Adrian Day: Ditch the risk and embrace the upside

Adrian Day: Even if the Fed had stuck to the $85B/month as advertised, tapering is a sham. The Fed reduced QE to $75B/month in January and now has announced a further $10B/month reduction. But $65B/month is still an enormous amount of stimulus. Very shortly, the Fed’s balance sheet will exceed $4 trillion. We’re focused on the wrong thing here.

TGR: Considering all this talk of recovery, the Jan. 10 jobs report was dismal, was it not?

AD: Absolutely. The employment situation in the U.S. is a long way from what one would expect from a decent recovery, let alone a robust recovery.

TGR: U.S. job creation since 2008 has been mostly part-time jobs, temporary jobs and low-paying jobs. How does this lead to increased consumer spending, which is, we are told, the basis of a robust recovery?

AD: Consumer spending is being fuelled by debt. Since 2007, it has increased 23% for the lower 40% of earners. The Fed reports that net household income and net household wealth have now exceeded the 2007 highs. If we break down the numbers, however, we see that net worth is actually down for 90% of U.S. households. For the bottom 50% of households, net worth is down an astonishing 44%.

TGR: We can’t have a recovery based on the purchase of yachts and multimillion-dollar New York City condos, can we?

AD: Of course not. We can’t have a strong economy based on just 10% of the population getting richer. Frankly, I don’t mind whether there’s a gap between the rich and the poor—so long as the rich are getting their wealth honestly and not from government handouts. And so long as the middle class is getting richer also.

TGR: President Kennedy said famously that a rising tide lifts all boats. Do we still believe that?

AD: Since 2008, the Fed’s stimulus has gone mostly to Wall Street, not to Main Street. That is a fundamental problem for the economy but also for the polis, for the public social good.

It’s not that I want the government to do things specifically for the middle class; I just want it to get out of the way. If small businesses are created and can expand and hire people, then we will have a rising tide lifting all boats.

TGR: The International Monetary Fund last month cautioned that debt levels have become so perilous that recovery, as Ambrose Evans-Pritchard of The Daily Telegraph wrote, “will require defaults, a savings tax and higher inflation.” Do you agree?

AD: Debt has become unmanageable. Now, there is nothing wrong with debt per se. When I argue against high government debt, people often respond that in the 19th century the U.S. debt to GDP ratio was higher than today. But that debt was used for capital investment (canals, railroads, etc.), which led to higher economic growth. Today, debt is being used to fund wars and welfare, not investments in the future.

Defaults? Perhaps. Taxes will never deal with the debt problem. You could tax 100% of income above $100,000, and you would fix the U.S. deficit only for a few months. Higher inflation? Perhaps. The one thing Evans-Pritchard didn’t mention was currency devaluation. Because the vast majority of U.S. debt is issued in U.S. dollars, the easiest way to liquidate it is to devalue the dollar.

TGR: In a speech last month in Shanghai, you said, “Gold moves in long cycles.” Do all commodities move in cycles?

AD: Most do because producers get price signals from the market with a delay. Take the retailer that sells TVs. If sales go down three weeks in a row, the retailer will order fewer units the next month. He gets an immediate price signal. The wholesaler gets signals with a bit of a lag but still relatively early.

But the producer of a rare earth that goes into TVs gets the signal from the market with a much longer lag than the retailer, the wholesaler and the manufacturer. So, metals cycles tend to be very long. And it’s far more difficult for miners to cut back or increase production than for retailers to adjust orders.

TGR: Where are we in the current gold cycle?

AD: Over the last 250 years, the shortest cycle on record was the 1970s, just over 10 years. Typically, gold upcycles have lasted close to 40 years. On that basis, we aren’t even halfway through the current gold upcycle.

TGR: So last year’s price collapse did not indicate the end of the gold upcycle?

AD: Significant corrections in long, secular bull markets are typical. Gold, from top to bottom, has declined 37% in this particular cycle. If you look back to the upcycle of the 1970s, 1975–1976 saw a midcycle correction of 47%. But that was right before gold went up eightfold to more than $800/ounce ($800/oz).

