In 2004, Analyst John Lee founded Mau Capital Management, a hedge fund based in Vancouver that invests mostly in junior mining companies. In this exclusive interview with The Gold Report, Lee deflates the deflation argument, discusses why he favors near-term gold and silver producers over early stage explorers and reveals some of his fund's top holdings.
The Gold Report: Everyone is concerned with the volatility in the markets. What's going on out there?
John Lee: Well, there's the proverbial "sell in May and walk away" going on, even though commodity prices have stayed fairly buoyant. In the junior market, there's a lot of paper that came out and began trading from the financing conducted in November and December. I think we're experiencing a little bit of a weak season where equity markets are vulnerable.
TGR: I was reading some of your presentations and one thing that you talk about is paper currencies being at the mercy of government and you consider gold a hedge against paper. On July 1st, one of the more popular gold futures contracts lost $40, its biggest drop since February. Investors seem to be gravitating toward T-bills because they fear deflation. Should we fear gold's prospects in a deflationary economic environment or should we expect gold ultimately to continue its record bull run?
JL: Well, you touched on a number of issues there. July 1 was Canada Day and Canadian markets were closed and you had the futures markets trading. There is actually some evidence to suggest that the markets, on a given Friday or the day before a holiday, will see a heavy correction—a one-day correction. However, gold is trading at $1,211 right now (July 2). It's only $50 from its all-time high. And so, the market is really healthy.
In terms of the discussion of inflation and deflation, I am firmly in the inflationary camp. In the history of fiat currency, there has never been a scenario where deflation has occurred. You have to adhere to the real definition of deflation, which is a decrease in money supply. The money supply is, in the history of fiat currencies, always on the way up, not on the way down. There may be brief periods when the increase in money supply slows, but rest assured that the money supply is still increasing. With deflation we're talking about an actual decrease in the money supply.
I think it's almost nonsense to become concerned about deflation. Going back to the Great Depression of the 1930s, the reason we had a deflationary scare was because gold was tied to the dollar. But this time it is not tied to the dollar. So in a true deflationary scenario, gold's purchasing power will go down because the paper currencies' purchasing power is going up. But this is not what we have today.
TGR: Right, but people like T-Bills because if you buy a $100 T-bill and you cash it out a year later or even three months later, it is still going to be worth at least the original $100. They're safe. Should people be buying T-bills, gold bullion or shares in gold companies as a hedge against what's happening right now in financial markets?
JL: You should have bonds and equities and in cash. Then you can break it down further: the equities into international equities and domestic equities; the cash, into precious metals and currencies. Also, you should really allocate a basket of commodities, and get some real estate as well. Depending on your risk tolerance, you may structure your portfolio differently. There is a place obviously for T-bills in the cash category. I think in terms of gold and precious metals, it's money, so it belongs to the same category as T-bills. And it's not necessarily a good idea to put all your T-bills in U.S. dollars.
I think in a reasonable portfolio you should have about 30% cash, which is a prudent way to go. I would say 10% in foreign currencies, 10% in U.S. dollars, and 10% in precious metals. It depends on which country you live in, because I think a number of currencies trend together.
TGR: Is there anything that you put faith in when it comes to monitoring global economic conditions? Charts? LIBOR rates?
JL: Usually commodity prices are a good indicator or forecast of what is to come, and so are equity markets, particularly the emerging equity markets such as Brazil, Shanghai and Hong Kong. What they're telling me is it's a pretty mixed picture, but I would say growth in commodity prices such as copper and oil, and growth in emerging equity markets are good signs. You talked about the bond prices; usually, if bonds and equities both go down together, that is a signal of something severe that could be coming into place. But right now the bond markets are still staying fairly stable, even though the equity markets have corrected somewhat from earlier this year.
It looks to me now like there is some profit-taking, given that all the major indices, including the Canadian TSX and S&P and the Asian markets, have racked up over a 50% gain since their low in March 2009.
Another gauge is the Baltic Shipping Index. It tells you the global shipping activities from everywhere else are pretty much gravitating toward Asia and China. Since the financial crisis (in 2008) it has recouped a lot of its losses; however, it's gone down the other way quite severely; 30%–40% in the last 30 days.
I think it's a mixed picture. Nobody really knows what's going on. Even within Asia there are mixed pictures between, say, Korea, Taiwan, Thailand and China. Only in China are things going on all cylinders.
TGR: Really? I think Hong Kong's Hang Seng Index is down about 20% so far this year.
JL: Yes, and the Shanghai is down more than that.
TGR: So if China is going on all cylinders, shouldn't those markets be performing better?
