Brad Trent for Barron's
"Thefinancial model of the nation-state…depends on deficit finance to fundpromises -- and the market is starting to say it is unsustainable," --John Hathaway
Hathaway,a thoughtful manager whose Manhattan-based fund (ticker: TGLDX) hassurged 49% in a year -- more than double the Morningstarprecious-metals category -- and has risen 11% year-to-date, wasconvinced in 2007 that bullion would easily get to $1,000 an ounce in ayear. Moreover, he rightly identified gold's upward climb to bepredicting a widening of credit spreads and lower asset valuations, aview that back then couldn't be underestimated.
Although gold last month set a record of $1,243 an ounce, and inflows into SPDR Gold Shares(GLD), the gold ETF, achieved a record of $1.8 billion in the last weekin May. Hathaway remains decidedly bullish, both on the metal and evenmore on gold-mining and royalty stocks. For more on why he thinksgold's still got plenty of room to shine, read on:
Barron's: You've said "Gold is a bubbleonly for those who maintain faith in the ability of politicians andfinancial authorities to swim against the tide of deflation." Explain,please.
Hathaway: There's an intellectual debateabout whether we are going to have inflation or deflation, and, in mymind, we have both at the same time. We have market forces that aredeflationary and policy response that is inflationary. The deflationarymarket forces brought down the housing bubble. And the policy responseto that was inflationary. I can't even keep track of the trillionsanymore.
Yet gold is the bubble du jour, at least in the media. You are a almost a contrarian.
I love it when the media, which never told you to get into gold inthe first place, is now telling you to get out. It is just classic. But[investor George] Soros has said that gold is in a bubble, and thatstatement has to be understood. I didn't speak to him personally. But Ithink what he is saying is, "This thing can really get out of hand andtherefore I'm positioning my investments to reflect that, because Ithink people are going to go nuts about it." I don't think he was beingdismissive; his funds own gold stocks and they probably own physical.But the media has taken it like that.
What do you mean by the bipolar nature of gold?
When the gold price is expressed in dollars, let's say, it is simplya ratio of the number of dollars it takes to buy an ounce of gold, andif you measure it in euros, it would be a different number. If anyobserver says the price of gold has gone too high, what a high rate ofchange in gold could reflect is the money creation that is driving it-- either current or anticipated.
So it is discounting?
Yes. The price of gold as quoted in dollars -- or in Zimbabwedollars, to make it a really absurd example -- can look like aridiculous chart. In terms of bubble analysis, it might look verydangerous. But then you look at what is driving it and you say, well,what is the real bubble? It really has been money creation.
Is this is why we are seeing gold up at the same time as the dollar?
Right. There was a fallacy from the last couple of years, which isthat when the dollar was weak against the euro that was a signal forgold to go up, the idea being that the euro was a strong currency. Butnow the euro has been exposed as -- to put it mildly -- a hugedisappointment to anybody who thought it was a safe haven. The factthat the euro has fallen against the dollar is good news for gold.
Because it goes back to the sovereign debt?
Yes, you come back to this idea that you are running out of safe havens. What's left?
How do you see the European debt crisis?
The next bubble -- and this is the lesson of what this Greek dramawas all about -- is sovereign debt. It is the financial model of thenation-state, which depends on deficit finance to fund promises thathave been made in the past and promises that are still being made tothe voters -- and the market is starting to say it is unsustainable.
Gold has gone up nicely, but do you see a significant trajectory -- and what would trigger it?
More damage to the monetary unit. The government's official stanceis that these deficits are just temporary. And the Fed says we have anexit strategy to reduce the liquidity on the U.S.' s balance sheet. Ifthe notion becomes widespread that this is permanent and that they haveto do even more in terms of more of this bad medicine, that's the kindof thing that could lead gold to go up dramatically from here.
In the near term, do you think we are going to have a significant pullback?
Backing and filling is in order. We look at various things thatflashed a yellow flag recently. But you are always going to get that ina bull-market trend. You are always going to get overbought.
Should people wait before they start investing? Can you time it?
It is very hard to say. Diversification into some form of goldexposure strategically still makes sense. If this were a football game,we would be at the beginning of the third quarter. The first twoquarters lasted about 10 years. The first quarter you had this stealthyaccumulation. Second quarter, gold became more fashionable to talkabout, and you began to see some very high-profile, smart investorscoming in. The third phase will be more people jumping on thebandwagon, and the fourth quarter is just silly season. It's justGreenspan's irrational exuberance.
