In
the past paper, we talked about the vast performance disparity among metals,
and offered our take on which metals to buy (Gold, Zinc) and which to avoid
(Copper) going forward.
Not
all metals are created equal - metals review:
http://new.goldmau.com/article.php?id=224
In
this paper, we will provide the rationale behind mining equity investment,
how to choose between metals futures or metals miners, and conclude with
which mining sectors to buy and which to avoid.
Rationale
behind mining equity investment:
The
key to investing in mining equity is leverage. Suppose a copper miner's
break-even point is 70 cents a pound. The company wouldn't have been worth
much when copper was 70 cents as it couldn't turn a profit.
At a
$1.00 copper price, however, the company will make 30 cents per pound of copper
produced. And at $4.00 copper, its earnings will go up eleven times over to
$3.30 cash earnings per pound.
Mining
vs direct commodity investment
So
the theory is that if copper prices go up 4-fold, copper mining stocks would
go up 11-fold. In fact, this is pretty much what has happened since 2002. As
copper went from 70 cents to $4.00, giant copper miners such as BHP went from
$8 to $90.
BHP
If
BHP's case were universal to miners, would all investors jump on the mining
bandwagon to take advantage of booming commodity prices?
Only
if the case is so clear cut; indeed, if we look at Oil and Gold mining
equities, a different picture emerges.
Crude
went from $22/barrel post-Iraq War to now over $130/barrel, yet Exxon Mobil
has merely doubled from $40 to $80.
Exxon Mobil:
Gold
went from $250/oz in 2001 to $970/oz today, yet Barrick, world's largest gold
miner, has merely tripled from $15 to $45.
Barrick Gold:
So
why have gold miners and oil companies underperformed relative to gold and
oil respectively? We can
only speculate:
- Equities seldom trade at fair value: investing
would be easy if all companies were to trade at fair value. The sentiment pendulum swings to from fear to
greed.
- Equity investors are different from commodities
futures investors. Mining investors seek earnings, while commodity
investors are speculating on future prices.
- Gold mining companies have "optionality
value", which means their resource of gold in the ground yet to be
mined. Such a concept is foreign to many earnings-focused money
managers.
- Mining is a risky business: accidents,
nationalization, appropriation, labor strikes, tectonic movements and
cost overruns are common.
- Rock or Jewel? Metals prices are volatile, and
stock valuations are forward-looking. What future metal price does an
analyst use to forecast the future earnings of a miner?
- Mining is a burning stick: Miners need to
constantly develop and acquire new reserves and properties. It is a
costly and lengthy process to develop new deposits, which makes a valuation
so much tougher to assign.
The
point here is that the success of BHP, while not unique, is not the standard
throughout the entire mining universe.
Junior
Mining Sector in the dog house
If
one looks for the speculative extreme in mining equities, the junior mining
sector, a dire case could be made against investing in mining. The sector has
utterly failed to live up to the expectations of investors. Junior resource
equities are supposed to provide greater leverage than major mining
producers. However, the nature of the business requires a constant injection
of capital to discover and develop deposits before the eventual handsome
operating cashflow is realized. This model is vulnerable to sudden and
occasional credit/liquidity crunches like the one we're experiencing now.
The
Toronto Stock Exchange Ventures Index, which is a proxy to junior stocks,
merely doubled from the bottom of 1,000 to trade at 2,300.
Cash
is king in uncertain times, and we like cash in gold.
We
live in uncertain times. GSE's (Freddie Mac and Fannie Mae) are on life
support with the Federal Reserve Bank of New York. All together, GSE's back $5
trillion US of low yield (5%-7%) assets. You have to wonder what the global
asset managers holding those debts are going to do.
Real
estate is cooling off worldwide now, from Singapore
and Thailand to Vancouver. I am not
seeing, nor do I think that housing will crash, though. The Asians are
running in a mad panic over inflation and yet we have interest rates at 2-3%
from Hong Kong to Singapore,
Thailand to Japan, Korea
to Taiwan.
On top of that, we have global equity indices rotting with most down by
double-digit percentages, with some, such as Vietnam's down some 70% this
year. The point is there's nothing stronger to invest in at the moment than
gold. We are now seeing a nice gold run as interest rates begin to trend up.
Conclusion:
This
four-page paper is no means exhaustive; I hope, however, that it has served
as a high-level overview on mining. The Barrick and junior resource camp may
be glad to know 10-bagger success does happen to miners, as BHP demonstrated.
The BHP camp might take caution in that mining isn't all risk-free glorious
business.
We
didn't have the foresight to put all our money in BHP, and instead we focused
on juniors exploring for gold in exotic locations such as Africa.
Being a Feng Shui student, I learn that every dog has its day, and perhaps
finally it's time for the past dogs of Barrick and other gold miners to
shine?
By :
John Lee, CFA
Goldmau.com
John Lee is a portfolio manager at
Mau Capital Management. He is a
CFA charter holder and has degrees in Economics and Engineering from Rice University.
He previously studied under Mr. James Turk, a renowned authority
on the gold market, and is specialized in investing in junior gold and
resource companies. Mr. Lee's articles are frequently cited at major resource
websites and a esteemed speaker at several major resource conferences.
Please visit www.GoldMau
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