Your Gold Mining Stocks—The Moment of Truth

by Kenneth J. Gerbino

 

 

Although I believe we are in a multi-year bull market in metals, this past month witnessed the worst gold mining share retreat in 23 months.

 

February was a very bad month for the mining stocks, the XAU (Philadelphia Gold and Silver Index) was down 13.4% and gold was also down.  So far in March, there has been more downside pressure as well and now the miners are holding their own in a nervous market.

 

I recently spent four days in Florida at the Bank of Montreal Nesbitt Burns Institutional Mining Conference and met with dozens of managements of large and small mining companies. Two of the themes were 1) continued demand for base metal and 2) the precious metal companies are all using much lower metal prices for cash flow projections and engineering studies. They are being conservative since production decisions involving billions of dollars are many times at stake. For the novice gold mining investor, which includes many billion dollar hedge fund managers, seeing cash flow projections based on $400 gold can paint a conservative future as well as present a high cash flow multiple to the current price. This is actually favorable to the long term gold bugs as it can help keep a lid on an explosion in prices which would make buying these stocks even more of a volatile proposition.

At my firm we are analyzing our mining stocks using $400 gold, $6 silver, $1.00 copper, and 50 cents zinc for our spreadsheets. These prices are well below current prices (gold $535, silver $10, copper $2.20, and zinc $1.00). If we can see a double in a stock over a three year period with metal prices substantially lower, then we know we have a winner. These stocks will do even better if the metal prices stay anywhere near current levels or go higher.

 

Over the next five years I expect metals prices to stay well above their long term averages but I have learned the hard way that it pays to take some money off the table once in awhile when markets get too hot.

 

There are going to be ups and downs but by avoiding overvalued or fundamentally flawed mining companies one should do better in down cycles and this should allow you to take advantage of what looks like a positive long term trend in the metals market. Most importantly, always remember that your gold and silver investments are a powerful insurance policy against a world gone mad in a political and economic sense.

 

Don’t Forget the Base Metal Stocks

 

We still have a long way to go in this mining stock bull market, because all the mining stocks together represent less than 1% of the S&P 500 Index. Therefore we still have the luxury of buying value at relatively good prices because Wall Street does not generally follow many of the base or precious metal stocks. You are ahead of the crowd.

 

In almost every other industry, when prices go up the makers of those goods build more factories and hire more people and produce as much product as they can ship out the door. New companies and people show up and pour lots of money into that industry to try and take advantage of the obvious shortages or price boom. In the mining industry it takes 5-10 years to build a mine….and that presumes you have found an economic mineral deposit. So when metal prices go up there is no fast business response available.

 

We are in an era where India and China need 5-6 times more raw materials than Europe and the U.S. did during the 30 years of booming economic expansion after WWII. However, the inventories of metals in the world’s major warehouses (Comex, London Metal Exchange and Shanghai) are down by more than 80% in the last three years and all the easy mineral deposits found near surface over the last century have been mostly consumed. Minerals and metals are becoming more scarce.

 

Consequently an acute supply squeeze will surely occur in the coming years. This means historic valuations of mining stocks based on global economic cyclicality is no longer valid. Growth from Asia and India changes the entire landscape of raw materials from a cyclical business to a growth business – and there is precedent for this; the 1950’s and 60’s, where old names such as Kennecott Copper, Reynolds Metals, St. Joseph Minerals and International Nickel experienced two decades of strong non-cyclical growth.

 

The above makes this investment thesis a unique opportunity and the mining sector could, again, become the long term darling of Wall Street.

 

Mining companies should now enter an era of sustained growth. Growth stocks sell for 20-30 times earnings. Base metal mining stocks in the last three decades usually sold for only 3-7 times earnings because of the constant ups and downs of the world’s economy (cyclicality). This is all changing right now.  Although we own plenty of gold and silver companies for our clients we are also invested in producers of copper, nickel, platinum, zinc and lead deposits and I recommend the same for you. These companies will experience higher valuation multiples of cash flow by Wall Street because they are enjoying very strong profit margins and sustained growth.

 

Even slow growth from India and China make these stocks big time growth companies that have huge asset values already in the ground and because no one can ramp up any supply in the short or medium term to meet demand, pricing power will be strong. Also these mineral deposits like everything else in the world become more valuable as inflation continues to move forward year after year.

 

The mining sector, up until 2002, had 20 years of lower prices, layoffs, and abnormally low investments in new mines and exploration. Consequently the mining companies were totally unprepared for the huge increase in global demand for basic metals in the last three years. They are now 5-7 years away from catching up. Shortages are here and now and they could get worse.

