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Chris Potter: 21st Century Alchemy—Paper to Gold
Source: Interviewed by Karen Roche, Publisher, The Gold Report (2/5/10)
Chris Potter, portfolio manager of Northern Border Capital Management, Inc., a Canadian-focused hedge fund, stands by his claim that India's big gold buy late last year was a game-changer, in this exclusive Gold Report interview. In addition to his belief that it's a 21st century take on the classic alchemist's quest of old—transforming lead into gold—Chris also shares some ideas about riding the rising tide in gold prices.
Chris Potter: I think so. For as long as I can remember, gold bears have warned that central bank gold is a massive source of supply that is capable of overwhelming any conceivable demand scenario. They said that this would make it very difficult for the gold price to rise significantly. It's been an easy argument to make because one fifth of all the gold ever mined is sitting in central banks' vaults.
But what we've seen over the last nine years is that argument being steadily dismantled, piece by piece. Year after year, signatories to the Washington Agreement have sold less than their quota of gold. We've also seen various central banks add and talk about adding to their gold reserves. Then when the world became aware that the International Monetary Fund—which I think is the third largest holder of gold—was a potential seller of 400 tons, there was all kinds of speculation that this would have a very detrimental effect on the gold price.
Well guess what, the opposite happened when the Reserve Bank of India announced that it not only bought 50% of what was for sale but bought it at market prices! All of a sudden people realized that central banks might be net buyers rather than net sellers of gold. This was a big development. We still haven't heard about who is going to buy the other 200 tons but the market no longer seems concerned that a buyer will be found. You mentioned that no other central bank has bought gold since the Reserve Bank of India announcement —well, we don't know that that is the case. If you were a central bank interested in increasing your gold reserves, you would not likely telegraph to the market that you were doing that until you were finished buying.
TGR: Is the IMF actively trying to sell the other 200 tons?
CP: They reported that they planned to sell 400 tons so I see no reason to believe that they have changed their minds about the remaining 200 tons. It had been rumored that the Central Bank of China was going to buy the whole piece and that is why the Indian announcement was such a surprise. Perhaps China buys what's left.
We've heard that the Chinese Central Bank has been a consistent buyer of gold over the last several years, but we haven't heard anything officially. I suspect that they do not want to signal that they have a lot of gold to buy because that would just drive the price up. If they are negotiating with the IMF for the remaining 200 tons, we won't hear about it until the deal is done.
TGR: Could China just be buying it in such small increments that it might take them a year to buy it but they wouldn't have to report it?
CP: I'm pretty sure that the U.S. Federal Reserve is required to report purchases and sales of gold and other assets. I'm not familiar with the reporting requirements in other countries, but I would take any lack of disclosure about Chinese purchases of gold with a large grain of salt. In other words, just because they have not announced that they have been buying does not mean that they have not been.
TGR: Jon Nadler, Kitco's senior investment products analyst, suggests that central banks' acquiring gold is no more than re-balancing their portfolios. It's part of a natural course of events since their portfolios are growing, and in that case, it shouldn't affect the price of gold one way or another. What do you think of that view?
CP: By purchasing 200 tons of gold, the Reserve Bank of India increased its gold holdings by 50% —I would hardly call that rebalancing. But what is even more important than the amount of gold that central banks are buying is the realization that they are buying and not selling. This is a brand new idea and completely alters market perception about supply and demand. This kind of change in perception can have a very meaningful impact on price. So no, I do not agree with Jon Nadler's suggestion.
TGR: So how do you look at it?
CP: If I were running a central bank and I had the ability to create money at virtually no cost and I could then exchange that cost less money for one of the earth's scarcest resources, why wouldn't I do that all day long? Why not exchange something that costs me nothing for something that is incredibly rare and incredibly valuable?
TGR: It's not a central bank's role to print money for the purpose of buying gold, though. Creating more money creates other negative trends in the economy.
CP: Sure, it's inflationary. But take the example of India buying 200 tons of gold. That's a very large amount of gold, but relative to the amount of money that they are creating for other purposes, it has a very minor inflationary effect.
TGR: I've always had the impression that central banks were held to a higher standard to do what's best for the economy.
CP: Well, maybe what they're doing is best for their economies. If you're a central bank and you're observing that around the world vast amounts, unprecedented amounts, of new money is being created, you have to realize that somewhere down the road every one of those currencies is going to take a big hit. So, how do you distinguish you currency and your economy from your neighbors'?
Well, one thing you can do is buy gold. So maybe the Reserve Bank of India is being proactive about their economy. They are saying, "Look, we can buy gold now for $1,000 an ounce and five years from now, when we are all swimming in newly printed money, gold might be $5,000 an ounce. We can increase our wealth without inflating our currency to the same extent as other nations." Essentially they are hedging against a decline in their currency and that is good for their economy.
TGR: A lot of financial advisors tell investors they should have assets that include 10% to 15% precious metals as "insurance." Are the central banks looking at this as an insurance policy, too, or in some other way?
