Gold Miners Over-Valued?

Putting a price on Gold Mining stocks in the absence of a Gold Price target...

An ECONOMICS PROFESSOR for almost two decades, John Doody became interested in gold due to an innate distrust of politicians, says the Gold Report.

Success with his method of finding undervalued Gold Mining stocks led Doody to leave teaching and start the Gold Stock Analyst newsletter late in 1994, covering only producers or near-producers that have an independent feasibility study validating their reserves are economical to produce.

Here Doody speaks to The Gold Report about why he believes most investors don't have enough gold stocks in their portfolios right now...

The Gold Report: John, why hasn't the mainstream media caught on to what's going on with gold?

John Doody: The CNBC types are always talking their own "book", which is mainstream stocks. If no one buys the broad market stocks, there are no jobs for the talking heads, et al, at CNBC. They're always pooh-poohing gold and love saying that gold at the current price, $1060, hasn't really done much from the $850 high in 1980. That's a false comparison. If you want to use that, then why not point to the S&P high in the 1500s or the Dow high in the 14,000s as a measure, instead of the March 2009 lows?

The Gold Price was controlled from the 1930s until March 1968 by eight central banks that were the gold cartel and fixed the price of gold at $35 an ounce. That ended in March 1968 when market forces overwhelmed the CBs. Unable to enforce $35/oz, they let gold's price float in the free market. Between themselves, they still traded at $35 and then, of course, all of that fell apart when Nixon went off the gold standard entirely in '71.

The appropriate measure for me as to how gold has performed is to go back to when the price was set free, March 1968. If you take the $35 Gold Price and adjust it for 41 years of the US CPI increases, the Gold Price would be about $220 an ounce, increasing at an average compound rate of about 4.5% a year. But since being set free in 1968, the Gold Price is now $1,060. So gold has provided great inflation protection, and growth. From $35 to $1,060 – that's about an 8.5% compounded annual rate per year. That's the true measure of gold's value for inflation protection.

TGR: So what's driving the price of gold? Is it just the devaluation of the US Dollar?

John Doody: Well, that's part of it; but gold is still about 10% below the all-time high in other currencies, such as the euro or the yen. So part of the growth of Gold Price is due to all fiat currencies falling, but it's mostly due to the Dollar going down because it's a Dollar-denominated commodity and that's what people want to escape – the Dollar's declining value. Gold provides appreciation and a safe haven.

TGR: How long do you expect this trend to continue?

John Doody: It could go forever. I don't think we're going to see the hyperinflation of Zimbabwe or the Weimar German Republic. The falling Dollar will eventually cure the trade and current account deficits because we'll stop buying foreign-made goods. They'll just be too expensive. Currencies go through these ebbs and flows of value. In the '80s we had high interest rates and the Dollar was too strong. Central Banks met at the Plaza Hotel in 1985 to knock down the buck's value, and they were successful. Now I'm not so sure, because foreign exchange markets and the Dollar amounts are so big that the Central Banks can really change the Dollar's direction.

Like a tugboat changing the direction of a battleship, they can nudge it a little bit in the short term; but long term, it's the economic fundamentals that control. The US will continue to take a laissez faire approach to the Dollar. They talk a good game, they talk strong Dollar, but they don't do anything to defend it and that's because they want a weak Dollar. A weak Dollar stimulates US exports and job growth.

TGR: What's your long-term target for the Gold Price?

John Doody: I really don't have one because my investing strategy is to find undervalued gold stocks at every Gold Price. So it's not necessary for me to say that the stocks I recommend are going to go up because gold's going to go up. My Top 10 Stocks should go up because they are not properly valued vs. others of comparable stature based on the three metrics I use: 1) market cap per ounce of reserves, 2) market cap per ounce of production, and 3) operating cash flow multiple. My Top 10 so far this year is up 124% and that's with one stock being flat. So the other nine have, on average, more than doubled. That's vs. gold at $1,060 up 22%, and the XAU up 45%.

This appreciation is why you should own the stocks more than the metal. Every Dollar of price increase gives you a Dollar more profit from current production, and it makes all the ounces that you've got in the ground that haven't been mined each worth a Dollar more. Typically, a mining company has 10 times the reserves in the ground vs. what it's currently producing. So that 10 multiple – it's even higher for some – that's where you get the leverage from a Gold Price.

