I’m no gold bug, but I’m looking at gold miners

Cards on the table: I’m not a gold guy. It pays no income. In the long run income makes up 97% of investment returns. Now, how about investing in gold miners?

Cards on the table: I’m not a gold guy.

I don’t own gold. I’ve never owned it. And I’ve had one or two heated debates about the merits of gold investing down the pub.

I don’t think it’s a good hedge for inflation… I don’t think inflation is coming… and I don’t think it’s a good “insurance” for your portfolio. It pays no income and in the long run, income makes up 97% of investment returns.

Glad that’s off my chest!

Now… how about investing in gold miners?

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A leveraged bet on gold

The first thing to say is that investing in gold miners is very different to investing in gold bullion. Gold bullion is an inert lump of metal which costs money to store and insure. Gold miners are businesses like any other. They generate cash and pay out dividends to their shareholders.

The second thing to say is that gold miners are a highly risky investment. The price of gold is itself highly volatile. It shot up by 600% or more in the ten years before 2011. Since then, it dropped almost 40% of its value.

Gold miners are even more volatile than gold. That’s because they’re a leveraged play on the gold price. In other words, a small change in the gold price leads to a big change in the value of gold miners.

Let’s say the gold spot price is $1,200/oz and a gold miner’s costs are $1,000/oz. The gold miner generates $100 of profit from every ounce of gold it sells at $1,200.

Now let’s say the price of gold goes up to $1,500, a 25% increase. Now the gold miner makes $500 in profit from every ounce. So a 25% increase in the gold price translates into a 400% increase in profits for the miner.

The same thing applies on the way down. A few years ago the gold miners capitalised on high and rising gold prices by opening new mines. These new mines had much higher costs than the old ones. But they were profitable all the same because the gold price was high.

You know what happened next – the fall in the gold price completely obliterated profit margins at those mines, and the entire gold mining sector fell on some very hard times.

Check it out for yourself – here’s a chart showing the Market Vectors Gold Miners ETF (in blue) compared to the SPDR Gold trust, an ETF which tracks the gold price (in brown).

 

GDX US Equity (Market Vectors Go

Pretty racy, right? Investors in miners saw bigger returns early on, when their profit margins were expanding. Then miners over-invested in new supply and when the gold price started to fall, their share prices got hammered.

And if that’s not racy enough for you, you should see how some individual mid-cap miners fared in that period. Here’s the chart for St Barbara (ASX: SBM), an Aussie miner which came within the skin of its teeth of going bankrupt in 2015. If you invested around the start of 2015 you could have made ten times your money.

 

SBM AU Equity (St Barbara Ltd)

I know, hindsight is 20/20. And well done to all investors who bought SBM for pennies last year. So what makes me think there’s still an opportunity in miners?

It’s all about something called “the capital cycle”. For certain types of stocks, the capital cycle shows you when you should be buying, when you should be selling, and how to spot the turning points.

It’s a meaty topic – worthy of an entire email. So that’s what I’m going to write about tomorrow. Until then…

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