Gold has been on a tear. Gold has marched past $1100 an ounce and its strength is unmatched. The price of gold has only dipped two days in the month of November.
The run, and the excitement surrounding it, has a lot of investors scared. But they shouldn’t be because…
Gold’s run is nowhere near coming to an end.
Granted, the strong rally has made gold one of the most talked about sectors in the world. More savers are discovering the value of owning gold every day. And more investors are realizing the explosive profit potential of gold mining stocks each day too.
For true contrarians, it’s too much excitement. But with gold at new all-time highs, this run in gold is still far from over. Here’s how to tell when it’s nearing an end.
Resource Stock Investing: A Different Set of Rules
When it comes to investing in gold stocks – or in mining companies in general – the rules are a bit different.
The classic valuation metrics just don’t matter. The common ratios like price-to-earnings, return-on-capital, and (even the one we’ve learned to pay close attention too) operating margins, are way down on the list of priorities.
The two factors that matter are the price of the commodity the company mines and the reserves that company holds.
For instance, the major gold miners have led the way during the current rally. Each incremental rise in the price of gold leads to an even larger increase for gold stocks.
No one is paying attention to the fact Goldcorp (NYSE:GG) beat expectations by 18% last quarter and Barrick Gold’s bottom line profits were 14% higher than expected. What matters most is the expected future price of gold and how large the company’s gold reserves are.
That’s why they’re so highly leveraged to the price of gold. It’s also the foundation for the simplest way to tell when gold stocks get too high.
When This Happens, You Will Know it’s Over
You’ll know when the run in gold and gold stocks is nearing an end when gold companies and investors pay ridiculous prices for gold reserves and gold development projects.
It happens all the time in natural resources. A price run-up sparks fear prices will only go higher. An emotional race creates a self-fulfilling prophecy where prices are pushed even higher. One of the most recent bubbles provides the perfect example.
In early 2008 agriculture commodities spiked to multi-decade highs. Corn, wheat, soybeans – were all soaring.
The first round of the agriculture boom (we’re currently in the second one) was in full swing and the market naturally turned to fertilizer stocks. Potash was all the rage. Potash Corp was featured by Jim Cramer. The Wall Street Journal had feature stories on Uralkali, a Russian potash producer. Goldman Sachs unleashed its full promotional muscle on the IPO of Intrepid Potash, which it led.
After years of steady gains, it seemed like fertilizer stocks would never go down (just like housing, oil, and dot-coms). Behind all the euphoria though, there was one quiet indicator that signaled this boom was about to go bust. It actually came from a little-noticed announcement from the unheard of town – Yekaterinburg, Russia.
Nowhere to Go but Down
On March 12, 2008, Russia’s Ministry of Natural Resources announced:
[Three] Russian fertilizer makers paid $2.4 billion to secure a share of the world’s second-largest potash deposit in a series of fiercely contested auctions on Wednesday.
This was huge news. These companies paid an average of $800 million just for the license to develop and build a potash mine. Keep in mind it takes at least three to five years of development and planning before you even start to build one. And then costs at least $1.5 billion to build on top of all that.
There are three “red flags” of the run coming to an end here:
1. The three companies who bought the licenses were Silvinit (Russian potash), Acron (Russian fertilizer), and Eurochem (Russian chemicals). Only one of these companies, Silvinit, has any experience mining potash. The other two were the warning sign. When companies with no experience pay any price to get into a hot sector, you know the end can’t be far away.
2. These companies shelled out $800 million just for the right to spend another $2 billion building and developing a potash mine. To put that in perspective, even the most highly prospective development licenses cost about $10 to $50 million. Some cost as little as a few hundred thousand dollars.
3. Russia’s Ministry of Natural Resources said this auction brought in more money than all of the licenses sold the previous year combined. When prices get high enough that a year’s worth of revenues are crammed into a few day period, there’s usually only one way for prices to go – down.
As in all bull markets and bubbles, things just go a bit too far sometimes.
Not There Yet
The key thing to remember is that the natural resource investing world is a bit different.
Commodity prices are far more important than P/E ratios. Reserves and resources carry much more weight than dividend yields.
Since it’s different, the indicators of things getting a bit too frothy are different too. But they do exist. And when it comes to gold, we haven’t seen them yet.
For instance, in a recent President’s List recommendation we looked at a small gold company with high-grade gold reserves valued at less than $13 per ounce. Also, as we’ve noted in past Prosperity Dispatch issues, junior gold shares are trading for 50% less than they were when gold first passed $1000 an ounce in early 2008. Some of them are fetching valuations of a mere $20 to $30 per ounce.
Opportunities like these will not be found in a genuine gold bubble.
For me, when companies start significantly overpaying for assets or there are no attractive values left in the sector, that’s the easiest way to tell we’re in a gold bubble. Gold will reach that point eventually, but it hasn’t yet. That’s why I believe there’s still a lot of room left to run for gold.
By Andrew Mickey