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Stock Picker's Market in Gold & Silver Miners

JOE REAGOR is a research analyst with ROTH Capital Partners, providing equity research coverage of the natural resources sector.

Previously working in equity research at Global Hunter Securities and at Very Independent Research, covering a wide array of resources companies including metals (steel and aluminum), mining (gold, silver and base metals) and forest products (containerboard, OCC, UFS, and pulp, Reagor today says that picking gold and silver equities in a stagnant price environment is a stock picker's game that requires a particular thesis – and a fair portion of patience, as he explains here to The Gold Report...

The Gold Report: In a report from RBC Capital Markets in late January, the firm said gold could reach as high as $1200 per ounce in the short term but remains in an overall downward trend. Does ROTH Capital Partners share that view?

Joe Reagor: A lot of people are reacting to a bounce in the gold price here in early February and need to set a number, but they still believe the factors that have held gold down over the last few years remain intact. Our view is a bit different.

Gold at $1100 per ounce is not a sustainable long-term scenario. The costs of production are still relatively high, and they're only going to get higher as companies mine higher grades to lower costs. Miners did this in the late 1990s, and that's why gold moved higher for 12 straight years in the 2000s before we had a healthy pullback. We think we're heading toward the end of the 1990s time frame again, where the fundamentals will drive the gold price higher.

TGR: Please explain those fundamentals.

Joe Reagor: Gold can't go much lower without costs having to adjust lower. The strength of the US Dollar helps non-US producers somewhat, but in general, the fundamentals suggest that if you want an industry to survive, it needs a 20% profit margin. If all-in sustaining cash costs are $1100 per ounce for gold, then you already need over $1300 per ounce to sustain the business. That is where gold needs to be in the long run or we won't have as much gold production for the world to consume.

TGR: The Bank of Japan recently cut its interest rate on bonds to minus 0.1%. In fact, much of the global economy now is in a negative interest rate environment. Is deflation now the global economy's greatest threat?

Joe Reagor: Deflation and inflation are difficult to peg. The governments of the world are good at spinning numbers to make them look like what they want them to look like. But loose monetary policy usually drives inflation – it just doesn't always drive the type of inflation that the government is seeking. Governments might insist we're in a deflationary environment, but that doesn't mean that the consumer or the investor is seeing deflation. Loose monetary policy is usually good for gold, and gold generally goes up with inflation. It's hard to say exactly what side of that fence we're on. The inability of lower interest rates to drive more economic growth is a real concern in the near term.

TGR: The global economy clearly has more faith in the US Dollar than in gold. Is that a case of misplaced faith?

Joe Reagor: Yes. We're the best of the worst, and the US Dollar is valuing up as most other currencies are devaluing. That can only go on for so long before the global recession finds its way back to the United States. Eventually the US Dollar momentum trade could come to an abrupt end and that would be good for gold. People know that but they're making money in the US Dollar trade. Similar to mortgage-backed securities and credit default swaps, people are taking advantage of it and hoping that they aren't the last person into the trade.

TGR: How does ROTH Capital Partners expect gold to fare amid all this uncertainty and fear in the global economy?

Joe Reagor: In the near term, we expect to see a slow, steady recovery in gold prices – $1200 per ounce seems reasonable. A healthy, slow, steady recovery in gold is possible based on more and more people moving away from the US Dollar and into gold as a store of value. If there is a global recession and it becomes obvious that it is going to be a multiyear issue, gold could see a big increase in value.

The big key is China. If China's growth rate continues to decline, that would significantly impact the world economy. Perhaps China can find new ways to spur its economy to continue to grow at closer to Third World than First World rates. If it does, there's some question as to how it funds that. It could sell our debt, which would likely result in a devaluing of the US Dollar and give it the funds it needs to start public works projects. The rest of the world could, in a sense, come out of recession but at the same time still cause gold to go up by devaluing the Dollar. There are lots of avenues where gold goes up, and very few where we see further decline toward that infamous $1000 per ounce level.

TGR: So you don't dismiss what's happening in gold as a strictly seasonal event.

Joe Reagor: There's usually a bounce in January following a down year, and in December we were talking to our clients about this possibility. But at the same time, we expected that without the world economy slowing and the US stock market pulling back. Now there are potential concerns about how the US Federal Reserve reacts or overreacts to the pullback in the market. The first move from $1050 per ounce to $1100 per ounce was seasonality. Now it's a little bit of a fear trade, in our view. Therefore, there's more room for it to run.

TGR: Silver typically fares worse than gold in a bear market given its heavy industrial use. How do you expect silver to perform in 2016 and into next year?

Joe Reagor: A lot of silver production comes from byproduct production, but the straight silver producers are not in a position to weather a lower silver price. The silver-only producers are near break even with their all-in cash costs. Maybe the silver-gold ratio could expand to 80:1 or 82:1, but we're expecting gold and silver to start to recover, and then as you get a recovery, the ratio usually contracts. The gold market is so many magnitudes larger than the silver market, so as people try to buy into the silver market, they can really move the needle. Once the recovery takes hold, we expect some form of contraction of the silver-gold ratio back to 70:1 or 65:1.

TGR: Do you see the US adopting a negative interest rate policy?

Joe Reagor: I don't think the Fed would re-lower rates. If the Fed decides to do some additional form of quantitative easing, it would do so in other ways. Lowering interest rates would send a very negative signal.

TGR: Is it more imperative now for a precious metals research analyst to have a firm grasp of the macroeconomic picture than it was pre-2007?

Joe Reagor: It's important for us to be aware of macroeconomic events but the investment strategy that we are recommending to investors is not one that relies on gold going up or gold going down in order for them to make a profit on an investment. Our approach targets the right companies in the right positions at the right times. That's been lost in this downturn. The fundamental side of equities has gone by the wayside, and stocks are trading very much with the gold and silver price until these companies make an announcement that no one was expecting.

TGR: So it's a stock picker's game.

Joe Reagor: In a down market it has to be. In an upmarket, everybody is a winner. In a downmarket, it's a matter of picking the winners and avoiding the really big losers. If you can avoid those and invest in names that have upside, whether gold is up, down or flat, then you can still make money in this market.

TGR: Please give us your investment thesis for precious metals producers and development-stage equities.

Joe Reagor: There are two types of producers that we look at as good investments. The first type are generally larger-cap defensive names that have succeeded in growing production and revenue, despite the down gold market.

Another type of producer is one that has made material changes in terms of costs, production, acquisitions, balance sheet or a change in company philosophy, yet really hasn't received much credit for those changes because these stocks typically trade with the gold and silver price.

TGR: What is the thesis for developers?

Joe Reagor: There are two types of development-stage companies we like to target. First are those companies approaching a construction decision on an asset. This generally results in some short covering.

The other comes down to companies that own assets that are clearly needed by a neighbor that's a larger company.

TGR: Investors remain nervous about precious metals equities and the resource sector in general. What would you tell them to allay their fears?

Joe Reagor: It's a matter of risk tolerance and time horizon. If you're expecting to invest in gold and silver stocks and see an immediate return, it's probably not the right investment for you. But if you have the mentality that you're going to buy some defensive positions or some positions where there's a clear catalyst 6 to 12 months out and you're going to hold them with that time horizon, things could work out.

TGR: How do investors muster the courage to dip their toes in these waters?

Joe Reagor: Any investments in this space need to be part of an overall portfolio that balances out the potential swings in the overall economy. When the economy is pulling back, generally speaking, that's good for gold and silver, and you need to have a small piece of those investments to properly balance out your portfolio so that when things slow down – as they are this year – not everything on your screen is red.

TGR: Thank you for talking with us today, Joe.

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