Brian Ostroff bullish on DANBrian Ostroff: Junior Gold Equities Worthy of Praise
Source: Brian Sylvester of The Gold Report (11/30/11)
As the market sloshes around, gold is searching for its identity. It hasplayed currency hedge and equity adeptly at different times this year.While other investors wade through the confusion, Brian Ostroff,managing director of Montreal-based Windermere Capital, is taking theopportunity to snatch up gold mining equities that have been quietlyperforming under the radar. In this exclusive interview with The Gold Report, he contemplates why the market isn't rewarding junior gold equities worthy of praise.
Companies Mentioned:Adventure Gold Inc.-Agnico-Eagle Mines Ltd.-Arianne Resources Inc.-Breakwater Resources Ltd.-Cartier Resources Inc.-Full Metal Zinc Ltd.-Teck Resources Ltd.
The Gold Report: There are unprecedented debt problemsthreatening the existence of the European Union. The U.S. government isexploring ways to cut more than $1 trillion from its annual budget,which could put the brakes on the U.S. economy. However, you don'tforecast a market plunge like in 2008. Why?
Brian Ostroff: It'sa tale of two cities. On the one hand, Europe has a lot of issuesaddressing sovereign debt and it has structural issues. The EU is agroup of countries that has been put together, but it's difficult to geta consensus to deal with those issues. A domino effect started withIreland, Greece and Portugal. Just today there was news about a poorbond auction in France.
Unlike the European economy, the U.S.economy doesn't seem to be stalled despite its debt issues. Economicindicators seem to be showing some improvement. Jobless claims in theU.S. were recently at a seven-month low and industrial productionnumbers are good. Even confidence numbers have been pretty good.
Atthis time, I don't expect that the U.S. will face a double-diprecession. The U.S. economy is starting from a lower level than it wasat in 2008, so it can't fall that far again. Home prices aren't going tofall another 30% or 40% and job losses aren't going to triple fromhere.
In 2008, commercial lending completely dried up. Thebiggest and the best companies that relied on the commercial papermarkets to get funding faced liquidity issues. However, over the lastcouple of years, there's been billions of dollars in bond issuances bythose companies as they moved out of commercial paper and intolonger-term debt. They wouldn't be subject to another liquidity crunchbecause they no longer have to rollover their paper every 30, 60, or 90days.
The primary risk, which unfortunately is currentlyoutweighing the statistics, is a psychological one. It takes a toll whenyou wake up every day and hear how bad things are and how inept thepoliticians seem to be at getting a consensus. To what degree is theU.S. economy impacted by Europe beyond psychology? That's the bigquestion but U.S. banks don't appear to have huge exposure to Europeansovereign debt on their balance sheets and let's hope not too muchcounter-party risk.
TGR: But we really don't know.
BO:Fitch Ratings has raised concerns, but St. Louis Federal ReservePresident James Bullard said recently that the European debt crisis isunlikely to impact the U.S. so I guess we will see but, realistically,the Europeans are not a big driver of the U.S. economy.
TGR: How will the global economic picture ultimately prove positive for precious metals?
BO:The reason to be bullish on gold is that there is most likely going tobe more money printed. The European Central Bank will likely get theokay from its member nations to put together a bailout fund of $1trillion euros or more—whatever is required. Although there are signs ofan improving economy in the U.S., I don't see the Federal Reservetightening any time soon. The last piece to this puzzle is China. Ittightened up last year and early into this year. Some are now concernedthat China is slowing down too much and with that the next move by theChinese could actually be a loosening.
Our belief has always beenthat gold is a currency no different from the euro, dollar or yen. Butgold can't just be printed. It's just a relative valuation. We see goldcontinuing to gain on the back of all this printing.
TGR:Some days gold trades like a reserve currency, but other days it tradeslike common stocks. When do you expect gold to find its identity in thisJekyll-and-Hyde situation?
BO: Gold seems to get caughtup in the risk-on/risk-off trade. Historically, gold has been inverselycorrelated to markets as a whole. That was apparent this summer whenthings really started to deteriorate in Europe. With all asset classesdropping, gold rallied up to $1,900/ounce (oz). It really was startingto regain its luster as a safe-haven asset. Lately everyone is saying,"Where's gold, where's gold? Why isn't it doing its job?" But let's berealistic, the gold price is still $1,750/oz with all the headwinds itseems to be facing. I'm encouraged that gold is going to continue to be agood place to be.
TGR: What do you expect the trading range to be in 2012?
BO: I'm not much for prognostication on trading ranges. I do believe that the trend is going to continue to be higher.
TGR: Do you forecast a similar trend for silver?
