11/97-Keep Digging
By Peter Lynch
So your Krugerrands haven't panned out. It's
still possible to uncover good gold-mining
companies.
Let's try this again. back in June 1995, I made my pitch for gold
in the pages of Worth. It seemed like the right time: Inflation was
showing signs of life, and world gold demand was on the rise.
Annual fabrication demand alone--for gold destined for actual
use, primarily in jewelry and the electronics industry, as opposed
to gold to be held in coins and ingots as investments--exceeded
the amount being taken out of the ground. Simply on a
supply-and-demand basis, it all seemed like a promising recipe
for gold prices and hence for gold stocks and funds.
Well, I was right about the demand side of the equation but
wrong about supply. Like most gold analysts and gold-fund
managers, to say nothing of the long-suffering goldbugs, I didn't
see some things coming. And therefore I didn't anticipate the
way the price of gold would stagnate for a while, pop nicely
higher for a while, and ultimately collapse like a central banker at
the end of a long, hard week. In mid-1995, gold traded at a spot
price of about $385 an ounce. It climbed in 1996 to $416. It
dropped nearly $100 an ounce, to $318, by early this summer,
and as I write, it's at $323.
The trend has been ugly, I know, but I think things may begin
looking up for gold--and, more important for our purposes, for
gold-mining companies. The best news is that if you buy the right
companies the commodity price doesn't have to jump for the
stocks to show a nice increase.
In the broadest sense, the problem with gold is that it is
undergoing a re-evaluation. The central banks of many countries
are wondering if gold's traditional role has any meaning in the
modern global economy. For centuries, a country's gold reserve
has been the representation of its wealth. The very definition of a
devalued currency has been one that isn't backed by gold. But in
some places the men with their hands on the levers are
weakening in their faith. Maybe the best measure of economic
strength, they're saying, is something less physical--purchasing
power in the world's markets, perhaps. Maybe gold is just a
metaphor--a metaphor that doesn't pay dividends or go up in
value. The heck with it.
I've talked with people who think this reassessment of gold is
savvy and long overdue and with people who think it's foolish,
perhaps catastrophic. It's not important to take a position here.
What's important is that in the past two years a number of central
bankers have decided they didn't particularly care whether their
vaults held gold anymore, and they sold (in some cases because
they needed to raise cash). I said I had messed up the supply
side of the scenario two years ago. That's a large part of what
went wrong: Central banks unloaded gold at an accelerated
pace.
The amount of gold dumped by the central banks wasn't
enormous--they still hold 97.6 percent of the gold they held at
the end of 1994. But that's not the point. Gold, much more so
than any other commodity, is about sentiment and psychology.
There's a sense that central banks aren't playing by the old rules.
Australia, for example, sold two-thirds of its reserves this
summer--the government said it would rather buy foreign bonds,
which at least pay some interest. Investors have seen this sea
change and have asked a pretty fair question: If banks don't want
gold, who the heck does? Gold has traditionally been regarded
as an inflation hedge, but that is dependent on the same
metaphor, the same set of assumptions. (Not to mention that
inflation has been quiescent more or less worldwide.) To some
people it has begun to appear that, as Jim Rogers said in Worth
earlier this year, gold just doesn't work anymore.
I should touch on the infamous Bre-X Minerals scandal. You
remember that: The company announced that it had found an
enormous reserve in the jungles of Indonesia. And then it
announced that there had been...a...mistake. There was no gold.
Recriminations followed, to say nothing of lawyers. A company
geologist leaped from a helicopter. The company itself has
disappeared.
In real terms, this shouldn't have mattered very much. It was
even possible to see the bad news as good news: No huge new
reserve meant less new supply to dilute demand. But investors
saw the scandal in the context of a market that had become odd
and unpredictable. They saw it as just another thing not to like
about gold. Bre-X didn't cause the collapse of gold prices and
gold stocks, but it darkened an already negative atmosphere.
