The Gold Report: You started your career, Dave, in the fixed income securities division of Goldman Sachs. And you worked as a junk bond trader before founding Golden Returns Capital. What prompted you to move into precious metals?
Dave Kranzler: After working as a bond trader on Wall Street, I was day trading. A friend suggested that I look at gold and silver. I initially poo-pooed that idea, as I was more interested in shorting technology stocks during the Internet bubble. I thought the tech valuations were based on nothing more than hopes and dreams, not on real wealth. The enormous growth in paper investments was driven by the incredible amount of money supply thrown into the system by Alan Greenspan's Federal Reserve.
But in late 2001, my friend finally convinced me to get serious about mining stocks. So I investigated the reasons why there had been a 20-year bear market in precious metals and why a long-term bull market was in the offing.
TGR: Why should we invest in gold instead of, say, Facebook?
DK: People like Warren Buffett, Charlie Munger and Bill Gates characterize gold as an investment. It's really not. It's a monetary metal. Gold represents the embodiment of real wealth. By contrast, Facebook has a sustainable business model based on revenues derived from advertising. But there's an extreme differentiation between what Facebook might be worth on the basis of long-term historical market capitalization measures versus what the market was willing to pay at its IPO. It quickly dropped in value, and it has a lot further to fall. Gold is more real.
TGR: How does gold as money differ from paper currency?
DK: Paper currency can be created at the whim of a central bank. The "fiat" currencies are politicized and based only upon the issuing entity's promise to pay. Gold is the world's oldest currency; it was used as a medium of exchange before the Roman Empire. Historically, gold replaced barter by providing the fungibility to enable widespread trade and commerce. Gold is very hard to produce, let alone counterfeit. It represents a true measure of wealth exchange.
TGR: You mentioned that gold is a medium of exchange, so it's a repository of value. It embodies a standard of value that represents the usefulness of other commodities, like a bushel of wheat. But if the gold itself is not the source of value, then what is the ultimate source of the value that it represents?
DK: Globally, the value of gold is rooted in supply. The supply of aboveground gold represents economic wealth, which is embodied in the price of gold, when there is a gold standard in place. A gold standard fixes the price of gold. Therefore, under a gold standard, the money supply can be increased by pulling more gold out of the ground. But if the price of gold is not fixed, then the price must rise and fall as new wealth is created or destroyed—regardless of the amount of aboveground gold in existence.
Unlike gold as money, paper currency is easy to reproduce. If the government wants to spend more money, it doesn't have to base that increase in spending upon incremental economic output. It can just decide to issue bonds and print money to pay for those bonds. Inflation occurs when the paper money supply is increased over and above marginal economic output.
TGR: So why is the price of gold volatile?
DK: The price of gold has steadily gone up every single year for 11 years. That's not really volatile; its one way, to the upside. The gold market is small and not very liquid. When someone wants to sell a lot of paper gold, and there are not many buyers, the price goes down, and vice versa to the upside. So we see large swings in price over short periods, but over the last 11 years, the price has only gone up. It has been less volatile than the S&P 500 over the last 10 years.
TGR: Large and institutional investors are showing some interest in gold. For example, George Soros has significantly increased his position. J.P. Morgan and other banks are investing in junior gold and silver mining companies, as are large mutual funds. Is this a significant change?
DK: Soros bought SPDR Gold Trust ETF (GLD:NYSE) shares, which is a derivative form of gold. It's not physical gold. SPDR Gold Trust is a decent way to index the price of gold over short periods, and I think that is what Soros is doing with his fund. But I'm also sure that Soros, himself, is accumulating physical gold.
A very, very small percentage of the institutional investment world is in gold—less than 1% of institutional funds globally. Very few of those institutions have taken physical delivery of gold. There are exceptions: Northwest Mutual took delivery of 400 million ounces (Moz) gold a few years ago; Texas Teachers Retirement keeps physical gold. There is a small institutional interest in accumulating gold via SPDR Gold Trust and other exchange-traded funds. But if you look at the three cycles of a bull market—smart money, the institutions and then the public—there is potentially a huge wave of institutional investing in gold yet to come.
TGR: Is J.P. Morgan's investment in Orezone Gold Corporation (ORE:TSX) a sign of increasing institutional interest in physical gold? Or is it just an aberration?
DK: We are starting to see some institutions wade into the world of junior mining stocks. If you look at the asset valuation of Orezone versus its market capitalization, it's very, very cheap. Its market cap is at a big discount in relation to its implied value.
TGR: What's the core investment strategy of Golden Returns Capital?
DK: My partner and I started Golden Returns Capital and our Precious Metals Opportunity Fund in 2008. We enable investors to accumulate physical gold and silver while also investing in a carefully selected portfolio of mining stocks. Our base case model is 50% physical metal and 50% mining stocks. We buy gold and silver bullion. It's either 1 ounce (oz) sovereign-minted coins like gold eagles or gold maple leaves, and we take delivery off the COMEX of gold and silver bars. We keep physical gold in a segregated account in a private, non-COMEX depository. Our fund directly owns the metal. The other half of the portfolio is invested in mining stocks. The breakdown is 50% large-cap mining stocks, like Goldcorp Inc. (G:TSX; GG:NYSE) and 50% junior mining stocks.
