We all know what the real golden rule states: "He who has the gold makes the rules." If the price of gold stocks is any indication, it appears investors have taken this rule to heart.
Since hitting a low of $254.20 in 1999, the price of gold has risen methodically, closing at $421.40 per ounce last Friday, a gain of 66%, or 11% annually. Thanks to operating leverage, gold-mining shares have performed far better than the metal, particularly the unhedged producers that make up the Gold Bugs Index (AMEX:HUI). The index has risen 557% from $36 in November 2000 to Friday's close of $236.50, on the backs of such companies as Newmont Mining (NYSE:NEM), Gold Fields (NYSE:GFI), and Goldcorp (NYSE:GG).
What makes the unhedged miners so special? Every gold company has a cost per ounce of gold mined, which is a combination of fixed and variable costs per unit. Generally, the more ounces a company mines, the lower the unit cost. Sales, on the other hand, fluctuate with the price of gold and can rise quickly over short periods of time. That is, provided the company isn't locked into selling at a specific price.
Here's where it gets interesting. Hedged gold producers follow the conservative strategy of selling future gold production forward, getting a guaranteed price per ounce for future production. Unhedged miners are just the opposite, selling most of their gold at the spot (market) price, exposing them to the fluctuations of the gold market.
As the price of gold has risen, unhedged producers have experienced tremendous sales growth, and -- more importantly -- significant gross margin improvements. Newmont's sales for 2003 totaled $3.2 billion, nearly double the $1.7 billion the company did just two years ago. While some of the sales growth is due to acquisitions, it's undeniable that a rising gold price helped push gross margin from 33% in 2001 to 41% in 2003. Similar sales and gross profit increases can be found in the other unhedged miners.
By standard valuation methods, gold stocks look pricey at this point, with the industry sporting an average trailing P/E of 27. And most of the companies are getting their first taste of profit in years. Yet, if gold is really in a long-term bull market -- which I believe it is -- the potential for explosive earnings growth makes these risky gold producers look downright cheap.
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Chris Mallon believes the gold bull is for real, but he doesn't own shares in any of the companies mentioned here.
