The Gold Report: U.S. Global Investors recently published a report outlining the two trades that drive gold demand: fear and love. Which one is more powerful right now?
Ralph Aldis: The love trade is the foundation of owning gold stocks and gold because 70–80% of gold goes into jewelry. On the margin, the fear trade is driven more by the headline risks that we've seen in the Ukraine and the Middle East, or by inflation spikes. That's what drives people to take action.
TGR: Do you expect recent events in the Ukraine and Middle East to further spur gold's fear trade over the course of the summer?
RA: Yes. We have some geopolitical situations where the tension is elevating. It's unfortunate. There are different brokerage firms saying that investors don't need to own gold or gold stocks because the S&P 500 is going to be much higher later in the year. That's assuming we live in a perfect world. Unexpected geopolitical events happen that make gold a reasonable thing to have in a small part of investment portfolios.
The fall season is always a strong demand driver for gold as the jewelry industry returns to replenish its stocks.
TGR: Could we see a better-than-expected late summer gold rally as these two demand drivers converge?
RA: It's hard to say. We normally see about a 10% seasonal uptick in gold in the fall. But these geopolitical issues are problems that are not going away in a matter of weeks.
TGR: Improved U.S. employment numbers and the expectation of further U.S. economic growth has pundits offering forecasts on the impact of inflation on investments. What's yours?
RA: The general consensus is that inflation is not going to be a problem, yet wage growth has been very stagnant. People are pushing for a higher minimum wage, while businesses will have to pay more to retain workers as the economy improves. The costs of things have gone up over time, yet wage growth has not. When that wage growth starts, we'll see some inflation. But I don't expect it to be extremely strong inflation in the near term.
TGR: The current U.S. rate of inflation is 2.1%; when you combine that with interest rates that are even less, you get negative real returns. That's typically a positive environment for gold prices, isn't it?
RA: Historically, low interest rates have been fairly positive for gold because when Treasury bills earn 6%, that's going to pull money away from gold. Federal Reserve Chairman Janet Yellen is talking about having low rates for a lot longer than we expected. That has set the stage for a positive environment for the gold price. When gold gets down to $1,230 per ounce ($1,230/oz) or even $1,300/oz, half the industry doesn't make money. That's another issue where we have good fundamentals on the support side.
TGR: Goldbugs have been predicting hyperinflation for six years or so. Are we any closer?
"Klondex Mines Ltd. recently raised more cash to drill vein discoveries at Fire Creek and other targets at Midas."
RA: When you hear hyperinflation that's not because you have growth—that's because there is no growth. In places like Zimbabwe, which is operating on a socialist model and people don't know where their next dollar is going to come from, inflation continues to skyrocket because there isn't any economic growth. If someone is selling something, he better get as much money as he can. In the U.S. we have some growth and we'll continue to have reasonable growth. We could still see some inflation from wage growth but certainly not hyperinflation.
TGR: What's your current pitch to investors given the malaise in the gold space?
RA: Gold stocks really fall into an asset class that's largely uncorrelated with the S&P 500. That makes it a great asset for portfolio diversification. Our recommendation is that investors should have something around 5–10% of their portfolios in assets that are uncorrelated with the S&P 500. Gold or gold stocks fit that very well.
Investors should also rebalance every quarter or at minimum once a year. When the S&P 500 is soaring they should take a little money off the table and buy some gold stocks and vice versa. The gold stocks had a big rally in H1/14. It probably wouldn't hurt to take some money off the table and rebalance to an asset mix that's appropriate for one's investment horizon.
"Pretium Resources Inc.'s Brucejack is going to have a small mine footprint but be very profitable."
TGR: Do you recommend raising the percentage of gold and gold equities in an investment portfolio during times of greater global uncertainty?
RA: That would be contrary to what I would normally think if you always have a gold allocation. Gold prices typically rally when the broad market falls. That may be your opportunity to take some money off the table and buy another asset class that's lagging. If you're adding to your portfolio during a period of higher global uncertainty, you may be buying when the price has jumped as much as 5%. As soon as that uncertainty goes away, you've lost money. It's better to have that allocation on a consistent basis and then take advantage of the volatility.
TGR: The U.S. Global Investors Gold and Precious Metals Fund (USERX) is up about 28% year-to-date and has averaged about 6% over the previous 10 years. Do you have a code when it comes to positions in your fund?
RA: First and foremost, we try to focus on the fundamentals. We're looking for that growth in revenue, which is normally a derivative of the growth in metals production.
We also want to make sure that these companies have positive margins, that they're not just growing production and losing money.
We look, too, at the relative value of these companies versus their resource statements. We find that there's a very high correlation between the valuation of a company and its resource statement.
