Source: Brian Sylvester of The Gold Report (12/18/13)
The best time to buy gold is when the market hates it, especially when it comes to junior explorers with market caps under $1 billion, asserts Ralph Aldis, senior mining analyst with U.S. Global Investors. In this interview with The Gold Report, Aldis shares his main modeling themes and companies that fit the bill. He also explains the win-win-win advantages of flow-through stock issuance, a technique allowed by some noteworthy Canadian provinces.
The Gold Report: At the New Orleans investment conference, U.S. Global Investors CEO Frank Holmes reminded investors that gold is not a means to get rich quick, but should act as a diversifier in a portfolio, a form of insurance. Do you have to remind investors of that?
Ralph Aldis: We do. We always stress that no more than 10% of a portfolio should be exposed to precious metals. Given gold's poor performance in the last two or more years, the trend has been to chase the market and the S&P 500. This is exactly when investors should be using gold plays to diversify and provide a bit of insurance. If they made good money in the market, they could take 5% or 10% off the table and deploy it in gold plays.
Right now, gold is one of the most hated sectors in the market. That's when investors should buy it-when nobody loves it.
TGR: You and some of your colleagues at U.S. Global Investors pay a lot of attention to the economic data published by the U.S. government. Recent data suggest that the American economy is gathering strength. What's your view?
RA: I think the economy overall is gaining strength. That's what the Federal Reserve has wanted: low interest rates and for the long end of the Treasury curve to go down. The 10-year Treasury note was free money on the table even though it did reflect economic risk; it was crazy not to buy it.
"Right now, gold is one of the most hated sectors in the market. That's when investors should buy it-when nobody loves it."
The same thing is true of the S&P 500 these days. The Fed wants inflation, and that starts with inflation of asset prices. Again, it's almost like getting free money.
If we look at Shadow Stats' indexes-which calculate inflation the way the Fed and the government used to-inflation is running close to 8% or 9%.
I would also point out the friction in the economy regarding wages. Wages will likely be the next step on the road to inflation. Worldwide, corporate balance sheets are flush with cash. Organized labor is gaining traction on the idea of a living wage. Not every industry will see wage growth all at once, but we will see a series of wage increases across the board.
Another interesting factoid: A recent report from the Harvard Joint Commission on Housing showed rents are up significantly because of the number of houses that have been bought by investors. In some cases, more than 50% of peoples' income is going toward rent. With rents rising and incomes remaining static, wage inflation will become a real driver.
TGR: Over the last five years, gold has outperformed the bond index, but not the S&P 500 Index. Will that pattern hold over the next five years?
RA: No. In the current economic picture, there is a potential for gold to outperform the S&P 500. If we look at a chart of the last 10 years, it's only in the last 18 months that the S&P 500 started to outperform gold.
TGR: We've seen some dramatic volatility in the gold price over the last few weeks. Should investors expect more volatility in the resource sector as the U.S. moves to exit quantitative easing in 2014?
RA: To the contrary, I think the volatility will subside somewhat. We've been in a period of uncertainty about when the Fed is going to act. There have been lots of big trades taking place at unusual hours of the night, when a billion dollars worth of gold futures hit the market and knock it down. I think the people who are bearish on gold have been hitting the markets at unusual hours when there's actually no liquidity out there.
"Individual investors are often overweight in a single name, thereby increasing company risk."
Players on both sides have been trying to knock the price down. When that happens, China or India comes in and buys to keep the price up. There certainly seems to be a floor under gold right now.
Once we've had sufficient tapering to get people to start reassessing the future, there will be more price direction. Volatility tends to go down during a trending market.
TGR: Janet Yellen is in line to become the next Federal Reserve chair. Will she be better or worse for gold than Ben Bernanke?
RA: From what I've read, Yellen tends to believe that markets are very inefficient and that the Fed needs to have a hand in it. To some people, that means more stimulus is coming.
In my opinion, the more the Fed gets involved, the greater the chances for policy mistakes. That is probably a positive for gold. When the Fed decides to intercede it just causes more dislocations and puts the markets out of whack.
