Tom Winmill on Gold: Recent Performance Due Mostly to 'Fear Factor'

by: The Manual of Ideas

In a special edition of Downside Protection Report (.pdf), released on March 10, 2009, we feature the following exclusive interview with Tom Winmill, portfolio manager of Midas Fund (MIDSX), a gold mutual fund.

The unprecedented size of the government’s intervention in the economy and the significant expansion of the Fed’s balance sheet raise the specter of runaway inflation once the current wave of deleveraging has run its course. Nonetheless, gold still fetches only about $1,000 an ounce. What are investors missing?

Our view at Midas is that inflation from expansion of the Fed’s balance sheet is less likely since the new money created barely recoups the market losses of capital in the banking and other financial industries. In any event, as current low interest rates suggest, there is little inflationary demand for credit as the economy contracts.

Your browser may not support display of this image.Inflation from fiscal expansion through the stimulus packages probably will take some time. The Federal government’s fiscal intervention has to trickle through the economy and has to offset the spending cuts of state and local governments, business, and the consumer to result in inflation. At Midas we see widespread deleveraging by state and local governments, business, and the consumer pitted against massive Federal government re-leveraging. Deflation is likely the near term result, with potentially massive inflation in the long term – but not from the current government intervention – from another source altogether.

Overall, among the four major factors we at Midas attribute to gold’s typical price movements, we believe gold’s most recent performance is due more to what we call the “fear factor” (when investors flee the market to seek what is perceived as a safe haven in gold), rather than economic factors. And that poses risks for short term investors because the fear factor is the fastest to leave the market once stability returns, which can result in dramatic falls in the gold price.

What is your outlook for the price of gold for the remainder of 2009?

Fluctuation between its marginal cost of probably mid-$700 per ounce and $1,000, with a possible rise over $1,000 should geo-political events give rise to more fear factors. At Midas, we believe an average price in 2009 somewhere in the low $900s per ounce is likely. Midas Fund often seeks to benefit from price fluctuations by overweighting the gold mining sector at lower prices and emphasizing other natural resources areas when gold appears to be approaching the high end of our price expectations.

Is gold the best choice for investors looking to protect themselves against inflation? What about silver or platinum?

At Midas, we believe gold provides the best protection against inflation among those three metals. Silver and platinum are primarily industrial metals. For example, up to 80% of platinum production is normally consumed by catalytic converter manufacturers for diesel and gasoline powered vehicles. Should the global economy continue to contract, industrial metals prices normally would not keep up with inflation, but rather drop to a level of the costs of lower marginal cost producers, while higher marginal cost producers go out of business. The Midas emphasis on quality means, in part, seeking low cost operations that can produce acceptable levels of cash returns even during low price environments.

Other than inflation, what factors will drive gold prices longer term?

At Midas, we generally consider four main factors: the monetary policies of the United States and other large economy countries; U.S. fiscal policies; fundamental supply and demand; and, as discussed previously, the geo-political fear factor. Geo-political and similar headlines often impel investors to seek safe havens to preserve wealth. For thousands of years, gold (for whatever reason, and whether rational or not) has offered a “store of value” and we currently do not foresee a time when investors will discard this role for the “barbaric relic.” Investing from fear, however, is typically not profitable. To maximize returns from this factor we would suggest that investors invest in gold when the sun is shining (and the price is low), and all’s right with the world. Then sit back, relax, and enjoy the flight to safety that inevitably occurs from time to time, and then sell at that point judged to be closest to the time of maximum pessimism (when prices are presumably higher). This suggestion, we admit, is much easier to make than follow.

When assessing the gold price in terms of the monetary policies of the United States and other large economy countries, at Midas we look at the relative interest rate policies of their central banks versus local rates of inflation to determine likely trends in real interest rates. In short, if relative U.S. real interest rates are low and trending lower, we believe it is reasonable to expect an increasingly favorable opportunity for gold investing for U.S. investors.

Loose U.S. fiscal policies, such as those we are experiencing now, can lead to U.S. inflation, a weaker dollar, higher U.S. tax rates, and many other unwelcome financial conditions that may lead many investors to bid up the price of gold. Earlier we referred to “another source altogether” of massive future inflation. At Midas, we think the unimaginably huge entitlement program obligations of the U.S. government that have been accumulated over the past decades, totaling roughly $54 trillion, will start coming home to roost in four to six years – when the cash payout to baby boomers for Social Security, Medicare, and Medicaid is more than what is collected in current taxes — and may lead to inflation expectations that will dwarf the current outlook.

Help us understand the supply/demand equation for gold. Who are the major suppliers, and how much gold remains to be mined? On the demand side, how important is gold's use in jewelry versus as a safe haven investment? Are there any material industrial or other sources of demand for gold?