Where is gold in relative measures?
The previous bull market in gold peaked when gold and the Dow wereroughly the same. So 800 and $800; and then in the '30s it was in themid $30s. It could be anywhere from $15,000 if we have thesuperinflation, or $5,000 if it is as bad as some people worry about.We also use gold as a percentage of financial assets. Gold worldwide isat 6%, versus 22% in 1980, and 20% in the mid '30s. We use a number ofmetrics, and the message of most of them is that this still has upside.
You have said that gold stocks are comparatively cheap. How do you measure that?
We have lots of ways. But the easiest one is taking our benchmark,the Philadelphia Stock Exchange's gold- and silver-stockexchange-traded fund, the PHLX Gold/Silver Sector[XAU], as a fraction of the gold price. This index has almost a 30-yearhistory, and was as high as 35% or more of the gold price. In the Crashof '08 it got down to 10%. Right now, it is around 15%. But the normwas somewhere between 20% or 30%, until the ETF was launched in 2004.The ETF in a way raised the bar of gold stocks. I don't think they willever get back to 35% of the gold price, because if you believe that,the benchmark would triple from here. That could happen, based on thegold price. But based on a change in valuation, that's a stretch. If weare at 15% now, gold stocks could easily trade in the low 20s as afraction of the gold price. The way they get there is a slow process.
They have underperformed the metal.
Shares of gold companies have fallen into the doghouse, becausethere has been excessive issuance of stock, so the connection between ashare and an ounce of gold has been diluted, in some cases egregiously.But why is that? It is partly because that is the culture of theindustry, particularly Canadian finance, and partly because theindustry didn't do a good job of capital allocation. They advancedprojects that were [not economical]. And until '08, the costs ofproducing gold were going up almost as fast, if not faster, than thegold price. So they didn't really benefit from the margin expansionthat you would normally expect. Now, that has changed dramatically --because gold relative to other commodities has outstripped everything.Those cost pressures have begun to disappear, so the margins ofgold-mining businesses have started to expand. People have forgottenthat.
Talk about asset allocation. Has the fund's percentage of bullion changed dramatically?
It is roughly 10% right now, and we've added modestly to theposition....We have never reduced it. But it is also going to be afactor of how gold has done relative to the rest of the portfolio. Sowhen we got really badly hit in '08, gold got up to something like 17%or 18%. But that was because gold was going up and the stocks weregoing down. I like 10% for what we are doing.
Clients of our firm also recently invested in Gold BullionInternational, or GBI, similar to Goldmoney.com, where people can buyphysical gold online. With GBI you can have it stored in the Brink'swarehouse in one of four locations: two in the U.S. and two overseas.
You have a spectrum for asset-allocation choices. You have goldstocks, you have an ETF of stocks, you have an ETF of gold, you haveclosed-end gold trusts, and then you have physical gold. The gold ETF,which is backed by physical gold, was very important in making goldmore accessible to people, who, before, had to buy coins at a premiumto the bullion content. And you have the Sprott Physical GoldTrust [PHYS], which was trading at a 20% premium to the net assetvalue. Some people want physical gold, and GBI is another way to buyit. But based on what I'm saying, I would rather put new money flows instocks.
Large-caps or small?
We are right across the board, and our weighted average market capis about $3.5 billion, well below our peer group. And the reason forthat is that we invest in companies in an earlier stage of theirdevelopment. We have, besides myself, three very good analysts who goall over the world. I've stopped doing it, but there is no substitutefor it. You see local management. You see local political issues in theway you never get here, where you get a varnished view. Our extensiveresearch effort gives us the confidence to invest in names that are abit more speculative.
What are your favorites?
Before we get into that, let me add that for a conservative investorwho simply wants protection and is risk-averse, whatever allocation hehas to gold should be more heavily weighted to the metal, becausethat's safer. The only risk with gold is the price you pay. But for theinvestor who is more of a risk-taker, and sees gold as a strategy toget positive returns in the current macro environment, then thatexposure should be more weighted to the stocks.
Understood. To the names.
