Robert Cohen's three drivers for the gold price in 2014

Shifting from bullion to equities

Like the rest of the market, Dynamic Funds is being choosy as it shifts cautiously from bullion to equities, in what Vice President and Portfolio Manager Robert Cohen describes as "baby steps." In this interview with The Gold Report,Cohen explains his method of analyzing miners and discusses companies that offer good prospects.

The Gold Report: Low interest rates, a cornerstone of recent modern Western economic policy, have proven positive for gold over the last several years. What do you see as the three primary price drivers for gold this year?

Rob Cohen: The primary price driver is global liquidity. That is fed by balance-sheet expansion in many Western countries and foreign exchange reserves, typically the result of trade deficits built up in countries such as China.

Number two is real interest rates. The Federal Reserve could tighten rates, but we don't know where inflation will be. Negative real rates are very good for gold. Mildly positive real rates are not harmful for gold. Positive real rates above 2% can stall the gold price.

Number three is geopolitical crisis. Strife can get priced in and out of the gold price.

We also believe that gold should maintain its purchasing power to oil. Over the last 40 years one ounce of gold typically bought 15 barrels of West Texas Intermediate oil. That ratio has been knocked down to about 13:1. I would expect some reversion closer to 15:1 this year. Taking that ratio in isolation would mean that gold is underpriced by about US$200/ounce (US$200/oz).

In 2013, the gold price was knocked out of whack with respect to other hard assets, driven by the 900-tonne liquidation in the gold exchange-traded funds (ETFs). The damage was probably a US$200/oz drop in the gold price.

We suspect that the massive amount of gold liquidated by the ETFs were driven by hedge funds and speculators. The gold ETFs have over one million investors, who for the most part have hung onto their gold holdings. It was the fast money that appears to have left and, therefore, we do not expect to see a repeat of last year from the rest of the investor base.

Between 2004 and 2012, the ETFs built up 2,600 tonnes of gold. Putting that into context, that made the ETFs the fourth largest holder of gold behind U.S., Germany and the International Monetary Fund. In one year, 900 of those 2,600 tonnes were liquidated. If a central bank the size of Germany's liquidated 900 tonnes of gold in one year, it would have made a lot more headlines. ETFs are now the sixth largest holders of gold, after the abovementioned entities and Italy and France. So far in 2014, the ETFs are back into accumulation mode, which implies that the investors are once again seeking this asset class.

TGR: Wasn't some of that 900-tonne selloff offset by gold buying in China?

RC: It had to be mopped up somewhere and, in our view China is a natural buyer. If China is serious about making the renminbi a global reserve currency, part of the formula to get there is to build up gold reserves. The U.S. gold reserve is about 8,300 tonnes. As far as we know, China has approximately 1,000 tonnes, hence we believe that China will need significantly more gold as a percentage of its foreign exchange reserves.

To put this into perspective, the whole gold market in a given year is about 4,300–4,400 tonnes. Approximately 2,500 tonnes come from new mine production; the rest is aboveground stocks moving around. Central banks, no matter how aggressive, can accumulate only in the hundreds of tonnes annually. Hence it could be a multidecade project for the Chinese to accumulate the gold it needs. The ETF liquidation last year would have been manna from heaven for China, allowing it to accumulate a few more hundred tonnes.

Jewelers also stepped in and bought gold on the pullback in price. As the Chinese middle class expands, the per-capita consumption of physical gold has increased.

The year 2013 was an anomaly. The 900-tonne selloff harmed the market to a large degree. Gold was due to go down last year on the back of a strong U.S. dollar. The herd mentality took the price drop to an extreme.

This year, U.S. employment and industrial production data are showing some cracks. That is strengthening sentiment for gold, and it's funneling down into gold equities.

TGR: Ukraine, Crimea and Russia have been in the headlines. At the Prospectors and Developers Association of Canada conference, I spoke with Canada's Foreign Affairs Minister John Baird. He said the situation in the Ukraine was the most troubling geopolitical situation since 9/11. Are you managing your funds differently in light of what's happening there?

RC: Not at all. We estimate that the situation in Crimea added approximately US$50–80/oz to the gold price. The price hit $1,380/oz and has already come back down. Our view is that the crisis has now been largely priced out for the time being.

TGR: Your Dynamic Strategic Gold Class Fund, which is 57% vested in bullion, is up about 21% since January. Last year wasn't as positive. How do you pitch your gold-based funds to investors?

RC: The Strategic Gold Class Fund, founded in 2009, gives investors a mutual fund that can own up to 70% gold bullion, and hence we view this fund as being well suited for those investors looking for gold exposure, but who are less comfortable with taking on the individual equity risk.

As far as the equity portion goes, we can expand and contract that depending on our view of the gold market. If the gold equities are building strong legs, we migrate the fund into gold equities by selling bullion and converting it to equities.

Typically, the fund is 30–70% bullion, skewed to the conservative side. Today, with 57% physical gold, we're in the middle. Although the market has been strong year-to-date, we're not ready to hand over all that bullion and put it into equities just yet. We have trimmed the gold position in baby steps.

