South African gold stocks, anyone?
November 14 2003
You may recall, or if not, you may have heard, that during
the gold bull market of the late 1970s many South African gold mining
companies were very kind to investors, paying annual dividends almost
equal to what their shares were trading for earlier that decade. Some
think it may happen again; but, I am sorry to say, it won’t.
Until 1971, the price of gold was arbitrarily fixed against
the US dollar, and set at $35 an ounce. When Nixon closed the gold window
and the gold price was allowed to float, it had to increase to account
for inflation of the US Dollar that was never accounted for in a fixed
gold price: an ounce of gold was certainly worth a lot more than thirty-five
1971-dollars. The market had to figure out, over time, just how many current
dollars an ounce of gold was worth.
When the gold price increased from $35 an ounce in 1971
to $700 an ounce in 1980, its price also increased in all the currencies
that were fixed against the dollar.
The South African Rand was one such currency, and it remained
pegged against the dollar for most of the 1970s. This increase in the
Rand-gold price was a windfall for the South African gold mining industry,
which, at the time, was the source of about 75% of the world’s gold
production. The result was an increase in the operating margins of South
African gold mining companies and the humungous cash flows were dutifully
paid out to shareholders, hence the large dividends.
However, this twenty-fold increase in the gold price over
the course of ten years played havoc on South Africa’s small economy.
South Africa’s Central Bank Reserves increased more than five-fold
just between 1978 and 1980. While the Rand-Dollar exchange rate remained
fixed, the real, effective Rand exchange rate with the country’s
major trading partners increased almost 30% from 1978 to 1981. So while
the South African gold mining industry was minting coin, companies in
the manufacturing sector, especially those with export contracts, were
In an attempt to deal with the volatility of its currency,
the South African Government introduced a dual currency system and went
as far as gradually allowing the Rand to seek its own trading range after
1979, albeit under heavy scrutiny and much intervention.
This time around the gold price is not trying to catch
up with more than two decades’ worth of monetary inflation. Rather,
the increase in the gold price is a result of a declining Dollar, which
in turn is merely a correction of an artificial Dollar-bull market that
developed during the 90s. Also, unlike the 70s, when many currencies were
fixed against the Dollar, most currencies today are free floating.
So while a lot of people are talking about the gold price
and its correlation to the US Dollar, I don’t think many people
understand that what we are facing is not so much a bull market in gold,
but a bear market in the Dollar. This means that while the Dollar-gold
price will increase, the gold price may not increase as much, if at all,
in other currencies.
It’s true that South Africa no longer produces 75%
of the world’s gold, but minerals still account for almost 30% of
South African exports, of which gold constitutes about half, so its economy
is still very sensitive to the price of gold. It is very likely, then,
that the Rand will continue to appreciate against the Dollar as the Dollar-gold
price continues to increase. The implication is that the Rand-gold price
is unlikely to increase as much as the Dollar-gold price.
The Dollar will not only decline against other currencies,
but also against gold, platinum, nickel, etc. South Africa exports many
of these commodities and therefore the Rand is likely to appreciate more
against the Dollar than many other currencies. The ultimate Rand-Dollar
exchange rate will depend on the relative upward pressure from a declining
Dollar and the downward pressure from monetary inflation of the Rand.
Ultimately the full benefit of a higher Dollar-gold price will not show
up in the operating margins of the South African gold mining sector, as
it did in the 70s, because much of it will be lost in the exchange rate
adjustment between the Dollar and the Rand. South African gold stocks
therefore do not offer the same upside potential as they did in the 70s,
but they still come with a good portion of political and social risk.
I think I’ll pass.
Investors will get maximum benefit from the increase in
the Dollar-gold price by investing in gold mining companies whose portfolios
are exclusively US based, as these will reap the full benefit of a declining
Dollar. Sadly, there aren’t too many of those.
Another way to go, for those with a speculating budget,
is to invest in junior exploration companies that are exploring in Nevada
and Alaska. Alternatively, play it safe by owning physical gold.
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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