Diamond engagement rings vs. gold

Disadvantages of gold mining stocks:

The quantity of a mine’s reserves is never accurately known.  Reserves (and their poor relative ‘resources’) are assessed by miners’ core drilling programs that sample a prospective gold seam to measure gold concentrations in the rock.  The amounts discovered in chemical analysis are extrapolated over a wider area to identify the likely reserve amount overall, but there is no guarantee it will be found in mining.  Consequently there is a risk that recorded reserves do not reflect reality.  Human nature gets in the way of accurate sampling, especially in companies whose function is principally exploration rather than the operation of mines.  Prospectors raise money by encouraging investors that there is gold underground, and although a great deal of effort may be made to keep the process honest you only have to overlook a couple of poor rock samples (let’s just call them damaged) to manipulate the likely reserves upwards.  In the end the investor must trust both the geologists and the company’s financial controller – both of whom may have to make the occasional fine judgment.  It is almost always in their interest to err on the side of optimism.  A pessimistic outlook rarely got a mine built.

There can also be unforeseen engineering problems in extracting ore.  These can increase the production costs, and only small percentage increases can eat into the mine’s profitability.

Another issue is that the costs of the mine can be borne in a currency other than dollars – the trading currency of the output.  Exchange rate movements can greatly affect mine profitability by creating currency translation adjustments – both profits and losses.

Perhaps the greatest variable is shareholder sentiment.  Because of the wide attraction of gold shares in good gold markets the shares tend to greatly outperform not only gold, but also any reasonable valuation of the mine’s future cash-flow.  Investors are often not familiar with the yield numbers they should expect on a mine compared with – say – a supermarket, because whereas there is no reason that using a supermarket will wear it out, the mine certainly will be worthless within a few years, once its ore is gone.  So the return on a mine must pay back both the original investment and provide some profit during its life. A 20-year lifetime mine must yield in excess of 5% per annum before it makes any profit for the long-term investor at all.  Few mining shares can do this, so in effect the share price of many mines already discounts a substantial bullion price improvement.

Corporate culture is another problem.  These days many companies (not just mining companies) are run more for the benefit of their managers than their shareholders.  Many managers don’t like paying dividends because it diminishes the cash pile remaining for staff salaries and new corporate adventures – like exploration or takeover activity.  Very few mining companies could be accurately described as vehicles for the straightforward exploitation of underground ores in the interest of shareholders.  Instead the assets can become the playthings of boards of directors whose best interest tends to be served by punting shareholders’ money on opportunities that are sufficiently credible to grant a possible future beyond the current working mine’s life.  In the absence of strict and generous dividend policies shareholders in gold mines are investing in the strategic competence of their board at least as much as in gold.

Gold shares are potentially risky but simultaneously an exciting investment.  They tend to be reasonably correlated to gold prices but typically much more volatile, and subject to many variations that are independent of bullion market forces.

There are far too many of them to keep track of, and anyway individual analysis is well beyond the scope of this site.  Fortunately stockbrokers will usually perform this function willingly, and many of them post their analysis – or at any rate a teaser – on The Gold Report’s Analyst Section.

Mining shares might be considered an appropriate gold vehicle investment for sums from $5,000 range upwards, but investors should remember the gearing and invest appropriately less than they would in bullion.  Buying and selling costs vary from market to market. Not uncommon is a spread of 2% (lower for the bigger mining companies) and transaction costs of 1-1.5% each way.  Combined, the trading costs would amount to up to 4-5% of the capital cost for each investment undertaken.