Thursday, January 9, 2014

Disadvantages of gold mining shares - Business - Product Reviews

- The quantity of a gold mine's reserves is never accurately known. Gold mining reserves (and their poor relative 'resources') are assessed by miners' core drilling programs which sample a prospective gold seam to measure gold concentrations in the rock at different locations. 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 during the extraction of commercial gold 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 l ikely 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 judgement. It is almost always in their interest to err on the side of optimism. A pessimistic outlook rarely got a gold 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 during good gold bullion markets the shares tend to 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 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 gold mining shares can do this, so in effect the share price of many mining shares already discounts a substantial bullion price improvement. That is an indication that they could be overvalued.

- Adding to the problem of evaluating the investment quality of even well-established mines is the fact that their accounts are unusually opaque. Many people (including your author) who are perfectly comfortable with general purpose financial statements, for ordinary commercial businesses, start to tremble when presented with gold mining company accounts.

- Corporate culture is another problem. These days many companies (not just gold 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 gold mining companies could be accurately described as vehicles for the straightforward exploitation of underground gold 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 which 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 mining companies are investing in the strategic competence of their board at least as much as in gold.

These disadvantages of gold mining shares have got worse in recent years. Exploration businesses which have found gold in smaller countries have been forced to build roads, hospitals, schools and other social infrastructure, as well as repair the damage they do. The host government is quite quickly able to assess the value of a newly discovered resource, and to load the permission to mine accordingly. The social costs have increased far faster than the value of the gold found.

Gold mining shares are a potentially risky but simultaneously exciting investment. They tend to be reasonably correlated to gold prices but typically much more volatile, and subject to many variations which are independent of bullion market forces. Buying gold bullion is less expensive on dealing costs.

Choosing the right gold mining stocks - or even just the right gold mining index to follow - is crucial. But while individual gold mining companies can offer the potential of high-risk returns, the gold mining industry as a whole is facing growing problems of cost, politics and finance.





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