JL: In the short run, there is obviously a disconnect between the equity markets and the economy. Although a lot of times the equity markets are forecasting what's going to happen, you can't read so much into the markets as they go up 10% and down 10% on a monthly basis. Keep in mind, China is very centralized; it's not a free economy. The government has $2.2–$2.5 trillion in their coffers so they can easily weather any sort of a storm and dictate the pace of progress. For example, they're spending around $1 trillion building high-speed railways; in three years time they're going to have more high-speed rails than the rest of the world combined. Any short-term corrections are not going to dissuade them from their plans. And they're building buildings, a lot of them. Their low occupancy rate is not going to stop them from trying to deploy as much of their $2 trillion as they can before the dollars go bad.
It's the first time since the 1960s that the dividend yields are lower than the interest rates. So, basically you have this giant casino going on; you have money coming in, going out; and you have the Greek situation and the Spanish situation. Every time the U.S. market rebounds, they're crediting that to Chinese growth, and every time you have an equity correction it's going back to China again. China has already surpassed the United States in both automobile purchases and auto production. Their rate of auto consumption is growing somewhere around 50% annually.
TGR: What did you think of today's job numbers out of the U.S.? 83,000 jobs added.
JL: Some people will tell you they're suspicious of the numbers and the way the numbers are calculated. If you look at the foreclosure rate, it's in the range of 15%–25%, depending on the region of the country. I think that's probably a better indicator of the employment rate than the government's stated numbers. Even though the official unemployment rate is 9.5%, the real numbers could be twice as much, depending on how you define that.
The U.S. economy is no longer the world's largest consumer of commodities; they're no longer the world's largest auto purchaser; they constitute 6% of the world's population. At the same time, they're not even the main influence on the U.S. equity market, given that S&P 500 companies derive somewhere around 50% of their revenues and profits from outside the U.S.
TGR: But you're still a big believer in junior mining companies, correct?
JL: Yes, I am. That's my specialty.
TGR: Can you talk about some of your favorite names among the junior miners?
JL: Yes, but first I would like to talk about the junior market scene. For example, on the TSX Venture Exchange, about 70%–80% of the companies listed are mining related in one way or another. It went from c$600–C$700 in 2001 to a high of C$3,300 in 2008, so that's about a 500% increase. In December 2008, it was down to C$700, and now it's back to about C$1,400. It's still less than half of what the peak was, and I think there's a lot of people who say, "You know what? If gold prices are $50 down from an all-time high, and copper is not that far from its all-time peak either—copper went from $0.70 in 2001 to $4 in early 2008, and now is trading around $2.80—then surely the juniors will have to follow, if not exceed its previous high of C$3,300." It would make sense because commodity prices have resumed their bull run.
TGR: What do you look for in a junior?
JL: I would not be so much focusing on value because a lot of management has lost a lot of their traditional means of financing. It used to be that you could just walk down a Vancouver street and get broker financing at a 20% discount (to market price). It doesn't work that way anymore; the model has broken down. So, you have a lot of companies that are sitting on very good assets, but the management doesn't have the energy to go to unconventional financing sources such as the Chinese, the Middle East or the Europeans.
Therefore, I tend to focus on companies with a higher market cap and—I can't believe what's coming out of my mouth right now—the companies that are trading at a slight premium. Those companies are on the path of becoming a producer. What I am trying to say is that the gap between a producer and an explorer is widening, and I don't see that trend changing anytime soon.
More than ever you've got to be really selective on the junior market. There is not a lot of stupid money around chasing promotional stories, and when there is, instead of driving it much higher, it's barely a blip on the radar screen. I would say that with the junior market today you've got really to be cautious and look for stories that will be in production in the near term. Or gold exploration companies that have legitimate ounces in the ground.
I am not so much into drill plays because these near-term producers are still selling at extreme discounts. You don't really have to go down that far in the food chain to gain leverage.
TGR: But what do you define as a good asset?
JL: A good asset is one that has a reasonable time line and road map into production. I would not be so much into a gold deposit way out there in, say Nunavut, that has tens of millions of ounces or tens of billions of pounds. I am more into where you have a modest size, say 1–2 million ounces, in a good jurisdiction, and also you have to look for management that has a history—proven history—of an ability to raise money. Ideally, the company is aligned with one of the big backers, whether it's Lukas Lundin or Ross Beaty or Hunter Dickinson; you really have to identify a company with a good management group that can raise money. And with a deposit that doesn't require billions of dollars for infrastructure because, like I said, money is very hard to come by now.
TGR: Could you give us some of the names that you like within those parameters?
JL: Sure. Like I said, I tend to be focusing on market caps of $50 million or more. In fact, more like a $100 million market cap or more, but that has crashed back down to less than $50 million. I would stay away from micro caps because of their inability to raise money because of their lack of liquidity. In the gold space, among my favorite holdings is Minera Andes Inc. (TSX:MAI, OTC:MNEAF). That's a company chaired by Rob McEwen; it has a great history, proven management, a good cash position and it's a gold-silver producer in Argentina, even though there is somewhat of a dispute with Hochschild Mining (LSE:HOC), the joint venture partner.
