devil will be in the details of the balance sheet when hyperinflation hits.
And while lots of companies have been using leverage to drive their ROE (and
their stock prices), the structure of their debt may spell the difference
between prospering and perishing. Those with low-interest debt that's locked
in for a long spell actually will be poised to retire their obligations with
cheaper dollars. But woe betide those stuck with floating rates. That's how
Sprott Asset Management senior portfolio managers Charles Oliver and Jamie
Horvat see what's brewing beyond the horizon, when time comes to pay the
price for running the money-printing presses too hot and too long. As Charles
and Jamie suggest in this exclusive Gold Report
interview, investors who base decisions on the strength and structure of the
balance sheet may not do too badly. In fact, they explain how the stock
market itself may serve as a hedge against hyperinflation.
The Gold Report: A lot has happened to influence gold prices since
the last time we spoke with you in June. India and Russia started buying
bullion, which helped increase the prices. Now, the news from Dubai has put
some downward pressure on prices. What does all of this mean for the gold
Charles Oliver: In terms of central banks buying, it's very positive.
You mentioned India, which just bought a couple hundred tons from the IMF.
Sri Lanka also bought 10 tons, and Mauritius bought two tons. We've also seen
the Russians buying and there's talk of China buying more—after the 400
tons they added in April.
So we're seeing some very positive fundamentals on the demand side of the
equation. The last decade the central banks have been net sellers. It looks
as if maybe over the next 12 months central banks will be net buyers, which
is a completely turnaround.
I am not going to make too much out of Dubai and its implications for the
gold price. We saw a small correction in every asset when the news came out.
Everybody sold a bit of everything; I think that was just a knee-jerk
reaction. If you look at the chaos in the financial markets, gold is actually
a safe-haven area.
Jamie Horvat: The only thing I'll add is that it appears gold is
reasserting itself as a currency, instead of being viewed solely as a
As far as Dubai goes, as Charles said, short-term it looks as if a lot of people
got spooked in the market and started taking profits. Gold, obviously, has
been pretty profitable year-to-date and we saw a couple of days of selling
where people got nervous and wanted to lock in their returns. But that panic
selling seems to have ceased.
TGR: Most people expect that all the money printing that's happened is
going to lead to inflation—or worse. What's your view on that?
JH: Our view is moving more toward the probability of hyperinflation
as governments have actually stepped up their stimulus programs and their
TGR: Let's define hyperinflation. Everyone knows it's big inflation,
but what does that mean?
CO: The dictionary gives no fixed definition, but one of the best
descriptions I have heard is that hyperinflation is an inflation in which the
rate is measured in months or days rather than years. In my mind, if you're
running at 50%, you're basically there. But again, there is no absolute
JH: One of the other things we've come across and talked about in the
past is the aspect of monetary debasement or monetary inflation, where
there's a definition for hyperinflation we came across stated as very high or
out-of-control inflation due to currencies rapidly losing their value
resulting in rapid price increases for all other goods.
TGR: So it's not necessarily the Zimbabwe type of hyperinflation, but
something that certainly North America hasn't seen.
CO: Just after the Civil War, the U.S. did go through a period of
hyperinflation. Everyone on the planet has at some point basically
experienced hyperinflation. And that includes the Chinese; I believe it was
around 1945 they went through a period of hyperinflation.
TGR: But this time you're looking at this potential hyperinflation as
being a worldwide phenomenon—not one country at a time.
CO: It all depends on what the individual governments do. Right now,
many of those countries are continuing to expand their monetary base. They're
spending money left, right and center. Governments that continue to expand
the monetary base at an increasing rate will share in the hyperinflationary
phenomenon. Not every country's going to do that, and we ultimately don't
know how it will unfold but as Jamie mentioned, we are seeing a lot of signs
that governments are continuing to spend vast sums.
Just as an example, the U.S. is spending a huge amount this year. The
healthcare program is going to cost them more money. The demographic story
that's going on out there, as people retire, Social Security payments will
increase while the tax revenues decrease. The Prime Minister of Japan and
government bankers there are reportedly having discussions about quantitative
easing, which, again, quantitative easing is printing money. The Bank of
England has embarked upon a huge program of quantitative easing. Those
governments that are going to ultimately pay the price.
