A Case for U.S. Investment
In South African Gold Shares
In South Africa

The reasoning below rests on certain assumptions that I am not in a position to explore and certify. If the assumptions do prove correct, it can be very rewarding for US investors to invest in South African gold shares by transferring their funds into South Africa (SA) and doing the purchases here in rand currency on the JSE.

Two arguments are presented. The first, based on the rand hedging properties of an investment in SA gold shares, is more certain. The second, which requires assumptions to be made about the way taxation in the US works are beyond my ability to ascertain; yet if the assumptions are close to the mark, purchases of SA gold shares made by US investors in South Africa could substantially improve the profitability of their investments.

The inverse relationship between the price of South African gold shares on the JSE and the rand exchange rate, at a stable gold price, offers US investors a rand hedge for funds which are transferred into South Africa, preferably during a time of rand weakness. This is illustrated by using a back of envelope calculation on Durban Roodepoort Deep, an established gold mine with a record of fluctuating earnings, but with very good gearing (what Americans call leverage) if the gold price should move sharply higher, or if the rand should collapse – two events that are not necessarily mutually exclusive. In principle the same reasoning would apply to any mine, whether it is running at a loss or not.

The rand price of gold has been rising recently, but we can use an average of about R1750/oz over the last 9 months. At this rand price for its gold production, Durban Deep according to the Business Day JSE data shows a 26% Earnings to Price Ratio (or a PE of about 4) for earnings per share of about 360 SA cents. Its closing price on Monday, 1st March, was 1400 SA cents per share (cps) - with buyers at 1450 cps! This is $2.25 US at a dollar exchange rate of R6.20.

Assuming that the gold price continues just below $300/oz, we can now explore what would happen if a US investor sent $22,500 to SA to purchase 10,000 Durban Deep shares on March 1. We can consider two cases – one where the rand appreciates by 10%, and the other if the rand depreciates by 10%.

All other things being equal we can say that the price of Durban Deep shares should fluctuate as expectations of its earnings vary with the rand price of gold. This implies there is no large change in capital expenditure or working costs and, as said before, also no significant change in the gold price. A sharp move in the gold price would affect market sentiment out of proportion to its effect on earnings and much more so than changes in the value of the rand.

A falling rand would increase the rand price of gold, the revenue of the gold mines and thus the rand price of gold shares, while a stronger rand would have the opposite effect.

Consider the 10% increase in the value of the rand. If the price of Durban Deep shares remained unchanged, the US investor would be making an exchange profit of 10% on the purchase price, or $2,250. However, a stronger rand would decrease the rand price of gold by 10% and this will reduce the mine's revenue for the same amount of production. The degree by which earnings are reduced will depend on the cost of production of the mine.

Durban Deep produces gold at a cost of R1680/oz (US $271 at R6.2). This means that a gross profit on working cost of R1750 – R1680 = R70/oz reduces to earnings of about R3.60/share.

If the rand firms to R5.56, the cost of production remains constant as it is not substantially influenced by the exchange rate. However, revenue rapidly falls to R1670 from the average of R1750. This is a decline of just less than 5% on the average price of the last 9 months. Given the working cost of R1680/oz, earnings would be wiped out and the mine would at best just break even or suffer a small operating loss.

While this should have a negative effect on the share price, it should be noted that the last time the rand price of gold dipped below R1680 for any sustained period was for all of November last year, when a low of R1614 was reached, with an average near R1660. During this period the price of Durban Deep varied around 1670 SA cps – a premium of 13% on the recent price! This shows that Durban Deep, as a very marginal mine, is sought more for its potential when prospects for the gold price appear promising than for its existing earnings stream. In November gold has just retreated from $300 and was holding above $290 most of the time and goldbugs were still bullish on the near term outlook for gold!

In principle, though, if the rand appreciated by 10% the price of the share should adjust to this change, but do so over time as the average income of the mine for its production declines. This process lags behind the change in the exchange rate.

The first 10% of any decline in the share price is however buffered by the 10% jump in the value of the rand, which represents exchange profits. If the US investor believes that the rand will firm further, with a progressively worsening effect on the share price, the shares can be sold before the full decline has been realised in the market and the proceeds can be kept in South Africa to take advantage of the stronger SA currency or the money can be repatriated to lock in the 10% exchange profit.