BO:Silver is the poor man's gold. It might be difficult for people to pay$1,750/oz for gold, but $33/oz for silver is pretty attainable. As morepeople start to understand the benefit of precious metals as a hedge,silver will gain from that.
TGR: Windermere Capitalcurrently manages two open-ended hedge funds with a natural resourcefocus, Breakaway Strategic Resource Fund and Navigator Fund, bothdomiciled in the Cayman Islands. How exposed are those funds to preciousmetals?
BO: Breakaway is exclusively mining and Navigatoris across all natural resources. Both funds have moderate-sizepositions in precious metals, but our focus is on a micro level. We gocompany by company. Right now, there is great value in stocks and weanticipate taking our holdings up.
Gold stocks are also a taleof two cities. Are they gold or are they stocks? Lately, they have actedmore like stocks. I like to look at the ratio of how much gold it wouldtake to buy the Philadelphia Stock Exchange Gold and Silver Index(XAU). Over the last 30 years, on average it would take about 0.23 ozgold to buy that basket of stocks, whereas today it would be about 0.116oz gold. That's about half of the historic norm. One could concludethat gold stocks are acting more like stocks than gold. Our anticipationis that the ratio will make its way back toward the norm.
Onereason we have seen such a distortion is gold exchange-traded funds(ETFs). Before ETFs existed, anyone who wanted exposure to goldtypically bought gold equities. Gold ETFs have definitely drawn in a lotof money that might have otherwise headed for the equities. Gold ETFs,however, really serve a different purpose than gold itself. People whobuy gold ETFs lean more toward the speculative crowd looking to profitfrom gold's movement as opposed to people who buy physical gold seeingit as a hedge and aren't necessarily looking to profit from it.
Ifwe were going to go through a period of a relatively narrow range ongold, the hot money would leave ETFs. The profit would have been made[or lost] and the trade would be over. Then that fast money would lookfor whatever other opportunities exist. With the gold price at theselevels, gold companies are going to make a lot of money. The sector isgoing to start to pick up attention and money will flow to it. We thinkthe ETF effect on the gold:stock ratio will dissipate over the next fewmonths.
TGR: Silver ETFs have proven to be much morestable than gold ETFs. Do you have any explanation for why the averagesare much different for the SPDR Gold Trust ETF compared to the iSharesSilver Trust ETF?
BO: Silver is really just gold onsteroids. Silver had a speculative spike last spring where it ran up toabout $50/oz. It's since worked its way back into the low $30s. That's apretty amazing collapse really—and it only took about a week. Silver isprobably consolidating its gains. A lot of investors are licking theirwounds, but silver will make another move.
TGR: Do your funds invest in ETFs at all?
BO:From time to time, however, the focus of our fund is mostly on thesmall- to mid-cap equities themselves. Our performance is driven by ourability to find some interesting, young companies much earlier than whenother financial players would look at them. Our group has a strongtechnical bias to it. A lot of our guys are geologists, mining engineersor metallurgists. We're even comfortable with micro- and nano-capstories where we feel there's the backing of good management on a goodproperty that the market inevitably will start to recognize.
TGR: Haven't the juniors suffered an even more drastic underperformance than the seniors have?
BO:I call the juniors a one-way market because investors typically eitherwant in or they want out; there's very rarely equilibrium. In August andSeptember, there was a lot of wholesale liquidation in the sector. Alot of funds had come down to the juniors looking for beta. Then theyfound themselves in a situation where they had to get out, but they werein a market where there wasn't much liquidity. It has really created alot of opportunity going forward for the juniors in particular.
TGR:Catalysts that once significantly moved share prices in the juniorprecious metal equity space are either not moving the share price orthey're moving it only a negligible amount. How are you taking advantageof that?
BO: These markets run in cycles. Right now,investors are exiting this sector. Even if a company issues some goodnews investors see that as a liquidity event and use it as anopportunity to sell rather than buy. For us, it continues to be a matterof looking at the company and looking at its progress. It's a perfectenvironment because there are companies that have done a great jobadvancing their projects, but their share price has not responded. I'dgo one step further—there are people that are looking to exit theirposition and providing us the liquidity we need to get into some of thestories that we find very attractive.
TGR:Adventure Gold Inc. (AGE:TSX.V)seems to be a good example of a company that has issued some very goodnews on several fronts, but its share price has really not responded.
BO:A couple of weeks ago Adventure Gold put out some early results on itsMeunier-144 property in Ontario that is a joint venture with Lake ShoreGold Corp. (LSG:TSX; LSG:NYSE.A) and RT Minerals Corp. (RTM: TSX.V).Early drilling has been very encouraging. The nature of the rock hasbeen exactly what they were looking for. There should be further resultscoming in the next few weeks from that property. The hole is about 2.4kilometers deep and has taken roughly a year to drill.
