Zeev's Turnips Patch-No Politics (ZEEV)

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*** Fleckenstein on Gold and other stuff ***

Imo, his methods of evaluating Gold miners are worth the price of admission.... <gg>


Contrarian Chronicles
Don't confuse this rally with a new bull market
The market's big gains will surely generate a lot of talk that the bull market's back. While I don't know how long this rally will last, I do know it will end -- and end with a thud.
By Bill Fleckenstein

The war rally that we have been expecting has just begun. What is not knowable at this early juncture is how far it can carry. The trick will be in determining that, because when the rally peters out, the next slide is liable to be quite brutal. In this week's edition of the Contrarian Chronicles, we'll take a look at all the ramifications, and, for those who have an interest in gold, I'll share my thoughts on how to value gold stocks.

A month ago, I talked about why we could expect a war rally. Last week, when war news was finally on the table, expectation became reality. Now, I'm shifting gears, from talking about the case for a rally to debunking the notion that this is anything but a rally -- and not the start of a new bull market. That's what plenty of people will be proclaiming as the rally unfolds, so right off the bat, here's advance warning on that score.

To step back a minute, I had said on Feb. 24, "We could expect a rally on the back of war, just because people now have an excuse to rationalize all the weakness we have been seeing." Last Tuesday, it was easy to see rationalization in action. The prior evening, Tech Data (TECD, news, msgs), the second-largest distributor of technology products behind Ingram Micro (IM, news, msgs), preannounced for next quarter, but folks just shrugged that off. In fact, the stock was up nearly 10% at one point during the day. Likewise, Applied Materials (AMAT, news, msgs) rallied 2.5%, even as it followed up its preannouncement from a month ago with the news that some 15% of its employees would no longer be material to its workforce.

That bad news doesn't matter right now is one ingredient of what I expected to see during the war rally period. To repeat, people who are still in denial about our real problems will turn war angst into an all-purpose scapegoat, a rationalization to go out and buy stocks. So, with the excuses already being made up and believed, it was perfectly "logical" why Tech Data and Applied Materials were able to overcome bad news last Tuesday. In view of this, as well as other examples of bad news being ignored, it seems very clear to me that for now, the risk/reward is against the bears, certainly in technology stocks. That said, we don't know yet how much bad news will continue to be ignored on the back of war angst. That's why trying to gauge how far this rally will go is not possible at this point.

Active duty for denial
Similarly, we don't know if there will be a lot of good news emanating from the war. If the war goes as swiftly as some people expect, President Bush will look better. His platform to push for another tax cut, which many people consider bullish, will be bolstered. People will talk about oil prices getting crushed as a form of tax cut. (Editor's note: crude prices dropped nearly 30% from March 12 to March 21.) Then, of course, all the technicians will be chirping about how we've successfully tested the lows, etc., etc. At this juncture, it is not possible to gauge the amount of bullish spin that good news on the war front could produce. But for now, people who want to rationalize away our problems will find plenty of ammunition. I bring all these examples up now so that people can assess them before momentum gathers further, and to know that it was possible to see this coming.

Meanwhile, depending on how things shape up, it might be possible to make money on the long side. I could make a case for a rather prolonged rally, which might be profitable to trade from the long side, or for a brief rally, which wouldn't be. At this moment, I do not have an opinion, though I'm sure I will have one before too long. (Of course, it will just be that, my opinion.) One complicating factor in trying to estimate how long and how far a rally can go is that the war has just begun. The course of events in the war will probably dictate how wild and crazy the second-half stories and the (erroneous) new bull market theses become. In any case, let me just state here my willingness to give the bulls plenty of rope, and to note that I am in the mode where I am not short.

Abstract on the extract

That brings me to the long side, where I recently added to my position in Newmont Mining (NEM, news, msgs) at a price of $25. For readers who are considering purchasing gold stocks, I thought I might take a moment to explain how I approach the subject of valuation. To begin with, I don't think price-to-earnings ratios are particularly meaningful, which is also often the case with cyclical stocks. (Though gold stocks aren't cyclical, they do share some of the same characteristics.) The important thing to focus on is that when you buy shares of a gold company, what you are buying is gold in the ground. You have to ask yourself, do I want to buy gold bullion, or do I want to buy gold in the ground via a gold stock?

We know what the price of gold bullion is. It's quoted on a regular basis. (It was $326 on Friday.) But determining the value of a mining company's gold in the ground is, at any moment in time, not so clear. Proven and probable reserves are pretty good estimates that also are a function of the price of gold. Often, a mine will see its proven and probable reserves go up as the price of the commodity goes up. That is because there is a cost associated with yanking this stuff out of the ground, and the higher the gold price, the more "higher-cost" ore can be mined. When the gold price drops, this process works in reverse.

Plus-and-minus mining

With Denver-based Newmont, the world's biggest gold producer, trading at $25, you're paying just under $120 an ounce for its proven and probable reserves. The estimated cash cost for Newmont's gold production is around $195 an ounce, meaning that when you "buy" the reserves and combine that with the cash costs to mine the metal, you're basically paying something on the order of $305, plus or minus, for an ounce of gold. However, the analysis cannot stop there, because in fact, cash costs are not the only costs associated with mining. There are exploration costs and the costs for amortizing equipment, not the least of which is the mill to process the ore, etc.

But on the other hand, you have a land package. Each mine and its adjacent land package are different. One has to make a mental tradeoff between those non-cash costs, and the value of the land package and whatever exploration may go on. This is something of an oversimplification, but that's how I look at it. So, the choice today is, do you want to buy Newmont at an imputed price of, say, $305 an ounce, plus or minus, or do you want to buy gold at $326 an ounce?

The gilt pre-catapult

There's no point in acting as though these estimates for Newmont or any other company are precise; they are not. Also, there is no rule that says you must insist that the imputed per-ounce price be less than the spot price of gold, though obviously, things are more compelling when it is. However, doing the math can provide a framework for further analysis, and it can help you to get a better sense of which companies look cheap and which look expensive vs. each other. I would just note that with respect to smaller companies or exploration plays, in particular, the estimates obviously go out the window, since you can't know what you're going to get. Those companies can be wildly overvalued and attract a lot of hype, sort of like we saw with Internet stocks.

In any case, I have settled on Newmont as my gold pick to click, in large part because of its top-notch management team that came over in the acquisition of Franco-Nevada. Most people who run gold businesses do not focus on return on capital. They're more engineers than capitalists. Throughout the 1990s, most of them just chewed up capital. (During that time, Barrick Gold (ABX, news, msgs) did not, but I don't like this company because of its hedging program.) Meanwhile, for folks who want some able assistance in beginning their own research, I recommend the work of John Doody, who, in my opinion, is the best gold analyst. His service, the Gold Stock Analyst (see link at left), is $350 per year, but it's a small price to pay for high-quality research. So, for what it's worth, that's my quick and dirty on how to look at gold companies.

Bill Fleckenstein is the president of Fleckenstein Capital, which manages a hedge fund based in Seattle. He also writes a daily Market Rap column for TheStreet.com's RealMoney site. At the time of publication, Bill Fleckenstein owned Newmont Mining. His investment positions, however, can change at any time. Under no circumstances does the information in this column represent a recommendation to buy, sell or hold any security. The views and opinions expressed in Bill Fleckenstein's columns are his own and not necessarily those of CNBC on MSN Money.

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Regards,
Dan