Some questions answered
December 19, 2003

Thanks for all the feedback following my last two columns. Even though I can’t reply to each individual comment, I do read all the emails I receive. Given the amount of feedback I got, and the overlap in the comments and questions, I decided to use this week’s column to respond to some of them. Here we go…

Question: Why do you dislike South African gold stocks so much?

I have nothing against South African mining companies in principle. In fact, Harmony Gold is one of the finest gold mining companies in the world. What I don’t like about investing in South African gold stocks, at this juncture, is the juxtaposition of the risks and the potential reward.

In addition to the usual risks associated with running a business anywhere in the world, South Africa has some unique issues that its mining industry has to deal with. One of these issues is the reshuffling of assets to compensate for apartheid era injustices. The blue print for this reshuffling has been spelled out in the new Mining Charter and proposed Royalty Bill. While almost all the South African mining companies have been making changes in accordance with the new Mining Charter, it has yet to become law. The Royalty Bill, that will impose a tax on South African mining companies, still has to make it into the law books too. Will either change, requiring further changes in the mining industry? I don’t know, but that’s a risk you have to contemplate if you own South African gold stocks.

South Africa has undergone incredible change during the past decade. The change from a minority-rule, apartheid regime to a democracy was, in my opinion as a South African, a vital one. I am not alone in being both impressed and relieved at how smoothly the transition went but I am perhaps less optimistic about the rate of social and economic recovery than some. This is the crux behind the political risk in the country.

Officially the unemployment rate in South Africa is about 25%. But that excludes “discouraged job seekers”: people who are unemployed but are no longer actively seeking employment. If you include them, the unemployment figure increases to somewhat over 40%. In the United States we have an unemployment rate of about 6%. I don’t think many people who have not lived in a third-world country can fathom what 40% unemployment is like.

Unemployment leads to crime. Crime destabilizes the entire society, leading to unrest, which in turn leads to a public outcry for the government to “do something”. But if the government is essentially bankrupt, what can it do other than levy more taxes on companies and those who are employed?

There were around 48,000 murders in South Africa from January 2000 to March 2002, but only 4,760 convictions. There were 21,108 murders in 2001 alone. For perspective, there were 16,110 murders in the United States that same year. Keep in mind that South Africa’s population is only one sixth that of the United States.

Do you think that the social and political risks in South Africa are negligible given the magnitude of its crime statistics? If social distress leads to political action, do you think that the South African government is done with the mining sector, or could the Mining Charter and Royalty Bill, neither of which is necessarily in its final version, be used to squeeze even more out of the mining sector?

Take another look at the performance of the rand against the dollar in last week’s column and ask yourself whether it’s a good bet to invest in South African gold stocks when you have to face not only social and political risk, but also the risk that the US dollar will continue to weaken against foreign currencies, including the rand.

Many people commented that the rand is not going to be strong forever and that the gold price is likely to increase in rands (and in fact in almost all currencies), even if the dollar does continue to weaken. I agree. Even so, you still have to consider that capital (your savings) is scarce and it is usually prudent to invest your savings where you can get the best return for the least risk. So even if we assume that the gold price is going to increase in all currencies, shouldn’t you seek out the most leverage?

One could argue that the relative valuations of South African gold mining companies already discount the currency, the political and the social risks. That may be so, and I am not advocating that you purge your portfolio of South African gold stocks. Nor am I claiming that you could not make money by investing in South Africa. What I am saying is that South African gold stocks are not going to give North American investors the kind of returns they did in the seventies. Then the rand was fixed against the dollar and the full impact of the higher gold price in dollars was felt in South Africa. Now that the rand is floating against the dollar, the increase in the dollar gold price will not necessarily be the same as the increase in the rand gold price. This time the leverage is in US based production.

I will invest in South African gold stocks again when, for whatever reason, I perceive the upside to compensate for the risks, which will probably remain the same.

Question: Won’t we see competitive currency devaluations that will ultimately lead to an increase in the price of gold across all currencies?

