The Gold Report: This is the first time you are speaking with The Gold Report, Florian, so maybe you could give us a brief overview of Precious Capital AG and its investment focus.
Florian Siegfried: Precious Capital is an independent, privately held fund-management company in Zurich, Switzerland, with a team of financial and mining professionals. Our investment strategy is to identify undervalued future winners in the precious metals mining space. Often these are companies that are not yet the focus of the bigger institutional brokers, have good future expansion potential, have reasonable market capitalization and are driven by good management teams. We took over the company in December 2008, and since then the business has grown quite consistently and this year is performing very well for us.
TGR: Can you give us your European perspective on the current global economic and financial situation and where things might be headed?
FS: We are long-term bulls on gold because we think that the debt crisis in Europe has been downplayed for too long and there is no solution to the problem. Eventually, we expect to see a credit deflation where most of these bankrupt governments in Europe are no longer able to repay their debt, which will translate into more stress in the banking sector. In our view, this will lead to a deflationary downward spiral, which cannot be manipulated any longer by printing money because eventually the insolvent banks will fail to lend, and then there is no possibility to lift asset prices anymore. When that happens, the investor community will have a huge preference for liquidity and unleveraged assets.
"Gold is the most favorable asset class in a time of credit deleveraging."
We think gold is the most favorable asset class in a time of credit deleveraging. An investor in gold will make money in real terms as the credit bubble deflates. Investors who are long in euros or commodity-based currencies will actually lose in purchasing power as credit deflation hits. This is our long-term view and we think that there is no further room to manipulate asset markets, as they have been in the past. I think that we are at the triggering event here.
TGR: How much air do you think can come out of this whole system? And how much can prices deflate overall?
FS: That's a difficult question. One has to look at various asset classes. We would be rather bearish on base metals, such as iron ore, which has already declined quite dramatically since the beginning of the year. China has to rebalance its economy, which largely depends on capital investments and exports and this could become a real problem now. I wouldn't be surprised if in two or three years we would see prices off by 30% or so. Oil prices are still getting some support because of the geopolitical situation, but as China slows down, consumption is probably going to decline and we could see oil off 20% over the next few quarters.
In the equity markets, I think earnings disappointment is going to be a major topic next year. Sooner or later, the market has to realize that if Europe is in a recession, China is slowing down and the U.S. is not getting ahead of the curve, where would earnings growth come from? So, I would expect equity prices, overall, in a year's time could be lower, probably by 10–20%.
TGR: In reading through your Precious Capital fund materials, it was interesting to note the major credit crises over the last 300 years, starting with the South Sea Bubble in 1725 and then the British Credit Crisis of 1772 and then the panics of 1825 and 1873, followed by the market crash in 1929 that started the Depression. Then we had the bad recession in 1973. Now we have this global financial crisis that started in 2008. If the previous 300-year pattern holds, it would indicate another severe event around 2025–2030. Do you think the Federal Reserve and foreign central banks can keep things together and prevent a major collapse in 2025–2030?
FS: These kinds of cycles have a common characteristic. In each, you have good times, with real or so-called "prosperity," mostly driven by excessive use of leverage and debt. 2008 was the same, with too much credit and debt. Bear Stearns and Lehman Brothers failed to serve the debt because they were too highly leveraged. Then the whole system broke down because if one bank failed, many others would fail.
"The precious metals industry does well in a deflationary environment because the gold price goes up against the whole commodity complex while input costs such as crude oil or steel are probably stabilizing or will become less expensive than they were in years of higher inflation."
I think we are still relatively early in this kind of cycle. The Federal Reserve and the European Central Bank have really acted ambitiously to solve the crisis and prevent the system from collapsing by just printing money to loan at 0% to the banking system. But, eventually, what is it going to change? In the long run nothing, because it's not just a liquidity crisis. It's also a solvency crisis. The only solution to too much leverage is less leverage. Only the market can bring that leverage to a level where it is actually sustainable. I believe the stimulus, TARPs and LTRO programs from all the central banks have only pushed the inevitable credit deflation cycle down the road.
TGR: So how does all this influence your investment strategy?
FS: We try to identify industries that actually make money in a deflationary environment. Lower commodity prices create margin pressure for most industries and they don't do as well as during times of inflation. The precious metals industry does well in a deflationary environment because the gold price goes up against the whole commodity complex while input costs such as crude oil or steel are probably stabilizing or will become less expensive than they were in years of higher inflation. Eventually, I think it is the market's desire for liquidity, which will cause gold prices to continue rising.
