Monday, March 21, 2011

Why The Gold And Oil Tandem Rise Means Lagging Gold Stocks

There's a reason why major gold stocks have been lagging both a surging equity market and gold itself. The rise in oil has been a boon for the metal, but said boon does not extend to the stocks of big mining companies. That's because a big producer finds it hard to grow these days.
In theory, mining stocks should be leveraged bets on the gold price. Consider a miner producing gold at a cost of $400 an ounce. Five years ago, with gold averaging about $600, their profit margin was $200. At $1,400 an ounce, the gold price has more than doubled. But the miner's profits have risen fivefold.

The big miners' big problem? Bigness. Five years ago, the stocks of leading miners Barrick, Newmont, Kinross Gold, and Goldcorp traded at an average forward price/earnings multiple of 28 times, according to FactSet Research Systems. Today, they average 17 times. Bang goes your leverage to the gold price.
In other words, it's too hard for a biggie to grow. The problem of bigness also explains why major integrated oil companies' P/Es have also sagged even though oil has risen too.

The stock market loves growth, that's true, but this explanation doesn't cover the case of growing profits. Admittedly, the need to take over juniors with huge deposits at large premiums does whittle down the profit margins of the taker-over'ers. But, there's also the issue of cost squeezes. As long as costs rise with profits, big mining companies won't see the benefit theoretically expected from leverage to the gold price. Those examples of leverage always assume the gold price rises but costs stay fixed.

If the market is fixated on growth at the expense of profits, though, then the big miners are out of favour. That said, there's no way of telling for how long. Companies that stay out of favour for years are known in the value-investing world as "value traps." Canadian forest product companies in the last decade, before the '08 crisis, were such a value trap.

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