So where do I get the nerve to suggest that you look into gold
stocks? I'd like to humbly point out that I was correct two years
ago about the demand side of the gold equation. Every year
since 1991, in fact, demand has outstripped what is known as
the mine and scrap supply. Last year, the gap was about 8.4
million ounces, about 2.3 times the gap in 1994. Much of the
demand comes from Asia--in particular India and China. The
economies in those countries are increasing rapidly and
producing a growing middle class. What are these people going
to do with their wealth? They tend to live a long way from a
Circuit City. Cars are still out of the question for many of them. If
Indians and Chinese can't convert their money to stuff, as
Americans so vigorously do, they're going to save it--and they
still like to do that, in part, by buying high-karat gold jewelry. A
lot of people think this demand, though it has proved
price-sensitive, provides a bottom for the market.
The supply issue is probably better under control now, too.
Beginning in 1980, when the price of gold shot up to $850,
mining companies reacted as you might expect: They explored
frantically, sunk new mines, re- opened old mines. They spared
no expense, and why should they have? If you can get $850 an
ounce, you can make a profit at almost any production cost.
Some of those mines are playing out now; they've had their eight
or ten years of production. Others are too expensive to operate
in a $330-an- ounce market. According to Gold Fields Mineral
Services, a London-based research firm, the industry-wide total
cost of getting an ounce of gold out of the ground has risen to an
average of $317--a dollar less than the recent low spot price.
Even the great mines of South Africa are finally winding down.
They've had amazing runs--100 years and more--but now the
gold isn't coming as easily. Or as cheaply: Labor costs have gone
in the opposite direction as gold prices. South Africa is not what
it used to be as a gold producer. As for central-bank sell-offs,
they probably won't be as numerous or have the same kind of
impact in the future. Investors now understand that banks can
sell. They also know there's a limit to how much they can sell.
Australia's sale a few months ago was dramatic symbolically, but
in relative terms the country never had much gold to sell. In
dumping two-thirds of its reserves, Australia put just 5.9 million
ounces of gold into circulation. The U.S., by comparison, has 44
times that much gold in reserve, 262 million ounces, and law
requires us to hold on to it. Germany, Switzerland, and France,
the next-largest holders of gold (95 million, 83 million, and 82
million ounces, respectively), aren't likely to destabilize the world
economy by emptying their vaults either.
What I'm describing is a fairly delicate balance. Demand is
healthy but price-sensitive. Supply is limited (if not in theory, then
in practice) but not so limited as to drive prices up.
This is a welcoming environment for investors? Yes, I think it
might be. That's because, first, the price of gold doesn't have to
rise for the best mining companies to produce respectable
profits. And second, if the price of gold is currently at a bottom
and does eventually rise, these companies will make huge profits.
I mentioned that the average company is now spending $317 to
get an ounce of gold out of the ground. Let's say you're
investigating a company that's a little better than average,
because of economies of scale or cheaper labor or simply
because its mines yield more gold per ton of rock. Perhaps this
company produces gold for 10 percent less than the average, or
about $285 an ounce. Even with the price of gold limping along
at $330, the company can earn good money.
There's ample proof that good companies can do well for
investors even when gold itself is a bad investment. I asked
Lipper Analytical Services to give me a list of all the gold mutual
funds that have been around for 17 years. Seventeen years ago,
of course, gold was at a peak. If you filled your dresser drawer
with Krugerrands then, at $850 an ounce, you have lost 60
percent of your money. But of the seven gold funds that have
been around that long, five show positive returns. The best,
Franklin Gold Fund I, has gained 257 percent. The next best,
Van Eck International Investors Gold Fund, is up 166 percent.
Three more funds managed to stay in the black during these dark
days for gold, and even the worst of them has done better than
gold itself.
And what if the spot price of gold actually rises? Again it
becomes clear that the best way to own gold is not to hoard
Krugerrands but to own shares in the best mining companies or
in the gold funds that invest in them. Let's say the spot price
manages a 25 percent rally: It rises to $412.50, a little below
where it was in mid-1996. Your Krugerrands are worth 25
percent more. Not bad. But the company's profits have almost
tripled. Where once it cleared $45 an ounce, it now clears
$127.50. When a company's profits jump like that, you can
imagine what happens to the stock price--and gold stocks
consistently pay modest dividends. Gold bars, obviously, don't
pay anything.