With the Fed wanting interest rates to remain low, Treasury bills are riskless right now, but that has to correct itself. The market has gone up strongly because the Fed wants asset price inflation to create a wealth effect. However, if corporate profit margins don't expand as rapidly because of wage growth, that could be a surprise.
RA: It won't change anything to any major degree. We try to stick with the main themes of our models: growth in resources per share, growth in production per share, growth in the cash flow.
Regarding the volatility of cash flow, we're looking at whether the market will pay a higher multiple for a cash flow that's less volatile. This can be a case of contrarian thinking; some people would advise buying the company that's the most out of the money because it will have the biggest move. That may work in the short term, but it's not sustainable.
We look at management's track record in managing the volatility of cash flow and the margins. Companies with more stable margins tend to outperform for longer; you can sleep at night with those types of stocks in your portfolio.
Another factor we look at is the relative performance of each stock to its peers to see what the market is saying about the stock. We also look at the stock price of each company and judge it against its resource statement. When we look at the resource statement, we monetize it into equivalence, treating all companies the same. We look at the company's actual market capitalization against our proprietary resource statement valuation. That is one way to really understand where there are financing needs. Obviously, if a company needs external money, we have to immediately dilute its current share price down to account for the monetization of the assets.
We're looking for what is catalyst driven. That's where we're trying to get our knowledge about processes and events to actually have that additional value for our stock picking.
TGR: That leads me to think that U.S. Global would buy on the dips in the volatility. And if volatility decreases, you would adjust your strategy. Is that the case?
RA: Well, 18 to 24 months ago, when the markets seemed to be losing momentum, we started thinking about which names we did not want to be in. We weeded out a lot that didn't have the right people, the right project or that would be exceptionally challenged in some way. Now, we have a portfolio of names that we want to own.
"Investors need to remember that in the 1970s, when adjusted for inflation, gold stocks did much better than the overall market. "
We always take advantage of volatility and do a little trading on the margin, but we want a core portfolio of names that we believe will not give us any big surprises.
But sometimes surprises happen. Pretium Resources Inc. (PVG:TSX; PVG:NYSE) is an example. The stock was knocked down hard because of a difference of opinion over the initial quality of its bulk sample. We took advantage of that and increased our exposure in the stock. The gold output from a bulk sample program topped its target by about 47%, producing 5,865 oz gold from 10,302 dry tonnes of ore from the Valley of the Kings deposit.
TGR: How would a hypothetical $10,000 investment in the World Precious Metals Fund have performed versus the New York Stock Exchange's Arca Gold Miners Index over the last 10 years?
RA: On a total price change percentage basis, from November 2003 through November 2013, we would be down 11.91% and our benchmark would be down 21.05%.
We started at the bottom and ran up as high as 175% in 2007-2008. Then both the fund and our benchmark fell. We accelerated again in 2011, outpacing the benchmark, and are now back to just below where we started 10 years ago.
TGR: According to the most recent data, 80% of the World Precious Metals Fund is mining equities with market caps under $1 billion ($1B). Why do you lean so heavily on that space?
RA: Looking at what the companies do over time, you get the best price returns-the tenbaggers-among the micro caps in the less than $100-500 million ($100-500M) range.
It's much easier to grow a production profile or resource statement substantially at that lower peer level. That also is where there are more takeovers by majors.
George Topping, who was at Stifel Nicolaus & Co. and is now in the private sector, did a study for us that looked at how much money Newmont Mining Corp. and Barrick Gold Corp. (ABX:TSX; ABX:NYSE) spent over the last 10 years and what had happened with their production. Both had spent more than their market capitalization to try to grow their production. Newmont's production is down a third; Barrick's down 15% or so.
You won't get the growth in the large-cap space. What you do get is volatility, in the sense that when the gold price moves, money tends to go in and out of the most liquid names the fastest.
TGR: How do you manage the lack of liquidity in the sub-$1B space?
RA: We try to spread our investments out. There are 2,000-odd mining companies listed in Canada. We spread investments across the 100 that are good projects run by good people.
As we do more research and get more comfortable with one company, we may raise its percentage or back off another that's not working out. We don't do a lot of rocket trading, blowing in and out of positions. That kind of trading affects the liquidity cost. When we find something isn't working, the weighting is small enough that we can work our way out of it over time. When we find something that's really good, we'll start to raise our weighting as we increase our certainty as to what's developing with that company.
