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With anticipated GDP growth insufficient to sustain
current market levels, Q1 Publishing's Founder and Chief Investment
Strategist Andrew Mickey asserts that great expectations tend to lead to
great disappointments. Although he's not foretelling a big crash, he tells Gold Report readers why it makes sense to expect
the market to fall back to a fair-value level over the next six months to a
year and there will still be plenty of opportunities for those in the right
spot.
The
Gold Report: In one of your recent articles, you suggest that even if good
economic news continues coming out next year, the market is likely to drop
20% to 25%. Would you go through the logic that leads you to that conclusion?
Andrew
Mickey:
If we look back to the way the stock market has moved over the past 20 to 30
years, it has always been valued relative to earnings. The most common
valuation for the market has 15 to 20 times the 10-year average annual
earnings. That smoothes out the up-and-down years and brings you to a fair
valuation—with the S&P 500 between 800 and 1000.
Granted
the stock market goes much higher and much lower than that—and can stay
at an extreme for longer than most investors expect—but it always
returns to its fair value.
Now that
so many stocks have had a great run, the S&P is up to around 1050, which
means it is overvalued. The market basically has a lot of positive
expectations built in. Earnings estimates are starting to rise, although all
CEOs are still trying to keep expectations low. Economic expectations are
rising. Expectations for everything are rising and we've learned consistently
throughout the years—great expectations usually lead to great
disappointments.
So as
long as GDP growth is low the market will fall right back to fair value.
That's why, even with the big picture news getting better, the very real risk
is that it's still insufficient to hold the S&P up at 1050, 1100, or
wherever it does eventually top out at.
We may
not have an outright crash because everyone is still on watch, but probably a
slow, steady fall over maybe six months to a year.
TGR: Are all
sectors currently overpriced, or will some continue to appreciate?
AM: There will be
some that will appreciate. But it won't be a case of great and greater
returns like we've had. There is some great historical research done on the
way stocks move. One important factor is the factors of market, sector, and
stock. If you break it down, basically 50% of a stock's movement is usually
tied the overall market. There's nothing you can do about that; it depends on
the market. Another 30% of that stock's move depends on the sector. And the
remaining 20% can be attributed to the individual company.
In other
words, you can expect the initial impact across all sectors. We see it all
the time when the markets go down. Just look at what happened last fall.
Everything is very closely tied together. Over time though, there will be the
divergence between the quality and value and all the speculative stuff.
TGR: How much focus
should individual investors put on international investments versus North
American-based investments in this environment?
AM: A lot of it
depends on your time horizon. If you have five years or more, you can build a
reasonable case for focusing 30% to 50% of your money in international
stocks.
That's a
very high concentration for any portfolio in any particular sector. If you're
looking out that far, you definitely want to be in the emerging markets. In
the short term, the falling dollar has been very helpful to some of the really
large, high-quality U.S. companies.
But if we
look at the massive U.S. dollar carry trade right now, we can see that is
going to be driving everything. We watched the Yen carry trade last for about
four years and then the credit crunch forcing the sudden unwinding of it.
With the U.S. dollar carry trade, it is going be even bigger, could last even
longer, and the when it is unwound, the volatility and fear even bigger.
TGR: In another of
your recent articles, you said that junior gold stocks offer exceptional
value because they're still in the relatively early stages of recovery. With
gold up 30%, major gold stocks down 15%, and junior gold stocks down 60%, you
asked, "Which one would you like to buy now?"
But with
the greatest opportunities for appreciation, don't those juniors also present
a correspondingly greater risk? If so, how do you minimize the risks of
investing in juniors?
AM: There are two
ways. The first is timing and picking the bottom, which is a very tough thing
to do. The other is diversification; I'd recommend owning at least five to 10
across the board. In addition, you'd want to buy consistently. The way we see
it, we'll be buying gold juniors for the next two years.
We don't
want to exhaust all of our capital right away. It's a lot less stressful and
you don't have to be exactly right to make a fortune.
Also,
when they're still deeply undervalued on a relative basis, you don't have to
risk nearly as much capital. So you could make 20% in big gold stocks, but
you may have missed 50% to 100% in juniors. The juniors are riskier, but the
amount of capital required to earn the equivalent nominal gains is less. Risk
is always relative to a lot more factors than simple percentage moves,
positions sizes are as equally important.
TGR: When you're
looking at juniors, do you differentiate between current producers and
near-term producers? Or JV models versus royalty companies?
AM: Most of our
valuations are based on traditional metrics such as net present value of
future cash flows for producers. Of course, once a company is producing and
we know much gold it is producing, there's a clear way to value it through
the cash flow model. That's how the big money values things, so that's how
you have to do it.
If you
really want to swing for something with just a little bit more upside
potential, maybe you select a near-term producer. There's a lot more room to
value them differently because as the big money managers continue to look at
gold, they're going to have to come up with ways to value those stocks.
Think of
it like the dot-com days. If a company had earnings, there was a way to value
it traditionally. But if a company didn't even have a chance of being
profitable, traders and investors would come up with all kinds of ridiculous
ways to justify lofty prices and bid them up even more. That's why the worse
a company was fundamentally, the better it actually did.
That
happens in all euphoric bubbles. And when it does, it will feel great, but
that's also the time to start taking money off the table.
TGR: Are any of
those on your radar?
AM: One junior gold
company I really like right now is in that larger junior tier, and that's Nevsun (TSX:NSU; NYSE.A: NSU). The first two years it produces it will produce
mostly gold, and then it becomes basically a copper-zinc mine in the out
years. It's fully financed now with debt from European and South African
lenders, and Nevsun is comfortable with building a
mine in Eritrea, Africa.