Then we try to balance those things with what the market is telling us. Everybody has access to balance sheets, but the current action of that stock tells us something else. If the stock is outperforming its peers, there may be something that's not in the historic financials, but that may be influencing what's happening now. Likewise, stocks sometimes hit on all of our metrics, but the performance isn't there. That's when we need to dig and find out why.
When it comes to stocks, I want a performance-based relationship. Companies may have great fundamentals, but if the performance tells me something is wrong, I'm probably going to walk away. We have to marry the metrics of the fundamentals with the price action.
TGR: Are valuations lagging the size of the resource more in this market than would have been the case perhaps five years ago?
RA: Yes. The markets got pretty frothy in 2008 and are risk averse now. We've seen that with transactions. Goldcorp Inc. (G:TSX; GG:NYSE) was willing to buy Osisko Mining Corp. because it was fully derisked. There were probably no more hiccups to expect and Goldcorp was willing to pay a premium to access that cash flow. Detour Gold Corp. (DGC:TSX), with similar Canadian assets, wasn't derisked at that point but was probably the company Goldcorp should have been buying. Now Detour has gone from about $2.50 to $13/share—a great move, but there are still some obstacles ahead.
Stocks in the junior space that aren't in production are selling for less than they should. The issue is that no one wants to be the person who buys a company and takes on the risk of getting that project into production. About 30 mining CEOs have lost their jobs in the last 24 months. I think mining CEOs look at Kinross Gold Corp.'s (K:TSX; KGC:NYSE) takeover of Red Back Mining Inc. in 2010 for $7 billion ($7B) and get nervous—that's when people started thinking about the cost of capital. You can't spend $7B to buy something that's worth $7B and then spend another $5B to build it. In this market the capital requirements often get priced into the valuation.
TGR: Are there other tenets in your code?
RA: Management is one thing that is difficult to put a dollar value on but we can estimate it by looking at the resource statement to determine what the company is worth and then seeing the premium the company sells for. One example is Randgold Resources Ltd. (GOLD:NASDAQ; RRS:LSE). CEO Mark Bristow has done a phenomenal job. Some might say the stock is expensive but here's a company with a manager that delivers—and he owns quite a bit of Randgold stock. Quality of management is another factor that fits into our model.
TGR: As of June 30, 2014, about 16% of the fund was in cash. Is that about where you prefer to be?
RA: That was probably just timing. Right after a quarter ends it's not uncommon to see hedge fund managers dump their stocks because they've already locked in their quarterly bonus. So we had a slight move in the gold stocks and there was some repositioning happening. That is not the normal cash position.
TGR: Should retail investors keep 10–15% of their portfolios in cash?
RA: A retail investor should always have some cash available to take advantage of any opportunities. Warren Buffett is a vulture investor in the sense that he likes to see turmoil and pain because that's when he's going make a sweet deal for his shareholders.
TGR: What companies does the fund have large positions in?
RA: One of the largest positions in the fund is Klondex Mines Ltd. (KDX:TSX; KLNDF:OTCBB). It's up almost 30% year-to-date. This is a great story. Most people haven't woken up to it yet. In 2013, Klondex was up about 28% when the Market Vectors Junior Gold Miners ETF (GDXJ) was down 61%. That's an example of stock performance signaling that something is going on.
At the end of the year, Klondex, which originally had just the Fire Creek mine in Nevada, was toll milling ore at Newmont Mining Corp.'s (NEM:NYSE) nearby Midas mill. Klondex then negotiated to buy the Midas mine and mill from Newmont for $83 million ($83M). (Note: $55M to Newmont, $28M to replace the reclamation bond and 5M common share purchase warrants at an exercise price of $2.25/share.) At that time the company's market capitalization was just under $100M and it raised close to that to complete the transaction. The stock did not get knocked down—it's up 30%.
The people at Klondex are key. CEO Paul Huet was the mine manager at the Midas mine for about 10 years. He knows that asset extremely well. The other key player is Chairman Blair Schultz. He left hedge fund K2 Partners to be the full-time chairman. Klondex recently raised more cash to drill vein discoveries at Fire Creek and other targets at Midas.
TGR: About 66% of Klondex is held by institutional shareholders, and about 8% is held by management and insiders. What are your thoughts on that mix?
RA: That's a pretty good mix. We find that when management doesn't own enough shares it seems to deliver mediocre to bad performance relative to companies with management that owns a significant percentage of stock.
TGR: Klondex is targeting free cash flow by the end of the year. Does it get there?
RA: Yes. I don't see any hiccups on that side at all.
