Tuesday, June 1, 2010

The case for gold miners

The reason why I like gold miners is really simple: When gold goes up, the companies profits multiply a lot faster than the price of gold. Here is an example:

Let's assume a hypothetical gold miner "A" can extract gold from ground with "cash cost" $600 per troy ounce of gold. In addition, let's assume that all other costs related to the ongoing mining operations (depreciation/amortization, financing costs etc.) are $200/oz.

With gold price $1200/oz the company makes profit of $400 per ounce.
If gold price changes 10% in this hypothetical case (i.e $120, up to $1320 or down to $1080) the profit changes 30% (i.e $400 plus/minus $120).

No wonder many prominent hedge fund managers are long on gold miners. So am I, but not as much long yet as I will be. The reason is that the mining stocks take as much beating on bear markets as any other sector or even more. You can check yourself what happened to gold miners between 2008 and 2009.

Currently I am confortable holding two large caps that are unhedged (i.e. do not have significant derivative positions that fix the price of gold that they are selling in future). What I just explained above does not apply to those miners that have large hedge books because they will not benefit from the raising gold prices. On the other hand they don't suffer if the price falls significantly.

Newmont Mining

Barrick Gold

It has been a while when I last took a deep dive into these companies, but here is what was my rationale behind taking a position in these companies.
  • They are large, have several big and profitable gold mines.
  • Most of the mines are located in politically relatively safe areas.
  • Newmont does not have hedge book, Barrick may have still a small one (but not significant in my opinion anymore)
  • They have huge reserves (especially  under "proven & probable")
  • Manageable debt levels
  • No preferred stock outstanding (I hate the concept of someone taking guaranteed cuts of profit before common stock)
  • They pay dividend, although still small compared to some other sectors
  • They look fairly priced compared to their peers, but not necessarily compared to other sectors. Newmont P/E is 16,3 (source: Google Finance) while you get many utilities, telecom and pharma stocks with P/E around 8-12. However, it's all about _future_ profits. Not 2009 or 2010 estimated profits. Barrick 2009 P/E was negative due to unwinding of their hedge books.

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