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
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
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
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
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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