TGR: In our last conversation, you mentioned that stock market studies
suggest one of the best ways to protect your assets is investing in the
market. Can you elaborate on why that works? And whether it would work in a
CO: If you go through a period of hyperinflation, the worst thing you
can own is cash because it becomes worthless. You want to own assets that
will protect you against inflation. Gold is one of the simplest things that
we all talk about as protecting against inflation. But interestingly enough,
if you go back to Weimar Republic, Germany and if you look at the Zimbabwe
Stock Exchange a few years ago, the stock exchanges actually acted as an
inflation hedge. That's because many of the companies on the exchanges
actually pushed through price increases on their end products. Hence, during
a hyperinflationary period, these companies were selling their products for
much higher year after year after year and their prices went up to reflect
that huge increase in earnings. The huge earnings increases were not the
result of improvements in productivity or expanding and growing their
companies. It was based purely upon the inflated prices they charged for the
goods they were selling. So, yes, the stock market can be a very good hedge
against hyperinflation as well as inflation.
JH: I'd argue that the stock market is potentially taking on this role
already. It may be starting to act as an inflation hedge, as discussions have
been coming out of China, Japan, Russia, and even the recent Fed minutes
talking about the low interest rate policy in the U.S. and the U.S. dollar as
potentially the new carry trade, resulting in this inflation of assets bubble
globally. If you can borrow money at prime less 25 or 50 basis points, or
essentially for free if you are one of the big U.S. banks that received a
bailout, and can put that to work in the market to buy stocks and assets
forcing prices up, or you can earn a yield spread, then under these
circumstances, I would argue—as many central banks have
stated—that this free money is causing the market to act as an
CO: Just a small counterpoint to my partner in crime. . . . At the
beginning of this year, we thought hyperinflation would happen several years
out. With the market performing as well as it has, it's a bit of a conundrum
with our belief of where we think the market should be valued. Jamie
correctly points out that you can explain this by talking about it acting as
a hedge against inflation or hyperinflation. But to some extent, my own
personal view is that the big movement in stocks will be several years out,
and that's contingent upon the governments continuing to expand and spend
money at an increasing rate.
People always ask what the risk is to your expected outcome. And the risk is
that at some point in time, some of these governments will start to get
religion. If you go back to the 1970s, the U.S. was going through a period of
huge stagflation. And then one man sort of stood out of the crowd—Paul
Volcker. When he got religion and raised interest rates and did the right
thing, people absolutely hated him. We look back now and say, "You know
what? He stood up; he did the right thing. The U.S. was in a much better
place and continued to be a very stable and good environment to invest in, to
grow in." So that's the one risk, that there's another Paul Volcker out
there who steps up to the plate.
JH: One counterpoint to my earlier argument about the market acting as
a carry trade, as Charles said earlier, the thing you have to monitor when
you look globally, is the U.K. still has a negative GDP number. The U.S.
recently revised the third-quarter number down from 3.5% to 2.8%. Look at
Canada. Look at Japan. There's no growth without government stimulus.
So if governments rein in or pull back the stimulus spending or someone gets
religion and bumps interest rates 25 basis points, we could easily set up for
a double-dip scenario or double-dip recession because the consumer is dead.
And without the incentive to spend there is no consumer spending and growth.
TGR: If you're looking at investing in 2010, it sounds like the
hyperinflation issues will happen several years out, and in the largest consuming
nations we continue to have government expanding the M1 to provide stimulus,
which will keep the market growing because the market is going to grow as a
hedge. So should we take advantage of the market hedging potential inflation
in 2010, and then bail out when we see hyperinflation on the horizon?
CO: We spend a lot of time trying to figure out how next year will
unfold. It's a very tough call. Having said that, as long as Ben Bernanke
says for the next 12 to18 months the Fed will keep rates low, you could see
the stock market show some strength. I think as the market goes higher, the
risk of a downturn increases because a lot of the growth in the stock market
is people paying higher multiples for earnings.
