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Why We Like Those Wretched Gold Stocks

Gold and silver mining stocks carry with them far greater risk than does the bullion. Mining is an utterly wretched business - don't let anyone tell you otherwise. It's an extremely capital intensive and cyclical business whose hallmarks have been a sickeningly low return on assets for nearly two decades now. In buying a mining stock, one is not getting a Coca Cola or a Walgreen's where steady earnings and free cash flow growth are the norm. Rather, especially after the brutal years in the 90's, many of these companies' profits are anemic and are only now beginning to rebound.

In addition to metal price risk, one also has to face operational risk in a mining stock. Say, for instance, gold goes to $500, but a mining company gets squeezed by high energy costs, rising local currencies, or poor mining results, an investor in a gold mining company runs the risk of missing out on the metal's appreciation if he is in the wrong stock. How frustrating that would be.

However, along with operational risk comes operational reward. Let's compare physical bullion appreciation vs. a hypothetical miner below. First we look at the unlevered gains an individual would achieve from physical ownership (again futures and leverage could magnify gains or losses but we would not recommend it on an individual level).

$425 Current Spot Gold  

% Increase

$500 Spot Gold

17.6%  

$600 Spot Gold

41.2%  

We can see from above that an increase from the current gold level of $425 an ounce to $500 yields a 17.6% increase and an increase to $600/oz. would yield a profit of 41.2% - all of which are taxed at the higher collectible rate. A miner's profit could expand on an equal physical price appreciation at a far greater rate:

XYZ Mining Company - Mines 1 Oz. annually at $ 350 total production costs, 100 shares outstanding

Here one can see the benefits of operational leverage - an equal metal price increase as above increases the miner's earnings 100% and 233% respectively. The leverage obviously cuts both ways, but if gold and silver rise as we believe they will, a lot of the mining stocks will be big beneficiaries.

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