Junior Gold Miners and the Magic of Leverage

The potential profits from investing in gold and silver miners always exceeds the potential return from bullion alone. Words: 1108

The original article by Jeff Nielson (www.bullionbullscanada.com) is presented below by the editorial team of munKNEE.com in a slightly edited ([ ]) and abridged (…) format to ensure a fast and easy read.

The Magic of Leverage
The obvious starting-point when it comes to a discussion of gold and silver miners is to discuss the basic proposition of “leverage” as it applies to a commodity-producer.

Let’s make the hypothetical example really simple: a gold miner who can produce an ounce of gold for $500 (its “cash costs”), with the price of gold at $1000/oz. As everyone can see, this miner earns $500 profit on each ounce of gold produced.

Now, let’s take two hypothetical investors: Investor A and Investor B. Investor A purchases gold at $1000/oz, while on the same day, Investor B purchases shares in the previously mentioned gold miner – at $10/share.

A month later the price of gold has moved to $1100/oz, and both investors are contemplating taking profits. The question is: which one will come out ahead? For Investor A, his potential profit is easy to observe: 10%. However, Investor B is about to benefit from the magical concept of leverage.

You will recall that the gold miner makes $500 profit on each ounce of gold mined, with the price of gold at $1000. However, with a new price of gold of $1100/oz, this gold miner is now earning $600 profit on each ounce of gold – a 20% increase in profitability.

With the gold miner now 20% more profitable, if we assume rational behaviour in the marketplace (often a BIG “if”), then we should expect the shares of the gold miner to also appreciate by roughly 20% (subject to other factors in its operations). In other words, in the current hypothetical example, investing in the gold miner (with the given parameters) provides 2:1 leverage versus investing in gold directly.

What is perhaps more interesting in this concept is that the less profitable a mining company is (at any particular price-level for gold), the greater the leverage.

Let’s go back to the example of gold priced at $1000/oz, and create another hypothetical gold-miner. This second miner is producing its gold at $900/oz, meaning at $1000/oz it is making only $100 on each ounce of gold mined. However, if, once again, the price of gold goes up to $1100, this second miner is now 100% more profitable.

Now let’s apply what we’ve learned to the “real world”, where the price of gold has gyrated over a wide price-range in just the last year. We’re all familiar with the market adage “buy low and sell high”, but what many people don’t realize is that in the world of commodity-producers this advice becomes wonderfully simple.

Whenever the price of gold (or silver) tumbles, so do the profit-margins of the gold miners. What these compressed profit-margins mean to investors is that every time gold bottoms in a trough, the leverage for all gold (and silver) miners is at its maximum.

For “swing traders”, this makes gold and silver miners very attractive vehicles because each time they bottom-out in a trough they can be expected to bounce back strongly as soon as bullion rebounds. Conversely, for many “shorts” these companies are also attractive, in that when bullion appears to have hit a short-term “top”, then that same “leverage” which works in the miners’ favour on the way up works against them on the way down.

We are now armed with the knowledge that gold and silver miners leverage the price of bullion to produce superior returns versus investing in bullion, alone, and that current valuations make these companies tremendous bargains in comparison to valuations at almost any other time in this precious metals “bull market”. This also puts us in a position to examine which segments of this sector offer the best potential returns.

The “Junior” Producers
I (and many other commentators) recommend the “junior producers”. There are many reasons to choose these smaller companies versus the larger, and more-popular senior, and mid-size producers and here are a few:

1. “junior” producers typically have far superior production-growth profiles. While most large producers would be happy to be able to increase production 10% to 20% in any given year, smaller producers are generally able to dramatically outperform this level of growth. A junior producer which brings a new mine on-line, or completes a major expansion of existing facilities, can easily generate production growth of 50% or 60% – or even more, in a single year.

2. companies with high profit margins offer less leverage than lower-margin producers but also less risk and, in the case of juniors, their more aggressive production profiles mean that they tend to spend more money on exploration and development (relative to their size) than larger producers. This means that few junior producers operate with large, net profit margins – even when bullion prices are relatively high. As a result, the leverage offered by junior producers will generally greatly exceed that of larger producers at any price for bullion and, naturally, these reduced margins mean more down-side for the stocks when the market is falling.

With the valuations of all these miners still terrible, there will rarely be a time when the risk/reward ratios are more favourable for investing in junior producers than now.

In Delationary Times
With gold and silver having demonstrated, historically, that they hold their value better than other asset-classes during deflationary periods, this translates into less risk for the shares of the miners than virtually any other sector of equities.

In Inflationary Times
I am completely convinced, given the reckless increase in the global money-supply and global debt-levels, that it is inflation which will assume dominance in most markets and asset classes in the future. This means that commodity-producers, in general, and gold and silver miners, in particular, also offer superior long-term growth/profit potential versus other sectors.

All investors need to have significant protection from the economic turbulence which lies ahead of us through the purchasing of gold and/or silver bullion. However, do not forget that it is the gold and silver producers that offer the greatest potential in surviving (and hopefully thriving) in these challenging times.