The Gold Report: You recently wrote an article called "It's Morning in India" that marked the election of Narendra Modi's pro-business government. How much of an impact can one man have on the demand for commodities?
Frank Holmes: At U.S. Global Investors, we believe that government policies are a precursor to change. That is why we focus on fiscal policies all over the world to understand the impact they will have on everything from interest rates to money supply. What makes Modi special is that he understands that job growth and creativity come from fiscal stimulus. Creating tax-free zones, breaking up monopolies and streamlining regulations and bureaucracy can unleash intellectual capital. Modi's track record in the state of Gujarat illustrates his ability to produce significant growth. He is a no-nonsense, pro-business person.
TGR: Let's look at what you have called the love trade. Its traditional seasonal impact on the gold market was quashed by taxation and import bans. How much of an effect could the pent-up demand have on the gold price if the government eliminates those disincentives?
FH: India is a big market and it can have a big impact. There is a high correlation of rising per-capita GDP in China and India and rising consumption of gold for gift giving. In the past three years, global GDP has shrunk from 5.5% to 3%. This year, it looks as if it is going to be back up to 3.5%. Growth and prosperity in America creates an economic sounding board that creates money around the world. Add to that the demand created by the religious holidays in the second half of the year—first Ramadan and then wedding and Diwali seasons, followed by Christmas and Chinese New Year—and it looks very positive.
Even JPMorgan Chase's Global PMI, the Purchasing Managers' Index, is looking up. The forecast of the next six months of economic activity shows the 1-month above the 3-month average. When that happens, consumption usually increases significantly in all commodities.
TGR: Let's quantify the term "significantly." Are we talking about a 2% increase? A 10% increase? More?
FH: Well, that's hard to say, but I have a suspicion that gold can easily jump 30%, up two standard deviations, because it's been down two standard deviations. Meanwhile, gold stocks are cheaper today than they were during the crisis of 2008, relative to the price of gold. So if we have a 30% increase in the price of the gold over the next 12 months, the gold stocks could rally 60%. For that to happen, we would have to see peace and prosperity in China, India, Southeast Asia and the Middle East, because that really triggers the consumption of gold.
TGR: How do you determine what companies in your portfolio are poised to do well if the gold price increases?
FH: Quality of management is a key factor. We look for technical engineers and geologists, but also at whether leadership understands the capital markets and has relationships with newsletter writers, buy-side and sell-side analysts. Those companies that have those relationships when they come out with news will enjoy a better response in the capital markets. So the quality of senior management is very important.
Our investment philosophy is driven more by the quality of the company rather than by leverage to the gold price.
We love Virginia Mines Inc. (VGQ:TSX). It's a high-quality, low-risk exploration and royalty company managed by André Gaumond, who has an incredible track record. He knows all the newsletter writers, he knows all of the sell-side and buy-side analysts, and the company owns a role in Goldcorp Inc.'s (G:TSX; GG:NYSE) high-grade Éléonore project, which he found and is slated to go into production in late 2014.
Another low-risk, high-grade gold producing company that we see as having significant upside is Klondex Mines Ltd. (KDX:TSX; KLNDF:OTCBB). At the beginning of the year, Klondex Mines completed what we think is a transformational transaction with the purchase of Midas mine and mill from Newmont Mining Corp. (NEM:NYSE). Management is highly respected. At one time, Franco-Nevada Corp. (FNV:TSX; FNV:NYSE) owned the Midas mine. Klondex Mines and Virginia Mines delivered 6% and 20% returns in 2013 when the Market Vectors Gold Miners Exchange-Traded Fund (GDX:NYSE) was down 60%. That is impressive.
TGR: What is the next catalyst for Klondex Mines?
FH: We see the value in the Midas project facilities. That's the catalyst. Once you unleash that and the quality of management and its ability to communicate its future growth, it could have an impact.
Another high-grade name with strong performance is MAG Silver Corp. (MAG:TSX; MVG:NYSE), which has two projects in Mexico.
TGR: MAG Silver just released a new resource estimate for the Juanicipio mine. Did that meet your expectations?
FH: MAG's 44% share is 71 million ounces grading 601 grams per ton silver. That makes MAG Silver stock very desirable right now. We think it could get taken over at some point.
Another company that we like is NGEx Resources Inc. (NGQ:TSX). It's got a great promoter, Lucas Lundin as chairman, and it's led by well-known CEO Wojtek Wodzicki. Los Helados, Filo del Sol and Josemaria are major copper-gold porphyry deposits between Chile and Argentina with tremendous upside. Lucas Lundin is not afraid of drilling up something and selling it. A lot of time management falls in love with the asset and the value never gets unlocked. We like the way NGEx's management thinks.
