Dear Daily Crux reader,
This week, we're covering a topic that's on the minds of many readers: gold mining stocks.
While gold has been consolidating between $1,600 and $1,700 since last summer, gold stocks have plummeted. The benchmark Gold Bugs Index (HUI) that tracks the sector is down nearly 30% in the past two months alone and now trades at its lowest levels in nearly two years.
The huge selloff has left many resource investors wondering what to do with gold stocks now.
For answers, we sat down with John Doody, editor of Gold Stock Analyst. Longtime readers know John is one of the world's most respected authorities on gold stocks. He is frequently quoted in top financial publications likeBarron's and the Financial Times… and counts many of the world's top money managers among his readers. He is our "go-to" source for information on the sector.
To learn what John is telling his subscribers now, read on…
Good investing,
Justin Brill
Managing Editor, The Daily Crux
www.thedailycrux.com
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The Daily Crux: John, as you know, gold stocks have been crushed over the past several months. What's going on here?
John Doody: It all comes down to the price of gold… There is suddenly very little confidence in the future price of gold. Gold stocks are simply a derivative of the gold price. If you don't have confidence in the future gold price, you're not a buyer of gold stocks.
But it's important to note that while they have been crushed, they haven't been crushed on high volume. They've been crushed on no volume. There's just been a complete lack of buyers, even though the stocks themselves are stronger financially than they've ever been in the past.
But again, there's not a lot of optimism on the part of analysts about the future price of gold. They're all running net present value calculations assuming gold will be back at $1,200 three or four years out. This assumption totally ignores the most important macroeconomic factor affecting gold, which is negative real interest rates.
This has created a rare opportunity, where the stocks of the best gold miners have become nearly as cheap as they were during the worst of the financial crisis.
Crux: In your recent issue of Gold Stock Analyst, you discussed just how incredibly cheap these stocks have become. Can you tell us a little more?
Doody: Sure… First, the operating margins of the miners have just exploded.
We continuously track 60-plus gold mining stocks – which is every one in North America and most of the world's producers – and the average cash costs in the industry are around $600 an ounce. That's the actual cost of mining an ounce of gold… paying for the labor, the power, and everything that goes into the daily operation and management of a mine.
At around $1,600 an ounce gold, the average operating margin or cash flow margin is about $1,000 an ounce right now. That's better than it's ever been in the entire history of gold stocks. Just a few years ago, gold didn't even sell for $1,000 an ounce.
So the margins are wonderful, the companies are in great financial shape, and they're paying dividends like they never have before. Financially, these companies are doing great… But looking at the stock prices, you'd think they're going out of business.
We constantly run regression analyses on the valuation of company reserves –companies typically have 10 times their annual production in reserves still in the ground – versus the gold price. We do the same thing for ounces of production versus the gold price and for operating cash flow.
Right now, we've got ounces of reserves selling at under $300 an ounce. To put that in perspective, the last time they sold under $300 an ounce was when gold was trading under $1,000 an ounce. We're also seeing ounces of production selling at just over $5,000 an ounce. Again, the last time production sold this cheaply, gold was just over $1,000 an ounce.
But the biggest disparity comes from the operating cash flow multiple. This basically tells you what price you're paying as a multiple of their cash flow… similar to a multiple of earnings. Right now, these stocks are selling at about five times operating cash flow. For reference, three times in the 2000s – 2003, 2006, and 2007 – the industry average was 20 times operating cash flow. So while gold is three to four times higher than it was then, the cash flow multiples are 75% lower.
Again, this is all a reflection of no one believing in the future price of gold. No one is paying any attention to the incredible expansion of money supplies around the world. No one is paying attention to what's going on in Europe and the potential that the euro is going to fall apart. No one is paying attention to the real drivers of gold.
The single biggest driving force for the gold price over the long term is the real interest rate… Meaning what do you get as a risk-free return on your money after inflation?
In the United States, you earn nothing on a savings account, while inflation is eroding the value of your savings by 2.5% or 3% a year. It's the same or worse in Europe, China, and India. And people go to hard assets as a way to escape that.
Now, during weeks like the one we just had, gold's not always a great short-term escape. But over the long term, it's been terrific. We've had inflation ever since gold was set free in the early 1970s at $35 an ounce, and look where it is now.
Have there been ups and downs along the way? Sure, but the trend is certainly intact… And it's the macroeconomic environment that creates that trend.
