| Currency
Exchange Rates and Gold mining Companies |
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Here is an extract from commentary
posted at www.speculative-investor.com
on 30th April 2003:
As investors in South African
gold stocks have found over the past several years, changes
in currency exchange rates can have a huge effect on the prices
of gold stocks. By considering two hypothetical examples,
we'll attempt to demonstrate why this is so. First, though,
it is worth mentioning that the currency in which a stock
is priced makes no difference and shouldn't form part of the
investment decision-making process. For example, it makes
no difference whether you buy the AUD-denominated stock of
Newmont Mining on the Australian Stock Exchange (NEM.AX) or
the USD-denominated stock of the company on the NYSE (NEM).
Regardless of whether you buy NEM or NEM.AX, each dollar you
invest will give you an identical claim on the assets and
profits of Newmont Mining. As such, the performances of NEM.AX
and NEM will be the same when the prices are converted to
a common currency. What does matter is the currency (or currencies)
in which a company's costs are denominated.
Example #1: A Canadian-based
investor buys shares in a US-based gold company for
US$1/share, which equates to C$1.40 assuming an exchange rate
of USD1 = CAD1.4. In this example the company is assumed to
be generating earnings at the rate of US$1M per year on revenue
US$10M (meaning that the company's total annual cost is US$9M).
The company has 10M shares outstanding so the profit equates
to 10c/share. The stock is therefore trading at a price/earnings
(P/E) ratio of 10.
Now, assume the US$ gold price
rises by 10% and the C$ also appreciates by 10% against the
US$. If the USD-denominated stock price remained the same
under these circumstances then the CAD-denominated stock price
would now be $1.26, that is, our hypothetical Canadian investor
would have a loss of 10% due to the appreciation of the C$.
However, it is extremely unlikely that the US$ stock price
would have remained the same under these circumstances because
the 10% increase in the US$ gold price would have resulted
in a 10% increase in the company's US$ revenue (from US$10M
to US$11M). And, if we make the assumption that the company's
costs were unchanged at US$9M then earnings would have increased
by 100% to US$2M (20c/share). Therefore, if the market still
valued the company at 10-times earnings the stock price would
now be US$2 (the stock price, in US dollars, would gain 100%).
This is equivalent to C$2.52 at the new CAD/USD exchange rate.
In other words our Canadian investor would have a profit of
C$1.12/share, or 80%, as a result of the 10% increase in the
US$ gold price and the 10% increase in the C$.
In the above example a substantial
profit was possible because our hypothetical gold mining company,
like most unhedged gold mining companies,
represented a leveraged play on the gold price. This, in turn,
meant that the increase in earnings resulting from a fall
in the mining company’s local currency far outweighed the
exchange rate loss that a foreign investor would experience.
Example #2: A US-based
investor buys shares in a Canadian-based gold company
for C$1/share, which equates to US$0.71 assuming an exchange
rate of USD1 = CAD1.4. In this example the company is assumed
to be generating earnings at the rate of C$1M per year on
revenue C$10M (meaning that the company's total annual cost
is C$9M). The company has 10M shares outstanding so the profit
equates to 10c/share. The stock is therefore trading at a
price/earnings (P/E) ratio of 10.
Now, assume the US$ gold price
rises by 10% and the C$ also appreciates by 10% against the
US$ (the same assumptions we made in Example #1 above). In
this case the gold price in Canadian Dollars would be unchanged
and company earnings would therefore be unchanged at 10 Canadian
cents per share. So, if the market still values the company
at 10-times earnings the stock price will remain at C$1, but
this is now equivalent to around US$0.79 due to the appreciation
of the C$. In other words our US investor would have a profit
of US$0.08/share, or 11%, as a result of the 10% increase
in the US$ gold price and the 10% increase in the C$. That
is, he/she would have gained nothing from the increase
in the US$ gold price but would have achieved a small profit
on the currency exchange.
The above examples are simplistic
because we assumed that costs and P/E ratios would remain
the same and we didn't take into account taxation. However,
by showing how a moderate change in currency exchange rates
can dramatically impact company earnings and therefore stock
prices we have hopefully been able to demonstrate why, with
all else being equal, it is better to own gold mining companies
that have most of their costs denominated in the weakest currencies.
In the current environment this would involve owning the gold
mining companies that have a large chunk of their operations
in the US.
Unfortunately, all else is rarely
equal. For starters, an investor only gains an advantage when
the price paid for a stock does not already discount the 'future
good news' expected by the investor. In the current environment,
for instance, the likelihood of further US$ weakness over
the next 12 months would only make the stock of a US-based
gold producer more attractive than the stock of a South African-based
gold producer if the effects of this dollar weakness had not
already been factored into stock prices. Taking a specific
example, it is hard to believe that the current stock price
of Harmony Gold doesn't already discount something close to
the worst case as far as the next year's earnings are concerned.
Also, when a currency is weak over a long period of time a
point will eventually be reached when the rate of increase
of domestic prices will exceed the rate of decrease of the
currency's exchange rate. Over the past year the US$ fell
a lot further against most of the other major fiat currencies
than it did against the labour, plant and materials used by
US-based miners to produce gold. At some stage, though, the
weakening dollar will begin to have a big effect on the "operating
costs" section of the income statements of US mining companies.
With the junior exploration stocks
- the area of the market on which we've focused over the past
6 months - exchange rate fluctuations tend to have less impact
on stock prices than is the case with the major producers.
However, even with companies that are years away from production
a substantial change in the currency exchange rate can have
some effect on the current stock price. This is because the
estimated future costs of production, and therefore the quantity
and value of gold reserves, will potentially be affected by
a change in the exchange rate.
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Steve Saville
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