I'm going to run contrary to the general pessimism and do one
more exercise: Let's imagine that gold hits $500 an ounce. When
it comes to investing, and especially when it comes to gold, I
tend to believe that nothing is impossible, especially if it has
happened before. So gold goes to $500 an ounce. If you bought
your Krugerrands at $330, you've cleared 52 percent. You're a
genius; maybe you should start a newsletter. Our imaginary
company, however, is now clearing $215 an ounce. Profits have
nearly quintupled. (This bit of leverage, by the way, explains
something you'll notice when you look up gold stocks in the
newspaper: They trade at extraordinarily high price-to-earnings
ratios. A p/e of 50 is not considered out of line for a well-run
gold- mining company at today's gold prices.)
Peter Ward, gold-mining and precious-metals analyst at Lehman
Brothers, is among those people who think that gold is becoming
just another commodity, that more central banks would sell if
they could only find a decent price, and that, with the possible
exception of brief spikes downward, the spot price isn't likely to
go much of anywhere in the next 12 months.
Nevertheless, he's excited about a couple of mining companies
that have the right qualities to thrive in the current environment.
His favorite is Barrick Gold (NYSE: ABX; recent price,
$21.69), a Canadian firm that is the world's third-largest
producer. The central fact is this: Barrick gets gold out of the
ground for a cash cost (the actual cost of extraction) of $200 an
ounce and a total cost of $265 an ounce. Barrick is also the
industry leader in hedging: It has contracts that guarantee it a
price of $420 an ounce for much of the gold it produces over the
next three years.
Ward also likes Placer Dome (NYSE: PDG, $16.13), because
it has some of the same qualities as Barrick. It gets gold out of
the ground cheaply (a cash cost of $215 an ounce and a total
cost of $280), it has a good hedging program, and it has a clean
balance sheet. Victor Flores, senior mining analyst at Marleau,
Lemire Securities of Toronto, thinks the long-term average spot
price of gold is going to linger in a range of $350 to $385. He,
too, sees good things for Barrick Gold.
Flores also likes some medium-size companies. One is
Meridian Gold (NYSE: MDG, $4.25), formerly known as
FMG Gold. Another is Crown Resources (Nasdaq: CRRS,
$6.50), a Denver-based exploration company that is involved in
a joint venture in Washington State with Battle Mountain Gold.
Finally, Flores mentions a company in which I own shares,
Boston-based Pioneer Group (Nasdaq: PIOG, $30.50).
Pioneer is actually a money-management firm--you've probably
heard of the Pioneer Family of Funds--but it also has mining
interests. Among these is a 90 percent stake in Teberebie
Goldfields Limited in Ghana. In Flores's opinion, Pioneer is fairly
valued even without Teberebie figured in. So when you purchase
Pioneer, it's like getting a $500 million gold company for almost
nothing.
Let's return for a moment to Barrick Gold. In the spring of 1985,
you could have picked up shares in this company for about 50
cents apiece, adjusted back for splits. Gold stood at almost
exactly the same price then that it does now. By the spring of
1996, despite a miserable environment for its industry, Barrick
traded at $32 a share--it had become a 64-bagger. Even if you
didn't buy until 1990, and you're still holding on through a recent
drop, you've tripled your money and been paid a small annual
dividend for your pains.
Barrick is the kind of company that too few investors are looking
for today. It has an old-fashioned business that anyone can
understand. It's not the next big anything. All it does is
consistently make a couple hundred million dollars a year.
No company, including Barrick, is a sure thing, of course. Say
the price of gold begins to rise. The hedging contracts that are
now making Barrick so profitable could become, in the short
term, an albatross. If the spot price rose above the hedging
price, Barrick's profits would hit a ceiling, which would suddenly
make it less attractive than some rivals. But don't miss the larger
point: There are great companies in just about every industry.
You don't have to understand cutting-edge trends to identify
these companies. You don't have to have an inside position and
buy at the initial public offering. You don't even have to peg the
direction of the world's most psychologically freighted
commodity. You just need to keep your eyes and ears open and
understand what makes a company worth owning.
Peter Lynch is vice-chairman of Fidelity Management and
Research. His third investing book, Learn to Earn, was published
last year by Simon & Schuster. He writes "Investor's Edge" with
Dan Ferrara. Research assistance is provided by John Fried.
Company Index
Barrick Gold
Placer Dome
Meridian Gold
The Pioneer Group, Inc. |