On a day-to-day basis, the gold price may be set in London and in the Comex, but that's not where the real demand for gold is. More than half the global demand for gold comes from China and India. And they are buyers at lower prices. If we stabilize here in the $1,600 range, there will be gold buyers coming out of the woodwork from China and India.
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Crux: What's your best advice for gold stock investors now?
Doody: We told our subscribers last July that we feared a future "Lehman-type" event. The collapse of Lehman Bros. in September 2008 was what really set off the crash of the stock market and gold, as everybody went to cash. Last summer, we weren't happy with what was happening in Europe, so we were cautious of another crisis event.
So in the July 2011 issue of the GSA Top Ten, we laid out our recommendations. We looked at what happened in 2008… at what had been the best positions to be in when Lehman failed.
Over the very shortest time frame, the very best position was cash. But as soon as you begin to lengthen that time, the best position turned out to be one-third cash, one-third gold, and one-third our GSA Top Ten stocks. So that's basically what we recommended to subscribers last summer and what we continue to recommend today.
Now obviously, we're not a financial advisor. It's not our role to tell people where to be invested on an overall basis. Our job is to find the 10 best gold stocks in the world, that's what we focus on, and people subscribe because our track record is second to none in the industry. We're up over 1,000% in the last 10 years. And as you know, that's an audited record… The audits are clearly published on our website.
So that's our primary focus. But from a portfolio strategy perspective, we're still very comfortable with the one-third, one-third, one-third weighting. If we're wrong and gold takes off immediately, we've got one-third in gold and one-third in the 10 very best gold stocks. If gold and gold stocks correct further, we've got one-third cash to jump back into the market and buy more gold and GSA Top Ten stocks when we can determine that the bottom has been reached.
Crux: Would you recommend buying gold stocks now for any readers who don't already have a full position?
Doody: Yes.I would immediately buy half, or maybe even a quarter, of what I ultimately want to buy. It's like getting into the ocean when it's still cold… You have to ease your way in.
We don't know exactly where the bottom is, but every indicator is telling us that we're either near the bottom or at it. It would be a huge mistake not to be invested now.
As of May 1, gold stocks were on average trading 29% below where they should trade with gold in the $1,600s. The only time they have ever traded at a greater discount to gold was in the October 2008 crash, when they traded at a 34% discount. Investors buying at that bottom saw a 237% gain in the next 15 months.
What inevitably happens if you're not invested, is by the time you're convinced that the turn has happened, you will have missed a big portion of the upside. The only way to avoid that is by taking a partial position now and adding more on weakness.
In GSA, we're in one-third now, and we're watching intently to see if we want to add more. If you were just getting into our Top Ten stocks, we wouldn't recommend buying your full one-third position all at once. Again, we'd recommend buying a partial position first… maybe one-third to one-half of the one-third position I mentioned earlier.
In the next issue of the GSA Top Ten, which is due out this week, we'll have more discussion on this kind of stuff because this is a topic that needs to be covered in greater detail to ensure our new and existing subscribers have some comfort. We'll be talking a lot about where we are now, running over the numbers and the data, and give our best assessment on whether the bottom has been reached. If so, we'll probably be moving to something like a 50% allocation in the GSA Top Ten, 25% in gold, and 25% in cash.
Crux: Finally, we know it wouldn't be fair to your subscribers to reveal your GSA Top Ten stocks, but could you share one or two of your favorite buys now?
Doody: Well, basically what you're asking me is to choose which of my children is my favorite… And you know no parent would ever answer that question.
Let me just say that our GSA Top Ten portfolio breaks down into different groups of companies… We basically have established companies with high growth, companies that are in the process of building profitable mines, and royalty companies, which we've talked about previously.
If I had to choose, the area I would probably favor most right now is the royalty companies. They're the safest… They have the broadest geographic distributions and portfolios.
As you know, Royal Gold and Franco-Nevada are the cream of the crop in that group.
Crux: Thanks for talking with us, John.
Doody: My pleasure. Editor's Note: John is currently offering Stansberry & Associates readers a special deal on his Gold Stock Analyst advisory. You can quickly get the details here (without having to watch a long video).
If you're interested in watching the video presentation on one of John's top Gold Stock Analystrecommendations, you can view it here. You can also read a transcript of the video here.
Monday, 14 May 2012
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