TGR: At a certain point, of course, stocks become overvalued. In your recent newsletter you said that they're fairly valued at a Gold Price of $997. We're now at $1060. Are we getting close to being overvalued?

John Doody: Not yet, because the Gold Price of $1060 now justifies higher values than at last month's $997 Gold Price. What I'm looking for is the market to go overvalued, as it's done in the past. I measure overvalued and undervalued based upon past relationships between the market cap per ounce values we calculate every month vs. Gold Price at that time. Right now we're at a fairly valued situation. But there's been four instances, in 2002, 2003, 2006 and 2007, when gold stocks were 20% or more overvalued based on my market cap per ounce metrics. It's investor enthusiasm that creates these overvalued situations, and as can be seen in the chart, we're not there yet.

People bid up the prices of the stocks so that the market cap per ounce we calculate goes to overvalued levels vs. where they've been in the past. So, even if gold did nothing from here and just stayed around this $1,050-$1,060 area, investor enthusiasm could drive the stock prices higher to make the stocks 20% overvalued.

So I see a lot more upside from here and I think this is evidence that we don't have a big retail participation in this market yet. People have been thinking there's a $1000 an ounce ceiling and they don't realize that it's become the floor. Maybe it's going to take a few months hanging over $1000 or maybe we're going to have to get to $1100. At some point investors are going to realize this gold bull market has much further to go and as they pile into the small gold sector with only a $250 billion market cap, they'll drive stock prices much higher.

One rationale for more investors coming to gold can be found in studying the S&P500 vs. Gold Price. As seen in the chart below, from 1973 to 1991, the Gold Price was higher than the S&P. From 1992 to 2008, the S&P 500 was higher than the Gold Price. Now we're back in the area of uncertainty where the Gold Price and the S&P price are about the same.

As you look forward, I can't make any argument for the S&P going higher. I think that it's overpriced now and that analysts are building in earnings numbers for the S&P that aren't going to be earned. The consumer's tapped out. So the banks have come back some, but they've got a lot of bad debt still to write off from credit cards and commercial loans.

The consumer is 70% of the economy. Without them aggressively participating, I just don't see any driver for the S&P 500 to even support this level. But I can see lots of drivers to support a higher Gold Price. Just look at monetary and fiscal policy, printing and borrowing too many Dollars The years ahead, in my opinion, have to be good for gold and not so interesting for the S&P 500 and I think as people realize this, we're going to get more retail investors coming to the gold sector.

TGR: So your Top 10 list that you came out with last January is up 124%. Nine winners and one flat one. Do you come out with another Top 10 list in January 2010?

John Doody: We do it on an ongoing, not an annual basis. We calculate the results on an annual basis, which is very unique in this industry. Nobody else does this unless they're a mutual fund. Every other newsletter wants to tell you what their results were based upon when they first recommended the stock, which might be five years ago. But we track the Top 10 the way any private investor would their portfolio and we put a monthly statement in the newsletter.

We've had one sell in 2009. We took one off that was up 58%. It hit our target price and we didn't see a reason to raise the target price. We sold it and we had 10% cash for about four months, and we just found a new company.

TGR: Many of your stocks are starting to approach your target price, yet you still sound pretty optimistic that there's a lot more upside.

John Doody: Yes, and we have to change the target prices. We'll probably do that in the November issue. The target prices were basically set when gold was $900. That's been my working price for the year and for the first six months, the average price was $912, so that was a good enough number. Now we're getting not only to the end of the year and we've got a much higher Gold Price, but we're also starting to look forward to what production is going to be next year. One of the things we look for, in addition to the three main metrics, is growth in production. So we'll start looking at what higher production will do for the stocks next year. We raised the target prices for two stocks in the October mid-month update, and because the November issue updates our reports on four of the Top 10, we'll probably be raising more targets.

At the gold shows I speak at, such as the coming one in San Francisco, people show me their portfolios. Most of them suffer from not having enough gold stocks. They have a big enough percentage, the proverbial 10% or 15% of the portfolio. But too often it's all in a couple of stocks and that's too much risk. You need to diversify your risk.

In the old days when it cost you $200 commission, it was expensive to own 10 stocks. But now with $10 internet commissions it's no big deal. Or they own too many and the risk of that is that you're just going to mimic the market at best. The typical gold mutual fund has 40 stocks in it and that's why they can't do so well. There aren't 40 gold stocks worth owning.

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