TGR: What other companies is the fund holding large positions in as of June 30?
RA: Northern Star Resources Ltd. (NST:AUX) was a 100,000 oz (100 Koz) gold producer in Australia and then about seven months back it bought a 52% stake in the East Kundana joint venture, as well as the Kanowna Belle and Plutonic gold mines in Australia, from Barrick Gold Corp. (ABX:TSX; ABX:NYSE). Now it should be a 200 Koz producer. In our models, Barrick's Australian assets were worth about $1B. In two separate deals, Northern Star paid a little under $100M for them.
Barrick wanted to exit Australia and those were considered small assets, sold based on the Proven and Probable reserve value—that meant that the Measured, Indicated and Inferred resources were essentially gravy. Northern Star's valuation has moved up a lot since those transactions. It has a great management team, too. These people are great operators.
Another holding is Dundee Precious Metals Inc. (DPM:TSX), a stock that got hurt in 2013 when the markets crashed on gold stocks. Originally led by Jonathan Goodman, Dundee brought Rick Howes into the fold a few years ago, and he has since become CEO. There are two primary assets. One is the Chelopech copper-gold mine in Bulgaria. The other asset is the Tsumeb smelter in Namibia. Both of these assets were underperforming. It's taken some time, but the company turned the Chelopech operation around. With the cash it was generating Dundee modernized the Tsumeb smelter to handle Chelopech's high-arsenic copper concentrate—only a couple of smelters in the world can handle it. Dundee also expanded the capacity at Tsumeb to 240,000 tons per year (240 Kt/year) from 180 Kt. In 2013 the company was getting $450/ton and its operating costs were $433/ton. In Q1/14 its revenue per ton was $569, with operating costs of $307, a margin of $262. Raymond James recently launched coverage on Dundee.
TGR: Dundee also has the Krumovgrad gold project in Bulgaria. When will that asset reach production?
RA: It's basically in the final permitting stage; it will go into construction in the next 6 to 12 months. The grade at Krumovgrad is about 4 grams per ton gold and it will cost less than $250M to build. That's another leg of growth for Dundee. It also owns stakes in Sabina Gold & Silver Corp. (SBB:TSX.V; RXC:FSE), Dunav Resources Corp. (DNV:CVE) and Avala Resources Ltd. (AVZ:TSX.V).
TGR: Other major holdings?
RA: Comstock Mining Inc. (LODE:NYSE.MKT), which is a very interesting story. The man behind it is John Winfield, a self-made billionaire in the real estate market. He recognized the potential of the former Comstock mining district in Nevada and spent time getting all the property interests in the region locked up.
Comstock started production over a year ago at about 10 Koz/year. It doubled that and now it's targeting a 40 Koz run rate in H2/14. In H1/14 the strip ratio was about 7:1. That ratio is going to drop in the second half of this year and with the expanded production volume I think Comstock is going to turn a profit. The company has permits to reach 4 million tons per year so Comstock should be a 100 Koz producer by 2016. It's a situation where people are creating value and John Winfield knows how to make money.
TGR: There are about 65 positions in the U.S. Global Investors Gold and Precious Metals Fund. Tell us about some of those.
RA: Orex Minerals Inc. (REX:TSX.V) is relatively new on the scene but its management is not. CEO Gary Cope and his team sold Orko Silver to Coeur d'Alene Mines Corp. (CDM:TSX; CDE:NYSE) in 2012. Gary now has four properties with Orex—one in Sweden, two in Mexico and another in Canada. One of the properties in Mexico is a joint-venture option with Fresnillo Plc (FRES:LSE). Gary will probably end up partnering with another company in Sweden or spin those assets into a separate company to unlock value. It's not just a one-property company. There is probably more opportunity than there is risk at these prices.
We're still big fans of Pretium Resources Inc. (PVG:TSX; PVG:NYSE). Brucejack is going to be a mine. This is the real thing. It's just going to take time. It's going to have a small mine footprint but be very profitable.
TGR: Pretium took a credibility hit based on some resource work that was being conducted on Brucejack. Did that make you question management?
RA: No. The engineering firm had processed maybe 3–4% of the bulk sample when those comments were made. It's insane to me. Yes, it is a complicated resource estimate and the mine plan will be complex, too; it's not a simple bulk-mining situation. There is some complexity but Pretium is probably one of the best takeout candidates out there. Nobody knows for sure but if that resource calculation is correct, then it's a tenbagger.
The other company we're big fans of is Virginia Mines Inc. (VGQ:TSX). That's run by André Gaumond. Virginia has the royalty on the Éléonore project that Goldcorp will put into production later this year. Royalty companies have been one of the better performing sectors in the gold space and Virginia Mines is no exception. It was up about 6% last year, while Franco-Nevada Corp. (FNV:TSX; FNV:NYSE) was down about 20%. Virginia has lagged some this year, but some important things are going to start there pretty soon.