If you look at the economy, we still have a very weak consumer and very weak
earnings growth. A lot of it is a result of cost cutting, and there comes a
point where you just can't cut any more costs out. Hence, you may see the
stock market continue to go up, but I think the risk is significant that we
see a double-dip recession, and as soon as the market catches a whiff that
rates are going to start increasing, it probably will take a very big knock.
Again, we don't know exactly how and when that will happen, but we do see the
market getting more and more expensive. So I think you'll want to tread very
carefully, because there's a significant risk that at some time in 2010 the
economy may go back into a double-dip recession.
TGR: Will it be as dramatic as the one that started in 2008?
CO: I don't think so, but it depends on how things play out. If you
see the market get really, really expensive and continue upwards, it's going
to have to come down further. My personal view is that it won't be as
aggressive, but we will continue to monitor that and be ready to be wrong.
In 2008 the whole financial system looked like it was about to implode, and
now we've seen if that happens, the government plans to take action.
Unfortunately, the action is taking taxpayer dollars and giving them to the
banks, but they are ready to act. In that case, the same degree of fear may
not exist as it did in 2008 when people were fearful that the whole system
JH: I agree with Charles as he hit it on the head. You have to
question how forward-looking is the market? When does the market wake up and
realize that the growth we had was all predicated on government spending and
cost cuts? We can't cost-cut our way to prosperity. At some point the
government stimulus and spending have to cease and we have to pay for all of
this through future concessions, lowering the benefits that we were going to
receive in the future and increases to our taxes.
Also we still need to repair our balance sheet. We haven't really solved the
problem of all of those toxic assets and the quadrillion or $800 trillion of
derivatives—whatever the number may be; it is still lingering out
So it's going to be an ongoing period of lower growth and balance sheet
repair. When does the market correct? As Charles said, and I said earlier, that
will happen as soon as we get a whiff that interest rates are going to go up.
TGR: Let's talk about some of those companies that have the model
balance sheet—debt is low, they'll be able to service debt, and should
a downturn happen either in the economy or in the market, they will be able
CO: Within every sector some companies have healthy balance sheets and
surplus cash, and some have debt. Look at base metals, for example. Last
year, HudBay Minerals Inc. (HBMFF.PK) was trading at a discount to its net
cash, and Teck Resources Ltd. (NYSE:TCK),
which had an awful lot of debt because it had purchased its coal assets at
the top of the market. Our preference is to take the one with the lower risk
profile in terms of its potential to continue operating.
The picture also varies from sector to sector. In certain areas, generally
speaking, you see a lot of companies with an awful lot of debt. For instance,
there's lots of debt in the banking sector. So from a macro point of view,
that would be something to avoid. On the other side, a lot of material stocks
have very healthy balance sheets. They've been getting high commodity prices
for the last several years; so unless they've been on spending sprees, for
the most part they have been building up cash balance sheets.
JH: In consumer staples, a lot of the big conglomerates serve as a
primary model of how they've been driving ROE through leverage. Their ability
to continue to finance going forward is doubtful once rates increase
substantially as overall the margins may be pretty slim. So you really have
to pick and choose within each segment—the HudBays versus the Tecks, as
TGR: As you said, material stocks have built up healthy balance sheets
due to increase in prices of the underlying commodities. Why haven't gold
stocks increased valuations to reflect the 35% increase we've seen in the
price of gold?
CO: There has been a disconnect between the gold price and gold stocks
certainly over the last year and a half. I think we can all agree that 2008
was really an anomalous year. A gold stock was a stock; the fact that it was
in gold did not matter. So gold stocks just went down with the rest of the
stock market, and this year we've been playing catch-up. The gold stocks have
done very well.
Having said that, one sub-sector of the gold stocks has been the best. We've
seen brilliant returns in some mid-cap gold producers, while at the same time
some big-cap gold names and some early-stage names whose access to capital
has been a bit of an issue have underperformed.
The S&P Global Gold Index is up around 10%, which really isn't a very
good return; you would have done better than that if you held gold. But look
at an index made up of mid-cap names or look at many of the gold funds in
those mid-cap areas. Or look at our own fund—we're up over 100%
year-to-date as we speak. There's been some very good performance from many
of our peers as well.
TGR: So, is the reason some are outperforming the gold primarily back
to that balance sheet issue and the debt?
