Frank Holmes, CEO and chief investment officer at U.S. Global Investor, gives his views on the prospects for inflation and the impact of China on global commodities makets and prices. Interview with The Gold Report.
The Gold Report:
Frank, U. S. Global Investors has published a chart showing copper price fluctuations on a monthly basis with 30-, 15- and 5-year trend lines. Can you speak to why that chart is important?
Frank Holmes:
First let me start with a little background. There was a wonderful book written back in the '30s called The Battle for Investment Survival by Gerald Loeb. When I first got in the business, I was told I had to read it every year to remind myself of the cycles, different asset classes, and the value drivers for them. And the book says buy copper when it's soft in November and sell in March.
The 30-year pattern on the graph follows what Loeb's book advised and what was the rule of thumb when I first got into this business-that "buy in November and sell in March." This was because of seasonal stockpiling during winter months leading into major building and construction projects in the spring and summer months.
About 15 years ago, when China started becoming a significant buyer of copper, the pattern started to change. This pattern shows copper prices rising from January through May and then trading pretty much sideways for the rest of the year, with modest peaks and valleys along the way. A similar pattern is drawn to represent the past five years. The five-year and 15-year cycles are very much aligned with the infrastructure spending taking place in China, as well as with the lack of new mine supply coming on-stream from anywhere in the world to meet this increasing demand.
China has changed the demand for copper by making very strong commitments in infrastructure spending. Five years ago they were building power stations - now they're building power lines. They're basically expanding their spider web of copper wire all across the country to get more people access to electricity, especially in the rural areas, and this is setting up demand for copper that relates to their infrastructure spending.
TGR: One of the theories I've heard is that China has been divesting U.S. dollars by stockpiling basic commodities, one of which is copper. If that's true, could China's copper buying boom be short-lived?
FH: You're not seeing the Chinese dump dollars to go and buy copper or gold, etc. What we're seeing is, rather than rolling dollars over and buying new notes where the yields are so much cheaper, they're going and buying other commodities. And that's a much different statement than saying "I don't like American dollars." They're just saying that they prefer at this stage to own commodities rather than a note that's paying 10 basis points.
I think it's important to take a look at seasonal patterns. You can see the relationship between infrastructure spending and demand. And one should always take a look at China and ask whether or not they are a net exporter of a specific commodity. If they are, then they've stockpiled that commodity. That's just a well-known fact. For example, at the beginning of this super-cycle, zinc prices lagged. Then prices exploded and all of a sudden China became a net exporter instead of a net importer. That's the tipping point.
TGR: How could a regular investor monitor this? Are there some key elements to look for?
FH: Use a good money manager. The best money managers understand macro themes and they understand stocks and stock picking.
TGR: When we spoke last October, you indicated that we were at a tipping point, moving from deflation to inflation. Clearly a lot has happened. Do you think we've moved from that tipping point yet?
FH: When I made that statement, it was because of the huge increase in money supply. Money supply is one important aspect of inflation. The other real key factor is protectionism and unionism. If you go back to the '70s, it was a combination of rising money supply, rising oil prices, and huge labor strikes all over Europe and all over America.
And so right now all this money that's going into the system is like shoveling sand with a pitchfork. Populist policies that are focused on protectionism and unionism will force inflation in America.
Do I see across-the-board inflation? No. Do I see certain commodities having stronger inflation than others? Yes. Will that permeate and destroy and create a huge inflationary cycle? I don't see that yet, but the threat of that happening is still there over the longer term.
TGR: What sectors do you think will do well over the next six months to the end of the year?
FH: As far as commodities demand, China is the 800-pound gorilla. After that it's India, and also Japan. Even if North America's economic growth is slow and Europe's growth is slow, it will have an impact on demand for oil and other commodities.
I think the real sleeper is platinum. If the car business turns around in America, I think platinum has the capacity to have a spectacular move. Something like 90% of all cars sold in America are financed with loans in some form. Of course, the car business started a huge contraction when banks weren't funding the loans, and that affected the platinum industry since it's used in automobile emissions control devices.
If that process of money turnover starts to expand, however, and if there are low interest rates, then we could see a boom in car demand. With such a strong environmental movement, commodities like platinum will do exceptionally well because of industrial needs coupled with environmental concerns.
TGR: What percentage of gold bullion versus stocks do you recommend in a portfolio?
FH: We're consistent in suggesting to investors that they consider a maximum 10% allocation to gold, half in gold equities and half in bullion. We preach a message of moderation. You shouldn't try to get rich with gold or gold stocks because you would take too much risk trying to do that. I have said you buy gold and gold stocks as a form of financial insurance in your portfolio. Even when the price of gold is soaring, as it was in 2006 and again last year, we never changed our position about not chasing the momentum. It's also important to rebalance at least annually, so every year or even each quarter when gold is up substantially, you take some profits and you maintain that allocation.
TGR: Regarding gold equities, what do you recommend that individual investors look at-explorers, near-term or producers?
FH: That depends on the risk profile and volatility they are willing to assume. The biggest potential for alpha is going to come from the junior mining stocks, particularly the mid-caps, where there is something coming into production.
The big money to be made with the least amount of risk is when a company is just coming into production, or a bigger company is going to increase its production. At that point there's sort of a re-rating that takes place in the market. The greatest risks are the explorers who have a discovery. It doesn't matter how far they go up, it all falls 70% before they ever produce an ounce. It's very risky as they go through this production phase, as it takes time and money. When you're within six months of that new production, and it's been well funded, that's a less risky decision.
