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Smart
companies are beginning to ignore analysts' insistence that production growth
is always good, and to focus instead on growing their margins by lowering
capital expenses. This is good news to U.S. Global Investors Inc.'s Brian
Hicks, co-manager of the Global Resources Fund, and Ralph Aldis,
senior mining analyst and portfolio manager of the Gold and Precious Metals
Fund and World Precious Minerals Fund. Learn what kinds of companies attract
the interest of these active managers in this Gold Report
interview.
The Gold Report: The Nov. 1
edition of Frank Talk suggested
that gold equities generally perform poorly in a U.S. election year but
rebound strongly the following year. Do you expect a better year for gold and
gold equities in 2013?
Ralph Aldis: This year
has not been a stellar year for gold equities. Most of the gold equity funds
have negative returns for the year.
Brian Hicks: We believe gold equities will do well
next year, largely due to macroeconomic factors that have been in place for
some time, but which will become even more pronounced in 2013. Those factors
include central banks expanding their balance sheets and increased concern over
deficit spending here in the U.S. Looking at how cheap gold equities are
relative to the bullion price, that spread will continue to be arbitraged in
2013.
TGR: Every media outlet in the country is
talking about the fiscal cliff. If the U.S. goes over the fiscal cliff, what
effect would that have on the gold price and on gold equities?
RA: No one has the stomach to let the
country fall off the cliff. A compromise will be reached. The most likely
scenario is that the government will have to print money in flight. That will
be a very clear signal to own gold bullion, and gold equities will be handed
their marching papers to go higher.
BH: Whether we get a compromise or go
over the cliff, which is the less likely event, gold will do well. Either
way, there will be a lot of uncertainty and concern about financial assets.
That will prompt people to see gold as a hedge.
TGR: Gold equity investors have seen more
volatility than gains in recent years. Should they expect more of the same
over the next four to five years?
BH: The volatility has held true for the
markets in general; it has not been specific to gold equities. On a relative
basis, gold equities have outperformed the broader market since 2008.
"Whether
we get a compromise or go over the cliff, which is the less likely event,
gold will do well." --Brian Hicks
To prepare for volatility, investors should be balanced, not
overweight in any particular sector. You want to be able to capitalize on the
volatility—to the upside or the downside. Gold equities are somewhat
countercyclical; they can diversify a portfolio and be additive to overall
risk-adjusted returns.
RA: When silver was hitting close to
$50/ounce (oz), the regulators raised margin requirements
something like five times in five days. That knocked silver for probably its
biggest correction ever in a single week. If you live through that type of
correction once, you become gun shy about going long on equities when the
metal prices are going up.
More generally, the tech bubble, the credit crisis, the real estate
crash and the large number of baby boomers approaching retirement are all
causing people to sell equities. They are turning to fixed-income or
structured interest-rate products. That provides a great buying opportunity
for equities.
BH: Generalists talk about gold being in
a bubble, but I agree with Warren Buffett that the real bubble is government
bonds. At some point, that money will have to come out. When it does, it will
be looking for returns and for yield. Gold stocks will be poised to
capitalize on that.
TGR: How should gold equity investors
handle common market corrections?
RA: One strategy, if you are certain that
you are in a bull market, is to stay long the entire time.
I would say you stick with it.
However, in managing our funds, we always keep some cash on hand so we
can buy stocks on these dips. For example, a company releases a good news
story and the stock starts moving twice as much as any other stock that day.
It is probably prudent to sell perhaps 1% of your position because you will
be able to replace it later at a cheaper price.
TGR: Another edition of Frank Talk discussed
how companies' margins are being compromised and growing thinner. What must
gold companies do to boost investor confidence?
RA: The industry's mantra has been
"grow production." That is what the analysts look for and what
companies are trying to do, but it is difficult to grow production.
"Companies
need to focus on growing their returns and not on growing the company or the
production profile."
--Ralph Aldis
You can grow production through your own organic discovery or through
acquisition. Too often, companies overpay or size up a marginal project from
say, 30,000 tons (30 Kt)/day to 60 Kt/day. They have tried to grow production at the expense
of lowering margins. If they lower their margins, they can no longer pay a
dividend. If the gold price corrects, the project may no longer be economic.
Management needs to focus on return on capital, on making a sound
investment in something that you can make money on.
