Everybody knows that markets move in cycles, yet nobody can predict when these cycles start or end. What we can say however, is that the down cycle in commodity markets is much closer to the bottom than the top. I make this statement without fear of retribution because many commodities including gold, silver, copper, uranium and nickel are selling for less than what it costs to produce them. This situation cannot last. Either the supply dries up, or the price goes up. In the case of gold specifically, the World Gold Council reported today (August 19, 1998) that gold demand increased by 50% compared to the previous quarter. Sooner or later gold prices are going to rebound and when that happens most people are going to look back and wish that they owned some gold stocks. Others, like you and me, are going to look back and smile because we do own some gold stocks. What we have to decide, are which gold stocks to own.

Good North American gold companies such as Barrick and Newmont are excellent investments right now. But South African gold companies by comparison are much, much cheaper and offer a lot more leverage to gold prices. Consider Goldfields Ltd., the second largest South African gold mining company: According to Goldfields’ management, the company should generate around $300 million in cash flow with gold trading at $300 an ounce. Goldfields’ market capitalization is only $1.2 billion, four times cash flow. That is dirt cheap for a company the size of Goldfields. Compare that to Barrick, which is trading for approximately twenty times cash flow and Newmont, which is trading for approximately twenty eight times cash flow.

Why you should invest in South African gold stocks?

The biggest gold reserves in the world
The discovery of a million-ounce gold deposit is considered a major discovery. It is the benchmark against which exploration companies measure themselves, each striving to discover that elusive million ounce deposit that is going to put them on the map. Rarely do any of them succeed, since million-ounce deposits are scarce. Once discovered though, a million-ounce deposit becomes a coveted possession, which junior companies try to leverage into either cash or a carried production interest. But we all know that the probability of finding such a deposit is slim, hence it’s value. It is also the reason why mining giants like Barrick and Newmont have a commanding role in the gold mining industry; they each have over 50 million ounces of proven reserves.

What is not commonly known, or at least those who know may need to be reminded, is that what is considered a major discovery in the rest of the world, is often table scraps in South Africa. To put South African gold mining in perspective, consider that Anglogold, whose mines are principally in South Africa, has more proven gold reserves that of Barrick and Newmont combined. A million ounces is often left unmined, because it may be difficult to get to. Gold mining in South Africa dwarfs the rest of the world both in terms of annual production and in terms of gold reserves. For a South African gold mining company the question is not “where are we going to find more gold?” but “when are we going to mine all this gold?”

South African gold mines rank among the largest in the world, bar none
Anglogold is the largest gold mining company in the world by a wide margin. Annual gold production is more than 6.5 million ounces compared to Newmont, ranked number 2 in terms of production, which produces almost 4 million ounces a year. Newmont has roughly 53 million ounces in reserves whereas Anglogold has in excess of 120 million ounces in reserves. This enormous size gives Anglogold the flexibility to fine tune its production profile according to prevailing market conditions. Anglogold also has the largest gold hedge book, with over 6 million ounces hedged at an average gold price of $470 an ounce. At the same time, Anglogold’s production costs are declining rapidly as the benefits of merging all their mines into one production company are realized and as the devaluation of the rand improves their operating margins.

These companies have extraordinary long lives, due to their size
Mine life has a major impact on the economics of a mineral deposit. Mines are very expensive to build, and capital is hard to come by. Investment decisions are based on the projected return on the capital employed and this is influenced by the life of the mine. The large size of South African gold ore bodies means that South African companies can invest capital with the knowledge that the mines will be in production long enough to pay back the capital employed and make profits for shareholders. Most world class mines have lives ranging from 5 years to 10 years, but seldom more than 15 years. South African mines have lives as long as 30 or 40 years with the majority of them having lives in excess of 10 years.

The Witwatersrand Basin yields large and predictable ore bodies
The Witwatersrand Basin is an enormous structure that spans more than 60 miles in width and 150 miles in length. The basin is thought to have been a large lake, or inland sea, into which rivers emptied and dropped their precious cargo of gold. Gold deposition occurred around the perimeter of the Basin and it is here where South Africa’s gold mining giants operate. Due to the nature of deposition and the amount of time that mining has taken place in the Witwatersrand Basin, mining geologists in South Africa understand the ore bodies very well. This enables them to predict where the gold is and assist in mine planning. Because of the relatively consistent nature of mineralization in the Witwatersrand Basin, large capital projects can be undertaken with a high degree of confidence.