Gold supply comes from mine production, forward sales, official sales (from central banks), and scrap gold. South African mines used to produce more than half of the world’s gold, but supply has become more diverse. China is now the world’s largest gold miner. South Africa produces a declining but significant amount of gold, as do the United States, Australia, Canada, and Russia. Many Latin American and Asian countries are joining the ranks of important gold producers as well.

How much gold remains to be mined? It depends on the price offered in the market. In other words, if gold sold for $100 per ounce, very little gold could be mined economically. If miners could get $10,000 per ounce, many, many areas of the earth’s crust on land and undersea could probably be found to profitably yield gold, including the “waste rock” from today’s gold mining operations.

On the demand side, jewelry fabricators are the largest normal consumer of gold, representing typically 2/3 of the demand total. Industrial demand is usually around 10% of all demand. In today’s world, however, jewelry demand has fallen to about half of the total, as high prices and the recession have pushed many price elastic jewelry buyers from the counter, and the safe haven investment buyers have moved to the forefront, taking possession of gold in bars, coins, and ETF shares. Investment demand for gold has risen from the 20-25% level to almost half of world total, according to the World Gold Council.

How does one go about analyzing one gold company versus another? What metrics do you look for when weighing which companies to invest in?

At Midas we look at the “3 P’s” – people, projects, and pricing. Regarding people, we like to meet with management and carefully examine their track record for obtaining above average returns for shareholders. In management, we seek quality, consistency, and a track record of success in bringing mines into production on time and within budget, meeting high IRR goals. Projects we like are large and high grade, involving simple metallurgy, with potential to add ounces and mine life through exploration, in a country with secure land rights and a fair tax regime – that’s the dream, anyway. Usually, we have to compromise on one or more of these preferences. We often seek the differing or confirmatory judgment of competitors, geologists, engineers, and others to assess the merits of projects. In analyzing the pricing of the shares, we most heavily weight discounted cash flows, since at the end of a mine’s life no business remains. We will weight P/Es and P/Cash flows, etc. for miners with long lived mines and large mineral resources—rare events.

In managing the Midas Fund, you presumably weigh the alternative of owning bullion versus investing in gold mining companies? How do you decide your allocation to bullion versus gold producers?

An old timer in the mining investment business once told me “You know, there’s probably a limited amount of gold that mining companies produce at this price, but there is an unlimited amount of shares they can produce at this price.” When the market for gold investments is subdued, quality mining company shares seem to outperform bullion in many cases. When the gold market gets euphoric, however, newly minted gold mining shares flood the market. That’s a time to re-emphasize bullion if the factors outlined above suggest a favorable outlook for the metal.

Are gold ETFs efficient investment vehicles? How do you convince someone to invest in Midas Fund versus an ETF or similar vehicle?

All the Midas Funds (Midas Fund, Midas Perpetual Portfolio, and Midas Special Fund) have certain efficiency advantages over a gold ETF, such as GLD. First, long term gains on gold ETFs shares, such as GLD, are taxed at the 28% rate for most investors. Long term capital gains, if any, on the Midas Funds are eligible for the 15% rate for most investors. Second, there is no commission on purchases of Midas Funds shares when purchasing directly from a Fund, and after 30 days no redemption fees or commission on sales. Third, unlike most ETFs, the Midas Funds offer dollar cost averaging and other attractive shareholder services.

As to “convincing” someone, we ask that investors interested in this sector carefully read the prospectus for both Midas Fund, which emphasizes gold mining and other natural resource companies, and Midas Perpetual Portfolio. Midas Perpetual Portfolio invests a fixed target percentage of its total assets in each of the following investment categories: gold; silver; Swiss franc assets; hard asset securities; large capitalization growth stocks; and dollar assets. The Fund’s gold and silver investments include bullion, bullion type coins, and exchange traded funds that invest therein.

In closing, our compliance department would like me to state the following: Past performance does not guarantee future results. Investment return will fluctuate, so shares when redeemed may be worth more or less than their cost. Dollar cost averaging does not assure a profit or protect against loss in a declining market and investors should consider their ability to make purchases when prices are low. One of Midas’ guiding principles is that we will communicate with our shareholders as candidly as possible because we believe shareholders benefit from understanding our investment philosophy and approach. Our views and opinions regarding the prospects of our portfolio holdings, Funds and the economy are “forward looking statements” which may or may not be accurate and may be materially different over future periods. We disclaim any obligation to update or alter any forward looking statements, whether as a result of new information, future events, or otherwise. Thus, you should not place undue reliance on forward looking statements, which also speak only as of the date of such statements. Current performance may be lower or higher than the performance quoted herein. Midas Funds are offered by a prospectus which contains more complete information, including charges, risks and expenses. Please read it carefully before you invest or send money. Investor Service Center, Inc., Distributor and FINRA member.

Disclosures: None.