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Like an early Christmas (published 6/07/06)
Wow! The markets are giving us Christmas presents in June this year!
Let's see if I have the big picture in proper focus. The Fed talks
tough (but talking is the only thing they can do, since the essential
national housing market resembles a California mansion just before the
hillside it is built on slides down a slippery slope into a sea of mud and
muck). The fantasy investments on Wall Street feel a draft from a brief
breeze of reality, and stocks catch a long overdue case of pneumonia.
And yet somehow, the precious metals babies are also sold off in sympathy
with the bath water tossed out by Wall Street. The Optimist sees a near
certainty that inflation and world tensions will continue to get worse, so an
opportunity to buy silver and gold at temporarily reduced prices is truly
wonderful and positive news.
Let's get physical
Olivia Newton-John said it well in 1981: "Let's get physical,
physical, I wanna get physical, let's get into physical".
Although Olivia's hit song was in another context, the Optimist doesn't know
of any songs which extol the virtues of investing in paper. A simple
experiment should be sufficient to demonstrate why investing in paper is not
celebrated in song and dance. Into one hand, place a ten ounce silver
ingot or a one ounce gold or palladium coin. In the other hand, hold a
few pieces of paper. It will not take most people long to feel the difference.
Regardless of what pretty artwork may be engraved onto the paper, or what
promises are written there, the physical silver or gold clearly demonstrate
their value in a far more immediate and satisfying way than the hopes one has
for eventually getting something of value from the paper. As another
example, consider buying a new car a few years from now. Imagine
offering alternative options to pay for the purchase by placing a 100 ounce
bar of silver on one side of the table, and a pile of paper on the other
side. Even though the paper may have the same market price as the
silver, the Optimist is confident that the car dealer will have a strong
preference for the silver. It is difficult to think of any situation in
which paper would be preferred to real physical silver or gold metal.
Mining stocks are paper
For those readers who were impatiently waiting for me to get to the point,
now is the time to wake up and pay attention. Although this commentary
is likely preaching to the choir, many members of that choir continue to sing
the praises of stocks in precious metals mining companies.
Historically, that may have made sense because stocks in mining companies
were easier to hold than a possibly large weight of precious metal.
However, the Optimist thinks it likely that many investors may prefer mining
company stocks over the physical metal because of the leverage that the
mining stocks promise.
The legendary leverage of mining stocks derives from the lower costs of
the mining company. Consider, for example, a hypothetical mining
company which could produce gold at a net cost of $350 per ounce. If
the company could mine 1,000 ounces when gold was trading at $400 per ounce,
then the company would make a reasonable profit of $50,000. If the
mining costs remained fixed while the price of gold increased 25% to $500,
then the company profits would explode 200% to $150,000.Since increasing
profit is the fuel that powers rapidly rising stock prices, a 200% rise in
mining company profits would bring far more exciting returns for stock
investors than for holders of bullion.Similarly, a subsequent rise in gold by
20% to $600 would translate into a mining company profit of $250,000,
assuming mining costs stay constant.A 67% increase in mining company profits for
a 20 % increase in the price of gold is a substantial plus for the investors
in mining stocks, but it is significantly less than the 200% indicated
above.As the price of gold continues to increase, the mining company profits
also increase, but the percentage gain in stock profits, as well as the
leverage ratio, reduce substantially from the initial surge at lower prices
of gold.The table below shows the results.
Note that the table above assumes that the mining company has a fixed cost
per ounce produced.In the real world, however, gold increases in price at the
same time that inflation also accelerates, and the rising inflation adds
significant additional costs to the mining operation.The continuously
increasing costs of mining will reduce the potential profits and the hoped
for leverage that a mining company stock might otherwise offer.If one also
considers that mining companies are subject to costs (dilution of the company
stock, depletion of the reserves, high taxes, etc.) and risks
(nationalization, mining accidents, embezzlement, etc.) which would further
reduce mining company profits, then investing in physical metal bullion
becomes an obvious winning strategy.
If it isn't heavy, then it isn't metal
Some investors who agree with the desirability of investing in real
physical metal try to make the process easier by having the metal stored for
them.Numerous companies, as well as the gold and silver ETFs, are happy to
hold your metal for you and issue paper equivalents of IOUs as your claim for
the value of metal that you have on deposit there.Although that out of sight
out of mind storage process works reasonably well during good times, it would
be beyond optimistic to simply assume that the metal you have entrusted to a
company for safe keeping will always be kept safe for you.One of the few
financial certainties we have is that there will be big problems in the
future.Many of the companies which offer to store your metal for you today
may abruptly stop taking phone calls when they go out of business or when governments
confiscate their inventory in the perilous times to come.The Optimist
presents the positive perspective that there will be no need to worry about
whether or not someone else will return the metal they owe you, if you simply
keep your metal in a safe place where you can get access to it at any time
without needing permission or assistance from anyone else.
In the past, the Optimist presented charts of selected mining company
stocks in addition to charts of silver, gold, palladium, the U.S. dollar, and
a few proprietary indexes.In line with the philosophy in this commentary, the
future Optimist charts will no longer show the mining company
stocks.My optimistic view is that precious metals alone are all the mining
sector news we need to see.Cheers!
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