The Gold Report: July 13–20 was an unusual week in the gold
market. In a May newsletter to Trapeze Asset Management clients, you argued
that the glass is "half full" for investors given current
macroeconomic signals. Much water has traveled under the bridge since. Has
your view changed?
Randall Abramson: Our view has not really changed. We rely on
certain macroeconomic tools to show us red flags. One is our economic
composite that looks at both the U.S. economy and economies around the world.
Our economic composite tool currently forecasts smooth sailing with no red
flags.
From a stock market perspective, our relative indicator momentum, which is
our other macro tool, only shows Brazil and Russia on sell. The only other
market on our watch list recently was the Chinese market. It came down to the
bottom of its TRIM line but didn't break through. In fact, it did a perfect
bounce off of the bottom. I'm hoping that indicates that what we've seen
recently in commodity prices is overdone.
That said, we do not like recent action in the Australian and Canadian
dollars. Both currencies can portend further economic weakness because both
countries are essentially hewers of wood and drawers of water–economies based
on the extraction of natural resources—and we are cognizant that the
commodity-hungry Chinese economy is clearly slowing, though it is still
performing at a significantly higher rate than those in the rest of the
world. Perhaps that's causing some of the weakness in "Commodityland."
But according to the signals, the glass still seems half full.
TGR: How do you explain the recent 4% drop and five-year low of the
gold price to Trapeze clients?
RA: That drop happened in a flash—a veritable flash crash, almost
6%—then gold rebounded to be down only half that amount on July 20. The
timing and size of the multibillion-dollar order responsible for that drop
made it look as if it was designed to spook the market. I'm not sure whether
it was forced or orchestrated selling.
TGR: What's your best guess?
RA: It looks orchestrated given the timing, but I'm more focused on
the second part of your question—the five-year low. What happens on a
day-to-day basis is difficult to put into perspective. It's easier to put
into perspective where we've come from and where we are today. We came from a
place where a number of commodities were overbought in 2011 because they had
bounced significantly from their respective lows in 2009. Gold and silver, in
2011, were selling above their marginal cost of production and way above the
average cost of production—gold normally sells for its marginal cost of
production, which is usually about a 30–40% premium to the average all-in
production costs.
Today, the gold price has fallen back to the average cost of production.
That's unusual. That means that on average there is essentially no free cash
flow being generated by producing gold. We've overshot to the downside. Could
we have a further overshoot? It's possible. If gold broke much below where we
are today, it could go to $900 per ounce ($900/oz) or slightly below. I don't
believe that's going to happen because it would be virtually unprecedented,
especially when we're not living through a major dislocation like a global
recession, for example.
TGR: Do you expect further weakness in the Chinese economy to bring
further weakness to Commodityland?
RA: If there is significant further weakness, the answer is yes.
There is still significant physical gold demand in China, both from the
central banks and the public. If there was further economic weakness there,
perhaps gold demand would further increase.
TGR: Do you see gold's drop as a U.S. dollar story given that the
gold price has fallen 40% in U.S. dollar terms from its 2011 peak versus, for
example, a 20% drop in Australian dollar terms over the same period?
RA: It's a combination of factors. The first factor is that
inflation is low. We still have inflation, but each year over the last few
years, the inflation rate has declined. So we have disinflation but not
outright deflation. Maybe the commodity prices are telling us that we're
about to have deflation, but that's something the central banks would fight
tooth and nail, so I don't think it's a likely outcome. But that doesn't mean
that it couldn't occur, at least for a short period.
The gold price coming down is a function of low inflation, which affects
demand at the margin because there's less hoarding. The other factor is that
the gold price went too high too soon in 2011. Financial markets always tend
to overshoot and undershoot around the mean. Gold will eventually go back up
to about $1,400/oz again because that's where it needs to be to meet yearly
demand.
TGR: How long do you expect that to take?
RA: I think it's going to happen over the next 6 to 12 months; I
just don't know whether it's heading lower first. I suspect not. At the
margin, exchange-traded funds have been dumping gold because hoarding has
been shunned with the price declining. That's not necessarily a bad thing.