When looking at the major companies, one has to look at the currency impact of the country where it's being produced. If you're looking at South African gold stocks, for example, one has to be aware of the Rand. If the price of the Rand is going up faster than the price of gold, that means there's going to be a compression in the profit margin. If the price of gold is rising and the Rand is falling, that means you're going to have a huge expansion in profit margin.
Look at those currency patterns when looking at the big producers; it's the number one, simple way to look at it. Those stocks that outperform their peers on an historical basis have the highest production per share. There have been so many gold-mining companies that immediately do a financing, and they dilute, which dilutes the investors' upside.
Our best-performing stock year to date and the number-one holding is Randgold Resources Ltd. (Nasdaq:GOLD). Why is that? Because Dr. Mark Bristow, the CEO, made a commitment not to dilute the production per share and to not do a financing for the sake of raising money. And that showed in the marketplace; it simply pulled a trigger, and it was the best-performing stock.
TGR: Are there other gold stocks either in junior mining or near-term that are performing well for you?
FH: Jaguar Mining Inc. (TSX:JAG) (NYSE:JAG) did well. They were able to do a funding to maintain what they were doing, so stocks like that have done reasonably well. One of the biggest disappointments was Yamana Gold Inc. (NYSE:AUY). Again, Yamana made commitments or made statements to the Street, and all the analysts were very bullish, and they just never delivered the production per share that they were going to deliver for each quarter for the past six quarters. So, they were the number-one pick for their growth, and they never delivered it.
Gammon Gold Inc. (NYSE:GRS) initially disappointed everyone on their production per share. Then they got a new management and started to deliver, and the stock started performing much better. They started showing that production per share.
TGR: Are there other companies that you're looking at and saying, "They're approaching near-term production, and we expect them to do quite well"?
FH: I was recently down in Colombia. I think that Colombia Goldfields Ltd. (TSX:GOL) (OTCBB:CGDF), which works on Marmato Mountain, with gold over it, has a huge resource. Medoro Resources Ltd. (TSX.V:MRS) is going to acquireCGL, and if management is able to consolidate Marmato Mountain, put that into the company, you will have a very inexpensive company, even though it will take two years to do this. Compare that with the average stock trading at $47 for an ounce in the ground, and this trades at substantially less.
So, I think it's stocks like Medoro that are very exciting and in a great area where there have been big discoveries. The Colombia government is very pro-America, very supportive for any type of resources in the country. I think that they have something that is very, very special. Medoro Gold is up 14%, and I think has lots of opportunity on the upside.
Now, the last one that I think is most interesting and is closer to the production profile as proven up is Romarco Minerals (TSX.V:R). But it's still several years away. The management there has done a wonderful job of pulling that asset together, fixing it up, and building it out, and as it gets closer to that production profile, it will probably be taken over.
And we're long on both of these stocks; I am speaking from a very biased long position.
TGR: You were following at one point Royal Gold. Is that still in your portfolio?
FH: Yes, We love Royal Gold Inc. (Nasdaq:RGLD), a precious metals royalty company, for a simple reason-high profit margin. That profit margin is very important because most gold stocks have a low profit margins.
Franco Nevada Corp. (FNV.TO) is also one of our holdings, and FNV has an attractive seven-year warrant. Pierre Lassonde is the chairman, and one of the largest shareholders. Of all the gold mining shareholders up there, I would think he's probably one of the wealthiest, and it's all been made as an investor and not by pre-stock options. He doesn't believe in that. They have a very, very tight policy about giving out stock options; they're very much of a Warren Buffett model.
Royal Gold-same thing-management owned, very focused, a return on capital model.
TGR: Any other gold insights you can give us for our readers?
FH: Red Back Mining Inc. (TSX:RBI) has been a great performer, with Lukas Lundin, a great entrepreneur, behind it. That's part of the Lundin empire. Made a bid for Moto Goldmines Ltd. (TSX:MGL). If the deal gets done, it's extremely accretive, and they're doing a wonderful job of executing.
[Editor's note: on July 17, Moto Goldmines Ltd. confirmed the receipt of an unsolicited acquisition offer from Randgold Resources Ltd. (GOLD, RRS.L) by way of a proposed plan of arrangement. Yesterday, the company's board decided that the Randgold offer is superior to the plan of arrangement it had with Red Back Mining Inc., announced on June 1.]
Red Back's CEO Rick Clark has done a fabulous job of building that company for the Lundin empire. So, Red Back shows up as an important part of our investments and I think that's one of the more exciting opportunities. They will probably become a big cap gold stock.
TGR: Thanks very much Frank, this has been great. We appreciate your time.
Frank Holmes is the CEO and chief investment officer at U.S. Global Investors Inc., a registered investment adviser managing 13 no-load mutual funds specializing in natural resources, emerging markets and global infrastructure. He is one of the world's most authoritative and respected voices on gold, and is the co-author of the book "The Goldwatcher: Demystifying Gold Investing." (2008: John Wiley & Sons). He is also the lead contributor to U.S. Global's investment blog "Frank Talk: Insight for Investors." U.S. Global's funds have received numerous awards and honors during Mr. Holmes' tenure, including more than two dozen Lipper Fund Awards and certificates. Mr. Holmes was named 2006 Mining Fund Manager of the Year by Mining Journal. He is a much-sought-after keynote speaker at national and international investment conferences. He is also a regular commentator on the financial television networks CNBC and Bloomberg, and has been profiled by Fortune, Barron's, The Financial Times and other publications.
Published courtesy of The Gold Report - www.theaureport.com
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