Yesterday I wrote in this column that we had taken a position, as advisor, in a couple of gold stocks — Newmont Mining and Homestake Mining. It’s been over 20 years since I’ve traded gold stocks — doing it again took me back to my earliest days of trading, back in the 1970s.
Back in the early 1970s you bought gold stocks because of their dividend yields. For a while there, some of them had literally absurd yields, topping 20% in some cases — especially the small-cap South African stocks. I remember having to learn to pronounce strange Afrikaner company names like Blyvooruitzicht or Bloemfontein, and thinking I was pretty sophisticated.
When inflation got out of control from 1977 to 1982, and gold hit $850 per ounce, these stocks went absolutely nuts. They ended up being the Internet stocks of the hyperinflation era. They were trading toys par excellance. And those dividends? What dividends? Fuggedaboudit!
But now gold languishes near 22 year lows. As exciting as last week’s breakout could be for what it implies for the health of the global economy, it isn’t even visible on the long-term gold chart.
Gold, spot price
Monthly, 1970 to present
As as for gold stocks, they aren’t yield plays anymore. And they’re certainly not trading toys — at least not until now. That could all be changing. So here are a couple of basic pointers for thinking about gold stocks, just in case you get the urge to play.
On one level, gold stocks are like any other stocks, and gold companies are like any other companies. They have earnings. They have assets. They have management. All the normal rules of analysis apply. But there are some very important differences in how investors and traders need to think about gold stocks.
The most urgent difference is that gold companies are asset plays. Their most fundamental valuation criterion is the value of their gold reserves — their “rocks in the box.” Think of it as their inventory — but while for Cisco inventory is bad, for gold companies inventory is good: it means value. But it also means risk, because the value of the inventory fluctuates every moment with the market price of gold.
And every gold company has its own way of dealing with the inventory risk. Some hedge the risk. Some don’t. And some lever it up. This turns out to be the most important difference between one gold company and another. Especially If you’re looking for gold stocks that will outperform in an environment with a rising gold price.
Producers that hedge sell gold forward as a way of locking in a known price for their product, the same way farmers can hedge by selling their crops in the futures markets. Hedging allows producers to cushion themselves against a falling gold price — not a bad thing over the last twenty years, considering that it’s fallen so far that many unhedged gold companies actually operate at a loss. According to Merrill Lynch, hedging accounted for 120% of the industry’s FY2000 operating profit — meaning that without hedging, this industry would have lost a lot of money last year. The cost, of course, is that hedged companies also hedge their upside.
Barrick Gold is one of the most heavily hedged gold producers. In fact, the company actually added to its hedge book in the most recent quarter, selling gold forward at an average price of $270/ounce. Analysts estimate that Barrick has between 27% to 39% of its total reserves sold forward, a huge number for a gold company. The chairman of Barrick is a philosophical supporter of the value of hedging. Gold Fields, in contrast, is completely unhedged. Gold Fields closed its hedge book on February 16 of this year, because its prescient CEO believed that the current low gold price was unsustainable.
But better even than unhedged companies are those that are levered — those that have structured their balance sheets and their hedge books so that their value will rise and fall more, in percentage terms, than the price of gold itself. Morgan Stanley’s gold analysts do a particularly good job of looking at the relationship between the gold price and the net asset value of a gold producer. They say that Newmont and Homestake are among the most highly levered of the large-scale producers. According to Morgan, for every 10% increase in the price of gold, Newmont’s net asset value should appreciate by 47% and Homestake’s should appreciate by 27%.
Some smaller companies are even more levered. For example, Morgan estimates that Kinross Gold’s net asset value should increase by 400% or more for every 10% uptick in gold.
Also, every gold company has its own cost function for getting its gold out of the ground. Some are efficient (and more profitable at low gold prices), and others are inefficient (and only profitable at higher gold prices). A gold company’s leverage can increase or decrease depending on where the gold price stands in relation to its profitability. A company that is on the borderline of profitability, based on the current gold price, is in the sweet spot of leverage. With the gold price slightly lower, it can simply shutter its operations and sit on its inventory like King Midas. But as the gold price rises, it can light up its operations and cash in.
According to a conversation I had yesterday with Morgan’s gold analyst Michael Durose, the average gold company starts making money on the incremental hunk of gold brought out of the ground using incremental capacity at a gold price of about $240 to $270 per ounce. And that’s just the level from which the price of gold is now breaking out to the upside. No wonder all the gold stocks have made such spectacular moves over the last couple months.
All that’s required to keep the action in gold stocks going is for the price of gold to keep going up. It’s that simple. But for that to happen, the Fed is going to have to keep supplying the economy with the liquidity it needs to reverse the deflationary spiral of the last four years. It will be great for gold stocks… and it just so happens it will also save the world. Are you listening, Alan?
The views expressed within represent those of the author, and do not necessarily reflect those of Capitalism Magazine’s publishers.
