I was 4-wheeling across the Nevada desert in a truck full of geologists some years ago, when someone asked which major gold producer I liked best. I don’t remember my answer, but I’m sure it would have been the most consistently profitable at the time. The geophysicist in the group disagreed. He argued in favor the companies making almost no money, because their margins would improve the most with higher gold prices, and so their share prices should rise more.
That does make some sense…

• Imagine a marginal miner that barely makes $5 per ounce of gold produced.
• Imagine a much healthier company that makes $500 per ounce produced.
• Now suppose that the price of gold rises $100.
• The company just barely making it just saw its margins increase 20x, while the profitable miner’s margins improved only 20% (0.2x).

Naturally, the market should reward the company with the soaring margins more, right? I know some famous resource investors say so. But I never speculate on this basis.

Here’s why…

First, this theory assumes that the main driver for share prices among produces is increasing margins. I grant that better margins are a good reason to expect more earnings and thus justify a higher share price. But when it comes to miners, there’s always a lot more going on. For instance, even among the larger players, a major discovery can move share prices even when margins remain the same.

The bigger and more dangerous assumption, however, is that marginal producers are just as sound investments as the healthy companies, just not making as much money.

This might be true in some cases, but in my experience, it’s almost never so. Even if a company was solid before its production became marginal, the moment the cash flow drops, so does spending on exploration—and even development and maintenance. In the best of cases, it can take time to recover from this belt-tightening. In the worst of cases, management may cannibalize the future of the mine to try to make it pay in the present, and it never recovers.

And some marginal producers are not just marginal because commodity prices didn’t go their way. Some are simply inefficient, or sloppy, unaware of rampant theft on their grounds, or incompetent in some other way. It’s possible for incompetent management to lose even more money at higher metals prices.

It should also be said that some mines should never have been built. Higher prices won’t help a fatally flawed mine.

Finally, even if a marginal producer is a great company run by wonderful people, and we really could be sure it would gush more cash at higher metals prices—we can never be sure metals prices will rise.

Imagine what would happen to the two companies in my example above if gold dropped $100 per ounce instead of rising by that amount? The marginal producer’s cash flow would turn negative. The healthy company would 20% less, but would still be making a lot of money.

You can guess what would happen to their share prices as well as I.

So, yes, marginal producers can offer more speculative upside… IF they do indeed turn higher prices into higher margins, and… IF the markets recognize that.

In short, there may or may not be more upside in marginal producers, but there’s usually more risk.

I’m okay with higher levels of risk in my explorers.

But I want my producers to be solid. I want the comfort of knowing that they’re likely to still be there even if something unexpected happens—like the world shutting down over COVID-19 even as gold prices reach eight-year-highs.

This is why, when it comes to producers, consistent profitability is a non-negotiable in my book.
That’s my take,