Ralph Aldis: How the Five Principles of Capital Allocation Can Mean Gold Mining Success

The Gold Report: The price of gold is flirting with a five-year low. Do you attribute this solely to the strength of the U.S. dollar, or are there other factors at work?

Ralph Aldis: There are other factors. Most important is the strength of the equity markets. Looking at a six-year window, we have seen, for the third time in the last hundred years, the highest returns for such a period. This happened before in 1929 and 1999. These phenomenal returns have been fueled not by fundamentals but rather by the U.S. Federal Reserve, which is trying to jumpstart the economy.

All this has taken people's eyes off gold, but it won't go on forever.

TGR: The bear market in gold equities is now four years old. This means lower gold production and less exploration. Gold production from South Africa has collapsed. Shouldn't lower gold production result in a higher gold price?

RA: Yes, but it's not always linear. The amount of gold mined annually is relatively small compared to total gold supply. That is one of the reasons some people argue that the mines don't matter that much. But I think on the margin they do.

South African gold production has fallen. And not that long ago, the central banks were selling 400–500 tons per year of gold to the market. Now, they're buying 400–500 tons. China is the world's largest gold producer, but it's not exporting. We can see what's happening and be invested for it, but we don't know when lower supply will lead to higher prices.

TGR: How do you see the mining industry adjusting to lower gold prices?

RA: I look at the income statements from all the mining companies and calculate their break-even point. Right now, it is about $1,149 per ounce ($1,149/oz). The forecasted average 2015 gold price remains about $1,200/oz. If the gold price continues to fall, companies will adjust. Some projects won't be built, but that is good because those are marginal projects.

About 40 CEOs in the mining industry have lost their jobs in the past couple of years. The new generation of mining CEOs is focused more on profit than growth. They know that even if the gold price falls more, the suppliers to them must drop their prices. If the gold price goes $100/oz lower, the smart companies will survive. Meanwhile, gold miners now benefit from lower energy prices, while the stronger U.S. dollar has been very positive for Canadian and Australian miners.

TGR: Why do you believe gold stocks can still deliver favorable returns?

RA: Because of the mindset of some of these new CEOs. One company doing the right things is Klondex Mines Ltd. (KDX:TSX; KLNDF:OTCBB). It was up 29% in 2013, while the Market Vectors Junior Gold Miners ETF (GDXJ:NYSE.Arca) was down 61%. In 2014, Klondex was up 21%, while the Market Vectors Junior Gold Miners ETF was down 23%.

Investors will need to buy very selectively, and they will need to buy those companies that are not growing ounces at thinner margins. Companies that know how to, if necessary, shrink production in order to get acceptable margins.

TGR: Could you explain the "Five Principles of Capital Allocation" and how they pertain to mining, given that mining companies typically have no revenues for years after their founding?

RA: These five principles are the work of a Credit Suisse writer, Michael Mauboussin. They apply to some companies in the exploration and development phase but obviously more so to producers.

The first principle is "Zero-Based Capital Allocation." This means, for instance, that you don't give your exploration department $20 million ($20M) this year solely because they got $20M last year. Companies need a strategy to determine the proper amount of capital spending.

The second principle is "Fund Strategies, Not Projects." In other words, capital allocation is not about assessing and approving projects; it is about assessing and approving strategies and then determining the projects that support those strategies. It is a common mistake for explorers to continue to push a project forward—particularly if it is its only project—even though it lacks the potential for great returns.

Randgold Resources Ltd. (GOLD:NASDAQ; RRS:LSE) is a good example of the proper approach. When it evaluates a project, it's looking for grade sufficiently high that it can produce a good margin at a $1,000 pit shell or even an $800 pit shell. Restricting your return calculation to the pit shell is more conservative, as you are only including those ounces contained within the mine's engineering plan.

TGR: Don't companies with only one project face a particular problem? Given that the market demands constant news, if a company does an internal evaluation that suggests that its sole project is marginal and then reorganizes to seek new projects, won't the disappearance of news about the original project lead to the market concluding that the company has essentially closed up shop and then valuing it to zero?

