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Gold Miners' Leverage Effect Is Gone, but for How Long?


Once bonds tank, investors will be forced into gold, and those who have quietly bided their time with these undervalued stocks could be set for a big payday.


Let's have a look at the so-called leverage effect that mining companies are supposed to have on the underlying metal prices.

To explain briefly why mining companies should have a leverage effect on increasing metal prices, I will illustrate with a simple example.

Suppose you have a mining company X.

X is mining gold, which is trading at $300 at the moment. However, the company has to pay its employees, has to pay for exploration of the mines, has to build the mine, and so on. Assume it costs $500 to mine one ounce of gold. Initially, the company will take a loss of $200 for each ounce of gold mined. However, when the gold price rises to $500, the company will break even.

With a gold price of $600, the company will make $100 profit for each ounce of gold mined.

Now here is the key: If gold rises now from $600 to $700 (16.66%), the profits will rise from roughly $100 to $200, which is +100%!

So even though the price of gold rose only 16.66%, profits doubled. So each dollar increase in the price of gold will lead to more profits for the company. When profits soar, the stocks are also expected to soar.

However, of what we have seen in recent years, it looks like this is definitely not always the case.

Some examples of gold stocks that have risen substantially more than the price of gold are Allied Nevada Gold (ANV) and Randgold Resources (GOLD).

Some other gold mining companies have performed equally to Randgold, such as Royal Gold (RGLD) and Goldcorp (GG).

Click to enlarge

However, as a result of the financial crisis in 2008, most gold stocks got beaten down so much, and sentiment has become so bearish, that it looks like these companies will never be able to increase profits or cash flows from their operations.

Some examples are AngloGold Ashanti (AU) and Newmont Mining (NEM). However, please notice that both these stocks are currently near their long-term red resistance line. If the price managed to break above these lines, these stocks could be in for a huge rally, as money will flow into the most undervalued stocks. When suddenly everybody starts to chase after them, they could rise at the speed of light:

Click to enlarge

When we look at the HUI Index (HUI), we can see that from 2005 until 2008 (right before the financial crisis), the price of the HUI Index was highly correlated with the price of gold. However, recently, the HUI Index has been lagging behind the price of gold in a way that asks for a huge rally of mining stocks, or a huge drop of the gold price, or a mixture of both. This can't sustain itself in the long term, and with gold now being in a favorable position, the HUI Index will likely play catch-up with gold.

When we measure gold stocks in gold, we can see that many stocks are now at or near historical low prices. Newmont Mining, for example, is now trading at about 3.8% of the price of gold. In order for the ratio to go back to its historical average of about 8%, Newmont could more than double, even if gold stayed flat.

Another nice example of a stock that is trading near its lows when measured in gold is Tanzanian Royalty Exploration (TRX), now cheaper than it was in late 2008.

Although the mining stocks should have a leverage effect on a rising price of the metals they have in the ground, because of the financial crisis, this leverage effect has often disappeared.

However, with the crisis in Europe only worsening, and the US on the brink of financial disaster, it's just a matter of time before the rating of the perceived "safe haven US government bonds" will be lowered again.

When this happens, investors have nowhere to go but gold. When the mass finally realizes that the mining stocks are severely undervalued, the mining companies could start a rally like you will only see once (or maybe twice if you're lucky enough to become old) in your life.

Editor's Note: For more from Willem Weytjens and others, check out Profitimes.

Twitter: @Profitimes

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No positions in stocks mentioned.

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