小北的不老歌

Today

IMG00021.jpg
There’s a band playing in the plaza downstairs today, and Anna couldn’t move her feet when she saw the drum set. When the band was done, the drummer invited her to the stage and let her play with the drums. I snapped a picture with my blackberry. Anna loves musical instruments. She now claims that she wants an oboe when she grows up. I am just glad that it’s not a trumpet or drum set that she wants.

* * * * *
Since the recruiting season is just around the corner, I thought I’d share one random question I came across when I was going through OCI. Can’t remember whether I heard or read it somewhere, or I was actually asked the question during an interview. Anyhow, the question is this: why would people ever want to invest in the stock of gold mining companies when they can directly invest in gold, the product of these companies? I think the unstated logic behind the question is this: Presumably the price of gold is positively correlated with the price of the stock of gold mining companies, and as some may argue, gold has intrinsic value as a hard currency, whereas the stock certificate does not. So why doesn’t every investor in gold mining companies just buy gold instead if they think gold is going up in price?

I think I have an answer. But this may well be one of those open-ended questions for which there is no “correct” answer, or multiple “correct” answers. What do you think the answer should be? Comments are, as usual, welcome.

Comments (7)

  1. Xinxin

    That’s an interesting question. My theory is, because gold mining companies’ market value is not the same as the value of their gold mine reserves. It is discounted because of exploration and exploitation costs , political risks, force majeure risks, etc. You would invest in a company if you think the costs/risks combined would be less than the difference between the value of the company’s reserves and the company’s market value, so you can get the extra value. This of course doesn’t work under the efficient market theory, but in reality, people think they can beat the market all the time.

  2. Yeqing

    If the price of gold is 100% positively correlated with the price of the stock of gold mining company, then the only reason to invest in the stock is to avoid the 28% capital gain tax for collectibles. The capital gain tax for stock is 15%.

  3. Alice

    This is an unexpected question to me … Would you mind sharing some law firm interview experience, when you have time?

  4. AK

    Maybe another factor is individual company vs. entire industry difference?

  5. littlenorth

    Thanks, guys. My original thought was similar to Xinxing and AK’s — if one company can distinguish itself by being more efficient in extracting gold than others, then there’s extra value in that company’s stock compared to gold, which is fungible and has a set price regardless of how you extract it. I hadn’t thought about the tax issue Yeqing mentioned at all…

    Then I thought perhaps there’s more to this. A stock certificate essentially represents the right to the company’s future earnings. A gold company’s earnings is much more volatile (and has a much higher potential upside — as well as downside) than the price of gold, so risk-seeking investors would prefer stock in gold mining companies rather than gold, especially when gold price is expected to go up.

    A hypo: if a company extracts one ounce of gold per year, at a cost of $900 and sells it for $1000, it earns $100 for the year. However, if the gold price goes up by 10% to $1100, its earnings will go up by 100% to $200. So if the P/E ratio for this company remains the same, its stock price will also double, providing much higher returns than one can get from investing in gold. Should be interesting to see whether this was indeed the case for oil companies last year.

    What do you think?

    Alice — I’ll try to think of something to share here.

  6. kshang

    I think the issue is whether, when the gold price rises, the price of gold mine also rises. If the gold price goes up 10%, I would imagine the cost would go up 10% too.
    In scenario one when the company does not own the gold mine as its equity, the value of the company beforehand would be 2,000 (present value of a perpetuity of 100, at a hypothetical rate of 5%), the cost would be 990, the earnings would be 110 (FMV of 1100 minus 990, instead of 200 when assuming the cost stays constant), and PV of the company after the price hike would be 2200 (PV of perpetuity of 220 at 5%), instead of 100% higher.
    In scenario two when the company does own the gold mine, the idea is like the company marking its balance sheet up by 10%, so even if the company is all equity and no debt, the upward room is only up to 10%, and the “cost of goods sold” for purposes of calculating P/E would still be 990, resulting in the same numbers. I understand that mark-to-market is mostly for marking down the price, but the difference is only the way of calculation–whether you want to mark the assets to the market instantly, or would rather look at it as 100% rise of profit margin for a few years–such rise will run out of steam after a number of years. Only when the investors believe that the rise at 100% will stay constant will they pay double the price. But most likely, the price will go only 10% higher.

  7. kshang

    p.s.: I think the choice between gold and gold mine is one’s liquidity tolerance/preference. If it’s a bank, it would probably like the metal sitting in its vault. If it’s a pension fund looking for better return in the long run, it may prefer gold mine, because at the same amount of present value, the market price of the gold mine already reflects a built-in discount rate (liquidity discount), whatever percentage that might be, and it has the patience to extract that, which would give a better rate of return at the end.

Comments are closed.