Importantly, when investors cash out, they can take delivery of their pro rata share of the gold and silver in the fund. If they want to cash out a couple hundred grand, and the breakdown is 50% bullion, 50% stocks, they have the option of receiving $100,000 in physical gold and silver. We'll deliver it, or we can arrange depository safekeeping.
TGR: But investors cannot cash out the value of the stocks as bullion, right?
DK: They could take delivery of the stocks, but it is easier to take the cash. The feature makes our fund unique. It's one of the few funds that have the ability to deliver bullion. Some of the ETFs can deliver, but an investor has to own a very high amount of shares—several million dollars worth.
TGR: What's the minimum investment in Golden Returns?
DK: Minimum investment is $100,000.
TGR: What metrics do you use to assess the value of junior mining stocks?
DK: We look at a range of firms: from companies poking holes in mineral lease claims to companies that have proved resources and are on the verge of becoming producers. I define a junior as a mining exploration company that's not producing and is depending upon the market for financing. I do not invest in evergreen companies. I look for a company that has a track record of drilling results. And, I want those results to come from areas that are proven producing areas, such as the Carlin trend in Nevada or the Durango silver belt in Mexico. Ideally, I like to see an NI 43-101–compliant mineralization report showing some Proved or, at least, Measured resources. I want a company to have on hand at least a year's worth of cash under normal operating and capital expenditure scenarios. Ideally, I want to see a large mining company as a sponsor. I want management to hold 5–10% of the equity. And the company must be operating in areas of relatively low political risk.
TGR: Are there are any junior firms that you like in particular?
DR: One of Golden Return Capital's largest positions is Rye Patch Gold Corp. (RPM:TSX.V; RPMGF:OTCQX). Management owns roughly 8% of the company. Kinross Gold Corp. (K:TSX; KGC:NYSE) owns about 15% of the equity. It has a little over 3 Moz in NI 43-101–compliant resources proved up. It is poking holes in the ground in a trend in Nevada that could potentially become the next Carlin trend. It has a $55–60 million (M) market cap. It trades around $0.60/share, and I see it as, at least, a $3/share stock down the road. It has about a year's worth of cash. The managers are experienced geologists, with a history of success in developing mining companies. Rye Patch is the perfect junior mining company model.
TGR: What about outside the United States or North America? Do you have any companies that you like?
DK: Orezone, which I mentioned, is in West Africa, a region that carries more political risk than Nevada. But the Chinese are buying up mining claims all over Africa. That lends the region stability. Orzone's market cap is about $136M. I have tentatively valued its crown jewel asset—the Bomboré deposit—north of $150M. Investors get the rest of the company for free, including a uranium exploration subsidiary that has a lot of upside. Management owns a decent amount of equity. It doesn't have a large-cap mining sponsor, per se, but various institutions own more than 50% of the equity. That's a stable investing base.
There may be some metallurgy risk regarding Orezone's ability to convert the resource into mineable gold at $1,700/oz, but I don't think that's a problem with the quality of its deposit. The company has already done a preliminary economic assessment (PEA); it is a couple of years away from putting in a mine. Management has a track record of developing a resource and then selling it. They just did that with one of its subsidiaries. It was a 450 Koz gold deposit, and Orezone sold it for the equivalent of about $45/oz in the ground. If I apply that metric to the Bomboré asset, I get an implied asset valuation of $155M versus the $136M current market cap. By definition, that's a value investment. That is why institutions are attracted to Orezone.
TGR: In March 2011, Orezone was trading at $5/share, and now it's roughly $1.75.
DK: It is a fact that the junior mining stock sector is down 60–70%. The whole sector has been beaten into the ground and, unfortunately, the babies are being thrown out with the bath water. We started accumulating Orezone when it was around $2.50/share. We are currently underwater, but we've been adding to the position as the price falls. When the pendulum swings back the other way, a lot of capital will flood into the juniors. I predict that junior gold stock prices will double and triple from their peaks a year and a half ago.
Let's say gold goes to $2,500/oz. What kind of market cap do you think investors are going to give companies with gold resources in the ground when gold is at $2,500/oz? If they're capping Orezone at $5/share when gold is at $1,500/oz, they're probably going to cap it at $10/share when gold is at $2,500/oz. If it gets back to $5/share in the next 12–24 months, we've had a hell of a return on our money.
This brings me back to what attracted me to precious metals back in 2001. In his newsletters, James Dines was pointing out that the total market cap of every publicly traded mining stock in the world in aggregate was less than the market cap of each of the Top 10 companies in the S&P 500. That's a staggering statistic. His thesis was that at some point, a massive wave of institutional money will flood into the precious metals sector, and it's going to be like trying to push Niagara Falls through a funnel. There will be a huge price explosion when that happens. We're probably a long way from that point. It's taken a lot longer than I expected, but I think eventually we'll get there.
TGR: What happens if we have Quantitative Easing (QE) 3?
