Mining companies, providing basic materials to fuel economies around the world, are unquestionably valuable economic contributors. But despite widespread demand for their products, mining companies may not be good investments for some investors. A common belief is that owning these companies gives shareholders exposure to growing commodities markets, a close proxy for the expanding global economy. But in reality, mining companies' profits don't always track price gains in commodities markets, given the unpredictable operating costs and ongoing capital expenditures of running a mining business.
Direct participation in commodities markets, however, either via trading commodity exchange-traded funds or straight commodities markets trading -- physical or financial -- may offer better opportunities to capture commodity price appreciation from periods of economic expansion.
Mining companies vs. commodities markets
Shareholders of a mining company must be aware of the many aspects of the business and willing to make a long-term investment commitment. Investment returns on mining stocks don't always come easy and quick, and sometimes may not be there at all.
Over the last three years, while commodities markets as measured by the S&P GSCI only flattened from previous highs because of slow economic recoveries, stock performance at major mining companies, including BHP Billiton (NYSE:BHP) and Rio Tinto (NYSE:RIO), turned mostly downward. In the preceding two years, commodity prices rose more sharply than mining stocks after coming out of the global recession.
The assumption that mining companies can always benefit from rising commodities prices overlooks operational challenges that exist even in good market conditions. Trading commodities, on the other hand, involves primarily evaluating supplies and identifying demands, a simpler service operation free of the nitty-gritty of the industrial production process.
Complex mining business issues are not limited to mining operations; there are also many nonoperational concerns facing companies, including environmental concerns raised by both social organizations and government agencies and sometimes difficult mining rights negotiations with local governments. There are often monetary payouts in reaching a resolution on disputed issues. Think about the environmental rehabilitation costs that mining companies have incurred over time.
At its core, mining operations must be efficient in all aspects, from mineral exploration and mine construction to mine production and price setting for their products. If that fails to occur, despite higher commodities prices, cost inefficiencies still lower mining profitability and undermine stock performance. One measure that mining companies have taken to boost earnings is cost cutting. In some cases, they might also sell off unprofitable assets -- a quick fix to please shareholders disappointed by the lackluster stock performance relative to the stronger showing for commodities markets.
Gold mining companies Barrick Gold (NYSE:ABX) and Goldcorp (NYSE:GG) are changing their expense-measuring metrics as a way of tackling the cost issues. Something called the "all-in sustaining cash cost" may become a preferred measure for calculating mining costs at the two companies in the future. The new measure adds certain capital expenditures to traditional operating costs, but involving only investments currently spent on existing mines to sustain a target level of mining production. As a result, cost numbers reported under the new measure will be higher. This should force management to pay more attention to profit margins and be more disciplined about operational spending.
Being up front about capital investments increases transparency for investors about the value of their mining holdings. Unrestrained capital expenditures on future new mines can be a huge drag on a mining company's current free cash flow, an important business-performance measure for investment valuation.
It's ironic that while mining companies are partly valued on the amount of proven mining reserves shown on the balance sheet, capital investments used to develop those reserves can lower reported earnings and reduce stock valuation for extended periods of time until new mines eventually come online. It's another reason why investors witnessing a rise in commodities markets may be surprised to see unequal returns on their mining stocks.
Another operational practice in the mining sector may also offer a clue to alleviate investor disbelief about the asymmetry of price increases between commodities and mining shares. Mining companies usually lock in a selling price for their products with commodities buyers beforehand. As a result, price increases in commodities markets may not necessarily affect ongoing sales at mining companies. Moreover, because mining stocks and commodities prices don't move in absolute lockstep, some investors who opt not to keep their holdings will also miss out when mining stocks do start to perform later, benefiting from higher preset selling prices during the cycle before.
To further complicate the situation, some banks take part in physical commodity trading, and they can play a dominant role in shaping commodities prices. As lenders to commodities producers, banks can use their power as a price negotiation leverage when trading with mining companies that need financing and may be pressured to give in on price agreements.
All things considered, investments in mining companies can be affected by multiple factors beyond just rising commodities prices, the most commonly assumed financial catalyst for mining companies. Investors must know that a successful investment in any company depends on how well run the company is, not just its product's prevailing market prices. Boost your 2014 returns with The Motley Fool's top stock
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Jay Wei has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.