So, the long-term view is very bullish, but it's a very volatile market, and last year gold stocks really underperformed. This is mainly explained by a lack of liquidity and investor confidence. The whole precious metal sector has overpromised and under delivered and many M&A transactions did actually destroy shareholder value. I guess investors have reset their expectations dramatically after all this frustration. However, this can provide opportunities and we try to use some of our technical indicators to trade these stocks while they are getting into an overbought or oversold condition. This past April and May, when the market was really capitulating, we were buyers in most of the stocks we like.
Right now we think the market is a bit overpriced and we've had a very good run in most of these gold mining shares. Now they could go into a little correction mode and probably lose another 10% or 15%. So, we sold some of our positions at the end of September and are waiting for more favorable buying opportunities in the next few weeks. It's not a buy-and-hold strategy that we want to apply here. One can really trade swings if you can get the timing right. We are always invested in the sector, but sometimes we have 30% or 40% cash.
TGR: How has your strategy paid off over the last couple of years?
FS: Since we took over the fund in December 2008, we are up about 140% in U.S. dollars and this year as of end of September we are up about 26%. We have some winners in the fund that performed well based on the discoveries and the operational improvements they made. We were regularly buying when the markets dried up, which forced stock prices to go lower. There were actually no signals that would suggest a long-term fundamental downturn. We see these corrections as tradable opportunities. I was calling brokers in May and it was unusual to see how defensive they were, saying to stay away from gold stocks until gold hits $2,000/ounce (oz). We got the feeling that was probably the bottom of the market. Timing is of the essence. Pick your stocks carefully, especially in the junior space, because most of these companies will never make money for their shareholders.
"When things move up and get overbought, always take profits and have cash on the sideline to buy into the dips."
That brings me to our selection strategy. The first thing we look at is management. The mining business is very challenging, with a lot of risks. The people with the right experience who have done it before will attract the money from the Street to bring a story to reality and attract institutional money in the future. The next thing we look for is geology. Can a good deposit become bigger and can this ever become a mine and what and how long will it take? In addition, a solid balance sheet with little leverage and good networking capital in the bank is key, so they don't have to tap the equity markets in these volatile times.
We are largely positioned in the midtier mining space because the industry as a whole has started to change. Many of the large gold mining companies have grown too big and aren't flexible anymore. Their strategy was for growth in size, rather than profitability. As a result, many have failed to make money for shareholders. Now, the whole industry has started to focus on smaller projects with lower capital requirements. As a result, we think the market has shown a preference for companies that run easy mines, which can be expanded operationally and can be financed by the market without the risk of significant equity dilution.
Many companies have good assets but don't have the critical mass to attract institutional money. We expect to see more mergers taking place between junior companies or midtier producers. It doesn't make sense to have two companies producing, let's say, 150,000 oz (150 Koz) per year trading at a market cap of $500 million (M). It would be an enormous task for them to get into a league where they could attract institutional money. Growing to a $1 billion (B) market cap internally is probably going to be a tough task. With smart merger and acquisitions (M&A), becoming a 200–300 Koz producer by combining two businesses can get it into the $1B market-cap range more easily. We think that M&A among junior producers is going to be a major topic in the next few quarters.
TGR: So, let's talk about some specifics on companies you're currently invested in that you think look interesting.
FS: One company we own that we think was undervalued at the beginning of the year is OceanaGold Corp. (OGC:TSX; OGC:ASX), which is a 250 Koz producer in New Zealand. It has transitioned from a company that only operated there, to a more internationally based one. Its Didipio project in the Philippines is well advanced and should get into commercial production next year. We think OceanaGold is going to make a lot of money as cash costs drop and production increases. It had some cost issues over the last 12 months or so mainly due to the strong New Zealand dollar versus the U.S. dollar. The Philippines operation has a lot of credit from copper, which will lead to ongoing cost improvements.
The company has good management and its growth is pretty well financed right now with no need to tap the equity markets in the near future. The stock has had a good run, up about 68% this year. I would rather wait for a correction before buying it here. If management continues to execute its strategy it has the potential to grow to 400–500 Koz/year of production over the next three to four years.