Therehave also been more results out of Adventure Gold's Pascalis-Colombiereproperty in Québec, which was the old Béliveau mine operated by CambiorInc. That mine had produced roughly 170,000 oz over a four-year periodin the early '90s and then was closed due to low gold prices. WhenIAMGOLD Corp. (IMG:TSX; IAG:NYSE) bought Cambior, it was no longer acore asset and it gave Adventure Gold the opportunity to pick up theproperty.
Adventure Gold subsequently initiated a couple ofdrill programs around the mine that have hit some very substantialresults at surface just to the northwest of the historic mine, includinglong intercepts from surface. We're really quite encouraged by whatthat means for the company going forward and for that particularproperty.
TGR: One of the intercepts you're talking aboutwas about 65 meters of 2.7 grams per ton. That's still open at depth. Itcould be a bulk tonnage target. It's in Val-d'Or, so there areestablished mines and a lot of infrastructure in the area. Why wouldn't aresult like that push the share price higher?
BO:Adventure Gold is not alone. Many companies have put out very positiveresults and have seen very little effect on their share price. Themanagement of Adventure is topnotch and is not discouraged. It really isa matter of them continuing to do their work. They're onto somethingvery exciting and they're going to continue to prove it up.
TGR: Another development in that area recently is that Agnico-Eagle Mines Ltd. (AEM:TSX; AEM:NYSE)shut down its underground bulk tonnage Goldex mine due to waterproblems. Is that likely to have any impact on Adventure Gold's variousproperties?
BO: Agnico-Eagle and Adventure do have a jointventure on the Dubuisson Property in Val-d'Or. A few weeks ago therewere some releases on the preliminary drill program. That will befollowed up with a secondary drill program into next year.
Agnicohas to reassess its situation with Goldex. It has shown itself to be anacquisitive company with a couple of recent transactions. Goingforward, it may continue to go the acquisition route to make up for theshortfall from Goldex.
TGR: You seem to favor a lot ofcompanies operating in Québec. Is it because you are in Montreal andthis is the space and people you know?
BO: Foremost for usis making an investment in a sound jurisdiction. It's hard enough tofind an ore body that's big enough to be economic and take it down thepath to production. To layer on an additional wild card of whether ornot a company may or may not own that mine tomorrow is just not whereour appetite is. We tend to stay in stable, well-known jurisdictions.It's pretty tough to beat Canada. And within Canada, Québec is awonderful place to do business. We do have a lot of investments outsideof Québec, but Québec definitely plays an important role in ourportfolios. The government is very pro-mining. It recently introducedthe "Plan Nord," which will put billions of dollars towardinfrastructure to assist mining companies.
TGR: Another Québec-based company you like is Cartier Resources Inc. (ECR:TSX.V).It has done some channel sampling on the Cadillac Extension property inthe Abitibi gold belt north of Adventure Gold. Cartier is going to testits geological theories with some drilling there. What do you expect?
BO:The Cadillac Extension has had some significant finds. Cartier has avery large package along that. The best place to find a new deposit isright beside an old deposit and, along that trend, there has been noshortage of significant finds. Cartier is a little earlier stage thanAdventure, but it does have a good suite of properties and an excellentmanagement team. Given some time and some resources, we're encouragedthat the company will be able to find something of significance.
TGR: Are there other commodities that you're bullish on?
BO:Our fund does look beyond gold and silver across the spectrum ofmetals. We are pretty excited about the prospects for zinc looking out abit. There will be some significant closures of mines that will distortsupply and demand over the next few years.
As an investor however, it is difficult to find a pure play in zinc. Teck Resources Ltd. (TCK:NYSE; TCK.A:TSX)is one of the largest zinc companies in the world, yet a significantportion of its revenues come from coal. BHP Billiton Ltd. (BHP:NYSE;BHPLF:OTCPK) and Rio Tinto plc (RIO:NYSE; RIO:ASX) are major players inzinc, but a significant move in the price of zinc isn't going to make ahuge difference to such big companies.
There are only a few pure plays on zinc and one of the purest [and early] plays we've found in zinc is Full Metal Zinc Ltd. (FZ: TSX.V),a spinout from Full Metal Minerals Ltd. (FMM:TSX.V). It took Full MetalMinerals' zinc asset, the Fortymile property in Alaska, in order tobuild out a zinc-focused company. It recently brought on Steve Hayes aschief executive, who used to head business development at Breakwater Resources Ltd. (BWR:TSX) in Ontario.
