Friday, August 17, 2007 0 comments

Purchase: Harmony (HMY)... thoughts on gold

I purchased Harmony (HMY) this morning at US$9.11. Ok, I have to admit that this was a questionable move done without too much deep thinking. To make matters worse, the online website for CIBC World Markets (Canada) was very slow this morning so I didn't have time to track the price closely to see if I can pick the bottom.

Having said all that, I think I would have gone into gold at some point over the next couple of weeks. So it isn't as impulsive of a decision as it seems. I came across a link to this week's Donald Coxe conference call where he was expressing his bullishness for gold (thanks to some poster on the message board at billcara.com for the URL link). If you have some time, check out Donald Coxe's comments. I personally don't like his convervative views (just like I'm sure he wouldn't like my liberal views :) ) but he is a thinker with insightful non-mainstream views. He has been very bullish on commodities over the years but now it looks like he likes gold. His view is that gold should do well since he expects the US$ to decline.

I had been thinking about gold stocks over the last few weeks but didn't really decide on a company. The main decision I had to make was whether to go with a junior or an established company. Gold bullion was also another choice--a safer choice--but I wanted higher returns. Gold equities haven't performed well relative to bullion in the last 2 years but historically that isn't the case. Theoretically, gold equities should outperform bullion. Equities have higher risk (management risk, fraud risk, discovery/failure risk, environmental issues, etc) so they should compensate shareholders more or else no one would invest in them. So I only thought about gold stocks and sort of ignored bullion.

I have had good success with producing juniors (I only look at juniors in production or close to production) in the past (Nevsun, Desert Sun Mining), and obviously the juniors have more leverage. But this time around I was thinking that juniors may be a bit risky. My concern was with the fact that the market may not be so enthusiastic about these companies if base metal juniors struggle (which I think they will if the economy slows as I expect). Furthermore, with the market starting to discount risky assets, such as subprime debt, junk bonds, emerging market stocks (hasn't happend yet), and so forth, junior miners may be discounted heavily by the market as well. Note that the market was accepting low returns for risky assets a few years ago so junior miners, just like junk bonds, performed exceptionally well. So I was leaning towards the mid-cap and large-cap gold producers.

The question that was running in my mind was whether to look at high-cost producers, which have far higher risk, or the low-cost ones. As I remarked in one of my prior posts, high-cost producers have higher leverage so the returns can be much higher. The way I look at it, there are two "types" of high-cost producers. Some have high costs because they have marginal assets; while others have high costs because cost of production is higher. The first category of producers tend to have ores with low gold density. Many of these companies either do not develop these assets into mines and simply wait (or spend their time on more exploration). The latter category tends to have decent ores by modern standards but their costs are high. Typically the problems are with high labour costs, deep mines (as opposed to the cheaper open-pit mining), high energy costs, or bad currency exchange effects.

I decided to go with the latter category of miners who have decent gold orebodies but higher production costs. The best area to find such companies is in South Africa, although some parts of Canada and Europe also have high costs. Some of the biggest gold companies in the world are South African and the ones I looked at were Goldfields (GFI) and Harmony (HMY). There are a lot of issues being faced South African producers:

  • Deep pit mines: A lot of South African companies are having to dig deeper and deeper to find more gold
  • Rand strength: The Rand has strengthened considerably versus the US$. Gold priced in Rand hasn't kept up.
  • Labour costs: Labour costs are increasing sharply due to government actions and stronger unions
  • High healthcare costs: Something like 30% of Harmony's employees are HIV positive for example.

A lot of investors will run away due to these issues but I think the stock price of HMY reflects a lot of the negativity. As well the stock got hammered when the CEO abruptly resigned, in a quarter where an expected profit was an actual loss. I can see the stock falling further if HMY doesn't turn its operations around. Harmony has been trying to turn around things for the last few years and most people thought it finally turned a corner only to see it posting a loss last quarter. But I'm hopeful. I know hope has no business when it comes to investing but if the gold price appreciates a bit then HMY should post a profit. Given that HMY is a high-cost producer, it should see huge increases in profits if gold actually goes up quite a bit. Some of negative issues also have more upside than downside. For example, labour costs are probably close to stabilizing and the Rand may not have much more room to appreciate even if the US$ index falls (I think the US$ will fall mostly against the Yen, not some currency like the Rand).

Purchase Price: US$9.11
Expected Investment Time Frame: short to medium (max 2 years)

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