Declining gold stocks
May 2, 2005
If you own gold stocks and follow the gold market
at all, then you are aware that the stocks declined by almost twenty
percent since the middle of March, while the gold price itself has
remained relatively unchanged. Why?
One possibility is that investors anticipate a decline
in the gold price. Gold stocks don’t always correctly indicate
coming changes in the gold price, but they are right more often
than they are wrong.
Another possibility is that gold stocks have simply
declined along with all the other stocks: the Dow Jones Industrial
Average is down nine percent since the beginning of March.
Yet another possibility is that gold stocks are down
because investors are disillusioned by the earnings from the sector.
Take Newmont, the largest gold mining company in the world, as an
example: it had marginally lower first quarter earnings than last
year, despite a ten percent rise in the dollar gold price. Why own
gold stocks if a ten percent increase in the gold price does nothing
to their earnings? Given the leverage that gold mining stocks should
have to the gold price, a ten percent increase should result in
a substantial increase in earnings.
The reason why many gold mining companies are hardly
making any more money now than they were a year ago is that the
gold price has been rising in US dollars because the US dollar has
been falling on foreign currency markets. That means if a company
is mining gold outside the United States (and not in any area where
the US dollar is the de facto currency), it may not have had any
benefit from the rise in the US dollar gold price. The gold price
in many other currencies has not risen at all.
Having said that, let me add that I don’t know
of any gold mining companies with projects exclusively in the US
that are worth owning. I own a few gold exploration companies working
in Alaska and Nevada, but no gold producers. The problem is that
the big names, like Newmont, Barrick and Placer Dome, are so geographically
diversified that they cannot be called US gold mining companies.
They may be listed on US stock exchanges, but because their operations
are scattered all over the world, the increase in the US dollar
gold price has had a marginal, if any, impact on their bottom line
Does this mean that gold stocks will continue to under-whelm
us when the US dollar gold price strengthens?
If the market were rational the answer would be yes.
Only the stock of those gold mining companies that have direct leverage
to the falling US dollar (in other words, gold mines in the US)
should see their share prices increase as the dollar falls.
However, a falling dollar not only means more dollar
revenue for gold production, it will ultimately also lead to higher
production costs. But the operating margins of gold mining companies
with direct leverage to the falling US dollar should continue to
expand for two reasons. Firstly, assuming the mine is cash flow
positive, the increase in cost is on a lower base than the increase
in revenues. Say the production cost is $300 an ounce and the gold
price is $400 an ounce. The operating margin is therefore $100 an
ounce. A ten percent increase in both revenue and cost would also
result in a ten percent increase in operating margin: 440 –
330 = 110. Secondly, the increase in revenue from a decline in the
dollar is instantaneous while the increase in costs will come more
gradually. Therefore, as long as the dollar falls faster than the
rate of inflation (the most likely scenario) the operating margins
of a US based gold mining company should increase much more rapidly
than the example above.
But the market is not rational. Most investors still
look at the US dollar gold price as “the” gold price
and when gold increases in US dollars they buy gold stocks almost
indiscriminately. Once enough investors figure out that an increase
in the US dollar gold price does not necessarily benefit all gold
mining companies, then the gold stocks as a sector could very well
under-perform the US dollar gold price.
Is this already happening? I do not think enough investors
are paying attention to the geographical location of mining operations
and the impact of currency exchange rates yet. So I suspect that
the lackluster performance of gold stocks at the moment has more
to do with the general malaise in the market.
We are at a precarious point in the economy and the
financial markets. I have written much about where I think the dollar,
the gold price and the economy is going. I don’t see anything
to change that view. Rather, I see current events as confirming
that we are on track to see a major decline in US economic growth,
further weakening of the dollar and, as a result, much higher US
dollar gold prices.
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
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