 

Just make sure you do your homework when buying mining stocks and remember there are a lot mining stock “experts” on the internet that are not as well versed as you might think. There are now hundreds. Back in the early 70’s when my friend Doug Casey and I were buying moose pasture at the beginning of our careers there were some very good advisers around. Now, it’s a different story. Mining is a tough business. Be a tough investor and work hard at it and you will be better off. But be careful of what you read from the new wave of “experts”.

 

The Best Sector on Wall Street

 

There are three phenomena converging right now that offer you a unique opportunity. 1) Prices are going up for gold, silver, copper, nickel, zinc, lead, uranium, and the platinum group. 2) Supply will be constrained for 5-7 years. 3) Warehouses are almost empty. The combination of higher prices and a growth aspect means that many properly evaluated mining stocks could have enormous moves to the upside.

 

The U.S. dollar will also continue to face tremendous pressure. Chinese and Japanese exporters will take more of their earnings in their local currency and this will be a huge strain on the dollar value vis a vis these currencies. If the dollar is going to trend down, anything denominated in dollars will be priced higher and that certainly includes gold and silver – the only liquid tangible assets with a globally standard value.

 

There is no better sector on Wall Street than the mining companies in my opinion. Take advantage of the above data and being in the right place at the right time. Most likely we have a 5-10 year major bull market coming in the metals. There will be some nasty corrections, but no one ever said it would be easy.

 

Up and Down Influences

 

The U.S. current account and budget deficits hit records in the latest reporting period. This combined with U.S. interest rates at less competitive levels internationally (compared to a year ago) and the fact foreign central banks may start to rebalance their reserves away from dollars, could bring on a period of dollar weakness. This should have a positive effect on gold which will help balance the “sticker shock” of gold jewelry buyers reacting to a 25-year high in the price of gold.

 

Along with the above trends, the gold market still has other factors that should positively affect the demand side of the equation and the price level. These are:

 

• Oil exporting nations recycling huge dollar surpluses outside of the dollar
• Continued strong Mideast gold buying
• Mine production forecasted to be flat to slightly down for 2006
• High energy prices creating a more inflation prone environment
• Political tensions regarding the Iranian nuclear situation and Iraq
• Higher than expected Chinese GDP growth
• ETFs taking more and more gold off the market as large international institutions now have a vehicle to own bullion.

 

The downside influences are: 1) the possibility of jewelry demand being stagnant or declining due to new higher price levels, 2) large hedge funds, active in the metals market could create some profit taking sell-offs and 3) normal price pullbacks from the last six months rise.

 

The latest Bank for International Settlements report on derivatives states a combined total global amount of $328 trillion. This is $100 trillion larger than 2003. Just to give you something to compare this number to; The U.S is the largest economy in the world, accounting for 25% of the worlds GDP at $12 trillion. According to the BIS there is a 25.2 times leverage factor of derivative value versus the money backing the transactions. This enormous leverage is so high and these market amounts so large that even a mild economic shock could have tremendous repercussions that could possibly bring down some large financial institutions. Having gold and silver investments in the current climate is mandatory for anyone’s nest egg.

 

Silver Should Do Well

 

The supply/demand fundamentals on silver are even more positive than gold. Silver is also the poor mans’ gold and there are billions of poor people in India and Asia, many who manage to save. Therefore, silver should have very strong demand going forward.

 

With a new ETF in silver most likely coming to market, many market players have bought in anticipation of this event and this might be somewhat anticlimactic. But, if the gold ETFs have bought $6 billion of inventory in less than a year, then the approximate 250 million ounces of silver inventory in various warehouses may not be enough to handle the demand.

 

Zinc is my favorite base metal because it will be in supply deficit for the next three years, has few substitutes and in most applications, higher prices do not diminish demand. For example a car uses about $17 worth of zinc. If zinc tripled in price, it would mean only a 2/10th of 1% percentage increase to a $20,000 car. However, the impact on a zinc mine of a few pennies per pound is substantial.

 

I would be cautious here and be patient as well. $600 gold may look good but will it last. A move to $600 sounds great but are you prepared for a normal correction back to $500 from there? I would suggest having a core portfolio that you hang on to as your insurance portfolio (this should not include any exploration stocks since they have zero gold) and another where you intelligently make good investments in quality, properly valued companies but don’t take losses if the trades go against you and only buy on dips.

 

Currently a price decline back to $460 is very possible and a run up to $600 is also possible. No one can predict this. Your only protection in the coming environment is to stay with real good merchandise and don’t be afraid to take some off the table on run ups. Good luck.

 

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Kenneth J. Gerbino

 

 

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