Ongoing inflation pressures and China’s investments in the African gold supply chain point to a higher gold price, according to Matt Badiali of Stansberry & Associates. Bullion in all its forms belongs in every portfolio and when it comes to equities, investors have their choice of business models—dividend payers, prospect generators and royalty companies. In this exclusive Gold Report interview, Badiali outlines companies whose equities should catch up to the higher gold price.
The Gold Report: Matt, in the February 2012 edition of Stansberry’s Investment Advisory, Porter Stansberry predicted gold would hit $9,600 an ounce (oz) someday. How should investors protect themselves from this coming crisis?
Matt Badiali: In general, I agree with Porter’s thesis. Bullion—gold, silver coins or bars—should be part of everyone’s portfolio. It is one of the best anchors against inflation. Gold and gold stocks also are important holdings because as the value of paper money falls, the value of gold rises.
TGR: Stock prices have not gone up as much as the gold price. Will that trend continue?
MB: We have been in an odd scenario. If gold miners were T-shirt makers and the price of T-shirts went up, the market would buy the company to match the earnings. That has not happened for gold stocks.
Last year, the Market Vectors Gold Miners ETF (GDX:NYSE.A) was down 25% while the price of gold was up 15%. Looking at just the last three years, stocks were up 40% while the gold price rose 90%. So, in the short term, the Gold Miners ETF has underperformed gold.
Gold miners’ earnings have climbed dramatically, but their share prices have not followed suit. I believe gold miners will outperform the metal just because they have to rebalance.
TGR: What does the volatility in gold tell us?
MB: Generally speaking, the market wants a stable U.S. dollar. It rallies to dollars for all sorts of reasons. I think that is false faith.
So many new dollars have been printed that the value of all tangible things has to increase in response. For example, we all think $110/barrel oil is crazy expensive. But, relative to gold, oil has been less expensive over the last couple of years. The price of oil is falling in terms of real money, but going up in terms of dollars. That is a good indicator of how much new paper money has been printed.
TGR: What effect would higher interest rates have on junior miners? Can the increase in the gold price offset the greater cost of raising capital?
MB: Raising interest rates immediately strengthen the dollar, and a strong dollar is hard on all real assets. They rein in inflation, and inflation is why the price of real things like gold and oil go up. Therefore, if rates increase, the price of gold will probably fall.
Many companies have already adapted their plans to a higher gold price. Recently, I have seen development plans based on $1,000/oz and $1,200/oz gold. If the dollar were to strengthen and the gold price fall, it would negatively affect the gold mining industry.
TGR: How does the price of oil affect the operating expenses of gold mining companies?
MB: A gold mine is essentially a commodity swap. A company uses fuel, diesel, gasoline, electricity, concrete and steel to build out a mine and recover gold. As long as the commodities you put in cost less than the commodity you take out, the mine is in business.
Over the last 10 years, the commodity cost to build mines has increased. In any business, when your costs rise as quickly as your revenue, your earnings stay pretty much the same.
TGR: On the earnings side, some large precious metals producers are offering dividends. Is that working?
MB: Newmont Mining Corp. (NEM:NYSE) pays a 2.9% dividend, tied to the price of gold. That is a spectacular idea if your operating costs are well enough in hand to support it.
The thesis is that the Federal Reserve will continue to stimulate the economy by adding money to the system, thereby driving up the gold price. If you trust that thesis, buying a dividend-issuing gold company now when they are relatively inexpensive will lock in your yield at a lower price.
Newmont’s profit went from $4.7 billion (B) in 2009 to almost $6.5B in 2011. The rising price of gold contributes heavily to its bottom line. Investors who get in now stand to see a 5–7% yield in a couple of years.
TGR: Can that same business model work for smaller companies?
MB: It depends. There are some opportunities out there, but there have also been some spectacular failures. For example, I thought the silver miner Hecla Mining Co. (HL:NYSE) would be a great company over the long term, but it had a problem with its Lucky Friday mine and the company tanked.
TGR: But that was a resource problem, not the business model.
MB: Sure, but the point is the dividend model works for the big miners like Newmont, Barrick Gold Corp. (ABX:TSX; ABX:NYSE) or Goldcorp Inc. (G:TSX; GG:NYSE). Companies that can diversify their revenue stream over many mines on many continents mitigate risk. They can absorb more hits and continue to pay dividends. If a company generates most of its revenue and income from one mine and that mine takes a hit, that company is done.
Our first rule is never take a big loss. I typically use a 30% trailing stop on mining companies, which means that if it falls 30% from the highest point reached during my investment period, I sell.
If a mining company falls 30%, there is a fundamental flaw. Either the market has changed or the company has a problem. We limit ourselves to 30% losses because we can recover that. A loss of 50% or 80% is hard to recover.
TGR: What about dividends for royalty equity companies?
