Why the Gold Mining sector is set for interesting times...
PRESSURES from inflation as well as China's investments in the African gold supply chain point to a higher Gold Price, according to Matt Badiali of Stansberry & Associates.
In this interview with The Gold Report, Badiali says 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.
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?
Matt Badiali: 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.
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?
Matt Badiali: Generally speaking, the market wants a stable US 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?
Matt Badiali: 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?
Matt Badiali: 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?
Matt Badiali: Some pay a 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.
TGR: Can that same business model work for smaller companies?
Matt Badiali: It depends. There are some opportunities out there, but there have also been some spectacular failures.
TGR: But that was a resource problem, not the business model.
Matt Badiali: Sure, but the point is the dividend model works for the big miners. 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?
Matt Badiali: I love them. Royalty companies are my favorite. The really big, safe ones are the best. 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?
Matt Badiali: 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?
Matt Badiali: 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?
Matt Badiali: 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?
Matt Badiali: 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?
Matt Badiali: 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: Any parting advice?
Matt Badiali: 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.
TGR: Matt, thank you for taking the time to talk to us.
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