DK: Some people would argue that the market's already pricing that in, and that's why the entire stock market hasn't gone lower right now. But there's a high expectation that the Fed will not do a QE3. If it does do it, gold and silver and the mining stocks will explode as they did when QE1 was announced in 2008 and QE2 in late 2010.
TGR: China, Russia, India and the Gulf States are accumulating massive amounts of bullion. How is that affecting the market?
DK: The Western central banks have been selling off bullion for the last 15 years. What I like to call the "Eastern Hemisphere central banks" have been accumulating that bullion. There has been a transfer of bullion from the Bank of England, the European Central Bank and the Fed to central banks in China, Russia and India. A lot of people don't realize that Vietnam is the fifth largest gold-importing country in the world. Obviously, the Gulf States have started accumulating it pretty aggressively. Recently, Mexico and some of the South American countries are showing up as large accumulators of physical gold, not through ETFs or any of the other paper forms, but actual physical gold.
TGR: How does that affect pricing?
DK: The steady climb of gold over the last 11 years reflects this accumulation by very wealthy interests in Europe and Asia. China has been voraciously accumulating gold. The International Monetary Fund sold 400 tons of gold a couple of years ago. But a lot of these central banks, instead of selling gold, are leasing it out. They rent their bullion to banks like J.P. Morgan and Deutsche Bank that turn around and sell it into the marketplace. That gold is going somewhere. It is going to these quiet accumulators of physical bullion. At some point and, again, it's impossible to measure when, the central banks and investors that have been buying physical gold will have to get more aggressive with what they are willing to pay. That will be the next stage in the bull market.
TGR: When you talk about leasing, these companies that lease the gold aren't actually taking physical possession of it?
DK: They're borrowing it. Then they go onto the London Bullion Market Association and sell it. It's a legal transaction, but it's a paper transaction.
TGR: Is it a form of derivative?
DK: That's correct. Say that you are J.P. Morgan and you've sold me some gold that you leased from a central bank. If I ask for delivery of the metal, you will have to find it and deliver it. That's where the problems are going to start.
TGR: That certainly could be a problem. Do you want to talk about any other junior mining firms that you're interested in?
DK: Our second largest junior position is Eurasian Minerals Inc. (EMX:TSX.V). It calls itself a project generator, but it's more analogous to the royalty model of companies like Silver Wheaton Corp. (SLW:TSX; SLW:NYSE) and Royal Gold Inc. (RGLD:NASDAQ; RGL:TSX). Eurasian explores the world for properties that have been discarded by the larger mining companies because they did not contain enough mineralization to make it worth their while to develop at the time. For example, Eurasian has been accumulating land in Haiti. Up until a few years ago, Haiti was considered taboo because it was extremely politically unfriendly, unstable and corrupt. After a recent leadership change, Eurasian bought potential mining properties on the cheap. Then it sold a development interest in these properties to Newmont Mining Corp. (NEM:NYSE). Eurasian got its investment out of the properties, plus it retained a 30% interest in the Newmont properties. Also, Newmont owns 10% of Eurasian. It gets even better than that. The CEO of Eurasian, Dave Cole, worked for 18 years at Newmont. So you can probably see where this is going down the road.
Eurasian also has joint ventures in other properties around the world, including with Newmont. It has a huge potential copper deposit in Arizona that Vale S.A. (VALE:NYSE) is developing. I never thought Kazakhstan was a potential gold mining belt, but Eurasian has several properties there with the same type of deal.
TGR: You have described yourself as an investment contrarian. What is your parting advice on mining stocks?
DK: Mining stocks are at an extraordinarily cheap level vis-à-vis their historical valuations, especially when you measure them versus the price of gold. Large and small companies are basically trading at the same valuation levels in relationship to gold that they were when gold was at $400/oz back in 2003–2004. To me, it's the ultimate contrarian and value play to hold your breath and invest in these companies now. I think if you do it now, you're going to be rewarded with a lot of money down the road, especially if the fundamentals for supporting gold and silver only get stronger.
TGR: OK, Dave. Thanks for your time.
DK: Thank you, Peter.
Dave Kranzler spent many years working in various analytic jobs and trading on Wall Street. For nine of those years, he traded junk bonds for Bankers Trust. He has a Master of Business Administration from the University of Chicago, with a concentration in accounting and finance. Currently he co-manages Golden Returns Capital, a precious metals and mining stock investment fund based in Denver. He writes a blog to help people understand and analyze what is really going on in our financial system and economy: www.truthingold.blogspot.com
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1) Peter Byrne of The Gold Report conducted this interview. He personally and/or his family own shares of the following companies mentioned in this interview: None.
2) The following companies mentioned in the interview are sponsors of The Gold Report: Orezone Gold Corporation, Goldcorp Inc., Rye Patch Gold Corp. and Royal Gold Inc. Streetwise Reports does not accept stock in exchange for services. This interview was edited for clarity.
3) Dave Kranzler: I personally and/or my family own shares of the following companies mentioned in this interview: Rye Patch Gold Corp. I personally and/or my family am paid by the following companies mentioned in this interview: None. I was not paid by Streetwise Reports for participating in this story.