TGR: All three of these stocks are up since the beginning of the year. Do you credit that to management?
FH: Absolutely. They are always communicating. We don't have to hunt them down to find out about a press release or news. The top analysts and fund managers know what they are doing. That proactive attitude creates trust in a personal or a professional relationship.
TGR: What are some other performers in your portfolio?
FH: One thing that is very important for stability in a portfolio is the royalty companies. Sandstorm Gold Ltd. (SSL:TSX; SAND:NYSE.MKT), Franco-Nevada, Royal Gold Inc. (RGLD:NASDAQ; RGL:TSX), and Silver Wheaton Corp. (SLW:TSX; SLW:NYSE) are all up this year.
Royal Gold has been the big champ. Last year, Franco-Nevada was the leader. Silver Wheaton was able to borrow $1 billion ($1B) for five years at 1.6%. That is unbelievable! Why would you ever want to own Newmont Mining or Barrick Gold Corp. (ABX:TSX; ABX:NYSE), when you can own Franco-Nevada? It has 60% gross profit margins and a royalty on all those operations. You don't have to worry about all the fiascos or leveraged balance sheets. Management owns a big portion of the company. Franco pays dividends on a regular basis. Just consider revenue per employee, which is $50 million ($50M). In most companies, $500,000 revenue per employee is good.
Today, royalty companies function like mining finance houses. That's a great business model. That is why they are one of the core holdings for any portfolio.
TGR: Is this an important time for royalty companies because there is such a desperate need for capital?
FH: Capital markets are broken. Regulations are so excessive for junior mining companies that it is increasingly difficult to just walk in with a beautiful piece of property in Quebec and raise money. Therefore, private equity and royalty companies are very significant for junior mining companies right now.
We are seeing a shake-up. Weak properties and weak management are just not going to get funded. Great management and great properties can go to Franco-Nevada or Royal Gold or Silver Wheaton and really advance their projects.
TGR: Your Gold and Precious Metals Fund (USERX) did very well at the beginning of the year considering the market. You're up 11.83% compared to the last 12 months when it was down 32%. Is that upswing a sustainable trend?
FH: It's all about concentration. Alpha comes from two things: a) the ability to pick better companies; and b) overweight them relative to any index.
If an index is 5% Franco-Nevada and I have 15% for my portfolio, I'm three times overweight the index and that stock outperforms. That is how I've massively outperformed the index. Conversely, underperformance comes from overweighting in a very poor stock. Our alpha is coming from focusing on the companies that I mentioned, like MAG Silver, Virginia Mines, NGEx Resources, and balancing those volatile names with the royalty companies.
TGR: Does the same logic hold in other commodities?
FH: The other commodity we love is diamonds. We love Lucara Diamond Corp. (LUC:TSX.V), which is another Lucas Lundin company. For less than $50M, he got his money back in a year. It's really simple math. We now have seven billion people on earth and if even 1% of those people experience a dramatic rise in per-capita GDP and they all buy luxury goods, that is a boon for companies like LVMH Moët Hennessy Louis Vuitton S.A. (LVMH:IT), which currently has a market cap bigger than Goldman Sachs Group Inc. We own Tiffany & Co. (TIF:DE) because when things start to get better, people want nice things.
Disruptive technologies are making millionaires and billionaires out of a concentrated percentage of the population like Dr. Dre and the five people behind WhatsApp.
TGR: Well, this isn't as sexy, but what about nickel and steel?
FH: Nickel is much more of a straightforward supply-demand story. Nickel is used in alloying steel, including the steel that will be used in the $550B pipeline China is building to Russia. If there is a supply shortage out of South Africa and mines shut down in North America, the price could immediately go up. Copper levitated a couple of years back even though the economy had slowed because earthquakes and strikes impacted the supply. If we get any type of supply constraints, then prices could change quickly.
Right now, we have an oversupply of steel. The Chinese have been dumping steel on the world. But that pipeline agreement with Russia could be a signal that the country is embarking on an infrastructure boom that will absorb a lot of the steel. Combined with Modi's infrastructure ambitions in India, that could mean a lot more demand for steel and copper.
TGR: Are you predicting the same significant impact as in gold, a couple standard deviations?
FH: I think we have the potential for one of those great global rallies we witnessed in 2003, 2004 and 2005. If China and India start building meaningful projects for their people and we get a bottom in Europe, with America on an upswing, I think that we could see a global surge. It's not going to be as inflated as it was in 2003 because the housing component is not going to be as leveraged. Housing has the highest multiplying effect for money because so many people touch each dollar to create a house. Therefore, I don't think we're going to get close to the surge we had 10 years ago, but I do think we can get at least three-quarters of that.