TGR: You mentioned that the sub-$1B space is where the tenbaggers are. How do you balance that get-rich-quick potential with advising investors to take a long view?
RA: Diversification. In a portfolio of 100 companies, I can't diversify away the gold risk, but I can diversify away some of the company risk by holding a variety of names. Individual investors are often overweight in a single name, thereby increasing company risk. If the risk profiles are structured correctly, the portfolio volatility should be less volatile than our benchmark.
TGR: Klondex Mines Ltd. (KDX:TSX; KLNDF:OTCBB) is a top 10 holding in the World Precious Metals Fund. It recently worked out a financing arrangement with royalty and streaming company Franco-Nevada Corp. (FNV:TSX; FNV:NYSE). Klondex sold 38,250 ounces (38,250 oz) of gold to Franco over five years for $35M. After that time, Franco will have a 2.5% royalty on Klondex's production. That amounts to $915/oz. What did you make of that deal?
RA: This was structured largely as a forward sale on the gold with a slight discount. That calculation that you just did-dividing the ounces by the money coming in by the ounces going out-is something many people in the industry don't do, but should.
Klondex had been toll mining. This deal gives the company the Midas mine and mill. Other players in the area will want to send concentrate to Klondex's mill. This is a transformational step that will give Klondex a lot of credibility in the market.
I visited Klondex in September. Paul Huet and the management team know what they're doing. The management team is buying stock, even in the market. It believes in what it is doing.
Klondex is doing almost its entire market capitalization with this deal. The stock is still trading above the deal price. I think this really sets it up to have a stronger production profile and better margins.
TGR: What will Klondex do with the money?
RA: For starters, Klondex will buy the Midas mine and mill. Roughly $83M is earmarked for Midas: $55M is being turned over to Newmont to buy the property and Klondex is putting up $28M for the reclamation bond.
In terms of liquidity, Klondex's November 2012 warrants, 8.49 million, are exercisable at $1.75. When those expire next year, it will bring in $14.8M. The company has 13-15 Koz already on the surface at the Klondex mine waiting to be processed. At current gold prices, that's $17.5M. The company also will be able to borrow against the $28M bond. That gives Klondex, say, $22M at 3-5% interest. The company has almost enough cash liquidity or financial resources to pay off that debt, which I assume it wants to do soon.
Klondex has a clear path to retiring its debt and issuing $30M of new equity. That would not be very dilutive and would be positive for the price.
TGR: Can you update our readers on some of the companies you discussed in July?
RA: Rye Patch Gold Corp. (RPM:TSX.V; RPMGF:OTCQX) has about $9M from a $10M cash transfer it got from Coeur d'Alene Mines Corp. (CDM:TSX; CDE:NYSE). The company also will have royalty streaming payments on its Rochester mine in 2014. Rye Patch is in a fine position to continue its work plan. Bill Howald is a good steward of the capital.
Pilot Gold Inc. (PLG:TSX) had good results in Turkey and at Kinsley Mountain in Nevada, where one hole returned 8.53 grams/ton (8.53 g/t) over 36 meters (36m). With Pilot's overall portfolio, the company has a lot of flexibility to actually add some value.
TGR: Investors were initially excited about what Pilot was doing in Turkey. Does Kinsley Mountain shift the focus?
RA: It probably augments the story. Turkey can be slow on the permitting side and Pilot has had some very good results there. If a company has two good projects, it can just chip away at both of them if it has the cash. I am pretty pleased with Pilot.
Almaden Minerals Ltd. (AMM:TSX; AAU:NYSE) has 101m of 1.92 g/t gold and 113 g/t silver-basically 4.2 g/t gold equivalent on its property in Mexico. Almaden CEO Morgan Poliquin is lamenting that Almaden has good results but no one seems to care much about gold, but he keeps chipping away and drilling it out. Almaden will probably release a preliminary economic assessment (PEA) in 2014.
TGR: Do you have other junior precious metal stories to share with our readers today?
RA: Virginia Mines Inc. (VGQ:TSX) has a great management team. André Gaumond found the Éléonore mine, sold it to Goldcorp Inc. (G:TSX; GG:NYSE) and maintained a royalty on it. He even managed to negotiate preproduction royalties before the project is in production.
