10 yrs Cycle and the KLCI

In response to a reader's question whether this cycle theory applicable to the KLCI. Below are the charts for the analysis:

1. 1980 - 1989

In the 80's we can see from the chart above, the KLCI was choppy with a horizontal trend with price index ranging from 200 to 500. It didn't follow the 10 year cycle theory whereby the first few years should be low, and there should be a run-up in the middle of the decade, finally reaching a peak at the later years and follow by a crash. However, in 1987 there was a crash of about 50% from its peak.

2. 1990 - 1999

In the 90's we can see clearly that the KLCI followed the theory whereby there was a nice run-up till 1997 and followed by a severe down turn with price index dropped 80% from its peak.

3. 2000 - 2009

Again during the millennium decade, there was a consolidation in the first few years, then price index had a steep rise from 2006 on wards and reaching the peak in 2008. This round, the KLCI dropped 42% from its peak.

From the above findings, we learned:

• except the first chart, first few years are consolidation years whereby prices are lower compared to the later years.
• prices tend to double from the year 0 to the peak. In the 80's KLCI started with 200 and reached a peak at almost 500 in 1987; In the 90's KLCI started with 600 and ended up at 1200 in 1997; Except in 2000, KLCI started with 1000 and reached a peak at 1400, but if you were to count from the low of 600 in 2001, it was more than double.
• In the 10 year period, there are phases of consolidation whereby prices move within a tight range before a breakout either to the upside or the downside.
• The crash is usually steeper and the duration is shorter than the bull trend.

There are many reasons for the way stock prices behave, in the technical analysis perspective, it is assumed that history repeats itself, from the past data we can predict future price movement. 

Having said that we have to acknowledge the importance of knowing the fundamental analysis too. The best trader will use both in their analysis. 

 

Cycle Analysis and The Stock Market

When we talk about cycle analysis we will definitely think of WD Gann, the legendary stock and commodity trader who had made tons of money from the financial markets. It was estimated that in his lifetime he made $50 million from stocks and commodities. Imagine how much is $50 million 80 years ago translated to today's money. What was his secret?

He had the ability to forecast the market by studying the historical prices. He said, "Everything works according to past cycles, and that history repeats itself in the lives of men, nations and the stock market." (more quotes from him)

In 1928 the year before the crash he successfully predicted the crash in 1929 and said that it would take years for the stock market to recover. You may read his detail prediction  here.

Today I want to talk about one of his famous theory on the cycle analysis, its known as the Decennial Cycle or the 10 year cycle. According to Gann, he compiled the past 100 years of price data and put them on a chart. He plotted the y-axis as the price while the x-axis as the year ending with 1,2,3,4,5,6,7,8,9,0. The actual chart was very blur as it was a very old chart, so I try my best to illustrate on the chart below:

From the above chart, we can see that the year that ends with 1,2,3 such as 1981, 1982, 1983, 1991, 1992, 1993 and 2001, 2002, 2003 have a similar price pattern, they start from low price levels. Year that ends with 7 or 8 usually experience crashes.

Below is an extract from Gann's teaching:

Each decade or 10-year cycle, which is 1/10th of 100 years, marks an important campaign. The digits from 1-9 are important. All you have learn is to count the digit on your fingers in order to ascertain what kind of a year the market is in.

No.1 in a new decade is a year in which a bear market ends and a bull market begins. Look up 1901, 1911, 1921, 1931...

No.2 or the second year is a year of a mirror bull market, or a year in which a rally in a bear market will start at some time. See 1902, 1912, 1922...

No.3 starts a bear year, but the rally from the second year may run to March or April before culmination, or a decline from the second year may run down and make bottom in February or March, like 1903, 1913, 1923...

No.4 or the fourth year, is a bear year, but ends the bear cycle and lays the foundation for a bull market. Compare 1904, 1914, 1924...

No. 5 or the fifth year is the year of Ascension, and a very strong year for a bull market. It can be a new bull market or a big correction in an existing uptrend. See 1905, 1915, 1925...