Where are we now? It would be optimistic to assume a V-shaped recovery, but gold has bottomed, and over the next 12 months we are likely to see a slow, if uneven, recovery. The typical recovery comes from a long midcycle correction. We should reach $1,550–1,650/oz in 2014 or early next year, and then gold will start to accelerate. Some gold stocks could recover a lot quicker in expectation of higher prices.

TGR: You noted in Shanghai that gold stocks have lagged behind the gold price in an extraordinary manner. Why?

AD: First, costs have gone up, in some cases more dramatically the price of gold. Second, companies grossly overpaid for acquisitions with no synergies. Barrick Gold Corp. (ABX:TSX; ABX:NYSE) comes to mind in this regard.

For these reasons, we’ve seen a great deal of new equity dilution. If we look at all-in costs—and not just mining costs— it’s been estimated that about half of all mines are losing money. So it’s no surprise that gold stocks have done badly, particularly in light of the attractive and simple alternative: gold exchange-traded funds.

TGR: When can we expect gold stocks to recover?

AD: As you know, many gold companies have made big mea culpas. They’ve fired CEOs and committed to not making the same mistakes. The irony is that with companies and individual mines so cheap now, when it’s so difficult for companies to raise capital, this is precisely when the big companies should be making acquisitions.

That’s why I applaud Goldcorp Inc.’s (G:TSX; GG:NYSE) bid for Osisko Mining Corp. (OSK:TSX). I think a few more mergers and acquisitions (M&A) like this will get the market excited again.

TGR: Assuming a general recovery in gold stocks, which sector do you think will do best—majors, mid-caps or micro-caps?

AD: Broadly, the seniors will probably move first because when generalist investors move into the gold sector, that’s typically where they first put their money.

But I don’t look at the gold sector that way. Today, the most important criterion is the balance sheet. Does the company have the cash to carry out its plans? If it must raise cash, can it do so in a nondilutive manner? Some seniors will be able to answer affirmatively, and so will some explorers. That’s the test.

TGR: It’s said that some companies are too big to fail. Are some gold companies, like Barrick, too big to succeed?

AD: There’s no systemic reason why Barrick is too big to succeed. It has a complex and far-flung structure, but so does Nestlé S.A., which buys from more than 100 countries and sells to more than 200. Nobody says that Nestlé is too big to succeed. Barrick’s problem is that it probably grew too big too fast.

Successful exploration entails risks and the understanding most risks will fail. It’s natural that lower-level managers in large companies become much more risk averse. The solution is for the majors to use the juniors as their exploration arm, as companies like Newmont Mining Corp. (NEM:NYSE) have done. Newmont does joint ventures (JVs) with other companies and then, if appropriate, buys the properties or buys its partners outright.

TGR: How long until Barrick’s new management can put its stamp on the company and tell investors: That was then, and this is now?

AD: The first thing Barrick must do is make it very clear exactly what kind of company it is: does it want to be a gold company or a diversified mining company? Will it hedge? Considering the way the management transition has been handled—the $11.9 million ($11.9M) signing bonus for new Co-chairman John Thornton and the two independent directors resigning because they think the “independent” directors are still too close to Peter Munk—I think it’s going to be a while before Barrick can draw a line under the past.

TGR: Why do you favor the royalty/streaming model?

AD: When a company acquires or creates a royalty on another company, that first dollar in is typically the last dollar in, meaning that the royalty company is not responsible for setbacks. If there are cost overruns, if the shaft floods, if taxes are raised, the company with the royalty is not responsible.

The worst that can happen is that royalty payments are reduced or delayed. For instance, the original capital expenditure (capex) of Pascua Lama, Barrick’s project that straddles Chile and Argentina, was $2.25B. By the time it was shelved, the capex had reached $10B.Royal Gold Inc. (RGLD:NASDAQ; RGL:TSX), which had a royalty on Pascua Lama, was not responsible for this huge increase. Of course, Royal still doesn’t have any revenue from that project, but at least it didn’t have to front any more money.