TGR: Your Holmes Macro Trends Fund (MEGAX) is a diverse basket of industrial, energy, technology, healthcare, consumer product and financial stocks that are impacted by the macro-issues you just outlined. What criteria do you use for building that portfolio?
FH: We look at companies that are actively growing their revenue more than 10%, generating bottom line up to 20% return on their equity, and demonstrating 20% growth in earnings.
As John Derrick described in his Periodic Table of Sector Returns, we can learn a lot by examining movement in the top sectors. This is an amazing indicator. We track quarterly how many S&P 1500 companies across all sectors qualify for this beauty contest. This past March the number went from 160 names to 180 names even though GDP was down in America. That shows wonderful, broad-based economic growth. Back in the peak of 2006, it was over 200 names, then it fell down to under 100 names. So it is going in the right direction.
Another positive is that industrials are strong, and that is usually highly correlated to the consumption of commodities and good for per-capita GDP because wages are typically more than $15/hour in that sector.
TGR: More than half of the Macro Trends Fund is composed of large-cap, over $10B companies. Are you worried about a bubble in the large indexes?
FH: The word bubble has been abused. If you research the causes of a true bubble, it's usually excessive leverage, borrowing. The great crash of 1987 when investors lost 40% of their wealth in two days was predominantly because the S&P futures market was leveraged 10:1. In the crash of 2008, we had a housing market leveraged 90:1. Today, there is some concern about leveraged buyouts, but governments are going to have to keep interest rates negative or extremely low to counter regulatory creep and keep the economy moving.
TGR: So you think today's stock prices correlate to the true value in the companies?
FH: Sure they do. Look at dividend yields. A 10-year government bond is 2.5%, and you can buy some of these big-cap stocks with a dividend yield greater than 10 years out. We don't know who will be president 10 years from now, but we do know we will still be using Procter & Gamble's products and drinking Coca-Cola.
Plus, fewer companies are issuing stock options. Instead they are giving executives stock grants over five years so there's a real aligned interest for senior management in these companies to buy back their stock, and increase their dividends against their cash flow. Look at Apple Inc. (AAPL:NASDAQ ). It announced a 20% buyback; revenue per share is jumping 20%. That's profound. There are very few IPOs relative to companies buying back their stock and increasing their dividend. That means the stock market is still very attractive.
TGR: Thank you for your time, Frank.
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. Holmes purchased a controlling interest in U.S. Global Investors in 1989 and became the firm's chief investment officer in 1999. Under his guidance, the company's funds have received numerous awards and honors including more than two dozen Lipper Fund Awards and certificates. In 2006, Holmes was selected mining fund manager of the year by the Mining Journal. He is also the co-author of "The Goldwatcher: Demystifying Gold Investing." He is a member of the President's Circle and on the investment committee of the International Crisis Group, which works to resolve global conflict, and is an adviser to the William J. Clinton Foundation on sustainable development in nations with resource-based economies. Holmes is a much sought-after keynote speaker at national and international investment conferences. He is also a regular commentator on the financial television networks CNBC, Bloomberg and Fox Business, and has been profiled by Fortune, Barron's, The Financial Times and other publications.
Want to read more Gold Report interviews like this? Sign up for our free e-newsletter, and you'll learn when new articles have been published. To see recent interviews with industry analysts and commentators, visit our Streetwise Interviews page.
1) JT Long conducted this interview for Streetwise Reports LLC, publisher of The Gold Report, The Energy Report, The Life Sciences Report and The Mining Report, and provides services to Streetwise Reports as an employee. She owns, or her family owns, shares of the following companies mentioned in this interview: None.
2) The following companies mentioned in the interview are sponsors of The Gold Report: Klondex Mines Ltd., Virginia Mines Inc. and MAG Silver Corp. Goldcorp Inc. and Franco-Nevada Corp. are not associated with Streetwise Reports. Streetwise Reports does not accept stock in exchange for its services or as sponsorship payment.
3) Frank Holmes: I own, or my family owns, 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) The following securities mentioned were held by the Global Resources Fund, Gold and Precious Metals Fund and World Precious Minerals Fund as of June 16, 2014: Franco-Nevada Corp., Goldcorp Inc., Klondex Mines Ltd., Lucara Diamond Corp., MAG Silver Corp., NGEx Resources Inc., Royal Gold Inc., Silver Wheaton Corp. and Virginia Mines Inc.
5) Interviews are edited for clarity. Streetwise Reports does not make editorial comments or change experts' statements without their consent.
7) From time to time, Streetwise Reports LLC and its directors, officers, employees or members of their families, as well as persons interviewed for articles and interviews on the site, may have a long or short position in securities mentioned. Directors, officers, employees or members of their families are prohibited from making purchases and/or sales of those securities in the open market or otherwise during the up-to-four-week interval from the time of the interview until after it publishes.