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5 "Tells" that the Stock Markets Are About to Reverse

Gold Mining Stocks Mergers and Aquisitions

Commodities / Gold and Silver 2010 Oct 29, 2010 - 10:27 AM GMT

By: Zeal_LLC


Best Financial Markets Analysis ArticleIf you are at all attuned to the gold-stock sector, you’ve likely noticed a pickup in activity on the deal-making front this year.  And indeed the gold miners are doing some moving and shaking.  In fact, this industry is undergoing a consolidation unlike anything we’ve seen in this entire bull market.  And for a variety of reasons, this may only be just the beginning.

Many investors have seen some of their own stocks directly affected by this consolidation, and it has been quite intriguing watching things unfold across the industry.  With so many deals, I was curious as to how 2010 is stacking up to other years.  And thanks to a recent report put out by PricewaterhouseCoopers (PwC), my eyes were opened to the sheer magnitude of what is happening.

PwC’s analysis of the global mining sector includes the tracking of mergers and acquisitions (M&A).  And its latest report quantifies and confirms what we are watching unfold.  Through the middle of August, the global mining sector has seen 1,324 deals worth a whopping $104b.  At this pace 2010 may surpass a record 2007 that saw 1,732 deals worth $159b.

But while these numbers are quite striking, it’s what is underneath them that should really arouse gold-stock investors.  Of all the individual sectors, PwC found that the gold-mining sector is seeing the most action.  Measured by volume and value, gold companies are responsible for 38% and 32% of these deals respectively.

And this gold-heavy weighting is all the more impressive considering the resources it is up against.  Measured by value, 2010 gold deals so far are nearly equal to the deals involving the major mineable natural resources of iron ore, coal, and copper, combined!  The capital markets of these resources dwarf gold’s, which says a lot about the money currently chasing this yellow metal.

So what exactly does this gold-happy M&A scene tell us?  It tells us a whole lot, but three things are glaringly apparent.  First, gold miners are bullish on the future price action of their underlying metal.  Second, economic gold deposits are harder to find.  And last, and most important, is gold assets are radically undervalued.

As for bullishness, it is natural for any company to have faith in its product.  And in the gold-mining industry this faith is supported by smashing fundamentals.  Gold’s secular bull still has a ways to go, and gold miners continue to see a lot of upside in its price.  The acquiring companies obviously don’t seem to be bothered by the fact that gold continues to blast through all-time nominal highs.  If they thought gold was at its apex, they wouldn’t be buying.

We’ve also seen a universal dehedging campaign across the entire gold-mining industry.  Even Barrick Gold and AngloGold, two of the world’s largest producers and also notorious hedgers, have diligently worked to wipe the hedges from their books in recent years.  Most miners now smartly want full price exposure when they sell their gold to market.

This M&A activity, coupled with anecdotal observations, also tells us that economic gold deposits are getting harder and harder to find.  In this industry the miners live and die by their ability to renew reserves.  And since every ounce mined subtracts from the reserve base, this is a constant uphill battle.  To complicate things even more, when miners get big enough they face the added pressure of growth expectations.

Adding to a miner’s reserve base is not an easy task.  In fact, there are really only two ways to do it.  First is the miner finds the gold on its own, and second is the miner buys it from someone else that found it.  Finding gold is of course very difficult.  If it was easy, everyone would be doing it and the metal wouldn’t be worth over $1,300 for just an ounce.

And since gold is finite and the low-hanging fruit is all but gone, the discovery of brand-new deposits has become increasingly rare.  With less easy gold to be found, the inherently expensive endeavor of exploring for it is more drawn-out and thus costly.

If a company actually does make a discovery, whether greenfields (a fresh new deposit) or brownfields (an extension to a known deposit or mineralized structure), advancing the deposit far enough to prove-up economic gold grades adds major costs to the exploration process.  And this is only the beginning if a project is approved for construction.  Building a mine can cost anywhere from tens of millions to northwards of $1b for a larger-scale operation.

So when faced with the ominous task of organic reserve renewal/growth, many miners choose what is typically a much easier method of adding reserves, buying them.  By going the M&A route miners are relieved of the growingly-difficult task of finding gold, and thus don’t have to apportion such a big chunk of capital towards exploration.  Instead they can focus on developing their pipelines in order to replace depleted mines and/or add additional mines to deliver production growth.

