Time to Favor Gold Equities
It’s not news that gold stocks are trading at some of their lowest valuations in the last decade; indeed by some metrics, they are at their lowest since the start of this bull market. There are many indicators to consider, demonstrating just how low the gold stocks have fallen.
Current price to cash flow, for example, for the XAU index is barely above eight times, the lowest level since 2000. It’s down from almost 14 times at the end of 2010 and 20 times the year before.
In terms of price, most senior gold stocks are down 25% or more over the past year; many are considerably lower today than they were in early 2008, when gold was trading under $900 an ounce; Newmont even traded higher in 1996!
Why are they so cheap?
Before trying to decide if the turn might be at hand, we should examine what has caused this astonishing underperformance, given gold’s strong record. Some culprits are well known. In the early years of the bull market, miners’ costs (notably energy) rose even more than did the price gold, squeezing margins even as the gold price jumped. Indeed, it was not until the second half of 2008, nearly eight years into the bull market, before major miners, in aggregate, actually made money.
Moreover, gold miners did not actually help themselves – well, they did help themselves – with excessive stock issuance to finance frequently pricey acquisitions that did not work. The sector as a whole has a terrible record of wealth creation. This poor record only helped drive many investors towards the gold bullion ETFs when they came out in 2005. Their dramatic growth in assets reflects this, and also that gold ETFs do not disappoint; the gold price goes up, the ETF goes up. Simple!
Why are people buying gold?
More recently, however, two other factors have come into play. A weak stock market last year, following a relatively nervous rally since the credit crisis in 2008, caused many investors, particularly individuals, to be skeptical of stocks…and that included gold stocks. And the very reasons that more people have turned towards gold assets in the last few years – protection from deflating currencies, insulation from global monetary and debt woes – favors gold bullion (or ETFs) over volatile mining stocks, which have numerous extraneous influences beyond the price of gold.
When profit replaces protection as the primary motive for gold buyers is when they will favor gold stocks over bullion.
Gold companies dealing with problems
In the meantime, some of the problems with the gold stocks are taking care of themselves. Margins finally are expanding, and mining companies have lots of cash on their balance sheets. Mining companies are exercising better financial discipline than in years past, largely as a result of shareholder pressure after a series of well-publicized write offs and write downs of prior expensive acquisitions. Many have boosted dividends (most notably Newmont, whose dividend is now tied to the price of gold) as a way of differentiating themselves from the ETFs (which of course has no yield).
So, many of the factors that hurt gold stocks have turned to the stocks’ advantage, while increasingly cash-rich companies are in a position to make acquisitions without equity dilution. Finally, valuations are now low enough to attract buyers; on three previous occasions during this decade-long bull market when valuations for gold stocks fell deeply into oversold, undervalued territory, they were followed by rallies of over 100%. We don’t know where the bottom will be, but the recovery will be strong enough to justify buying now.
Adrian Day will talk on " Top Seven Low Risk Resource Stocks for the Year Ahead" and "Is the Resource Boom Over" on Monday, May 14, and participate in a "Bulls & Bears" keynote panel on Tuesday, May 15, during the New York Hard Assets Investment Conference.
About the Author
Adrian Day is president of Adrian Day Asset Management, a boutique money management firm which handles accounts in both global and gold equities for individuals. Contact him at assetmanagement@adrianday.com or www.adriandayassetmanagement.com.
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