The Gold Report: Frank, you are one of the most positive people I know. What happened to gold in mid-April, and could it happen again?
Frank Holmes: I often remind investors that gold has two drivers: the fear trade and the love trade.
The fear trade captures most of the attention. Many people who have put money into the SPDR Gold Trust (GLD:NYSE.A) and other gold ETFs have bought for the fear trade. The fear trade kicked in due to governments monetizing debt at an excessive rate, creating negative real interest rates. For example, last year Japan, Europe and the U.S. rolled over about $8 trillion from three-year paper to five-year paper below the inflationary rate. Historically, this is very important for gold.
The other half of the equation is the love trade, which is gold bought for cultural reasons, such as gift giving for holidays, weddings and birthdays. Given that China and India account for 40% of the world's population, the rising per-capita gross domestic product (GDP) in emerging economies is important for the love trade. Even a modest slowdown on per-capita GDP in those countries has a significant impact on the demand side of the equation.
In the last year, India's government tried to slow down the amount of gold being imported. In January 2013, India imposed a 6% tax, which slowed love trade demand in the short term. And the per-capita GDP of China and India slowed down modestly.
Still, the love trade remained strong over the entire year. According to official statistics from the World Gold Council, as of the end of the first quarter of 2013, the year-over-year change in consumer gold demand for jewelry, bars and coins rose 27% in India. In China, gold demand grew 20%.
TGR: If the love trade demand changed over the last year, why did we have that sudden, one-day fall in the price?
FH: I do not know. I try not to get caught up in all the conspiracy thinking out there, but rather appreciate cycles, where historically gold has climbed after Chinese New Year and had little rallies all the way until summer. Typically, in June, gold investors see a bottom. In late July and early August, 35 years of data show that the love trade demand picks up and runs until February.
TGR: What could happen between now and July when love demand historically picks up?
FH: We will have to see when the Indian and Chinese economies start to pick up. That will be important for the love trade.
But the love trade is not going away. Even in North America, when gold dropped, we saw gold going from paper hands in the exchange-traded funds (ETFs) to strong hands. Gold analysts in Toronto told me about lines of people 30 yards long waiting to buy gold. Everything smaller than 5 ounces was sold out.
TGR: In a May 11 article, you list three reasons to buy gold equities today. Can you tell me what you look for in a gold company today?
FH: We like a board of directors that is consumed with the return-on-capital model. One of the best ways to get a return on capital is to grow revenue, to have a profit margin for capital costs and to pay dividends. The final ingredient is to buy back your shares. With the S&P 500 making all-time highs, one can see the high correlation of companies buying back their stock and increasing their dividends. That is what has propelled the stock market to where it is.
Alamos Gold Inc. (AGI:TSX) is one recent gold company to have done that.
Many other gold mining companies, which people tend to think of as large market-cap companies, have been value destroyers. Newmont Mining Corp. (NEM:NYSE) has a market cap below $20 billion ($20B). It has spent $17B trying to increase its production, which has decreased from 8 million ounces (8 Moz) to almost 5 Moz/year. It would have been better off using $7B to sustain its cash flow from operations and spending $10B to buy back stock and increase dividends. Had it done that, it would have a much higher valuation. Now, all of a sudden, companies like Newmont say they will increase their dividends and share some of that return from the higher price of gold.
"We like a board of directors that is consumed with the return-on-capital model."
The other companies in a bad situation are those that issue stock options faster than they increase their reserves or their production. That dilutes shareholder interest. They make acquisitions that dilute on a reserve-per-share or production-per-share basis.
Investors want to look at companies that have the discipline to increase their dividends and have leadership like Alamos Gold's that will increase dividends and buy back stock for the free cash flow.
TGR: Is paying a dividend an important part?
FH: Absolutely. Over the past 50 years, almost half of the total returns of the S&P 500 alone have been reinvested dividends.
Too many companies were hungry for cash to expand just for the sake of expanding. They destroyed capital rather than focus on margin. I think the gold industry is waking up to this situation.
Some of the silver stocks are showing increased capacity for dividends, more free cash flow and low cash-flow multiples. One of my favorites is Franco-Nevada Corp. (FNV:TSX; FNV:NYSE). It pays a monthly dividend, higher than what you can make on a five-year government note. It has high profit margins, and management is very disciplined about its return-on-capital model.
TGR: What about the explorers? Are there certain types of explorers or jurisdictions that you like?
