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Digging for Opportunity in Precious Metals, Part 2

The investor is successful. Gold moves from $500 to $1,000/oz. Now let's see how this price- hange has impacted upon this hypothetical portfolio. The effect of the rise in price on this investor's bullion holding is simple. With the price moving from $500 to $1,000, he has doubled his money. However, the picture is much different when he looks at his mining investment.

With the cost to produce each ounce of gold being $400/oz; at $500/oz the miner was making $100 (or a 25% margin) on each ounce of gold produced. Not too shabby, but nothing to get excited about...yet.

With the price of gold at $1000/oz, this same mining company is now making $600 profit on each ounce of gold produced as its profit margin soars from 25% to 150%. The investor's bullion has doubled in value but the mining company in which he holds shares has become six times as profitable.

Does this leveraging of gains in price mean the share price of the miner should have automatically risen by an equivalent six-fold gain even in our hypothetical world? In a word, no.

The share price may increase by less than that six-fold increase in profitability. There are risks involved with "producing" anything. The small risk of natural disaster or the larger risk of human error are two of the most obvious. Those considerations may result in the share price of the miner reflecting somewhat less than the six-fold rise in profitability. This is the "fear" dynamic.

The share price may increase by more than the six-fold increase in profitability. A "smart investor" may ask himself the following question: If I can potentially leverage all of the gains in bullion prices by (in this example) a factor of six, why wouldn't I invest all of my capital in the miner instead of bullion itself?

Translating that thinking back into the real world, since the miners must leverage gains in the price of bullion (over the longer term) one can afford to absorb the occasional individual "loser" and still prosper with these investments over the longer term. In other words, even discounted for risk there is at least the potential to come out well ahead by choosing the miners.

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