Digging for Opportunity in Precious Metals, Part 2

VANCOUVER (Bullions Bull Canada) -- Part 1 of this three-part series identified the basic premise of successful investing ("buy low/sell high"), and then explained both empirically and as a study in psychology how/why most investors violate this Golden Rule with their investing.

Readers were introduced to the Contrarian paradigm of investing. It was then shown how adopting this Contrarian perspective offered investors the only realistic possibility of buying low and selling high on a potentially consistent basis.

The first part of this series then concluded by explaining what makes gold and silver mining companies a Contrarian's dream: a "low tide" sector currently bereft of any investment capital that despite its unloved status has a 12-year bull market behind it.

The obvious inference here is if a sector at "low tide" can have a 12-year rising trend behind it, imagine where it will go when the tide finally comes in. Part II will illustrate how/why precious metals and precious metals miners have the most-favorable fundamentals of any sector going forward.

There are far too many bullish fundamentals backing gold and silver to merely list them all. Readers interested in why the metals' price must rise have plenty of past commentaries from which to choose, beginning with The Three Legs of the Precious Metals Bull.

When one speaks of any commodit -producer "leveraging the gains" in price for the commodity they produce over time, this notion is not a mere suggestion, theory or conventional wisdom. This is simple arithmetic, and so, just as 2+2=4, it must be true. An easy, hypothetical example demonstrates this concept in tautological terms.

An investor enters the market with a specific quantity of capital to invest. The investor wishes to position his capital in the precious metals sector. However, he is torn between investing in bullion or the miners, so he puts half into each. For simplicity, I will use a starting price of $500/oz per gold (the principle is true with respect to any numerical value).

Making things even simpler, there is only one gold miner in which investors can purchase shares and it costs this miner $400/oz for each ounce of gold it digs out of the ground and then processes.

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.

This is the "greed" dynamic: accepting a higher level of risk in return for (significantly) greater profit potential. Arithmetic can tell us precisely how much these mining companies should be able to leverage gains in the price of bullion. How much they actually leverage metals prices is the net product of the fear/greed dynamic.

This is where things get interesting. Gold and silver miners must (over time) leverage gains in the prices of the commodities they produce. However, the media have told us again and again that for most of the 12-year bull market in bullion prices the miners have "not leveraged" the gains in bullion prices.

But it's much more than that. For most of the time they have "underperformed" bullion. This doesn't mean partial leverage, or "only a little" leverage. We're talking about less-than-zero leverage. This can only mean one of two things.

Perhaps we have "the market" telling us that we're witnessing the most intense fear dynamic in market history. Low tide in the precious metals mining sector...for 12 years. Investors fleeing in panic because these companies are reporting "record profits" throughout most of this 12-year run. Twelve years of the most cowardly and/or ignorant investor behavior ever witnessed in our markets.

The other explanation is much simpler: The share prices of these mining companies have been ruthlessly/relentlessly suppressed to prevent them from reflecting the leverage inherent in the business model of all commodity-producers. This question can perhaps be resolved with a simple (if ad hoc) investor "test."

With the entire precious metals sector at "low tide" throughout this 12-year bull market, most of the investors reading this will have never held any bullion or shares in the miners at any time in this epic run. Those readers can ask themselves this question: Have you shunned this sector because you're a cowardly idiot, or simply because you have been deceived?

Even those who accept "suppression" as the more likely explanation, why risk investing in a sector subject to serial suppression? The reply comes in two parts. Like pushing a cork beneath water, such price suppression inevitably fails and the "cork" pops back up.

The more interesting half of the reply is that we have good reason to believe we're nearing an absolute bottom. However, don't accept the words of a "gold bull" here, but rather get that same sentiment from Lauren Templeton Investments, which doesn't like gold:
At first glance, it may seem strange to use the words bargain and gold in the same sentence. However, the distinction lies not in the shiny yellow metal but rather in the observation that the mining firms operating in this space have not traded at such low valuations since the Lehman induced panic of the financial crisis during late 2008...

The rally in the gold- and silver-mining companies that followed that bottom was the most spectacular of this entire bull market.

There is one final, but crucial caveat here for investors: the major distinction between the large-cap miners and the junior miners producing in this sector. This will come in the conclusion of the series.

This article was written by an independent contributor, separate from TheStreet's regular news coverage.

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