Very quietly, gold has been a shining star in 2017. Though the lustrous yellow metal is actually lower by 3% from where it stood a year ago, and down 2% over the past month, it's up by more than $130 an ounce, or more than 11%, from where it began the year as of Sept. 27.
Three reasons gold has been lustrous in 2017
Why are investors buying into gold, you wonder? A big reason has been the steady decline of the U.S. dollar. Usually the dollar declines when the outlook for U.S. growth gets murkier, or recently as a result of legislative stagnation in Washington. Since the dollar and gold tend to have an inverse relationship, investors, in response to seeing their cash decline in value relative to other currencies, will occasionally seek the safety of gold. As a finite resource, and having been used as a form of currency for many centuries, gold is viewed as the ultimate safe-haven investment.
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Building off that first point, uncertainty has played a role in pushing gold prices higher. Republicans in control of the legislative branch of the U.S. government have had no success in passing healthcare reform, and there's serious concern as to whether they'll have the votes necessary to pass tax reform. There are also worries about North Korea and its recent escalation with the United States. There will always be some degree of uncertainty to drive investors to gold, but right now there appears to be more uncertainty than normal.
The Federal Reserve's monetary policy is another catalyst for gold. Generally, monetary tightening, which is where the Fed is raising interest rates, tends to be bad news for physical gold. You see, higher interest rates lead to higher yields on interest-bearing assets. Since physical gold has no yield, higher yields on interest-bearing assets could lead some investors to sell their gold in favor of a safer return in, say, bonds or bank CDs. Thankfully, though, the Fed has been walking on eggshells with regard to its rate increases. Even following four quarter-point rate increases since December 2015, yields on interest-bearing assets are still well below their historic norms. This continues to support investment in gold.
Gold stocks could be primed for huge EPS beats in Q3
But these catalysts aside, it's not physical gold investors who should benefit most from its recent run higher. Instead, gold-mining stocks could be primed for considerably larger gains, since gold prices play a critical role in determining their profit margins.
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During the second quarter, many of the largest gold producers reported an average sales price for gold of around $1,250 an ounce. With gold hitting a low of $1,219 an ounce and a high of $1,293 an ounce during the second quarter, this midpoint average selling price isn't a surprise. However, during the third quarter we've seen gold take a new leg up. Despite a low of $1,212 an ounce in early July, gold recently closed as high as $1,348 an ounce in early September. In other words, we're probably looking at an increase of between $10 and $30 an ounce in the average selling price of gold for the major producers during Q3.
Yet if we take a closer look at Wall Street's third-quarter EPS estimates for some of the largest gold miners over the past 30 days, we see most haven't budged an inch. Here's a quick look at the number of analysts who have increased Q3 EPS estimates over the past 30 days for a few major gold miners, as compared with the total number of Wall Street analysts offering an EPS estimate for Q3.
- Newmont Mining (NEM -0.03%): four analysts increased EPS estimates out of 13.
- Goldcorp (GG): three analysts increased EPS estimates out of 12.
- Barrick Gold (GOLD 1.68%): two analysts increased, and one lowered, EPS estimates out of 15.
- Yamana Gold (AUY): one analyst increased EPS estimates out of eight.
It's pretty much the same story across the board. With Wall Street failing to adjust EPS estimates in step with a steadily rising gold price during Q3, some of the largest producers may be primed to crush the Street's EPS estimates.
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And it gets better
However, investors would be discouraged from solely focusing on what should be a strong Q3 performance for gold stocks. Instead, I'd suggest examining the cash flow of gold stocks to determine how much intermediate-term upside they really have. I find cash flow to be a more important measure than profits for gold miners, since cash flow determines whether they have the means to expand their existing operations and explore new properties.
Though there is no concrete fair-value measure when it comes to cash flow per share, I've found over my nearly two decades of investing and following the gold industry that most gold stocks tend to be fairly valued at around 10 times their cash flow per share (CFPS). Any significant discount below this 10 times CFPS figure could represent an intriguing entry point for investors with a long-term mindset.
Perhaps no gold miner offers a bigger discount than Yamana Gold at less than four times next year's CFPS. Yamana's share price has taken a hit in recent quarters because of higher expensing tied to development projects, but those investments are soon going to bear fruit for the company. Both its Cerro Moro and C1 Santa Luz mines are expected to come online in 2018, with the Suruca development within the Chapada mine yielding commercial production by 2019. All told, we could be looking at a 35% to 40% boost in annual production by the end of the decade, and presumably lower all-in sustaining costs.
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At just 7.6 times next year's CFPS, Goldcorp appears cheap as well. Already among the lowest-cost gold miners, thanks in part to the sale of byproducts to offset the costs of mining the lustrous yellow metal, Goldcorp's management believes it can further reduce its all-in sustaining costs by 20% by 2022, while expanding its production by 20%. This year alone, Goldcorp plans to recognize about $200 million in efficiency savings from an internal review of its mines, and it'll probably exceed the $250 million target initially set for annual cost savings.
The story is similar for Barrick Gold and Newmont Mining, both of which are valued at a respective 7.2 and 9.1 times next year's CFPS.
Long story short, not only do gold stocks appear set for a market-topping quarter, but there also looks to be ample upside potential for most companies throughout the industry based on a quick look at their cash flow.
