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After looking at different industries and comparing average return on equity to average price-to-book multiples, gold stocks appear overvalued in aggregate. As a whole, these stocks appear promising for constructing net-short positions because they produce below-trend average ROE for their average price-to-book ratio. Using this top-down approach to choose industries for a net-short position, attractively-priced stocks and overpriced stocks were identified among gold stocks.

The Problem with Gold Miners

Business schools teach Porter's five forces which is a framework for assessing the profitability of an industry's firms. Industries whose firms have more bargaining power with customers, more bargaining power with suppliers, low rivalry between firms, few substitutes for their goods, and high barriers to entry tend to be more profitable. The model is so simple and intuitive that it is common instruction for MBA students.

Despite the logic of this model many investors-including some hedge fund investors-crave firms in commodity industries. They don't seem to care that commodity producers are rivalrous because their products are barely distinguishable, or that new competitors could spring up without any proprietary barriers to entry. These overzealous investors don't seem to mind that suppliers to these firms like land-owners and laborers can demand high prices. A recent example of this is how miners in South Africa went on strike and crippled production of platinum group metals.

With this in mind, it is generally better to go long the commodity than it is to go long commodity producers. What's worse, gold mining companies are currently trading at very high valuations, which make them even less attractive.

Long/Short Opportunities

Alpha hunters might consider net-short positions in industries trading at indefensible multiples, market neutral positions for fairly valued industries, and net-long positions in industries with attractive valuations. If they are willing to hedge their positions, they can find more investment opportunities than they would by just hoping to find the best industries or stocks to buy today. Instead, they can use fully or partially hedged positions to bet on the mean reversion of different stocks in an industry while minimizing or reducing exposure to industry and market volatility.

Gold Stocks

Plots of these companies reveal how some stocks are much more attractively priced than others:

(click to enlarge)Earnings Growth vs. PE

(click to enlarge)ROE vs. PB

(click to enlarge)Sales Growth vs. PS

In each of these graphs a predictor of growth is plotted on the y-axis as a function of a measure of cheapness on the x-axis. Historical price-to-earnings multiples, price-to-book multiples, and price-to-sales multiples were used as measures of cheapness. Analyst estimates for earnings growth, historical return on equity, and historical sales growth were plotted as indicators for future growth. More attractive stocks are found up and to the left while less attractive stocks are found down and to the right.

Two above-trend stocks are presented in bold and three below-trend short picks listed in italics were found:

Ticker

Company

P/E

P/S

P/B

Earnings Growth Est

Sales Growth

ROE

Country

ABX

Barrick Gold

10.5

2.9

1.7

2.0%

20.5%

17.7%

Canada

AEM

Agnico-Eagle Mines

4.7

2.7

1.0%

30.2%

-15.8%

Canada

AU

AngloGold Ashanti

9.1

2.0

2.5

-4.0%

19.3%

33.1%

South Africa

AUQ

AuRico Gold

13.8

5.4

0.9

5.0%

44.3%

8.8%

Canada

AUY

Yamana Gold

34.5

6.6

1.9

10.6%

66.6%

5.6%

Canada

BVN

Compania de Minas Buenaventura SA

12.5

6.9

2.9

12.8%

19.2%

25.1%

Peru

EGO

Eldorado Gold

29.9

9.7

1.9

7.8%

67.0%

6.9%

Canada

GFI

Gold Fields

9.7

1.6

1.6

-8.3%

16.8%

South Africa

GG

Goldcorp

28.6

7.2

1.7

17.1%

26.6%

7.0%

Canada

HMY

Harmony Gold Mining

15.5

2.1

1.0

35.2%

11.8%

6.0%

South Africa

IAG

IAMGOLD

17.4

3.6

1.7

11.2%

40.7%

10.2%

Canada

KGC

Kinross Gold

2.9

0.9

34.2%

-17.0%

Canada

NEM

Newmont Mining

98.8

2.7

2.2

52.0%

16.2%

2.2%

USA

NGD

New Gold

45.4

8.4

2.5

5.0%

210.2%

5.9%

Canada

RGLD

Royal Gold

60.4

21.8

3.1

10.0%

40.3%

5.6%

USA

Data from finviz.com

Barrick and AuRico were found to lie among stocks in the upper left of these plots (higher growth, undervalued stocks) while Agnico-Eagle Mines, Eldorado Gold, and Royal Gold were found to lie at the lower right of these plots (lower growth, overvalued stocks). Based on this work, a net short position for gold stocks can be constructed by buying ABX and AUQ shares while hedging with a larger total short position in AEM, EGO, and RGLD shares.

Investors may consider constructing a market neutral or net-long position in gold by adding shares of SPDR Gold Shares (GLD) while retaining a net-short position in these stocks. Due to the volatile nature of stock investing, investors who do not want to deal with the hassle of shorting stocks could buy puts on AEM, EGO, and RGLD shares. Put options would benefit from price declines in these stocks with a limited risk.

Please read the article disclaimer.

Source: 2 Gold Miner Buys And 3 To Avoid