Picking Undervalued Gold Equities Akin to Picking Strawberries: Randall Abramson

The Gold Report: A 10-year U.S. bond yields 2% currently. How is that changing the market?

Randall Abramson: We typically view the markets and our investment process through top-down and bottom-up lenses. Our top-down tools are telling us that all systems are "go," and that there are no immediate hurdles ahead. This low-growth environment has allowed the broader markets to remain in a bull phase for longer than is typical. In fact, we've not had even a market correction of 10% or so for way longer than normal.

TGR: The World Gold Council (WGC) reports that central banks bought 477.2 tons of gold in 2014, which was nearly a 50-year high. What do you make of central banks buying gold at peak Cold War-era levels?

RA: Gold does not have a built-in return. When interest rates are higher, everybody is less apt to hold gold because there's too much of an opportunity cost. When interest rates are negative, as they are in some countries today, you'd probably rather own gold than lose money on bonds.

Central banks are perhaps trying to spur inflation by buying gold, or they could be less interested at these elevated U.S. dollar prices to hold dollars in their reserves, or they could be concerned about the U.S.'s balance sheet. All of those are factors. But the key driver is that there are places like China, which is flush with cash and willing to hold more gold. China always takes a long-term approach to the way it manages things. It may even be making a run at the U.S. dollar for reserve currency status and holding more gold in its coffers will help.

TGR: The WGC report also said gold demand jumped 6% in Q4/14 to 987.5 tons but was down 4% year-over-year. Does that bolster your spirits as a gold investor?

RA: The 2014 growth rates were a bit deceiving because the 2013 numbers were out of sight, driven by huge investment demand in both India and China. And at the same time, India put curbs in place to limit gold buying, which probably slowed down demand growth for gold last year. In the overall picture gold demand has been growing nicely over time, while the supply has more or less flatlined. Now that the price of gold is around $1,200/ounce ($1,200/oz) and close to the all-in sustaining cost of production, our take is that about half of the global gold producers would not make a profit below $1,150/oz. That should support the price at that level. And given that the marginal cost of production for gold is around $1,400/oz, we believe that we will see $1,300–1,400/oz gold in the not-so-distant future.

TGR: Pick one: long gold or short gold?

RA: Long. The world's central banks are, in aggregate, accommodative, some of them highly accommodative, in terms of quantitative easing. We think that they will ultimately win the day, and this disinflationary period that we've lived through for years will transition into a reflationary period. The key indicator of that so far is that the gold price, while it's near a recent low in U.S. dollars, looks terrific on the charts in just about every other currency.

TGR: Trapeze positions itself as value investors, stock pickers. Are we in a stock picker's market for gold equities?

RA: That's a great question. You can go through periods where the overall sector is a better bet than finding a specific stock, especially from a risk-reward perspective. For instance, when the market bottomed in 2009, using a net to capture a bunch of stocks might have been better than a mere handful of particular stocks because the whole market was trading near $0.50 on the dollar. You didn't want to miss out on the market reverting to fair value.

The gold equities market is in a similar phase. You would have been better off as a stock picker over the last couple of years to avoid highly levered or high-cost producers. Those companies witnessed unprecedented declines in their stock prices. But now that we're sitting with gold stocks versus bullion at the lowest level in 75 years and the price:book value (P:BV) of the overall senior golds in the sector trading at about one times P:BV, it seems to be a period where casting a wide net may make more sense. And that's an interesting comment coming from a bottom-up value investor like me.

TGR: Everyone obviously has their own methods of picking everything from fresh fruit to baked goods. Tell us about your process for picking equities, especially precious metals equities, in this market.

RA: You pick baked goods based on what you like to eat. Some people like éclairs. Some people like cookies. But we pick our fruit differently. Most of us like strawberries but not all strawberries are the same. If a strawberry looks terrific other than a tiny blemish, that's no problem. You can cut out the blemish and enjoy the rest. But if that piece of fruit turns out to be rotten, the entire strawberry is for the birds. That's similar to how one should look at stocks on a bottom-up basis. Is the stock price below fair market value because there's a little blemish and the market is over-reacting? Or is it a sign that the stock is rotten to the core? That's what we do as value investors.

TGR: As you suggested, the large-cap gold space has been beaten up and pushed down the stairs. Where are you finding value?

RA: Our favorite in the space is Goldcorp Inc. (G:TSX; GG:NYSE) because it is one of the lowest-cost producers, has years of significant growth ahead, has a solid balance sheet, and trades at a reasonable valuation below its net asset value (NAV). We think we're getting a margin of safety, not just from the price to our appraised value but within the underlying aspects of the business, the fundamentals.

TGR: What are the near-term catalysts for Goldcorp?

