Currency Exchange Rates and Gold Mining Companies

As investors in South African gold stocks have found over the past several years, changes in currency exchange rates can have a huge effect on the prices of gold stocks. By considering two hypothetical examples, we'll attempt to demonstrate why this is so. First, though, it is worth mentioning that the currency in which a stock is priced makes no difference and shouldn't form part of the investment decision-making process. For example, it makes no difference whether you buy the AUD-denominated stock of Newmont Mining on the Australian Stock Exchange (NEM.AX) or the USD-denominated stock of the company on the NYSE (NEM). Regardless of whether you buy NEM or NEM.AX, each dollar you invest will give you an identical claim on the assets and profits of Newmont Mining. As such, the performances of NEM.AX and NEM will be the same when the prices are converted to a common currency. What does matter is the currency (or currencies) in which a company's costs are denominated.

Example #1: A Canadian-based investor buys shares in a US-based gold company for US$1/share, which equates to C$1.40 assuming an exchange rate of USD1 = CAD1.4. In this example the company is assumed to be generating earnings at the rate of US$1M per year on revenue US$10M (meaning that the company's total annual cost is US$9M). The company has 10M shares outstanding so the profit equates to 10c/share. The stock is therefore trading at a price/earnings (P/E) ratio of 10.

Now, assume the US$ gold price rises by 10% and the C$ also appreciates by 10% against the US$. If the USD-denominated stock price remained the same under these circumstances then the CAD-denominated stock price would now be $1.26, that is, our hypothetical Canadian investor would have a loss of 10% due to the appreciation of the C$. However, it is extremely unlikely that the US$ stock price would have remained the same under these circumstances because the 10% increase in the US$ gold price would have resulted in a 10% increase in the company's US$ revenue (from US$10M to US$11M). And, if we make the assumption that the company's costs were unchanged at US$9M then earnings would have increased by 100% to US$2M (20c/share). Therefore, if the market still valued the company at 10-times earnings the stock price would now be US$2 (the stock price, in US dollars, would gain 100%). This is equivalent to C$2.52 at the new CAD/USD exchange rate. In other words our Canadian investor would have a profit of C$1.12/share, or 80%, as a result of the 10% increase in the US$ gold price and the 10% increase in the C$.

In the above example a substantial profit was possible because our hypothetical gold mining company, like most unhedged gold mining companies, represented a leveraged play on the gold price. This, in turn, meant that the increase in earnings resulting from a fall in the mining company’s local currency far outweighed the exchange rate loss that a foreign investor would experience.

Example #2: A US-based investor buys shares in a Canadian-based gold company for C$1/share, which equates to US$0.71 assuming an exchange rate of USD1 = CAD1.4. In this example the company is assumed to be generating earnings at the rate of C$1M per year on revenue C$10M (meaning that the company's total annual cost is C$9M). The company has 10M shares outstanding so the profit equates to 10c/share. The stock is therefore trading at a price/earnings (P/E) ratio of 10.

Now, assume the US$ gold price rises by 10% and the C$ also appreciates by 10% against the US$ (the same assumptions we made in Example #1 above). In this case the gold price in Canadian Dollars would be unchanged and company earnings would therefore be unchanged at 10 Canadian cents per share. So, if the market still values the company at 10-times earnings the stock price will remain at C$1, but this is now equivalent to around US$0.79 due to the appreciation of the C$. In other words our US investor would have a profit of US$0.08/share, or 11%, as a result of the 10% increase in the US$ gold price and the 10% increase in the C$. That is, he/she would have gained nothing from the increase in the US$ gold price but would have achieved a small profit on the currency exchange.

The above examples are simplistic because we assumed that costs and P/E ratios would remain the same and we didn't take into account taxation. However, by showing how a moderate change in currency exchange rates can dramatically impact company earnings and therefore stock prices we have hopefully been able to demonstrate why, with all else being equal, it is better to own gold mining companies that have most of their costs denominated in the weakest currencies. In the current environment this would involve owning the gold mining companies that have a large chunk of their operations in the US.

Unfortunately, all else is rarely equal. For starters, an investor only gains an advantage when the price paid for a stock does not already discount the 'future good news' expected by the investor. In the current environment, for instance, the likelihood of further US$ weakness over the next 12 months would only make the stock of a US-based gold producer more attractive than the stock of a South African-based gold producer if the effects of this dollar weakness had not already been factored into stock prices. Taking a specific example, it is hard to believe that the current stock price of Harmony Gold doesn't already discount something close to the worst case as far as the next year's earnings are concerned. Also, when a currency is weak over a long period of time a point will eventually be reached when the rate of increase of domestic prices will exceed the rate of decrease of the currency's exchange rate. Over the past year the US$ fell a lot further against most of the other major fiat currencies than it did against the labour, plant and materials used by US-based miners to produce gold. At some stage, though, the weakening dollar will begin to have a big effect on the "operating costs" section of the income statements of US mining companies.

With the junior exploration stocks - the area of the market on which we've focused over the past 6 months - exchange rate fluctuations tend to have less impact on stock prices than is the case with the major producers. However, even with companies that are years away from production a substantial change in the currency exchange rate can have some effect on the current stock price. This is because the estimated future costs of production, and therefore the quantity and value of gold reserves, will potentially be affected by a change in the exchange rate.

Steve Saville

Hong Kong

May 24, 2003

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