TGR: What are the advantages for royalty companies besides risk mitigation?

AD: Staffs tend to be small, so profit margins tend to be high. And royalty companies have exposure to exploration upside. If a company has a royalty on a particular mine, it will typically have a royalty on at least some of the exploration ground around that mine. If there is a discovery on that ground, the royalty owner benefits just as much as if it were the company making the discovery. Royalty companies get most of the upside and very little of the downside.

TGR: Which royalty companies do you like?

AD: I like most of them. Having said that, Franco-Nevada Corp. (FNV:TSX; FNV:NYSE) is, in my view, far and away the best. It has great management, a great balance sheet, about $900M in cash and no debt. It has a very broad portfolio of properties. It has royalties on 37 producing mines and more than 300 other, nonproducing royalties.

TGR: Which of the smaller royalty companies do you like?

AD: It’s not in the gold business, but Altius Minerals Corp. (ALS:TSX.V) has morphed into a royalty company. It began as a low-risk operation, partnering on JVs. It then innovated by spinning off projects but retaining shares and royalties.

Altius has just acquired a package of royalties on coal and potash. Add that to its royalties on Vale S.A.’s (VALE:NYSE) Voisey’s Bay nickel mine and Alderon Iron Ore Corp.’s (ADV:TSX; AXX:NYSE.MKT) developmental Kami iron ore project in Newfoundland and you have a very attractive company.

I also like Virginia Mines Inc. (VGQ:TSX), which, like Altius, has grown largely with JVs. It has a royalty on Éléonore in Quebec, which is Goldcorp’s next major mine to come onstream, in Q4/14. Production is estimated at 600,000 oz annually after ramp up.

TGR: Your January portfolio review noted that Altius was up 24% for 2013, and Virginia Mines was up 16%.

AD: Most of the mining companies that did well last year had very good balance sheets and weren’t associated with high risk. That’s certainly true of Altius and Virginia.

It amazed me that Virginia was still so inexpensive even as Éléonore’s net present value continued to grow and Virginia’s royalty came ever closer to fruition. The explanation is that investors are short-term oriented. Virginia is arguably a little ahead of itself after the recent run, given today’s gold price, but it is still one of the top companies I would want to hold long term.

TGR: Any other royalty companies you’d care to mention?

AD: Callinan Royalties Corp. (CAA:TSX.V). Again, it’s not gold. Callinan actually pays a dividend, about 4.6%. It’s quite nice to get a decent dividend on a resource-related company. Callinan has a good balance sheet and is continuing to make investments in other companies where it retains royalties. Over the next few years, investors will see Callinan expand from basically one producing royalty to several. In the meantime, investors get paid.

TGR: Reservoir Minerals Inc. (RMC:TSX.V) was up 21% last year. What’s its story?

AD: Reservoir has a JV with Freeport-McMoRan Copper & Gold Inc. (FCX:NYSE) on the Timok copper-gold project in Serbia. This proves again the worth of the JV model. Reservoir had to give up 75% of Timok, but with Freeport paying for the exploration, Reservoir can maintain its balance sheet.

Reservoir has about $18M in cash right now, which is a lot, considering what its expenditures are. It has had continually spectacular results from Timok. I think that Freeport is going to buy Reservoir or, at least, buy Timok. This could mean a very significant premium over the current stock price. Most shareholders are waiting for the endgame, so there aren’t a lot of shares available. So it’s important to look for any setback to buy, and to use a limit.

TGR: Moving to British Columbia’s biggest exploration story, could you explain the “battle of the consultants” over the quality of Pretium Resources Inc.’s (PVG:TSX; PVG:NYSE) Brucejack deposit?

