In the market place, the broad picture is a capitulation in gold mining stocks and lots of frustration of their underperformance vs gold. So why take the stock risk if Beta is not rewarded? Everything is coming back to the main issue of poor management. The entire gold mining sector has not yet understood that shareholders want to be rewarded with dividend payments or share-buy-back programs to boost EPS and therefore achieve higher valuation multiples. Mining CEO's only think about increasing resources and growth. They never seriously think about the bottom line.
Current market dynamics:
Investors' mood regarding Gold Mining Stocks is pretty clear: they want gold mining companies to dramatically increase dividends as a point of differentiation with the gold ETF, rather than investing in expansions or overly expansive M&A for example Kinross Gold (KGC). Even though gross profit, operating income and operating margins improved steadily since 2008 (when gold rose from USD 800 to over USD 1'900) valuation multiples have compressed. We see the same picture in the overall stock market. While many companies generate a multiple of profits compared to 10 years ago, stock valuations have sharply corrected. This valuation compression even happened for gold mining stocks. I strongly believe this was due to the lack of yield, lack of real operating performance, rising cost, lack of exploration success, etc. Now with the gold price weaker, market de-risking, still rising input cost, it is even harder to justify higher multiples.
The following table shows Goldcorp (GG) and Newmont Mining (NEM) vs. Gold and some well known value stocks. Obviously, Goldcorp's and Newmont Mining's performance was a disaster. Investors are looking for companies that distribute profits back to shareholders and increase payouts over time. Even though gold has increased by 46% (1/1/2010 to 5/8/2012) dividend yields are still not really competitive vs the stock risk (with the exception of Newmont).
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In the next table you will find an overview with Goldcorp's financial results. Goldcorp was able to increase its operating cash flow but steadily rising CAPEX has decreased its free cash flow. In the course of the last years, Goldcorp was able to generate a lot of cash: cash & cash equivalents rose from USD 556 million in 2010 to USD 1'394 million in 1Q2012. However dividend payout ratios are rising much less. In other words: Goldcorp prefers to spend its cash for M&A or project developments rather than distributing it back to shareholder.
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Newmont Mining's financial situation is similar. Newmont could also increase its operating cash flow from USD 1.3 billion in 2008 to USD 3.6 billion in 2011. It's the same picture for net income, but operating margin has already peaked in 2010 (Goldcorp in 2011). Newmont's cash positions rose from USD 435 million in 2008 to USD 1.8 billion in 2011 (end of 2010 even USD 4.1 billion). Interestingly or better alarmingly, Newmont has not increased its dividend payout ratio until shareholders began to revolt. Coming back to my criticism that gold mining companies tend to throw away money for way too expansive M&A. Newmont is an excellent example for that behavior: in 2010 Newmont generated substantial profits and increased its cash positions to USD 4.1 billion. Instead of paying profits back to shareholders, Newmont thought it's wise to acquire another gold mining company (Fronteer Gold for CAD 2.3 billion). In its 2011 financial results Newmont had to report write-down of property, plant and mine development of USD 2.1 billion. What happened? In 2007 Newmont Mining acquired Miramar (owner of the Hope Bay project) for over CAD 1.5 billion. Only 4 years later, Newmont had a write-down of USD 1.6 billion from the acquired Hope Bay project in Canada. Obviously a bad take-over. I can only emphasize that Newmont Mining and most gold mining companies should be 'forced' or 're-educated' by activist investors or private equity companies to distribute profits to shareholders instead of conducting expansive and risky M&A transactions.
Profit Margin Forecast:
Profit margins have peaked in 2011 and will retreat in 2012. In the light of steady rising input costs, particularly labour and oil, I don't see any meaningful improvement until the next up leg in gold starts.
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Current sell-off and short term action:
The current sell-off was triggered when the important 300 day moving average was breached at USD 1'630. The 300 day moving average was much more reliable than the often watched 200 day moving average. Short term, it's very important that gold can cross its 300 day moving average again, otherwise the entire picture has turned bearish and the correction could become much more severe. In that view, I think it's very likely that gold will test USD 1'300 (50% Fibonacci retracement level established between 2008 and 2012). For that reason, I recommend to take profits in gold and move to the sideline. Investors should also consider that the summer months are seasonally weak for physical gold demand. The bull market in gold will take a break in 2012 but ends not until central banks start to decrease money supply (printing) and real interest rates turn positive.
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Trigger for higher returns in gold mining stocks:
I expect a valuation mean reversion when activist investors or private equity companies enter the sector and maximize profits. I'm still wondering why this hasn't happened yet. There is so much hidden value waiting to be unlocked. Vocal gold investors such as John Paulson should rather focus on one big cap gold mining company and get really involved rather than looking for numerous high beta gold stocks in the hope management will decide wisely what they sadly won't. Below you find a regression analysis between gold and the Gold Miners ETF (GDX). Based on the statistical correlation gold mining stocks (Gold Miners ETF) should be trading at USD 56.82 (with gold at USD 1'593) rather than USD 43.23. For the short term, gold mining stocks are extremely oversold and I expect they will rebound between 10% to 15% (even if gold remains more or less flat). But this bounce will be short lived until we see some activist investors enter the sector. That would be the trigger point for a revaluation and finally substantially rising gold mining stocks.
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