The recent volatility in the gold market has investors taking a second look at their strategies. In this interview with The Gold Report, Frank Holmes and Brian Hicks of U.S. Global Investors discuss their criteria for their investment decisions, the factors they think will affect the gold sector and how ETFs are distorting the gold equities market.
The Gold Report: Frank, you are one of the most positive people I know. What happened to gold in mid-April, and could it happen again?
Frank Holmes: I often remind investors that gold has two drivers: the fear trade and the love trade.
The fear trade captures most of the attention. Many people who have put money into the SPDR Gold Trust (GLD:NYSE.A) and other gold ETFs have bought for the fear trade. The fear trade kicked in due to governments monetizing debt at an excessive rate, creating negative real interest rates. For example, last year Japan, Europe and the U.S. rolled over about $8 trillion from three-year paper to five-year paper below the inflationary rate. Historically, this is very important for gold.
The other half of the equation is the love trade, which is gold bought for cultural reasons, such as gift giving for holidays, weddings and birthdays. Given that China and India account for 40% of the world's population, the rising per-capita gross domestic product (GDP) in emerging economies is important for the love trade. Even a modest slowdown on per-capita GDP in those countries has a significant impact on the demand side of the equation.
In the last year, India's government tried to slow down the amount of gold being imported. In January 2013, India imposed a 6% tax, which slowed love trade demand in the short term. And the per-capita GDP of China and India slowed down modestly.
Still, the love trade remained strong over the entire year. According to official statistics from the World Gold Council, as of the end of the first quarter of 2013, the year-over-year change in consumer gold demand for jewelry, bars and coins rose 27% in India. In China, gold demand grew 20%.
TGR: If the love trade demand changed over the last year, why did we have that sudden, one-day fall in the price?
FH: I do not know. I try not to get caught up in all the conspiracy thinking out there, but rather appreciate cycles, where historically gold has climbed after Chinese New Year and had little rallies all the way until summer. Typically, in June, gold investors see a bottom. In late July and early August, 35 years of data show that the love trade demand picks up and runs until February.
TGR: What could happen between now and July when love demand historically picks up?
FH: We will have to see when the Indian and Chinese economies start to pick up. That will be important for the love trade.
But the love trade is not going away. Even in North America, when gold dropped, we saw gold going from paper hands in the exchange-traded funds (ETFs) to strong hands. Gold analysts in Toronto told me about lines of people 30 yards long waiting to buy gold. Everything smaller than 5 ounces was sold out.
TGR: In a May 11 article, you list three reasons to buy gold equities today. Can you tell me what you look for in a gold company today?
FH: We like a board of directors that is consumed with the return-on-capital model. One of the best ways to get a return on capital is to grow revenue, to have a profit margin for capital costs and to pay dividends. The final ingredient is to buy back your shares. With the S&P 500 making all-time highs, one can see the high correlation of companies buying back their stock and increasing their dividends. That is what has propelled the stock market to where it is.
Alamos Gold Inc. (AGI:TSX) is one recent gold company to have done that.
Many other gold mining companies, which people tend to think of as large market-cap companies, have been value destroyers. Newmont Mining Corp. (NEM:NYSE) has a market cap below $20 billion ($20B). It has spent $17B trying to increase its production, which has decreased from 8 million ounces (8 Moz) to almost 5 Moz/year. It would have been better off using $7B to sustain its cash flow from operations and spending $10B to buy back stock and increase dividends. Had it done that, it would have a much higher valuation. Now, all of a sudden, companies like Newmont say they will increase their dividends and share some of that return from the higher price of gold.
The other companies in a bad situation are those that issue stock options faster than they increase their reserves or their production. That dilutes shareholder interest. They make acquisitions that dilute on a reserve-per-share or production-per-share basis.
Investors want to look at companies that have the discipline to increase their dividends and have leadership like Alamos Gold's that will increase dividends and buy back stock for the free cash flow.