Like an early Christmas (published 6/07/06)

 

Wow!  The markets are giving us Christmas presents in June this year!

 

Let's see if I have the big picture in proper focus.  The Fed talks tough (but talking is the only thing they can do, since the essential national housing market resembles a California mansion just before the hillside it is built on slides down a slippery slope into a sea of mud and muck).  The fantasy investments on Wall Street feel a draft from a brief breeze of reality, and stocks catch a long overdue case of pneumonia.  And yet somehow, the precious metals babies are also sold off in sympathy with the bath water tossed out by Wall Street.  The Optimist sees a near certainty that inflation and world tensions will continue to get worse, so an opportunity to buy silver and gold at temporarily reduced prices is truly wonderful and positive news.

 

Let's get physical

 

Olivia Newton-John said it well in 1981: "Let's get physical, physical, I wanna get physical, let's get into physical".  Although Olivia's hit song was in another context, the Optimist doesn't know of any songs which extol the virtues of investing in paper.  A simple experiment should be sufficient to demonstrate why investing in paper is not celebrated in song and dance.  Into one hand, place a ten ounce silver ingot or a one ounce gold or palladium coin.  In the other hand, hold a few pieces of paper.  It will not take most people long to feel the difference.  Regardless of what pretty artwork may be engraved onto the paper, or what promises are written there, the physical silver or gold clearly demonstrate their value in a far more immediate and satisfying way than the hopes one has for eventually getting something of value from the paper.  As another example, consider buying a new car a few years from now.  Imagine offering alternative options to pay for the purchase by placing a 100 ounce bar of silver on one side of the table, and a pile of paper on the other side.  Even though the paper may have the same market price as the silver, the Optimist is confident that the car dealer will have a strong preference for the silver.  It is difficult to think of any situation in which paper would be preferred to real physical silver or gold metal.

 

Mining stocks are paper

 

For those readers who were impatiently waiting for me to get to the point, now is the time to wake up and pay attention.  Although this commentary is likely preaching to the choir, many members of that choir continue to sing the praises of stocks in precious metals mining companies.  Historically, that may have made sense because stocks in mining companies were easier to hold than a possibly large weight of precious metal.  However, the Optimist thinks it likely that many investors may prefer mining company stocks over the physical metal because of the leverage that the mining stocks promise.

 

The legendary leverage of mining stocks derives from the lower costs of the mining company.  Consider, for example, a hypothetical mining company which could produce gold at a net cost of $350 per ounce.  If the company could mine 1,000 ounces when gold was trading at $400 per ounce, then the company would make a reasonable profit of $50,000.  If the mining costs remained fixed while the price of gold increased 25% to $500, then the company profits would explode 200% to $150,000.  Since increasing profit is the fuel that powers rapidly rising stock prices, a 200% rise in mining company profits would bring far more exciting returns for stock investors than for holders of bullion.  Similarly, a subsequent rise in gold by 20% to $600 would translate into a mining company profit of $250,000, assuming mining costs stay constant.  A 67% increase in mining company profits for a 20 % increase in the price of gold is a substantial plus for the investors in mining stocks, but it is significantly less than the 200% indicated above.  As the price of gold continues to increase, the mining company profits also increase, but the percentage gain in stock profits, as well as the leverage ratio, reduce substantially from the initial surge at lower prices of gold.  The table below shows the results.

 

Gold

Gold percent

Mine costs

Mining Profits

Mining percent

Ratio of %

$400

 

$350

$50,000

 

 

$500

25%

$350

$150,000

200%

8.0

$600

20%

$350

$250,000

67%

3.3

$700

17%

$350

$350,000

40%

2.4

$800

14%

$350

$450,000

29%

2.0

$900

13%

$350

$550,000

22%

1.8

$1,000

11%

$350

$650,000

18%

1.6

$1,100

10%

$350

$750,000

15%

1.5

$1,200

9%

$350

$850,000

13%

1.5

$1,300

8%

$350

$950,000

12%

1.4

$1,400

8%

$350

$1,050,000

11%

1.4

 

Note that the table above assumes that the mining company has a fixed cost per ounce produced.  In the real world, however, gold increases in price at the same time that inflation also accelerates, and the rising inflation adds significant additional costs to the mining operation.  The continuously increasing costs of mining will reduce the potential profits and the hoped for leverage that a mining company stock might otherwise offer.  If one also considers that mining companies are subject to costs (dilution of the company stock, depletion of the reserves, high taxes, etc.) and risks (nationalization, mining accidents, embezzlement, etc.) which would further reduce mining company profits, then investing in physical metal bullion becomes an obvious winning strategy.

 

If it isn't heavy, then it isn't metal

 

Some investors who agree with the desirability of investing in real physical metal try to make the process easier by having the metal stored for them.  Numerous companies, as well as the gold and silver ETFs, are happy to hold your metal for you and issue paper equivalents of IOUs as your claim for the value of metal that you have on deposit there.  Although that out of sight out of mind storage process works reasonably well during good times, it would be beyond optimistic to simply assume that the metal you have entrusted to a company for safe keeping will always be kept safe for you.  One of the few financial certainties we have is that there will be big problems in the future.  Many of the companies which offer to store your metal for you today may abruptly stop taking phone calls when they go out of business or when governments confiscate their inventory in the perilous times to come.  The Optimist presents the positive perspective that there will be no need to worry about whether or not someone else will return the metal they owe you, if you simply keep your metal in a safe place where you can get access to it at any time without needing permission or assistance from anyone else.

 

In the past, the Optimist presented charts of selected mining company stocks in addition to charts of silver, gold, palladium, the U.S. dollar, and a few proprietary indexes.  In line with the philosophy in this commentary, the future Optimist charts will no longer show the mining company stocks.  My optimistic view is that precious metals alone are all the mining sector news we need to see.  Cheers!

 

 

* * * Notice * * *

This commentary presents only the viewpoints of the Optimist, and it is intended only for perspective and entertainment. Please do not interpret any portion of this work as investment advice. If any of the concepts discussed here appeal to you, then you must do the work to decide if and when and how you should invest. The Optimist does not ask for any profits you make, and he cannot be liable for any losses incurred as a result of your investment decisions. The Optimist wishes you the best of luck in whatever you decide to do or not to do. Cheers!

 

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