Current prices for gold equities exhibit a low correlation with the price of gold. With the bull market in gold and historically low interest rates, it benefits these companies to sit on their reserves. This increases their book value, but because investors and equity analysts focus primarily on shorter-term earnings, their stock prices may be lower as a result. Do you expect gold miner equity prices to languish for a long time, underperforming other industry groups?
We had a similar question from one of our subscribers some time ago. Here's what we replied back then:
As we explained previously there are reasons for miners' underperformance even without taking the manipulation theory into account. Each stock's share prices are ultimately driven by a company's earnings power. In other words, the more sustainable net income a company generates per share, the bigger the price of this share. Profits are not only driven by revenues but also by costs. If costs rise, then profits may not rise even with an increase in revenue.
In the case of mining stocks we need to consider not only the price of metal that a given company produces, but also the company's costs. Since a big share of the company's costs is related to the price of crude oil (the most versatile commodity), we need to take into account oil prices. With oil around $100 and expectations of higher prices investors discount this and project lower profits. Thus, the share price does not increase as one would expect based on the gold price alone.
The point about miners' earnings and their link to stock prices is indeed interesting. Here's our take:
- We'd say that in the mining business earnings don't get as much attention as in most sectors. Naturally, they are very important, but in the mining business, the company's properties are just as important. There are (were?) even some analysts that focus almost solely on the price / ounces-in-the-ground ratio, which is close to the P/B (price to book value) ratio. Therefore, even with lower earnings, a company might still be viewed as attractive because of what it owns and what can ultimately be extracted at a sizable profit. Take Silver Standard Resources. This company was one of the most popular silver miners (and a high-performing one too) for many years before they started producing silver.
- Assuming that earnings and their quality are the key factors behind the stock price valuation, we should take into account all future earnings, not just the current ones or the ones that will likely be seen in a year or two. While simple P/E (price to earnings) analysis is popular among individual investors, we think that institutional players and those with a lot on their broker accounts will prefer to use FCFF valuation or a similar cash flow discounting method. In the current low interest rate environment, the weights for future cash flows will not be much different than the weights for present cash flows. This, in turn, means that moving cash flows through time will not severely damage a company's valuation even if these cash flows don't change based on higher gold/silver prices in the coming years. In other words, with low interest rates people will not care much about having their company's earnings in a few years instead of right now. Even if the company takes a loan to cover their expenses in the meantime, this will not cost very much as the interest on the loan will be very low. Naturally, by "not caring much" I don't mean that it will not lower the valuation - it will, but to a small degree. Now, this is under the assumption that cash flows don't change. Since we are in a bull market in precious metals (and this belief is certainly shared among those who decide whether to invest in gold stocks instead of gold or vice-versa), we should on average expect the revenue from gold/silver sales to increase over time. So, if (1) cash flow will be greater as a company waits to sell their metals, and (2) simultaneously, time will not destroy the value of this cash flow to any considerable degree (again - low rates), then we could expect that when a miner decides to wait to sell their assets (and thus temporarily reduce their earnings), it should in fact increase the value of the mining company for those who believe in the bull market in precious metals.
Of course, the above is not a complete analysis, because we didn't mention costs that are also likely to rise (rising fuel prices, high inflation making workers demand higher wages, and so on) along with the prices for precious metals. However, writing a detailed fundamental analysis of the sector was not our point here. Our point was that a company's decision to pause their production may not only have no negative impact on its price, but it may actually have a positive one.
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