Precious Metals: A Tempered Case For Growth And Value

by: Emmet Kodesh

It helps to have a low pulse rate when you invest in PMs (precious metals). The volatility is extreme and their price action often defies logic. The strong hands of short sellers often speak more loudly than the mighty hands of heavy buyers like Asian Sovereigns. Recent comments however suggest that things may change, at least a bit, on the positive side for this embattled sector which remains vital to industry and monetary arrangements.

Eric Sprott, investment analyst and resource specialist has released an open letter to the WGC (World Gold Council) in which he examines ongoing problems with the Reuters GMFS and WGC reporting on gold production and demand. Because Russia and China keep all the gold they produce, Sprott notes that annual world output is about 25% less than the 2800 tons usually cited. Absent Russian and Chinese output all of which is absorbed in-country, 2013 world production (projected from 1H 2013 results) will be 2142 tons rather than 2800. Moreover, the charts and discussion in Sprott's letter show that global demand, led by India, China, Thailand, Turkey, Hong Kong, retail investors and other Central Banks is 5184 tons. YTD outflows from Spider Gold (NYSEARCA:GLD) and other ETFs have left only about 1900 tons of physical gold to cover this 3000 ton annual gap between demand and supply which current buying trends will widen. "This contradictory situation," Sprott reasonably observes, with "demand for gold extremely strong" while prices on COMEX "have fallen precipitously" has done and is doing great damage to the gold mining industry. Even companies with great metrics and sites (noted below) suffer in the general rout.

Sprott's plea that WGC report accurately the fundamentals of the industry for which it purports to speak will get some attention from those who follow the sector and perhaps a few words on a news ticker outside of it. More significant is the fact to which he points: in six months or so, the large and growing gap between demand for physical gold and silver and the paper markets that influence its pricing will become difficult to bridge. Barring new initiatives by strong Sovereign hands and affiliated investment banks, prices of gold and silver bullion and even more so PM miners should rise, perhaps rise greatly. Many investors in PMs are banking on the approach of this moment of truth as the vindication and payoff for a buy and hang-on strategy.

PM pricing since early April makes it unclear that fundamentals alone will govern in the sector. Let's consider price action in T-bills October 22-23 which may shed some light on whether true price discovery can emerge in markets driven by QE and massaged by ZIRP.

China's main news outlet recently demanded "de-Americanized" world finance and trade and the Japanese chimed in. The two nations are the top holders of US Treasury bonds, $1.3 trillion and $1.1 trillion respectively. 1H 2013 saw record sales of US debt. Some believe that selling by foreign governments of American debt (50% held overseas) and sales by domestic holders may cause the Fed to lose control of the bond markets. The thought is that rising yields then will wreck the housing industry, bond and then equity indices. Actually, China needs our technology, grains and even military training but let's pursue the logic of possible impact of bond market frailty.

There is logic to such thoughts. Against them is reality: while QE continues creating $85 billion new debt a month, the Fed has brought down the ten-year yield from 3% in the summer to 2.48% October 23. In the last two days alone, while some foresee doom in a falling USD now again at the level of early February, the bottom of its 52-week range, the ten-year T-bill yield has dropped 13 basis points, from 2.99% to 2.48%. There has been no clear correlation between the DXY index and markets. The lesson for those who overstress the governing force of fundamentals is that there are many tools to manage markets and finances: don't take logic-based assumptions as givens.

PM sector action since April led me in the past six weeks to urge that investors reconsider and reduce allocations of 10-20% or more. The higher one's net worth the more flexible one can be about allocation decisions (and many other matters). The chutes-and-ladders pattern in the sector has not changed. October 18 - 22 saw strong gains, the appearance of a much - awaited rebound while October 23 was yet another day of steep declines that spared no miners from 2% (Fortuna Silver (NYSE:FSM)) to 6.8% (debt-free junior, McEwen Mining (NYSE:MUX)) drops. Volatility clearly is not ready to depart. It seems that the main pattern of PM miners being the first risk-off assets on red days still is in place.

While price action suggests that investors should be careful about allocating more than 10% of their holdings to PMs, it also is my view that no one should have less than 5%. Quite simply, this is the one area of great value amid a sea of artificially inflated assets. Because there are many profitable, productive and well-run companies with multiple rich properties and because prices are artificially low, PMs also are a great growth opportunity for those who can be patient and can avoid over-playing their hands.

Takeaways: To invest in this sector and get positive results one needs to learn price action for at least two years in the companies in which one is interested, learn their fundamentals, the value of their sites and experience of their management. For example, investing in reserves leader and lowest cost producer Barrick Gold (NYSE:ABX) without knowing the history of its world-class development site at Pascua Lama, its recent sales of non-core, higher-cost assets and the recent spate of analyst upgrades that has followed its long, heard fall would be taking a leap of faith the sector tends to punish heavily. As it stands, ABX below $20 and certainly below $18 is a strong buy whose target price recently was raised by Deutsche Bank to $30.

Other PM companies to follow include First Majestic (NYSE:AG), down very hard today (-4.49% after what looked like the beginning of a sustained rise based on its outstanding 3Q and YTD progress), Endeavour Silver (NYSE:EXK), Yamana Gold (NYSE:AUY), debt-free FSM and MUX and Silver Wheaton (NYSE:SLW). At the right entry points which again are near or at hand, these are companies to own and hold: pick your handful of favorites. Also consider Freeport McMoRan (NYSE:FCX) which is a major (305k oz./year) producer of gold, the world leader in copper, molybdenum and, more recently, with a bushel of oil and natural gas properties in America. Its outstanding 3Q results (earnings up 25%, revenues up 40%) have boosted its price to $36.63. While its upside is huge, for a margin of safety one might wait for the market to fade while it digests 9 trading days of strong gains since the morning low at S&P 1646 October 9. It went ex-dividend October 10 and will pay its 4Q dividend November 1.

The bottom of the S&P 52-week up-channel from November 15, 2012 to October 9, 2013, tested but not broken December 28, 2012 and June 24 this year, is about 1675. The top of the current trend is 1750-60 which may partly account for today's pause. Whatever weight one puts in charts, investors at least should be familiar with the pattern as it is quite clear since second week of March 2009: higher lows and higher highs. It also is clear that the rise has been inflated by fiscal policies that do not help a sluggish or even deteriorating economy. For a sobering overview, read the analysis of John Hussman here.

The final takeaways then are to buy and own the best PM companies, taking some profits at a time that suits your overall financial position and the trends and developments in the sector, the economy and policy issues. Volatility in PMs suggests that one need to take some gains periodically to avoid heartbreak and grit-your-teeth territory. Lastly, the macro situation Sprott describes, plus the tech-industrial importance of silver and monetary importance of gold counsel holding some of the best companies for the long term. As much as consumer goods and services, health care, the best industrials and energy, PMs merit a significant place in nearly every portfolio.

Disclosure: I am long ABX, EXK, FSM, MUX. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I hold various PM companies individually and in a diversified fund.

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