No. 6 or the sixth year is a bull year, in which a bull campaign which started in the 4th year ends in the fall of the year and a fast decline starts. See 1896, 1906, 1916, 1926...

No.7 or the seventh year is a bear number, and the seventh year is a bear year because 84 months or 84 degree is 7/8 of 90. See 1897, 1907, 1917, 1927...

No.8 or the eighth year is a bull year. Prices start advancing in the seventh year and reach the 90th month in the eight year. This is very strong and a big advance usually takes place. Review 1898, 1908, 1918, 1928...

No.9 the highest digit and the ninth year, is the strongest of all for bull markets. Final bull campaigns culminate in this year after after extreme advances and prices start to decline. Bear markets usually starts in September or November at the end of the ninth year and a sharp decline takes place. See 1899, 1909, 1919, 1929...

No.10 the tenth year, is a bear year. A rally often runs until March and April; then a severe decline runs to November and December, when a new cycle begins and another rally starts. See 1910, 1920, 1930...

This is just one of the cycle theories, there are also the Presidential cycle (4 year cycle), secular bull and secular bear, yearly cycle, monthly cycle and many more. From the study of past cycles, we see a very clear picture that history seems to repeat itself and by learning more technical analysis theories we can make better investment decision to help ourselves to grow our wealth.

Finally, I'm going to end this article with a statistical table to show how accurate is this theory:

Happy investing,
Pauline Yong

Is the Eurozone Crisis Bottoming?

In ECB President Mario Draghi's words: "The worst is over for the EU crisis, but risks remain!". He was refering to the low inflation registered in the EU region. As long as the inflation is kept below 3%, the ECB is happy at keeping the benchmark refinancing rate and the deposit rate unchanged at 0.75% and 0% respectively, and the ultra low interest rate will spur economic growth in the EU.

However, not many economists share the same view with Draghi. 

A London professor of economics, Costas Lapavitsas said:

"This misleading impression has been created by Mario Draghi of the ECB, who announced that he will lend freely to countries in trouble, driving interest rates down. There has been virulent opposition, led by the Bundesbank. For conservative German opinion, Draghi is the devil of Goethe's Faust, luring Angela Merkel into a deadly pact of inflation. Also for ECB lending to materialise, a country must accept tough austerity conditions. Which European politician will do that?"

Indeed, the austerity condition has already caused social unrest in Greece, Spain and other EU countries to go on strike in the streets as spending cuts tend to affect lower income groups, especially when the cuts are to welfare payments.

In addition, the fiscal union is not easy to realised as that would means centralised control of national budgets and tax policy in the Eurozone. Germany is the main driver behind the fiscal union as they want to make sure other EU countries do not overspend if they want to use the German's money! 

We have already seen at the current European Summit that France and Greece are opposing the idea of fiscal union, they want "solidarity" to balance the budget austerity demanded by Germany. 

Hence, the actual solution is not whether the interest rate is low enough to stimulate growth in the economy, it's the "confidence" that matters most. In order to judge whether the Euro crisis is over depends on how each of the EU members cooperate with one another, minimise their conflicts, and to reinstate the confidence back to the economy. 

What Does QE3 Mean?

Someone asked me QE3 announced during the market peak, will the stock price go higher?

To answer the question, let us understand what QE means. QE stands for Quantitative Easing. It is a kind of monetary policy that increases the money supply in the financial institutions, so that the financial institutions have more funds at lower cost for lending.

The key here is "more lending", so that consumers borrow money to spend and firms borrow money to invest, all these will drive at more economic activities and finally reflects in the GDP figures.

Hence, whether QE3 will work depends on the willingness of the consumers and producers to borrow money to expand their economic activities. Let's take a look at the following charts:

The first chart is the US consumer confidence index. We can see the general improvement in the confidence level in the consumer sector.

