Equities Have Added Risks & Costs

We used this phrase earlier in the first part of the article, when we said "Corporate Risk". What does it mean?

• Mining companies have all the risks of a commercial enterprise except the difficulty in selling its products. What it has little to no influence on is the price it sells its product at. It is at the mercy of all the market factors that contribute to price-making. The only impact the company has is its contribution to supply.
• Finding the gold or silver it intends to mine. It has to not only find it but establish just how much of it there is to mine and under what conditions it must be mined. These can directly affect the cost of producing gold or silver. For instance in South Africa at Goldfields mine miners work at depths of around three kilometers or nearly 2 miles deep. Mining costs don't only cover getting to that depth but the cooling systems needed to lower the temperature to bearable working levels.
• Laborand energy costs used in getting the ore out. With labor becoming more demanding each year, production halts are increasing. The worst incidences of this are being seen now in South Africa.
• Milling the ore and extracting the gold and silver.
• Refining the gold to acceptable selling standards.
• Management effectiveness risks.
• The life of the reserves which are profitable. These are affected by the price of gold or silver. Where silver is mined as a by-product, this is not as important of an issue and with the average cost of mining silver currently so low, we do not regard it as nearly as important of an issue as it is with gold mining. Bear in mind that the return on capital not how long the mine can keep mining is the focus of investors and should be for mine management.
• Political risk is becoming of paramount importance as we watch country after country see mining profits as a major source of tax revenue. When mining companies are threatened with nationalization or 'windfall taxes' or are appropriated by governments, nothing could undermine investor's incentives to invest more. With more and more gold mining occurring in nations where this is a possibility, investors, who may have been inclined to invests, may take a closer look at where the mining will take place.
• Currency is an increasing risk as the global monetary scene decays. Can you believe that the South African Rand was traded at R1.84 to the British pound? Today 37 years later it trades at R13 to the British pound. At that time South Africa produced 1,000+ tonnes of gold per annum, today this total is somewhere south of 200 tonnes. This affects the cost of fuel and capital equipment in particular. South Africa remains reliant on labor for the bulk of its mining costs. Even though it remains a local Rand cost, wage demands are frequently well above inflation there.

Add all these risks up and you have an industry that carries far more risks than the ordinary commercial enterprise. Because of this, investors look for much better returns on their investments. What has helped lately is the growing trend to link dividend payments to profit and to the gold and silver prices. Several silver and gold mines, i.e. Coeur d'Alene and Newmont, follow this practice and have seen their share prices outperform their competitors who do not follow this practice. After all, it's not enough to simply keep mining without rewarding investors directly through dividends.

Should Gold Shares Keep Pace with the Gold Price?

The concept used to be that if you invested in a gold mining company, it would be able to hold back costs and ensure profits rose faster than the gold or silver prices. This would, in itself, add leverage to the dividend payments to the investor. Or the mining companies could increase reserves and the life of the mine to increase the capital value of the company with the intention of rewarding investors over a long period of time in a way that the gold and silver prices could not. But this is not the case today as it becomes increasingly difficult to replace used reserves. Until the last couple of years it was not the policy to reward investors through good dividends. The rising capital value of the company was supposed to translate into higher share prices allowing investors the joy of capital gains.

But mining equities in general have not outperformed the metals themselves and have not rewarded investors sufficiently for the added risks they take. Consequently their attraction has lessened. Investors should remind themselves that mining companies are in the business of rewarding investors first. If this were the overall focus of the industry we would expect to see mining company share prices move far closer to the metal's price than is the case at present.

By linking dividends to the gold and silver price, equities should keep up with the gold or silver price, but to ameliorate the risks of mining equities, the total return on the shares of gold and silver mining shares should be well ahead of the total return gold and silver itself. Is that what their performance has shown?

Until this sort of adjustment is made the attraction of the precious metal mining companies will be less than the metals themselves.

Do gold mining company profits keep pace with the rise in gold price? Are gold and silver mining companies costs stable?

A look at the rising costs of gold and silver mining companies -particularly gold mining companies--shows that they've climbed too fast. In 2005 when the gold price was close to $300 the mines were profitable. Today in South Africa costs are shooting past $1,000 an ounce. Barrick Africa costs are at $692 [total cash costs per ounce] Barrick's average costs over the whole company are at $460 an ounce. Elsewhere, to a lesser extent, the same has been happening -costs are rising so strongly that profits are not rising in line with the rising gold and silver prices.

There appears to be an insidious belief in the minds of suppliers that they can increase prices as the mines reap a higher reward for their mining. No matter what efforts mining companies make to keep down costs, profits do not rise as expected, i.e. as the precious metal prices rise.

Investors see this and do not feel that their profit potential justifies a far greater investment. To understand this, an investor must look at the reasons he has for investing. If his investments supply this, then he keeps them. If not, then he sells them. An investor's needs should rule the dividend policies. These days, when markets aren't giving the total returns expected, successful equity investing is harder to achieve.

Generally, there is far less certainty to the profitability of gold and silver mining companies then there is to the pure gold and silver investment. But is this always the case?

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