David Einhorn's Actions Confirm That Gold Miners Are Cheap Relative To The Price Of Gold

by: Devon Shire

I’ve always thought that investing in the gold sector was a bit beyond my pay grade so to speak. I just think predicting the future price of gold belongs firmly in my “too hard” pile."

Jim Grant recently eloquently explained why he is still bullish on gold:

“It is the nature of gold that its valuation must forever be a mystery. It earns nothing. It pays no dividend. No conference call, no management to call up and complain to. What I do think is gold is simply the reciprocal of the world's faith in the institution of managed currencies. It is one divided by T, where T stands for trust. And trust is a shrinking number and will continue to shrink. Therefore, I am still bullish on gold.”

And that explanation makes sense to me, but my concern is how do I know when faith in the institution of managed currencies is hitting bottom? When a stock becomes fully valued in relation to its cash flow yield I know it is time to sell. How do I know when it is time to sell gold?

I have taken an interest in one investment idea in the gold sector though. And that idea is that gold mining stocks are very undervalued in relation to the current price of gold. If gold stays where it is or goes higher, these companies as a group are very cheap in relation to their cash generating ability.

Eric Sprott who was very early to the gold party almost ten years ago recently wrote the following confirming this undervaluation of the gold miners:

Last week, the HUI Gold Index marked a new all-time high as it surpassed 600. Recent gold equity investors were undoubtedly happy with this move, but for longer-term holders, the recent strength is actually somewhat disappointing ... while the gold price has almost doubled since early 2008, the HUI Index has appreciated by a mere 22% over the same period. If the HUI was justified at 500 in early ’08, it should surely be justified at 1,000 today, given the appreciation of the gold price over that time.

In many of the funds we manage at Sprott, we’ve transitioned out of gold bullion and into gold equities to better participate in the continuation of the trend indicated above. As long-time investors in this space, we can assure you that the production growth rates will be significantly higher in the junior stocks. They continue to trade at discounted valuations, and we believe they offer the best opportunity to build exposure. Margin expansion is the key metric for this industry, and the market is now acknowledging the miners’ improvement in margin capture – which has occurred despite the increase in capital and operating costs. We meet with a large number of gold mining management teams on a weekly basis, and based on those meetings, it appears that the average cost of producing an ounce of gold today, all in, is now around $800. At $1,200 gold, these companies can capture roughly $400 in EBITDA. At $1800 gold, however, they’re now capturing $1,000 per ounce in EBITDA - representing an increase of 150% in profit margin. That is significantly far above what any other equity sector has been able to generate over the past year.

Amazingly – despite this new reality for gold producers, we are still finding opportunities in select gold and silver mining companies that can be purchased today at 2-3 times their 2-year-out forecasted cash flow. These multiples are based on the current gold and silver spot price, and if these companies hit their production targets, and gold and silver continue their appreciation – we may discover that these stocks were trading at less than 1 times 2-year-out cash flow today. Having been in the business for many years, we can tell you that investing in a stock at 1 times 2-year-out cash flow tends to be a winning proposition – let alone in an industry that literally mines the world’s reserve currency out of the ground.

Yesterday, I noticed that David Einhorn of Greenlight capital had added to a gold miner ETF and made it one of his three largest positions. At the end of Q2 Einhorn had gold amongst his largest positions, but his weighting to the ETF was smaller.

The ETF that Einhorn added to is the Market Vectors Gold Miner ETF (NYSEARCA:GDX). As at October 11, 2011 the largest positions were:

  • Barrick Gold (NYSE:ABX) – 16.36%
  • Goldcorp (NYSE:GG) – 13.24%
  • Newmont Mining (NYSE:NEM) – 10.9%
  • Kinross (NYSE:KGC) – 5.5%
  • Anglogold (NYSE:AU) – 5.3%
  • Cia Da Minas Buenaventura (NYSE:BVN) – 4.61%
  • Yamana Gold (NYSE:AUY) – 4.51%
  • Gold Fields (NYSE:GFI) – 4.54%
  • Randgold (NASDAQ:GOLD) – 4.34%
  • Eldorado Gold (EG) – 4.26%

The actions of Sprott and Einhorn certainly confirm that gold miners are likely quite cheap if you believe that current gold prices are going to be with us for a while. I’m still not sure I want exposure to those gold prices, but if I were I would be investing in the gold equities and not directly in gold at this point.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.