However, the US business confidence (Chart 2) is rather weak with figures below 50 for the last 3 months.

This may mean that the QE3 of US600 billion of fresh funds may not reach the desired result that the US government wants.

So does that mean we shall stay on the sideline and keep our money in the bank? No! Because your money in the bank will lose purchasing power as the bank rate is negligible. We should invest in dividend stocks and income generated assets such as REITS or even properties.

Recently, I took advantage of the sell down in the KLCI by re-balancing my portfolio. I cut loss on non-performing stocks and switch to dividend yielding stocks. Immediately I see my portfolio appreciated 4% within a week.

Currently, all major indices are pointing at bullish trends, however do take note that the US market has been in an uptrend since June, the next resistance for the S&P 500 is 1480. As for our KLCI, you may want to take into consideration of our election risk, and switch to dividend stocks or REITS.

Happy Investing!

Irreversible Euro

During the ECB press conference last Thursday August 2nd, Mario Draghi, the President of the ECB, mentioned that the Euro is 'irreversible'. A media reporter asked him what did he mean when he said 'irreversible'? Mario spoke in a firm and clear tone, "when I said irreversible it means Euro can never go back to lira or drachma, it is here to stay for ever!"

Through out the whole Q&A session, he answered many questions on bond purchase and financial aids for the Eurozone, but it is nothing compared to the above statement about Euro dollar sent a very strong signal that whoever think Euro is going to collapse, will need to think twice!

The next day, DJI soared 2% and subsequently other Asian markets rebounded on Monday. Whether this rally genuine or not depends on the following factors:

- Corporate earnings - As we've come to the earnings season in August, what drives the market very much depends on the individual corporate earnings. If economies are recovering, we should see better corporate earnings.

- Economic data - GDP figures from the major countries such as the Eurozone, US, and China will indicate the financial health of the economies that in turn affect the stock markets. So far these figures have been weak, confirming economic slow down globally.

- Government effort - So far since the financial crisis in 2008, governments around the world are the true followers of the Keynesian philosophy, not only that, they went beyond it - they use the last resort of printing money to finance their fiscal stimulus! And amazingly, prices for these money printing countries have been able to keep low. Does that sound like the lost decade- Japan? Remember, inflation arises when people are spending, or when too much money chasing too few goods. Obviously that did not happen or may be not yet because the consumer and business confidence are still weak.

In the end, these governments who spent huge stimulus to artificially shore up the economy will need to reconsider this option. They need to think about these questions:

1. If interest rates are already low, how can we further stimulate the economy with monetary policy?

2. If monetary policy is not working, can we use fiscal policy to stimulate the economy?

3. Then the next question is: How do we finance the additional fiscal spending? By borrowing more money (debt level already high) or by printing more money? Borrowing more money will lead to higher debt level which jeopardise the valuation of the currency and credit rating. How about printing money? Firstly, printing money is inflationary. In addition, printing money will lead to inflationary asset bubble and the depreciation of the currency as well.

Since in the periods of recession, monetary policy generally doesn't work well, the best measure is still fiscal policy. But this has to be finance within your means, and make sure allocation of funds is towards the improvement of labour skills and the efficiency (or productivity) of the work force, rather than constructing white elephants projects or spending money on unnecessary infrastructures that do not drive long term growth for the economy.

Below is the chart of the S&P which shows an ascending triangle is forming, if S&P could break 1400 level, there is a high chance of reaching the next target level of 1500.

KLCI At Historical High

KLCI recorded another record high of 1629! As we can see from the chart above, there was a reverse head and shoulder formed during the period of April to mid June 2012. On June 19th, there was a breakout from this bullish chart pattern and now heading towards the price target of 1646.

While technical analysis tells you the possibility of near term price action, in a larger picture, we still rely on the fundamentals to give us a glimpse into the future.

