Hathaway: Trepidation in Gold Mining

Gold Mining equities are spending a lot of money as their stock price lags bullion...

JOHN HATHAWAY is the senior managing director of Tocqueville Asset Management, where he manages all Gold Mining equity products and strategies.

Gaining a bachelor's degree from Harvard University, a Master of Business Administration from the University of Virginia, and also becoming a chartered financial analyst, John Hathaway began his career in 1970, going on to founding Hudson Capital Advisors in 1986, and then becoming chief investment officer of Oak Hall Advisors.

Here, in this special interview with The Gold Report, John Hathaway shares why he is and will remain bullish on gold, the advice he most often gives Gold Mining companies, and the investing advice that has stayed with him for almost 50 years.

The Gold Report: When we spoke last October, you were bullish on gold and Gold Mining equities. You blamed lagging gold?mining stock performance on competition from exchange?traded funds [ETFs], lack of investor confidence and investor doubts on the sustainability of higher Gold Prices. Now that prices are hovering below $1600 an ounce, will that dynamic change?

John Hathaway: The dynamic will change based on higher Gold Prices. When one looks at Newmont Mining Corp., which is trading at about five times cash flow, one has to scratch one's head and say, in a world of $1600 per ounce gold, what is that discounting? The market expects Gold Prices to go lower. Otherwise, at $1600 per ounce gold, a Newmont could trade at least at an eight or nine times multiple of cash flow.

I'm using that as an example. Looking at the research material on Newmont – we included input from 29 sell?side analysts – the consensus expectation for Gold Prices in five years is $1270 per ounce.

That is just one example that not even $1600 per ounce is considered to be a sustainable Gold Price.

But it is sustainable. Up to $2000 per ounce is sustainable. It's something that we can get to. The monetary debasement that we're in the midst of is ongoing. Federal Reserve Chairman Ben Bernanke said on Feb. 29 that there won't be any more quantitative easing. The Fed's minutes reiterated that about a month later. Both times gold took a hit, but it didn't go to new lows, which I thought was pretty interesting. Because for the average person, the narrative for the last two years has been all about QE.

TGR: So if there is no QE, what takes it to $2000 per ounce?

John Hathaway: Gold was going up before QE was even a term in the English language. Gold went from somewhere around $300 per ounce to $800 per ounce before we had QE. The thing that drives gold is not dramatic – it's not like a new round of QE and it's not geopolitical; it's the fact that real interest rates are negative right now, close to 3%. So, if you have money that's saved up and you want to put it in a bank or want to put it in treasuries, you're losing about 3% a year. And you have to think about something else.

You could consider a lot of options. Gold is certainly on that list. Last summer, when gold got to $1900 per ounce, the story was overcooked. The press was hyperventilating about the government shutdown over the debt ceiling and the downgrade of the US debt rating.

We've gone from that situation, where it was basically boiling over, back to a simmer. The stove is still on. Real rates are still negative – with the promise of more of that. I can speculate as well as the next guy can on what's going to be the next thing, and it may be QE. QE could come about simply because the Fed has been buying 61% of all new treasury issuance for the last year. If it goes away, as Bernanke says it will at the end of June, what's going to happen to short?term rates? What's the market going to demand if the Fed's not there buying treasuries?

China's buying a little bit, but it's way down from what it used to buy. In theory, we've got the two biggest supporters of the treasury market, and the principal reason for low interest rates, not being around in a big way after June 30.

TGR: China has been a hot topic: Whether it's growing...whether it's shrinking...just not growing as fast. What impact can China, India, Russia and Europe have on the price of gold?

John Hathaway: Certainly, financial repression is not uniquely American. The Indians see it. The Chinese have it. So, yeah, there's definitely a non?US bid for gold. It's not based on what's happening on the Comex. It's based on the fact that liquid capital cannot get a decent return.

If interest rates went to 5%, which would be a decent return in a world with 3% inflation, that would add in the US $800 billion to the budget deficit. So whatever fiscal rectitude we might be able to gather would be a drop in the bucket compared to another $800bn. That would take our annual deficit to well over $2 trillion every year. It's hard to imagine that. I don't have any answers – I just know that this simple arithmetic doesn't show any path out, other than some kind of money printing.

TGR: I know it's hard to predict dates, but Dec. 31 could be an important date, because tax cuts are going to expire and there will be cuts at the Pentagon and there will be debt ceiling issues. Do you see a lot of hand?wringing leading up to Dec. 31, similar to last summer?

John Hathaway: Whoever gets elected in November is going to be on the hot seat. There will be fiscal drag in spades when the tax cuts expire.