MB: I love them. Royalty companies are my favorite. The really big, safe ones are the best: Silver Wheaton Corp. (SLW:TSX; SLW:NYSE), Franco-Nevada Corp. (FNV:TSX) and Royal Gold Inc. (RGLD:NASDAQ; RGL:TSX). These companies have 50 to 80 royalty streams. If their royalty stream on one mine ends, it is just a dimple in their revenue stream. Most of these royalty companies could survive 10 losses with only a modest hit to their revenue.
The other great thing about these royalty companies is they have none of the carrying costs of mines. Because they take such a small piece of a lot of mines—typically 2–5% of production—they have very diluted political and mine-specific risk.
TGR: Does the dividend model work there?
MB: Typically, they pay a very modest or no dividend because they reinvest their capital.
Right now, mining companies are coming to these royalty companies for cash to develop their mines. In return for $5 million (M) of its cash, the royalty company gets 2% of the gold produced over a mine’s 15- or 20-year lifespan. I would rather see the company reinvest because mining is so cyclical and there are so many opportunities now.
TGR: In February, you produced a report, “How to be an Investor in China’s Fort Knox.” What is its investment thesis?
MB: We have been watching China’s investments in Africa for a while now. China is spending billions of dollars in Africa in very specific ways: financing power plants, building railroads and developing other infrastructure plays.
Why? If you want to build a mine, you need electric power. You need to be able to get ore from the mine to a port. China is laying the groundwork for mine development all over Africa.
Look also at what China is buying: one of the world’s largest undeveloped uranium deposits, bullion and shares in African gold miners, from major mining companies to partnerships with juniors and exploration projects.
At the Mines and Money Conference in Hong Kong, I asked representatives of major Chinese investment banks and funds if gold is a major target for Chinese investment in Africa. Across the board, they all said yes.
TGR: How can people outside of China get involved in that?
MB: That was my next question. The best approach is to find companies where the Chinese government or government entities have already invested. I think serious investors who want to participate in mining—especially in Australia, Africa and China—need to understand the Chinese philosophy of resource investing.
When a company gets money from a Chinese bank, it gets far more than funds. It gets exposure to the entire Chinese system. The banker will help the company find a market for its goods or find a Chinese engineering firm to provide technical expertise.
Chinese banks protect their investments. Once a Chinese bank is involved in a mining program, the company typically can get more cash without problems.
TGR: You often emphasize the importance of diversity within the mining company and within portfolios. Where do precious metals fit into a good portfolio mix?
MB: There is a spectrum of risk in precious metals. Bullion is fairly low risk; it is limited to the commodity risk.
With major mining companies, your risk of a 50% loss is pretty low. For investors with low tolerance for risk, a senior mining company is the best place to be.
Mid-cap growth gold miners all have risk. For older investors looking toward retirement, I do not recommend putting a large portion of your portfolio at risk. If 5% of your portfolio is higher risk, some percentage of that can be in mining.
Junior miners are just little bundles of risk. They are not safe; 90% of them bomb. When I write about junior mining companies, I advise investing only if you can afford to lose 50%.
TGR: What do you look for to downplay risk?
MB: The first thing I look for is management. Imagine two junior mining companies, both listed on the Canadian TSX Venture Exchange. Company A is run by a lawyer and a serial stock promoter. Company B is run by a mine executive who worked 25 years for one of the majors. To reduce risk, I would choose B.
Company A is most likely what I call a “lifestyle company.” Its high-rise offices have a spectacular view; management wines and dines you, all on the company’s dime.
Company B, my ideal investment, has offices in a building where the elevator barely works. There are rocks stacked in the lobby and geologic maps on the walls. These guys are working; this company offers opportunity.
TGR: What are some examples of Company B?
MB: ATAC Resources Ltd. (ATC:TSX.V) is a great example. I know the CEO and the principals. I knew the area and spent a lot of time there. In 2008, after the company put out a press release on a discovery, we wrote it up and made 597% on the trade.
Another is Riverside Resources Inc. (RRI:TSX), led by Dr. John-Mark Staude, who has years of experience as an exploration geologist. This company uses the prospect generation business model, which means it uses other people’s money to find projects. Cliffs Natural Resources Inc. (CLF:NYSE) funds Riverside’s exploration and gets a first look at whether its projects are worth anything. Choice Gold Corp. (CHF:CNSX) is Riverside’s partner on the Sugarloaf Peak project, a low-grade gold resource.
Typically, only 1 in 3,000 exploration projects becomes a mine down the road. John-Mark and his crew have generated more than 11 projects, most of them with partners.
TGR: Riverside seems to have lots of technical knowledge, a great database and great partners, including Antofagasta Plc (ANTO:LSE). But its stock is at $0.86. What catalyst could take it higher?
MB: With a prospect generator like Riverside, you have multiple shots on goal. Even though Riverside does not own 100% of Sugarloaf, 30% of a major gold discovery will take an $0.86 stock to the moon.
