You see, people tend to either love gold or hate it… and I’m a hater. But I have to admit, there’s a good case to be made for investing in gold stocks right now.
As ever with gold miners it’s a risky bet, so proceed at your peril. But it’s got my attention. Here’s why I’m nosing around mid-cap miners this week.
Not for widows and orphans
In the piece yesterday I quickly explained the economics of the gold mining industry:
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 $200 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 150% increase in profits for the miner.
The same thing applies on the way down, too. 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.
So that’s the backdrop. Today I want to talk about something called “the capital cycle”, and what it means for gold miners today.
How booms turn to bust
The capital cycle describes how industries boom and bust in the long run.
It’s a supply side theory of the market. It describes how the behaviour of companies causes booms and busts, rather than the behaviour of consumers. And it’s all about investment.
First part of the theory says that when there’s an upturn in the market, companies will tend to over-invest. That’s because they’re more fixated on the demand side of the equation than the supply side.
So they get caught out. They’re slow to figure out that profits might be temporarily high, but those big profits induce everybody to invest in new supply. That “second order effect” pushes prices back down. To make matters worse investment bankers are attracted to booming industries like vultures. Their entire raison d’etre is to provide finance. So they’ll pitch big ambitious projects of dubious merit.
That’s the first part of the theory – let’s call it the upswing. The downswing happens after all that extra production appears in the market. Naturally, it pushes prices back down. Then all the ambitious, optimistic or downright idiotic investments made during the upswing go bust. You’ve probably heard Warren Buffet’s line about this: when the tide goes out, we see who’s been swimming naked.
In the long run, the supply crunch sows the seeds for the next upswing… And the cycle continues.
I’m going to show the same chart I showed yesterday, which shows the Market Vectors Gold Miner Index relative to the SPDR Gold ETF, which tracks the gold price. It’s not hard to spot the “upswing” and “downswing”, is it?
Capital cycle theory describes certain industries pretty neatly – commodities in general, and gold in particular. So where in the capital cycle are the gold miners?
The gold miners have been dreadfully managed for the last ten years. At the top of the boom they were far too optimistic and ambitious, just like the capital cycle predicts.
For example, the cost of mining an ounce of gold in the year 2000 was $200. But by 2012, when the orgy of investment was really swinging, costs had risen to $1200/oz. Even when gold was touching its all time high of $1800/oz their cash flows were negative on average, because they were ploughing so much money into new production.
The upshot of all this is that we appear to be near the bottom of the capital cycle for gold miners. Mines have been shut. Costs have been cut. Some have gone out of business. According to Thomson Reuters GFMS precious metals team, output is expected to fall 3% this year. That’ll be the first fall in seven years.
If you buy the idea of the capital cycle, then it’s pretty clear cut: this is when you buy gold miners.
P.s. A correction. Yesterday I wrote: 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.
Of course, that should’ve read $200 of profit. Thanks to the attentive Gordon Norris for pointing it out.
P.p.s Thanks for all the great messages yesterday. A couple of you had invested in gold recently, without much joy. Jon wrote:
Gold is strange. As an ex dentist I have scrap gold (recovered from failed restorations) which was worth a few hundred pounds when I quit – now it’s worth £1500 or so (not including the scrap Platinum and Palladium). I don’t understand why. I have some silver (a useful metal) bullion – which has devalued! As for miners, I bought Avocet, Centamin and Aurum – but they have since dropped – and while they are not an HMV, I’m debating keeping them – fortunately it’s a hobby more than a pension. Gold is an enigma!
I agree – gold is definitely an unusual investment. You can’t value it in the standard ways. I’m glad this case for miners doesn’t depend on any special insight into the gold market itself.
Keep the ideas coming: Sean@agora.co.uk