The Euro debt crisis is still on, the politicians have not come up with the best solution yet. The concern is the bond yield (or the cost of borrowing) for Greece, Span and other debt ridden countries are much higher than their counterparts like Germany, Sweden and Denmark. For example, the 10 yr bond yield for Germany is below 3% while Spain is closed to 7%. It is believed that those debt ridden countries cannot survive with such high cost of borrowing and that they are suggesting the richer EU countries like Germany and Denmark to share the weaker countries debt burden by jointly issuing government bonds. By doing so, the borrowing cost of Spain and Greece is lowered while that of the Germany is raised.

During the recent Brussel Summit in June the above proposal did not materialized but instead a temporary measure is agreed upon. That is the 120 billion euros growth package was agreed upon during the 2 day summit with funding from the ECB to help solve the problem temporary.

In the US, concern is with the unemployment data that remain stubbornly high at above 8% but it is declining which is a good news for the US. In addition, the corporate sector is generating huge profits as products such as Microsoft, Apple, Johnson & Johnson etc are selling all over the world!

On a contrary, things are not looking good in China. Recently the Chinese data shows that the economy is contracting with weaker PMI and GDP data.

Hence we shall expect the markets to remain choppy until the situations get better in the EU and China.

Happy investing,
Pauline Yong

Sigma Wealth Stock Analysis Advance Course

Last weekend we had just completed a 4 day stock analysis course. It was overall a comprehensive learning experience for the participants as they learn about economics, ratio analysis, intrinsic value, value investing, charts and patterns, price and volume analysis, Dow theory, Elliott Wave, Fibonacci support and resistance, market sentiment indicators and more!

What a list! Yes, we covered so much in just 4 days, of course, we have all the follow ups through our exclusive facebook "secret group" - only for the graduates, to discuss our daily trades and so that we can all make money together! Also, I've to thank Iqbal for coming all the way from KL to attend our seminar in Johor Bahru!

Here are some of the graduates comments:

"This course provides me a bigger pictures of how the stock market works and an in-depth analysis of stocks performance. I'll recommend friends to join this course as it transforms me from a novice into a knowledgeable investor. Lecturer is helpful and willing to share." Dickson Tan

"This course is useful for my future trading and investment!" Iqbal

"This course helps us to understand the fundamental and technical side of stock analysis, very useful for my trading!" Tan Teng Huat

"Overall the course covers a lot in the given time. Most other trading course do not include Fundamental Analysis, which I think is important to know. Value for money!" Joshua Lim

Our next intake is August 25 & 26, Sept 8 & 9. Interested please enquire through email: info@stocktips123.com or call Ms Teh at 012-7795292.

Where Are We Heading To?

Where is our KLCI heading to?

Everyone is asking this multimillion dollar question!

In order to answer this question, we must first look at the S&P 500 chart, as that will determine our market in the near term. According to the above chart, we are at the cross road whereby the S&P is below the 50 day moving average but was supported by the 200 day moving average. This spells some uncertainty over the market in the short term. Now we have to observe for the next 2 weeks whether we can stay above both 50 day and 200 day moving average, if yes, it means the bull trend continues. However, it S&P 500 breaks below these two moving averages, it means we have the "death cross", which is bad news for our KLCI as well.

Of course, we must not forget the Greece re-election is around the corner, this Sunday, as all eyes will be on the outcome whether the New Democratic Party (New Democracy, in support of the euro zone) and the radical left-wing coalition (Syriza, left-wing, opposed to rescue) will win?

Happy investing,
Pauline Yong

Pay Attention to the Trendllines

What is a trendline?

Trendline is a straight line drawn on a chart through or across the significant limits of any price range to define the trend of market movement.

Trendlines are one of the first technical aspects of the market to be discovered. Technical analysis is based on the fact that the stock prices move in fairly definite trends. Technical analysts use trendlines in two ways: first, to identify the direction of the movement of the stock prices; second, to determine if and when the movement will change.

Uptrends and Downtrends

An “up trendline” is whereby a line is drawn on the chart by connecting the low points of the security as its price continues to rise. Each low point is successively higher than the previous low. This progression gives the trendline its upward slope.

