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Investing Like a Mining Fund Manager

Tips from the recent Silver Summit for investors wanting to 'lever' a recovery...

WITH the precious metals markets so beaten up, how is an investor to determine the best way to leverage the upside of any recovery?

At the recent Silver Summit in San Francisco, The Gold Report hosted a standing-room-only fund manager panel featuring insights from three very different points of view.

Axel Merk is the president and Swiss founder in 1994 of the now US-registered Merk Investments. Robert Mullin was co-founder in 2010 and is now co-portfolio manager of Real Assets Equity Income Funds LLC (RAEIF). And Greg Orrell, president and portfolio manager of the epnoymous OCM's Gold Fund, has 30 years' experience across broking, investment banking and money management.

The Gold Report: Do headlines or fundamentals drive metals and commodity prices?

Greg Orrell: It depends on where you are in the cycle. Right now, capital flows aren't coming into the sector, especially in the futures or paper market for gold, which tends to set the price. Everyone is worried about the headline fear of the Dollar being an overweighting factor or a bump in interest rates negatively impacting gold prices. Investors are reacting to the headlines by staying away or pulling money out of gold assets, disregarding strong fundamentals.

Axel Merk: We have seen in our gold ETF that while it has been growing quite steadily, it is doing so at a much lower level. Right now, most of the folks who wanted to sell have sold. A lot of people are on the sidelines, especially ahead of the Federal Reserve rate hike. If we get this rate hike out of the way, those people will stop waiting and come back into the market.

TGR: Are you saying that a rate hike will influence the prices of the commodities or the prices of the equities?

Axel Merk: Everything. Right now, the Dollar is rising on the back of the stock market and falling on bad news. That is an anomaly. As the Federal Reserve tries to move away from 0% interest rates, I happen to think that risk premiums are going to expand again and fear is going to come back into the market. There could be negative consequences for equities and gold could be pounded for that.

Speculative positions, both against gold and for the Dollar versus currencies, are at extremes right now. We may have a sell the news situation. At the same time, I don't see real interest rates moving up any time soon in any significant fashion.

TGR: Should investors be worried about actual commodity prices when they are considering investing in the mining equities?

Robert Mullin: We are firm believers that markets make news. Large moves in underlying commodities or stocks happen, and then people scramble to write reasons why that happened. We look at the commodity price decline, particularly the intense one over the last six months, and we see a fundamental driver behind it.

When the commodities market started to liquidate four or five months ago, the market was sending a very clear message that Glencore and Noble Group had too much debt. Their removal of liquidity is why a small move turned into a very aggressive one.

The commodities market does look pretty washed out and in fact may be modestly below fair value, even though I am not ready to say we have seen bottom. Most of the risk in them looks like it's been priced in.

TGR: What is the catalyst that's going to begin to move the stock prices and the commodities prices up?

Robert Mullin: The narrative that's been built around the most recent commodity price crash is that we have an implosion of emerging market demand. That's been the driver of people who believe Chinese commodity consumption is crashing. I am not buying it. Chinese gasoline consumption is up 10% year over year (YOY). Indian gasoline consumption is up 15% YOY. That does not indicate major emerging market economies contracting. I agree Brazil is a basket case; Russia is a basket case. But we think a number of the emerging markets are actually growing quite strongly.

The time will come when the energy markets turn. For mining guys, that's a tough one to swallow because you want oil prices to stay down, making your mining more economic. But I think energy is the quickest self-correcting of the commodities because you pull back spending and it immediately translates into production. If we're right and if oil starts to turn around in Q1 or Q2/16, it dispels this narrative that the emerging markets are imploding. If that narrative is taken away, then I think all commodities can start to benefit again as optimism returns.

Axel Merk: The farther you get away from China, the more pessimistic people seem to be about it. Clearly, there are some challenges. But Australia, which is closest to China, seems to have found a bottom, so that's encouraging.

We look at the market less from the producer side and more from the currency side. Most people may not realize we are still at zero with interest rates. The rest of the world is going to go further down and the Eurozone might go further down as well. So much good news is priced into the Dollar that we have to come back to reality at some point. In the medium to long term, I don't see how we can afford positive real interest rates.

Even when nominal interest rates aren't zero, historically physical gold and silver have performed because real interest rates aren't all that great. In the meantime, people are shell shocked. I happen to think the catalyst for higher commodity prices is going to be lower overall equity prices. Risky assets have been moving higher and higher as investors are being told that central banks will come to the rescue. As the Federal Reserve is trying to extricate itself from this position, fear may come back to the market. That sort of environment will be negative for risky assets. The money will have to go somewhere and I think commodities are going to be the beneficiary. I like gold because I like to keep it simple.