RA: I agree. Look at Allied Nevada Gold Corp.'s (ANV:TSX; ANV:NYSE.MKT) Hycroft mine. It was premised on a higher gold price, but there were probably things Allied Nevada could have done to maximize wealth as opposed to merely moving forward. It might have closed down Hycroft sooner and perhaps salvaged some value as opposed to being forced into bankruptcy.

TGR: What is the third principle?

RA: "No Capital Rationing." Typically, miners believe that capital is scarce but free. They believe that profits are free money, or if they're raising equity, they sometimes don't seem to care enough about dilution. Properly speaking, capital is plentiful but expensive. Profits need to be spent in a manner that results in future profitability. And equity financing is only plentiful if you have a good project.

No. 4 is "Zero Tolerance for Bad Growth." In other words, don't throw good money after bad. Barrick Gold Corp. (ABX:TSX; ABX:NYSE) fell into that trap with its Pascua-Lama project in Argentina. Long before its price tag reached $8.5 billion ($8.5B), the company should have thought hard about whether it would ever generate good returns. Mining companies should always seek to upgrade their portfolios.

TGR: And what's the final principle?

RA: No. 5 is "Know the Value of Assets and Be Ready to Take Action to Create Value." So many people in the mining industry don't know the value of their assets. We value companies based on their resource statements, and we get a very high correlation to where these stocks trade. But we constantly see companies decide to spend, for example, $1.8B on a project that the market values at only $800M. It makes no sense to spend that much because similar projects could be acquired for less capital.

To sum up, the proper use of capital allocation is to maximize long-term value per share.

TGR: Besides understanding capital allocation, what else do you look for in management?

RA: A significant ownership stake. You get a much higher standard of care when you're an owner instead of a mere manager. Investors need to look at a company's general and administrative expenses, whether it is in production or not. If those expenses are too high, this tells you that the managers' interests are not aligned with the shareholders' interests.

TGR: Let's talk about specifics. Which are your favorite Canadian gold producers?

RA: Those that are focusing on profit. If they have debt, they pay it down; they maximize their returns. Kirkland Lake Gold Inc. (KGI:TSX) is one example. CEO George Ogilvie has really done a great job in turning that company around.

Another example is Claude Resources Inc. (CRJ:TSX). Its CEO is Brian Skanderbeg. Claude has been around for a long time, but its new management understood that it had to change its mining method, which has made a big difference.

Another company with new management doing the right things is Richmont Mines Inc. (RIC:NYSE.MKT; RIC:TSX). Recently, Renaud Adams joined Richmont as president and CEO, and he is highly respected on the street. In addition, Renaud is a board member of Klondex Mines where he has helped oversee its success. With the higher grades Richmont is encountering at Island Gold Deep, I believe the company has a much more robust asset to work with now.

TGR: Kirkland Lake announced March 11 year-to-date free cash flow generation of $22M. Were you impressed by that?

RA: Yes, I was. Lake Shore Gold Corp. (LSG:TSX) is another company that really seems to have figured it out. It repaid $45M in debt in 2014 and now has $60M in cash and bullion.

TGR: Can you comment on any major Canadian gold producers?

RA: Goldcorp Inc.'s (G:TSX; GG:NYSE) bid for Osisko Mining Corp. ran the risk of buying a great company at the wrong price, so I'm glad that CEO Chuck Jeannes walked away. Since it announced its takeover attempt of Osisko, Goldcorp has sold its Wharf mine in South Dakota to Coeur Mining Inc. (CDM:TSX; CDE:NYSE) and its Marigold mine in Nevada to Silver Standard Resources Inc. (SSO:TSX; SSRI:NASDAQ).

TGR: What's your opinion of Goldcorp after these deals?

RA: Goldcorp has done a really good job of capital allocation. It looks at the cash that it's generating, and it looks at how to maximize the assets on its balance sheet. It created Silver Wheaton Corp. (SLW:TSX; SLW:NYSE) and Tahoe Resources Inc. (TAHO:NYSE; THO:TSX) out of existing assets. It helped create Primero Mining Corp. (P:TSX; PPP:NYSE). So I give it kudos. It is a little bit undervalued on our models but not terribly.

TGR: Can Barrick rescue itself?

