Miners downsizing capital expenses for smart growth
Smart companies are beginning to ignore analysts' insistence that production growth is always good, and to focus instead on growing their margins by lowering capital expenses. This is good news to U.S. Global Investors Inc.'s Brian Hicks, co-manager of the Global Resources Fund, and Ralph Aldis, senior mining analyst and portfolio manager of the Gold and Precious Metals Fund and World Precious Minerals Fund. Learn what kinds of companies attract the interest of these active managers in this Gold Report interview.
The Gold Report: The Nov. 1 edition of Frank Talk suggested that gold equities generally perform poorly in a U.S. election year but rebound strongly the following year. Do you expect a better year for gold and gold equities in 2013?
Ralph Aldis: This year has not been a stellar year for gold equities. Most of the gold equity funds have negative returns for the year.
Brian Hicks: We believe gold equities will do well next year, largely due to macroeconomic factors that have been in place for some time, but which will become even more pronounced in 2013. Those factors include central banks expanding their balance sheets and increased concern over deficit spending here in the U.S. Looking at how cheap gold equities are relative to the bullion price, that spread will continue to be arbitraged in 2013.
TGR: Every media outlet in the country is talking about the fiscal cliff. If the U.S. goes over the fiscal cliff, what effect would that have on the gold price and on gold equities?
RA: No one has the stomach to let the country fall off the cliff. A compromise will be reached. The most likely scenario is that the government will have to print money in flight. That will be a very clear signal to own gold bullion, and gold equities will be handed their marching papers to go higher.
BH: Whether we get a compromise or go over the cliff, which is the less likely event, gold will do well. Either way, there will be a lot of uncertainty and concern about financial assets. That will prompt people to see gold as a hedge.
TGR: Gold equity investors have seen more volatility than gains in recent years. Should they expect more of the same over the next four to five years?
BH: The volatility has held true for the markets in general; it has not been specific to gold equities. On a relative basis, gold equities have outperformed the broader market since 2008.
"Whether we get a compromise or go over the cliff, which is the less likely event, gold will do well." –Brian Hicks
To prepare for volatility, investors should be balanced, not overweight in any particular sector. You want to be able to capitalize on the volatility—to the upside or the downside. Gold equities are somewhat countercyclical; they can diversify a portfolio and be additive to overall risk-adjusted returns.
RA: When silver was hitting close to $50/ounce (oz), the regulators raised margin requirements something like five times in five days. That knocked silver for probably its biggest correction ever in a single week. If you live through that type of correction once, you become gun shy about going long on equities when the metal prices are going up.
More generally, the tech bubble, the credit crisis, the real estate crash and the large number of baby boomers approaching retirement are all causing people to sell equities. They are turning to fixed-income or structured interest-rate products. That provides a great buying opportunity for equities.
BH: Generalists talk about gold being in a bubble, but I agree with Warren Buffett that the real bubble is government bonds. At some point, that money will have to come out. When it does, it will be looking for returns and for yield. Gold stocks will be poised to capitalize on that.
TGR: How should gold equity investors handle common market corrections?
RA: One strategy, if you are certain that you are in a bull market, is to stay long the entire time.
I would say you stick with it.
However, in managing our funds, we always keep some cash on hand so we can buy stocks on these dips. For example, a company releases a good news story and the stock starts moving twice as much as any other stock that day. It is probably prudent to sell perhaps 1% of your position because you will be able to replace it later at a cheaper price.
TGR: Another edition of Frank Talk discussed how companies' margins are being compromised and growing thinner. What must gold companies do to boost investor confidence?
RA: The industry's mantra has been "grow production." That is what the analysts look for and what companies are trying to do, but it is difficult to grow production.
"Companies need to focus on growing their returns and not on growing the company or the production profile."
You can grow production through your own organic discovery or through acquisition. Too often, companies overpay or size up a marginal project from say, 30,000 tons (30 Kt)/day to 60 Kt/day. They have tried to grow production at the expense of lowering margins. If they lower their margins, they can no longer pay a dividend. If the gold price corrects, the project may no longer be economic.
