During furious bull markets the valuation measures do not work properly. Let me take the ongoing bull market in silver and silver-related stocks. Since the beginning of 2016 the stocks of silver producers went strongly up:
Source: Simple Digressions
The chart above shows year-to-date returns delivered by fifteen silver plays (mining companies producing significant amounts of silver). It is easy to spot that most of these plays delivered very impressive returns (eight of them returned more than the median return of 238.2%).
As a result, current valuations are overshot to the upside. For example, let me take a multiple of EV / EBITDA (enterprise value to earnings before interest, taxes, depreciation and amortization) as a valuation measure. The graph below shows current EV / EBITDA ratios calculated for silver plays:
Source: Simple Digressions
As the chart shows, many plays are currently trading at a multiple of around 40 - 45, which is regarded as overvaluation. In a nutshell, it means that an investor paying 40 times a company's annual EBITDA to acquire a company's shares accepts the fact that his / her money will be returned in forty years. I am sure no prudent investor would invest significant amount of money into such a company.
I believe that today the entire precious metals market is not driven by values. Quite contrary, it is driven by psychology and mixed expectations.
Below I am discussing this thesis in three detailed sections.
Valuations do not matter
First of all, let me check what happened in the past. I have calculated the EV / EBITDA multiples at which silver plays were trading at the beginning of the previous bull market phase in silver / gold (2009 - 2012):
Source: Simple Digressions
- Yellow rows indicate the companies currently trading at similar levels as at the end of 2009
- Red rows indicate the plays currently trading below 2009 valuations
- Plays trading today at higher valuations than at the end of 2009 are not highlighted
Well, the table does not show too much. Of eleven plays as many as six (Impact (OTCPK:ISVLF), Great Panther Silver (NYSEMKT:GPL), Fresnillo (OTCPK:FNLPF), Pan American (NASDAQ:PAAS), Hecla (NYSE:HL) and Endeavour Silver (NYSE:EXK)) are currently trading at much higher levels than at the end of 2009. Five plays (First Majestic (NYSE:AG), Fortuna (NYSE:FSM), Coeur (NYSE:CDE), Silvercorp (NYSE:SVM) and Hochschild (OTCPK:HCHDF)) are currently trading at similar or lower levels than at the end of 2009. So it is something like a fifty-fifty situation - there is no distinct correlation between today's valuations and those recorded at the end of 2009.
To be honest, I am not surprised. Financial markets value the future. Investors purchasing precious metals stocks bet on higher silver / gold prices. To say that any stock is overvalued /undervalued / fairly priced an analyst has to prepare a number of silver price scenarios. Let me take a small silver producer, Impact Silver, as an example.
Impact Silver case
The company produces silver, gold and two base metals (lead and zinc). It reports its sales in Canadian dollars per ton of ore processed /sold. I assume that the company will produce 960 thousand ounces of silver in 2016 (to produce this amount of silver, the company has to process 180 thousand tons of ore).
In 2015 Impact was getting C$84.96 per ton of ore processed and sold, on average. Assuming that the average price of silver in 2016 will stand at US$20 per ounce, the company should get around C$107.5 per ton of ore processed and sold (an increase of 26.5%, compared to 2015).
Further, in 1Q 2016 the company was spending C$70.4 in direct costs to process one ton of ore (excluding depreciation, depletion and amortization). Overhead was standing at C$19.4 per ton of ore processed (also excluding depreciation, depletion and amortization). Assuming that the company would replicate these costs in the entire fiscal year 2016, it means that Impact is going to make C$17.7 on each ton of ore processed and sold. It is equal to EBITDA of around C$3,200 thousand (C$17.7 x 180,000 tons of ore processed). Then, I am assuming that at the end of 2016 Impact will hold debt of C$1,168 thousand and cash of C$3,337 thousand (I am taking into account the last public offerings announced by the company).
Now, the tricky part of the valuation process. To calculate the value of Impact shares I have to apply a proper EV / EBITDA multiple. However, this figure may be set in many ways, for example as the industry average, the silver segment average, the forecasted industry average etc. To avoid being classified as a biased analyst I have calculated the value of Impact shares using a number of multiples. The results are presented in the graph below:
Source: Simple Digressions
How to read this graph? First of all, all values are calculated assuming that in 2016 the average price of silver will be US$20 per ounce.
Then, an investor assuming that the long-term multiple EV / EBITDA should stand at 10, should pay not more than C$0.42 per share.
Another investor, this time assuming the long-term multiple EV / EBITDA of 20, will pay not more than C$0.81 per share.
And so on.
Today Impact shares are trading at C$0.98 a piece, which means that such a price is acceptable for an investor using a multiple of 25 or higher. In my opinion, such a multiple is too high for a small silver producer so, in my opinion, these shares are generally overvalued today.
However, there is another trick. If somebody assumes that the long-term price of silver will stand at, for example, US$30 per ounce, then the multiple of 6 justifies today's share price.
Summing up - today's relatively high prices, at which Impact shares are trading, do not have anything to do with historic valuations. Investors try to value the shares of any mining company (Impact included) taking into account future scenarios, mainly silver / gold prices.
Valuation measures are very important at tops and bottoms of any cycle. Then it is psychology that drives share prices.
Let me present a graph delivered by Incrementum AG:
Source: CSI Investing
According to this graph, now we are exiting the bottom in the gold cycle. In my opinion, we are at some point between "Depression" and "Hope". During these periods investors are totally misguided. Some of them think that this rally is only a relieve bear market rally and very soon the gold / silver market is going to continue its previous cycle (bear cycle). The others think that we are at the beginning of another bull market phase in gold / silver. However, a majority of investors simply do not know at which phase the gold cycle is now. As a result, mining stocks are valued rather randomly - some of them show very high EV / EBITDA multiples and some are trading at relatively low multiples.
How to play this market?
If valuation measures do not work and investors are not sure at what phase the gold cycle is now the question arises: "How to play this market?"
To answer it I want to remind my readers one of my earlier articles on this issue (refer to this link). In this article I took the famous trader, Jesse Livermore, as a classic example of investor playing a furious bull market:
"Adopt a buy-and-hold strategy in a bull market and sell when it loses momentum. Livermore always had an exit strategy in place"
In other words - I believe that investors should currently focus on market action. Assuming that we are in an early stage of a bull market in gold / silver, the most important thing is to participate in the market action, for example using a buy-and-hold strategy. At this stage the valuation measures are less important.
However, it does not mean that I do not care about the quality of any investment. Not at all. I do care but in a little bit different manner. In my opinion, it is much more important to know which stocks should be avoided than which stocks should be purchased.
Using different wording - problematic companies should be avoided because even during a furious bull market they generally deliver much lower returns (if any) than the broad precious metals market. On the other hand, the stocks not qualifying to the category "Avoid", should deliver very good or above-average returns. But it is an issue for another article…
Disclosure: I am/we are long FSM, FNLPF.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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