RA: The reserves should lift nicely this year and projects not in the official pipeline yet could come to the fore with the potential to add millions of ounces. But the key catalyst is the price of gold itself because Goldcorp needs to make, like all others, a higher operating profit per ounce for the market to get excited. Part of that should come from a decline in the U.S. dollar; however, the U.S. dollar continues to show remarkable strength. To have this kind of move in a currency, especially in the world's reserve currency, in such a short period, is not normal.

TGR: Most of our readers follow small-cap precious metals equities. Please give us an overview of that sector.

RA: It's been beaten up as badly as the large-cap sector. The large caps are trading at about book value, and the small caps are valued similarly. About 2,000 companies are listed on the TSX Venture Exchange and about two-thirds of those are resource equities, mostly gold and oil and gas stocks. The Venture started in 2001 and the index is now below the level at which it started. It's essentially at the same level it was at the market bottom at the end of 2008. There is a treasure trove of potential investments there.

The problem is that a lot of companies need capital and the gold business is complex—there are geological issues, engineering issues, commodity price fluctuations and other moving parts. When the sector is out of favor, it's very difficult for some companies to attract capital. It's the ultimate value trap. Having said that, there are companies out there without debt, with cash on their balance sheets and that ultimately can control their own destiny.

TGR: What are some equities that Trapeze Asset Management believes are in control of their destiny?

RA: Our two favorites at the moment are St Andrew Goldfields Ltd. (SAS:TSX) and Dynacor Gold Mines Inc. (DNG:TSX). St Andrew is the largest landholder in northern Ontario's Timmins mining camp. It's in a good jurisdiction. The company has production of just shy of 100,000 oz (100 Koz), if you annualize its Q1/15 numbers. It has been in the penalty box for over a year because in 2013 St Andrew produced 100 Koz, but in 2014 it took its guidance down to 75–85 Koz, only to reach about 91 Koz gold for the year. The company has had something like 14 consecutive quarters of positive cash flow, but because there is little coverage on the company and only a few hundred thousand shares are traded each day, the company has been underfollowed and largely ignored. Meanwhile all-in sustaining costs should remain below $1,000/oz, and guidance for 2016, with the Taylor mine coming on, is 125-135 Koz—that's meaningful for an orphaned company.

TGR: How is the Canadian dollar changing the company's fortunes?

RA: The Canadian dollar has fallen heavily against the U.S. dollar and the Canadian dollar price of gold is about CA$1,440/oz. That should give a material advantage to most Canada-based producers that collect revenue in U.S. dollars but with costs in Canadian dollars.

St Andrew should do well into next year as it ramps up production at its Taylor mine, which is already delivering ounces in pre-production, but should reach commercial production later this year. At 130 Koz of production, St Andrew should generate more than CA$65 million (CA$65M) in earnings before interest, taxes, depreciation and amortization (EBITDA). St Andrew is trading at one times enterprise value/EBITDA (EV/EBITDA), net of its approximately CA$25M net cash balance, based on CA$65M of EBITDA. I wanted to see how that compared to other stocks in North America, so we screened all the stocks in North America that have enterprise values over $50M. It was No. 3 on the list out of about 1,500 companies. This year St Andrew should generate CA$15M of free cash flow, as it competes its spending on Taylor, and next year in excess of CA$30M. It's trading for about 2.5x free cash flow, net of cash on hand. Trading at around CA$0.29/share, this is an extraordinarily cheap stock.

TGR: What will be the impact of St Andrew's toll-milling business?

RA: The toll milling business is small. It is conducting toll milling for a couple of companies, which allows it to help fill the mill, but it's a minor part of its business.

TGR: At its current share price, it's almost impossible for St Andrew to be the consolidator in the Timmins Camp. Do you see it becoming a target at CA$0.28/share?

RA: It's likely there are players who would like to consolidate the camp because it is big and fragmented. St Andrew has a lot of land, though, so it could spend many years drilling off the 120 kilometers (75 miles) it has along the Porcupine Destor Fault. Like any other company out there, if the market isn't prepared to pay a fair value for a company, often someone else comes along and buys it.

TGR: Tell us about Dynacor.

RA: Dynacor, unlike St Andrew, is predominantly a toll-milling company, which hopes to have production of its own one day. It operates in Peru, though its head office is in Canada. The company has about US$15M cash, no debt and only about 36M shares outstanding—a considerable amount of cash per share considering it's trading around CA$2.10. Almost one-quarter of its market value is in cash.

The company has had solid earnings for years. Its recent quarter was somewhat masked by a few items, one of which was the 4% withholding tax on repatriation of funds from Peru; Dynacor took several quarters of earnings and brought them back to its bank in Canada in one quarter. Nevertheless, the operating profits held in beautifully, and I point that out because even though gold came off, Dynacor is still making healthy profits. The company makes a certain price per ounce as it collects high-grade ore from the various miners that don't have their own mills in the regions where it operates. The icing on the cake is that it was just approved for a new, more efficient mill.