FH: Three things will hurt the junior resource cycle for another couple of years. Number one, the laws of Mother Nature dictate that the odds are against junior mining companies in making a discovery. Number two, a lot of the geologists who are out there exploring have no relationship with money managers, sellside brokers or capital markets. Number three, you have layer after layer of governmental regulations that are not always well thought out.
The jockeys are very important in the explorer space. You have to have someone who puts money up, who has a successful track record. We really have to know the jockeys and their expertise, following and track record.
TGR: Brian, who are some of the jockeys you like to follow who fit those criteria?
Brian Hicks: Lukas Lundin, chairman of Lundin Mining Corp. (LUN:TSX), writes his own checks and puts up his own risk capital. We have had some success with him. Ross Beaty, chairman of Pan American Silver Corp. (PAA:TSX; PAAS:NASDAQ), is another; he also has skin in the game.
TGR: Your World Precious Metals Fund includes just over 79% gold and silver and 11% cash. It is down about 37% for the year. How are you adjusting your portfolio in this volatile environment?
"Too many companies were hungry for cash to expand just for the sake of expanding. They destroyed capital rather than focus on margin."
FH: I think it's important to outperform the ETFs that are out there competing for capital. Cash is one component of how we are adjusting to the volatility. Last year we looked at all the juniors we own; we scrutinized every quarterly financial statement to see how much cash each company had and the burn rate. If a company had no discovery or was early, we sold them. That helped us in the junior space.
BH: We continue to have a broad stable of 25 or so junior resource names, but we high graded the portfolio by eliminating the names that would be unlikely to get financing. We elected to take those stranded names out of the portfolio.
The space has seen so much carnage that it is difficult even now to say what was a junior and what was a small or mid cap.
FH: To add to what Brian is saying, we took a hard look at all producers that were producing less than 1 gram per ton (1 g/t).
TGR: How many were in that category?
FH: Not too many, since grade is king in any gold price environment.
TGR: Your Gold and Precious Metals Fund is about 41% mid cap, which you define as $1–10B, and 48% small cap, which you define as under $1B. The World Precious Metals Fund is 79% small cap. Do those small caps expose the fund to more upside?
FH: Yes, they expose it to more volatility. The World Precious Minerals Fund will look at greenfield and brownfield companies, therefore, that fund has more volatility.
TGR: If it gives you exposure to the upside, how do you protect from the downside?
FH: We do what we have described. We shrunk the number of names with greater risk; many of them have fallen—some as much as 90%—from a year ago. When looking at producers, we look for a higher grade.
Acquisitions are another phenomenon for gold mining companies in the capital markets. As soon as someone acquires another company, we tend to sell it. The stock is usually dead money for 18 months while the acquiring company digests the acquisition.
TGR: But you still get the upside from the bump up in the share price when it is bought, correct?
FH: Yes, and that has helped the portfolios, as we have had several companies that were purchased.
TGR: B2Gold Corp. (BTG:NYSE; BTO:TSX; B2G:NSX) dropped to $2/share. Is that because of its acquisitions in the last quarter or is that part of the industry trend?
FH: B2Gold has been a great mid-cap, higher-grade company that performs well. Its drop is the mutation that is caused by ETFs. Money has flowed into the Market Vectors Junior Gold Miners ETF (GDXJ:NYSE.A) and whenever a stock is one of the Top 10 positions, it gets tossed out because its market cap then exceeds $3B. It has nothing to do with the quality of the company; it is all about access.
B2Gold rebalanced when the company it acquired was also on the Market Vectors Junior Gold Miners ETF and its market cap got too big. It ended up orphaned because it lacked a U.S. listing and could not qualify for the Market Vectors Gold Miners ETF (GDX:NYSE.A).
The same thing happened with SEMAFO Inc. (SMF:TSX; SMF:OMX) and Romarco Minerals Inc. (R:TSX). Romarco exploded on the upside in 2010. The Market Vectors Junior Gold Miners had $400 million come in within three days.
TGR: Do you still like B2Gold's fundamentals?
"There is complacency in the equity markets, but at some point, money will flow back into gold because of the difficult state of the global economy."
FH: We sold a lot of B2Gold going into the merger and then reloaded. The risk was that by March it would have to be pushed out of the Market Vectors Junior Gold Miners and would have to rush to get a U.S. listing.
As a fund manager, we have to factor in the change in holdings of these big ETFs because money flows, not gold companies' discoveries or fundamentals, are dictating the price volatility of many small-cap stocks.
TGR: Are you nervous about the redemptions some large funds are experiencing? What is your strategy to calm down nervous investors?
