Robert Cohen, lead portfolio manager with Dynamic Funds, has been kicking up dust at conferences and in board rooms with his "revolutionary and simple" idea that gold mining companies should hold gold on their balance sheets and use gold-based loans. But the idea is gaining traction and he suggests in this Gold Report interview from the Prospectors and Developers Association of Canada conference that management teams and investors alike would do well to question their use of U.S. dollars as a functional currency.
The Gold Report: Robert, you presented a paper at the Prospectors andDevelopers Association of Canada conference that focused on, among other things, the uses of gold as a monetary asset. Please tell our readers about that.
Robert Cohen: Gold is quintessentially a monetary asset. Many people believe it is the most ideal monetary asset on the planet, given that the world's other monetary assets are fiat currencies that can be expanded at the whim of a government.
Every ounce of gold ever produced is still kicking around on the surface, a total of about 160,000 tons. Half of that may be in the banking system. Miners produce about 2,500 tons a year. So only a very tiny expansion of liquid gold accrues every year, especially compared to the global liquidity created by printing money.
Imagine that we could remove currency from the world. We would have to think about hard assets such as real estate, oil, primary and precious metals relative to how one has performed with respect to another. If you do that, you see that since 1971 the average gold-to-oil ratio has been about 16.5 barrels of oil per ounce of gold. If you had been paying the gas station attendant in gold every time you filled up, you would have paid the same amount in gold for the last 40 years without noticing any price inflation.
You can extend it further, to real estate if you filter out the real estate bubbles. Thirty years ago, the average home in America was valued at about 200 ounces (200 oz) of gold. Today, the average home is still about 200 oz of gold.
TGR: So for investors to understand the value of gold, they have to understand gold's historic ability to buy goods and services at a relatively consistent rate.
RC: Right. You need to look at price changes from a macro perspective. From a monetary point of view, the prices of oil, gold, copper or your house have increased for the same reason. Most price levels are driven by the global monetary base, its debasement and the expansion of global liquidity.
One reality check is to look at the cross ratios of gold to other hard assets and that of one hard asset to another.
TGR: In other words, the gold price is fluctuating because of what is going on with the fiat currencies?
RC: Yes, and today's currency war is creating confusion in the market. When the yen falls, the U.S. dollar goes up. But you have to ask yourself if the yen has been engineered by the Japanese government to be devalued or is there fundamental strength in the U.S. dollar?
People think very linearly: If the U.S. dollar is up, gold is supposed to be down. Not necessarily. Think of gold as a sovereign country with a currency called gold. If the yen-dollar ratio drops, so should the yen-gold ratio, but the dollar-gold ratio should remain constant.
I think the right way to think about gold is to ask how many yen it takes to buy an ounce of gold. Gold is most commonly quoted in U.S. dollars, but if you are outside the U.S., it is better to think about the gold price in your local currency. That is an absolute measure of your country's purchasing power against the world's most stable monetary asset.
TGR: And your belief that gold is the most stable monetary asset is why you think gold companies should keep gold as an asset on their balance sheets.
RC: Yes, because investors are trying to escape the ravages of fiat currencies. Gold in the ground is not a liquid asset, but as soon as the gold companies turn it into a liquid asset, they immediately dispose of it and trade it for U.S. dollars.
TGR: Devalued U.S. dollars.
RC: Yes, devalued U.S. dollars or any fiat currency. Gold would be the best functional currency for the industry.
Let's extend this further. Companies can get gold loans instead of paper money loans. With a paper loan, the financier will require the company to hedge some of its gold forward to ensure that the loan is repaid. If the company banked it in gold, it would be producing the exact same asset it will use to repay the loan. There would be no need to hedge.
As you know, the main costs in the gold industry are labor, fuel, energy, steel and chemicals. If there is monetary debasement, labor will be sticky on the upside, but the costs of steel, chemicals and power all move up proportionally with gold. This makes gold a perfect hedge against rising costs.
However, if a company is forced to hedge its revenue line, it no longer has any protection against fluctuation on its cost lines. The best thing gold companies can do is remain unhedged and hold their retained earnings in gold. This allows them to keep their purchasing power for their next project. Banking earnings in dollars erodes their purchasing power.
TGR: How have public companies reacted to your idea?
RC: Reactions vary, and they are not related to the company's market cap. Some big companies think it is a great idea - others do not get it. Same among the mid caps. It is sometimes easier to talk about it with smaller companies and their management teams.
TGR: How have the shareholders reacted?
RC: It is too early. They may not even be aware of the change.
Miners, for the most part, are taught in mining school to dig up the rock - gold, coal, whatever - to sell it on the market and to take what is left over as profit margin.