Dynacor's management believes that once the new mill is built, it will be able to operate both mills, taking its earnings power closer to CA$0.50/share, up from just shy of CA$0.30/share from the middle of this year since it will be boosting throughput with a recently approved expansion at its existing mill. If you merely put a 10 times multiple on the fully expanded earnings power, it's much more than double the current share price.

TGR: You mentioned production. How far out is that?

RA: Dynacor is spending about CA$2M per year to explore the Tumipampa gold-silver project in Peru, and the results there have been staggering—as much as 111 grams per ton (111 g/t) on some intercepts. Even if the grade ultimately came in at 15 g/t, Dynacor should have a viable mine—its drilling to date has averaged over 20 g/t. The company will continue drilling Tumipampa over the next year or so and then will likely make an application for a permit to begin mining, perhaps in two or three years. We should be getting an NI-43-101-compliant resource estimate by the end of 2015. It should be above 1 million ounces.

TGR: Other juniors like Inca One Resources Corp. (IO:TSX.V) have entered the toll-milling business. Do they pose a threat?

RA: Peru went through a process called formalization where it forced companies to be compliant with two things: the way they milled ore and remitted taxes. A lot of companies either couldn't do it or had been in the business for so long, doing it other ways, that they refused to. That allowed Dynacor to pick up more business and others to come in and scoop up some business as well. The bigger mills have survived, while some of the smaller mills have gone. So even though there looks to be more entrants because we hear about them listing on Canadian exchanges, the reality is there are fewer market participants and some serious barriers to entry.

TGR: Do you have targets on St Andrew and Dynacor?

RA: Today's gold price and a little bit of an inflationary lift to gold over the next few years give St Andrew a NAV above CA$0.60 today—potential future value is even higher as the company increases its reserves, which jumped 25% last year. Most gold companies normally trade above their NAVs. And St Andrew is the cheapest in its universe based on EV/oz, EV/EBITDA and EV/free cash flow.

Dynacor, using a 10 multiple on, say, run rate earnings per share of at least CA$0.40, in a year or so should be about $4, plus whatever Tumipampa is worth, which could be significant—there's an amazing chart in its most recent presentation showing all of the landholders around Tumipampa; it's a who's who of majors.

TGR: What's your best guess as to when the bear market for gold bullion will end?

RA: Gold in every other major currency except the U.S. dollar is clearly out of a bear market because it's up significantly. Gold in U.S. dollar terms, while it's barely off of its bottom, has already triggered a buy signal in our proprietary Ratio of Adjusted Capital work. Since 1990 we've seen that buy signal happen 14 times with an average gain of about 25% from its trough. Only once did it decline.

TGR: Could that just be a bear market rally?

RA: It's possible, but it's unlikely because you have to liken gold to any other commodity, like pork bellies, and look at the commodity fundamentals. While the gold supply is flatlining and demand is growing, at current levels gold is far below the marginal cost of production. Gold is sitting at the average cost of production, but commodities typically sit, on average, at 40% above the average all-in cost of production. The gold price has to normalize to the upside. What's inhibiting gold isn't necessarily disinflation, it's the U.S. dollar and that could continue given that interest rate differentials still favor the U.S. over other regions. If you're a pension investor, you've been earning 2% on your U.S. Treasuries versus next to nothing, or even negative yields, on your European bonds, and worse, the euro has plummeted versus the dollar. But that could all turn on a dime.

TGR: If you start to see more evidence that your theory holds water, will you increase your weighting in gold equities?

RA: Yes. There are other names like Randgold Resources Ltd. (GOLD:NASDAQ; RRS:LSE) and Newmont Mining Corp. (NEM:NYSE) that we've been in and out of over the last couple of years.

TGR: Any parting thoughts?

RA: It's interesting that I just conducted interviews with The Gold Report and The Energy Report because as you look around the world, it's very difficult, more than any other time that I've seen, to find value. When you're in a bear market, value abounds, and when you're in a bull market, you can still typically find pockets of value. Yet it's difficult to find undervalued stocks today. But the two groups that keep coming up on our screens, from all over the world, on a bottom-up basis, are energy and gold stocks. Now, if we could just get commodity prices to cooperate.

TGR: Thank you for your insights, Randall.

Randall Abramson, CFA, is CEO and portfolio manager of Trapeze Asset Management Inc., a firm he cofounded in 1999 shortly after founding its affiliate broker dealer, Trapeze Capital Corp. Abramson was named one of Canada's "Stock Market Superstars" in Bob Thompson's Stock Market Superstars: Secrets of Canada's Top Stock Pickers (Insomniac Press, 2008). Trapeze's separately managed accounts are long/short or long only, and have either an all-cap orientation or large cap-only mandate via the company's Global Insight model. Abramson graduated with a bachelor's degree in commerce from the University of Toronto in 1989, and his career has spanned investment banking, investment analysis and portfolio management.