FH: We advocate keeping a 5% or 10% weighting in gold and rebalancing. When gold moves, it moves explosively, and you end up buying at the top. Conversely, gold today is extremely oversold on all mathematical models. The value being offered by many of these companies is so much more attractive and compelling to investors.
If interest rates were to climb 2% above the inflation rate, it would totally distort the gold crisis. If short-term interest rates in the U.S. were to reach 4%, the boom in the housing market would end. That would affect job creation. But we do not see that happening.
FH: They will, no doubt. Governments are always trying to manage their currency using relative purchasing power parity. They are using low interest rates to stimulate economic activity. We believe that will continue.
BH: I would echo that. We still have a large output gap and high unemployment.
There is a lot of complacency in the equity markets. That has taken some money growth out of gold, but as Frank has said in the past, gold is insurance. At some point, money will flow back into gold because of the tenuous and difficult state of the global economy. Gold is a good portfolio diversifier.
FH: Gold is volatile because it is the inverse of currency moves. The fundamentals that would change things are 1) a dramatic fall in the per-capita GDP of most of the emerging market countries and 2) a rise in interest rates 2% above the Consumer Price Index. We just do not think that will happen for a while.
The other long-term implication is the delay in new mines coming onstream. Every time a government moves the goal posts for taxing these companies, capital will be squeezed. Neither banks nor the equity markets will put up the money. The result will be a drop in supply for many commodities.
TGR: Particularly platinum and palladium, or gold and silver as well?
FH: Gold and silver, too, as projects get delayed.
TGR: Frank and Brian, thanks for your time and your insights.
Frank Holmes is CEO and chief investment officer at U.S. Global Investors Inc., which manages a diversified family of mutual funds and hedge funds specializing in natural resources, emerging markets and infrastructure. The company's funds have earned many awards and honors during Holmes' tenure, including more than two dozen Lipper Fund Awards and certificates. He is also an adviser to the International Crisis Group, which works to resolve global conflict, and the William J. Clinton Foundation on sustainable development in nations with resource-based economies. Holmes co-authored "The Goldwatcher: Demystifying Gold Investing" (2008). Holmes is a former president and chairman of the Toronto Society of the Investment Dealers Association, and he served on the Toronto Stock Exchange's Listing Committee. A regular contributor to investor-education websites and a much-sought-after keynote speaker at national and international investment conferences, he is also a regular commentator on the financial television networks and has been profiled by Fortune, Barron's, The Financial Times and other publications.
Brian Hicks joined U.S. Global Investors Inc. in 2004 as a co-manager of the company's Global Resources Fund (PSPFX). He is responsible for portfolio allocation, stock selection and research coverage for the energy and basic materials sectors. Prior to joining U.S. Global Investors, Hicks was an associate oil and gas analyst for A.G. Edwards Inc. He also worked previously as an institutional equity/options trader and liaison to the foreign equity desk at Charles Schwab & Co., and at Invesco Funds Group, Inc. as an industry research and product development analyst. Hicks holds a Master of Science degree in finance and a bachelor's degree in business administration from the University of Colorado.
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1) JT Long conducted this interview for The Gold Report and provides services to The Gold Report as an employee. She or her 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: Franco-Nevada Corp., Goldcorp Inc., B2Gold Corp. and MAG Silver Corp. Streetwise Reports does not accept stock in exchange for its services or as sponsorship payment.
3) Frank Holmes: I or my family own shares of the following companies mentioned in this interview: None. I personally am or my family is paid by the following companies mentioned in this interview: None. I was not paid by Streetwise Reports for participating in this interview. Comments and opinions expressed are my own comments and opinions. I had the opportunity to review the interview for accuracy as of the date of the interview and am responsible for the content of the interview.
4) Brian Hicks: I or my family own shares of the following companies mentioned in this interview: None. I personally am or my family is paid by the following companies mentioned in this interview: None. I was not paid by Streetwise Reports for participating in this interview. Comments and opinions expressed are my own comments and opinions. I had the opportunity to review the interview for accuracy as of the date of the interview and am responsible for the content of the interview.
5) The following securities mentioned were held by the Global Resources Fund, Gold and Precious Metals Fund and World Precious Minerals Fund as of 3/31/13: Alamos Gold Inc., B2Gold Corp., Franco-Nevada Corp., Lundin Mining Corp., Market Vectors Gold Miners ETF, Market Vectors Junior Gold Miners ETF, Newmont Mining Corp., Pan American Silver Corp., Romarco Minerals Inc., SEMAFO Inc., SPDR Gold Trust.
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