The Education Vault
|A Novice's Guide to Precious Metals, Part II: the miners|
In “Part I” of this series, I provided a basic overview of what separates gold and silver from all other commodities, why gold and silver are so attractive today, and dispelled the popular myth that “bullion-ETF's” are the same as owning real, “physical” bullion. In Part II, I will explain why the potential profits from investing in gold and silver miners always exceeds the potential return from bullion, alone.
The obvious starting-point when it comes to a discussion of gold and silver miners is to discuss the basic proposition of “leverage”, as it applies to a commodity-producer. Let's make the hypothetical example really simple: a gold miner who can produce an ounce of gold for $500 (its “cash costs”), with the price of gold at $1000/oz. As everyone can see, this miner earns $500 profit on each ounce of gold produced.
Now, let's take two hypothetical investors: Investor A and Investor B. Investor A purchases gold at $1000/oz, while on the same day, Investor B purchases shares in the previously mentioned gold miner – at $10/share.
A month later the price of gold has moved to $1100/oz, and both investors are contemplating taking profits. The question is: which one will come out ahead? For Investor A, his potential profit is easy to observe: 10%. However, Investor B is about to benefit from the magical concept of leverage.
You will recall that the gold miner makes $500 profit on each ounce of gold mined, with the price of gold at $1000. However, with a new price of gold of $1100/oz, this gold miner is now earning $600 profit on each ounce of gold – a 20% increase in profitability.
With the gold miner now 20% more profitable, if we assume rational behavior in the marketplace (often a BIG “if”), then we should expect the shares of the gold miner to also appreciate by roughly 20% (subject to other factors in its operations). In other words, in the current hypothetical example, investing in the gold miner (with the given parameters) provides 2:1 leverage versus investing in gold directly.
What is perhaps more interesting in this concept is that the less profitable a mining company is (at any particular price-level for gold), the greater the leverage.
Let's go back to the example of gold priced at $1000/oz, and create another hypothetical gold-miner. This second miner is producing its gold at $900/oz, meaning at $1000/oz it is making only $100 on each ounce of gold mined. However, if, once again, the price of gold goes up to $1100, this second miner is now 100% more profitable.
Now let's apply what we've learned to the “real world”, where the price of gold has gyrated over a wide price-range in just the last year. We're all familiar with the market adage “buy low and sell high”, but what many people don't realize is that in the world of commodity-producers this advice becomes wonderfully simple.
Whenever the price of gold (or silver) tumbles, so do the profit-margins of the gold miners. What these compressed profit-margins mean to investors is that every time gold bottoms in a trough, the leverage for all gold (and silver) miners is at its maximum.
For “swing traders”, this makes gold and silver miners very attractive vehicles – as each time they bottom-out in a trough, they can be expected to bounce back strongly, as soon as bullion rebounds. Conversely, for many “shorts” these companies are also attractive, in that when bullion appears to have hit a short-term “top”, then that same “leverage” which works in the miners' favor on the way up works against them on the way down.
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