I like Klondex Mines Ltd. (TSX:KDX, OTCQX:KLNDF). It's a gold story out of Nevada, and again, I am a shareholder on all of these issues. I have some smaller companies like Apogee Minerals Ltd. (TSX.V:APE)—it's a silver explorer in Bolivia, but because it is in Bolivia it has been extremely heavily discounted.
TGR: What's the issue with Bolivia?
JL: For investors that follow Bolivia they will know that Evo Morales came on the scene about four or five years ago now, and it's a lot of the same talk as Hugo Chavez (president of Venezuela) in wanting to nationalize a lot of the mining industry. However, there's walking the walk and talking the talk. Morales has been talking about possibly nationalizing foreign mining companies, but it hasn't happened. A lot of the conversations are taken out of context by the Western press and because of his words, a lot of Bolivian explorers are being somewhat unjustifiably punished in terms of lower valuations than similar mining companies.
TGR: But does Apogee have a good project there?
JL: Yes, their Pulacayo Deposit silver project, which I visited. I am a shareholder of Apogee and it's a good project. It's one of the few advanced silver projects, and, in fact, I would say this is probably the only silver junior that I will hold. But then because of its geographical political risk, I would just place a small holding there. You would not mortgage your house and put all that money into a lottery ticket; you would not do the same with Apogee. However, at these prices, trading around $0.07, with over 100 million silver-equivalent ounces, which includes some very high-grade pockets, it's a very low-risk stock, very low risk for silver. And they're backed by Stan Bharti, who is well-known in Toronto. This is one company I would consider buying besides the couple of other companies I talked about earlier.
TGR: One of the companies you mentioned earlier was Minera Andes. A company that's similar to Minera is Minefinders Corporation (TSX:MFL;;NYSE:[[MFN]].) Its Dolores gold-silver project in Mexico is in production. The company has a solid market cap, its mine is in a safe jurisdiction. Would that company fit your parameters for investment?
JL: Yes, it's a good gold and silver deposit, modest in size, and it does have a fairly hefty market cap, around half a billion dollars, as I recall. Its production is still in its infancy. It's a good jurisdiction, in my view. I would like to see more stabilized production and some cash flow coming out of production, because so far it is still sort of cash flow neutral. When you're in the early stage of production, there tends to be a lot of times where things might go wrong, so it's not an optimal choice for me.
TGR: It's ramping up, so that could easily change.
JL: I would wait a quarter or two to see what the situation is. I think, again, Minefinders has good management; it's a good story; it's been around for a long time. It has proven its ability to raise money; so, I think it's a story that one should follow.
TGR: Earlier you talked about China and how it is running on all cylinders. What about some junior mining companies operating there? Maybe a junior like Jinshan Gold Mines Inc. (TSX:JIN)? It's in a safe jurisdiction, it's producing gold too. It would seem to fit your guidelines.
JL: Jinshan used to be run by Canadian companies, but now it's run almost like a quasi-state enterprise because the management has been taken over by the Chinese. I think one good thing about being run by China National Gold Group, which is one of the largest gold producers in China, is that they will always save face and not let companies go down, because these are icons of how the international investors perceive the prowess of the Chinese companies. So, you're not going to lose your pants on Jinshan as a producer in China. At the same time, investors should take note of the possible transparency issue with Chinese management running a Canadian company.
TGR: What are your top five holdings?
JL: My top five holdings right now? I like the idea of evenly spreading your bets through different commodity sectors. I tend to have the top-down approach. Currently, I favor gold and silver. But even then, that's only about 50% of my portfolio.
My top holding is Prophecy Resource Corp. (TSX.V:PCY), because recently I was appointed chairman. Besides Prophecy, my second largest holding is silver. As I said earlier, I like gold and silver, even though gold equities are trading at a bit of a discount to metal prices, but we're entering into a traditionally slow period, the summer.
TGR: And the others?
JL: The second is Minera Andes; then we have a lot of other bets across the other commodities. I like Candente Copper Corp. (TSX:DNT) for copper; I like some natural gas producers. I think natural gas is a good contrarian play. So in natural gas, I like Anderson Energy Ltd. (TSX:AXL); I also have some uranium issues, and some platinum producers—it's just all over the map. I have some zinc companies. One thing that comes to mind that I like quite a bit at current prices ($0.18) is Donner Metals Ltd. (TSX.V:DON). Donner has a joint venture with Xstrata PLC (LSE:XTA), so Xstrata is footing all the exploration bills at the Matagami copper-zinc-silver project and looking to advance Donner into production within the next 12–18 months.
John Lee, CFA, founded Mau Capital Management in 2004. John has been investing in equities for over 10 years and is a keen student of market history and psychology. Since 2001, Mr. Lee has researched hundreds of mining companies and personally met with dozens of management teams. John has degrees in economics and engineering from Rice University. He previously studied under James Turk, a renowned authority on the gold market.
John is a speaker at all major resource conferences, including the Cambridge House resource conference series among others. John has gained invaluable insights by living in three continents and making frequent globe-spanning site visits.
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