Being in Canada, we also have the option to hedge or not hedge the Canadian dollar on that physical bullion. When the Canadian dollar is rising we are likely to hedge to give investors a better return. When the Canadian dollar is weakening, we want to have more of a U.S. dollar return. If you're naked on the hedge, you get the Canadian dollar exposure. In other words, if the Canadian dollar has fallen 10% year-to-date, even without a change in the gold price, you would see a 10% gain in the gold price in Canadian dollars.

TGR: Do you see a lot of value in gold equities right now?

RC: On a broad level, many equities are trading near fair value at current spot prices. Some are more expensive, but it's usually a case of paying up for quality. Some of the junior companies are lagging, but investors remain cautious and conservative. Sentiment has moved a lot this year, but there's still way more liquidity in the senior companies.

Smaller companies, even those that have performed well in the context of the total market capitalization, might not come back so easily. The market is building legs very slowly and investors are being choosy, especially on the exploration side. Companies with interesting discoveries are generally doing better than those at the grassroots level.

TGR: One ongoing saga is Goldcorp Inc.'s (G:TSX; GG:NYSE) bid to take over Osisko Mining Corp. (OSK:TSX), which Goldcorp seems likely to win. What does that transaction tell potential investors in the gold space?

RC: I'm not sure Goldcorp will win. The timing of the bid has resulted in some interesting dynamics. In January, the gold price was starting to move up and the Canadian dollar was moving down. This strengthened the Canadian dollar gold price.

A company with less leverage to the gold price was bidding for a company with more leverage. Hence, Osisko's year-to-date performance has been no better than its peer companies without a bid on them. Osisko is up 61% year-to-date. Kirkland Lake Gold Inc. (KGI:TSX) is up 59%, Lake Shore Gold Corp. (LSG:TSX) is up 65%. Osisko is trading in the middle of the pack and some investors could therefore argue that the stock may have performed better without a bid.

Part of the reason for this is that the bid itself is not an all-share bid; it's CA$2.26 cash plus 0.146 Goldcorp shares. In January, had the gold price gone down, the Goldcorp shares would have gone down, but the CA$2.26 cash would have stayed the same. The cash would have represented a put option and made the bid look more attractive in a downward-trending gold market.

The opposite happened: The gold price has increased substantially and the cash component has gone the opposite direction. Instead of acting as a put option, it becomes a cash drag. The bid no longer looks as interesting, given the improved gold price. The market price is reflecting this, and the shares are trading above Goldcorp's offer.

At the time of the bid most shareholders balked at the idea of tendering. Those who did sell probably lacked confidence that the gold price would continue to rise. The buyers would have been arbitragers.

TGR: Osisko has come out with a revised mine plan.

RC: The revised mine plan pegs a lot more value on the Osisko shares than they've been given credit for in the market. It puts pressure on Goldcorp to revise the offer.

I don't know if Goldcorp will succeed. It depends on where the shareholding now lies. We don't know how many shares have traded since the bid or to what degree. It's in the hands of the arbitragers.

TGR: Is there a Canadian theme at work here? Osisko has a scalable Canadian project. The Canadian dollar is falling.

RC: I don’t see this as a Canadian theme, but one could argue that the low-hanging fruit in politically safe countries has been plucked over in the gold sector and it's harder for companies to find world-class deposits in Nevada or Canada. Acquisitions are one way for companies to stay in countries that have very strong mining laws, where it's relatively easy to permit.

My view is that the next generation of high return projects will likely pop up in West Africa or other jurisdictions with more political risk.

TGR: What metrics did you pay most attention to in the Q4/13 results reported by the gold producers you follow?

RC: I was interested in cash flow per share and the sustainability of those cash flows. We look at the quality of the cash flows on the horizon to capture a net asset value calculation. Two companies may have the same price to cash flow, but one has a significantly longer and more robust mine life, the other has high grades that are expected to drop after a certain number of years.

For development companies we look at internal rates of returns (IRR) on the projects and their economic robustness. Single-digit or low double-digit IRRs don't interest us much. We like to home in on projects with higher IRRs. We own perhaps six development companies that we like a lot. Otherwise we stick with producers, about 24 names in the entire fund.

TGR: Are there silver companies among the gold?

RC: A couple. We own some Fresnillo Plc (FRES:LSE). Tahoe Resources Inc. (THO:TSX; TAHO:NYSE) is a significant holding. We also have a bit of Fortuna Silver Mines Inc. (FSM:NYSE; FVI:TSX; FVI:BVL; F4S:FSE).

Silver is a double-edge sword. It will outperform gold in a strong market, but in a weak market it could underperform gold.

TGR: What do you think of Tahoe's Escobal mine?

RC: The Escobal mine is fantastic. The knock on that stock is the fact that the mine is in Guatemala. Before Tahoe built Escobal, the company came through a lot of challenges from environmental groups. But Tahoe got it built.

There are more than 360 million ounces of silver in this one project. A polymetallic silver mine is unusual. Escobal has zinc and lead. You don't often find rock in the ground that's worth more than $350/tonne. It's really hard to come up with a higher quality investment.

TGR: Fortuna didn't meet the Street's expectations for earnings per share, but it's having a good year. Is there more upside left there?

RC: We think that there's upside left. Fortuna is well managed and it has a high-grade discovery in Mexico that will show up in near-term production. Some people will consider Fortuna politically safer. They might prefer Mexico and Peru over Guatemala, but that varies from individual to individual.

Next page: Companies in the sweet spot

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