Management needs to focus on return on capital, on making a sound investment in something that you can make money on.
For example, Randgold Resources Ltd. (GOLD:NASDAQ; RRS:LSE) models all of its projects on $1,000/oz gold. Its cutoff is a 20% return on $1,000/oz gold. That focus on delivering a return is why Randgold's share price has done so much better than everybody else's.
BH: Randgold's success also is a function of having its CEO, Mark Bristow, as such a sizable owner of its common stock.
We looked at stocks with high insider ownership versus those with low insider ownership. By a wide margin, precious metals companies with significant management ownership have outperformed companies that do not have much participation from their management teams.
TGR: What will drive up the value of gold equities over the next five years?
RA: Gold prices will go higher. Central banks around the world are hedging by buying gold in lieu of currency for their reserve holdings. Also, investor demand will push values higher.
Companies need to focus on growing their returns and not on growing the company or the production profile. Focusing on returns will allow them to pay a dividend.
TGR: Do you own any companies with a market cap over $300 million (M) that do not pay a dividend?
RA: Yes. There are companies in the growth phase, in the capital phase where they are not cash-flow positive in the sense of having sufficient free cash flow to start writing checks to shareholders.
While some companies are paying modest dividends of 1–2%, paying a dividend is more the exception than the rule. The only high-price dividend payers are companies whose share price has been knocked down, like Gold Fields Ltd. (GFI:NYSE).
TGR: Given gold companies' heavy capital expense (capex) demands, do you see the major players getting to dividends in the 4–5% range?
RA: Rather than increasing dividends, companies have been upsizing their projects to grow their production profile. The only people making money are the consultants earning fees by telling the mining companies what to do with their project and the companies building the actual mines.
Gold companies are making profits but they are not yielding exceptional returns. The majors are all trying to push upside of the project in the false belief that if they move all the cash flow forward, they will get a higher multiple.
TGR: If the companies in your funds are making less money than their consultants, why are you in this sector?
RA: Our funds are weighted differently from indexes that focus on the big four: Goldcorp Inc. (G:TSX; GG:NYSE), Barrick Gold Corp. (ABX:TSX; ABX:NYSE), Newmont Mining Corp. (NEM:NYSE) and Newcrest Mining Ltd. (NCM:ASX).
As active managers, we are trying to scope out the companies that are doing the right things to achieve the top returns we want for our shareholders.
BH: Ralph and I agree that Randgold would be the bellwether and it has been a core holding for many years. It has created shareholder value throughout the cycle. It is defensive in that it has high grades; its projects are stress tested at $1,000/oz gold. It has done very well since 2000, much better than the price of bullion. That is the type of company we look for.
RA: Agnico-Eagle Mines Ltd. (AEM:TSX; AEM:NYSE) is another company that got severely punished earlier in the year for a couple of missteps, but management knows what it is doing.
TGR: Were you disappointed to see President and COO Ebe Sherkus step down?
RA: Agnico-Eagle's culture is strong enough to survive that. The company has a deep pipeline of talent to fill the voids when they come up.
TGR: What is your investment thesis?
BH: Our view is that gold stocks have been derated since the introduction of the SPDR Gold Trust (GLD) exchange-traded fund. That derating is reflected in lower multiples to cash flow and earnings, because returns on capital have not been sufficiently higher than their cost of capital. However, lower oil prices and fuel costs, as well as the delay or outright cancellation of many capital projects, could provide some relief in the cost of labor and raw materials. From that standpoint, over the intermediate term, margins could start to expand. That would be good for gold equities.
"Historically, if you pick the right stocks, you get 2:1 leverage by owning the stock versus the commodity."–Brian Hicks
We also think money will continue to flow into the sector because we are bullish on gold. Historically, if you pick the right stocks, you get 2:1 leverage by owning the stock versus the commodity. Our job as active money managers is to sift through the large universe of companies and pick stocks that will exhibit that leverage in a rising gold market.