But if you look at the situation as an economist, you realize that gold mining produces the only monetary asset outside of the paper money world that is acceptable to central banks. Central banks have been trying to get their hands on more gold because the U.S. dollar has become too prominent as a global banking currency. With nearly $17 trillion ($17T) of U.S. debt, and another $13T of debt in Europe, there is a lot of fear about central banks using the euro and the U.S. dollar because there are very few other choices of paper money for foreign exchange reserves. This makes gold a great diversification agent.
TGR: Why would miners - the people who have first access to the gold - not want to keep it?
RC: That is why I wrote the paper, to get boards and management teams thinking about questions such as: Should we use U.S. dollars, a different currency or gold as our main functional currency?
In a gold-centric world, companies would not experience capital cost increases on their projects because they would have cost the project out in gold ounces.
It is easy to calculate payback in ounces. Say you spend 250,000 ounces (250 Koz) to build a project that produces 125 Koz annually. You will need half of that to pay all your consumables and labor, leaving you with 125 Koz in retained earnings. You will owe taxes on that amount, of course.
This approach offers stability in terms of payback and in terms of capital costs not inflating because everything is expressed in ounces. That way the market can adjust the share price based on what is going on with the currency.
TGR: It also might offer shareholders some comfort to buy shares in a producing mining company that is hoarding gold as a store of value.
RC: For sure. If you look at 10 years of balance sheets for the big gold companies, you can find the ballast in the balance sheet, the point that the cash level never dips below. Had that ballast level been in gold instead of cash or a low-yielding corporate bond, the company would have retained a phenomenal amount of shareholder value.
I think the gold industry should be perceived more like an exchange-traded fund where a company has a hoard of gold and a little machine that converts gold in the ground into aboveground stock. The value of that aboveground stock is indisputable. It is the gold price in your local currency multiplied by the number of ounces, with some adjustment for capital gains tax.
I would run my whole life in gold if I could. I would accept my salary in a gold-denominated bank account and pull cash from an ATM to fill immediate needs and pay bills.
TGR: Had the big mining companies been doing this for 10 years, how would the whole mining landscape look different?
RC: The landscape you live in would look different. We are seeing a real downdraft in the prices of the gold equities. Looking at profit margins, I think the absolute fall in the gold price and by extension in the oil price was triggered by the devaluation of the Japanese yen. Using round numbers, when gold was $1,700/oz, a typical gold mine was earning a 50% profit margin; $850/oz pre-tax. When the gold price goes down $100/oz, that $850/oz margin also goes down by $100 to $750/oz. The big-cap equities have been hammered by that amount. It is even worse for the small caps, who have to take off that $100/oz and who will never be able to get access to equity or debt. They go down a perceived dilutionary spiral.
TGR: We have definitely seen that.
RC: But assume that 25% of your cost, some $200/oz, was for fuel. The oil price moves day to day, so you pick up $20 or so an ounce in savings from the fall in the oil price. Savings on chemical and steel prices could add more savings. Ultimately, the change in margin is not $100/oz, but more akin to $60 or $80/oz, assuming all the costs are the same. If we take a midrange fall of $75 on what was an $850/oz profit margin, it is less than a 10% change in profit margin.
At the end of the day there is margin respiration, but not to the degree the fear mongers are proclaiming. We have seen herd mentalities before, but this is extreme. We are seeing a complete evacuation of the room.
TGR: That is apparent in the plunging volumes in the TSX Venture and the TSX - across most equities in the mining space.
RC: Everyone is squeezed out through a mouse hole into the other room called the S&P Index and the bond market.
The jack-in-the-box effect of compressing valuations down to all-time lows brings me right back to where I started. As we are speaking, I am putting my finger on my pulse, asking: How is gold? What is gold doing with respect to other hard assets? What is moving in its currencies? Doing this should keep rational investors comfortable that they are not losing purchasing power in real estate or hard assets.
Here is another scenario. Ten years ago, twin brothers started out with $100,000 each to invest. Ted was fearful of the paper money world, and Tom was comfortable with it. Each told his financial adviser he did not want to lose any money in his portfolio.
Tom's financial adviser put all of Tom's money in a bank savings account. At the end of 10 years, Tom could accurately claim that he had not lost any money.
Ted's adviser put all of Ted's money into physical gold and held it for 10 years. Ted still held the same number of ounces, but with the 80% pickup in gold, expressed in U.S. dollars, Ted's investment had more value. In effect, the brother who held cash can buy fewer goods and services with his money than the brother who held gold.
TGR: You mentioned a jack-in-the-box effect that happens when people start to realize that gold miners have value, either in cash or in gold they may be holding. What is its effect on the market?
RC: Gold equities have been through a tailspin. This has not been happening in other sectors. The oil price has come down harder than the gold price, yet recently some oil stocks hit 52-week highs.