Experienced miners and an entrenched mining culture
Gold was discovered in South Africa more than 100 years ago. In fact, gold has been mined without hiatus for more than 100 years in South Africa. This mining heritage is a huge advantage to the mining companies that operate there. First of all, there is no shortage of skilled and unskilled labor willing to work in the mines. Secondly, the laws of the country are conducive to mining, unlike some other countries such as the United States. Labor unions in South Africa are also well versed in the intricacies of gold mining, which helps to stabilize labor relations between the mining companies and their workers.

What are the problems facing South Africa and hence risk to investors?

The Mandela factor
I don’t know if anyone else could have done what Mandela did. To be released from prison after serving over 25 years of a life sentence and orchestrate the peaceful change of government in South Africa is no small feat. Mandela is very charismatic and has demonstrated amazing ability at bringing opposing people together in a peaceful manner. But Mandela is now an old man, and his successor is not as charismatic.

However, the government does not have the financial resources to fulfil the expectations of the masses. Savings in South Africa are not sufficient to supply the capital required and foreign investment is crucial. But foreign investment is not forthcoming mainly due to political and social risks, which are not adequately offset by the profit potential. One of the main reasons why the profit potential is not there, is the high tax rate in South Africa. This is an issue the government is going to have to tackle but I doubt if they will have the foresight to forego current tax revenue in exchange for private capital investment.

Education and labor skills
During the apartheid era, there was a dual education system that put black students at a distinct disadvantage to their white counterparts. In addition, student riots often caused millions of dollars’ damage to schools and books. The result of this is that what should have been an educated and motivated workforce of people between the ages of twenty and forty, South Africa has a disillusioned, uneducated and very militant population in this age group. In order to compete effectively in an international market, South Africa must either have a highly skilled, efficient and inexpensive labor force, which it does not have or else a very, very low cost, unskilled labor force, which it could have. The key is how the government structures its taxes and labor laws in order to attract foreign capital and businesses.

Crime
This is a big problem in South Africa. Violent crime statistics in South Africa are among the worst in the world, if not the worst. Crime such as theft is commonplace and often accompanied by more serious offences such as murder. In addition to economically motivated crime, there is a conflict within South Africa between supporters of the ruling political party, the ANC (African National Congress), and supporters of the IFP, whose constituency is predominantly Zulu. This conflict’s roots are embedded deep in South African history and dates back to conflicts between the Zulu and the Xhosa. Politically motivated slaughter is not uncommon in Africa and even though we only hear about the truly horrendous acts, which are tantamount to genocide, such violence unfortunately is part of Africa for the time being.

Unemployment, the root of all evil
Economically motivated crime in South Africa is a direct result of unemployment. The government released statistics indicating that unemployment in South Africa has reached 35%. Recently they published a new study that employed a different technique for estimating unemployment and this new study put the rate at around 22%. This is ridiculous. Anyone who lives in South Africa will tell you that the 35% number probably underestimates the problem. Unemployment is South Africa’s single biggest problem. Hungry and starving people turn to crime and it is estimated that almost half of the population in South Africa lives under the bread line. This means that a lot of people are motivated to steal, not because they are bad people, but because they are hungry and their children are dying of starvation. But crime breeds violence and in South Africa violence is a problem. The solution, however simple, is elusive. More jobs require more investment, which can only be achieved by higher savings rates and unfortunately the household savings rate in South Africa is a paltry 1%.

Inflation
Money supply growth in South Africa has been in double-digit territory since 1994 and as a result, inflation as reported by the average consumer, i.e. the people I know and talk to, has increased dramatically. According to the government, inflation as measured by the CPI is declining from 7.4% in 1996 to around 5.5% at the moment. If anyone believes that inflation is South Africa is 5.5%, then he or she probably also believes in the tooth fairy. Another indication that inflation is not as low as the government would like us to believe, is the fact that the bank rate in South Africa has not been under 15% since 1995. The bank rate was replaced by the repo-rate this year, which is currently over 21%. Inflation is a very nasty thing. It affects the poor much worse than the wealthy, since the poor live from hand to mouth and their meager income never keeps pace with inflation. The wealthy can at least invest some money in real assets to combat inflation. In this way, inflation exacerbates the dire situation of the unemployed and acts as a further inducement to crime.