I am sure that many countries are considering competitive devaluations to sustain the attractiveness of their export products to US consumers. But I sincerely don’t believe that governments can always get what they want. The US dollar did not strengthen throughout the nineties because either Bill Clinton or Alan Greenspan wanted it to.

The US dollar strengthened as capital flight from the currency crises of the nineties (starting with Brazil in 1992, then Mexico, Japan, South East Asia, Russia, Argentina, Europe, Turkey and Brazil, again) created demand for the US dollar.

The dollar strengthened, on average (GDP-weighted average), by 120% from 1990 to 2002 against the rest of the world’s currencies. This increase in the dollar caused a trade imbalance because imports became very inexpensive and US exports became uncompetitive. Now that trade balance has to be corrected.

As far as I know, every reversal of a large trade imbalance in history has lead to a recession, the magnitude of which was proportional to the size of the trade deficit. Because the US trade deficit is still at a historically high level, I am convinced that the recession in the US economy is not behind us, it is still unfolding.

The reversal of the trade deficit is also what is going to drive the US dollar lower against foreign currencies regardless of how much some of those countries wish, and try, to competitively devalue their currencies. It just won’t work because the US cannot sustain the current trade deficit any more than you can jump up in the air and stay there.

Given the magnitude of the correction in the dollar’s exchange rate, the gold price in dollars will increase more than what it will increase, on average, in other currencies. So while the gold price certainly could rise in other currencies, we will get maximum leverage from this devaluation by investing in companies that have US based operations.

Question: Won’t mining stocks appreciate against the dollar even if those same stocks only maintain parity against their local currencies?

Yes, they might, depending on what the relative exchange rates actually do. But let’s consider the purpose of investing, which is to maximize our returns for the least amount of risk. If we know that the US dollar is busy depreciating against foreign currencies, and we know that that process will continue for as long as the trade deficit remains out of control, then we also know that the best leverage to gold is going to come from US based projects. How smart is it to strive to under-perform?

If your goal is to mitigate risk by diversification, which is a perfectly rational and intelligent approach, then owning gold stocks with exposure to North and South America, South Africa, West Africa and Australia makes a lot of sense. In such a portfolio some upside is sacrificed for the mitigation of geopolitical risk by diversification. If that is your approach, don’t be offended when I say that it will give you average results, at best.

I am not trying to earn an average return on my investments because, unlike people with real jobs, I invest for a living. Therefore I have both the time and the inclination to try and figure out how to gain the maximum leverage without significantly increasing my risk.

What I write about in these columns are some of the ideas that have shaped my own investment paradigm. That doesn’t mean I’m right, or that I will indeed be able to outperform the market, but it does make writing these columns a lot more fun. What I am writing about is the real thing: my money is on the table.

I can explain my ideas about markets and investing here, but this is not the forum for discussing specific stocks. I am not in the business of stock promotions. If you want to know what I am actually doing with my own money, you can subscribe to my newsletter (www.paulvaneeden.com).

Be forewarned though, implementing theoretical ideas is much harder than coming up with the ideas. I am looking for exposure to good US based projects, but it’s easier said than done. The result is that I am investing outside the US as well. Another thing to keep in mind is that because I do this on a full-time basis, I tend to invest in companies that would, for most people, represent too much risk. I try to mitigate this risk by staying in close contact with the companies and making a sincere attempt to understand, in much more detail than most investors, what it is they are doing. Most of my money right now is invested in mineral exploration companies, which are, as a group, highly speculative. But just like there is a good reason why I am investing in the gold sector, there is a good reason why I am currently focused on the exploration industry. That, though, is a topic for the future.

I am taking a two-week break and will have the next column for you on January 9th.

Wishing you a Merry Christmas, or Happy Hanukkah, and a very, very prosperous New Year,

Paul van Eeden

Paul van Eeden works primarily to find investments for his own portfolio and shares his investment ideas with subscribers to his weekly investment publication. For more information please visit his website (www.paulvaneeden.com) or contact his publisher at (800) 528-0559 or (602) 252-4477.

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