RA: The company is talking about returning to the old Barrick model, but I don't know if it can do that. It certainly faces a lot of challenges.

TGR: What's your favorite junior gold producer in the U.S.?

RA: I've already mentioned Klondex in Nevada. It is my favorite junior producer anywhere. Considering what it has achieved and what it is likely to achieve, I think it probably offers at least a double of its present share price. Some people might say it has a short-life resource statement, but the recent discoveries at Fire Creek are not yet in the resource statement. And the free cash flow it generates will pay for its exploration program at Midas. I expect more discoveries from Klondex and a bigger resource statement. Its very robust ore body will allow it to produce gold at even lower prices, should the market demand that. I talk to its management team, and they understand capital allocation.

TGR: What's your favorite gold producer elsewhere in the world?

RA: I like Mandalay Resources Corp. (MND:TSX). Its management is very experienced in rescuing assets that have been mismanaged. Mandalay has turned around the Cerro Bayo silver-gold mine in Chile and the Costerfield gold-antimony mine in Australia. Last year, it bought the Björkdal gold mine in Sweden from Elgin Mining, and I think Mandalay will turn that around too.

Management owns a lot of stock. Mandalay pays a healthy dividend: 5.4%. The market has not yet completely woken up yet to this stock. We still think it's easily a 100% gain. It's one of our top five holdings.

TGR: You mentioned earlier that you admire Randgold.

RA: CEO Mark Bristow, as ornery as he can be, deserves all the respect in the world. We download all the data, taking the quarterly net income or net operating profit after tax provisions (NOPAT), multiply that by four and divide it by the investment capital base to get a quarterly return on invested capital. We did that with the Market Vectors Gold Miners ETF stocks, and Randgold came in with a 10.32% median return on invested capital. That's for 8+ years. We also measured the volatility of these returns over time, and Randgold's was only 6.4%.

Over the same time period, Barrick had a median return on investment capital of 7.09% with a quarterly volatility of 24.4%. So Randgold gets about twice the returns with half the volatility. That's management skill for you.

TGR: What are your favorite silver producers?

RA: There are two that really stand out to us based largely on management skill and management ownership of stock. The first is Tahoe Resources. Kevin McArthur is the CEO. It recently bought Rio Alto Mining Ltd. (RIO:TSX; RIOM:NYSE; RIO:BVL), which has two run-of-mine heap-leach mines in Peru. One is in production. Alex Black will be the new CEO of the new company. He put Rio Alto in production for very little capital and achieved tremendous returns for shareholders.

The combination of McArthur and Black results in a team that really understands the value of assets and has the ability to deliver. We like high grade, but adding those heap-leach mines gives Tahoe more flexibility. That's one of the things we look for in companies.

TGR: And what's the second?

RA: Fortuna Silver Mines Inc. (FSM:NYSE; FVI:TSX; FVI:BVL; F4S:FSE). The Ganoza brothers have done a great job, especially with the San Jose mine in Mexico and the discovery Fortuna has made there. This is a management team that understands capital markets.

TGR: What are your favorite near-term production stories?

RA: The one with the biggest potential is Pretium Resources Inc.'s (PVG:TSX; PVG:NYSE) Brucejack project in British Columbia. If its resource matches its published results, this is one of the best discoveries we've seen in the last decade. Its initial bulk sampling delivered 10% more ounces than expected. It is now drilling to confirm that the ore body is pretty well mathematically modeled. We anticipate substantial value correction based on our models. Pretium probably leads the pack in that category right now.

In Northern Ireland, Dalradian Resources Inc. (DNA:TSX) and CEO Patrick Anderson have a very good, well understood, high-grade gold project at Curraghinalt. Patrick also has a successful track record in selling Aurelian Resources, which was one of the best gold discoveries in the prior decade, to Kinross Gold Corp. (K:TSX; KGC:NYSE) in 2008. It is important to us that management understands capital markets.

