Today’s question for you to ponder: When will the takeovers start in the precious metals sector? At what point will the share prices of gold and silver stocks be viewed as so cheap that bigger players have no choice but to buy them? Here are the facts:
Year to date, the price of gold is basically flat, up a mere 1.42% year to date:
Here’s the same chart for the HUI, the AMEX Gold Bugs Index, which is down around 23% year to date:
We all know that share prices are leveraged to gold; if gold goes up by 50%, it would not be unreasonable to expect the share price of an individual company to go up by 100%, 200% or more, because of leverage. In general terms the cost of producing an ounce of gold is relatively fixed, so an increase in the price of gold is pure profit.
For example, if the cost of production is $1,000 per ounce, and the price of gold is $1,500, that’s a 50% margin. If the price of gold goes up by 33%, to $2,000, the profit for the producer goes up to $1,000 ($2,000 – the cost of $1,000). That’s an increase in profit of 100%. In this example, a 33% increase in the price of gold results in a 100% increase in profit, so you would expect the stock price would also go up 100%.
So why, with the price of gold flat, are gold stocks down 23% year to date? There are a few reasons, including:
Costs: If production costs (for fuel and labor) are increasing, that reduces the margin and the profit.
Risk: Mining is a risky business. If perceived risk is increasing, share price increases will be reduced. For example, if your gold mine in Kyrgyzstan could be nationalized by the government, you’ve got big trouble. The gold bullion in your bank vault can’t be nationalized by a foreign government.
There is also production risk. If your mine floods, or something else happens, down goes the stock. That’s not a problem with bullion that is already out of the ground.
Only the good die young: If the stock market tanks, and investors are faced with margin calls, what do you sell to cover your margin requirements? You sell whatever you have that has value. If your gold stocks are up, you may have no choice but to sell your “good” stocks, and that depresses their share price.
At the moment, these factors, and others, are depressing gold stocks as compared to the price of bullion. But, at some point, gold stocks will become so cheap that there will be so much potential upside with stocks that they will become the logical investments. For example, here’s a stock that was in the news this week:
Tragically Kinross was in the news on Thursday due to the crash of a Mauritanian military plane that was chartered to carry gold from its Tasiast mine in Mauritania. No Kinross personnel, and no gold, were on board, but sadly seven people were killed. This is poignant proof of the risks of operating a gold mine in a remote area.
Kinross is an interesting case study in the vagaries of the gold market, dropping from a peak of over $24 in 2008 to the $8 range today. I can see a very compelling reason for avoiding this stock like the plague: it’s dropped from $24 to $8; that’s not a good direction. However, here’s an alternate viewpoint, and two reasons for buying the stock:
First, at current prices it has a dividend yield of 2%. Kinross pays dividends twice a year, on March 31 and September 30. The dividend has steadily increased from 4 cents twice yearly in 2008 up to 8 cents (US) per share on March 31, 2012. So, simple math, 8 cents twice a year is 16 cents, so with the stock trading at $8 that’s a 2% annual yield. That’s not great, but it’s better than what your savings account pays you, and you’ve got all of the upside if gold increases in value.
Second, is Kinross a takeover target? The word on the street says that it is. For example, on June 14 to Financial Times of London ran an interesting article describing how Kinross advisor chatter heats up. The premise of the article (which you should read for yourself) is this:
Kinross has apparently retained a financial advisor to “explore strategic options”, presumably because the stock is down over 30% year to date, and mining costs are rising. The interesting twist is that Stock links ABX.TO – Barrick Gold Corp. fired their CEO back in May, presumably for poor performance, even though Barrick has performed better than most gold stocks. The implication is that the Barrick board wants to go back to their roots, as a company built on mergers & acquisitions, and the old CEO didn’t want to go that route.
Barrick has a subsidiary, African Barrick Gold (traded in London, ABG), which conceivably would be a logical place to house the Tasiast mine. Could Barrick buy all of Kinross? Perhaps. Could the company be broken up? Perhaps.
Kinross is due to provide more details on mines and mining costs in August, so if a merger or acquisition is to be announced it could be done in the dog days of summer.
So what’s my plan?
First, I’m not buying Barrick. I haven’t owned it in the last ten years, primarily due to their former hedging program, and if they take on more debt to acquire Kinross I will like it even less.
As for Kinross, I picked up a small position this week, in the $8 range (which is looking good so far, since Kinross popped 5.85% on Friday up to $8.51). I don’t see it falling much lower, so for now I’m content to hold, collect the dividend, and wait to see what happens.
That’s my report. All comments welcome. Thanks for reading; see you next week.
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