THE BULL CASE FOR GOLD MINING STOCKS

By JJ Abodeely, CFA, Value Restoration Project

Gold mining stocks, as measured by the AMEX Gold Bugs Index (HUI), are down nearly 40% from their August 2011 high. Representative ETFs such as GDX and GDXJ as down similar amounts, if not more.  Mining company stock prices look to be falling into the abyss.

While buying mining stocks here could certainly look foolish in the near-term, NOT accumulating positions, or selling them for that matter, is likely to be the bigger mistake over the long term.

Gold mining stocks are attractive here for three primary reasons:

1. The sentiment on gold, and gold mining stock in particular, is at extreme bearish levels.

2. They are historically very cheap by a variety of relative and absolute measures of valuation.

3. The macro environment is likely to turn very supportive, thereby improving the fundamentals of the stocks, reversing the negative sentiment, and driving the valuations higher.

All That Glitters?

The price of gold, being a non-productive asset and all, has always been subject to the changing whimsy of investors/collectors/hedgers/speculators. Yet the extreme change from bullish to bearish sentiment over the last 6-9 months has been pretty incredible.

This is true when you consider the opinion of the public:

source: www.sentimentrader.com

Or the opinion of market professionals:

as of 04/17/12 source: http://www.kitco.com/ind/Holmes/20120417.html

And also true for the publishers of Gold-focused investment newsletters, who now recommend a net short -14.8% position in the anti-currency monetary unit:

source: www.sentimentrader.com

A corollary to poor sentiment on gold is the overwhelmingly bullish sentiment with respect to the US Dollar

source: www.sentimentrader.com

Of course, one does not have to be bearish on the dollar versus other paper currencies like Euro, Yen, Pound, Aussie or Canadian Dollar, etc. to be bullish on gold. Gold can just as easily strengthen (or weaken for that matter) against those other currencies more than it does against the dollar to have a scenario where both gold and the US trade weighted dollar move in the same direction.

The extreme pessimism is also visible in mining stocks, which do not necessarily trade congruently with the price of the metal on which their business relies (more on this below). Please consider the sector sentiment measurement, again from wwww.sentimentrader.com. As of March 28, 2012 the extreme pessimism for gold stocks stood out relative to the rest of the market:

source: www.sentimentrader.com

Since then, negative sentiment in other sectors has started to catch up with the mining stocks:

source: www.sentimentrader.com

What investors say is another matter from what they do. An investors have been pulling away from gold-related investments. This is true when one looks at the ETFs and ETNs that track gold, which the World Gold Council estimates saw a 58% DECLINE in the volume of gold purchased in 2011 despite rising prices and growing global demand for physical gold.  And it is also true for fund flows into mining stock related funds as evidenced by the Rydex data

source: DecisionPoint.com

Valuation Matters

Are gold mining stocks cheap? The answer is yes, by almost any objective measure. One way to look at mining stocks is to compare them to the price of gold itself.

source: Sitka Pacific; Stockcharts.com

While the instructive, this measure doesn’t do you a lot of good if the price of gold is set to drop precipitously. Consider the case of 1980, when gold was experiencing an epic top and the mining stocks seemed to anticipate the lack of sustainability of the move, driving ratio of miners to gold to low levels. That said, the ratio has provided a pretty good clue to what future long-term returns will look like. Consider the following chart from John Hussman:

source: John Hussman, http://www.hussmanfunds.com/wmc/wmc111121.htm

However, the miners are also cheap on a variety of traditional metrics such as price to earnings and price to cash flow ratios. Consider the trailing, current, and estimated ratios depicted for these three large mining companies. While one must be careful of future estimates of operating metrics and the consensus estimates are likely to be wrong in some way (please see my prior post, Run, Don’t Walk Away From Forward P/Es) when I see single digit P/E ratios and mid single digit price to cash flow ratios, I pay attention.

Select Senior Mining Stocks Are Cheap

Of course, the true value of the mining stocks resides not simply in their ability to generate cash flow over the next few years, but in the intrinsic value of the resources that the companies can reasonably expect to extract. Even with long-term gold price estimates well below current prices, the stocks are trading cheap relative to their estimated Net Asset Value. The following chart shows the senior mining stocks price to estimated Net Asset Value courtesy of BofA Merrill Lynch.

Senior Mining Stocks: Price to NAV source: BofA ML

By many measures, Junior mining and exploration stocks are even cheaper. I know of several that trade for little more than the net cash on the balance sheet, despite strong evidence of proven and probable gold reserves. These companies will likely be acquired at some point. However, there are too many caveats to enumerate here, so I’ll leave further inquiry to the eager and opportunistic among you.

Determining whether or not an investment is attractive requires understanding WHY something is mispriced, as understanding market expectations is equally important as fundamentals.

Market expectations for gold stocks seem to relying on two key assumptions:

1. The price of gold will not go up significantly and may have a long-term average well below today’s price.

2. The costs for mining will continue to grow at a fast rate, negatively impacting margins and earnings growth.

These two conditions have certainly been in place over the last 6 months, a period which has seen mining stocks decline by approximately 25%. Mr. Market is once again extrapolating recent trends into the indefinite future which can be particularly dangerous at turning points. Anticipating a change in one or both of these two conditions may set the stage for a meaningful rally in mining stock shares.