Similar calculations can be used to show that if the rand loses value by 10% the gross earnings of the mine improves by 10%. When the rand declines to R6,82 the rand price of gold improves to R2045 at $300/oz, for an operating profit of R2050 – R1680 = R370/oz. This is better than 400% improvement in operating profit and implies earnings of R18.00 per share, other things being equal. Over time, as the new rand rate remains constant, the price of the share should reflect this 400% improvement in earnings. The US investor now loses 10% on the exchange rate, but has gained much more than this – if not the full 400%! – on the rand share price.

This reasoning shows that a US investor buying South African gold shares has a measure of cover against the reduced earnings of a gold mine that results from a stronger rand, because of the exchange profit that can be realised. On the other hand, if the rand should lose value against the dollar, thereby reducing the nominal or dollar value of the original investment in the gold mine, the prospect of increased revenue and earnings for the mine will increase the share price by much more than what is lost on the exchange rate.

Not all the mines would have a similar very gearing (leverage) to the rand price of gold as not all production costs hover so near to the ruling rand price of the metal. However, the same principle would apply to all the mines. The lower the gearing of the mine itself and the higher its operating income, the more its price will be affected by a stronger rand. This means the buffer protection the US investor enjoys against a stronger rand is likely to be reduced. The higher the cost of production and the greater the gearing to the rand gold price, the better is the protection to the US investor – and the greater the profits if gold should really get going, even if that should result in a much stronger rand!

Of course, exactly the same reasoning would apply to the US investor who buys ADR's and keeps his money in the US. He too will enjoy the exact same buffering effect if the rand should gain in value and the good gearing if the rand weakens. Why then go to the trouble of sending money out of the US and having to develop a new relationship with an unknown broker in a far off country?

This is where the second and much more tentative part of the reasoning kicks in.

I understand the US and South Africa, like many other countries, have an agreement to avoid double taxation, although I have not the least knowledge of its terms. For what follows I assume that if a citizen of the US earns income in South Africa and this income has been fully taxed in South Africa according to South African tax law, then the US citizen is not expected to pay US taxes on that income when it is declared on 15 April.

Further, I also do not know what the (marginal?) tax rate in the US is, and whether dividends are taxed at this rate or a reduced rate, or even taxed at all. However, since there is a capital gains tax in the US, I would assume that dividends are also taxed and probably as normal income at the marginal rate. The other details are not important.

In South Africa there used to be a 15% with-holding tax on dividends that accrue to investors resident outside the country, but this fell away at the time when dividends received by South Africans were no longer subject to tax , i.e. a 0% tax rate on dividends.

I think, given these facts, that a US citizen can make the following case: he has earned interest on any fluctuating cash balance in his account at the South African broker, and has also received dividends on the gold shares he owns. Typically, these dividends would also be remitted through his broker. The interest earned on any balance in his account attracts a certain rate of tax. Finally, the combined proceeds of the interest and the dividends, less the tax on the interest alone, accrue to the US investor – fully taxed according to South African tax system and therefore, if my understanding is correct, not subject to any additional US tax.

This is the potentially very profitable difference between investing in ADR's – where, I believe, dividends received on ADR's will attract US tax at the marginal rate – and taking the funds to South Africa for local purchases on the JSE.

There is a second part to this question. Could any profit on the sale of the South African held shares – and taxed at the current SA rate of capital gains tax, which is the same as the tax on dividends, also 0% – be classified as income earned and taxed in South Africa under the double taxation agreement? That would be a real bargain if gold takes off and the shares are held long enough to avoid the tax which would apply to trading income!

If the intention is to trade, it would be better if the US investor registered a business in South Africa. The marginal rate on individual taxable income is well above 40%, while the marginal tax rate on profits made by a business is set at 30%

It could be a very rewarding exercise for US investors to explore the legalities of this matter.

If I have erred in my reasoning, it is because I have now ventured well outside my field of knowledge. However, if the above is correct in substance, if not in detail, it offers our US friends an opportunity to reduce the hole the 15th of April tends to leave in one's pocket!

© 1999 Daan Joubert
daanj@mweb.co.za

4 March 1999