A “down trendline” is drawn with a line on the chart connecting the high points of the security as it continues to fall. Each high point is successively lower than the previous high. This progression gives the trendline its downward slope.

How to use trendlines?

Prices move in trends. Once a trend has been clearly identified, it's likely to continue for a time. Technical analysts look at trendlines for their ability to support price declines or resist price advances.

In addition, the slope of the trendline tells us the strength of the security price. In general, a healthy trendline should be around 45 degrees sloped. The steeper the slope, the more aggressive is the underlying security, however, it may not be sustainable. On the other hand, the flatter the slope, the weaker is the trend and there may be a possible correction in near term.

An Excercise:

Below is our KLCI chart, you may practice your chart reading skill by studying the chart carefully, let's see if you can make a forcast based on the information given. There's no right or wrong answer, it all depends on your forecasting skills. Enjoy!


(Click to enlarge)

The Moon And The Stock Market

Have you heard before that human tends to be emotional during the full moon? The reason why I want to talk about this is because statistically shown that mankind behaves irrationally during these periods and this will affect our decision making process in the financial markets.

A study suggests that a full moon really can bring out the beast in us, turning us into irritable animals.

While we may not actually transform into the bloodthirsty creatures of fables and movies such as An American Werewolf In London, research suggests we do display worrying symptoms.

A study conducted in Australia found that in 2009, 91 emergency patients with violent, acute disturbances were happening in one hospital north of Sydney.

According to the research, "some of these patients attacked the staff like animals, biting, spitting and scratching, and the patients had to be sedated and physically restrained to protect themselves."

Of course we can do another research on the crime rate and the full moon to confirm the above claims. But today I have done a small research on this topic and compare to our Malaysia KLCI and to see whether the moon does affect our stock market.

This research is about the distance of the moon to the earth and how this relationship affect our stock market. It is generally believed that people are more rational when the moon is furthest away from the earth, and the name for this type of moon is called "Apogee Moon". Another extreme case is when the moon is closest to the earth and we can see the moon big and round right infront of us, this type of moon is known as "Perigee Moon". It is this perigee moon that often cause people become emotional, anxious, and pessimistic.

So I did a research on the dates of the perigee moon and marked them on the KLCI chart. (The chart may be unclear but if you click the picture, it will be enlarged.)

Amazingly I discovered that the claim is about 86% accurate that the KLCI did experience local low during the investigating period.

On the other hand, there's a research done by FutureAnalyzer.com, they studied not only the perigee moon, but also the apogee moon (when the moon is furthest away from the earth). They discovered a high correlation between the "highs" and "lows" with the agogee and perigee moon. Most of the time, "highs" happen during apogee and "lows" happen during perigee! In other words, it means that "highs" happen when people are more rational while "lows" happen when people are emotional.

I hope this article is not trying to convince you that astrology is perfect, but just to highlight to you that these little researches help us to look at the stock market in different perspectives.

Happy investing,

Pauline Yong

What Is Volatility Index (VIX)

In 1993, a new measurement for the index of volatility for the S&P 500 stock index came out with the purpose of measuring fear and greed. It is called the “VIX”. If the VIX index goes up, the traders and investors may be heading for the exits. Conversely, if the VIX goes down, confidence and optimism are restored, money is coming off the sidelines and moving into equities.

We can't trade the VIX directly but the VIX is traded on the futures exchange and can be traded just like any other investments. In general, VIX values greater than 30 are generally associated with a large amount of volatility as investors are fearful of uncertainty; VIX values less than 20 associate with less volatility and less stressful in the market.

On the other hand, when the VIX is consistently below 20, it means that the underlying S&P is in overbought position and it is due for a correction and vice versa.

