What makes money in a deflation...?
MANY Gold Mining stocks are now trading at bargain prices but the old "buy and hold" strategy no longer applies in this fluid market environment, says Florian Siegfried, CEO of Precious Capital AG.
In this interview with The Gold Report, Siegfried says investors need to do their homework and pick their entry and exit points carefully.
The Gold Report: This is the first time you are speaking with The Gold Report, Florian, so can you give us your European perspective on the current global economic and financial situation and where things might be headed?
Florian Siegfried: We are long-term bulls on gold because we think that the debt crisis in Europe has been downplayed for too long and there is no solution to the problem. Eventually, we expect to see a credit deflation where most of these bankrupt governments in Europe are no longer able to repay their debt, which will translate into more stress in the banking sector.
In our view, this will lead to a deflationary downward spiral, which cannot be manipulated any longer by printing money because eventually the insolvent banks will fail to lend, and then there is no possibility to lift asset prices anymore. When that happens, the investor community will have a huge preference for liquidity and unleveraged assets.
We think gold is the most favorable asset class in a time of credit deleveraging. An investor in gold will make money in real terms as the credit bubble deflates. Investors who are long in Euros or commodity-based currencies will actually lose in purchasing power as credit deflation hits. This is our long-term view and we think that there is no further room to manipulate asset markets, as they have been in the past. I think that we are at the triggering event here.
TGR: How much air do you think can come out of this whole system? And how much can prices deflate overall?
Florian Siegfried: That's a difficult question. One has to look at various asset classes. We would be rather bearish on base metals, such as iron ore, which has already declined quite dramatically since the beginning of the year. China has to rebalance its economy, which largely depends on capital investments and exports and this could become a real problem now.
I wouldn't be surprised if in two or three years we would see prices off by 30% or so. Oil prices are still getting some support because of the geopolitical situation, but as China slows down, consumption is probably going to decline and we could see oil off 20% over the next few quarters.
In the equity markets, I think earnings disappointment is going to be a major topic next year. Sooner or later, the market has to realize that if Europe is in a recession, China is slowing down and the US is not getting ahead of the curve, where would earnings growth come from? So, I would expect equity prices, overall, in a year's time could be lower, probably by 10–20%.
TGR: In reading through your Precious Capital fund materials, it was interesting to note the major credit crises over the last 300 years, starting with the South Sea Bubble in 1725 and then the British Credit Crisis of 1772 and then the panics of 1825 and 1873, followed by the market crash in 1929 that started the Depression. Then we had the bad recession in 1973. Now we have this global financial crisis that started in 2008. If the previous 300-year pattern holds, it would indicate another severe event around 2025–2030. Do you think the Federal Reserve and foreign central banks can keep things together and prevent a major collapse in 2025–2030?
Florian Siegfried: These kinds of cycles have a common characteristic. In each, you have good times, with real or so-called "prosperity," mostly driven by excessive use of leverage and debt. 2008 was the same, with too much credit and debt. Bear Stearns and Lehman Brothers failed to serve the debt because they were too highly leveraged. Then the whole system broke down because if one bank failed, many others would fail.
I think we are still relatively early in this kind of cycle. The Federal Reserve and the European Central Bank have really acted ambitiously to solve the crisis and prevent the system from collapsing by just printing money to loan at 0% to the banking system. But, eventually, what is it going to change? In the long run nothing, because it's not just a liquidity crisis. It's also a solvency crisis. The only solution to too much leverage is less leverage. Only the market can bring that leverage to a level where it is actually sustainable. I believe the stimulus, TARPs and LTRO programs from all the central banks have only pushed the inevitable credit deflation cycle down the road.
TGR: So how does all this influence your investment strategy?
Florian Siegfried: We try to identify industries that actually make money in a deflationary environment. Lower commodity prices create margin pressure for most industries and they don't do as well as during times of inflation. The precious metals industry does well in a deflationary environment because the Gold Price goes up against the whole commodity complex while input costs such as crude oil or steel are probably stabilizing or will become less expensive than they were in years of higher inflation. Eventually, I think it is the market's desire for liquidity, which will cause Gold Prices to continue rising.
So, the long-term view is very bullish, but it's a very volatile market, and last year gold stocks really underperformed. This is mainly explained by a lack of liquidity and investor confidence. The whole precious metal sector has overpromised and under delivered and many M&A transactions did actually destroy shareholder value. I guess investors have reset their expectations dramatically after all this frustration. However, this can provide opportunities and we try to use some of our technical indicators to trade these stocks while they are getting into an overbought or oversold condition. This past April and May, when the market was really capitulating, we were buyers in most of the stocks we like.