TGR: We talked about companies being profitable at $1600 per ounce gold. High energy prices have taken a toll on mining company performance. How many companies can be profitable at these current prices?

John Hathaway: At $1600 per ounce gold, most existing mines are very profitable. Any company that has a producing mine that's out of the startup stage, where all the money has been spent, is gushing cash flow at $1600 per ounce gold.

You'd have to go case by case for the new mines that they're building. But there are some new mines that are on the drawing board that require $1600 per ounce gold or more to be profitable. The return on capital is likely to be less than anything that's in existence. The market sees that and that's a reason the gold stocks have been penalized, because in order to regenerate what they have, they may not be as profitable as they are right now.

TGR: So the lagging share price would be because they're forward looking?

John Hathaway: That's a possibility. When a Newmont says that it's going to add 40% to the current production base, you know that that's a big capital expenditure. I talked to AngloGold Ashanti Ltd the other day. Last year it generated $800 million of cash flow, which is pretty good. I think the market cap is around $13bn. This year it's spending $2.2bn and it'll eke out some free cash, according to what it's saying right now. That's still pretty good. Here's a market cap of $13bn and the equivalent of about 20% of that is cash flow. What's the presumed return? I know what AngloGold's projects are. They're by and large going to be good projects.

But that's the issue that the Gold Mining industry faces – and maybe a reason for the trepidation – is about the possible blowout in capex. So you have to go on a case?by?case basis and see which companies actually have projects where most of the costs are already dialed in. There are others that are further out in terms of permitting and ordering the long lead?time items – pouring concrete and all that stuff – that might not be producing for five, six, seven years. There you have an issue.

One thing I've been saying to most of these companies is they don't need to grow. They just need to maintain what they have. The market won't mind that, as long as they pay it back in dividends.

TGR: Is paying a dividend a big plus in your stock?picking scorecard?

John Hathaway: Absolutely.

TGR: Do you see more companies moving toward that?

John Hathaway: Yes. They should be paying out more and more. At the current Gold Price, the payout ratio among large producers is less than 20%. It's way too low. One reason it's too low is because mining companies think they have to build all these new projects. But they don't. Their stocks would probably double if they said, "We're just going to maintain steady?state production and declare a dividend of X amount."

But these guys don't think that way because they want to build big mines with shiny new trucks and they want to send their exploration guys out to all corners of the earth. That's their modus operandi. So it's going to take time for the industry to change. The more enlightened management will start to look more and more at restricting capex.

It's not a growth industry. It's a capital?intensive business that's fraught with risk. Why not just take a time?out, generate cash for the next five years and pick spots? They have to build new mines to replace what they have, but they don't have to build so many new mines. If you take the 11 largest gold stocks, gold producers, which account for something like 40% of global production, and you go from 2008 to now, there's been no growth at all in production. They're producing the same ounces that they were producing then. These guys are crazy if they think they can grow. Consider the scale of these big mines and then the risks that the mining companies undertake with government intervention at the host?country level, excess profits tax and you name it – obstacles come in many forms, many disguises. There's going to be a huge headwind.

TGR: Is acquisition the better way to go, instead of exploration?

John Hathaway: Yes. There have been takeovers every year. That's something companies could do. But they can't overpay. Newmont paid way too much for Miramar because it's the frozen north and that mine just isn't going to get built. Newmont has better opportunities. So, acquisitions are fine, but companies have to do a better job of it.

TGR: Some countries are a bit more difficult to do business in than others. What's your take on risk versus opportunity, and what countries do you favor or stay away from?

John Hathaway: We do not invest in China or Russia. Rule of law is the first thing that we look at. But every country has issues, even the US It's a very localized business. You have to ask which state in Argentina is the mine located, for example. Which part of Mexico is the mining company dealing with? You have to generalize about countries, and we do that, but once you've done that, you have to ask about specific locations.

But my general rule of thumb is that local governments will try to hold companies up because they see a Gold Price of $1600 per ounce. Companies have bull's?eyes on their backs. It's cold extortion. "Resource nationalism" is the polite term. It's a way of life; it's nothing new. And so the differences are in how these companies deal with it. It obviously affects margins and profitability.

The game is worth it if the company has a good asset; if the Gold Price is going to do as we expect it to in a world of monetary debasement; and if the country has good geology, a mining culture and some infrastructure. So, for me, the only countries that are off?limits are Russia and China. Also, probably Bolivia, Venezuela and Pakistan. We also look for countries that have a bad temporary rap, as Indonesia does right now. It has just passed a mining law that basically takes some of the equity 10 years out. But then, if the stock discounts all of that, and the company gets enough of a reflection of the obvious problems and it still has a good asset and a decent team of people, then we'll look at something like that.