CO: Except for some of the large caps, I think most gold companies
generally have fairly strong balance sheets. A lot of them avoid too much
debt because it's a very tough business, and they don't want to get
themselves over-leveraged. For the most part, I think the dichotomy between
the performance of the large and small caps relative to the mid-caps is just
one of those things. Next year I wouldn't be surprised to see—in fact,
I expect to see—large caps and small caps outperform the mid caps. They
get out of whack sometimes, but eventually they tend to act as a group, so I
expect that to become more normalized next year.
TGR: So if we want to look at companies with sound balance sheets in
the group, which companies fall into those categories from your
analysis—small caps, mid caps and big caps?
CO: The large caps—companies like Goldcorp (TSX:G)
(NYSE:GG), Barrick Gold Corp. (NYSE:ABX), Newmont Mining Corp. (NYSE:NEM), AngloGold Ashanti (NYSE:AU), Gold Fields Ltd. (NYSE:GFI), Randgold Resources Ltd. (NASDAQ:GOLD), Kinross Gold Corp. (NYSE:KGC), IAMGOLD (IAG). Silver Wheaton Corp. (NYSE:SLW)—Silver
Wheaton is actually on the verge of becoming a large cap; it probably is a
large cap now.
JH: Red Back Mining Inc. (RBIFF.PK) is probably considered a large cap now
CO: Among the mid-cap names, I think of companies such as Osisko Mining Corporation (OSKFF.PK), Wesdome Gold Mines Ltd. (TSX:WDO) and San Gold Corporation (SGRCF.PK).
JH: Also Lake Shore Gold Corp. (LSGGf.PK) and Aurizon Mines Ltd. (AZK) .
And Romarco Minerals (RTRAF.PK) have strong balance sheets.
CO: Romarco is sort of a small cap breaking into the mid-cap range.
Generally speaking, the small caps tend to be more in exploration or
development-stage projects. Some of the names may not be familiar. Within
every country you can see a lot of small caps. One of our themes is
monitoring the jurisdictions these companies operate in because governments
sometimes change loyalties. We like stable areas. North America is a pretty
good region to operate in. Companies like Rainy River Resources Ltd. (RRFFF.PK). What else do we have in North America,
JH: Premier Gold Mines Limited (PIRGF.PK). Brett Resources Inc. (BBRRf.PK)—the
Hammond Reef project. International Tower Hill Mines Ltd. (THM).
CO: Let's pick some small-cap players in Brazil— Verena Minerals Corporation (TSX-V:VML.V). Amarillo Gold Corporation (TSX-V:AGC), Brazauro Resources (TSX-V:BZO), Magellan Minerals Ltd. (TSX.V:MNM). So
that's just a smattering of names in the different groups.
TGR: Four companies made it into your top 10 for both the Sprott Gold
Precious Metals Fund and the Sprott All Cap Fund— IAMGOLD, Kinross,
Osisko and Silver Wheaton. Can you give us some more insight into how and why
they achieved that ranking?
CO: I think of those as anchor names within the portfolio. It acts as
a core. They're good, sound companies, well-diversified and with a number of
different operations. The one that's a bit of an outlier among those you
mentioned is Osisko. We've owned it for awhile, but increased our position
over a year ago because we thought it was very cheap. Osisko has a very big,
very promising deposit in Quebec. We felt that the market was undervaluing it
dramatically. Great growth story, very cheap, strong balance sheet, fully
JH: Another point about our top 10—many of them grow into those
positions. Just over a year or even two years ago, people hated IAMGOLD and
wouldn't give CEO Joe Conway any benefit of the doubt. It was a show-me
story. Everyone saw a declining growth profile for the company for the next
couple of years until a few other projects came on. But Joe was one of the
few people out there willing to do something at one of the dour times in the
market. He bought the Essakane Project in West Africa and advanced it
forward, and now he's ahead of schedule and is showing a really good growth
profile. People are willing to pay for that growth now, and you saw
significant movement in the stock price.
Another example is Silver Wheaton. A year or so ago, people were dour in the
market, silver was down and we had the financial collapse, but with
Peñasquito coming on out of Goldcorp and the silver stream there along
with a few other assets, investors became positive on the silver and gold
price and the profile for the company. You can witness the movement in Silver
Wheaton's stock price as a result.