TGR: How about some other ones that you like?
FS: We have also been acquiring Endeavour Mining Corp. (EDV:TSX; EVR:ASX), which is proposing a smart acquisition of Avion Gold Corp. Unlike many M&A deals that have hardly created long-term shareholder value because of management issues and lack of synergies among operations, both Endeavour and Avion are West African gold producers. Avion was running out of money in the second quarter and Endeavour took the challenge to pick up the whole company in a share deal. The combined entity would be a gold-focused producer with four mines and combined annual production of about 300 Koz. Its reserve base would be close to 3 million ounces (Moz), with a resource base of about 10 Moz and a market cap of close to $1B. Compared to companies with similar production profiles and resource bases, we think Endeavour looks rather cheap. The political situation in Mali in West Africa is certainly holding the stock down to a certain degree. I think the management team will make this deal happen and create shareholder value in the long term.
TGR: How about some other ones?
FS: Another company we were just adding to our portfolio is Keegan Resources Inc. (KGN:TSX; KGN:NYSE.MKT), which is in a relatively safe jurisdiction in Ghana, West Africa. It had a sharp price decline from trading at a little over $9/share, down to around $2.38/share by the middle of May. Its Esaase project had the classic capital expenditure (capex) overruns. They underestimated the cost of the project. When financing requirements changed, the markets became very skeptical and the shares dropped. We feel the project economics are still favorable and that it can operate on a smaller scale than the planned 300 Koz/year with a $500M capex budget. Management is in the process of recalculating a smaller plant with a much lower capex, about $150–200M, rather than $500M.
After the recent rally, Keegan's market cap is now about $270M, with about $170M in the bank and 6 Moz resource in the ground. The company is almost trading at cash, which provides good market support. When the new project economics are published, it will probably show a 100–160 Moz/year operation with a lower strip ratio and lower operating costs. The recoveries will be the same, say 92–93%. Many of the long-term shareholders and institutions went in at $7–9/share. With the stock trading around $3.97/share, we think it has some real catch-up potential from here. PMI Gold's Obotan mine is about 10 kilometers southwest of Keegan's Esaase project and PMI just raised $100M to start construction of the mine. We originally invested in PMI Gold at $0.10/share back in October 2009.
TGR: How about companies that are a little closer to home? Certainly the Yukon has had quite a bit of activity lately. What do you like there?
FS: We think the Yukon is a great jurisdiction for mining. With devolution of resource management responsibilities in April 2003, the Yukon has its own policy for mining, which we regard as a major benefit for mining companies. The top part of the Yukon has great and underestimated potential from a geological standpoint. The main challenge is the remote locations where you have to bring in all your equipment by helicopter and the short drilling season, which goes from about April/May until the snow comes in October.
In the silver space there we like Alexco Resource Corp. (AXR:TSX; AXU:NYSE.MKT), which is producing silver from its Bellekeno mine in the historical Keno District. It is fully financed by Silver Wheaton Corp. (SLW:TSX; SLW:NYSE) with a very tight share structure of about 65M shares outstanding. We think it has the potential to grow resources and production through internal cash flow and no debt. Nevertheless, the company suffered a 27% increase in cash costs in the first half of the year versus 2011 due to lower base metal credits and mining of lower-grade material. These factors brought the price down quite significantly this year by -45%, to about $3.80/share.
What we like about Alexco is that the company is producing now and has many exploration and development projects in the same district. Most of the exploration and development money it's spending will add to future production. It will probably produce around 2 Moz silver this year. As new projects are added, it will become a two- or three-mine operator in the next two to three years, all funded by internal cash flow. The Keno District has very rich silver grades, historically averaging 50 ounces/ton or so. It's all underground, which is a big plus because the mine can operate year-round with the concentrate being shipped out by road throughout the year. The management team has a good reputation and when we visited the mine in May of last year our impression was that the exploration and development team are all solid and experienced mining people.
TGR: Any others you'd like to mention up there?
FS: Some of these Yukon stocks really fell out of favor over the last few months. One company we like, especially because the shares are also still trading at very depressed levels despite good news, is ATAC Resources Ltd. (ATC:TSX.V). This is a pure exploration company with a large land package. All the gold discoveries it released this year point to a potentially huge system that could be described as a Carlin-type gold discovery.