TGR: We talked about investing in Africa earlier. What are some exploration and development companies there that interest you?
MB: My favorite African play right now, which is ridiculously cheap, is Keegan Resources Inc. (KGN:TSX; KGN:NYSE.A) in West Africa. Its Esaase project will be a mine, the other, Asumura, is just starting to find gold in its drill results.
Keegan is in a bad place in terms of the mining cycle. It is spending money on permitting and environmental reports. The only news that could come out would be bad news, like a permit delay. Add to that its location in Africa, a jurisdiction that scares people. Everybody expects it to be bought by a major mining company. While that drags out and the company continues to spend money, the share price continues to erode.
I think Keegan will be taken out. My concern is that its share price has sunk so low, it may get taken out at a modest premium and wind up not being anywhere near the value I anticipated.
TGR: If it is not taken over, could Keegan be a successful mine developer?
MB: If it gets the right partner, it can be very successful. Many small mining companies have come in as junior partners and have done quite well. MAG Silver Corp. (MAG:TSX; MVG:NYSE), through its partnership with giant silver miner Fresnillo Plc (FRES:LSE), for one.
TGR: How about safer jurisdictions like Canada?
MB: Canada has its own risks. There are a lot of taxes and some of the projects, even in British Columbia, are remote.
Seabridge Gold Inc. (SEA:TSX; SA:NYSE.A) owns the Kerr-Sulphurets-Mitchell (KSM) project. I love this company and KSM, which is a big, low-grade project. The most recent development estimate was somewhere north of $4B. Seabridge is a great company to play arbitrage on the gold price. When the market does not like gold, Seabridge shares fall to nothing; when the market likes gold, Seabridge trades much higher.
However, there’s another deposit up near KSM that’s exciting. Brucejack, owned by Pretium Resources Inc. (PVG:TSX; PVG:NYSE), is a high-grade gold and silver deposit. It’s just a few miles from KSM and is likely related. In Brucejack, the gold and silver are concentrated. Brucejack’s resource is 4.9 million ounces (Moz) of Indicated gold ounces at 17.3 grams per ton (g/t). That’s over half an ounce of gold per ton of rock. There is another 10.4 Moz of Inferred resources at 25.5 g/t. Those are spectacular grades. In November 2011, one of its drill holes ran 17.75 kilograms (kg) gold per ton. It was beautiful, striped with gold in places. Pretium’s shares went from $8.50 to $12.30. The stock is at $15/share now. Unless Pretium brings in a development partner, it will probably get bought for this project.
TGR: Will more strikes be announced?
MB: There is more exploration drilling to come. I don’t have it as a Buy, but this might be a good time to add a position. With such a great deposit at high grades, Pretium will have a lot of leverage to the gold price if it starts to climb. At $2,000/oz, this project is a cash machine.
I see this whole Valley of the Kings area as a catalyst for the entire region. Over the next 25–30 years, this part of British Columbia. could become a major, major gold and copper mining center.
TGR: Let’s go south to Mexico. Do you have a name or two there?
MB: Silvermex Resources Inc. (SLX:TSX; GGCRF:OTC) was recently acquired.
I like Endeavour Silver Corp. (EDR:TSX; EXK:NYSE; EJD:FSE) and have for a long time. Again, it’s a great example of a company run by industry experts with 30 years in the business. It has two operating mines, Guanacevi in Durango State and Guanajuato in Guanajuato State in Mexico. Its Q112 results were spectacular: 20% increase on silver production and 26% increase on gold production. We’re looking at a very healthy silver producer. That should increase further, as the company expands both mines in 2012.
If the Fed does more quantitative easing, silver prices are likely to touch $50/oz in the near future. Endeavour is a good company now; when silver gets to $50/oz, it will be a spectacular company. It offers fairly low downside risk with the potential of a big gain.
TGR: Any parting advice?
MB: One of the best pieces of advice I was given is: The best time to make an investment is probably when you are most terrified about making it. When an investment is easy, it is probably near the top. I love to hear people say they will never invest in gold or silver again because they got burned before. If people like that flee the sector, I have less competition.
For folks who despair over the gold and silver market, I say, hold your nose, figure out how much money you can afford to invest and do it. The risk is fairly low and the potential rewards are pretty high.
TGR: Matt, thank you for taking the time to talk to us.
Matt Badiali is the editor of the S&A Resource Report, a monthly investment advisory that focuses on natural resources—from small exploration outfits to equipment companies, to the biggest commodity companies in the world. He also writes S&A Junior Resource Trader, which focuses on the “bloodhounds” of the mining and energy industries—small gold, copper, oil, diamond and uranium miners—and how to earn thousands of percent in the coming years. Badiali has real-world experience as a field geologist, lecturer, researcher and a consultant. He holds a master’s degree in geology from Florida Atlantic University.