Smart Spending by Gold Miners
Wednesday, 3/25/2015 10:00
Credit Suisse's 5 principles of good capital allocation applied to gold mining...
RALPH ALDIS, CFA, rejoined US Global Investors as senior mining analyst in November 2001, and is responsible for analyzing gold and precious metals stocks for two of its funds.
Coming from Eisner Securities, where he was an investment analyst for its high net worth group and oversaw its mutual fund operations, Aldis had previously worked for 10 years as director of research for US Global Investors, where he applied quantitative skills toward stocks, portfolio tilting, cash optimization and performance attribution analysis.
Here he tells
The Gold Report why few in the mining industry understand the proper allocation of capital. The valuation of assets also separates the winners from the losers, highlighting principles every investor should consider...
The Gold Report: The price of gold is flirting with a five-year low. Do you attribute this solely to the strength of the US Dollar, or are there other factors at work?
Ralph Aldis: There are other factors. Most important is the strength of the equity markets. Looking at a six-year window, we have seen, for the third time in the last hundred years, the highest returns for such a period. This happened before in 1929 and 1999. These phenomenal returns have been fueled not by fundamentals but rather by the US Federal Reserve, which is trying to jumpstart the economy.
All this has taken people's eyes off gold, but it won't go on forever.
TGR: The bear market in gold equities is now four years old. This means lower gold production and less exploration. Gold production from South Africa has collapsed. Shouldn't lower gold production result in a higher gold price?
Ralph Aldis: Yes, but it's not always linear. The amount of gold mined annually is relatively small compared to total gold supply. That is one of the reasons some people argue that the mines don't matter that much. But I think on the margin they do.
South African gold production has fallen. And not that long ago, the central banks were selling 400-500 tonnes per year of gold to the market. Now, they're buying 400-500 tonnes. China is the world's largest gold producer, but it's not exporting. We can see what's happening and be invested for it, but we don't know when lower supply will lead to higher prices.
TGR: How do you see the mining industry adjusting to lower gold prices?
Ralph Aldis: I look at the income statements from all the mining companies and calculate their break-even point. Right now, it is about $1149 per ounce. The forecasted average 2015 gold price remains about $1200 per ounce. If the gold price continues to fall, companies will adjust. Some projects won't be built, but that is good because those are marginal projects.
About 40 CEOs in the mining industry have lost their jobs in the past couple of years. The new generation of mining CEOs is focused more on profit than growth. They know that even if the gold price falls more, the suppliers to them must drop their prices. If the gold price goes $100 per ounce lower, the smart companies will survive. Meanwhile, gold miners now benefit from lower energy prices, while the stronger US Dollar has been very positive for Canadian and Australian miners.
TGR: Why do you believe gold stocks can still deliver favorable returns?
Ralph Aldis: Because of the mindset of some of these new CEOs. Investors will need to buy very selectively, and they will need to buy those companies that are not growing ounces at thinner margins. Companies that know how to, if necessary, shrink production in order to get acceptable margins.
TGR: Could you explain the "Five Principles of Capital Allocation" and how they pertain to mining, given that mining companies typically have no revenues for years after their founding?
Ralph Aldis: These
five principles are the work of a Credit Suisse writer, Michael Mauboussin. They apply to some companies in the exploration and development phase but obviously more so to producers.
The first principle is "Zero-Based Capital Allocation". This means, for instance, that you don't give your exploration department $20 million this year solely because they got $20m last year. Companies need a strategy to determine the proper amount of capital spending.
The second principle is "Fund Strategies, Not Projects". In other words, capital allocation is not about assessing and approving projects; it is about assessing and approving strategies and then determining the projects that support those strategies. It is a common mistake for explorers to continue to push a project forward – particularly if it is its only project – even though it lacks the potential for great returns.
TGR: What is the third principle?
Ralph Aldis: "No Capital Rationing". Typically, miners believe that capital is scarce but free. They believe that profits are free money, or if they're raising equity, they sometimes don't seem to care enough about dilution. Properly speaking, capital is plentiful but expensive. Profits need to be spent in a manner that results in future profitability. And equity financing is only plentiful if you have a good project.
No. 4 is "Zero Tolerance for Bad Growth". In other words, don't throw good money after bad. Mining companies should always seek to upgrade their portfolios.
TGR: And what's the final principle?
Ralph Aldis: No. 5 is "Know the Value of Assets and Be Ready to Take Action to Create Value". So many people in the mining industry don't know the value of their assets. We value companies based on their resource statements, and we get a very high correlation to where these stocks trade. But we constantly see companies decide to spend, for example, $1.8bn on a project that the market values at only $800m. It makes no sense to spend that much because similar projects could be acquired for less capital.
To sum up, the proper use of capital allocation is to maximize long-term value per share.
TGR: Besides understanding capital allocation, what else do you look for in management?
Ralph Aldis: A significant ownership stake. You get a much higher standard of care when you're an owner instead of a mere manager. Investors need to look at a company's general and administrative expenses, whether it is in production or not. If those expenses are too high, this tells you that the managers' interests are not aligned with the shareholders' interests.
TGR: Realistically, how many gold producers are prudent investments?
Ralph Aldis: Of the 80 or so producers that Western investors can buy into, there are about 20 that get it and have the flexibility to be able to adjust. Not so much the seniors. It's the smaller, midsized companies that have a better handle on their operations.
TGR: Ralph, thank you for your time and your insights.
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