There are 4 variations of the volatility index: the VIX tracks the S&P 500, the VXN tracks the Nasdaq, the VXD tracks the Dow Jones Industrial Average and the RVX tracks the Russell 2000. Investors can trade VIX futures for hedging purpose. For example, if VIX starts to rise, it means the level of fear and uncertainty is increasing and you may purchase VIX futures contracts on the Chicago Board Options Exchange (CBOE). If the market does indeed start to sell off and the VIX rises, the profits gained by the VIX futures can help to offset some of the losses that you might experience in other investments.

The Peril of Printing Money

Traditionally, printing money supposed to be the last resort to the monetary policy. However from the recent sovereign debt crisis in the Euro zone and the U.S., we can see these policy makers are embarking on large scaled quantitative easing process to avert the collapse in the financial system.

The US embarked on the QE1 and QE2 with each over US$1 trillion respectively in the last 2 years, similarly, the Bank of England had its first QE1 in Mar 2009 and the QE2 in Oct 2011 with £75b and £50b respectively. And recently, in saving the mess in the Euro zone, the ECB has engaged in the so called long-term refinancing operations (LTRO) which is equivalent to the back-door quantitative easing, with €409b and €529b for the last 2 months.

Essentially, what is QE and LTRO? QE refers to the central bank implements quantitative easing by purchasing financial assets from commercial banks and other private sector businesses with printing new money. While LTRO refers to the central bank lending money at a very low interest rate to euro zone financially troubled banks with printing money, which has led to the term “free money" and these banks are suppose to pay back at a much later date.

For the LTRO, the injection of cheap money means that banks can use it to buy higher-yielding assets and make profits, or to lend more money to businesses and consumers – which could help the real economy return to growth as well as potentially yielding returns.The best part, the banks can borrowed these money and pay back to the ECB after 3 years rather than the usual 3 months or 6 months.

So what's the consequence?

The biggest consequence is the income gap between the rich and the poor will widen significantly!

As we have too much money supply in the market it will result in "too much money chasing too few goods", which means the food prices will increase in tandem which drives up the cost of living. This is the demand-pulled inflation that is brewing in the economy.

On the other hand, during inflation, asset prices will rise accordingly while the paper money will lose purchasing power. Hence, the poor being not able to invest in stocks and houses, will be the greatest losers in the economy.

On top of that, commodity prices such as precious metals and energy will escalate too. The poor definitely do not benefit from this because not only do they own minimum precious metals, they need to face up to the consequence of the rising oil price that make their living even worse off. The rising energy prices will act as a double wammy to the economy because this cost-driven inflation will push the inflation rate higher. Hence, demand-pull inflation coupled with cost-push inflation, the economy will likely to run into "hyperinflation"!

Does the policy makers know the consequences? Why did they do this?

Well, with the QE, bank rates are artificially kept at an ultra low levels which makes borrowing easier for the business sectors. At least that's their intention - to promote more borrowing which in turns stimuate groth in the economy. But whether the low interest rate helps to revive the economy really depends on the business confidence because we can have the lowest rates in history but if the public shows lack of interest in borrowing the "free money", the economy can't move forward! Hence, QE did pump lots of money into the banks but this only improves banks' liquidity, not the economy. Even though, the minority rich will get richer as asset prices like stocks, properties and commodities will soar, but the majority of the population is still poor and unemployed!

Now with the fear of inflation, how would the business confidence improve? Whether the central banks print money or not, it will take time for any economy to recover. If I were the Fed, I'll stop printing money, let the economy go through the cycle, let the commodity prices fall and hopefully tommorrow will be better!

Happy investing,

Pauline Yong

The Economy Stimulus Story

In the midst of the European sovereign debt crisis, I would like to share with you a story that I came across a few years ago about the economy and how it is stimulated through spending. Here's the story:

The story started with a rich tourist came to a town in which everyone living there was in debt. The tourist put down a 100 Euro note for the hotel owner as a deposit while he went round to check the conditions of the rooms. With the 100 note on hand, the hotel owner quickly ran to pay off his debt – his supplier, the butcher. The butcher received the money and he quickly settled his debt with the pig grower. Next, the pig grower used the receipt to pay off his debt with his supplier of feed and fuel. And this supplier ran to pay off his debt to his creditor - the prostitute, and finally, the prostitute went to the hotel owner and settled her debt with the hotel owner with the same 100 Euro note.

