Gold and mining investors tend to believe in hard money and have an interest in Austrian Economics. They understand the moral, economic and structural harms that the fiat-currency system causes. They worry about the nature of fiat currency, which promises to pay nothing more than a similar currency bill of the same denomination.
Despite their understanding of monetary economics, those who have been involved in gold mining have in the last decade participated in a worse debasement of their wealth using share-certificates than what central banks have done. When challenged, such investors often rationalize that gold that is not doing well and that it is likely manipulated.
Gold has actually done quite well. Over the last 10 years, gold has gone up from about US$450 per oz. to US$1,200 today, an increase of 167%. The NYSE ARCA Gold Bugs Index during the same period has fallen about 25% and TSX Venture Composite Index about 50%. You can try fudging the timeframe, but your conclusion is unlikely to change: the equity market in gold mining has hugely underperformed gold. The real situation is actually much worse from the investor’s point of view, for most of these companies raised a lot of money at prices much higher than today.
Fountainhead of the problem: the investors
There are many myths, obsessions, and fashions that pervade the mining industry. This is particularly ironic considering that these hard-money investors were expected to be rational, rooted in reality.
One major myth has been about “leverage.” The belief is that when the gold price goes up, the value of a project would go up by a multiple. So, if gold is US$1,200 per oz. and the all-inclusive cost of production is US$1,100 per oz., it would leave a net profit of US$100 per oz. Now, if gold went up to US$1,320, the profitability would go up to $220. In other words, if gold went up by 10%, profitability would go up by 120%, and hence the “leverage” would give outsized share price gains.
Alas, the above has proven to be a myth. Despite the fact that gold has gone up very significantly over the last 15 years, most gold mines have fallen in profitability. When the gold price went up, the cost of making it grew faster; when gold fell, the cost did not fall in proportion – the costs were too sticky.
At different periods, investors have invested expecting a certain commodity to significantly outperform, outshining the rest of the commodities, hoping for another kind of “leverage.” Expectations about increasing demand for different commodities — gold, silver, uranium, rare earth elements (REEs), “strategic metals,” and more recently zinc — have on each occasion driven the market into a trance. When this happened, one did not even have to do even basic due diligence. Investors again forgot the other side of the equation: the supply grew too, often out of proportion to demand (as is currently the case with iron ore), when prices went up.
Another deeply entrenched myth is about “ounces in the ground.” One who believes in this typically looks for metal resources that a company has in the ground in the projects in its portfolio. He then multiplies the resources by US$10 per oz. or US$50 or whatever number that holds sway over his mind. He fails to see the mistake inherent in his methodology. Using US$50 per ounce-in-the-ground instead of US$10 results in a 400% valuation difference. This is such a flawed method and so deeply entrenched that, instead of focusing on creating a mine, a lot of companies focused on creating resource ounces in documents irrespective of whether they could ever be mined economically.
Projects that have no hope of ever becoming mines have traded for hundreds of millions of dollars.
More recently, a new fashion has come into existence: grade is king. Without looking at other aspects of the project, such believers look merely for grades. They forget to see that 6 gram gold per tonne rock 2,000 metres underground in thin veins might actually be much more expensive to produce on a per-ounce basis than an at-surface, bulk-tonnage deposit grading 0.8 gram gold per tonne in leached rock, that is close to infrastructure, and in a socio-politically conducive environment.
A mine’s economics are the product of tens of variables. Simplistic valuations of properties lead to disastrous valuations, financing of the wrong kinds of projects, and provides terrible feedback to management teams.
A very large number of companies exist only to sustain the lifestyles of their management. In many ways, these small mining companies exist in a sweet-spot for executives: They are often too small for a hostile change to be realistic, or for the media to be interested if the management is incompetent or crooked.
Such lifestyle companies came to exist and were sustained because they were financed by investors not rooted in rationality. They were rooted in myths and fashions. They provided incentives to the management to create fancy stories, good websites, and nice presentations.
In hindsight, the consequences were easy to see. Why should you be doing the hard work of creating value when people line up to ask the management to take cash off their hands. During the height of the venture market, companies could raise tens of millions of dollars for projects with such low grades that a rational mind could have seen right away they would never become mines. Often such financings were so much in demand that only “favoured” institutional investors were allowed.
All this has created a culture of promotion rather than of value-creation in the mining industry. Lawyers, brokers, analysts all got well-entrenched. Those who had worked out how to play the irrationality of the investors did very well.
The mining industry attracted a lot more money than it should have, resulting in a massive bubble. Virtually all mining companies traded for many times their net present value (NPV). Broker reports, to keep the flow of the share-market going, would kept increasing their target prices. It was not uncommon for them to give their target prices using several times the multiple of NPV. Six-times NPVs using very low discount rates and very high metal prices—all officially declared in analyst reports—were not uncommon. This was a recipe for disaster.
Big mining companies with high liquidity were so over-valued that they had no option but to keep acquiring development projects, by paying outrageous prices in their own paper as long as the price paid was lower than the multiple of NPV the acquirer was trading at.
Would a major mining company trading at six-times it NPV have a problem paying three-times the inherent value of a project? None. This created a cycle of irrationality. Even very good management teams lost their moorings. How can you invest for value when you know you would be bought at several times your inherent value?
Everything down to the smallest junior mining company traded at prices with no relevance to what it had. Overvaluation and wealth-destruction affected every corner of the industry.
I claim no superiority for I too got sucked into this vortex.
And then reality started to catch up, in 2011.
Across the board, mining companies have been cutting costs. They have been cutting travelling expenses, bonuses, and salaries. They have been mining and milling higher-grade ore. Capital expenditure has been cut. Several projects under development have been stalled. Even at producing assets, exploration budgets have been slashed.
Unfortunately, if you don’t invest in capital and exploration, and if you process higher-grade material now, you are positioning yourself for problems tomorrow. Maybe not for a year or two, but this is not a foundation fo
r a good future.
The problem is the culture of the mining sector. It is still based on promotion and survival, not on creating a shareholder return. Indeed equity prices have fallen hugely, but those thinking that this is the bottom might be making an erroneous assumption — profitability and fundamentals of most of these companies have fallen faster. A lot of them still trade for many times their NPV. They are still very over-priced.
If the producing assets are over-priced and many must shut down and if approved projects with hundreds of millions of dollars already invested have been stalled for lack of economics, what can one expect from early stage projects, and exploration companies?
In societies and industries, changes do not happen without a major “reset.” It should not be this way, but those deeply involved resist change unless shaken, often vigorously.
One should expect a major reset in the mining industry. Those who continue to invest irrationally in the market, based on their obsessions and myths will likely regret it. They will blame the Federal Reserve or the mining executives or whoever, but they will have lost even more of their money.
Today, many disenchanted and distrustful investors in the mining space are mere spectators. This means that a lot of good companies with good value and good projects have fallen much lower than their inherent values. The reset as it carries on will create interesting and profitable opportunities for those who can ground themselves to reason and give up on myths and obsessions.
— Jayant Bhandari is a mining analyst and an advisor to institutional investors. He writes often on political, economic and cultural issues and runs a yearly seminar in Vancouver titled Capitalism & Morality. He can be reached through his website: www.jayantbhandari.com.