Barry Allan: Which Way Will You Make Your Play in Gold?
Commodities / Gold & Silver 2009 Mar 21, 2009 - 01:49 AM GMTBy: The_Gold_Report
Consistently ranked as one of the top-10 gold and precious metals mining analysts in Canada, Capital Research's Senior Vice President and Director Barry Allan offers a well-rounded perspective on the mining sector that combines geological fieldwork, equity research and finance. Now, after more than 16 years in the industry, he remains bullish on both gold and silver. In this exclusive interview with The Gold Report, Barry discusses his criteria for evaluating major and junior miners, explains how value price moves in gold are more driven by investors than jewelry demand and offers some risk-based guidelines for investors looking to preserve and build wealth in gold.
The Gold Report: Let's start with your economic overview. Where do you see things going?
Barry Allan: I characterize it as my 35,000-foot view. Generally speaking, right across the board we remain positive on the prospects for gold and silver. We look at silver as really a derivative of gold. If we're bullish on gold, as we are, we are also bullish on silver.
We have argued, and continue to maintain, that demand for gold is really more driven by investors than it is by jewelry demand. Yes, jewelry demand does put a floor under the price, but jewelers are more price takers than they are price makers. It really has been the investment part of the equation that has continued to demand more gold and set higher prices.
We look at interest rates, short-term rates, particularly like a one-year rate. We want to see a low interest rate. Not only does that make the cost to carry-on bullion trading low, your benchmark of investment comparison is low, but also it erodes any forward gold price in the futures market that would attract forward selling. So we do look at interest rates, and I think we're seeing rather uniform interest rates at some historical low levels and don't really see that changing.
We also look at the prospects for the U.S. dollar. What is going to happen with the U.S. dollar? It was recently stated to me in New York more precisely: “Yes, the prospects of the U.S. dollar are probably not good—but, guess what? It's probably the tallest midget in the room.” What that really means is there is a crisis of currencies worldwide. If we think we've got a problem with the U.S. dollar, well, let's go look at the Irish punt, let's go look at the English pound. All currencies are in crisis at this point in time, and I believe that has been a driver behind gold and the U.S. dollar moving together—that's rare.
So you've got this phenomenon, which is a bit unusual, of the two moving together. But I think we, in our part of the world at least, still find that the crisis of currencies will persist and that just feeds into investment demand for gold. Therefore, the fundamentals all look good for us. Of course, we also do want to keep our eye on are the technical charts. We always want to be cognizant of what the charts are telling us, and certainly everything that you look at on the technical level, short term or long term, is constructive. The charts look quite bullish.
It all looks very good with one slight caveat. We have 29 years of monthly data, and we've looked at seasonality trends in gold. You tend to get some second quarter weakness in volume. Maybe that weakness this year is gold going sideways but, certainly, we are coming into that period now. So we're expecting a little step back here short term in bullion and, as I say, that step back might just be going sideways. So we're a little bit cautious, as well.
The one thing that we would be concerned to see is the Central Bank having to defend its currency by selling gold. That could be a wild card. I have never seen that yet and large portions of Central Bank transactions in gold are not cleared through the market. They're referenced to the market, but cleared Central Bank to Central Bank without that disrupting the price. That could be a bit of a worry. If things really do get dark, perhaps some of the bullion reserves that are held by Central Bank might get liquidated. But as yet, I've not seen that.
So we are positive on both gold and silver. What we have had collectively within the senior, junior and intermediate sectors is that they have dramatically outperformed the broad market industries and have been the best-performing sector bar none since, really, the October 30th low. In the second quarter of this year, we do not expect quite as hot a performance but certainly for the second half of the year. Yes, absolutely, we continue to be longer term quite optimistic about prospects for gold and the valuations on gold stocks.
TGR: Barry, if you're looking for some possible weakness in the commodity or the bullion itself in the second quarter, how does that translate to the stocks in general?
