We’ve never been big believers in owning gold and silver. Warren Buffett’s comment (most recently in his 2011 letter released on Saturday) that all the gold in the world could be exchanged for “all U.S. cropland (400 million acres with output of about $200 billion annually), plus 16 Exxon Mobils…” with $1 trillion left over is one of the more eloquent ways to describe the value of gold. It is one of those commodities whose value is derived from the expectation that others will pay even more for it; most gold is expensively mined, moved and buried again in a vault somewhere. It seems a wasted effort.
But we take the world as we find it rather than as it should be. Developed country governments are providing more reasons to be suspicious of fiat money, and the notion that the solution to excessive debt is steady currency debasement is not easily dismissed. The New York Times noted on Monday that interest expense on the Federal debt is roughly where it was in 2006 even though the debt outstanding has doubled; the government is setting its own interest rates at levels too low to provide a real return to savers, and as such the budget’s sensitivity to higher interest rates is more acute. If the Federal Reserve does ever raise rates their analysis will need to incorporate the increased fiscal drag of higher interest expense, perhaps resulting in negative real rates for longer than might otherwise be the case. And the latest LTRO operation by the ECB has created another 500BN Euros or so of liquidity. So it’s not difficult to construct a dark, inflationary outlook.
That’s not our central view, though it is a real possibility. But you don’t need to be an extreme gold bull to find value in mining stocks. Coeur D’Alene (CDE) is a name we’ve owned (in small to modest size depending on valuation) for a couple of years. They are one of the few pure silver miners around, although gold is becoming an increasing percentage of their output. Silver is an interesting metal in that it has highly inelastic supply and demand. Most silver is produced from non-silver mines, so silver supply is driven by the price of nickel, copper or whatever is the primary output of a given mine. Demand is similarly inelastic because silver is a vital but tiny input into many manufacturing processes from consumer electronics to medical products. So the price has to absorb changes in supply and demand, making it very volatile. Around 50% of silver demand is for commercial use.
Gold has less industrial demand and “investment” (i.e. speculation) has been growing. Figures from GFMS (used in some research published by JPMorgan) reveal that gold jewelry demand has still barely rebounded from its 2008 trough of 1,800 tons (2012 estimates are 2,120 tons compared with 2001 demand of 3,000 tons). The big swing factor remains speculation (around a third of 2011 demand). But mining stocks appear quite attractively priced relative to bullion and are an interesting investment even if you’re not bullish on gold/silver. Using CDE’s proved reserves of 51 million silver ounces and 830K in gold ounces and assuming modest decreases in capex from 2012 guidance, 3% annual increases in extraction costs and current prices values the company at $30, around its current price. We think of this as our Downside Case. In the Upside Case, if all their probable reserves were successfully mined the same analysis results in a $50 price. CDE is cheap to the NPV of its likely production assuming no new discoveries. They also represent a levered way to invest in gold and silver because if precious metal prices rise their operating leverage will result in more quickly increasing profits. They may even start returning cash to shareholders through a dividend at some point, and because CDE never hedges it makes valuing the stock and managing an investor’s risk simpler.
CDE is not unique. Gold and silver miners have generally been lagging precious metals, and the last six months is a case in point. For similar reasons we also think GDX is an attractive investment. Even an investor who’s not totally convinced that governments are about to inflate away our savings can find something to like in precious metal mining stocks.
Disclosure: Author is Long CDE, GDX