For example, Randgold Resources Ltd. (GOLD:NASDAQ; RRS:LSE) models all of
its projects on $1,000/oz gold. Its cutoff is a 20%
return on $1,000/oz gold. That focus on delivering
a return is why Randgold's share price has done so
much better than everybody else's.
BH: Randgold's
success also is a function of having its CEO, Mark Bristow, as such a sizable
owner of its common stock.
We looked at stocks with high insider ownership versus those with low
insider ownership. By a wide margin, precious metals companies with
significant management ownership have outperformed companies that do not have
much participation from their management teams.
TGR: What will drive up the value of gold
equities over the next five years?
RA: Gold prices will go higher. Central
banks around the world are hedging by buying gold in lieu of currency for
their reserve holdings. Also, investor demand will push values higher.
Companies need to focus on growing their returns and not on growing
the company or the production profile. Focusing on returns will allow them to
pay a dividend.
TGR: Do you own any companies with a
market cap over $300 million (M) that do not pay a dividend?
RA: Yes. There are companies in the
growth phase, in the capital phase where they are not cash-flow positive in
the sense of having sufficient free cash flow to start writing checks to
shareholders.
While some companies are paying modest dividends of 1–2%, paying
a dividend is more the exception than the rule. The only high-price dividend
payers are companies whose share price has been knocked down, like Gold
Fields Ltd. (GFI:NYSE).
TGR: Given gold companies' heavy capital
expense (capex) demands, do you see the major
players getting to dividends in the 4–5% range?
RA: Rather than increasing dividends,
companies have been upsizing their projects to grow their production profile.
The only people making money are the consultants earning fees by telling the
mining companies what to do with their project and the companies building the
actual mines.
Gold companies are making profits but they are not yielding
exceptional returns. The majors are all trying to push upside of the project
in the false belief that if they move all the cash flow forward, they will
get a higher multiple.
TGR: If the companies in your funds are
making less money than their consultants, why are you in this sector?
RA: Our funds are weighted differently
from indexes that focus on the big four: Goldcorp
Inc. (G:TSX; GG:NYSE), Barrick Gold Corp. (ABX:TSX; ABX:NYSE), Newmont Mining
Corp. (NEM:NYSE) and Newcrest Mining Ltd. (NCM:ASX).
As active managers, we are trying to scope out the companies that are
doing the right things to achieve the top returns we want for our
shareholders.
BH: Ralph and I agree that Randgold would be the bellwether and it has been a core
holding for many years. It has created shareholder value throughout the
cycle. It is defensive in that it has high grades; its projects are stress
tested at $1,000/oz gold. It has done very well
since 2000, much better than the price of bullion. That is the type of
company we look for.
RA: Agnico-Eagle Mines Ltd. (AEM:TSX; AEM:NYSE) is
another company that got severely punished earlier in the year for a couple
of missteps, but management knows what it is doing.
TGR: Were you disappointed to see
President and COO Ebe Sherkus
step down?
RA: Agnico-Eagle's culture is strong
enough to survive that. The company has a deep pipeline of talent to fill the
voids when they come up.
TGR: What is your investment thesis?
BH: Our view is that gold stocks have
been derated since the introduction of the SPDR
Gold Trust (GLD) exchange-traded fund. That derating
is reflected in lower multiples to cash flow and earnings, because returns on
capital have not been sufficiently higher than their cost of capital.
However, lower oil prices and fuel costs, as well as the delay or outright
cancellation of many capital projects, could provide some relief in the cost
of labor and raw materials. From that standpoint, over the intermediate term,
margins could start to expand. That would be good for gold equities.
"Historically,
if you pick the right stocks, you get 2:1 leverage by owning the stock versus
the commodity."--Brian Hicks
We also think money will continue to flow into the sector because we
are bullish on gold. Historically, if you pick the right stocks, you get 2:1
leverage by owning the stock versus the commodity. Our job as active money
managers is to sift through the large universe of companies and pick stocks
that will exhibit that leverage in a rising gold market.
RA: George Topping, an analyst at Stifel Nicolaus, caught the
gist of what needs to happen in his report, "Don't Build It and They
Will Come." Since that report, companies like Rainy River Resources Ltd. (RR:TSX.V) have
started looking at how to downsize projects. That may be the catalyst that
will take some of the pressure off the margins.