BA: Generally, we've looked at a couple of things. We've looked at what we call the ‘betas relative'—the movement of gold stocks relative to the commodity. Clearly, there is a very good correlation and you have quite a range of betas relative to gold. But, generally speaking, a 1% drop in gold has translated into a 1-1/2% drop in the value of the sector overall. Still, it tends to be a pretty good long-term average. That's come down, actually. The correlation or the volatility of a gold equity relative to the commodity has diminished over time.
Anyone who wants gold exposure doesn't necessarily have to buy a gold equity; they could buy an ETF. Over the past three years, the gold equity companies have not really distinguished themselves. We've had higher gold prices, but we haven't seen it translate into earnings and cash flow the way it should, so I think people have really kind of shied away and looked at the ETF as a nice way of saying, ‘alright, I want gold price exposure without all the operating risk and geological risks that may go along with a gold equity.'
TGR: If we were to get another sell-off, we could see some significant weakness in the gold stocks where the bullion might go sideways, as you said.
BA: We will have, and we have had, decoupling of performance of gold equities and the commodities, and that does happen from time to time. It's not typically unique for just gold stocks. It generally reflects the fact that a gold equity is an equity—it's a market instrument. It will react with general market conditions. You know, I saw the exact same thing on October 19, 1987—there were good gold price moves up, but the equities were down. You had a total disconnect with what was going on and that's because the market was just running over every equity; it didn't matter what it was. It didn't run over the commodity as much at that specific date, but it certainly did run over the equities.
TGR: If the price of gold continues to go sideways, because you've linked it to interest rates and the value of the U.S. dollar, would you expect gold equities to increase only if gold goes up?
BA: We have always tried to maintain a strategy wherein we try to choose the companies that do not necessarily need the gold price to go up, companies that will do their business well and show progression in earnings and cash flow without the need for higher gold prices. What I'm talking about is probably what I would call a ‘low beta gold stock.' It's one where the fundamentals are very, very strong, they have growth in the pipeline, the balance sheet is clean, there's not a lot of leverage and they're a low-cost producer. That typically attracts us more than a high beta gold stock, where you're operating costs are quite high, you're probably in the high 400s and have a lot of debt on the balance sheet.
So we have tried to focus more on what I'd call the low-risk stocks and the low beta stocks than the higher-risk stocks. But the practical part of it is, for traders and for people who are pushing hard for quarterly performance, which a mutual fund typically does, you can usually go back and forth between a high beta gold stock and a low beta gold stock, depending on your view of where the sector is going to go. For example, we're at a pretty good high right now on gold and we've had good runs in it. And we say, ‘well, one of our pairings is what do we take right now, a Newmont Mining Corp. (NYSE:NEM) or a Barrick Gold Corporation (NYSE:ABX) ?' For us, a Barrick is a low beta gold stock, Newmont is a higher beta gold stock just by virtue of the fact it's got more debt behind the company, it's completely on hedge with respect to exposure to fuel or gold price. So we've had a nice run there. Maybe we want to go to the more conservative company, which would be Barrick, which shouldn't be as volatile around gold price movements or Goldcorp (TSX:G) (NYSE:GG) , who is the lowest cost amongst the seniors and has no debt on the balance sheet. It, fundamentally, is the most conservatively run of all the gold companies; and, hence, that's our low beta gold stock. So, given the view that maybe gold goes sideways or down, we want to get off our high-risk stocks into our lower-risk gold stocks and still remain exposed to the equity market and gold overall just in case we get it wrong.
TGR: Given the bounce back in these majors since October, has most of the upside been achieved?
BA: I've been in the unfortunate situation of having to go back to holds for the near term. I've got to do one of two things. I've got to say to myself, I'm a little bit worried about the second quarter. I'm not going to say hugely worried, but certainly maybe some weakness—it's a historical trend. It works 9 out of 12 times, roughly. I'm in an unfortunate circumstance where most of the gold stocks are trading at my target prices, so I'm in a hold pattern.
