5 Gold Stocks For Gold Bulls

Are you thinking about jumping on the gold bug bandwagon?  If you are already on board, are you thinking about jumping off?

There are two ways to make money on 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 share price of producers roughly parallels the price of the commodity but gold miners have not closely tracked the price of gold of late.  Some see this as an issue of the increasing cost of producing gold and potential sovereign risk in new mining areas of gold exploration like Africa.

Some experts have ridiculed investors for failing to recognise the underlying value of the gold mining sector.

The outlook for the gold price has been the subject of much debate since topped $1900 an ounce, give or take a few pennies, in the third quarter of 2011. Back then the prospect of a US recession and the threat of the European debt crisis loomed large.  At that time some experts were predicting a rise to $2500.

It didn’t happen, and it now appears that those who speculated that the price of gold would stabilise 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 gold miners.  Again you will find considerable variance of opinion, with some experts claiming there is no rush to get in as ongoing sharemarket turbulence will hold miners’ share prices in check.  Others argue that the present gap between gold miners performance and the performance of the gold price will narrow as the market becomes convinced that the price of gold is in fact stabilizing and is not about to drop off the cliff.  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 AMEX HUI gold index chart for the past six months, which represents a basket of gold stocks around the world (Newcrest, one of the world’s largest gold producers is not part of the HUI).

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.

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 realise 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 more important market valuation ratios.

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.  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 of Resolute Mining (RSG) is well below both the liberal value benchmark of 15 and the more conservative 10 (Essentially, 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 ratios for 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 as well.

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.  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’s going on with this stock.

To further illustrate the point, let’s look at a six month price chart for these two stocks:

Why do investors prefer Persues Mining (PRU)?  There are extra ratios we can analyse 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 three such ratios – Return on Equity (ROE), Return on Assets (ROA) and Operating Margins.

Here is the table:

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 Perseus Mining (PRU) is a market favorite.  The clear choice based strictly on the numbers is Northern Star Resources; although Newcrest’s (NCM) superior operating margin supports its reputation as a low cost producer.  How does the market value Nothern Star Resources (NST) versus Perseus (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.Perseus   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 Perseus (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 fear a similar event, which would put companies with low liquidity and high debt at great risk.

The following table compares our target miners on these ratios:

All businesses have assets and most have debts, some of which are payable within a fiscal year.  Liquidity ratios measure how quickly a company can convert assets into cash should the need arise to meet current bills without sacrificing ongoing operations.  The two most widely used measures are the Current Ratio and the Quick Ratio.  Both ratios divide current assets by current liabilities, but the quick ratio strips out inventories from the equation.

A ratio of 1 means a company has just enough to meet its current liabilities should the need arise, which it rarely does.  Some analysts believe that 1.5 is a minimally acceptable current ratio, and most of the target companies meet that standard.

Newcrest (NCM) has a lower Quick Ratio, but coupling the liquidity ratios with the company’s Debt to Equity ratio offers a more accurate picture.  This ratio includes short term and long term debt in its calculation.  It is a measure of how much a company relies on “other people’s money” to operate versus how much it relies on its own money – shareholder equity.

As you can see, NCM has the lowest ratio on the table.  In normal times, a Gearing at 71% for Norton Gold Fields (NGF) may not be a major cause for concern.  Does this relatively high Debt to Equity ratio relative to its peers bother investors?  Let’s see how this tiny junior miner compares to our mystery stock, Perseus (PRU).  Here is a six month chart for both.

Norton Gold Fields (NGF) is yet another example of why fundamental analysis based on numbers alone can mask a potential gem that could be uncovered with a little qualitative analysis thrown in. NGF’s share price spiked from $.016 to around $0.23 following a trading halt; an unsolicited takeover bid for $0.27 per share come from a company currently holding a 17% stake. It was an obvious vote of confidence in the future prospects of Norton Gold.

You can spot companies like NGF by looking at their Debt to Equity and long term debt.  A company with bright prospects without the ability to raise needed capital on its own is a prime takeover target.  High debt companies are not often good candidates for outside financing and if they rely on issuing shares, dilution often drives down the share price.

Prospects, however, cannot be determined without qualitative fundamental analysis.  PRU offered a clue with its low P/EG and therein lays the story.  The analyst community is bullish on this company because of their growth potential in the gold fields of West Africa.  Four out of five major Australian brokerage houses have a BUY rating on PRU with BA-Merrill Lynch the holdout with an UNDERPERFORM, High Risk rating.

Please note that TheBull.com.au simply publishes broker recommendations on this page. The publication of these recommendations does not in any way constitute a recommendation on the part of TheBull.com.au.You should seek professional advice before making any investment decisions.