Mining Stocks Are Double Edged Swords- Analysis
- Soren K
If you are looking for recommendations, stop reading. If you want your hand held ask Jim Cramer (click to scroll down). But if you are interested in acquiring some tools to help you think for yourself, read on brother. If you are tired of being spoon-fed what to do and just want some basis for thinking on your own, amen sister! Because, judging from the views and email questions on our actual advice on the GDX from 10/4 (the low is likely not in yet), a ton of people got smoked on the next leg down. Are we bitter? Yup! Do we think that the media has abdicated its responsibility to feed the ratings god? Yes.
Worse, do we think that more and more people have succumbed to their comfortable chairs and iphones while other people think for them? Damn straight we do. In fact, we think, I think, that if a pill were invented that prevents tooth decay, a whole new market for people who forget to take that pill would be created. But I digress. Let's check in with CNBC for its opinion on Gold:
I've been told to calm down. The title pic was not my idea. But the point is well taken.
Moving on. Here are 3 reasons why mining stocks perform differently than the ore they produce.
- Financial Leverage (start up)
- Under/Over Hedging (all mines in production)
- Operating Leverage (increases with mine size)
Financial Leverage
After geological surveys have quantified the reserves, a mine must commit large amounts of capital to investing in mining equipment. These capital expenditures are often financed and a necessary expenditure for a mine at this stage of the game.
Mines borrow money from Banks, VC firms, Hedge Funds, or other mines to purchase equipment to get ore out of the ground. Frequently they use their "proven reserves" as security against the equipment purchases.
- Why They Finance
- They have to. Their capital up to this point is: intellectual, sweat, and land rights. Not cash.
- Mining equipment is a capital expenditure, not an operating cost
- Risk in a Selloff
- Shareholder: Leverage of any type acts as a multiplier on a mine stock's price in both directions. And depending on how quickly they get metal out of the ground, the debt service could choke them
- CEO: Depending on the situation. Large Equity holder. Frequently shares the same risk as the investor. Can walk away with no personal liabilities if mine defaults. Loses his time, personal capital already invested, and reputation in the industry.
- How They Secure Financing
- Frequently using the land and Geological Assays as collateral
- Due to Geological survey variances, snd being unable to do get at teh collateral on a defaulted loan, financiers often give deals worse than VC levels to the mine.
2. Under/Over Hedging Production
When a miner does not hedge his production properly he is not running a business. He is running a spec trading account. The operation is either being run out of greed (bullish) or fear (bearish)
- Why UnderHedging Happens- Stick and Carrot
- Stick: Shareholder pressure to perform is negative pressure to underhedge production. Executives of poorly run firms who want to keep their jobs will underhedge to keep pace with other mines in rallies.
- Carrot: Mine executives are paid in stock, and this is incentive to "punt" or speculate that Gold will go higher, which results in a bigger pay day or them.
- Risk in a Selloff?- Shareholder and CEO
- Shareholder Loses: money at a rate often greater than the drop of Gold price since a company is valued at a multiple of earnings. The effect cuts both ways
- CEO Wins: if fired, a fat "golden" parachute is given. If not, he can negotiate his own stock option prices be lowered if he is to stick around and "fix this mess"
- How to Avoid?- compare firms. It is all relative
- Underhedged: If the Hedge book doesn't cover current liabilities and cash flow.- Bail (every mine between 1985 and 1995)
- Overhedged: or hedged at a price too close to production cost relative to peers- Bail (Silver producers 1997)
- Complexity: the more complex a hedge book, the bigger the risk and the less likely they know what they are doing, especially in a crisis. (Ashanti 1999)
3. High Operating Leverage
High Operating Leverage means that an increase in mine output reduces cost per ounce and increases profit at the margin. This is due to its incremental costs for ramping up production being variable and small compared to the sunk cost of equipment, as its mining equipment is already in place. Mining is also generally a high margin business with low sales volume. Thus, operating leverage in mines is a function of both fixed (high) cost, to variable (low) cost ratios, and profit margins per sale (high) vs total sales volume (low)
a. Risk/Reward
- A mine has high operating leverage and increases in profitability at the margin just by producing more. Thus when prices go up, it can enjoy higher profits per ounce mined
- high operating leverage works both ways. If market prices drop and a mine shutters production, the fixed cost looms larger as a production cost. And reducing variable costs will do little to help
b. Management
- operating costs are very much dependent on the mines operations. And that is a function of management's business skills
- A company with operating leverage ideally should have low financial leverage. The goal in any high margin, low sales business like mining is to remove financial leverage as soon as you can in favor of operating leverage.
- A company with high operating leverage adn high financial leverage is in general very risky
- A company with high operating and financial leverage frequently has hedge book issues as well as they try to ensure cash flows to keep running by hedging too cheaply, or conversely are run by loose cannons to begin with
Help us Jim- Should we buy Gold?
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