That could be a sign of a capitulation. Gold has not really behaved all that
differently than oil, which was also above its marginal cost of production,
reverted to it and then went down through it. The difference is there was an
oversupply of oil in the U.S., which is now being alleviated. The U.S. dollar
has clearly been a factor in the low gold price too, but I don't think it's
the driving factor.
TGR: You said gold could hit $1,400/oz in the next 6 to 12 months.
Do you see it higher than that in the medium term?
RA: If history is any guide, the gold price is typically 30–40%
above gold's all-in sustaining costs of production. And if the all-in
sustaining costs today are somewhere around $950–1,050/oz industry-wide, then
$1,400/oz gold is where we should be. In the months to come, that's the magnet
that's going to pull the gold price higher. After that, it should rise by the
inflation finding costs, which over the last 15 years or so have grown by
about 7–8% a year. The main reason for that has been higher energy costs. And
there have been few major discoveries, so that alone drives up the cost per
ounce.
TGR: The flash gold sale and some gold reserve numbers out of China
seemed to spook the market, but was it part seasonal, too?
RA: Possibly, yes. But August is almost always the best month for
gold. I'm hoping that we get a nice big bounce into next month.
TGR: The last time gold was this low relative to the S&P 500,
it signaled that it was time to buy gold. Do you see the recent gold selloff
as another buy signal or do you see further downside risk?
RA: Unless there's something that's going on that we don't know
about like outright deflation, this is the time to be buying gold.
TGR: Reuters says about $3.2 billion ($3.2B) in mining mergers and
acquisitions (M&A) has occurred this year versus roughly $4.4B in all of
2014. Will the drop in gold push the pause button on M&A?
RA: Probably, because normally boards of directors tend to react
when things are going well. That's when business combinations take place.
M&A often marks the top, not the bottom, of a cycle in virtually every
industry unless a company swallows up somebody in a distress situation.
TGR: Isn't that what is happening in the gold space? Oban Mining
Corp. (OBM:TSX) is buying several juniors and Crocodile Gold Corp. (CRK:TSX;
CROCF:OTCQX) is merging with Newmarket Gold Inc. (NGN:TSX.V) to go after
distressed gold assets.
RA: Those are examples of one plus one equals more than two. In the
gold sector a 300,000–500,000 ounce (300–500 Koz) producer receives a much
higher multiple relative to net asset value (NAV) than a sub-100 Koz
producer. It truly is one plus one equals more than two.
TGR: What is the best strategy for gold equity investors at this
point?
RA: The best bet is always to have low-cost producers with solid
balance sheets because both of those items will give you staying power.
TGR: Some large-cap gold names in Commodityland, like Barrick Gold
Corp. (ABX:TSX; ABX:NYSE), are trading at multiyear lows. Should investors believe
in higher near-term gold prices to take a position in a major gold producer
or is there value there even with gold trading around all-in sustaining
costs?
RA: Our favorite large-cap name is Goldcorp Inc.
(G:TSX; GG:NYSE) because it's a lower-cost producer with a reasonable
balance sheet and decent production growth, which is unusual among the large
producers. It's now trading at a valuation that is probably less than $0.50
on the dollar vis-à-vis its NAV using even $1,300/oz gold.
The whole group looks cheap; you could almost throw a dart among the
large-cap producers because on the low recently, we got to 70% of book value.
To put that in perspective, the lowest we had seen in many years was the 2008
low where the large-cap producers as a group stopped at book value. There has
to be cheap names in the junior space, too, because the TSX Venture Exchange,
our Canadian proxy for small-cap resource companies, just made an all-time
low—lower than when it started in 2001.
TGR: What are your thoughts on the ramping up of the Éléonore gold
mine in Québec?
RA: Goldcorp has incurred start-up issues since the launch of the
mine in the spring so it's a slower start than expected, but this particular
mine should still hit the low end of the expected production range for the
full year. And, regardless, the company is now guiding to the high end of its
overall previous production guidance.
TGR: Do you know what its all-in sustaining costs are at this stage?
RA: They are around sub-$900/oz, so it still a decent margin.
TGR: What are some smaller names that Trapeze continues to own?
