Gold Stocks Are Super Cheap on a Valuation Basis - from Adam Hamilton (06/24/12)

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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!
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.

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Podcast: Dave Skarica on Europe, Greece, and Gold - Mike Swanson (06/21/12)

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