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Back to 2003 in Commodities

Frank Holmes outlines demand developments in natural resources...
FRANK HOLMES is CEO and chief investment officer at US Global Investors Inc., which manages a diversified family of mutual funds and hedge funds specializing in natural resources, emerging markets and infrastructure.
Holmes purchased a controlling interest in US Global Investors in 1989 and became the firm's chief investment officer in 1999. Under his guidance, the company's funds have received numerous awards and honors including more than two dozen Lipper Fund Awards and certificates.
A regular commentator on the financial television networks CNBC, Bloomberg and Fox Business, Holmes has been profiled by Fortune, Barron's, the Financial Times and other publications. Here he speaks to The Gold Report about his outlook for a sharp surge in natural resources demand worldwide...
The Gold Report: You recently wrote an article called "It's Morning in India" that marked the election of Narendra Modi's pro-business government. How much of an impact can one man have on the demand for commodities?
Frank Holmes: At US Global Investors, we believe that government policies are a precursor to change. That is why we focus on fiscal policies all over the world to understand the impact they will have on everything from interest rates to money supply. What makes Modi special is that he understands that job growth and creativity come from fiscal stimulus. Creating tax-free zones, breaking up monopolies and streamlining regulations and bureaucracy can unleash intellectual capital. Modi's track record in the state of Gujarat illustrates his ability to produce significant growth. He is a no-nonsense, pro-business person.
TGR: Let's look at what you have called the love trade. Its traditional seasonal impact on the gold market was quashed by taxation and import bans. How much of an effect could the pent-up demand have on the gold price if the government eliminates those disincentives?
Frank Holmes: India is a big market and it can have a big impact. There is a high correlation of rising per-capita GDP in China and India and rising consumption of gold for gift giving. In the past three years, global GDP has shrunk from 5.5% to 3%. This year, it looks as if it is going to be back up to 3.5%. Growth and prosperity in America creates an economic sounding board that creates money around the world. Add to that the demand created by the religious holidays in the second half of the year – first Ramadan and then wedding and Diwali seasons, followed by Christmas and Chinese New Year – and it looks very positive.
Even J.P.Morgan Chase's Global PMI, the Purchasing Managers' Index is looking up. The forecast of the next six months of economic activity shows the 1-month above the 3-month average. When that happens, consumption usually increases significantly in all commodities.
TGR: Let's quantify the term "significantly." Are we talking about a 2% increase? A 10% increase? More?
Frank Holmes: Well, that's hard to say, but I have a suspicion that gold can easily jump 30%, up two standard deviations, because it's been down two standard deviations. Meanwhile, gold stocks are cheaper today than they were during the crisis of 2008, relative to the price of gold. So if we have a 30% increase in the price of the gold over the next 12 months, the gold stocks could rally 60%. For that to happen, we would have to see peace and prosperity in China, India, Southeast Asia and the Middle East, because that really triggers the consumption of gold.
TGR: How do you determine what companies in your portfolio are poised to do well if the gold price increases?
Frank Holmes: Quality of management is a key factor. We look for technical engineers and geologists, but also at whether leadership understands the capital markets and has relationships with newsletter writers, buy-side and sell-side analysts. Those companies that have those relationships when they come out with news will enjoy a better response in the capital markets. So the quality of senior management is very important.
Our investment philosophy is driven more by the quality of the company rather than by leverage to the gold price.
TGR: Well, this isn't as sexy, but what about nickel and steel?
Frank Holmes: Nickel is much more of a straightforward supply-demand story. Nickel is used in alloying steel, including the steel that will be used in the $550B pipeline China is building to Russia. If there is a supply shortage out of South Africa and mines shut down in North America, the price could immediately go up. Copper levitated a couple of years back even though the economy had slowed because earthquakes and strikes impacted the supply. If we get any type of supply constraints, then prices could change quickly.
Right now, we have an oversupply of steel. The Chinese have been dumping steel on the world. But that pipeline agreement with Russia could be a signal that the country is embarking on an infrastructure boom that will absorb a lot of the steel. Combined with Modi's infrastructure ambitions in India, that could mean a lot more demand for steel and copper.
TGR: Are you predicting the same significant impact as in gold, a couple standard deviations?
Frank Holmes: I think we have the potential for one of those great global rallies we witnessed in 2003, 2004 and 2005. If China and India start building meaningful projects for their people and we get a bottom in Europe, with America on an upswing, I think that we could see a global surge. It's not going to be as inflated as it was in 2003 because the housing component is not going to be as leveraged. Housing has the highest multiplying effect for money because so many people touch each Dollar to create a house. Therefore, I don't think we're going to get close to the surge we had 10 years ago, but I do think we can get at least three-quarters of that.
TGR: Your Holmes Macro Trends Fund (MEGAX) is a diverse basket of industrial, energy, technology, healthcare, consumer product and financial stocks that are impacted by the macro-issues you just outlined. What criteria do you use for building that portfolio?
Frank Holmes: We look at companies that are actively growing their revenue more than 10%, generating bottom line up to 20% return on their equity, and demonstrating 20% growth in earnings.
As John Derrick described in his Periodic Table of Sector Returns, we can learn a lot by examining movement in the top sectors. This is an amazing indicator. We track quarterly how many S&P 1500 companies across all sectors qualify for this beauty contest. This past March the number went from 160 names to 180 names even though GDP was down in America. That shows wonderful, broad-based economic growth. Back in the peak of 2006, it was over 200 names, then it fell down to under 100 names. So it is going in the right direction.
Another positive is that industrials are strong, and that is usually highly correlated to the consumption of commodities and good for per-capita GDP because wages are typically more than $15/hour in that sector.
TGR: More than half of the Macro Trends Fund is composed of large-cap, over $10B companies. Are you worried about a bubble in the large indexes?
Frank Holmes: The word bubble has been abused. If you research the causes of a true bubble, it's usually excessive leverage, borrowing. The great crash of 1987 when investors lost 40% of their wealth in two days was predominantly because the S&P futures market was leveraged 10:1. In the crash of 2008, we had a housing market leveraged 90:1. Today, there is some concern about leveraged buyouts, but governments are going to have to keep interest rates negative or extremely low to counter regulatory creep and keep the economy moving.
TGR: So you think today's stock prices correlate to the true value in the companies?
Frank Holmes: Sure they do. Look at dividend yields. A 10-year government bond is 2.5%, and you can buy some of these big-cap stocks with a dividend yield greater than 10 years out. We don't know who will be president 10 years from now, but we do know we will still be using Procter & Gamble's products and drinking Coca-Cola.
Plus, fewer companies are issuing stock options. Instead they are giving executives stock grants over five years so there's a real aligned interest for senior management in these companies to buy back their stock, and increase their dividends against their cash flow. Look at Apple Inc. (NASDAQ:AAPL). It announced a 20% buyback; revenue per share is jumping 20%. That's profound. There are very few IPOs relative to companies buying back their stock and increasing their dividend. That means the stock market is still very attractive.
TGR: Thank you for your time, Frank.

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