Even the best investments can go awry for reasons beyond the control of companies and investors. One of the most important factors in this regard is currency fluctuation.

As investors in South African gold stocks have painfully learned over the past several years, changes in currency exchange rates can have a huge effect on the price of resource stocks. In the first half of 2003, the South African rand appreciated 23% against the US dollar. The result being that despite a 10% increase in the average gold price, and a 20% jump in the platinum price, the rand price of these metals actually fell 14% and 7%, respectively.

Similar trends were observed for several other minerals. The rand continued to strengthen into 2004, surging more than 40% in a 12-month period and more than wiping out a 20% lift in bullion prices. Companies with operating mines in South Africa, and other countries where the currency appreciated significantly against the greenback, saw their profit margins squeezed because such firms pay most of the costs in the local currency while earning US dollars for their output.

In fact, by early 2004, two of every five South African gold mines owned by the country’s major producers were operating at a loss despite higher gold prices, while another third were making less than 10% profit. Companies with marginal operations have thus been devastated. Because of the strong currency, Harmony Gold (HMY-N) saw its stock fall from $17.80 to $9.25 in six months and Thistle Mining’s (THT-TSX) stock plunged from C$0.75 to C$0.08 over a year. In the second quarter of 2004, Thistle’s cash costs to produce an oz of gold hit $570, compared to the $393 per oz they received in payment. Harmony’s costs were $395.

It’s important to note that, for a producing company, the currency in which a stock is priced should make no difference and shouldn’t form part of the investment decision-making process. Whether you buy Newmont Mining on the Australian Stock Exchange or on the NYSE, each dollar you invest will give you the same interest in the company’s assets and profits.

What is crucial is the currency in which a company’s costs are denominated. Such currencies affect earnings, and earnings affect share price. For example, suppose a Canadian investor buys stock in a US-based gold company with $100 million in yearly revenue and $10 million in annual profits, priced at US$1, or C$1.24, per share. If the gold price rises by 10%, the company’s revenue goes up a corresponding 10%. If the C$ also rises 10% against the USD it matters not to the miner – costs to produce an ounce of gold remain unchanged, generating an additional US$10 million per year in profits. The stock price should hit $2, giving the Canadian investor an 80% gain even when the 10% currency exchange loss is factored in.

This is, of course, oversimplified. Just because gold goes up by 10% does not mean a stock will necessarily go from $1 to $2. On a smaller scale, suppose a company sells 100 ounces of gold annually at $400 per ounce for revenue of $40,000. Cost to produce gold is $300 per ounce, generating a profit of $10,000. With 10,000 shares outstanding, earnings of $1 per share and a market P/E of 10, the stock would trade at $10. A 10% rise in gold to $440 per ounce generates revenue of $44,000 resulting in a profit of $14,000, with costs remaining at $300 per ounce. At a 10 P/E this makes the stock trade at $14, giving the Canadian investor a 27.4% gain, even when taking into account a 10% appreciation in the Canadian currency. Still a tidy profit.

But beware the inverse situation. Suppose a US investor buys shares in a Canadian gold company with the same specs – revenues of C$100 million and earnings of C$10 million per year, for a share price of C$1, or US$0.81. If the US$ gold price increases 10% and the C$ rises 10%, the revenue gain from the increased gold price would be wiped out by the gain in the currency, the end result being that the stock adds no overall value and maintains the C$1 share price. Of course, a US investor would make slight gains on the currency exchange, but only in the amount of US$0.08 per share, or 11%.

For US investors, the implication is that, with the USD likely to continue weakening, it’s best to buy into operations either in the US or in countries where the currency is not likely to appreciate significantly against the dollar. Another way to gain is buying non-producing Canadian exploration issues, which offer leverage to rising commodity prices plus a slight added upside from the exchange on the rising Canadian dollar, without exposure to increasing production costs. Exploration stocks tend to be less impacted by exchange fluctuations than are major producers, although even juniors are not completely immune to currency considerations.

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For information on an early stage gold company exploring in Nevada check out: Keegan Resources.