The hotel owner then put the 100 Euro note back on the counter as it was the deposit of the tourist. The tourist decided not to stay and took his money back.

After all these drama, amazingly, the whole town is now without debt and everyone looks to the future with a lot of optimism. In the final sentence of the story, it says: “This is how the United States Government is doing business today.”

“Does the story make any sense?” I’m sure most of you are pondering hard about this story. In fact, I’m truly amazed that this little story has embraced a number of important economic concepts that I’m going to explain next.

First, the story has brought out one major economic theory - the Keynesian mulitiplier theory. The initial 100 Euro note has changed a number of hands, from the hotel owner, to the butcher, to the pig grower … and back to the hotel owner. Starting with 100 Euros, the economy has created 600 euros worth of market transactions. In order for the Keynesian multiplier theory to function, the initial 100 Euro has to be an autonomous (independent) injection in the form of investment, government spending or exports to the economy. In this case, the rich tourist’s 100 Euro note is treated as exports because the rich man is a foreign tourist, the money is considered as an outside independent source of injection to the economy. (For simplicity, I have left out the multiplier formula here)

Next, we come to the most important concept of the multiplier theory that says that the injection of money creates round after round of spending. In other words, the cycle of ‘one man’s spending creating another man’s income’ repeats itself round after round just like the story.

But the story says each of them “pay back” their individual debt, not “spending” as stated in the multiplier theory. I would argue that the spending has been performed before each one received the 100 Euro note, which means they spend first and pay later. Just like most of us are doing now.

So, did the people in the town really get rid of their debt? The answer is “Yes!”

Because during each round of spending, income is created at the receiver’s end. This means that no matter what is the source of income (be it borrowed money or earned money), the economy is stimulated in the form of more economic activities created by the many rounds of spending. As long as the rate money earned is faster than the rate of debt increased, by theory, we can settle the debt. But in real world, most government in the world is building their debt at a much faster rate than the collection of taxes because in a democratic society when the government is elected based on people's votes, the ruling party tends to run into budget deficits.

Hence, this is how most of the governments in the world are doing business today!

How to value a mining company

By Paul van Eeden

I received an interesting question about company valuations from one of my newsletter subscribers that I thought I would address as a Commentary. It is a multi-part question that will take more than one Commentary to address; this week is part one: Valuing Mining Stocks.

Mining is a finite business. Mineral deposits contain a certain amount of ore and when that ore is mined out the deposit is depleted, no matter what you do or wish.

That is in stark contrast to say, an auto parts manufacturer, who can adapt to new demands and specification changes and (hopefully) stay in business for many decades. When you value an auto parts company, you can compare the company's price to earnings, price to cash flow, operating margin and net profit margin (among other things) to the company's peers to assess whether the stock in question is relatively cheap, or relatively expensive. You can also get a sense of whether the stock is cheap or expensive in an absolute sense by looking at the book value per share and comparing things like the profit margin and dividend rate to prevailing interest rates. But, embedded in all this (except book value per share) is the implicit assumption that the earnings and cash flow are for all intents and purposes infinite. When you are dealing with a business that can be reasonably expected to continue in a similar fashion for many decades, earnings per share, cash flow per share, dividend rate, etc. are meaningful. That is not the case with mining.

Take a hypothetical mining company that has only one mine as an example. Let us assume that mine is going to produce for another five years before the ore will be depleted. Now, let us say that the company's price to earnings ratio is ten. A hypothetical auto parts manufacturer also has a price to earnings ratio of ten. Based on just this one metric, we cannot differentiate between the two stocks. Let us also assume that the prevailing ten-year interest rate is five percent.