CP: I suppose you could call it an insurance policy and that is the way a lot of people think about gold. But that is not the way I think about it. I view gold simply as a currency whose supply and demand characteristics are vastly superior to other currencies. Perhaps that is a more accurate explanation for why central banks are exchanging their paper for gold.
TGR: Gold's been trading around $1,100 for the past few weeks. There seems to be some resistance at that level. Some gold bugs say gold will be at $2,000 before the end of the year. Where do you project as a trend for the physical gold price through 2010?
CP: I have a much stronger view of where the gold price will be in two or three years than I do over the next few months. It's had a good run so I am not surprised that it is taking a breather here. If I had to guess I'd say we'll see new highs before the end of the year. I just think that the path of least resistance is up because the amount of debt that continues to mount around the world is staggering— a lot of that has to be monetized.
Everyone talks about deleveraging but the U.S. ran a budget deficit of $1.4 trillion or $1.5 trillion last year, and it looks like we're going to do something similar this year. I think I just read we're trying to increase the debt ceiling here by $1.5 trillion dollars to $14 trillion. These numbers would have been unheard of a couple of years ago. I think back to a speech that Bernanke gave in January of 2007, in which he worried that the U.S. budget deficit would approach 9% of GDP by the year 2030.
TGR: Oh, we're way beyond that already, and 2030 is still 20 years away!
CP: Absolutely. Last year at $1.5 trillion, our budget deficit was more than 10% of GDP. Bernanke's great fear about what the budget deficit might do occurred 20 years early and it happened not because of our unfunded Social Security and Medicare liabilities that he worried about but because of the global financial meltdown. When we layer on the unfunded liability issues we have a really gigantic problem that will be extremely difficult to grow our way out of, despite what Washington tells us. That is why I say that the path of least resistance—the solution to this—is to inflate these liabilities away.
That requires printing money. It requires a lot of new dollars, a lot of new Renminbi, a lot of new yen, a lot of new Euros, a lot of new rubles. I think you're going to see all of those currencies depreciate against other assets, and probably most against gold. I imagine that will continue this year, but anyone who has been involved in the gold market over the last seven to nine years knows to expect some scary rides up and down.
TGR: You've laid out a compelling argument about all governments increasing their money supplies and we'll have inflation worldwide. How much higher do you think gold can go?
CP: It's always difficult to put a number on it, but the inflation-adjusted gold price, depending on your assumptions and in which year you start, is somewhere between $2,200 and $3,100 per ounce. I've run a number of different models to see where the gold price could go and have come up with anything from $1,500 to $3,500 an ounce. In the end it's anyone's guess as to what the ultimate high will be, but as I said, the path of least resistance seems to be up.
TGR: If you follow the gold patterns, the summer months have historically been relatively low, with prices picking up again for the holiday seasons, particularly in India. Given that more gold is being bought as an investment or as insurance now, do you see that seasonality coming into play over the next two to three years?
CP: As you point out, more often than not we've seen a rise in the gold price in October and November, which coincides with the Indian wedding season. I have no particular expertise here, but I'll guess that that seasonal pattern will continue. Ultimately though it is not a primary driver of the gold price If you look at a nine-year price chart, those seasonal moves are just blips.
TGR: Should investors be looking at physical gold, the majors, the juniors? How should they play what you see as upward trends in gold prices over the next several years?
CP: My strategy is to own both physical gold and gold mining equities. I focus on the smaller capitalization gold companies, the exploration companies, the early-stage producers just because if you get those right, they have a lot more leverage to a rising gold price. The problem with owning only gold equities is that in a market sell-off, they can go down with everything else. I know people who were managing gold funds who had a very difficult time in 2008 despite the fact that the gold price was up. As we saw, gold mining companies were decimated. Many of those equities were down by 50% to 90% in 2008, and the gold price was actually up that year
TGR: So is the combination of physical and equities a kind of a hedge against each other?
CP: I wouldn't characterize it as a hedge. I would just say that it gives you a greater chance of participating in a rising gold market under various market scenarios.
TGR: Do you have any junior mining companies either in gold or silver that you're following that you'll share with us?
CP: Sure. I own shares in a company called Sandstorm Resources (TSX.V:SSL), which is a gold version of Silver Wheaton Corp. (NYSE:SLW, TSX:SLW). It is a metal stream company that focuses on acquiring gold streams from small to-mid-size development companies. They look for junior miners with exceptional projects but limited access to capital. They'll buy the gold stream, or a percentage of the gold stream, and give the junior mining company an up-front payment and then pay a fixed cost per ounce of gold. In return for this financing, Sandstorm gets gold production at a very low cost and without many of the issues associated with building and running their own mines.
