Divergence Between Gold and Miners Continues: But for How Long?

James is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

For about 18 months now there has been a sharp divergence between the price of gold and the stock price of gold miners that is unsustainable in the long run.  Taking into account the massive consensus that global inflation is coming, then it might be a good idea to revisit some major gold miners during these oversold conditions to look for a long term buying opportunity.

First let me illustrate exactly what I am talking about when I say a divergence.  Looking at a three year chart (Figure 1), we can see the separation began in the spring of 2011 using the Spdr Gold Trust (NYSEMKT: GLD) and Market Vectors Gold Miners ETF (NYSEMKT: GDX).

Figure 1:


<img src="/media/images/user_14634/gld-gdx_large.png" />


The main reason for the divergence seems to have been the slowdown in China, which had a negative effect on all basic materials stocks as a whole.  For the record I am not saying this divergence is over.  However, I believe it would be wise to begin evaluating companies for when miners again find themselves in the market's favor.

For other ideas on how to play the China recovery see my article Basic Materials: How to Play the Recovery.

Future macro economic conditions will benefit gold in the very long run.  The reasons are many, but the majority revolve around shortsighted governmental policies that will only serve to prolong and compound the underlying problems.

Well-positioned miners with good management should benefit.  But bottom calling is a scary business, which is why it's always nice to look for a company with solid value during these conditions.  Fortunately this sector has been beaten down so badly that several companies are selling at what I consider bargain prices.

Barrick Gold Corp (NYSE: ABX) is the largest pure gold mining play.  Looking at a long term chart (Figure 2), it's painfully obvious that ABX is currently trading at three year lows.

Figure 2:

<img src="/media/images/user_14634/abx-3-year_large.png" />


However, looking over the books and the future plans for operations, I feel confident in this company's future, even without including the grim predictions of global inflation.

Allow me to sum it all up (Figure 3) with a table rather than a lengthy description.

Figure 3:

<table> <tbody> <tr> <td>Valuations</td> <td>Barrick Gold Corp.</td> <td>Industry Average</td> </tr> <tr> <td>P/E</td> <td>9.75</td> <td>19.20</td> </tr> <tr> <td>Forward P/E</td> <td>6.77</td> <td>Not Available</td> </tr> <tr> <td>Price to Book</td> <td>1.30</td> <td>1.56</td> </tr> <tr> <td>Yield</td> <td>2.40%</td> <td>1.70%</td> </tr> <tr> <td>Payout Ratio</td> <td>21.00%</td> <td>25.00%</td> </tr> <tr> <td>Capital Spending 5 Year Growth Rate</td> <td>84.35%</td> <td>3.09%</td> </tr> </tbody> </table>

ABX is trading at a discount to the industry yet is positioning itself better than anyone in the sector through aggressive re-investment.  When it comes to profitability they score high marks as well, with a 23.70% net profit margin for the most recent year.  Compare that with an industry average of 0.16%.

Conclusion: Value, growth, and a macro-economic backdrop that should provide great opportunities for the next decade make ABX my top pick in the gold sector.

Newmont Mining (NYSE: NEM) is another gold mining play.  But before one gets too carried away and starts snatching up gold miners left and right based on my above thesis, let's take a quick look at this company and see if it's really worth our money.  Using the above table and valuations (Figure 4), let's drop Newmont into the mix and see if it stacks up against Barrick.

Figure 4:

<table> <tbody> <tr> <td>Valuations</td> <td>Barrick Gold Corp.</td> <td>Newmont Mining</td> <td>Industry Average</td> </tr> <tr> <td>P/E</td> <td>9.75</td> <td>197.10</td> <td>19.20</td> </tr> <tr> <td>Forward P/E</td> <td>6.77</td> <td>9.44</td> <td>Not Available</td> </tr> <tr> <td>Price to Book</td> <td>1.30</td> <td>1.60</td> <td>1.56</td> </tr> <tr> <td>Yield</td> <td>2.40%</td> <td>3.20%</td> <td>1.70%</td> </tr> <tr> <td>Payout Ratio</td> <td>21.00%</td> <td>636.00%</td> <td>25.00%</td> </tr> <tr> <td>Capital Spending 5 Year Growth Rate</td> <td>84.35%</td> <td>9.88%</td> <td>3.09%<br /><br /></td> </tr> </tbody> </table>

Net profit margin for the most recent year was 5.20%, lower than the five year average net profit margin of 13.10%.  The amount of gold mined in 2012 decreased 4% from 2011.  A pathetic 2 billion has been set aside for development while M&A appears to have been put on hold.  Declining operations in numerous areas will continue to decrease mining totals.  Oddly the amount saved on these declining operations roughly matches the capital committed for other development meaning not a lot of genuine re-investment is happening.  Governmental hurdles for increased production still remain in Suriname.  Finally, if you think that the copper operations of Newmont will keep you safe think again.  Copper production year over year was down around 30% from 2011 to 2012.

Conclusion:  Not as much value as Barrick.  Not nearly as much in the way of re-investment.  Decreasing profit margins in comparison with the long term averages.  An obscene payout ratio that is eating away at book value.  Finally, management doesn't seem to be offering any plans to correct these problems.  I would stay away.

IAMGOLD Corp (NYSE: IAG) is my small cap pick in the gold mining sector.  With a recent price drop to three year lows (Figure 5) this could be a perfect opportunity to snatch up this well-run miner.  This drop has placed it on my real life watch list, but I'm not quite ready to commit real money to it just yet.

Figure 5:

<img src="/media/images/user_14634/iag-3-year_large.png" />


Using the same table as before (Figure 6), let's compare this small time operation to the industry leader ABX.

Figure 6:

<table> <tbody> <tr> <td>Valuations</td> <td>Barrick Gold Corp.</td> <td>IAMGOLD</td> <td>Industry Average</td> </tr> <tr> <td>P/E</td> <td>9.75</td> <td>8.35</td> <td>19.20</td> </tr> <tr> <td>Forward P/E</td> <td>6.77</td> <td>7.60</td> <td>Not Available</td> </tr> <tr> <td>Price to Book</td> <td>1.30</td> <td>0.85</td> <td>1.56</td> </tr> <tr> <td>Yield</td> <td>2.40%</td> <td>3.00%</td> <td>1.70%</td> </tr> <tr> <td>Payout Ratio</td> <td>21.00%</td> <td>25.00%</td> <td>25.00%</td> </tr> <tr> <td>Capital Spending 5 Year Growth Rate</td> <td>84.35%</td> <td>Not Available</td> <td>3.09%<br /><br /></td> </tr> </tbody> </table>

On top of all this I feel compelled to point out some other highlights of this solid company that is set for great things in the future.

Year over year quarterly earnings growth of 91.60%.  A five year average profit margin of 22.00%, with the most recent year at 25.00%  Finally, a nearly debt free company with a LT Debt/Equity ratio of 0.17 and over $1 billion cash on hand.

Conclusion:  Speculative due to the nature of a small cap stock and how easily big money can push it around.  However, the value is there and if you can stomach a bit of volatility I believe this stock could reward the patient investor over the long run.  Speculative long term buy and hold.

Lulupoopsalot has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

blog comments powered by Disqus