Written by Jeff Nielson Thursday, 28 February 2013 14:44
Parts I and II of this series presented an overview of the precious metals mining sector. There it was noted that these companies have been (in the most neutral terminology possible) chronically undervalued in our markets.
The basic business model of these miners (and all commodity-producers) was described/explained. Specifically, it was demonstrated that over time all such producers must “leverage” the price of the commodity they produce – as a basic proposition of arithmetic.
However, despite being in the best-performing commodity sector for the past 12 years, and despite the superlative fundamentals for precious metals going forward; as the saying goes, all gold- and silver-miners “are not created equal.” Notably, there is a dramatic schism between the large-cap corporations in this sector (which tend to attract the most investor dollars and attention) and the smaller producers.
To understand the night-and-day difference between these companies, it’s best to begin by looking at the typical large-cap business model with respect to precious metals miners. As with large corporations in general, their philosophy is the epitome of simplicity – in other words utterly simplistic. Bigger is better.
In a world populated by small corporations, and blessed with abundant resources; this simplistic mantra was in fact a general economic truism…about a hundred years ago. In today’s world of scarce resources, already over-populated with mega-corporations; it is a dinosaur-strategy, assuring one’s path to extinction.
While this observation is appropriate to most of the corporate world, it is especially easy to illustrate the truth of this (modern) principle by examining precious metals mining. Look at every large gold mining company on the planet, and one will see the clear illustration of a strategic decision by management: the choice to operate a (relatively) small number of mega-mines, versus choosing instead to produce gold from a larger number of smaller mines.
At a very elementary level, this strategy may seem to represent wisdom. The simplistic corporate mantra is that larger operations must be “more efficient” than smaller ones. While this assertion is not necessarily true in general, it is patently untrue with respect to precious metals mining (and most forms of mining).
In a world of diminishing resources, resource-scarcity necessarily implies two realities in mining. The number of (undeveloped) “large deposits” in the world is steadily declining, and the “grades” (i.e. richness) of the ore is also steadily declining. This means extracting/crushing/refining more and more tons of ore to get less and less ounces of gold.
From an environmental standpoint, this is an appalling dynamic. To begin with, the amount of environmental disruption/devastation which results from mining operations rises exponentially with the size of the mine. One large mine (typically) doesn’t produce an equal amount of “pollution” to four mines, ¼ its size; but often two or three times that quantity.
Yet even from the standpoint of corporate efficiency this is clearly an inept if not suicidal strategy. In our world of scarce resources, nowhere is this reality more apparent (and expensive) than with respect to energy. At best (i.e. producing high-grade ore from efficient mines), mining companies represent a highly energy-intensive form of industry.
Deliberately choosing to produce gold from deposits with rapidly declining grades, in an economic paradigm of soaring energy costs, in an energy-intensive industry is nothing less than a recipe for destroying one’s own profit margins. Out of desperation, the large-cap gold miners have turned to polymetallic deposits for their jumbo mines, bolstering their sagging bottom-lines by using the “credits” from these other metals to offset soaring production (energy) costs.
Written by Jeff Nielson Sunday, 24 February 2013 16:19
Part I of this three-part series dealt mainly with the general. It identified the basic premise of successful investing (“buy low/sell high”), and then explained both empirically and as a study in psychology how/why most investors violate this Golden Rule with their investing.
Readers were introduced to the Contrarian paradigm of investing. It was then shown how adopting this Contrarian perspective offered investors the only realistic possibility of buying low and selling high – on a potentially consistent basis.
The first part of this series then concluded by explaining what makes gold and silver mining companies a Contrarian’s Dream: a “low tide” sector which is currently bereft of any investment capital; yet despite the un-loved status of this sector it has a 12-year bull market behind it.
The obvious inference here is that if a sector at “low tide” can have a 12-year rising trend behind it; imagine where it will go when the tide finally comes in. Emphasizing this premise; Part II will illustrate how/why precious metals and precious metals miners have the most-favorable fundamentals of any sector…going forward.
There are far too many bullish fundamentals backing gold and silver themselves to merely list them all. Indeed, summarizing only the reasons why precious metals “must rise” in price over the long term is beyond the scope of this piece. However, readers interested in such analysis have plenty of past commentaries from which to choose, beginning with The Three Legs of the Precious Metals Bull.
It will full occupy the space available for this analysis just to explain why gold and silver miners must leverage those gains in bullion prices over the longer term.
When one speaks of any commodity-producer “leveraging the gains” in price for the commodity they produce (over time); this notion is not a mere suggestion. It’s not a “theory.” It’s not even merely “conventional wisdom.”
This is simple arithmetic, and so (just as 2 + 2 = 4) it must be true. An easy, hypothetical example demonstrates this concept in tautological terms.
An investor enters the market with a specific quantity of capital to invest. The investor wishes to position his capital in the precious metals sector; however he is torn between investing in bullion or the miners, so he puts half into each. For simplicity, I will use a starting price of $500/oz per gold; however the principle is true with respect to any numerical values.
Making things even simpler, there is only one gold-miner in which investors can purchase shares; and it costs this miner $400/oz for each oz of gold it digs out of the ground and then processes.
The investor is successful. Gold moves from $500 to $1,000/oz. Now let’s see how this price-change has impacted this hypothetical portfolio. The effect of the rise in price on this investor’s bullion holding is simple. With the price moving from $500 to $1,000, he has doubled his money. However, the picture is much different when he looks at his mining investment.
With the cost to produce each ounce of gold being $400/oz; at $500/oz the miner was making $100 (or a 25% margin) on each ounce of gold produced. Not too shabby, but nothing to get excited about…yet.
With the price of gold at $1000/oz; this same mining company is now making $600 profit on each ounce of gold produced, as its profit-margin soars from 25% to 150%. The investor’s bullion has doubled in value, however the mining company in which he holds shares has become six times as profitable.