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Eric Sprott – The Time to Buy Gold Stocks is Now !

November 04, 2010 | About:
CanadianValue

CanadianValue

209 followers
Thanks to being very early to the bull run in gold prices, Eric Sprott has been one of the most successful asset managers of the last decade. In addition to being bullish the right commodities, Sprott was also in front of the overleveraging of the American financial system.

Here is his most recent letter to investors with some specific stock ideas:

http://www.sprott.com/Docs/MarketsataGlance/10_10%20Bonfire%20of%20the%20Currencies.pdf

World governments just can’t get enough conflict these days. They’ve now resorted to battling each other with money printing. The devaluation race is in full gear, and it’s tough to keep track of who’s winning.



It’s been just wonderful for investors, of course. In addition to contending with 0% interest rates, they now have to navigate through increased currency volatility and uncertainties associated with potential inflation. Gold and silver are benefitting greatly from this ‘currency war’ as investors seek safe harbor in hard money.

We can’t say we’re surprised to see gold and silver where they are, but it has been surprising to witness just how willing and open governments are to blasting their own currencies down in value. Although we have complete confidence that the economists at the world’s various central banks know exactly what they are doing, we’re content to own precious metals investments in the meantime until such a day arises when the currency war winner is finally announced.



Just to make sure you’re up to date in currency war news, the most recent devaluation shot was fired by the Federal Reserve on August 17, 2010, when it initiated its permanent open market operations(POMO) to stimulate economic activity. The central bank announced its intention to reinvest the proceeds of its maturing mortgage-backed security holdings back into Treasury bonds. Combined with recent comments by the Federal Open Market Committee (FOMC) on increasing the US inflation rate (through money printing), world governments have been coerced into action. They’ll be damned if they let the US devalue against their own respective currencies and slam their exports, so everyone’s devaluing in tandem. It’s literally a “race to the bottom”, with all major currencies on the potential fi at currency chopping block.

By our count, no less than 23 separate countries have now intervened in the foreign exchange market in some way since September 21, 2010. The goal for all is to increase the supply of their respective paper currencies in order to drive them down in value. In the cases where countries can’t print outright, they have intervened through capital controls or “open mouth” operations (ie. talking down your currency in policy meetings, etc.). Both approaches have significantly increased the currency market’s volatility. Japan’s October 5th announcement of a “new fund” to purchase assets ranging from government to corporate bonds has forced other countries to pursue the same policy, and the world now awaits similar announcements from the United States and UK in the form of new Quantitative Easing programs.

Investors aren’t clueless, however, and many are shifting capital to protect themselves. A large number of commodities are now benefitting from the uncertainty created by the devaluation race. Gold, silver,oil, copper, wheat, sugar and platinum are all on the run, and yet we have no reported infl ation!

Kudos go to the Central Banks for orchestrating that economic miracle.

Nonetheless, regardless of what the CPI says, it’s clear that investors are proactively preparing themselves for more printing, and gold and silver seem to be the most popular choices for investors seeking safe harbor.



If you haven’t participated in gold’s recent rise, don’t fret, because the fun has only just begun. While gold and silver bullion have increased by 20% and 32% since January 1, 2010, respectively, gold stocks as represented by the Market Vectors Gold Miners ETF (GDX), the Philadelphia Gold and Silver Index (XAU), the NYSE Arca Gold Bugs Index (HUI) and the S&P/TSX Global Gold Index have all trailed gold’s performance for the entire year. You wouldn’t expect the senior gold producers to be trailing behind gold in this environment. After all, at $1,300 gold, these companies literally have a license to print money. What better business is there to be in right now? These are companies that can process an ounce of gold for $800 and sell it for $1,300, with virtually no sales risk. What other investment sector can boast that kind of margin in this environment?

We believe the gold producers present an excellent investment opportunity right now.

To explain why, consider the NYSE Arca Gold Bugs Index (HUI). The HUI is a modifi ed equal-dollar weighted index of companies involved in major gold mining. The HUI was designed to give investors exposure to near term movements in the gold price by focusing on companies that do not hedge their gold production beyond 1.5 years. The HUI was launched with a base value of 200 in March 1996 and includes some of the largest gold mining companies in the world. Despite a 35% increase in the price of gold since March 2008, the HUI has barely moved at all.