Every time gold equities have crashed, it has been part of something else, like the 1997 selloff. The 1990s were characterized by a very strong U.S. dollar, so a low gold price was not unusual. But for the last 13 years, paper money has been constantly devalued, making gold the safer currency for storing wealth.
TGR: Given that, would you be more bullish on selected mining equities?
RC: Yes, with the caveat that the stock market also has to work more akin to the way it has worked in the past.
What would happen if you were the only bidder in an auction room filled with Rembrandts, Picassos and Monets? Even without other bidders, you only have so much money in your pocket. One person cannot make a market. The market as a whole needs to start coming back. Typically, when something is oversold and the profit margins are still there, private equity steps in. Later on, the stock market moves back in.
I cannot predict the speed of the recovery. Is it V-shaped? Is this a short-term financial anomaly or will it take time to change investors' mindset?
TGR: We have seen groups with mining assets from Europe to Brazil to Australia choosing not to go public with projects because the market will not give them the value that the asset is worth. Instead, they are keeping certain projects private until the public markets come back.
RC: This goes back to the point I raised suggesting that companies try to get a gold loan in the meantime. In a gold-centric lending and paying environment the returns appear to be totally intact. It is the paper-money environment that interferes with people's thinking patterns.
TGR: As a fund manager in the mining space, how would you encourage investors to get back into the market? How would you entice more people into the auction room, to use one of your images? There is a lot of good art on the walls.
RC: You need a diversified portfolio. If everything in your portfolio is firing on all cylinders at the same time, maybe the portfolio is not diversified. You need to be invested in an asset class, like gold and gold equities, that starts performing when other parts of the portfolio are going wrong. That is a true diversified portfolio.
At the very least, people should start allocating to gold stocks right now with the view of buying through the trough.
TGR: Should those purchases be among the producers that have cash flow or have the potential to hold gold as a store of value? As a portfolio manager, do you invest in explorers?
RC: I do invest in explorers because the alpha generated by this industry is where you get your real pick up. You can buy gold and maintain the purchasing power of your wealth. You can buy gold stocks, seek alpha and get a real wealth pick up.
When you are seeking alpha, you need to look at development companies that might not yet be financed. The economics of discovery lend itself to a two-to-four-year payback, which typically is a 25-50% internal rate of return.
Producers are safer because they have financing and cash flow. As a fund manager, I like to stratify across the gold sector. I want my favorites among the senior and mid-cap producers. I want my favorite development companies.
TGR: What about the mid-cap producers?
RC: Yamana Gold Inc. (NYSE:AUY). Osisko Mining Corp. (OSKFF.PK), which had some startup hiccups but has resolved the mechanical problems at its Canadian Malartic mine.
TGR: What about the developers?
RC: Perseus Mining Ltd. (OTCPK:PMNXF) is sort of in-between. Its Edikan mine in Ghana had some crushing issues.
If I had to choose between a mining company with a reserve problem and one with a mechanical problem, I would raise my hand up as an engineer and say mechanical problems can be solved. That is what Osisko and Perseus have done.
Other interesting discoveries that I think have economic deposits include Torex Gold Resources Inc. (OTCPK:TORXF) out of Mexico and Belo Sun Mining Corp. (OTCPK:VNNHF) in Brazil. Roxgold Inc. (OTC:ROGFF) is a smaller company with a project in Burkina Faso and an Australian company called Papillon Resources Inc. (OTC:PAPQF) has a project in Mali.
Of course, all of those countries have a degree of political risk, but they are the best risk/reward opportunities. All have some critical mass in terms of market cap, a bit of safety on the downside, and all should be financeable. Even Roxgold, the smallest, is financeable because it is a very small, 2,500 ton/day operation, at a very low capital cost.
TGR: Do you want to give us any parting words?
RC: If you stay in a dollar-centric world build a stomach of steel. If you can get into the mental mindset of living in a gold-centric world, you will be fairly comfortable.
TGR: Thanks for your insights, Robert.
This interview was conducted by Sally Lowder of The Gold Report and can be read in its entirety here.
A mineral process engineer by training, Robert Cohen has nearly 20 years combined experience in the mining industry and is lead portfolio manager for Dynamic Precious Metals Fund and Dynamic Strategic Gold Class. Named a TopGun portfolio manager by Brendan Wood International in 2009, 2010 and 2011, Cohen has been lead portfolio manager for Dynamic Precious Metals Fund since November 2000 and Dynamic Strategic Gold Class since inception, with top-performing mandates also in distribution in Europe and the United States. Cohen completed his Bachelor of Applied Sciences in mining and mineral process engineering at the University of British Columbia in 1992. In 1998 he received his Masters in Business Administration and in 2003 Cohen received his CFA designation.
1) Sally Lowder conducted this interview for The Gold Report and provides services to The Gold Reportas an employee. She or her family own shares of the following companies mentioned in this interview: None.
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