So, that
one really makes sense to me, and it's really doing well. The stock is $3
now, and the biggest risk I see to it, aside from commodity price risk, is
that it gets taken out at around $5 or $6 before it realizes its full
potential. In a market like this, that's a risk worth taking.
TGR: Most of those
you follow are really exploration companies. Would you share some of those
with us?
AM: One that has me
really interested is Otis Gold Corp. (TSX:OOO). It has a unique kind of deposit at its Kilgore
Gold Project in Idaho. The early exploration results have been good mixed in
with the occasional high-grade greatness, but I don't think the market
completely understands what it may have at this point.
It's
similar to past discoveries in Nevada in that it has small pockets of
high-grade gold. Otis has discovered just one of those pockets so far, but
that pocket has maybe 500,000 to 750,000 ounces of gold—and that justifies
the current market cap of around $15 million excluding everything else.
It's
fairly valued at that point if the company stopped all exploration right now
and did nothing else. But if this is like the Round Mountain mine in Nevada,
which also has pockets of very high grade gold in a large low-grade deposit,
has already produced 10 million ounces and with almost 2 million ounces of
reserves left.
You never
know, of course, but at this point, the company is really cheap based on what
is known and there's all kinds of potential. Since
we start looking at things with a risk-first approach, we like the low
downside mixed with the truly unlimited upside. The company's drilling. The results will be coming out over the next few
months. And we'll soon have a better picture, which, at this point, can only
add value to the company. It just seems like the right time.
TGR: So the market's
basically only valuing the current pocket and there may be several more?
AM: That's what it
seems like. There's no premium at all built into the exploration upside at
this point.
TGR: You mentioned
copper a bit earlier. We always hear about copper as the leading indicator of
the market expansion, because building, construction, housing, electricity
and durable goods are all very copper-intensive. Timber is apparently
emerging as another such indicator, and not long ago, you referred to timber
as "the next silver" in terms of its appreciation potential. Do you
see timber's prospects greater than copper's?
AM: Copper demand and
timber demand are both driven fundamentally by population growth, plain and
simple. Where there are more people, they want more things—more copper
demand. More people need more houses—more timber demand.
Over the
long run, it really is that basic. During the housing bubble, timber shot up
to $450 per 1000 board feet, and when the bubble burst, it fell two-thirds to
about $150 just like almost every other commodity.
Now it's
back up to the $180-$190 level now and still I can't find too many people remotely
interested in timber.
It's not
that I expect a housing bubble to return. I don't. But 660,000 houses are
currently under construction in the United States. But just to keep up with
average population growth, housing growth is pegged at 1.2% per year over the
next 40 years. That means we need about 1.3 million more houses per year just
to meet basic demand for new houses and replacement of old ones. That rebound
would justify a lumber price of $250 to $300 per 1000 board feet. That's kind
of the long-run average for timber and it'll rebound there over time.
But what
timber has over copper is a supply problem that's potentially much more
severe. This is caused in large part by the pine beetle infestation in North
America. Over the last decade, the pine beetle has decimated the forests in
British Columbia, and is now hitting the U.S., as far down as Colorado.
Basically, the pine beetle has taken 20% of the future world timber supply
off the market. Think about that in terms of other commodities such as copper
or oil. If one-fifth of the supply went away, you know we'd see a big surge
of demand. Once people start to figure that out, timber assets will really be
worth something again.
TGR: Any other areas
that interest you at the moment?
AM: As you may know,
about 80% of manganese is used in steel production, but there's a new demand
for it now in hybrid car batteries. If you like lithium and rare earths, you
should look into manganese could be a big opportunity in manganese as well.
In that
space, your readers may be interested in a company called Wildcat Silver Corporation (TSX-V:
WS). Some of the same people are behind one of our top-performing picks
we found February, Ventana Gold Corp. (TSX:VEN). Ventana was actually
spun out of Wildcat, which owns 80% of what is basically a silver/manganese
deposit in Arizona.
There's
plenty of exploration upside there, and Wildcat's net present value is about
four to five times higher than its market cap. It's something with the right
mix to do well, but it's not going to be one the biggest gold discoveries of
the decade, so it will take a little bit of time.
DISCLOSURE:
Andrew Mickey
I
personally and/or my family own the following companies mentioned in this
interview: Nevsun Resources, Otis Gold, and Wildcat
Silver. I personally own shares in all of the mentioned companies. You've got
to eat your own cooking.
I
personally and/or my family am paid by the following
companies mentioned in this interview: None.
Andrew
Mickey is Q1 Publishing's Chief Investment Strategist. Q1 Publishing provides
investors with "well-researched, level-headed, no-nonsense"
business analysis and advice that claims to filter out 99.9% of the noise in
the financial world to help investors "secure enduring wealth and
independence in today's turbulent financial markets." Its products
include subscription-only communications such as Andrew Mickey's Prudent
Investing and the President's List as well as a free eletter
called Prosperity
Dispatch.
Andrew's
investment philosophy is based on being prudent (limiting risk without
surrendering upside potential), paying close attention to risk-reward
relationships and evaluating a variety of asset classes. He searches
relentlessly for explosive assets and businesses off the beaten track,
traveling often to unearth hidden gems. Over the past few years he has
visited Indonesia, the Ukraine, Papua New Guinea, Russia, Mexico, Australia,
China, Thailand, Albania, Croatia, Norway and many other places. His research
has been featured on CNBC, BNN, BusinessWeek and
other media outlets.
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