The other thing that has hurt gold companies in this cycle is
understating their cash costs. Only government officials really believe a
cash cost of $700 to produce an ounce of gold. Governments look at those
numbers and say, you guys are making windfall
profits, so we need to raise your taxes. To combat that, companies need to
talk about the cost to produce an ounce of gold in total cost terms.
That is beginning to happen. The World Gold Council met at the Denver
Gold Show to talk about how to transition from a cash-cost definition to a
total-cost definition. This would make the industry more transparent and the
companies more accountable.
TGR: Can you name some companies with
projects that have downsized capex to mine more
efficiently and more intelligently?
RA: Rainy River and Keegan Resources Inc. (KGN:TSX; KGN:NYSE.MKT) just
announced downsizings. Kinross Gold Corp. (K:TSX; KGC:NYSE) has
talked about rethinking its development process.
We will see a trend of companies taking the foot off the pedal and
thinking about what makes sense. If you can develop a project at a higher
margin, that is the smarter choice.
TGR: What equities are you bullish on?
RA: You have to give the royalty
companies some serious thought. They are insulated from capital cost
increases, at least on the cost-structure side.
Franco-Nevada Corp. (FNV:TSX; FNV:NYSE), Silver Wheaton Corp. (SLW:TSX;
SLW:NYSE) and Royal Gold
Inc. (RGLD:NASDAQ; RGL:TSX) have done
very well. Sandstorm Gold Ltd. (SSL:TSX.V), an
up-and-comer, has created good returns.
These companies have to be careful about buying a royalty on a project
that has margins that may be too thin and getting in too deep. The royalty
company may not be on the hook for more capital, but it has a lot of costs if
that project is not built.
BH: Several silver companies look interesting. The price of silver is
high enough for some of the lower-cost silver companies to generate free cash
flow and superior returns on capital compared to their precious metal peers.
Tahoe Resources Inc. (THO:TSX; TAHO:NYSE) is run by
Kevin McArthur, former CEO of Goldcorp. A proven mine builder, and we
particularly like that he owns 4M shares of that stock, so he has a vested
interest in the company's success, which may translate into a substantial
dividend yield.
TGR: Would now be a good time to look at
Tahoe, after its stock prices have come off its high?
BH: Yes. Tahoe is entering a sweet spot
in the lifecycle of a mine. It is far along in development and is poised to
start production. If you look at the earnings power Tahoe has at current
silver prices, it looks cheap to us.
RA: Kevin McArthur has a vision for
taking Tahoe forward. If anybody can build it in Guatemala, he's the man to
do it. I recently attended one of Kevin's presentations in Panama, where he
talked about paying a $2/share dividend. But he understands this is a cash
cow.
BH: The Escobal
project in Guatemala is a world-class deposit. The further along it gets in
development, the more derisked Tahoe becomes and
the higher the share price.
TGR: Silver Wheaton CEO Randy Smallwood
expects a strong Q4/12. What is underpinning that optimism? Is there a new
stream about to start up?
RA: I am not aware of a new stream coming
on-line. It may be related to a timing delay in ounces sold,
or to production setbacks over water issues at Peñasquito.
If those issues are cleaned up, production can return to normal.
BH: The important thing with Silver
Wheaton is that it is a large-cap company now but it can still grow its attributable production via silver stream north of 10%
between now and 2016 with no ongoing capital expenditures. It also has a
dividend policy of 20% of its cash flow. Plus Silver Wheaton has over $500M
in cash that could be used to make further investments that would be
accretive to earnings and operating cash flow.
TGR: Are you buying companies now in the
expectation of more merger and acquisition (M&A) activity as the gold
price rises?
RA: Not really. I think M&A activity
is on hold as companies figure out how to optimize their existing projects
and increase their margins. Stupid acquisitions are one of the best ways to
destroy capital. I do not believe M&A is the way to go right now.
However, a couple of companies could be in play just on valuation. Dundee Precious Metals Inc.
(DPM:TSX) gets penalized for being in Eastern
Europe and for having a smelter in Namibia that was recently attacked by the
environmental minister without any evidence for his allegations. Dundee
Precious Metals is looking at putting a pyrite recovery circuit at its main
mine, Chelopech. It would not cost much to do, but
would probably boost gold production by half. With that circuit in place, it
may be a good purchase for Eldorado Gold Corp. (ELD:TSX;
EGO:NYSE). Dundee Precious Metals probably has 50% upside from where it is at
right now.