Concerning the price of gold…

A review of research on gold and silver mining stocks reveals that analysts use long-term price forecasts for gold of around $1,200 when attempting to value the companies. Additionally, the sentiment data demonstrated above indicates that market participants hold little hope that the price of gold is set to rise from it’s current level of below $1,600/oz.

There have been numerous pressures on the price of gold, ranging from USD strength making gold more expensive to foreign buyers to strikes by gold merchants in India to a general liquidation mentality to the markets in the last few weeks.

However, what appears to be completely absent from the market’s current assessment of gold and silver mining stocks is the likely actions by the Fed and other central banks in the coming months and years in response to lower trend growth in global GDP and the ongoing sovereign debt crisis. In a point made by colleague Brian McAuley in a series of recent client letters, the Fed and other central banks will likely print a lot of money in the coming years in response to slower economic growth and high government debt levels. On a global scale, this money printing has continued almost without interruption since 2007, and over the past two years it has accelerated.  The balance sheets of the eight largest central banks tripled from 2007 through 2011, and during that time the price of gold and silver also tripled. Sitka Pacific colleague Mish, has provided a nice update here courtesy of Saxo Bank:

source: Saxo Bank via Mish’s Global Economic Analysis

However, even with this dramatic central bank balance sheet expansion, economic growth remains slow and we have yet to deal with the eventual impact of our buildup in government debt.  That impact is just starting to be felt in Europe, and it has resulted in a stalled Eurozone economy and a dramatic expansion of the European Central Bank’s balance sheet to the tune of $1.3 Trillion which the ECB handed out to banks in late 2011 and early 2012 via LTROs.  The U.S. will likely face a similar set of circumstances at some point in the coming years, and when we consider the likely path of central bank balance sheets within the broader context of low growth and high debt, it seems very likely the expansion we’ve seen in recent years will only continue, supporting gold prices further. It is notable that even a breath of the potential for future easing which came from the FOMC’s April meeting notes were enough to stop gold’s slide and take metal prices higher the last few days.

Sitka Pacific CIO Brian McAuley writes that

with the current sell-off in miners, the market is factoring in no additional central bank activity in the coming years and a decline in gold and silver prices beyond the declines seen since last summer, to the point where many mining companies will become only marginally profitable.  While it is always possible gold and silver prices could decline in the short-term, especially if market conditions were to worsen dramatically before additional easing by the Fed, the current panic out of gold and silver mining stocks appears to be a substantial long-term opportunity in light of our economic circumstances.

Concerning the price of everything else…

Consider the year over year change in cash cost estimates for the 1st quarter of 2012 from the analysts at BofA. With costs “unexpectedly” rising so fast, it is no wonder so many holders rushed for the door!

source: BofA Merrill Lynch

So while miners are reporting record earnings and cash flows (when it costs you around $600 to produce something that you can sell for $1,600, life is pretty good) investors are disappointed the earnings are not currently growing anywhere near revenues. The list of things driving mining costs higher is daunting:

• Energy prices, especially diesel
• Mining equipment prices, driven by higher base metal prices among other things
• Wages for relatively scarce mining-related labor (though SG&A appears fairly well contained)
• Merger & Acquisition costs
• Taxes, Environmental and Regulatory Costs, etc.

 

Source: stockcharts.com — lines represent average prices for each year

 

Please see  Mish’s post 12 Predictions by Michael Pettis on China; Non-Food Commodity Prices Will Collapse Over Next Three to Four Years; Nails in the Hard Landing Coffin?

If mining stock prices are being held back by a negative view of the gold price and concern over input costs then the shares should rally if either one of these conditions is resolved favorably. The input costs for miners will decline if the economy weakens from here. The reversal in the price oil the last few weeks seems to be confirming this view. At the same time, it seems likely that evidence of further economic weakness, regardless of the origin, is going to be met with a policy response that will benefit gold.

There is strong historical evidence that mining stocks respond very favorably to environments where the economy is weakening, real interest rates are falling, and the stocks are priced inexpensively relative to the metal. As John Hussman illuminated way back in 1999

Not surprisingly, the combination of all of these is rare but extremely powerful. In the rare instances when 1) The rate of inflation has been higher than 6 months earlier, 2) Treasury bond yields have been lower than 6 months earlier, 3) the NAPM Purchasing Managers Index has been below 50, and 4) the Gold/XAU ratio has been above 4.0, the XAU has soared at an astounding rate of 123.63% annualized. In contrast, when none of these have been true, the XAU has plunged at -53.21% annualized. That’s a gaping difference

Since 1999, the combination of those factors has become increasingly less rare. So has overly accomodative monetary policy and money printing. Ditto for spectacular gains in mining company shares.

The timing of these events is highly uncertain, but not really that important. The incredibly cheap valuations for mining stocks coupled with the extreme bearish sentiment provides for a substantial margin of safety. Mining company stock prices look to be falling into the abyss; I am jumping in after them.

JJ Abodeely

JJ is a Director and Portfolio Manager for Sitka Pacific Capital Management, LLC, a SEC-Registered Investment Advisory firm offering Absolute Return and Global Multi-Asset Class strategies. Prior to joining Sitka Pacific, JJ spent more than 10 years in various capacities for a $1.2 Billion asset and wealth management firm based in Seattle, WA. As Portfolio Manager, Analyst, and a member of the Investment Policy Committee, he was responsible for the development and management of several new investment strategies, including Global Multi-Asset Class ETF strategies and an equity long-short strategy.

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