RA: George Topping, an analyst at Stifel Nicolaus, caught the gist of what needs to happen in his report, "Don't Build It and They Will Come." Since that report, companies like Rainy River Resources Ltd. (RR:TSX.V) have started looking at how to downsize projects. That may be the catalyst that will take some of the pressure off the margins.
The other thing that has hurt gold companies in this cycle is understating their cash costs. Only government officials really believe a cash cost of $700 to produce an ounce of gold. Governments look at those numbers and say, you guys are making windfall profits, so we need to raise your taxes. To combat that, companies need to talk about the cost to produce an ounce of gold in total cost terms.
That is beginning to happen. The World Gold Council met at the Denver Gold Show to talk about how to transition from a cash-cost definition to a total-cost definition. This would make the industry more transparent and the companies more accountable.
TGR: Can you name some companies with projects that have downsized capex to mine more efficiently and more intelligently?
We will see a trend of companies taking the foot off the pedal and thinking about what makes sense. If you can develop a project at a higher margin, that is the smarter choice.
TGR: What equities are you bullish on?
RA: You have to give the royalty companies some serious thought. They are insulated from capital cost increases, at least on the cost-structure side.
Franco-Nevada Corp. (FNV:TSX; FNV:NYSE), Silver Wheaton Corp. (SLW:TSX; SLW:NYSE) and Royal Gold Inc. (RGLD:NASDAQ; RGL:TSX) have done very well. Sandstorm Gold Ltd. (SSL:TSX.V), an up-and-comer, has created good returns.
These companies have to be careful about buying a royalty on a project that has margins that may be too thin and getting in too deep. The royalty company may not be on the hook for more capital, but it has a lot of costs if that project is not built.
BH: Several silver companies look interesting. The price of silver is high enough for some of the lower-cost silver companies to generate free cash flow and superior returns on capital compared to their precious metal peers.
Tahoe Resources Inc. (THO:TSX; TAHO:NYSE) is run by Kevin McArthur, former CEO of Goldcorp. A proven mine builder, and we particularly like that he owns 4M shares of that stock, so he has a vested interest in the company's success, which may translate into a substantial dividend yield.
TGR: Would now be a good time to look at Tahoe, after its stock prices have come off its high?
BH: Yes. Tahoe is entering a sweet spot in the lifecycle of a mine. It is far along in development and is poised to start production. If you look at the earnings power Tahoe has at current silver prices, it looks cheap to us.
RA: Kevin McArthur has a vision for taking Tahoe forward. If anybody can build it in Guatemala, he's the man to do it. I recently attended one of Kevin's presentations in Panama, where he talked about paying a $2/share dividend. But he understands this is a cash cow.
BH: The Escobal project in Guatemala is a world-class deposit. The further along it gets in development, the more derisked Tahoe becomes and the higher the share price.
TGR: Silver Wheaton CEO Randy Smallwood expects a strong Q4/12. What is underpinning that optimism? Is there a new stream about to start up?
RA: I am not aware of a new stream coming on-line. It may be related to a timing delay in ounces sold, or to production setbacks over water issues at Peñasquito. If those issues are cleaned up, production can return to normal.
BH: The important thing with Silver Wheaton is that it is a large-cap company now but it can still grow its attributable production via silver stream north of 10% between now and 2016 with no ongoing capital expenditures. It also has a dividend policy of 20% of its cash flow. Plus Silver Wheaton has over $500M in cash that could be used to make further investments that would be accretive to earnings and operating cash flow.
TGR: Are you buying companies now in the expectation of more merger and acquisition (M&A) activity as the gold price rises?
RA: Not really. I think M&A activity is on hold as companies figure out how to optimize their existing projects and increase their margins. Stupid acquisitions are one of the best ways to destroy capital. I do not believe M&A is the way to go right now.
However, a couple of companies could be in play just on valuation. Dundee Precious Metals Inc. (DPM:TSX) gets penalized for being in Eastern Europe and for having a smelter in Namibia that was recently attacked by the environmental minister without any evidence for his allegations. Dundee Precious Metals is looking at putting a pyrite recovery circuit at its main mine, Chelopech. It would not cost much to do, but would probably boost gold production by half. With that circuit in place, it may be a good purchase for Eldorado Gold Corp. (ELD:TSX; EGO:NYSE). Dundee Precious Metals probably has 50% upside from where it is at right now.