AD: That was unfortunate. Pretium had two independent consultants, Strathcona and Snowden. Strathcona is the company that blew the whistle on Bre-X, so it has credibility. Pretium was doing a bulk sample to assess the value of Brucejack because the deposit is high-grade but spotty. The two companies had different methodologies for conducting and assessing this sample. These were technical differences, and I don’t know why Strathcona believed it had to resign from the project so publicly.

TGR: You sold Pretium, but now you’re bullish on it again.

AD: We sold because I was in a risk-averse mode at the time. I know Pretium’s CEO, Bob Quartermain, and his integrity is unquestioned. Nonetheless, I knew that a very public controversy like this would cause the stock to decline for quite some time, which it did.

Then the initial bulk sample results were released, and they were excellent. So I thought it was time to jump back in. I feel very positive about the deposit, and the bulk sample results have only gone to support that confidence. I think Pretium is a good buy at this point.

TGR: You have stressed the correlation of success with cash and/or cash flow. Name a company that demonstrates these attributes.

AD: Almaden Minerals Ltd. (AMM:TSX; AAU:NYSE) has great management, about $16M in cash plus a couple of million in gold bullion. The beauty of having cash means that a company can raise money or sell assets only when it wants to.

Almaden owns the Tuligtic gold-silver property in Puebla, Mexico. The company continues to drill the Ixtaca zone aggressively, and the results continue to be strong. A just-released updated resource estimate on the Ixtaca zone on this project shows an increase in total resource of about 20% and a Measured and Indicated resource of 3.5 million ounces; the deposit continues to grow. A preliminary economic assessment is scheduled for early March and I am expecting it to be positive. This stock is a bargain.

TGR: Any other bargains come to mind?

AD: Midland Exploration Inc. (MD:TSX.V), another prospect generator. It has 10 main projects in Quebec, five of which are currently under joint venture. Key projects are the Maritime-Cadillac gold project with Agnico-Eagle Mines Ltd. (AEM:TSX; AEM:NYSE), the Patris gold project with Teck Resources Ltd. (TCK:TSX; TCK:NYSE) and the Ytterby rare earth project with Japan Oil, Gas and Metals National Corp. (JOGMEC). These partners have already re-upped, which demonstrates confidence in the projects, and the company is working on finding partners for more of its projects. Midland has $4.5M in cash, more than enough, considering the money its partners are spending.

Midland’s stock is at $0.97/share. It’s a very thinly traded company, so I would urge investors to use a limit price when they buy, otherwise they’ll just push the price up on themselves. (Our clients actually own more than 10% of Midland, and we’re considered an insider.)

TGR: Could you rate the balance sheets of some other gold companies?

AD: We own Detour Gold Corp. (DGC:TSX). It does have cash, but it also has ongoing capital expenditures on its Detour Lake mine in Ontario. It’s more leveraged on the gold price than some of the other companies I’ve mentioned. If gold goes from $1,200 to $900/oz, it’s not going to be a great investment. But if gold goes from $1,200 to $1,500 or $1,600/oz, Detour will be one of the better performers. It is also a potential takeover candidate.

We also own quite a bit of New Gold Inc. (NGD:TSX; NGD:NYSE.MKT). It has four producing mines: Cerro San Pedro in Mexico, Mesquite in California, New Afton in British Columbia and Peak in Australia. It also has very strong management. Randall Oliphant, the executive chairman, is a former Barrick CEO, and board member Pierre Lassonde is chairman of Franco-Nevada.

New Gold has a good balance sheet and a good pipeline of projects. It is one of the most undervalued of the senior gold companies. So I would definitely be a buyer there.

TGR: Adrian, thank you for your time and your insights.

Adrian Day, London born and a graduate of the London School of Economics, heads the eponymous money management firm Adrian Day Asset Management (www.adriandayassetmanagement.com; 410-224-2037), where he manages discretionary accounts in both global and resource areas. Day is also sub-adviser to the new EuroPacific Gold Fund (EPGFX). His latest book is “Investing in Resources: How to Profit from the Outsized Potential and Avoid the Risks.”

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