Investors tossed gold stocks out the window during that panicky period in 2008, forgoing rational analysis and value propositions in favor of a mad dash for cash.
A similar phenomenon has gripped most gold stocks this year, though thankfully to a far lesser degree. The key difference between that mass exodus in 2008 and its re-enactment in miniature now, however, is that the price of gold has increased by 9% since the start of 2011. The Market Vectors Gold Miners ETF (NYSE: GDX ) reflects the mirror image of gold's advance with a year-to-date decline of 13%, while megaminer Barrick Gold is 16% less mega than it was at the start of the year. As a careful observer of this space, I see multiple gold stocks trading as though gold has lost its luster entirely and slipped back below $1,250 per ounce.
To the contrary, however, gold has held the line with impressive strength since striking its 2011 low near $1,320 in late January. The metal continues to build a new floor here above $1,500 in support of its next likely advance, so this weakness in gold mining shares heralds a timely opportunity for investors to build (or make an overdue entry into) this lucrative segment of the market.
Peculiar challenges to valuing miners
I have rigidly turned my back to employing price-to-earnings ratios as a tool for assessing share valuations in the mining sector over the years, and I believe I've had good reason. You see, the need to appropriately account for the value of a miner's underground reserves and resources causes P/E ratios within the sector to often appear quite elevated in relation to stocks from other sectors, resulting in what I have felt was an unnecessary psychological barrier that obscured value propositions for the less experienced resource investor. Of course, I pay very close attention to earnings and cash flow, but for valuation purposes I am far more interested in the longer-term perspective gleaned by comparing the value assigned to identified underground resources.
Newcomers to the resource sector may wish to imagine what might happen to their favorite industrial stock if all the materials required to produce their product were buried underground adjacent to the production line. If Ford Motor were to fortuitously discover 1 billion completed chassis of vintage Mustangs buried beneath its Detroit facility, and all the company had to do was to excavate them, drop in some engines, and pop on some tires, you can bet we'd see a major pop in the shares. Because that underground inventory would contribute to revenue over time, auto investors would also have to adjust their notions of an appropriate P/E ratio for the stock to account for the value of that inventory. Gold and silver royalty stocks form another peculiar subset of the group, and CAPS member speedybure recently offered some creative alternative valuation techniques for Silver Wheaton (NYSE: SLW ) and Sandstorm Gold.
These issues are not unique to gold and silver miners but are rather a shared peculiarity of all the extractive industries, including oil, coal, iron ore, etc. The effect can be partially overcome by using P/E ratios in the manner in which they are intended: strictly as a relative metric relevant only among a group comparable peers. In practice, however, I see far too many investors developing notions that anything above a certain P/E value is "expensive" regardless of sector, relative growth rates, etc. Even when properly utilized, however, P/E ratios remain a flawed metric for resource extraction stocks.
Resuscitating the shunned valuation metric
As I explained above, I have de-emphasized P/E ratios within my analysis of mining stocks because the peculiar impact of established underground resources (and even perceived exploration potential) has tended to elevate those values to where these stocks may seem fully valued to the untrained eye. However, this latest bout of weakness in the gold mining shares -- occurring when quality producers are awash in record cash flow and cozy profit margins -- has yielded valuations so remarkably depressed that P/E ratios no longer present that potential perception trap.
Stated another way, many gold stocks are as cheap as I've seen them relative to trailing earnings since the aftermath of the 2008 financial crisis, so I am resurrecting the P/E metric to highlight some quality gold miners trading for lower multiples to trailing earnings than I've observed in quite some time.
With a gargantuan production growth spurt in the works that will expand gold output by 60% over the next few years, Goldcorp (NYSE: GG ) is deserving of a generous premium over the P/E multiples of its slower-growing peers like Barrick and Newmont Mining (NYSE: NEM ) . As fate would have it, however, Goldcorp currently trades for just 17.6 times trailing earnings, which in this Fool's opinion is far too close to the multiples of roughly 12 represented by shares of Barrick and Newmont. Meanwhile, given the expansive mineral wealth underlying these companies' existing properties, I consider all three stocks ludicrously disconnected from any semblance of fair value. With an enterprise value that stands at just 19% of the market value of Newmont's proven and probable gold reserves, the lowest such ratio of the three, a strong value-based argument can be made for Newmont Mining on the basis of both earnings- and reserves-based valuation metrics. Interestingly, all three are presently trading at lower valuations relative to the market value of their gold reserves than they did when I prepared this report in October 2008 -- just as gold mining stocks dipped to astounding post-crisis lows before finally staging a rally.
But relative to trailing earnings, the bargains grow deeper still. Stymied by recent downward revisions to global growth and resulting concern over near-term copper demand, Freeport-McMoRan Copper & Gold (NYSE: FCX ) has seen its trailing P/E dip to just 9.4 (not to mention a forward 2012 P/E ratio of 7.7!). I expect copper prices to deliver resilience along with those for gold, and so I consider Freeport a doubly compelling choice. Another hybrid miner sporting a single-digit P/E multiple of just 6.3 is Thompson Creek Metals (NYSE: TC ) . Though primarily a molybdenum producer right now, this miner is busily constructing an exciting gold and copper mine, dubbed Mt. Milligan, in British Columbia. The stock has slipped nearly 35% during 2011, and I consider it a resounding top pick for investors scouring this market for outstanding value.
Although inherently flawed as a valuation metric for stocks relating to the extractive industries, P/E ratios are nonetheless instructive, and -- provided they are properly interpreted -- they deserve a spot in the resource investor's toolbox with several sector-specific valuation methods. Still, when P/E ratios dip to levels considered bargains within non-resource sectors where massive mineral inventories would not form part of the value proposition, they may rightfully have value investors thinking the sector at large may be oversold. Happy bargain hunting!