We also like Rye Patch Gold Corp. (RPM:TSX.V; RPMGF:OTCQX) in Nevada. CEO Bill Howald staked the unpaid mineral rights at Coeur Mining's Rochester mine. As a result, Rye Patch got about a $21M settlement in the form of a royalty on Rochester. Rye Patch's Lincoln Hill deposit is within kilometers of Rochester. Howald has about a $26M budget to bring that into production, but I expect that after he does all the technical work and gets his permitting, Coeur will take it out and thereby extend Rochester's mine life. Because Howald has funded Rye Patch with that royalty, and Lincoln Hill is such a simple, cheap operation, he doesn't need to come to the market and dilute shareholders, so Coeur taking it out should be a slam dunk. In addition, Rye Patch has two other targets quite close to Lincoln Hill.

TGR: What about a gold project in South Carolina?

RA: Romarco Minerals Inc.'s (R:TSX) Haile project is fully funded. What was interesting about that company's last financing is that I think that a major gold mining company may have participated in the placement, which speaks to the company as a potential takeout target in the near term. Haile is completely derisked, and so for a bigger producer with production drop-offs or operations in less-safe jurisdictions, Romarco makes a lot of sense.

Haile has great potential to grow over time. And management was smart not to supersize the project. This goes against the history of the 20 years, where investment bankers see a net asset value (NAV) model with cash flows extending into years 10–20. They believe these cash flows aren't worth anything, and so the project size is doubled to move the cash flows forward and maximize NAV. That's the worst thing you can do, and Romarco hasn't done it.

TGR: What's your favorite royalty company?

RA: Osisko Gold Royalties Ltd. (OR:TSX) probably has the safest royalties. It has a lot of room to grow but not so much as to draw the attention of Franco-Nevada Corp. (FNV:TSX; FNV:NYSE), Royal Gold Inc. (RGL:TSX; RGLD:NASDAQ) or Silver Wheaton. Osisko's royalties might be too small for the big players, but royalties such as the 5% on Malartic and the 2.2–3.5% on Éléonore are tremendously valuable to Osisko. These Canadian mines will continue to produce for a long time.

TGR: Do you approve of its takeover of Virginia Mines Inc.?

RA: Yes. CEO Sean Roosen is a marketing genius, and this takeover complements the Canada-centric powerhouse he has put together. The company owns a significant stake in Falco Resources Ltd. (FPC:TSX.V). It has royalties on a portfolio of projects Agnico Eagle Mines Ltd. (AEM:TSX; AEM:NYSE) and Yamana Gold Inc. (YRI:TSX; AUY:NYSE; YAU:LSE) control after their takeover of Osisko Mining.

Plus there is a whole suite of Canadian assets it would make a lot of sense for it to get involved with. Maybe it does something with Integra Gold Corp. (ICG:TSX.V; ICGQF:OTCQX). One of the advantages Osisko Gold Royalties has is that its assets are not dependent on other commodities. Franco-Nevada has oil exposure, and maybe oil prices don't go up very soon. Royal Gold has base metal exposure in some of its assets, and if prices of those were to drop tremendously, some of its assets could be shuttered. Osisko doesn't have those worries.

TGR: What's your favorite junior gold explorer?

RA: The one that really stands out to us is Orex Minerals Inc. (REX:TSX.V). It's not well known now, but everybody would know the deal that its management was last involved in, the sale of Orko Silver Corp. First Majestic Silver Corp. (FR:TSX; AG:NYSE; FMV:FSE) tried to buy Orko but was outbid by Coeur. Now management has returned with a new company with four assets.

Orex has just signed a joint venture (JV) on its Barsele project in Sweden with Agnico Eagle. It took a year to negotiate. At the time the deal was announced, Orex had a $30M market cap. Agnico gave it $10M and will spend a further $7M into exploration. As you know, Agnico already has assets in that area, and if Barsele meets the test, Agnico will probably do something serious with it.

Orex also has a JV with Fresnillo Plc (FRES:LSE) on one of its two Mexican properties. Fresnillo late last year was moving more rigs on that, so I think it liked what it saw. Orex has an asset in Canada that it will probably be able to JV. This company has great geologists, and its management knows how to make deals.

TGR: Realistically, how many gold producers are prudent investments?

RA: Of the 80 or so producers that Western investors can buy into, there are about 20 that get it and have the flexibility to be able to adjust. Not so much the seniors. It's the smaller, midsized companies that have a better handle on their operations.

TGR: Ralph, thank you for your time and your insights.