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Why would mining stocks beat the rest of the market?

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January 19, 2012 – Comments (7)

First and foremost please don't turn this blog into a debate on hyperinflation.

 

Quick thought (as are my usual blogs)

I don't understand why people think that mining stocks are the best play on hyperinflation.

Yes, of course metals will rise in hyperinflation...everything would

 Metals would rise, but so would the input prices for everything the miners used to get it out of the ground...labor, machines, oil, etc.

Sale price goes up 50% (2000 to 3000, to make up random numbers), input cost goes up 50% (1000 to 1500), that means profit goes up 50% (1000 to 1500)

The same is true for mcdonalds though...beef goes up, hamburger sale price goes up.  Profit up 50%

Same goes for the actual commodity...price goes up 50%, no input price, no sale price

 

Now if you think there is manipulation in a certain commodity that is a completely different story.

Therefore, all commodities and all stocks should go up equally in aggregate.

 

The one thing that confuses this whole equation is that inflation can put some companies out of business due to bad projections, etc.  This makes the commodity the safer choice.

Bad economy = less lending = less inflated stocks.

So, the commodity appears to be the winner over the stocks.  Which is why

 

So....why should a mining stock go up more than the rest of the stock market in a hyperinflation scenario?

7 Comments – Post Your Own

#1) On January 19, 2012 at 11:42 AM, TMFBabo (100.00) wrote:

Good thoughts, but I do have a few things for you to ponder:

1. Commodity companies allow for good management teams to create (and destroy) tons of value. In oil and gas (similar to mining), companies can only pay for leases with a high IRR using conservative estimates. When management teams are overly bullish on a commodity and overpay, they are destroying value.

2. Vertical integration: if you own your own equipment, you will not see input costs rise so dramatically. In oil and gas (sorry, I don't know mining), if you own your own drilling rigs and frack crews, you can shield from cost inflation, which happens to be running high right now.

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#2) On January 19, 2012 at 11:45 AM, TMFBabo (100.00) wrote:

Crap, meant to title my first point "capital allocation"

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#3) On January 19, 2012 at 12:21 PM, portefeuille (99.60) wrote:

Why would mining stocks beat the rest of the market?

I am pretty sure they will not beat "biopharma" stocks in the next few years ...

my "biopharma focus fund" is here.

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#4) On January 19, 2012 at 12:41 PM, Mega (99.97) wrote:

Buffett has often written that contrary to conventional wisdom, low capital intensive business (for example See's Candy) are better suited for inflation.  Not commodity companies.

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#5) On January 19, 2012 at 1:01 PM, amassafortune (29.66) wrote:

Mining companies are an alternate store of value. They mostly underperformed as gold funds, PM ETFs, and physical alternatives did very well in recent years.

The revelation that some funds did not have enough gold to cover all accounts put more emphasis on holding physical.

Holding physical, even in a safety deposit box, adds expense. If held in a residence, theft becomes more of a possibility and transaction cost increases.

Junior miners have had more incentive to drill with the higher price of PMs and commodities. With more documented proven reserves, some individual miners have risen just because they have better documentation of reserves. 

There has also been price manipulation at the market level with sudden, large changes in margin requirements. These bouts of sudden volatility do not affect miners as much as they do commodity trading instruments. 

Proven reserves in the ground have very low security expense and as the Fed has now stepped up its back-door bailout of the euro, miners are not a bad place to put eroding U.S. dollars if one is not yet comfortable in the general market.

Most gold reserves are sitting right where they were during the fall of the Roman Empire, as Vikings pillaged, pirates boarded, Rommel rolled, central banks plundered, ganstas invaded, and survivalists hoarded.

Underlying property and plant and equipment balance sheet assets are also holding value better than many other industries. Just approaching precious metals miners as companies with good long-term customer demand prospects may indicate good value. 

The largest risk to holding proven reserves via mining stock is probably that management could take action to subordinate or dilute the value of the shares, independent of underlying PM price trends.

Miners are less undervalued than they were a year ago, but they are still a reasonable alternative after weighing all risks in this economy. 

 

 

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#6) On January 19, 2012 at 2:29 PM, SN3165 (< 20) wrote:

I disagree but alsos do check out the royalty plays that have their costs fixed - Sandstorm Gold, Franco Nevada are two I own.

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#7) On January 20, 2012 at 1:17 PM, leohaas (32.65) wrote:

The reason here is that mining companies are leveraged to the price of the commodity. For instance, if a gold miner has a cost of $1,000/oz to mine the stuff, and the gold price is $2,000/oz, their profit is $1,000/oz. If the gold price goes to $3,000/oz, their profit will be $2,000/oz. So the price of the commodity goes up by 50%, and the profit of the miner goes up by 100%.

There are 2 basic flaws in this thinking.

1) The "leverage" argument works best if the gold price would be just above the cost of production. In other words, for marginal mines and miners. The better the margin of the miner to begin with, the smaller the leverage will be. Translation: buy not the great mining companies, but the marginal ones. Sorry, but when I was looking for a PM miner to buy, I went with the best...

2) The thinking ignores the fact that production cost may also go up. In a hyperinflationary environment, they definitely will. However, probably not as fast as the rate of inflation. Some costs are fixed. So your assumption that if inflation drives up the price of the commodity by 50%, the cost to produce would also go up by 50% is incorrect.

Comment #5 makes excellent arguments on why the whole thinking has proven to be false last year for PMs. People who believe that gold and silver are the only safe stores of value also tend to believe that markets are manipulated; that stock of miners is no exception to this manipulation; and that holding the PM physically is the only way around these problems. This correllation drives prices of physical PMs up and miners down, relatively speaking. In most commodities outside PMs, this effect is absent. For instance, I know of quite a few folks trading oil futures as well as oil producers, but nobody who actually takes delivery of oil.

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