After the 'excesses' of the boom, now comes the deflation of cost for miners...
MARKUS BACHMANN has advised the Craton Capital Precious Metal Fund since its inception in 2003 and has more than 18 years of experience managing and advising natural resources and related portfolios.
Formerly at Credit Suisse (in corporate finance) and UBS (as analyst and fund manager for SBC Brinson) in Zurich, Bachmann holds numerous awards for fund management.
Now, from his perch in Johannesburg, the Swiss-born Bachmann tells The Gold Report here why the days of mining company managements using shareholders to support their lifestyle may be nearing an end at last...throwing off free cash-flow even with depressed gold prices and so offering opportunities to get in on the ground floor of turnaround stories.
The Gold Report: What are the indicators you watch when evaluating the fundamentals behind gold, silver and copper? Are you looking at financial policies in the US? Gross domestic product in China? Economic headlines from Europe? Something else entirely?
Markus Bachmann: Those are all short-term catalysts. A potential interest rate increase in the US might be a midterm overhang, but it could also be a catalyst. We shouldn't overanalyze the gold market. The gold market will do what the gold market will do. It often comes down to a longer-term sentiment. We learned over the last few decades that gold moves in rather lengthy cycles.
One fallacy is that gold is a safe haven. During a financial crisis like the one in 2008, gold is often used as a source of liquidity of last resort. That's why when the world goes to pot, gold declines because it is being sold into a falling environment to fulfill margin calls or it is sold because other assets are falling even harder.
Distressed financial markets, as we saw when the Shanghai Composite declined and corrected significantly over a very short period of time, can put pressure on the gold price, too. We suspect a lot of gold was released into the market during what many thought would be a positive for the shiny metal. The reality is that gold was used as collateral to buy equities by some of the Chinese investors.
All of these headline issues might have a short-term news impact or a midterm overhang, but overall, they don't move the needle. We don't know when the sentiment in favor of gold is going to turn, but it will. It may depend on where you sit. An investor in Sydney, Australia, probably sees gold's value in Aussie Dollars completely differently because it had a great return over the past two years. Someone sitting in New York, Los Angeles or San Francisco will use a US Dollar measurement and had a negative return over the same time period.
Calling the market can be a fool's game. It's difficult to say that June/August was the bottom for gold after a four-year correction. We're a little cautious. We are convinced it is the last curtain call approach for a correction. Gold always has a few tricks up its sleeves, but I think we are probably close to 97% through. While we are waiting for the last act in the metals correction, investors should watch it very carefully and keep their powder dry. Companies are sweating costs out, capital expenditures are falling and a free cash flow cycle is emerging. If gold turns the corner it will trigger a strong recovery in equities. But to call the bottom in bullion I would like to see an increase to about $1280 per ounce for the multiyear low to be confirmed.
Plus, the investing world became much more complex over the last few years with the introduction of algorithmic trading. That makes everything more challenging to try to understand the direction.
TGR: How does your understanding of the cyclical nature of commodities, including the cyclical nature of all-in costs for mining companies, impact your investing strategy?
Markus Bachmann: The high cost inflation we saw from 2003 to 2012 was a function of the biggest investment cycle of the past 200 years. That investment boom led to a lot of capital chasing a very limited pool of skills, labor, equipment and contractors in a neglected sector. The result was massive cost inflation and company excesses.
Since the investment cycle peaked in 2012, costs have moved into a deflationary direction. Shareholders have forced companies into austerity mindsets. Capital investments are coming down dramatically. For the first time, shareholders could benefit. For years to come, we could enjoy good free cash flow generation. That cycle of declining costs has a lot of legs across the sector.
TGR: You are a Swiss-born fund adviser living in Africa. How does that impact your analysis?
Markus Bachmann: The Swiss aspect is that we might be a bit pedantic when it comes to numbers. We want to find the reasons behind a specific event. The African component is that we learn to improvise because often things do not work the way they should. That is great preparation for operating in commodity markets. Particularly in the gold space, you always have to expect the unexpected because there is no fixed rule book.
In Johannesburg, we are very close to the commodity complex. The city is actually built on gold and mining tailings. My children go to school with the children of owners of iron ore mining companies, suppliers, refiners and financiers. We live very tangibly with the ups and downs of the commodity cycle every time we go to a barbecue.
TGR: What do you consider to be countries with manageable risk?
Markus Bachmann: It's a tricky question because, again, there are fallacies. You would think that a First World country is a safe jurisdiction to operate in, but you have a lot of regulator risk in places like the United States. While you may not have people protesting at your factory gates, you might have lawyers harassing you, and legal bills and fines can be excessive. Mexico has its own different challenges. It's a very prospective mining domicile, but companies need to give the security aspect a high importance. That goes for places in Latin America, like Colombia, as well.
It might actually be easier to operate in a country perceived as a "challenging environment" because the political system is less stable and the infrastructure is underdeveloped. There are domiciles to avoid, places with hostile mining policies or a lack of rule of law. I would probably include South Africa in that category. But by and large, I think every domicile is workable with a few exceptions. If you show respect, work on relationships and stand your ground, you can be successful almost anywhere.
In particular, we like Canada. It has a clear regulatory environment, great infrastructure and a skilled workforce. To a large extent, that applies to Australia as well. China has suddenly started to make acquisitions in domiciles like Canada and Australia; that tells you a lot.
TGR: Can companies in Canada and Australia take advantage of the exchange rates to help cash flow and profitability?
Markus Bachmann: Most definitely, but these things can go both ways. Australian gold producers have definitely benefitted from a favorable exchange rate environment. African costs are often linked to the Euro. That has also been favorable in comparison to the US Dollar over the past couple of years. Companies can take advantage, but the exchange rate is the wrong tool to bail you out when you do a bad job. It might be a bit of a tailwind, but first and foremost, you need to do a good job on the ground by being very cognizant of your cost structure.
TGR: How do you use that unique perspective to evaluate companies?
Markus Bachmann: We have very simple investment criteria. We consider companies that do not manage more than five different assets. We are of the view that even a very good management team is not able to efficiently manage more than that, particularly if the portfolio includes geographical diversification.
Another criterion is that companies be run as proper businesses, not lifestyle projects for management. Management must align its interests with the interests of shareholders. We look for companies that are able to self-fund future growth with generated cash flows and just a little bit of outside funding. We look for companies that are able to extend their life of mines, usually through exploration. Companies have to be able to be successful in today's metals price environment and have a sound balance sheet, operating in the lowest quartile of the cost curve. That filter gives you a relatively limited number of companies to look at closer.
TGR: You've talked about the importance of management teams that have interests aligned with shareholders. What's an example of someone who knows how to make projects work?
Markus Bachmann: We can give you a long list of examples of how it shouldn't be done. But one that is doing the right things is Brad Mills, founder of Plinian Capital, who runs an operationally competent and financially savvy team. His investment company is acquiring underutilized, unloved, underexplored and badly managed assets and turning them around. The company has avoided the huge correction that took place over the past few years. Most important, it is a substantial owner in the companies it takes an interest in and pays themselves dividends in line with all other shareholders instead of taking obscene salaries.
TGR: What words of wisdom do you have for investors who are looking to adjust their portfolio to fit a changing resource world?
Markus Bachmann: Gold moves in big cycles. It is at the inflection points that you make the best returns. Right now, the gold industry is going through a significant change and costs – including long overinflated management costs – are coming down significantly. That will lay the foundation for much healthier companies with stronger balance sheets and lots of cash that, hopefully, will be distributed to shareholders.
TGR: Thank you for your time, Markus.