TGR: Do you think that André Gaumond would ever monetize that royalty and dividend it to shareholders?
RA: If André is going to monetize it, the driver would be how much would a Franco or a Royal Gold Inc. (RGL:TSX; RGLD:NASDAQ) pay for it? It's a fantastic royalty. Goldcorp updated its Éléonore resource statement at the beginning of this year. We calculated $1B worth of value created by the additional drilling of the resource that Goldcorp originally defined, plus there are some additional parallel zones. I don't think André will get rid of it any time soon.
TGR: With the exception of SEMAFO Inc. (SMF:TSX; SMF:OMX), the U.S. Global Investors Gold and Precious Metals Fund's top 10 equity positions do not have projects in Africa, or South America and few have projects in Mexico. Even in this troubled market for small-cap resource equities, do companies operating in safer jurisdictions offer greater upside?
RA: Atico Mining Corp. (ATY:TSX.V; ATCMF:OTCBB) is in Colombia and it is run by the brothers that run Fortuna Silver Mines Inc. (FSM:NYSE; FVI:TSX; FVI:BVL; F4S:FSE). Other than that I think companies operating in safer jurisdictions are probably more desirable as takeover targets.
TGR: Are there any gold stocks out there that deserve a second look at this point, considering that gold prices seem to have bottomed?
RA: Yes, one that comes to mind is Gran Colombia Gold Corp. (GCM:TSX). Its share price is off 95% from its first financing in August 2010. For the last couple of years Gran Colombia has been running with a production run rate of about 100 Koz gold per year with a current enterprise value of roughly $200M. The positive changes that have recently taken place are the hiring of a new CEO, Lombardo Paredes Arenas, in February 2014, and the construction of a modern day milling plant at Pampa Verde. The new plant will allow Gran Colombia to grow its production to 170 Koz gold by 2015. A higher gold price, new management and increased production will go a long way toward turning this company around.
TGR: Parting thoughts?
RA: As I said earlier, don't get married to any stock. It's a performance-based relationship. If the stock is not behaving and it's going down, you can probably make money someplace else.
TGR: Thank you for your time and considerable insight.
Ralph Aldis, CFA, rejoined U.S. Global Investors as senior mining analyst in November 2001. He is responsible for analyzing gold and precious metals stocks for the World Precious Minerals Fund (UNWPX) and the Gold and Precious Metals Fund (USERX). Aldis also works with the portfolio management team of the Global Resources Fund (PSPFX) to provide tactical analyses of base metal, paper, chemical, steel and non-ferrous industries. Previously, Aldis worked for Eisner Securities, where he was an investment analyst for its high net worth group and oversaw its mutual fund operations. Before joining Eisner Securities, Aldis worked for 10 years as director of research for U.S. Global Investors, where he applied quantitative skills toward stocks, portfolio tilting, cash optimization and performance attribution analysis. Aldis received a master's degree in energy and mineral resources from the University of Texas at Austin in 1988 and a Bachelor of Science in geology, cum laude, in 1981, from Stephen F. Austin University. Aldis is a member of the CFA Society of San Antonio.
Read what other experts are saying about:
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) Brian Sylvester 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 independent contractor. He owns, or his family owns, shares of the following companies mentioned in this interview: None.
2) The following companies mentioned in the interview are sponsors of Streetwise Reports: Klondex Mines Ltd., Comstock Mining Inc., Fortuna Silver Mines Inc., Gran Colombia Gold Corp., Pretium Resources Inc. and Virginia Mines Inc. Goldcorp Inc. and Franco-Nevada Corp. are not affiliated with Streetwise Reports. Streetwise Reports does not accept stock in exchange for its services.
3) Ralph Aldis: 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. My company has a financial relationship with the following companies mentioned in this interview: None. Funds operated by U.S. Global Investors hold the following companies mentioned: Atico Mining Corp., Comstock Mining Inc., Detour Gold Corp., Dundee Precious Metals Inc., Fortuna Silver Mines Inc., Goldcorp Inc., Gran Colombia Gold Corp., Kinross Gold Corp., Klondex Mines Ltd., Newmont Mining Corp., Northern Star Resources Ltd., Orex Minerals Inc., Pretium Resources Inc., Randgold Resources Ltd., SEMAFO Inc. and Virginia Mines Inc. 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) Interviews are edited for clarity. Streetwise Reports does not make editorial comments or change experts' statements without their consent.
6) 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.