Articles & Blogs - Gold Commentary

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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.

Please be clear on this: I do not advise anyone to “short” gold and silver miners – at any price-level of bullion. There are two reasons for this. First of all, as I pointed out in Part I, gold and silver have been heavily manipulated for decades – meaning their current price is far below any long-term equilibrium.

This means that at any time, when bullion may appear to be at a “top”, technically, there is a rising probability each time this happens that bullion will simply keep going higher and higher. With the losses on any short position potentially infinite, those shorting these companies are playing a very dangerous game.

The second reason you should not be shorting these companies in the near term is that valuations are terrible. As has been widely reported, during the market “crash” last fall, gold and silver miners plunged to their worst valuation (versus the price of bullion) this decade. While bullion has made a big “run” since then (with gold recovering its value better than silver), the miners have not been leveraging these gains in accordance with their own profitability.

This means that while gold is within “sniffing distance” of its all-time high, gold miners are still extraordinarily cheap. For those who would like to read-up on this issue in greater detail, I recommend the work which Adam Hamilton has done in this area.

We are now armed with the knowledge that gold and silver miners leverage the price of bullion to produce superior returns versus investing in bullion, alone, and that current valuations make these companies tremendous bargains in comparison to valuations at almost any other time in this precious metals “bull market”. This also puts us in a position to examine which segments of this sector offer the best, potential returns.

In this respect, I (and many other commentators) recommend the “junior producers”. There are many reasons to choose these smaller companies versus the larger, and more-popular senior, and mid-size producers.

To begin with, “junior” producers typically have far superior production-growth profiles. While most large producers would be happy to be able to bump-up production 10% to 20% in any given year, smaller producers are generally able to dramatically outperform this level of growth. A junior producer which brings a new mine on-line, or completes a major expansion of existing facilities can easily produce production growth of 50% or 60% - or even more, in a single year.

The other reason why juniors can generate far superior gains to larger producers also comes with a “catch”, the added profit-potential also translates into higher risk. This returns us to a discussion of leverage. Previously, I illustrated through simple numerical examples that companies with high profit margins offer less leverage than lower-margin producers – but also less risk.

In the case of juniors, their more aggressive production profiles mean that they tend to spend more money on exploration and development (relative to their size) than larger producers. They need to drill-out existing deposits to increase their resources, and generally have additional development projects aimed at yet higher production in the future.

This means that few junior producers operate with large, net profit margins – even when bullion prices are relatively high. As a result, the leverage offered by junior producers will generally greatly exceed that of larger producers at any price for bullion.

Naturally, these reduced margins, mean more down-side for the stocks when the market is falling. However, I will remind people of what I pointed out previously: the valuations of all these miners are still terrible. As a result, there will rarely be a time when the risk/reward ratios are more favorable for investing in junior producers. Canadian markets are the “home” to the vast majority of these junior producers – making such companies especially attractive (and accessible) to North American investors.

For people with a strong fear of deflation, they may be inclined to shun any and all equities. However, with gold and silver having demonstrated, historically, that they hold their value better than other asset-classes during deflationary periods, this translates into less risk for the shares of the miners than virtually any other sector of equities.

I will add to this that for a variety of reasons (mostly connected with the reckless increase in the global money-supply, and global debt-levels), I am completely convinced that it is inflation which will assume dominance in most markets and asset classes in the future. This means that commodity-producers, in general, and gold and silver miners, particularly, also offer superior long-term growth/profit potential versus other sectors.

All investors need to have significant protection from the economic turbulence which is certain to lie ahead of us, through purchasing gold and/or silver bullion. However, do not forget that it is the gold and silver producers which offer the greatest potential in surviving (and hopefully thriving) in these challenging times.

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