The Gold Mining Pendulum

"The more the mining companies fail, the more investors simply turn to gold itself..."

ADRIAN DAY, principal of Adrian Day Asset Management, which manages portfolios for high-net-worth clients, believes that it is time for the gold pendulum to swing away from the excessive pessimism in the market.

In this interview with The Gold Report, Day explains why gold is ready to rebound and why prospect-generator and royalty companies are king. 

The Gold Report: Some investors think that we won't see Gold Mining stocks come back in a big way. What do you say to them?

Adrian Day: With regard to the seniors, we are not going to return to the valuations that gold stocks have traditionally enjoyed, gold stocks selling for 40, 50, 60 times earnings. With regard to the juniors, we've had this sentiment before. The juniors are incredibly volatile, and we go through these periods of excessive optimism and excessive pessimism. 

At the end of 2008, clients called me, wanting to go 100% to cash because they thought these juniors were finished. The key is to buy quality companies with quality management and strong balance sheets and then, even if it takes another year or two, you know they're going to survive.

TGR: In your book Investing in Resources: How to Profit from the Outsized Potential and Avoid the Risks (Wiley, 2010), you said that majors often focus on a single property when they're looking at takeovers, and you even suggested some takeover targets. Do you believe that they still remain targets?

Adrian Day: Many of them. But with the prices that we've seen recently, several juniors with attractive properties have essentially taken themselves off the market for now. 

TGR: You suggest in your book that anytime the ratio of the Philadelphia Gold and Silver Index (XAU), which is the gold and silver index traded on the Philadelphia Exchange, to the Gold Price is five times or higher, it's a good time to Buy Gold companies. As of July 23 the ratio was almost 11:1. Does that mean that rule of thumb needs an adjustment, or does it mean that it's an exceptional time to Buy Gold companies? 

Adrian Day: A little bit of both. The S&P/TSX Global Gold Index is now at its cheapest level relative to bullion since 1986, the beginning of the bear market. The XAU Index of senior North American gold and silver stocks is now cheaper than the S&P. I can't remember a time when the gold stocks were cheaper than the broad market. 

We have to recognize that, for the most part, gold companies have not been well-managed companies over a long period of time. They've generated horrible returns, overpaid for acquisitions and management has issued too much dilutive equity. 

Ten years ago, if you were a generalist interested in gold, you looked at the big mining companies and you hoped that the Gold Price would bail you out and take care of all the problems. Now there's competition from the exchange-traded funds (ETFs). An investor can buy an ETF and get direct exposure to gold without worrying about cost overruns, overpaying, dilution and everything else. The more the big companies fail the more big investors simply turn to gold itself. 

We shouldn't forget that mining is a difficult business. But mining companies have not been their own best friends, and investors are becoming more and more unforgiving of corporate errors simply because there is an alternative now. Over the last 12 months, the big companies seem to be getting the message. The move toward mining companies paying dividends, for example, is part of their response to the accusations of fiscal irresponsibility. We're not going back to the days of the XAU selling at 60–70 times earnings multiples, because now there's competition, ETFs, which there wasn't in the past.

TGR: How does a 30% rise in the Gold Price mean a 140% increase in the margin of a major producer?

Adrian Day: If the price at which you sell your product goes up at a faster rate than your costs, that's when you get the leverage. For example, when gold is selling at $800/ounce (oz) and your costs are $600/oz, you've got a 20% margin. If gold goes to $1,200/oz and your costs go up to $800/oz, you've now got a 50% margin. In the last five years, we've seen costs go up dramatically: for energy, which is the major component for mining; labor; mercury; truck tires; currencies. 

For instance, if a Canadian company has mines in Brazil and Australia, until recently, those currencies were both going up a lot more than the Canadian Dollar. The margins were pretty static from 2001 all the way through to the end of 2008—we didn't get any leverage expansion at all. 

TGR: What about dividend yields? Are your clients seeking yield?

Adrian Day: My clients are certainly seeking yield, but I don't Buy Gold stocks for dividends. 

TGR: Let's focus this on another segment of the business that you like: the prospect-generator model. In your book, you illustrate your point by noting that some prospect generators actually end the exploration season with more money than when they started due to the various JV agreements that they have in place. What is this model, and how do the good prospect-generator companies make it work?

Adrian Day: As the name implies, these are exploration companies that generate prospects. They then tend to JV those projects with companies with money to spend. The generation of prospects, while not easy, is not high cost. When the prospect generators get to the high-cost point of exploration and development, they look for a partner to spend the money. I like the model because it enables the exploration company to maintain its balance sheet. It doesn't have to keep going back to issue new dilutive equity, and it's able to build portfolios of exploration projects. Consider companies that have been around a little while and have interest in not just three or four properties but 10 and 20 properties. It's a little bit like owning shares in lots of lottery tickets instead of just one whole lottery ticket. It increases your odds of discovery in what is a very long-odds enterprise, looking for a gold discovery. It's said that only 1 in 5,000 anomalies ever becomes a mine. The prospect-generator model doesn't guarantee success, but it means that the company can stay alive to fight another day.

How do the good prospect generators make it work? They maintain discipline to the model so that they maintain their balance sheets, and they strike good JV agreements, meaning they maintain the greatest share of their property while incentivizing the other company to spend money. 

TGR: We're seeing a big selloff in Western markets as Spanish bond yields are at record Euro-era levels, and there are whispers that Germany could force Greece out of the Eurozone. Is now the time to head to the royalty model, which is likely the lowest risk play in the gold space?

Adrian Day: I've always liked the royalty companies because they are a low-risk model. In this business, you have enough risk to begin with, whether it's misappropriation or the geology not turning out the way you thought it was going to turn out. And I've always felt, if you buy really good quality companies, not just in resources, but in everything, where you are focused on the downside, the upside takes care of itself. When gold goes to $2,500/oz, the quality companies will move. You don't have to worry about it. 

TGR: Do you have any other advice for investors?

Adrian Day: Number one, understand what you know and what you don't know. If you're not a geologist, don't try to be one. Focus on the things you can understand, like a business model, management, balance sheets. Number two, stick with quality. I would rather pay up to quality then underpay for junk. 

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