The first half of 2016 was definitely good for those who invested in precious metals. However, great results of gold and silver are nothing to compare to the equity of miners. Since the bottom of 18 January index of small miners (with a capitalisation of 5 bn USD or below) nearly tripled.
I have a lot of reasons to be glad because of this. My ‘Intelligent Investor’ students were given GDXJ buy recommendation when its price was 19 USD. Today it is 49 USD. After such a great race to the top should we start looking for cheaper assets?
Before I analyse this question I want to highlight that the equity price of mining companies is much more volatile than the precious metals themselves. In the past, when gold price gained 10% the equity of gold producers tripled that yield. This is why we call miners the ‘gold on steroids’. Why is that?
Let us say that the price of gold is equal to 1200 USD/oz and total cost of production for company ‘X’ equals 900 USD/oz. For each ounce of gold, this company earns 300 USD. Now price of gold increased to 1500 USD/oz, a 25% increase. This means that the profit of company ‘X’ is now 600 USD/oz, this is a 100% increase. The leverage makes miners so attractive but it is a double-edged sword.
The profit of miners’ equity in the last 6 months is impressive. Looking at the bigger picture miners are still cheap.
In 2011 when gold was sold at 1950 USD/oz, silver at 50 USD/oz, GDXJ (ETF of small mining companies) was worth 175 USD. Next, thanks to a 5-year slump in metals, 90% of their price was wiped out. This is when notoriety of miners put them very low on the ladder of investors’ choices.
Recent highs are, in my opinion, only the beginning of a longer bull market. The spectacular race of the first half of the year, GDXJ price is equivalent to only 27% of 2011. The potential for gains is still very big.
We are left now to wonder what level the share price of miners can reach given that the price of precious metals could return to 2011 highs. Would it be 175 USD in case of GDXJ?
In my opinion, it will be much better. The reason is simple. Between 2001 and 2011 the price of gold climbed continuously for 10 years straight. In circumstances like these, managers of mining companies don’t care about their costs. If the price of gold is growing year after year, you can invest more and increase the production notwithstanding of the costs. This mentality resulted in production being very costly. In 2012 the all in sustaining cost (AISC) per ounce was 1680 USD.
Last 5 years of slump in precious metals made the majority of companies postpone their expensive developments. They focused on economically viable projects and this drastically decreased the cost of production.
Today the AISC revolves around 880 USD for GDXJ and 895 USD for GDX (over 5 bn USD capitalisation).
Reduction of costs is truly remarkable and we can safely assume that with gold and silver price similar to 2011 levels companies have a chance for even bigger profits and this will reflect in their share price.
Another argument for an investment in mining companies is their undervaluation vis-à-vis gold itself.
To check relation between gold producers and the metal I prepared a chart:
What you see is a quotient of the HUI value, representing gold miners, divided by the price of gold. As you can see the situation is similar to 2009 (bottom of the crash in stocks) and marginally higher than 2001 bottom when the real boom in precious metals started.
Putting aside lower production cost, miners have at least three times better prospect than gold itself. Here we have to touch a very important issue. Gold is a good insurance policy. It gives us safeguards in case of whole system crashing and as one of few assets, it’s free from the burden of debt. Simply – superb protection of our capital irrespective of any turmoil in the monetary system.
Gold miners are not that great. During emergencies - for example, a bankruptcy of brokerage companies – trade of stocks could be suspended for 6-9 months. More tax oppressive states would be ready to increase fees and charges on natural resources. We saw that scenario materialising for the biggest silver producer KGHM. The more governments are bordering bankruptcy the bigger threat of their sudden moves. The GDXJ index consists of over 80% of companies from Canada and Australia, countries with very high legal standards but we cannot rule out politicians ‘trying to help’ with their policies.
I believe the possible earnings from the investment in mining companies outmatch the risk. I have to point out the fact of a strong climb recently. If the asset price rises 185% in just half a year, as an investor you have to be aware that should metals crash, miners could lose 65% of their worth. Unless you are mentally ready for such volatility you shouldn’t buy. Additionally, mining companies raced to the top very swiftly both in terms of USD and vis-à-vis their underlying metal. In other words, we could use some correction. “Small” correction in terms of miners means 20-25% cut.
Investment in mining companies is a good example of a philosophy I practice. If I see a big potential in certain assets, I just buy it. I understand that cheap asset may get even cheaper but it is very hard to ‘catch’ the bottom and in case you do, luck more than any of the thousand analyses had something to do with it. The market always calibrates variations from the average. When something is cheap, investors are going to get interested in this after some time, capital will migrate from expensive assets towards cheap ones rewarding patient investors.
IF high volatility does not scare you off and you still want to put your money in miners you have two cheap ETFs. I already mentioned couple times GDXJ and similar fund from Eric Sprott with SGDJ ticker. Both NYSE – available.
Some of you wonder why I focus so much on small companies. The ‘small’ adjective is far from the real value of those companies – SGDJ average firm has a capitalisation of 2 bn USD and the smallest one is equal to over 300 million USD. Those ETFs are not investing in any shell companies being connected to gold only through their name. What is the crucial factor for me is that practically those companies have no net debt. This delivers a financial buffer in the situation of sudden nose dive of metals to January levels. It is unlikely but we cannot completely disregard this eventuality. Small companies are much cheaper than big ones also when comparing their P/E or P/BV ratios.
At the end, I want to stress again that after such strong surge we could use a correction. Even if this is not going to happen in a month we have to account for that in the future. Unless you can cope with a temporary loss of 30% you should rather invest in physical metal. Profit may not be equally spectacular but you will sleep way better.