And not only are more and more miners finding M&A easier than organic development, they are finding it necessary.  Even the miners good at exploration just aren’t discovering economic gold deposits fast enough to replace reserves.  And in this industry you can’t afford to fall behind in this critical element of running your business.  If investors are seeing mining life pare too much too fast, they will head for the exits and not look back.  This is of course detrimental to a stock.

So with the producer outlook on gold prices bullish and a growing need to acquire reserves rather than develop them internally, this ongoing industry consolidation seems completely normal.  But this big run on gold assets of recent is far from normal, right?  Provocatively there is one other major factor that currently makes these assets irresistible to the reserve-hungry deal vultures.  They are radically undervalued!

There are many ways to demonstrate how undervalued gold assets, or gold stocks, are.  And one of our favorites here at Zeal is the HUI/Gold Ratio (HGR).  The HGR is calculated by dividing the daily close of the venerable HUI gold-stock index by gold’s daily close.  And charted over time we can clearly see how gold stocks are trading relative to the performance of their primary driver.  With 10 or so years of bull market data to glean from, the HGR paints a very telling picture.

The chart above is pulled from my business partner Adam Hamilton’s essay, Gold-Stock Recovery 3, published just last month.  And though I won’t be getting into the bells and whistles of Adam’s excellent chart in this forum, it is vital for investors to grasp the message that this metric delivers.  And the best way to truly understand the HGR is to view it.  This chart speaks volumes!
With a current HGR of only 0.38x, you can see that gold stocks are well under secular support.  In fact, the last time we saw an HGR at these levels, prior to the stock panic, was 2003.  And do you know where gold was trading back then?  Brace yourselves … in 2003 gold averaged $364.  Gold stocks aren’t even close to pricing in $1300+ gold per historic HGR precedent.  I encourage you to peruse Adam’s essay for more in-depth HGR analysis.  You’ll be amazed to find out where gold stocks should be, and where they could be heading.

With this chart clearly showing gold stocks still disconnected from gold, should we expect today’s HGR as the new norm?  I doubt it!  To me the big question is how long will investors accept gold stocks’ underperformance?  Due to their inherently-risky nature these stocks simply must possess positive leverage to their underlying metal.

Investors demand this leverage, or else owning these stocks is not worth the risk.  Unfortunately thanks in large part to the stock panic, this leverage has been thrown out of whack.  And while the HGR has slowly recovered since the panic low, greatly rewarding us few contrarians who remained in the game, its still-low level tells us the great majority of gold-stock investors are still on the sidelines.

We believe the HGR will eventually be restored to pre-panic levels, which would mean huge gold-stock gains are still to come.  And while investors have not yet realized this, the gold companies have.  As demonstrated by the flurry of M&A activity, the miners are taking advantage of these cheap prices and snatching up gold assets while the getting is good.  They know that once the investing class rejoins the game, things will get a lot more expensive.

As for the types of deals we are seeing, they certainly haven’t been lacking in variety.  And as one would expect, the larger gold miners are making the biggest waves.  And why shouldn’t they be?  Many of these miners are making money hand over fist, and have the cash to invest in their pipelines.  In fact, even those miners that don’t have large treasuries can’t pass up the values out there today.  These cash-strapped companies are able to circumvent their shortfalls by simply issuing enough shares to get what they need.

Some of the bigger deals result in not only the addition of reserves, but the addition of production volume.  Such examples are Australian major Newcrest Mining acquiring neighbor Lihir Gold and its massive mine in Papua New Guinea, and Canadian giant Kinross Gold making a big move into Africa, acquiring Red Back Mining.

When not adding operating mines, the larger miners have aggressively sought after in-ground resources to strengthen their pipelines.  Some of these companies prefer advanced-stage deposits with proven reserves that are ready for development.  Goldcorp and its recent $3b+ bid for one of South America’s finest undeveloped gold deposits is a great example.

Other miners are not afraid to go after early-stage discoveries, those yet to prove their economic worth.  Kinross Gold’s 2010 buying spree included the acquisition of a small explorer operating in Canada’s Yukon Territory.  This C$139m deal brought over what could be a major discovery.  And Kinross jumped on it before investors were able to bid this junior to the moon.

But the big miners aren’t the only ones in the M&A fray.  Smaller miners are making moves to capitalize on these cheap assets as well.  Mid-tier and junior-level producers are acquiring companies and projects to secure their own longevity.  And we are even seeing consolidation within the junior-explorer realm.  Savvy explorers are buying or merging with other small exploration companies to enhance their own project portfolios in hopes of developing mines on their own or becoming all that more attractive to the bigger fish.