I like to find companies that have small share structures in which the management owns a lot of the stock and where there's a compelling valuation. Sandstorm is a great example of that model and it is way off the radar of most investors. It also trades at a significant discount to its royalty company peers. Its CEO was the CFO of Silver Wheaton when Silver Wheaton was born, and I think he was the youngest CFO of a New York Stock Exchange company at the time. He is extremely driven and his interests are totally aligned with shareholders, so much so that to date I don't believe he has paid himself any salary. He believes his big win will come from his equity position.
TGR: Where are most of the gold streams they're acquiring? Are they focusing in on North and South America? Are they more international than that?
CP: Their first two deals were done in Mexico and Brazil.
TGR: Any other precious metals companies that you can share with us?
CP: Alexco Resource Corp. (TSX:AXR; AMEX:AXU) is another company that I own. It is about to begin production from the Keno Hill Silver district in the Yukon, one of the most prolific and highest grade silver districts in the world. They basically have the whole play. They'll make a lot of money from their current resource but the exciting part is that they have a decent chance of making a new, really big silver discovery. There is nothing in the current valuation for that..
I think Alexco's going to produce three million ounces of silver a year, and because of the by-products and the high-grade nature of their ore they will be producing silver at potentially zero dollars cash cost. At three million ounces a year and $18 silver, they are trading at three or four times my estimate of next year's cash flow. That is dirt cheap for any silver company, let alone one that has the potential to make a giant discovery.
TGR: Do they need any more financing to bring this mine into production?
CP: Silver Wheaton purchased 25% of Alexco's silver production, and that investment gave them almost all of the capital that they needed. They just did an equity financing a few weeks ago as well. So, yes, they're fully cashed up and have no need for any additional capital.
TGR: You mentioned focusing on Canadian-listed stocks, particularly small caps. As I understand it, you consider the Canadian market somewhat less efficient than the U.S. market, thus making it easier to uncover attractively valued companies. What do you think accounts for the discrepancy, and is it specific to small caps or also true of large caps?
CP: It's really true of both large caps and small but it's not a permanent discrepancy. It's more of a lag. What I mean is that U.S. investors take a lot longer to recognize and buy high quality Canadian companies than U.S. listed ones. I used to be concerned that this lag would somehow be arbitraged away, but I've been doing this now for 12 or 13 years, and it has not.
There are a lot of reasons behind that. For one thing, there seems to be an apathy or ignorance on the part of U.S. investors about almost everything Canadian. There's also a perception that the Canadian securities laws are lax, that its investment community is run by mining promoters, and that U.S. investors won't get a fair shake up there. While there are certainly landmines to look out for when investing in Canada, they are no more dangerous than those in the U.S.
To characterize the entire Canadian investment scene as corrupt because of the Vancouver mining community and the Bre-X Scandal in the late '90s ignores the fact that the U.S. has had plenty of its own investment scandals such as Enron and a banking system that perpetrated the greatest financial fraud in history this past decade.
But I can't tell you all of the reasons for the valuation lag that I continue to see between U.S. and Canadian companies.
TGR: You just know it's there.
CP: Let me tell you about the greatest example of that in my experience—and the reason I started investing in Canada. Back in 1997, I stumbled across Research In Motion Limited (TSX:RIM; NASDAQ:RIMM) just by accident. Here was this little Canadian company trading at $4 a share. Split-adjusted that would probably be 50 cents today. It had $2 a share in cash and $2 a share in backlog. And it had a technology that was going to revolutionize the way people communicated.
CP: They gave us the Blackberry—and no one was paying attention. Here was this little company in Waterloo, Ontario, developing this unbelievable technology. Its market capitalization was miniscule. Had Research In Motion been in Silicon Valley, its valuation would have changed very, very rapidly, but we had six months to do our homework on it before anyone really cared.
TGR: Wow! That's really a great story, like finding a Rembrandt in your garage.
Christopher K. Potter is the principal of Northern Border Capital Management, Inc., a Canadian-focused hedge fund that he founded in 2002. A 1987 graduate of Hamilton College in Clinton, NY—which earned a place on U.S. News & World Report's "Best Colleges 2010" list of Tier 1 liberal arts institutions—in 1988 he went to work for Preferred Utilities Manufacturing Corp., a leading combustion equipment design firm. By the time he left to study for his MBA at Columbia University, Chris was managing Preferred Utilities' New York office. After being awarded his master's degree, he joined Ten Squared L.P., a hedge fund focused on North American publicly traded securities. He was an investment analyst with the fund from 1996 until 1999 and the co-portfolio manager from 1999 until 2001. It was his last three years at Ten Squared, when he developed and managed the fund's Canadian investment business, that led Chris to found Northern Border Capital Management.
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1) Karen Roche of The Gold Report conducted this interview. She personally and/or her family own none of the companies mentioned in this interview.
2) The following companies mentioned in the interview are sponsors of The Energy Report or The Gold Report: None
3) Christopher K. Potter – I personally own shares of the following companies mentioned in this interview: Sandstorm Resources Ltd. and Alexco Resource Corp.