John,
I don't pretend to understand currency exchange rates well. Some of that stuff is downright counterintuitive. One source for the opinion I expressed is the commentaries of Paul van Eeden. There have been various opinions expressed on these boards about his skills as a commentator, and sometimes those opinions were obviously not based on what he had been writing recently. He has some free commentaries on his website (www.paulvaneeden.com) that do not require a subscription or password to access. Assuming that reposting one of those free commentaries here constitutes "fair use" and that he would not object since he's put it in the public domain already anyway, here's one of his commentaries from Dec. 2003 that makes the point in somewhat more detail that I made. See what you think (by the way, he has amplified, modified, or qualified his opinion on some things over the time I've been reading him, so you might want to look at some of the more recent commentaries too):
Gold and gold stocks
December 12, 2003
Last week I commented that even though I am confident gold will exceed $1,000 an ounce in the not-too-distant future, I also think many investors are going to be disappointed with the performance of their gold stock portfolios. Not surprisingly, I got several emails asking for a clarification of that statement, which is what this week's column is about.
Just so that we can start on the same page, the gold price, in my opinion, is going to increase in US dollars because the dollar will continue to decline. As the dollar gets weaker on foreign exchange markets it loses buying power relative to other currencies. A loss of relative buying power makes everything that we buy on global markets more expensive in dollars relative to other currencies.
Although gold is quoted in US dollars, it is not unique to the United States. In fact, most gold is mined and owned outside the United States. The US may well have the largest market for gold derivatives but most physical gold is traded outside the US.
While the gold price is increasing in US dollars, it may not necessarily be increasing in other currencies. Take a look at the following chart [not reposted here] that shows the gold price in US dollars, South African rands and Australian dollars. South Africa, the United States and Australia are the three largest gold producing countries in the world. As you can see the gold price in these currencies has acted quite differently over the past two years. It has been flat in Australian dollars, down twenty-two percent in South African rands and up forty-five percent in US dollars.
Gold stocks give investors leverage to the gold price because there is a cost associated with producing gold. As an example, if a gold mining company has a twenty percent cash operating margin and the gold price increases by twenty percent, then the operating cash flow of the company doubles.
Because mining is a depleting business, mining companies should not be valued on a price to earnings basis. The value of a mining company depends on the net asset value of the future cash flow of its operations. If we go back to our example, and assume that a twenty percent increase in the gold price lead to a hundred percent increase in the cash flow of a mining company, then that mining company's net asset value would also have doubled and the company would be fundamentally worth twice as much. That's the benefit of owning gold mining companies when the gold price increases.
There are other forms of leverage that also come into play. A company's mineral resources may be uneconomical at low gold prices but as the gold price increases some of the resources could be reclassified to the reserve category since it becomes economically viable to mine them. This is particularly true of some South African mining companies that, in addition to having low operating margins (high leverage), typically have large gold resources that become more economical at higher gold prices.
Gold mining shares also have an "option" value due to the leverage they have on the gold price. This option value is very volatile but can successfully be quantified using the Black-Scholes option-pricing model. Gold share prices are generally quite accurately priced based on the net asset value of the operations plus the option value on gold that the shares represent.
Even though most investors never pay much attention to mundane things like operating margins, net asset values, and option values, these are ultimately what determine share prices over the long term.
Although gold stocks have been rising in tandem with the US dollar gold price, the fact that the gold price in other gold producing countries has not kept pace implies that non-US operations will not necessarily see increases in operating cash flows and earnings. While this may not strike some investors as important, it is. It is the reason why gold shares are likely to disappoint investors those who disregard fundamental value.
Realize that non-US based gold operations will not benefit from the increase in the US dollar gold price and that this, in turn, will lead to selling that will cap the increase in gold mining company shares, even if the majority of investors are buying out of emotion, ignorance and greed. Ultimately if the discrepancy between value and price of gold mining shares increases sufficiently, it will set up an arbitrage whereby one could short the stocks and go long physical gold. I can see that happening as the gold price in US dollars continues to increase without a concomitant increase in the gold price in other producing countries.
Because the gold price is increasing predominantly due to a decline in the US dollar, it implies that only gold mining operations located in the United States will reap the full benefit of the increase in the gold price. Most mining companies, however, have diversified geographically and among the major gold producers there aren't any that have predominantly US based production. Even companies like Barrick and Newmont, that were built on Nevada production, now produce a significant amount of their gold elsewhere. It's almost impossible to find good, solid companies with predominantly US based gold production.
The perceived bull market in gold, which in reality is only a bear market in the dollar, is drawing a lot of capital into the sector. As time goes on this capital will seek more and more exposure to US based gold assets. Unlike producing gold mining companies that may ultimately not receive the benefit of a declining dollar, exploration companies in Nevada and Alaska will benefit from an increase in the demand for projects in those two regions and, if they happen to find an economic deposit, benefit from the full impact of the declining dollar. Thus, investing in exploration companies with significant exposure to Nevada and Alaska is, in my opinion, the best way to gain the most leverage from the current increase in the US dollar gold price.
Paul van Eeden |
