How to make money in gold miners

Humour me while I make a point. Reuters carried this news item way back in 2013: Anglo American Platinum (the world’s biggest platinum producer) announced that it would mothball two South African mines, sell another, and cut 14,000 jobs.

The South African government was extremely perturbed. After all, it would involve cutting jobs in an economy already battling high unemployment. For workers who faced the dire prospect of being retrenched, the news came like a hammer blow.

Traders in the metal were thrilled; the stock price rallied. The reduction in supply would provide the necessary tailwind for the price of the metal. Shareholders shared their enthusiasm. The previous year’s strikes had adversely hit production and the company’s bottom line. Soaring labour and power costs and depressed metal prices translated into weak profitability.

Labour unions vowed to fight this by striking in all the company’s operations across the country. That is a classic example as to why investing in mining stocks is fraught with uncertainty. Let me explain.

When it comes to mining stocks, there are multiple factors that tend to play havoc with the stock price; much more than what regular businesses face. There are macroeconomic factors to look at, such as an economic slowdown or a boom. Commodity prices. Labour unrest and strikes. The wrath of human right activists and environmentalists.

Also, once discovered it takes a few years for the company to start producing that metal. For example, the Oyu Tolgoi mine in the South Gobi desert in Mongolia, was discovered in 2001 proving geologists right who believed that the green-stained surface rocks were clues to deeper treasures. But mine construction began many years later. So actual production right from discovery, can be a very long wait.

Add interference from the government of the country in which they are mining, and the brew turns positively potent. Let me throw in some examples.

Years ago, a law was proposed in Guatemala that would allow the government to acquire as much as 40 per cent of the stake in any new mining project. That was quickly shot down.

Churchill Mining claimed that the Indonesian government wrongfully cancelled the company’s coal-mining licenses and filed a legal suit at the International Centre for Settlement of Investment Disputes in 2013, claiming $1.3 billion requital for its investment in the project. Last year, it lost that battle.

Argentina ruled that no mining can take place on the country’s glaciers. Barrick Gold decided to fight it. Last year, Argentina's Supreme Court upheld the country's glacier protection law.

Now that you are sufficiently cautioned, and if you possess the stomach for a rocky ride and the fortitude to break away from the herd, it could be a rewarding investment. Why?

Mining apologists are quick to point out that despite being beaten down mercilessly, these stocks eventually rebound. The supply of precious metals is relatively inelastic. Demand, over the long term, will not slow down and the diminishing number of new reserves will fail to compensate for dying mines. Reserves are, by and large, being depleted faster than they can be discovered.

Mining is an extremely capital-intensive business, be it Capex or Opex. Capital Expenditure is associated with exploration, as well as the development and construction of mines. Then comes the added infrastructure costs such as roads or power generating stations to facilitate extraction and transportation of the ore. Operational Expenditure would cover expenses such as wages, camp costs for employees, fuel, etc.

The supply of precious metals is relatively inelastic. Demand, over the long term, will not slow down and the diminishing number of new reserves will fail to compensate for dying mines.

In the light of the above, the current low interest rate across the globe is an added tailwind. As was recently reported, Newmont managed to negotiate a lowered interest rate of 2.25 per cent on its debt while Barrick managed to lower its debt by 17 per cent from the end of Q4 2019. Other gold miners too are clearing their debt, a good move in an industry once known for fiscal irresponsibility.

Mining stocks act as a proxy for the price of the underlying metal, as well as a leveraged play. This is because the value of the company reflects various other issues: size of the mines, tapped potential, untapped potential, effective management, growing production volume, expanded margins, optimisation of capital, and so on and so forth.

For instance, let us assume gold stocks offered a 3-to-1 leverage. What this means is that when the price of the metal goes up by, say, 1 per cent, typically the share price could go up by 3 per cent. On the flip side, it also means that it could fall harder on the way down.

Kristoffer Inton, director of equity research, basic materials, for Morningstar, explains:

“There are a lot of factors that impact the price of a mining stock, including financial leverage and capital spending,” Inton says.

“Operating leverage comes from the fact that the company mines gold for cheaper than its current price. If it costs $700 to mine an ounce of gold and the price goes from $1000 to $1500, the profit per ounce will go from $300 per ounce to $800 per ounce.

“In addition to the operating and financial leverage that investors get in mining stocks vs. the metal, there’s also operational upside. Say the gold price does not move for a year. A miner’s stock could still go up if it is able to drive its production costs lower or boost production volumes out of a mine.”

But to go back to what I earlier said, even if the price of gold goes through the roof, but the company has to shut down a mine or encounters some other issues, the stock price could get beaten down. That risk comes with the terrain. The Midas touch is not a given.