We upgraded most right across the board in October. As a result of the values, I even went to a buy on Newmont, which, boy, I can't remember the last time I did that. But now I'm in the uncomfortable position where I'm saying, ‘okay, I've got to take some profits.' I have even issued outright sells only because of valuation. And the one that really hit there was El Dorado Gold Corporation (ELD.TO) (AMEX:EGO) It's a great company; there's no doubt about that. But just on pure valuation, it went from $4 to $11 and on what? Nothing. Well, sentiment for the sector, but there was nothing really fundamental to account for it, and its valuation is one of the higher within that tier. So we just said, ‘you know what, we've got to go looking somewhere else.' And maybe the strategy for someone who is a little bit more nimble, if you take the value out of the gold stock equity, put it into an ETF, into the gold itself.
TGR: What about moving into the intermediate equities?
BA: The intermediates seem to be where a lot of the focus of attention had been. A lot of these intermediate gold stocks were trading like on the valuations of a senior. I was having a hard time finding decent value within that tier. Even before the recent kind of run that we've had, I was saying most of these had already become stretched.
Currently, I've capped my gold price for this year at $945 or $940 and I'm really thinking that probably what's going to happen here come end of the quarter is I'm going to be upping my long-term gold price assumption and my gold price assumption for the second half of the year, which will bring back some of the value into these stocks.
At $940 gold, I'm pretty full valued and I'm going to have to get something much higher on my commodity price, but I'm not prepared to do that until I get through my period of seasonal weakness. That's the quandary that I'm at currently. I do want gold; I want to exposure to it, so probably where I'd point people is to the ETF or to a low beta gold stock like a Goldcorp, which is largely, like the group, fairly strong fundamentally. Or I'd suggest they start looking down into the junior producers, where you've got higher-risk tiers but you also have some valuation points that you're trading below NAV.
TGR: Let's talk about some of those names. What are some of those names for those investors who are willing to assume that risk?
BA: Well, the two that I most had talked about, where I'm fundamentally comfortable with what's going on, albeit there are some issues to overcome, have been Western Goldfields Inc. (TSX:WGI) (AMEX:WGW)** and Northgate Minerals Corp. (TSX:NGX) (AMEX:NXG) —two companies that are earning their stripes, so to speak, as far as a redevelopment or development of assets. It's about them doing what they say they're going to do, showing earnings and cash flow and demonstrating to the market that they are legitimate, true operating companies. And, as I've seen so far, they're earning that credibility, but yet still not trading at the valuations levels within the tier overall.
So I look at it from a value perspective; they represent reasonable value. I look at it from a management perspective; they have very strong management. And I look at it from an asset perspective; these assets should perform. There's no fundamental reason why they should not.
Now Western Goldfield had a little bit of hiccup last year. They said they were going to get their mine started this time last year. It didn't happen; there was a three-month delay. And we in the investment community had given these guys the royal crown. They have a very strong management group for a company of that size—Randall Oliphant, former CEO of Barrick, along with Ray Threlkheld, former senior vice president of Development at Barrick and Brian Penny, former CFO of Kinross Gold Corporation (K.TO) (NYSE:KGC) . We said, here are the guys that can do it.
So we put them in the penalty box and they're kind of working their way out of it. Many of the mining startup stories that we've had over the last two years have not delivered. They've either been well over budget, behind schedule, or the mines haven't performed as advertised in the feasibility study. That has been more the rule than the exception. What we had said about Western Goldfields was that these are the guys who can do it. So they did have a hiccup in the first half of last year. They're only now kind of coming out of that.
Northgate is a bit more of a reach in the sense that what it's really good at is turning around assets. When people break their pick on something, that's when Northgate gets interested. They really have been hesitant to go out there and pay the market prices. They like to find distressed assets, assets that people have not had much success with, and then throw their shoulder to that wheel. They acquired an asset in Australia that was exactly that, called Perseverance; two gold mines in Australia that were not operating very well and really didn't look all that attractive. The problem with those kinds of strategies, even though Northgate management has had a track record of doing this, is that the market doesn't really like turnaround stories.
