Gold Mining: A New Strategy

Why cost control is trumping M&A...

A SLUGGISH US economy is creating a positive environment for gold, according to Michael Fowler, senior mining analyst with Loewen, Ondaatje, McCutcheon Ltd. By calculating ounces-in-the-ground values and assessing for risk, Fowler has concluded, in this interview with The Gold Report, that the junior/midtier sector offers the best growth potential. He expects to see companies of all sizes try and control costs instead of looking for mergers and acquisitions to add value. 

The Gold Report: Michael, in August you said $2,000/ounce (oz) gold would push up equity prices in 2013. Are you still of that mindset?

Michael Fowler: Yes, although it has taken longer than I expected. The US Dollar price of gold was up 6.2% in 2012, but the real increases in the gold price took place in other currencies. For example, in 2012 gold was up about 15% in the Euro. The strengthening US economy has been a headwind to gold. I remain bullish on gold and am keeping my $2,000/oz average for 2013.

TGR: A $1,675/oz gold price would require an increase of almost 20% to reach $2,000/oz. Will it require a downturn in the US economy to accomplish that?

Michael Fowler: To some degree, I hope the US economy will not speed up because that would be a major risk to my analysis. The US economy is relatively lackluster. We think the Fed will continue with quantitative easing and increasing the money supply. Interest rates will continue to be low. All of that creates a very positive environment for gold. 

The risk factor here is that if the US economy does speed up and outperforms expectations, it will create a renewed headwind for gold. However, that is not my scenario right now. I think the US economy will move along at 1–2% growth rate per annum, basically static.

I expect more quantitative easing around the world will cause gold to rise. Japan, for example, is intent on devaluing its currency. In Washington, D.C., the recurring debt ceiling debate may be a potential flashpoint. Potential downgrades by the rating agencies and the Federal Reserve continuing to buy up bonds are other factors. 

TGR: Tom Albanese was sacked in mid-January due to a $14 billion (B) write-down on assets, mostly owing to overpaying and takeovers. Similar firings have happened in the gold space. Do these dismissals signal a changing mindset toward merger and acquisition (M&A) activity among the largest players?

Michael Fowler: Yes, I think so. I am not predicting numerous M&As, although I would suggest that this is a good time to acquire. 

The CEOs you mentioned made acquisitions at the top of the market. Major strategic mergers are, in my opinion, value destructing. I do not think we will see another major merger or takeover in this environment.

I think we will see a lot of smaller transactions happen, and M&A activity will be lower this year.

TGR: Some experts in the gold space are floating the idea that some major gold producers may change their model to something closer to an exchange-traded fund (ETF): They would sell a portion of their produced gold and hold the remainder. What do you think of that as a business model?

Michael Fowler: I have not heard that, but there is a precedent. I like the idea of holding gold on the balance sheet because it shows that the company actually believes in its own commodity. 

These companies have to find a way to be more judicious with their capital and to focus more on return on investment rather than go down the ETF route. If they are not growing, they could increase their dividends to the 4% range. That would be of interest to investors. 

Quite frankly, I am more interested in companies that grow their reserves and resources, their earnings and cash flow. 

TGR: With gold equity prices slumping badly, have you had to adjust your price-to-ounces-in-the-ground valuations or make other changes to your model to reflect what is happening in the market?

Michael Fowler: The valuations are all over the place and they are cyclical. In 2009, the value-per-ounce-in-the-ground values went for about $20/oz average. In 2010, they went to $90/oz and are now at about $40/oz. It looks as if the cycle now is one to two years, and we are on one of the lows. 

But as an analyst you have to look at what that value might be in a one-to-two-year horizon. Therefore, I do not adjust my models for swings in sentiment. Although we are on a low valuation right now, good valuations are out there. We are using a range of $50–70/oz for target prices on small companies.

TGR: Michael, can you give our readers a reason or two to stay positive about the gold market?

Michael Fowler: All is not lost in the gold sector. First of all, the gold sector is cyclical. We have been on a down cycle for about 20 months. Although that has been pretty depressing, history shows us that 20 months is about as long as a typical down cycle lasts.

Second, institutions and money managers have been selling their gold juniors. Typically, when the institutions are long juniors, it is time to head for the hills or sell them and vice versa. They tend to be contrary indicators at extremes. Institutions are overly negative on juniors right now. So now I would not head for the hills. I would accumulate. Valuations are cheap. I expect the mid-junior/midtier producers to be the first to move, followed by some of the junior explorers. 

Quite frankly, the negativity floating around now sets us up for a very good, positive environment going forward.

TGR: Michael, thank you for your time and your insights. 

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