One of our people visited recently and learned from Goldcorp that there may be another parallel ore shoot running right next to the deposit that is already outlined. That could double the size of the resource.
TGR: Would Virginia's royalty apply to that new find?
RA: Based on André's excitement about it, I would say yes.
TGR: Virginia already has close to $40M in cash.
RA: Yes. The share price is over $10 and André could do a flow-through financing at $20.
TGR: Could you explain what you mean by flow-through for our readers?
RA: Certain Canadian provinces let companies raise money for exploration by issuing shares at a premium to their share price. For the initial buyers of the shares, who don't hold onto the shares, it's an opportunity to lower their taxes.
Here's how it works using Virginia, whose benchmark share price is $10, as an example. The company issues flow-through shares at $20. Investors who buy at $20 don't intend to hold on to the shares. Rather, they sell them that same day, at $9. This crystallizes a loss for the initial buyers, which helps them manage their tax situation. This benefits Virginia because it can issue shares at a premium and get less dilution.
It's a win-win-win. The company gets money. The initial investors get tax relief. The company working in that province gets money to explore for new mines. It's a great way for the province to encourage development of its resource base.
TGR: What are you thinking about as we close out 2013 and head into 2014?
RA: I think pessimism has reached a maximum, particularly in the gold space. Historically, when pessimistic consensus is this strong and gold stocks are hated this much, these are turning points.
The opportunity is here; don't get discouraged. I think we are going to see inflation, driven by wages, housing, rents-things that the Fed can't substitute away in its calculations.
I see profit in the pipeline. The S&P 500 will probably do okay, but investors need to remember that in the 1970s, when adjusted for inflation, gold stocks did much better than the overall market.
TGR: Ralph, thank you for your time and insights.
Ralph Aldis, CFA, rejoined U.S. Global Investors as senior mining analyst in November 2001. He is responsible for analyzing gold and precious metals stocks for the World Precious Minerals Fund (UNWPX) and the Gold and Precious Metals Fund (USERX). Aldis also works with the portfolio management team of the Global Resources Fund (MUTF:PSPFX) to provide tactical analyses of base metal, paper, chemical, steel and non-ferrous industries. Previously, Aldis worked for Eisner Securities, where he was an investment analyst for its high net worth group and oversaw its mutual fund operations. Before joining Eisner Securities, Aldis worked for 10 years as director of research for U.S. Global Investors, where he applied quantitative skills toward stocks, portfolio tilting, cash optimization and performance attribution analysis. Aldis received a master's degree in energy and mineral resources from the University of Texas at Austin in 1988 and a Bachelor of Science in geology, cum laude, in 1981, from Stephen F. Austin University. Aldis is a member of the CFA Society of San Antonio.
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1) Brian Sylvester conducted this interview for The Gold Report and provides services to The Gold Report as an independent contractor. He or his family own shares of the following companies mentioned in this interview: None.
2) The following companies mentioned in the interview are sponsors of The Gold Report: Pretium Resources Inc., Klondex Mines Ltd., Rye Patch Gold Corp., Pilot Gold Inc., Almaden Minerals Ltd. and Virginia Mines Inc. Franco-Nevada Corp. and Goldcorp Inc. are not affiliated with The Gold Report.Streetwise Reports does not accept stock in exchange for its services or as sponsorship payment.
3) Ralph Aldis: I or my family own shares of the following companies mentioned in this interview: None. I personally am or my family is paid by the following companies mentioned in this interview: None. The following companies are held in U.S. Global Investors' Gold and Precious Metals Fund and/or World Precious Metals Fund and/or Global Resources Fund: Almaden Minerals Ltd., Barrick Gold Corp, Franco-Nevada Corp, Goldcorp Inc, Klondex Mines Ltd., Newmont Mining Corp, Pilot Gold Inc, Pretium Resources Inc, Rye Patch Gold Corp, Virginia Mines Inc. I was not paid by Streetwise Reports for participating in this interview. Comments and opinions expressed are my own comments and opinions. I had the opportunity to review the interview for accuracy as of the date of the interview and am responsible for the content of the interview.
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