TGR: You hold about 10% in physical gold; 40% in the larger cap companies, with some royalty companies; 30% in near or small producers and the rest in the juniors. Are you adjusting your portfolio after some of the declines recently?

John Hathaway: We've taken a little money out of the ones that are very fully valued. When something like Agnico-Eagle Mines Ltd. gets beaten up, then we'll look at that as a buy.

We typically have a low turnover; we're not very active in trading. Our basic mix hasn't changed. And we wouldn't change it dramatically because the thing that's given us excess return over the years has been the fact that our average market cap is smaller than that of our peers, at 60% of our peer group, which tells you we're skewed to smaller cap size. Those companies are the ones that can grow. They're the ones where discoveries can make an impact on the valuation of the whole market cap. So, if you don't have those, then you might as well just own Market Vectors Gold Miners ETF. You might as well just own the ETF of big?cap stocks. And we try to do better than that.

But we always keep our eyes on companies, and if the story changes or if there's a valuation question, we'll look to see if we can deploy it in a better way.

TGR: A number of companies have mentioned you as a key piece of the junior mine?building process. How do you decide which companies to participate in, and what are some examples of when you've really been able to make a difference in a company?

John Hathaway: Osisko Mining Corp. is the best example; we were an early supporter of Sean Roosen. This goes back five years or so. He had an interesting thesis that most of the mines in Quebec were very deep because people were chasing grade to great depths. Roosen said they missed all the stuff on the surface. It is much lower grade, but as the Gold Price went up, what was considered to be not worth mining had become economic.

We backed Osisko early on. And then we backed it in several subsequent financing rounds. The miracle of that stock is that Roosen financed a huge capital expenditure through the meltdown in 2008. I would never want to do that again. The result is that here's a company with a new mine – it just started producing about a year ago. It has the usual startup issues, but they're not fatal. And we figure that at these Gold Prices, Osisko's going to generate a lot of cash flow, maybe $600m a year. This is a company that had a market cap five years ago of probably less than a $100m.

TGR: That is dramatic. And you supported him based on the fact that he had an interesting idea.

John Hathaway: And also because every step of the way he had a credible way to deal with whatever came up. And there was always something coming up. He had to move a town. He had big financing problems, as all these companies do when the markets dry up. But he met the challenges very believably.

We do hold investments in some companies that we think are good assets, but we're disappointed in the management. That's better than having bad management and no assets, but it's not ideal. And we make our displeasure known.

TGR: So you're active Gold Mining investors?

John Hathaway: We're very vocal backseat drivers. We see these guys all the time, in all these conferences that we go to and mining trips we take. We're in constant contact. They know who we are. They know where to come for the money, but they know it's not a free ride.

TGR: Any other examples you want to give of how you were an active backseat investor?

John Hathaway: International Tower Hill Mines Ltd has been very frustrating recently. But I've been through it before. The stock has been very disappointing lately, but when I see a good asset like that, it's worth sticking with. We'll get it right. Not on a timing that will make everybody happy, but we'll get it right. And we view it as a partnering. We're vocal shareholders, but we never want to seem abrasive or hostile. Basically, everybody's got an interest in making the thing work.

We've been a long?time investor in International Tower Hill. The market is scared right now because there's a big capital expenditure program. But we've financed the company in several rounds. Before there wasn't more than just a couple million ounces there and today the company claims it could have as much as 20 million ounces in various categories. And it's in Alaska. So when you read all these terrible headlines about Mali and Indonesia, Alaska sounds pretty darn good. Alaska's got infrastructure. International Tower Hill is in a mining?friendly jurisdiction, near Fairbanks. There's every reason in the world it would want to get this thing permitted and built. I think it will. We just have to figure out how to get from here to there.

TGR: What was the best investing advice you ever received – whether you took it or not – or the best investing advice you ever gave?

John Hathaway: I had a finance professor at the University of Virginia in business school, before it was called Darden, back in the 1960s. He was a very conservative guy: He wore both a belt and suspenders – he had backup systems. He said something that I've never forgotten: "To be successful in investing, there's only one thing you need to know. You have to know when to sell." Is that ever true. The most successful investors are the ones who know when to sell. And you only know when that is with 20–20 hindsight. I look back and say, "Should we have sold this stock or that stock, when gold was $1900 per ounce and the pot was boiling?" But then I remember that I'm such a bull on gold. Even though this seems like a short?term peak, I expect the precious metals stocks are going to trade much higher.

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