History Says Buy

Posted by Ivan Lo Equedia

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Two weeks ago, I wrote the letter “Prepare for Upside.” The title speaks for itself. But if you missed it, these were my final thoughts:

The world is coming close to finalizing a plan to bailout Europe. I fully  expect a major infusion of liquidity, which should bolster both stocks and precious metals. Look for buying opportunities in the market ahead of any major announcements. While the market has moving up based on this premise, there remains room for more upside short term.

Since that letter, the markets have done nothing but climb – the S&P completed a fourth straight weekly advance, the longest streak since January and the markets extended the biggest monthly rally in U.S. equities since 1974. European leaders agreed to expand a bailout fund to stem the region’s debt crisis. Treasuries and German bonds fell as predicted, while metals and oil led a rally in commodities.

As such, the four stocks I mentioned back on October 2 continue to fly:
The Claymore Oil Sands ETF (TSX: CLO) is now up 28.73%
The SPDR S&P Oil & Gas Exploration & Production ETF (NYSE: XOP) is now up 42.29%
The Market Vectors Gold Miners ETF (GDX)is now up 8.56%
• and the Market Vectors Junior Gold Miners ETF (GDXJ) is now up 17.75%.

Copper rebounded strongly as predicted in the letter Prepare for Upside two weeks ago – it is now already nearing my predicted price range of $3.75 – $3.90. Copper fell to a low of US$3.08 earlier this month, but has already rose back to US$3.65 on Thursday – rising 14 percent alone this week. Copper is now on track for the biggest increase since Bloomberg data stats in April 1986.

Gold and silver continue to rebound with strong buy signals for precious metals equities across the board. But when you compare the price to net asset value (P/NAV) of precious metals stocks, they still remain very well undervalued.

At the beginning of the year, senior and intermediate gold producers were trading at an average of 1.13x P/NAV (5%, spot) and junior producers were trading at 0.94x P/NAV (5%, spot).

Today, seniors/intermediates are trading at around 0.85x P/NAV (5%, spot) and juniors are trading at 0.70x P/NAV (5%, spot). It has been nearly 11 months now, yet gold equity valuations are roughly 25% lower on a P/NAV basis. So what’s wrong with this picture?

Many so-called experts have given different reasons for the lower multiples.  They say investors are now investing in ETF’s to play the rise in gold without company-specific risk. They say individual stocks are prone to a confluence of company-specific circumstances. But at the end of the day, these multiples reflect a flight to safety mentality. Pure and simple. 2008 changed a lot of people.

The lack of liquidity and the risks associated with the stock market post 2008 has led to a prolonged decline in multiples. With such a prolonged decline, everyone is thinking if equity multiples will eventually improve for the gold producers. And even if they do, will they revert back to levels consistent with historical stats?

Blast to the Past

If we were to revert back to historical stats from the past, precious metals stocks would need to rise at least another 25% from current levels. While this may seem farfetched in this type of market environment, fundamentals tell me otherwise.

I have no doubt that gold prices will continue to climb which should drive strong cash flow growth for the producers, leading to increased dividends. This gives investors more of a reason to own gold stocks over gold itself – which pays no dividend. Keep in mind that dividends within this sector have never been a game changer for owning precious metals stocks. But with record prices, times have changed.

Already we have seen dividend levels recently raised by Yamana (+50%), Kinross (+20%) and Eldorado(+20%), with silver producer Hecla Mining also announcing a silver-linked dividend policy last month. Just last week, both majors Barrick Gold and Newmont Mining raised their dividends 15% and 17%, respectively. These gold producing giants continue to reap the strong benefits of record gold prices and continue to make significant amounts of money every quarter; thus allowing them to channel their money to acquisitions, explorations, and reserve/resource expansion.

The gold producers are making tons of cash and you can bet they will be making even more in the years to come as gold continues to climb and production continues to increase. If you want another reason to favour gold stocks, just take one look at their ever-increasing cash flow.

While gold equities look cheap on a P/NAV basis, they’re even cheaper on a price-to-cash flow basis(P/CF). Right now, the senior/intermediate producer group currently trades around a multiple of 8.1x. Two years ago, they were trading at a forward P/CF multiple of 14.8x, representing an over 80% re-rating potential to historical levels. This clearly shows that while cash flows have been increasing, share prices have not responded the same way.

One look at the XAU Index and you can see the massive divergence in the  value of the Index and its P/CF multiple since mid-2005. The XAU Index currently trades at an average P/CF multiple of 10.8x versus a multiple of 16.8x two years ago – representing a 55% rerating potential to historical levels.

History Says Buy

Over the last 20 years, the months from September – January have been strong for precious metals prices.

While this year, macroeconomic conditions have caused a slight deviation from historical data, I fully expect gold and silver to perform well. November – January have generally produced strong gains in the prices of precious metals and this year should be no different. As a matter of fact, given the macroeconomic climate, they should do even better.

The Indian agrarian population should have a fruitful harvest this year and these guys have always channelled surplus money into buying gold. With Christmas and Chinese New Year in the following months, we should see more physical gold demand.
As such, I expect gold to end the year strong as macroeconomic conditions continue to favour investment into the sector.

Final Thoughts

While things are looking good and Europe has come to terms, we still don’t  know how the banks are going to be recapitalized and we still don’t know what the overall effects of a 50% write down from Greek debt will bring to the markets and the banks.

I have always said in many letters to focus on what we do know as opposed to what we don’t. So while the rest of the future remains unknown, I do know that it is inevitable the US will continue with some sort of QE. I do know that while Europe has come up with a plan, it is far from finding a real solution to address its problems. I know that no matter which way the world heads, under both a bear or bull scenario, gold prices should climb.

Inflation pressures are increasing while governments continue put the brakes on interest rates. This combination is extremely good for gold.

But more importantly, because governments cannot afford to raise rates, which would threatenthe fragile global economic recovery, real rates are negative. This makes for an easy case for holding gold as an inflation hedge with no opportunity cost.

Last week, I saw a lot of funds increase their positions in gold stocks. I saw a heavy spike in favour of insider buying, with more than 5 times the number of insider buy transactions vs. insider sell transactions over the trailing 30-day period for Metals and Minerals and more than triple the buys vs. sells for the Precious Metals. While insider trades don’t always signal a bull market, the combination of fund flows into the sector show extreme confidence.

Seriously, I have stressed over and over again that the time to invest in gold and silver stocks is here. Mania or not, the valuations and forward fundamentals remain far too strong. In our current state of volatility and world riots, no other sector can provide a better bang for your buck.

The buy signals, albeit short term, are here. I will be aggressively investing in this sector moving forward and trading it on the ups and downs. As such, you can expect upcoming letters to focus more on specific companies that I believe represent great value in this market. With many battered companies over the summer, this may be your best short term chance at picking up bargains in the markets.

Until next week,
Ivan Lo
Equedia Weekly



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