With Northgate, when they go out, as they did with Perseverance, you kind of look at it and say, ‘oh, my God, you've got two mines here that aren't making money. Why would you want them?' That's why Northgate wants them—because they're cheap, they see the opportunities in them and they're now showing us that those assets can deliver cash flow. We've had one quarter out of it. They need to show us at least a couple more quarters; but they're earning their stripes. And the beauty is it's trading at half the valuation within its tier peer group.
What I find at the upper end of that valuation range are companies like Alamos Gold Inc. (TSX:AGI) and Gammon Gold Inc. (GRS) (even though Gammon's valuation has come off a little bit, they're clawing their credibility back as well). I just find them expensive. They're good operating companies. I think Gammon has legitimately overcome its operational issues and is doing a good job, but it's trading at the upper end of the valuation range, so I'm a little less inclined there at this point.
TGR: One of the names that pops out on your buy list is Rubicon Minerals Corp. (TSX:RMX) (AMEX:RBY) . What would you say about Rubicon these days?
BA: We have been involved with Rubicon for some time and the reason why we initially got involved with them was because they had quite a good property holding in the Red Lake Camp of Ontario; and Red Lake is the home of our high-grade gold mines. So what impressed us about Red Lake was that not only did they have property right in the geological heart of the belt, but they also had the people—principally David Adamson—who had a very good understanding of the geological controls that were required to allow for high-grade mineralization to occur. He had a very good handle on the Camp. So we started off just backing the horse, so to speak, and liked what we saw in their strategy.
Luckily, about a little over a year ago, they intersected an area of mineralization called the F2 zone, which had very, very good grade material, the splashy kind of grade stuff. They have drilled through that F2 zone approximately 40 odd holes. All the holes pretty well have hit. They now have in the data 82 pierced points within the core of the F2 zone and it is good grade material. The question now is how big is it? It's good grade over mineable widths. Now let's just keep drilling to see how big this is. This is some of the best exploration that we've seen outside of the Red Lake mine, itself; well, it is the best success that we've had outside the Red Lake mine. So it has been a geological success, and it's still early days yet.
Rubicon continues to drill good holes. A couple of weeks ago, they released results from two drill holes, which showed the area looks to have some lateral extent; but they really need to connect the dots now and continue to see how big this thing is. So this is one that we call ‘the best of class in the exploration'.
TGR: Another one that caught my eye was Premier Gold Mines Ltd. (TSX:PG) .
BA: We're talking about the two best of class explorers that we have in the gold sector. The practical part is I don't like to make a steady diet of exploration plays.
The interesting thing about Premier is the consistent exploration strategy. You may have heard the strategy about drilling in the shadow of a head frame, and that's exactly what Premier has done. All its properties are adjacent to either old existing mines or existing operating mines, so they're drilling known structures that host mineralization and they're being very aggressive about it. This year, they will spend approximately $15 million in drilling and that's going to be the most aggressive exploration program amongst the juniors. Rubicon will be close only because they are sinking a shaft and dewatering it, so they'll spend $9 million right there. But a $15 million drill campaign in Canada, particularly now, is a fairly aggressive program. It'll be over 500 holes drilled this year and it's on four separate properties in Ontario, so we're not just talking about one horse here; we're talking about four separate properties—all adjacent to mines. And they've already started to show us some of the results. They're getting good mineralization, but it's very early days for them. It will take some time, but they may be in a position to have something to crow about by the end of this year. That's how early it is.
TGR: What about Westdome Gold Mines (TSX:WDO) ?
BA: Wesdome is one of those legacy companies—juniors—that we've had in Canada for a number of years. Originally, it was broken into two companies called River Gold Mines and Wesdome. About three years ago, we advised them that two companies didn't make a lot of sense and that they should combine them, which they did. They're now operating as a merged entity with two mines in two old camps of Canada, one in the Val d'Or region—the Kiena mine, which was a former Placer Dome mine and is operating, and the Eagle River mine, which is near the town of Wawa in Ontario.