Osisko Mining [OSK.Canada] is a company thatwe have been invested in for at least six years. We first financed themat 50 cents a share; now it is 10 bucks, and we like the management.Sean Roosen owns a lot of stock personally in the company. He had avision that we believed in six years ago, which is that a large,low-grade ore body in a politically safe jurisdiction could beeconomic. It is in Quebec, which is nirvana for gold. They have hydropower and they love mining and the codes are great.
They are building a mine that is backed by resources of 12 millionounces. We've financed them at every step along the way, which is whyour position has become large, in addition to the appreciation. This iswhat every little gold company should aspire to -- they either aspireto a takeover or what these guys have done. They will be pouring goldwithin the year.
What is their market cap?
It is about 3.8 billion Canadian.
Go ahead.
Randgold Resources is the next one. Theticker is GOLD; the market cap is $7.7 billion. Terrific management,who also own a lot of the stock in the company. The mines are mainly inWest Africa, which is a very good place to be doing business if you aremining gold. The governments tend to like it. Basically, gold mining isa force for good in the developing world. The companies create jobs.They educate the workforce, build hospitals and schools. This is alarge company with a growth profile that's been pretty much organicallydriven by their own exploration.
They know what they are doing, they are finding gold.
CEO Mark Bristow is a very impressive and forceful guy, and hisleadership and vision are important parts the Randgold story. Thiscompany has gone from a couple of hundred thousand ounces when we firstinvested in it, and they're on track to be producing, I think it is 1.2million in a couple more years. There is enormous value creationindependent of the gold price from that whole process, if it is donecorrectly. The return on capital is good, and again, the proviso isthat they don't overissue stock; these guys have done a good job ofkeeping the share count tight. Bristow's a shareholder, so heunderstands that. It is a growth story.
Another name?
Newmont Mining [NEM], where we have been very patient holders. It has been an underperformer and they would be the first to admit it.
Dick O'Brien came in as CEO about three years ago. He is not fromthe industry. He is very keen on financial analysis and all the thingsthat I think the industry has to do. It is just terrible how bad a jobthe industry has done. So when you see a guy like Dick come in, yousay, well, that is an uptick, because that is what has to happen.Newmont isn't a growth story. They have very high-quality assets. It ismore about upgrading the returns on capital, which they are doing, andthat's kind of the mandate that he has given to them.
Would they be buying more reserves?
They could be an acquirer, and they certainly have madeacquisitions. But I think the acquisitions they make going forward willmake sense. It's a very diversified portfolio. They are in Indonesia,which isn't great. But they are in Australia, Nevada and West Africa --those are the core operations. They have things elsewhere, too. Here isa company which has assets in place to take advantage of a rise in thegold price.
They don't have to do anything, in other words?
They're there; all they have to do is do a better job of what theyalready have in place, which I think they are doing. And you arealready seeing it in their earnings reports; they are producing a lotof earnings and cash flow. They should be able to start paying reallyhandsome dividends.
One of the things I think needs to happen is for the industry tocommit to giving shareholders back their capital, which some of themare on board with. Then they'll go from the doghouse to more mainstreaminvestments, maybe even trust department core holdings. That's how thevaluation goes from 15% to somewhere in the 20% ratio of the XAU togold.
And it can even be more as long as the gold price keeps going up?
Right. The 15% to 20% is just relative. So you get 30% if the goldprice is the same, and everything that we talked about takes place. Butif the gold price goes up 50%, let's say, that compounds into somethinga lot more than 50% that you could expect from owning shares versus themetal.
Give us another name.
People should look at the gold-royalty companies. Royal Gold [RGLD] and Franco- Nevada[FNV.Canada] are terrific business models, because they just capturerevenue streams from the process of mining gold. Franco-Nevada was aroyalty company spun out of Newmont Mining. Both are very high-qualityoperations. Both have the same business model, and what's to like isthat 85% of the revenues are free cash, because they are royalties. Onthe surface, they may look expensive, but they provide growth capitalto finance new mines. They get a slice of the revenue stream, which canbe defined in many different ways. They could have a very diversifiedportfolio, with maybe 35 to 40 assets. They give you long-dated optionson the gold price. What you get with the royalty companies is the joyof optionality without the pain and suffering of mine construction andall the stress.
Sounds good. Thanks, John.