cover these cash outflows.
So gold-stock dividend yields are way above panic extremes while gold-stock price-to-earnings ratios are way below. By both of these standard valuation metrics, gold stocks are now as cheap as they’ve been for their entire decade-plus secular bull. This unloved and forgotten sector has seen its stock prices beaten so low that it is now a value play today, something literally unheard of in the gold-stock world.
When the bears assert that gold stocks’ earnings are falling, realize they are either lying or too lazy to do the research themselves. We’ve spent nearly a decade building extensive databases of gold-stock earnings, and their trend is crystal-clear as this chart shows. Gold stocks’ brutal correction since September’s latest peak was a sentiment thing, driven by fear. It had nothing to do with fundamentals.
Traditionally in this series of essays on gold-stock valuations, I’ve included an alternative valuation measure to buttress the case argued by P/E ratios and dividend yields. It looks at the HUI relative to the gold price, which ultimately drives gold-stock profitability as a whole. As I discussed this HUI/Gold Ratio in depth in another thread of research last week, I won’t dig in deep today. But it is important to consider.
Relative to the gold price which drives their profits, gold stocks were recently bludgeoned back down to 2008’s stock-panic levels. But such extreme undervaluations couldn’t persist then and they won’t persist today. Gold stocks need to and will rebound sharply to reflect today’s prevailing gold prices. Even if gold goes nowhere, the HUI would have to nearly double just to regain its 5-year pre-panic HGR average!
So this nontraditional valuation metric of the HUI/Gold Ratio totally agrees with what the classic P/E ratios and dividend yields are screaming. The gold stocks are dirt-cheap today, radically undervalued relative to the profits that gold mining is spinning off. Sooner or later this gold-stock pricing anomaly is going to catch the attention of value investors, and capital will flood in to buy this sector’s future profits cheap.
If you can buy a dollar of annual future profits in elite gold stocks for $12 today, why pay $18 for the same dollar in the general stock markets? The earnings stream of gold stocks is a third cheaper, which is unheard of for this sector that traditionally trades at high valuations. Prudent investors want the biggest bang for their hard-earned dollars, the best value, and gold stocks are offering that in spades these days.
Like the rest of the markets, sentiment flows and ebbs in the gold stocks. Sometimes investors love them and bid them up to dizzying heights as greed reigns. But then the great sentiment pendulum starts swinging towards the opposite extreme of fear. And gold stocks are crushed to ridiculous unsustainable lows like we saw last month. Realize neither excessive greed nor excessive fear can persist for long.
And once sentiment inevitably shifts, it won’t take much capital to drive massive gains in this tiny sector. As of the end of last month, the total market capitalization of all the HUI’s component stocks was under $182b. Meanwhile the biggest stocks of the general markets as measured by the S&P 500 were worth $12,394b. Worth less than 1.5% of the broader markets, the small gold-stock sector can easily rocket.
The only real threat to this bullish gold-stock thesis is the price of gold, but for a wide variety of reasons its secular bull is likely to continue gradually powering higher. And the higher the gold price, the higher the gold stocks will ultimately be bid. The goofy Federal Reserve continues inflating the narrow and broad money supplies in the US like there is no tomorrow, and fiat-money inflation is gold’s best friend.
The Fed’s latest data shows it has grown the broad MZM money supply by an absolute 8.3% over this past year! Meanwhile the global gold supply grows by a fraction of that from new mining, on the order of 1% annually over the long term. With relatively more dollars available to chase relatively fewer ounces of gold, it’s hard to imagine gold’s secular bull giving up its ghost anytime soon. Couple this with extreme uncertainty heading into November’s critical US elections, and gold should thrive in the months ahead.
So today’s beaten-down gold stocks are an incredible fundamental bargain. They are super-cheap relative to their earnings, dividends, and the price of gold which drives their performance. We’ve never seen such a confluence of extreme undervaluation in this entire secular bull, so speculators and investors strong enough to fight the crowd and buy low have one of the best buying ops of this bull today.
And among the gold stocks, none have been hammered harder and lower than the junior golds. Their upside potential vastly exceeds that of the HUI’s major miners. We are constantly researching this realm, which includes many hundreds of publicly-traded stocks. The great majority are junk, doomed to fail. But the rare winners will prove wildly successful and earn vast fortunes for the investors who buy in early.
The bottom line is gold-stock valuations are incredibly low today. In fact, they have never been lower throughout this entire decade-plus secular bull. Despite all the bearishness and pessimism out there, gold miners are practically minting money at today’s high prevailing gold prices. Profits are very high both absolutely and relatively, and high dividend yields irrefutably confirm these high cashflows.
So it is not fundamentals that have been plaguing gold stocks, but psychology. Traders are scared because gold stocks have corrected sharply. This always happens after major selloffs. But this very fear paves the way for massive uplegs as sentiment slowly swings to the opposite greed extreme. As that shift accelerates, gold miners’ high profits will attract in more and more investors as gold-stock prices surge.
Adam Hamilton, CPA
June 22, 2012
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