Greg Orrell: For overall commodities, debt liquidation is in the cards so credit quality comes into question. That's where gold actually outperforms all asset classes because of its historic monetary role as money and not debt. The explosion of debt over the last seven years had led to misallocation of capital, which we've seen across the board. That has to be unwound. A lot of the markets are indicating that commodities have too much capacity built up relative to demand. If the Fed raises rates, a rush of investment capital could be looking for safety because of the fear of the debt unwind. That will push funds toward gold. At the same time, you could still see oil and copper rolling over if the economy is weak.

TGR: Should investors wait for commodity prices to start going up or are there opportunities in equities now?

Greg Orrell: The whole industry – especially the gold sector – is going through a fundamental change because of the introduction of ETFs. Before, investors could find leverage to gold through mining companies and there was an optionality value inherent to the mining shares along with value to the reserves in the ground. Now, there are other options. That means the mining companies have to have a more sustainable business plan. In the past decade, the mining companies debased their shareholders more than the central banks debased their currencies. The resulting negative sentiment in the mining sector from investors has been absolutely horrible for good reason. Now the mining companies are supposedly listening to investors. They are getting their acts together, but the quality of management across the sector is still a bit suspect. The ones that want to hold equity dear are pretty limited. For this business to be sustainable, the returns have to be higher. The industry still needs to shrink just because there aren't that many economic deposits out there.

Robert Mullin: Analysts go through four stages in analyzing a company. The first stage is when a guy comes into your office with a map and some overhead shots, shows you some land and gesticulates wildly. It might be a geologist or a lawyer, but they all fall under the realm of promoter. In order to invest, you have to believe in the information that they give you.

Stage two is when they actually drill. While there is a lot of information in the results, it's very difficult to interpret the translation into a confirmation of an economic deposit. Brent Cook is on the shortlist of people who have that skill set.

The third stage is a feasibility or a prefeasibility study where the accountants figure out what it's going to cost to make a deposit into a mine. That tells you how diluted you're going to get on the way. The last stage is the one that we like to concentrate on. It's a little known document released quarterly called the statement of cash flows. We think that the statement of cash flows is the ultimate arbiter of whether a deposit is economic.

When you can find companies, even in this environment, where at $1000 an ounce ($1000 per ounce) gold you can have growth capex, sustaining capex and pay a dividend and put cash on the balance sheet, that is an economic deposit. In a bull market, that's not terribly sexy because everybody knows about it, but in a bear market where everything's been thrown out together, there are some really extraordinary opportunities in companies like that. They may not deliver as much ultimate upside, but their limited downside offsets that, in our opinion, more than fairly.

Axel Merk: All of this is in the context of price. When companies fall out of favor, a lot of bad news is priced in. Mining companies have had the sins of the past priced in. The new focus on cost could reap some benefits. Different stages of companies come with different risk profiles. Juniors are highly speculative, but if you know what you're doing, there are some great opportunities. The majors are a little less dependent on credit, but subject to other dynamics. On the commodity side, it's different still. When you compose a portfolio, it's about what risks you can afford to take and where you want to place your bets. Do you want to do it where everything is popular or do you want to do it where everything is out of favor? Out of favor and cash flow positive is my choice.

TGR: What else should investors consider when looking at juniors or small-cap mining companies?

Greg Orrell: Small Canadian and Australian producers are already outperforming the majors. But investors still have to look for companies that can sustain themselves without having to issue equity. One of the things that we had an issue with is companies trading Dollars. If the gold price goes up, they continue to lower the cutoff rate, so there's no margin. Historically, investors bought gold shares as leverage to the gold price. If the gold price was $300 per ounce and it goes up $100 per ounce and cost was $200 per ounce, you would have a 100% increase in cash flow. That leverage never translated on this last cycle because costs rose as fast as the gold price.

Investors need to focus on a company's ability to generate free cash flow. Can a company deliver a dividend? One of the things that really irks me is companies that take money from this hole in the ground, put it in another hole in the ground, and never pay their shareholders. I want to see project returns in the 30%-plus range because that's going to allow a company to be able to pay off capital. That doesn't necessarily mean a mine has to be funded with all equity. If the project is good enough, it should be able to support some debt. If the assumptions are correct, the capital will be paid off with cash flow, there will be money for shareholders and there will be money to sustain the business without having to go through a dilution cycle. That's how you grow shareholder value. That's the road forward for this industry.

In order to do that, we will have to focus on smaller projects. These big 4 or 5 million ounce projects are not real ounces in terms of economics. There might be 1.5 Moz that are economic of that 4 Moz. There is a lot of attractiveness to projects with smaller market caps and bigger rewards for shareholders.

TGR: Thank you all for sharing.

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