So what does all this M&A activity mean to investors?  Well ultimately I believe this consolidation is a foreshadowing of a big run-up in gold stocks as mentioned earlier.  The smart managers seeking to grow their companies are buying these cheap assets before investors bid them too high.  It also means investors should own the highest-quality gold companies, as these are the ones that will be the targets of future deals.

At Zeal we seek to find these highest-quality gold companies, and profile our favorites in our acclaimed research reports.  And indeed we are finding that these companies are high-probability takeover targets in the midst of this recent M&A extravaganza.  Of the 40+ gold stocks we’ve profiled in the last 18 months, 7 no longer exist as a result of acquisitions.  And as you can imagine, the average premiums have been quite spectacular.

Investors looking to own some of these elite gold stocks have several options when it comes to uncovering the winners.  They can of course wade through the dross of the hundreds upon hundreds of gold stocks out there and methodically explore the entire pool in hopes that the best come to surface.  This will take hundreds of hours, and if they don’t know what to look for it can be an exercise in futility.

Another option is to rely on the experts, leveraging their hundreds of hours of research searching out the best of the best.  Zeal reports profile what we believe to be the best stocks within their given peer groups.  And a 16% acquisition rate in just the last 18 months speaks to the quality of companies profiled in these reports.

And interestingly if you go back farther than 18 months, another dozen-plus of the gold stocks we’ve profiled have also been acquired.  Two of these were parties to this year’s biggest gold deals, Red Back and Lihir as mentioned above.  We profiled both of these companies in our November 2007 report, back when they had respective market caps of $1.1b and $6.7b.  With Red Back taken out for $7.1b and Lihir $8.5b, investors riding these stocks the last few years have made out pretty well.

But even though many of our favorites have been taken out, there are still plenty that have not.  Seeing incredible value in the assets they hold, I ultimately believe these companies would better reward shareholders by grinding it out on their own.  But as we’ve seen all too often in this industry, it is their quality assets that make these companies all the more attractive as M&A targets.

And what better targets than the small junior-level companies that hold the next-generation gold deposits.  Even PwC notes that the opportunities for “mega deals” have become scarce.  It points out that smaller companies are now gaining favor on the deal-making scene.  And this fits well for the stocks profiled in our latest reports.

We spent nine months canvassing the pool of 500+ junior-level stocks trading in the US and Canada to find those with the highest probabilities for success.  This research is distilled into three action-packed reports that profile our 12 favorite early-stage explorers, 12 favorite advanced-stage explorers, and 12 favorite junior producers.

And of the 32 still left standing as of this week, a lot of potential exists.  These juniors not only reside in the sweet spot of the M&A action, they have the strength to greatly reward investors if they continue to go at it alone.  Buy your reports today to have these detailed fundamental profiles at your fingertips!

These reports also serve to feed many of the trades in our acclaimed subscription newsletters.  For nearly a decade our monthly Zeal Intelligence subscribers have enjoyed timely stock recommendations that have greatly outperformed the markets, with average annualized realized gains of +43.2% for all stock trades (including all losers).

Our weekly Zeal Speculator newsletter for more-active traders has also found great success.  In fact, in early September we closed a trade in the stock (profiled in our advanced-stage explorers report) bought by Goldcorp mentioned above.  This six-month trade netted our subscribers a realized gain of 156% … not bad!  For real-world trade recommendations, expert market analysis, and even access to the subscriber chart section of our website that updates the HGR weekly, subscribe today!

The bottom line is PwC’s recent report speaks volumes, and confirms what we’ve seen happening on the gold-stock scene.  2010 has had a lot of M&A activity so far, and considering the current market conditions there could well be a lot more to come.

Gold companies are ahead of curve, and recognize that they can get assets for cheap right now.  And by owning shares of the thinning population of quality gold companies, those astute investors who also recognize this disconnect can buy in for cheap as well.

By Scott Wright

So how can you profit from this information? We publish an acclaimed monthly newsletter, Zeal Intelligence , that details exactly what we are doing in terms of actual stock and options trading based on all the lessons we have learned in our market research as well as provides in-depth market analysis and commentary. Please consider joining us each month at …

Thoughts, comments, or flames? Fire away at . Depending on the volume of feedback I may not have time to respond personally, but I will read all messages. Thanks!

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