This means that you can invest your money in a ten-year bond and earn five percent per year while taking relatively little risk (other than the risk of interest rates rising, which could negatively impact all the investments under consideration and is therefore not considered).

The auto parts manufacturer has a price to earnings ratio of ten. That means for every dollar's worth of stock you buy, you expect to earn ten cents, or ten percent, in earnings. It does not really matter for our purposes whether those earnings are retained by the company or paid out as a dividend since, either way, the earnings accrue to the benefit of shareholders. Furthermore, you can reasonably assume that the auto parts manufacturer is going to be in business for several more decades and, because you have done lots of due diligence, you can also assume that the future earnings are likely to be the same as the current earnings. So, if you buy the auto parts stock, you will earn ten percent per year as opposed to five percent on your bonds. The auto parts stock is probably riskier than a bond; however, if you can make twice as much money it might be tempting.

Then you look at the mining stock and notice that it, too, has a price to earnings ratio of ten and, therefore, you can also make ten percent a year if you bought that stock. But you would be wrong. The mining company's mine only has a five-year life ahead of it. So, if it has a price to earnings ratio of ten it means that for every dollar of stock you buy you get ten cents in earnings. But the earnings are only going to last another five years, so your total earnings per dollar of cost will only be fifty cents — - half of what you paid for the stock — - and then the mine is depleted. That's why comparing a mining stock to other investment opportunities on the basis of price to earnings, price to cash flow, or dividend yield is complete nonsense. It is just as futile to compare mining stocks to each other based on these metrics because mining companies have different mine lives in their operations.

The only reasonable way to evaluate a mining company is to look at the net present value of the potential future cash flow, discounted at an appropriate discount rate. You have to take into account not just the cash flow that the mine(s) is generating, but also sustaining capital costs (including future exploration and development costs) associated with keeping the mine in production. Assuming you can derive a suitable cash flow model for each mine that a company owns you can then calculate the net present value of future cash flow by using an appropriate discount rate to represent the geological, political, social and financial risks. If you sum all the net present values together, add any other assets on the balance sheet and subtract any debt, you will arrive at the net asset value per share. In a rational world you would expect to pay no more for a mining stock than its net asset value per share — - how do you expect to make money if you consistently pay more for stocks than what they are worth? But, in the real world, mining stocks almost always trade for more than the net asset value of their constituent mines, and for a good reason.

Mining stocks also offer leverage to commodity prices. Take a gold mining company as an example. Assume we have a company that mines gold for a total cost of $400 an ounce, and let us pretend the gold price is $500 an ounce. The net present value of the mine would be calculated based on the $100 margin. If the gold price increases by 20% to $600 an ounce the net present value of the mine will double, since the margin would now be $200 an ounce. Thus the value of the company increased five times more than the increase in the gold price. Most people buy mining stocks because of this leverage.

What should be immediately evident is that if you pay more for mining stocks than what they are worth, on the speculation that the price of the underlying commodity will increase, you are merely gambling on the commodity price. Fortunately there is a way to quantify the premium that one should pay for a mining stock to incorporate the leverage it has to the underlying commodity price. There is a formula called the Black-Scholes Model that can be used to calculate the "option" value of a mining stock [Editor's note, you can find more information on the Black Scholes model and further links at http://en.wikipedia.org/wiki/Black-Scholes ]. What should be done is to calculate the discounted net present value of the all the company's mines and then add the "option value" of the mines as calculated by the Black Sholes formula to obtain a more realistic asset value per share. By adding the optionality of mining shares to the net present value of the mines themselves we can account for the fact that mining shares trade at a premium to their net asset value because of their leverage to the underlying commodities.

If you calculate the net asset value of a mining stock as described above you will get a result that can be used to compare different mining companies to each other, and mining companies to investments in other sectors. Unfortunately, very few mining analysts employ the Black Sholes model to calculate mining net asset values, so for most people buying mining stocks really comes down to blind speculation on commodity prices.