As Chart A illustrates, this gold equity index is currently trading at the same approximate level it was when gold was barely over $1,000. The current HUI valuation doesn’t reflect the operating leverage that the $350 increase in the spot gold price could potentially have on earnings – which brings us to an important point that investors often overlook in gold stocks.

Because of the nature of gold mining’s fi xed costs, any increase above the total cost per ouncesignificantly increases a gold producer’s net income on a percentage basis. Consider a hypothetical gold producer with cash costs of ~$500 per ounce, which is around the industry average. At $1,000 gold, this company generates an EBITDA of $500 per oz per ounce mined.

Simple enough. But most mining companies have extra costs on top of their operating expenses. For a new gold project these extra expenses will typically add another $300 or so per oz. So for every ounce mined, our gold mining company is now only generating $200 of margin based on 2009 input costs and $1,000 gold. With $1,350 gold, however, and the same cost structure of $500 in operating costs and $300 in additional costs, our hypothetical gold company has now increased its margin from $200 to $550 an ounce, representing an increase of 175%! We don’t believe current gold equity valuations refl ect this potential margin increase at all, but they soon will. A re-rating is just around the corner.

The bullish case for gold stocks is even more compelling if you consider the historical trend goingback to 2000. Chart B plots the HUI index in gold terms. When this ratio is rising, it means that gold companies as measured by the HUI are outperforming gold. Conversely, when this ratio falls it means gold is outperforming the HUI. As you can see, the recent relative underperformance to gold is not in line with the historical trend. Chart B illustrates that gold stocks are currently trading at the same relative valuation they did when gold was priced at $313/oz!

We were investing in gold stocks in 2003 and did not fi nd them to be rich in valuation. We believe this discrepancy indicates that gold stocks have a ways to appreciate in order to match the underlying metal’s recent performance.

For those readers who are more technically inclined, the HUI Index chart is signaling a very bullish uptrend. For a more astute confirmation, we asked our prime technical analyst Ross Clark from CIBC Wood Gundy to review the HUI’s technical patterns. Ross has always had a very accurate perspective on the gold market in our opinion. As he explained to us, “Capitulation in the dollar (October 1st) is generally followed by a low in mining stocks within six weeks. When the HUI is pushing through to new highs (as seen this month) it is normal for it to pause, making a three to four week correction. If it holds in the mid 400’s we can look forward to a three to four month run with an 80% to 90% rise (emphasis ours). This targets the upper 800’s in the HUI by the end of the first quarter.”

It is very rare to have fundamental and technical analysis align to predict such a strong move in an equity sector.

Now is the time to own gold stocks. Most gold companies will report their Q3 earnings at the endof October. Due to a higher year-over-year average spot gold price (which has increased 27.8% to $1,228/oz in Q3 2010 vs. $961/oz in Q3 2009), virtually every precious metal company is forecast to exhibit substantial net income growth.

These fantastic net income results will be augmented by higher by-product prices (average silver, copper, and zinc prices were up 28.7%, 24.2%, and 14.8% year-over-year), which should set the stage for banner year-over-year earnings increases.

One of the best axioms for investing is painfully obvious, but so often forgotten by seasoned investors: it’s all about earnings. Earnings are what drive stock prices over the long term. Investors seek out earnings growth wherever they can find it, and we can’t think of a single equity sector that exhibits better year-over-year earnings growth potential than the gold producers. Despite the buzz you’ve heard about gold and silver over the last two months, the stocks haven’t caught up. We expect that to change over the next two quarters as investors realize how much stronger gold producers’ earnings will be at $1,350 gold. As countries decide to burn their currencies in the devaluation race, gold has responded, and now it’s the producers turn to perform. We’ll gladly take the earnings.

About the author:

CanadianValue
http://valueinvestorcanada.blogspot.com/

Rating: 2.9/5 (15 votes)

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