Another company, Gran Colombia Gold Corp. (GCM:TSX.V), was taken over two years ago and the assets were bought out of bankruptcy. It has hired new people on the ground who are really doing first-class work. I visited last week with the new mining engineer in charge of the underground work at its Segovia operation. We reviewed every stope model and the pay yields on everything needed to turn the asset around.
Gran Colombia also has its Marmato operation, a high-grade underground operation that never had a mine plan. Its new consultant, Lee Hill, has worked all over the world and he loves this project. Marmato has probably 17 Moz gold, with an official number around 13 Moz. But when you look at the four holes already drilled, you can see substantial amounts of gold. Then, you start thinking that this may be an underground mine, not an open pit.
Its share price is in the $0.35 range and if it shows the asset can be turned around, that stock is very cheap and is a potential takeout.
TGR: You place a premium on communication. Why is that?
RA: We try to keep the lines of shareholder communication open because that signals to people how engaged we are in what we are trying to do. Shareholder education builds shareholder loyalty.
We cover a lot of topics. Frank Holmes travels the world and talks to thousands of people. Brian and I visit projects and have regularly scheduled calls with analysts three and four times a week. We try to synthesize our view and share it. The overall market seems to be highly depressed, and everybody just wants to talk about the negatives, but there is opportunity.
BH: As analysts and portfolio managers, summarizing what happened over a week's time, help us put events in perspective. When you have to write about it, you have to think clearly about the issues. It's a good tool for us as well.
TGR: What is a good rule of thumb for precious metals equities investors?
RA: On the gold and precious metals side, at a minimum they should keep 5–10% of their overall portfolio in gold and gold stocks and rebalance it annually.
The good thing about gold and gold stocks is that they are not as positively correlated to the overall market. When your gold equities are down, your other stocks tend to be up; if other stocks are down, the gold equities are probably making up the losses. We find that to be a great portfolio diversifier over time. If you do the efficient frontiers, gold equities not only lower the overall volatility, they also raise the average return.
TGR: And you, Brian?
BH: The precious metals market is surprisingly inefficient. There are opportunities to trade around core positions when you have dislocations in the market, whether it is a geopolitical event or a change in government policy.
On an individual basis, it can be daunting to navigate that on your own. We add value by having the resources and the time to be active managers and to capitalize on these dislocations and inefficiencies. I would say let professionals manage your gold portfolio for optimal risk-adjusted returns.
TGR: Brian and Ralph, thanks 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 (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.
Brian Hicks joined U.S. Global Investors Inc. in 2004 as a co-manager of the company's Global Resources Fund (PSPFX). He is responsible for portfolio allocation, stock selection and research coverage for the energy and basic materials sectors. Prior to joining U.S. Global Investors, Hicks was an associate oil and gas analyst for A.G. Edwards Inc. He also worked previously as an institutional equity/options trader and liaison to the foreign equity desk at Charles Schwab & Co., and at Invesco Funds Group, Inc. as an industry research and product development analyst. Hicks holds a Master of Science degree in finance and a bachelor's degree in business administration from the University of Colorado.
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1) Brian Sylvester of The Gold Report conducted this interview. He personally and/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: Goldcorp Inc., Franco-Nevada Corp., Royal Gold Inc. and Tahoe Resources Inc. Streetwise Reports does not accept stock in exchange for services. Interviews are edited for clarity.
3) Ralph Aldis: I personally and/or my family own shares of the following companies mentioned in this interview: None. I personally and/or my family am paid by the following companies mentioned in this interview: None. I was not paid by Streetwise Reports for participating in this interview.
4) Brian Hicks: I personally and/or my family own shares of the following companies mentioned in this interview: None. I personally and/or my family am paid by the following companies mentioned in this interview: None. I was not paid by Streetwise Reports for participating in this interview.