RA: Our biggest holding by far in the space and my biggest personal
holding is St
Andrew Goldfields Ltd. (SAS:TSX), which at the moment is, unbelievably,
trading at 1x enterprise value:earnings before interest, tax, depreciation
and amortization (EV:EBITDA), assuming next year's EBITDA at today's Canadian
dollar gold price. Typically, when we see a mining stock trading that low,
someone automatically says that it must be a highly leveraged company or it
has virtually no mine life. The answer to both is a resounding no. St Andrew
has no debt and over $26 million in cash, which represents $0.07 a share on a
$0.25 share price. And its cash should be climbing materially with the free
cash flow it churns out each month. The mine life at the current run rate of
production is about eight years and growing. It just added 25% to its
reserves at the end of last year. Its NAV is in excess of $0.60 per share.
TGR: What are its all-in sustaining costs?
RA: They're around US$900/oz, and are being helped by a weak
Canadian dollar. St Andrew receives revenue in U.S. dollars, but its costs
are in Canadian dollars.
TGR: Why is the market punishing St Andrew?
RA: It's a matter of it being under the radar. The company has had
virtually no analyst coverage. In fact, an analyst just published the first
report on the company in some time. There used to be four or five analysts
who covered it, but most of those firms have vanished. Also, there's been
little float in the company; it hasn't required any financing over the last
number of years. But there is one major catalyst ahead: the Taylor mine is
coming on line in the next two months and it should take production from just
shy of 100 Koz to 130+ Koz. The low Canadian dollar also helps materially. So
we're seeing excellent production growth and low costs, and St Andrew has
cash on hand—it's been cash flow positive for around 15 consecutive quarters.
TGR: There has been some consolidation in the Timmins Camp since
our last interview.
Could St Andrew become a target?
RA: Anybody can become a target. As we discussed before, in this
industry, one plus one equals more than two, especially when a company is
producing more than 300 Koz annually. Plus St Andrew owns 120 kilometers of
land along the Porcupine-Destor Fault, making it the largest landholder in
the Timmins mining camp. There are at least three companies in that camp that
could combine with St Andrew to produce over 300 Koz per year, not to mention
the synergies of combining with a nearby competitor.
TGR: What are some other small names you follow?
RA: Dynacor
Gold Mines Inc. (DNG:TSX) is another one that we continue to own. It's
predominantly a miller rather than a miner in Peru, though it does have the
Tumipampa gold project there that it continues to develop, which could add
tremendous value. In the meantime, the company is trading, ex-cash on hand,
at about 5x its current earnings power. I use earnings power because this
month the company is expanding the production capacity at its mill. Dyancor's
earnings power should go up even further from its new plant, which will have
double the capacity of the existing one and ultimately be much lower cost.
Its earnings power could be about $0.40 a share this time next year or
higher. And it is still developing Tumipampa, which could have at least 1
million ounces and potentially more.
TGR: Is Dynacor considered a reputable brand among the gold millers
in Peru?
RA: Dynacor is certainly trusted in the community.
TGR: With the growing number of contract miners in Peru, is the
competition for milling ore a threat to the Dynacor business model?
RA: I don't think that many more mills have entered the space. That
is the perception because there are two or three companies that are now
listed, but I think more capacity has left the space than entered it. It's
just not as visible because the capacity that's vanished was from players
who'd been there for a number of years but who are now noncompliant with new
regulations set by the Peruvian government. In fact, that's why Dynacor's
performance has improved so much in the last 12 months; it has been sopping
up the ounces that were previously going to other mills.
TGR: We are in the dog days of gold's summer of discontent. What
would you say to the remaining investors in the space?
RA: Unless we're into something different this time—which could be
an outright deflation because I can't think of anything else that would cause
everything in Commodityland, not just gold, to suddenly start trading below
their respective average costs of production—then we should be seeing the
lows right here. It does not appear that we are in a global recession. Au
contraire, there are signs of a global acceleration after the mid-cycle
slowdown we've been living through.
August is typically a good month for gold and the U.S. dollar appears set
to peak given that it's overvalued, stretched, and the U.S. government and
U.S. Federal Reserve probably would prefer a weaker U.S. dollar. The average
global all-in sustaining costs to produce gold are always growing and
normally support the low in the price of a commodity. We are at or slightly
below that mark. If the global economy even slightly picks up here, perhaps
that leads to a little more inflation and allows the supply and demand
equation to rule the day.
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.
