Rule #1 in the investor’s guidebook reads ‘Buy At The Bottom And Sell At The Top‘.
But if only it was so easy!
Because how do you ever know the market is at the bottom?
Well – I’m writing to you today to say that I firmly believe that there is one group of stocks right at the very bottom of the market right now…
And that is the gold sector.
The first clue that we’re at the bottom for gold stocks, is that they are so deeply out of favour.
It’s hard to think of any other type of mining stock more ‘on the nose’. Even uranium is getting more attention at the moment!
Gold stocks have been serial underperformers, falling two years running – even as gold bullion rose. But it is precisely when investors turn their back on something that you get the best prices. And this is when the bargain hunters ‘back up the truck’.
The chart below shows just how cheap gold stocks have become. It shows an index of gold stocks (the Market Vectors Gold Miners Index) to show how dismally they have performed as a group.
But to really put the chart in context I’ve divided the index by the gold price. You see, since October 2008, the US gold price has climbed by 143%, from $700 to $1650. So, dividing the gold stock index by the gold price gives a better idea of gold stocks’ relative performance.
And you can see straight away they are CHEAP. On this basis, gold stocks are back to relative valuations seen in the depths of the GFC!
We saw these ludicrously cheap valuations twice last year, which was my original trigger for buying gold stocks.
While frustrating, being back here again gives investors who thought they’d missed the boat another chance to buy gold stocks very cheaply indeed.
And, as I’ll explain shortly, these bargain prices come right when the sector is about to receive a surge of adrenaline to turn things around.
Technical chartists identify a pattern called a ‘double bottom’, when a price bounces twice from the same level, paving the way for the next leg up. What you are looking at above is a ‘triple bottom’, which is a far more powerful indicator of a coming rally. And this is the second clue that we are witnessing a bottom for the gold sector right now.
The big question of course is just why have gold stocks done so badly?
Competition from Exchange Traded Funds (buying gold metal through a broker) is part of it for sure, as is the poor track record of dividends from gold stocks.
But the real meat-and-potatoes of the matter is the rising cost of production.
Gold producers have done a terrible job of keeping production costs under control. As you can see in the chart below, the average cost of production (C1 cost) has doubled in the last five years, and quadrupled over the last ten.
So why have their costs blown out so much? One reason you get is that costs for factors of production like oil, labour and machinery have gone up. Also, taxes have increased.
It’s all true, but I think a bigger reason is that miners are mining lower grade ores. Five years ago the average ore grade mined globally was 1.7 g/t, but today it is just 1.1 g/t. The lower the grade, the higher the cost of mining it, producing it, and dealing with the waste.
Anyway, these rising costs have now cost the Chief Executive Officers of four of the world’s five biggest gold companies their jobs. The world’s biggest gold producer, Barrick (NYSE:ABX), has recently sacked CEO Aaron Regent.
This sort of blood-letting is a third clue that we are nearing the bottom. The new execs will have to reduce costs if they want to keep their jobs.
As I wrote to you in yesterday’s Money Morning, it looks like gold’s next rally is very close now. And this is just the shot of adrenaline the sector needs to catalyse a turnaround.
It would be a very potent combination to see a rising gold price at the same time that the new management of the big five gold producers are reducing costs.
This would herald a clear turning point for the sector. All gold stocks should benefit to some extent as the sour mood turns sweet again.
But you still want to be positioned in the best possible gold stocks when this happens. There is no shortage of two-bit operators on the market with bad projects and inexperienced or shonky management. It is essential to pick the right stocks, and frankly they are in the minority.
Having a low cost of production is essential, and it is the first thing I look at for Diggers and Drillers tips. Not just the headline C1 cost, but the all inclusive costs. It is the lower cost producers that will do the best when the gold price takes off again, as the profit margins grow faster than higher cost stocks.
Another factor that will draw investors back in quicker is dividends. A few gold stocks have started paying dividends recently, and one stock I tipped could be looking at a 6.1% yield this year at current stock prices.
The bottom line is that when gold starts rising soon – the good quality gold stocks will move even faster.
And from their current depressed prices, I’m betting on it being quite a move indeed.
Dr Alex Cowie
Editor, Diggers & Drillers
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