So more often than not, these are companies that have grown into these
positions over time.
CO: Jamie was quite right, and I think it's very important to know. We
don't generally go in to a portfolio and say, "We're going to make this
our largest position." It's usually growth from an initial position that
gets larger through the performance of the stock that brings it to that
magnitude. Our gold fund's top 10 is usually big, well-diversified producers
or stocks that have run an awful lot. In the case of the first three, they
are big, well-diversified producers, and as I said, Osisko's been a great
performer. It's one of those mid-cap names that I mentioned that has had
One of things I can tell you is somewhere below that top 10 list there's
another Osisko, which next year will probably break into the top 10. Again,
it will be through the outperformance of the company and growing recognition
by the investment community of the value of that company's projects and
TGR: If investors are already well into their gold positions in their
portfolio, what other sectors should they be looking at?
CO: Gold is our favorite sector. On a long-term basis, we're believers
in peak oil, too, so we believe that energy should be part of an investor's
outlook. In terms of mid-term themes, we think over the next decade there are
some areas in which to have some exposure that maybe over the last two
decades weren't so important. Agriculture is one example. A decade ago nobody
talked about agriculture. I think now it's very important, and the macro
themes are very compelling for why investors would want to get into
TGR: Okay. Agriculture is one. Where else?
CO: We think infrastructure will be a good area. With all the
government spending that's going on, there's going to be a lot of spending in
infrastructure. We've gone through a year of talking about it. So far, the
infrastructure companies haven't really benefited that much because it's been
a time for signing contracts and getting everything put in place. The real
spending comes on later down the line.
JH: We're looking at areas of the healthcare sector as well, but it's
more on the productivity, technology and medical equipment side and not so
much in biotech and pharmaceuticals. So the bread-and-butter supply types of
companies look pretty good.
There's some appeal in the technology space as well, with developments that
enhance productivity and make companies a little more efficient.
TGR: Anything else you'd like to tell our readers?
JH: Keep the faith. As long as governments continue to print money and
debase fiat currencies, hard assets should continue to appreciate and do well
as a store of value.
Bringing more than 21 years of experience in the investment industry,
Charles Oliver joined Sprott Asset Management (SAM)
in January 2008 as an Investment Strategist with focus on the Sprott Gold and
Precious Minerals Fund. Prior to joining SAM, Charles was at AGF Management
Limited, where he led the team that was awarded the Canadian Investment Awards
Best Precious Metals Fund in 2004, 2006, 2007, and was a finalist for the
best Canadian Small Cap fund in 2007. At the 2007 Canadian Lipper Fund
awards, the AGF Precious Metals Fund was awarded the best 5-year return in
the Precious Metals category, and the AGF Canadian Resources Fund was awarded
the best 10-year return in the Natural Resources category.
Jamie Horvat joined SAM in January 2008. Jamie is co-manager of the Sprott
All Cap Fund, the Sprott Gold and Precious Minerals Fund, the Sprott Opportunities
Fund LP and the Sprott Global Equity Fund. Jamie has over 10 years of
investment experience. Prior to joining SAM, he was co-manager of the
Canadian Small Cap, Global Resources, Canadian Resources and Precious Metals
funds at AGF Management Limited. He was also the Associate Portfolio Manager
of the AGF Canadian Growth Equity Fund, as well as an instrumental
contributor to a number of structured products and institutional mandates
while at AGF. He joined AGF in 2004 as a Canadian Equity Analyst with a
special focus on Canadian and Global resources, as well as Canadian small-cap
companies. Prior to joining AGF he spent 5 years at another large Canadian
mutual fund company as an Investment Analyst.
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
Gold Report: Romarco Minerals Inc., Aurizon Mines Ltd., San Gold, IAMGOLD,
Goldcorp, Gold Fields
3) Charles Oliver: I personally and/or my family own none of the companies
mentioned in this interview. I personally and/or my family am paid by none of
the companies mentioned in this interview.
4) Jamie Horvat: I personally and/or my family own the following companies
mentioned in this interview: Aurizon Mines I personally and/or my family am
paid by the following companies mentioned in this interview: None.
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