Right now we think the market is a bit overpriced and we've had a very good run in most of these gold mining shares. Now they could go into a little correction mode and probably lose another 10% or 15%. So, we sold some of our positions at the end of September and are waiting for more favorable buying opportunities in the next few weeks. It's not a buy-and-hold strategy that we want to apply here. One can really trade swings if you can get the timing right. We are always invested in the sector, but sometimes we have 30% or 40% cash.
TGR: How has your strategy paid off over the last couple of years?
Florian Siegfried: Since we took over the fund in December 2008, we are up about 140% in US Dollars and this year as of end of September we are up about 26%. We have some winners in the fund that performed well based on the discoveries and the operational improvements they made. We were regularly buying when the markets dried up, which forced stock prices to go lower. There were actually no signals that would suggest a long-term fundamental downturn. We see these corrections as tradable opportunities. I was calling brokers in May and it was unusual to see how defensive they were, saying to stay away from gold stocks until gold hits $2,000/ounce (oz). We got the feeling that was probably the bottom of the market. Timing is of the essence. Pick your stocks carefully, especially in the junior space, because most of these companies will never make money for their shareholders.
That brings me to our selection strategy. The first thing we look at is management. The mining business is very challenging, with a lot of risks. The people with the right experience who have done it before will attract the money from the Street to bring a story to reality and attract institutional money in the future. The next thing we look for is geology. Can a good deposit become bigger and can this ever become a mine and what and how long will it take? In addition, a solid balance sheet with little leverage and good networking capital in the bank is key, so they don't have to tap the equity markets in these volatile times.
We are largely positioned in the midtier mining space because the industry as a whole has started to change. Many of the large gold mining companies have grown too big and aren't flexible anymore. Their strategy was for growth in size, rather than profitability. As a result, many have failed to make money for shareholders. Now, the whole industry has started to focus on smaller projects with lower capital requirements. As a result, we think the market has shown a preference for companies that run easy mines, which can be expanded operationally and can be financed by the market without the risk of significant equity dilution.
Many companies have good assets but don't have the critical mass to attract institutional money. We expect to see more mergers taking place between junior companies or midtier producers. It doesn't make sense to have two companies producing, let's say, 150,000 oz (150 Koz) per year trading at a market cap of $500 million (M). It would be an enormous task for them to get into a league where they could attract institutional money. Growing to a $1 billion (B) market cap internally is probably going to be a tough task. With smart merger and acquisitions (M&A), becoming a 200–300 Koz producer by combining two businesses can get it into the $1B market-cap range more easily. We think that M&A among junior producers is going to be a major topic in the next few quarters.
TGR: Certainly the Yukon has had quite a bit of activity lately.
Florian Siegfried: We think the Yukon is a great jurisdiction for mining. With devolution of resource management responsibilities in April 2003, the Yukon has its own policy for mining, which we regard as a major benefit for mining companies. The top part of the Yukon has great and underestimated potential from a geological standpoint. The main challenge is the remote locations where you have to bring in all your equipment by helicopter and the short drilling season, which goes from about April/May until the snow comes in October.
TGR: Maybe you can summarize what our readers ought to be doing in the coming months to take advantage of what you think lies ahead.
Florian Siegfried: The key is to see the fundamentally positive development of the industry. Gold mining shares are trading at historically low valuations, e.g., on a price-to-earnings ratio basis or compared to the price of bullion. I would stress, however, that these shares can be very volatile and people can get frustrated if they don't perform. They sell in a down market and then miss the opportunity to buy when the market rebounds. One has to be really disciplined. Never get married to a company, no matter how good it looks. When things move up and get overbought, always take profits and have cash on the sideline to buy into the dips.
But, as long as we have these fundamental problems in the world with money printing and low economic growth, recessions and depressions, it will be very bullish for gold mining companies. In order to outperform the Gold Price, you can't just be long all the time and not trade these stocks. One really has to be more active and when the market is capitulating, you have to pick up your most attractive shares. Always do your own due diligence on these companies. Check out the management and how it does operationally, and look at past track records. Once you have identified the right companies that fit your portfolio, then just try to play the sector in a little bit more of a contrarian way. That's my advice.
TGR: Thanks for talking with us today, Florian.
Florian Siegfried: Thanks for having me.