We visited the project last year. The company has identified multiple targets on its so-called Rackla Gold Belt, which is about 185 kilometers long. Every time the company releases results, we see that this system is potentially growing into something much bigger. The grades are phenomenal, like 10.24 grams/ton (g/t) over 46 meters, and not very deep. The stock is down to around $2.36/share, from $10/share in July 2011. The company is well financed and has a good management team. If one looks for value in exploration, I think ATAC is a good name to have at these low levels.
TGR: What about companies in other parts of Canada?
FS: We have St Andrew Goldfields Ltd. (SAS:TSX), which has had a choppy ride in the last few quarters and is now attractive from a valuation standpoint. Based on the progress the company has made since the beginning of the year, we see a turnaround with bottom line net profits and operating cash flows. Production is growing steadily toward 100 Koz this year and costs are coming down. However, a few weeks ago it announced an overstatement of its Inferred resources on its operating Holloway and Holt mines, which brought the share price down to about $0.46/share.
We like the experienced team headed by Jacques Perron and the location in Ontario, which is one of the best places to be for mining. The projects are rather high-grade underground operations, which is a positive factor because it makes for more stable operating margins when you have volatile gold prices. The company seems to be on track to achieve its production goal in 2012, but given the operational problems in 2011, the stock is still on a depressed level. The company is fully financed and both production and resources should grow in the next three to four years. Operationally and financially the story looks now much better than last year. The company also has a large land package for exploration and a tax pool of $190M on its balance sheet, which is more or less the market cap right now. The share price doesn't reflect underlying resources and the reserves in the ground.
One shareholder who probably has a high degree of control in the company may contribute to the market underperformance. But, in a good gold market, a stock like St Andrew should probably trade at $0.80–1.00/share, to reflect the operational business.
TGR: Let's turn to some projects and companies that have operations in the U.S. What do you like there?
FS: We have a development stage company in the fund called Romarco Minerals Inc. (R:TSX), which has the Haile project in South Carolina. This project has been delayed due to the completion of a full Environmental Impact Statement (EIS). The stock is therefore in a penalty box, but the project economics are very favorable. It will have low costs and gold grades of about 1.8 g/t open pit, which is rather high. The stock is trading at about $1/share. I would say that Romarco could be a takeover target for a midtier producer or even a senior, based on the quality of the asset and the location. Once the EIS issue has been resolved, probably next year, then we think it will be a very attractive stock to own. The main risk is permitting and finance, should the company require to raise more equity, which would be dilutive with the current low share price.
TGR: Maybe you can summarize what our readers ought to be doing in the coming months to take advantage of what you think lies ahead.
FS: The key is to see the fundamentally positive development of the industry. Gold mining shares are trading at historically low valuations, e.g., on a price-to-earnings ratio basis or compared to the price of bullion. I would stress, however, that these shares can be very volatile and people can get frustrated if they don't perform. They sell in a down market and then miss the opportunity to buy when the market rebounds. One has to be really disciplined. Never get married to a company, no matter how good it looks. When things move up and get overbought, always take profits and have cash on the sideline to buy into the dips.
But, as long as we have these fundamental problems in the world with money printing and low economic growth, recessions and depressions, it will be very bullish for gold mining companies. In order to outperform the gold price, you can't just be long all the time and not trade these stocks. One really has to be more active and when the market is capitulating, you have to pick up your most attractive shares. Always do your own due diligence on these companies. Check out the management and how it does operationally, and look at past track records. Once you have identified the right companies that fit your portfolio, then just try to play the sector in a little bit more of a contrarian way. That's my advice.
TGR: Thanks for talking with us today, Florian.
FS: Thanks for having me.
Florian Siegfried is the chief executive officer of Precious Capital AG, a Zurich-based fund specializing in global mining investments. Siegfried was previously the CEO of ShaPE Capital Ltd., a SIX Swiss Exchange-listed private equity company, where he was instrumental in raising more than CHF 50 million in equity capital. Siegfried is also a board member of GoldQuest Mining Corp. He holds a master's degree in finance and economics from the University of Zurich.
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1) Zig Lambo 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: Avion Gold Corp. and St Andrews Goldfields Ltd. Streetwise Reports does not accept stock in exchange for services. Interviews are edited for clarity.
3) Florian Siegfried: I personally and/or my family own shares of the following companies mentioned in this interview: OceanaGold Corp. and Alexco Resource 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 interview.