Breakwaterwas a pure play on zinc and was bought by Nyrstar NV (NYR:EN Brussels),which is a zinc smelter. As a smelter, it needs feed. It probably seesthe same thing coming down the line as we do in the next two to threeyears. It chose to vertically integrate to secure that feed.
TGR: Are there other commodities that you're bullish on?
BO:The largest holdings in our fund are in the phosphate sector. About 85%of phosphate is used in fertilizer. The dynamics of the phosphatemarket are very compelling, particularly in North America. North Americaruns a deficit in phosphate and the deficit is going to become moresevere in the coming years as Agrium Inc.'s (AGU:NYSE; AGU:TSX)Kapuskasing mine in Ontario shuts down. The Mosaic Co. (MOS:NYSE) hasencountered some environmental problems that have shut down some of itsexpansion plans in Florida, as well.
The bulk of the NorthAmerican deficit in phosphate is made up through imports from Morocco.I've got to believe that North American producers would love to havegreater security of supply. We have holdings in several phosphate plays,but our largest holding is currently in Arianne Resources Inc. (DAN:TSX.V; DRRSF:OTCBB; JE9N:Fkft) in Québec. It recently put out a prefeasibility study and is advancing nicely. I think it shows it to be a world-class asset.
Thecompany said that it is going to enlarge its study to include a largerproduction profile of 3 million tons (Mt) a year of phosphate instead of2 Mt. Preliminary numbers show it would improve its net present valueby about 60%, or over $1 billion, with just a 20% increase in capitalexpenditures. As far as we are concerned, the prefeasibility report hasshown what's important: It is a large, high quality ore body that makes avery high-purity concentrate, which has been turned into a high-qualityphosphoric acid.
TGR: Institutions that get involved inthese types of projects usually like to see a faster payback period thenthat and probably a rate of return maybe a bit higher. You believe thatby tweaking some of the aspects of that study they can get there?
BO:Yes. The study currently assumes a $175/ton (t) sale price for therock, while the current market price is north of $200/t. For every $1 inmargin, by either cost savings or selling at a higher price, it willmean $17 million in pre-tax NPV to the project.
TGR: The price can fluctuate greatly so that's why companies use a lower-than-market price in studies.
BO:Absolutely, however the fact that Arianne can produce one of the purestphosphate concentrates in the world should give it pricing power wellabove benchmark pricing.
TGR: Arianne sounds verycompelling. That will certainly remain on our radar screens. Do you haveany parting thoughts for us today, Brian?
BO: It'simportant for investors in the sector to understand the nature of thismarket—it's a very volatile sector. It's important to understand thecompany as an investor, so that when there are periods where the marketdoesn't give any appreciation for the assets, investors understand whythey are holding it. If the company does a good job moving forward,inevitably investors will get a good return on their investments.
TGR: Do investors also need to have a defined exit strategy?
BO:It has to be a little bit more fluid. Investors definitely have tounderstand why they invested in a company. They should understand whatthat company's benchmarks are to see that it hits them. Then they'llunderstand why they should continue to hold a stock or, if a company hasfallen short of those benchmarks, why it's time to exit.
TGR: Thanks for sharing your thoughts with us, Brian.
Brian Ostroffgraduated from the University of Toronto in 1986 and joined RBCDominion Securities in 1987 where his focus was on small-cap specialsituations and alternative investments. In 1999, Mr. Ostroff joinedM&A advisory firm Goodrich Capital where he was the Canadianmanaging partner overseeing mandates across a spectrum of industrieswith a focus on display technologies and mining. In 2004, Mr. Ostroffmoved over to the trading side of the business where he spent a year as aproprietary trader with a large Canadian bank and then subsequently onhis own for four years before joining Windermere. His area of focus isthe junior and mid-tier mining sector.
Want to read more exclusive Gold Report interviews like this? Sign upfor our free e-newsletter, and you'll learn when new articles have beenpublished. To see a list of recent interviews with industry analystsand commentators, visit our Exclusive Interviews page.
DISCLOSURE:
1) Brian Sylvester of The Gold Report conductedthis interview. He personally and/or his family own shares of thefollowing companies mentioned in this interview: None.
2) The following companies mentioned in the interview are sponsors of The Gold Report: Adventure Gold Inc.
3)Brian Ostroff: I personally and/or my family own shares of thefollowing companies mentioned in this interview: Adventure Gold Inc.,Lake Shore Gold Corp., RT Minerals Corp., Cartier Resources Inc., FullMetal Zinc Ltd., Arianne Resources Inc. I personally am paid by thefollowing companies mentioned in this interview: None.