Because of the nature of gold miningās fixed costs, any increase above the total cost per ounce significantly increases a gold producerās net income on a percentage basis. Consider a hypothetical gold producer with cash costs of ~$500 per ounce, which is around the industry average. At $1,000 gold, this company generates an EBITDA of $500 per oz per ounce mined. Simple enough. But most mining companies have extra costs on top of their operating expenses. For a new gold project these extra expenses will typically add another $300 or so per oz. So for every ounce mined, our gold mining company is now only generating $200 of margin based on 2009 input costs and $1,000 gold. With $1,350 gold, however, and the same cost structure of $500 in operating costs and $300 in additional costs, our hypothetical gold company has now increased its margin from $200 to $550 an ounce, representing an increase of 175%! We donāt believe current gold equity valuations reflect this potential margin increase at all, but they soon will. A re-rating is just around the corner.
Chart B
The bullish case for gold stocks is even more compelling if you consider the historical trend going back to 2000. Chart B plots the HUI index in gold terms. When this ratio is rising, it means that gold companies as measured by the HUI are outperforming gold. Conversely, when this ratio falls it means gold is outperforming the HUI. As you can see, the recent relative underperformance to gold is not in line with the historical trend. Chart B illustrates that gold stocks are currently trading at the same relative valuation they did when gold was priced at $313/oz! We were investing in gold stocks in 2003 and did not find them to be rich in valuation. We believe this discrepancy indicates that gold stocks have a ways to appreciate in order to match the underlying metalās recent performance.
For those readers who are more technically inclined, the HUI Index chart is signaling a very bullish uptrend. For a more astute confirmation, we asked our prime technical analyst Ross Clark from CIBC Wood Gundy to review the HUIās technical patterns. Ross has always had a very accurate perspective on the gold market in our opinion. As he explained to us, "Capitulation in the dollar (October 1st) is generally followed by a low in mining stocks within six weeks. When the HUI is pushing through to new highs (as seen this month) it is normal for it to pause, making a three to four week correction. If it holds in the mid 400ās we can look forward to a three to four month run with an 80% to 90% rise (emphasis ours). This targets the upper 800ās in the HUI by the end of the first quarter." It is very rare to have fundamental and technical analysis align to predict such a strong move in an equity sector.
Now is the time to own gold stocks. Most gold companies will report their Q3 earnings at the end of October. Due to a higher year-over-year average spot gold price (which has increased 27.8% to $1,228/oz in Q3 2010 vs. $961/oz in Q3 2009), virtually every precious metal company is forecast to exhibit substantial net income growth. These fantastic net income results will be augmented by higher by-product prices (average silver, copper, and zinc prices were up 28.7%, 24.2%, and 14.8% year-over-year), which should set the stage for banner year-over-year earnings increases.
One of the best axioms for investing is painfully obvious, but so often forgotten by seasoned investors: itās all about earnings. Earnings are what drive stock prices over the long term. Investors seek out earnings growth wherever they can find it, and we canāt think of a single equity sector that exhibits better year-over-year earnings growth potential than the gold producers. Despite the buzz youāve heard about gold and silver over the last two months, the stocks havenāt caught up. We expect that to change over the next two quarters as investors realize how much stronger gold producersā earnings will be at $1,350 gold. As countries decide to burn their currencies in the devaluation race, gold has responded, and now itās the producers turn to perform. Weāll gladly take the earnings.
1 Wheatley, Jonathan (September 27, 2010) "Brazil in ācurrency warā alert" Financial Times. Retrieved on October 22, 2010 from:http://www.ft.com/cms/s/0/33ff9624-ca48-11df-a860-00144feab49a.html
2 Ishiguro, Rie (October 5, 2010) "FACTBOX-BOJ to set up fund to buy JGBs, corporate debt" Reuters. Retrieved on October 22, 2010 from: http://www.reuters.com/article/idUSTOE69405K20101005
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