Another company, Gran
Colombia Gold Corp. (GCM:TSX.V), was
taken over two years ago and the assets were bought out of bankruptcy. It has
hired new people on the ground who are really doing
first-class work. I visited last week with the new mining engineer in charge
of the underground work at its Segovia operation. We reviewed every stope model and the pay yields on everything needed to
turn the asset around.
Gran Colombia also has its Marmato
operation, a high-grade underground operation that never had a mine plan. Its
new consultant, Lee Hill, has worked all over the world and he loves this
project. Marmato has probably 17 Moz gold, with an official number around 13 Moz. But when
you look at the four holes already drilled, you can see substantial amounts
of gold. Then, you start thinking that this may be an underground mine, not
an open pit.
Its share price is in the $0.35 range and if it shows the asset can be
turned around, that stock is very cheap and is a potential takeout.
TGR: You place a premium on communication.
Why is that?
RA: We try to keep the lines of
shareholder communication open because that signals to people how engaged we
are in what we are trying to do. Shareholder education builds shareholder
loyalty.
We cover a lot of topics. Frank Holmes travels the world and talks to
thousands of people. Brian and I visit projects and have regularly scheduled
calls with analysts three and four times a week. We try to synthesize our
view and share it. The overall market seems to be highly depressed, and
everybody just wants to talk about the negatives, but there is opportunity.
BH: As analysts and portfolio managers,
summarizing what happened over a week's time, help us put events in
perspective. When you have to write about it, you have to think clearly about
the issues. It's a good tool for us as well.
TGR: What is a good rule of thumb for
precious metals equities investors?
RA: On the gold and precious metals side,
at a minimum they should keep 5–10% of their overall portfolio in gold
and gold stocks and rebalance it annually.
The good thing about gold and gold stocks is that they are not as
positively correlated to the overall market. When your gold equities are
down, your other stocks tend to be up; if other stocks are down, the gold
equities are probably making up the losses. We find that to be a great
portfolio diversifier over time. If you do the efficient frontiers, gold
equities not only lower the overall volatility, they also raise the average
return.
TGR: And you, Brian?
BH: The precious metals market is
surprisingly inefficient. There are opportunities to trade around core
positions when you have dislocations in the market, whether it is a
geopolitical event or a change in government policy.
On an individual basis, it can be daunting to navigate that on your
own. We add value by having the resources and the time to be active managers
and to capitalize on these dislocations and inefficiencies. I would say let
professionals manage your gold portfolio for optimal risk-adjusted returns.
TGR: Brian and Ralph, thanks for your time
and insights.
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.
Brian Hicks joined
U.S. Global Investors Inc. in 2004 as a co-manager of the company's Global
Resources Fund (PSPFX). He is responsible for portfolio allocation, stock
selection and research coverage for the energy and basic materials sectors.
Prior to joining U.S. Global Investors, Hicks was an associate oil and gas
analyst for A.G. Edwards Inc. He also worked previously as an institutional
equity/options trader and liaison to the foreign equity desk at Charles
Schwab & Co., and at Invesco Funds Group, Inc. as an industry research
and product development analyst. Hicks holds a
Master of Science degree in finance and a bachelor's degree in business
administration from the University of Colorado.
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DISCLOSURE:
1) Brian Sylvester of The Gold Report conducted this interview. He
personally and/or his family own shares of the following companies mentioned
in this interview: None.
2) The following companies mentioned in the interview are sponsors of The
Gold Report: Goldcorp Inc., Franco-Nevada Corp., Royal Gold Inc. and
Tahoe Resources Inc. Streetwise Reports does not
accept stock in exchange for services. Interviews are edited for clarity.
3) Ralph Aldis: I personally and/or my family own
shares of the following companies mentioned in this interview: None. I
personally and/or my family am paid by the following
companies mentioned in this interview: None. I was not paid by Streetwise
Reports for participating in this interview.
4) Brian Hicks: I personally and/or my family own shares of the following companies
mentioned in this interview: None. I personally and/or my family am paid by the following companies mentioned in this
interview: None. I was not paid by Streetwise Reports for participating in
this interview.
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