A devaluing currency
South Africa’s currency, the rand, has devalued steadily against the dollar since 1981, shortly after it was allowed to float freely. This is in part due to the state of the South African economy and in part due to the growth in money supply within South Africa. A devaluing currency has an inflationary effect within the country and as we said earlier, this tends to make things worse. But the devaluing currency has some benefits for the mining industry. Because gold is sold for dollars, if the rand devalues against the dollar, there is a de facto increase in gold prices as measured in rands. In 1996 gold was around R1400 an ounce and today it is approximately R1800 an ounce even while the gold price has declined from $400 an ounce to less than $285 an ounce as measured in dollars. As long as the rand devalues, the gold mining companies have relief since there is a lag time between the increase in production costs and the immediate increase in the gold price. This buffering effect of the devaluing rand is an important aspect, which is often missed by investors who are looking for gold stocks with substantial leverage to gold prices without absurd risk.

Summary
As you have seen, there are many reasons to seriously consider South African gold stocks for your investment portfolio. These include the fact that South African gold mining companies have among them the largest gold reserves in the world. They don’t have to worry about where they are going to get more gold from - they have plenty. The large size of South African gold mines assures that mining will continue for a long time since with size comes flexibility, enabling them to change their production as dictated by the gold price and other factors. The fact that South Africa’s gold deposits are relatively predictable help geologists plan the life of mine production with more certainty, eliminating some of the risk associated with any mineral extraction business. The vast experience and entrenched mining culture ensures an ample supply of trained labor and eases the strain between labor and management. So which companies’ stock do you buy? That depends on how much leverage you want to gold prices.

Leverage to gold prices
There are two ways that gold companies are leveraged to the gold price: First of all, there is the way that profits are leveraged to gold prices. For instance, look at Anglogold. Its cost of production is $250 an ounce. If the gold price increases from $300 an ounce to $400 an ounce, Anglogold’s gross margin increases from $50 an ounce to $150 an ounce, a whopping 200%.

Secondly, there is the leverage to gold resources. Anglogold has over 280 million ounces that are uneconomical at this gold price. At higher gold prices, some or all of these resources become economic and the impact on Anglogold’s share price should be phenomenal. It could double, or triple the value of the stock without regard for the leverage to their gross margin described above. Taken together, an increase in gold prices to $400 an ounce could easily cause Anglogold’s share price to go up 5 to 10 times. That is the kind of return one would expect from a speculative junior stock, not the largest gold mining company in the world.

High dividend yield
South African gold stocks are well known for the high dividend yield investors enjoy. The low gold price has of course put a damper on dividend yields, but with a view of higher gold prices, it can be anticipated that these companies will once again pay unparalleled dividends. Given the amount of leverage to gold prices, it would not be surprising to see them pay dividends in excess of 10% once the gold price assumes an upward trend. This is not far fetched since Anglogold is currently paying roughly a 5% dividend yield and that is with gold trading under $300 an ounce. Imagine the dividend yield if gold goes to $400 an ounce.

An overview of some of South Africa’s gold mining companies
The table below lists some of the more salient features of South African gold mining companies. If you are unsure which ones are most suitable to your investment requirements, don’t hesitate to call me at my office. I will most gladly assist you in choosing the right gold stocks for you portfolio.

Salient features of selected South African gold stocks

The US share prices were calculated on August 21, 1998 using an exchange rate of USD/ZAR = 6.3.

Cost of production is estimated from available quarterly reports using the exchange rates mentioned above.

Cash cost and annual production were estimated from available quarterly reports and converted from kilograms to ounces. In the case of Anglogold, the production is an estimate based on incomplete information.

Reserves and resources were estimates based on available company information and are subject to change depending on gold prices and exchange rates.

Much of the information in the table above was obtained from Investec Securities in South Africa.