Are you thinking about jumping on the gold bug bandwagon? If you are already on board, are you thinking about jumping off?
As you know there are always two ways to make money with commodities – either through trading the commodity itself or through trading the companies engaged in producing the commodity. In the case of metals you have some companies engaged in exploration with the intent to produce and others producing and exploring.
Gold as a commodity has appreciated dramatically, but the price of gold producers and explorers has not followed suit. Typically, with most commodities the price of the producers roughly parallels the price of the commodity but the gold miners have been atypical. Some see this as an issue of the increasing cost of producing gold and potential sovereign risk in newer areas of gold exploration like Africa.
Some experts have gone so far as to blatantly ridicule share market participants as a whole for their irrational behavior in failing to recognize the underlying value of the gold mining sector.
The future of the price of the commodity itself has been the subject of much debate since it reached its high of $1900 an ounce, give or take a few pennies, in the third quarter of 2011 as the prospect of a US recession and the threat of the European debt crisis loomed large on the horizon. At that time some experts were predicting a rise to $2500.
It didn’t happen and it now appears those experts who speculated the price of gold would stabilize in the mid $1500 to $1600 range were right, at least for the time being.
In recent weeks we have begun to see a glimmer of hope that the worst may be over for the gold miners. Again you will find considerable variance of opinion, with some experts claiming there is no rush to get in as continued market concerns over global issues will hold the miners’ share prices in check. Others feel the disparity between the performance of the miners and the performance of the commodity will ease as market participants become convinced the price of gold is in fact stabilizing and will not go substantially lower. Finally, there are those who exuberantly proclaim the long awaited recovery of the gold mining sector is at last underway.
As evidence we have the following very basic and understandable chart from Yahoo Finance on the last six month price movement in the AMEX HUI gold index:
With the advent of Exchange Traded Funds it is now possible to buy a basket of gold mining stocks to minimize the inherent risk of investing in a promising performer that ends up underperforming. However, the rewards are greater when you find that gem of a company.
We are going to look at a representative sampling of Australian pure play gold miners – those going strictly for the gold – beginning with Australia’s biggest, Newcrest Mining. But first, we need to add a word of caution regarding the use of an index like the HUI for Australian investors. While it is one of the world’s largest gold producers, Newcrest is not part of the HUI.
Even with stocks included in an index like the HUI, a basic principle of value investing applies. That principle is that if the fundamentals of an individual company are sound, market participants will eventually realize the true value and the share price will rise accordingly.
We are going to look at this sampling of Australian gold miners from a fundamental perspective. Our first table lists the companies by Market Cap with some of the most popular market valuation ratios.
Northern Star Resources
Norton Gold Fields
Market Valuation Ratios are highly popular because they combine some real company fundamentals like earnings, sales, asset value, and projected earnings, with what the market is willing to pay for those underlying fundamentals – the share price. As you should know, the ratios taken in isolation represent “hot spots” for further research. As an example, the company that draws the attention of bargain hunters to the sector is Resolute Mining (RSG).
The Price to Earnings Ratio is well below both the liberal value benchmark of 15 and the more conservative 10. The P/E indicates how much investors are willing to pay for each $1 in earnings. For RSG, one would say the stock is trading at only roughly 5 times earnings. The P/E needs to be compared to peers and its overall sector. We have included the Materials Sector where these gold miners are broadly classified. However, you should know the resources metals and mining subsector includes all miners. In essence then, the sector P/E contains iron ore and uranium miners.
The P/EG ratio adds projected growth to provide more than an indicator of past earnings performance. A P/EG of 2 or less puts the company into value territory, and a P/EG under 0.5 produces a reaction in value investors akin to Pavlov’s Bell in canines. However, the P/EG may prove a false indicator if growth expectations are not met.
In short, no one should buy Resolute Mining based on these numbers alone. All they tell you is that you have a candidate here that is worth looking into in more depth. Similarly, with a negative EPS, Perseus Mining looks like a candidate to remove from the list but again, with a P/EG of 0.11, you may want to dig deeper and see what is going on with this company.
To further illustrate the point, let’s look at a six month share price movement chart for these two companies to see which market participants prefer at this time:
Why do investors prefer PRU? There are additional fundamental ratios we can look at for possible answers.
Profitability and performance ratios are independent of share price and therefore an important part of fundamental analysis. We are going to look at 3 – Return on Equity (ROE), Return on Assets (ROA) and Operating Margins.
Here is the table:
Return on Equity (ROE)Cap
Return on Assets (ROA)
Northern Star Resources
Norton Gold Fields
Return on Equity tells us how much profit the company creates with shareholder equity, or the money shareholders have invested. An ROE of 15 or above qualifies a share as a potential value investment by the standards of most value investors.
Return on Assets tells us how well the company does with the assets available. Here assets include debt as well as shareholder equity. In effect, ROE shows profitability with the company’s own money while ROA shows profitability using both shareholder and borrowed money. When comparing company ROA’s, higher values indicate the company is earning more with less investment.
Finally, Operating Margins, which exclude taxes and interest, tells us how much profit a company extracts from each dollar of sales. Obviously higher margins are better. An operating margin of 50% means the company generates 50 cents for every dollar in sales and is a good indicator of low cost producers. Lower production costs lead to higher margins and more profit.
The values in our table give further pause as to why PRU is a market favorite. The clear choice based strictly on the numbers is Northern Star Resources; although NCM’s superior operating margin supports its reputation as a low cost producer. How do share market participants see NST versus PRU? Here is a six month chart:
Northern Star had an NPAT (Net Profit after Taxes) of -$1.3M in FY 2010 and jumped to $16.3M in 2011. PRU has not been profitable for the last three years, with losses of -$4.8M in 2009 followed by -$9.7M in 2010 and an astounding -$48.2M in 2011. How does this compare with Australia’s premier but unloved gold miner Newcrest?
NCM showed a profit of $248.1M in 2009, a profit of 556.9M in 2010, and a profit of $908M in 2011. Despite that record, investors preferred PRU. Here is a 5 year comparison chart:
Debt and liquidity ratios should always be a part of fundamental analysis, especially in times like these. As you know, global credit markets froze in the wake of the Lehman Brothers US Investment Bank failure. Some experts fear a similar event, which would put companies with low liquidity and high debt at great risk as it could become virtually impossible to restructure existing debt.
The following table compares our target miners on these ratios: