Our Current Credit Contraction
We are in the midst of a credit contraction. The great trading institutions on Wall St have gone broke, changed their nature or merged with other firms. Banks everywhere are under examination as to whether they are sufficiently capitalized. Loans by financial institutions are all being examined to see their validity. There is talk of a double dip recession, and fear of a continuing economic Tsunami. Insurance companies are under examination to see if their investment losses threaten their ability to meet their obligations to their policyholders. We are in a credit contraction.
The Last Major Credit Contraction
The last major credit contraction occurred during the Great Depression in 1929. During that time, gold miners (such as Homestake Mining) were among the few companies to reward its shareholders. Overseeing the current credit contraction, the striking similarities have to make the observer realize that similar sectors will again do well, for the same reasons. Starting September 2008, gold once again has started to outperform all commodities and assets.
Gold Mining Shares as an Investment
An examination of current factors indicates that that gold mining represents the best wealth creation opportunity over the next several years. In 1971, the price of gold was $35 per ounce. An investor could have bought gold bullion in 1971, and have a thirty-five fold return and counting as of today. Yet despite the price of gold increasing thirty-five fold, gold mining itself has not generally been a productive enterprise for investment. Why? Because the input costs (the cost o produce an ounce of gold) increased faster than the price of gold, resulting in little margin for the industry as a whole.
Finally, a Fundamental Change in the Cost of Mining Gold
In September 2008 private credit growth peaked. Since then, the price of gold has increased steadily, while the costs of mining gold have decreased significantly. The real price of gold, as measured against all commodities and assets, has increased. Today large cap miners have robust 40%+ operating margins as they are benefiting from the increase in gold prices relative to the costs to mine gold. We are only two years into a twenty year trend. It’s not late; it’s early to understand this sector and get into buying shares of companies in this sector.
Shares of Gold Miners are Cheap
Examination of shares of gold miners on the basis of price to net asset value or price to book value, shows that the miners as a whole are not underpriced on traditional metrics. Gold mining today is a value creation play in which the macro variables, increased real price for gold and decreased input costs, have aligned and the sector is now experiencing a basic change in valuation. As the real price of gold increases, mining profits will increase dramatically.
In recent years gold and gold miners have underperformed most other asset classes, but. in late April 2010, there was a turn from relative weakness to relative strength in gold and gold mining shares. Gold miners are the new leaders and have once again started to outperform all asset classes.
A Credit Contraction Creates an Increase in the Real Price of Gold
Whether we have deflation or inflation, we should remember history’s record that in a credit contraction, the real price of gold increases relative to all commodities and assets. This increase in the real price of gold and decrease in the price of mining it (including significant advances in technology), results in increasing profit for gold miners.
Gold mining will be one of the few, if not only, sectors to enjoy this type of tailwind in the years ahead.
Of course, the road will continue to be volatile and laden with pitfalls, but the trend remains our friend.
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