Both these assets have been run very tight fistedly in the sense that the company management is very close with the purse strings. It's taken a while for them to get up to where last year it was a record year for them. We don't know what the up costs are going to be for the year, but there's 90,000 ounces of gold they produced for the year, which was a record high. Should be very good operating costs. I'm expecting it will be in the mid-400s Canadian operating costs. They had a particularly high-grade pocket that they mined through at their Eagle Gold mine in Wawa, so last year was a good year, generally good cash flow, but it was a slightly non-representative year due to that high-grade section they mined through.
This year will be much more stasis type level of production, probably more in the 75,000 ounce range, which is where this thing has lived for some time. It's been run pretty well, and what you see is what you get; it really doesn't have—and has not had—the "what next" kind of story. They have a discovery, which they're trying to get market attention on in the Kiena camp, but it's still too early to know what that's going to mean to the bottom line. It is a company that we say is ‘what you see is what you get.'
TGR: One last name, one I'm not familiar with on your list, Foraco International (FAR.TO) .
BA: Two things caught our eye about Foraco: (1) They're unusual in the sense that they are based out of Marseilles, France; and (2) They've cut their teeth in water drilling in Africa. They are really the water-drilling people in Africa. They have worked, and continue to work, for many of the world agencies looking to increase the quality of life for Africans, so they're the people that actually drill the wells and install the water handling, lifting and storage facilities. They got involved in mineral drilling back in the ‘70s and they've developed quite a franchise in specialized drilling.
What we really found nice about Foraco was very high quality. They are a driller for the senior companies who need specialty type drilling. They are true specialist drillers. They're not the kind of mom-and-pop guys that you might find in Siberia; they've got a drill rig that they've had for 20 years, and they just do it all again. Foraco designs and builds its drill rigs for specific solutions. For example, Rio Tinto (RTP), when they were bulk testing their iron ore deposits in Africa, came to Foraco and said, ‘look, we need to bulk sample this thing. Can you design and build for us and operate a bulk sampling drill rig?' Foraco built five of these large drill rigs that have a hole that's a meter and a half in diameter, and it takes big chunks of rock out for bulk sampling program.
So, we found Foraco to be a very high-quality company. The only problem is that, when we took them to the market a while back, not enough of the company came to the market. The principals still retain about 60% of the shares, and a large investment fund out of Zurich has pretty well bought the rest of it, so there are not a lot of shares that trade. It trades by appointment. And as such, the valuation always lagged relative to its peer group—the upper end of which would be a Major Drilling Group International (TSX:MDI) . A more direct peer at the lower end would be an Orbit Garant Drilling (TSX:OGD) , although Orbit is not the same kind of driller. Orbit is a specialized underground driller and 80% of its business is within a six-hour drive of Val d'Or, Quebec. So it's more of a traditional type driller. Then you have some others out there— Layne Christensen Company (Nasdaq:LAYN) , Cabot Corporation (NYSE:CBT) and Energold Drilling Corp. (TSX.V:EGD) , as well.
TGR: These are all public?
BA: Yes, they're all public drillers; but these are mine-services companies. What is important to look at now is the composition of the drill contracts and where their clients are spending their money.
We've seen quite a drop and cut back in exploration drilling. It's been the first thing that's taken the brunt, particularly for copper, nickel and zinc. That's virtually come to an end. We do still have a good level of exploration activity in gold and uranium, and we still have a pretty good level of exploration activity for potash. So we're looking at the composition of the client base for each of these guys. How much is in gold, how much is in base metals, where is it? Is it in Canada or Africa? And what percentage of their client base is small cap companies, who rely on equity markets vís-a-vís operating companies who generate their own cash flow and are just outsourcing their drilling?
The equity markets have largely shut off for the junior-type guy. We have this mechanism in Canada called flow-through, which has still been working, but it's a fraction of what it was two years ago.
TGR: I really appreciate your taking the time today, Barry.
****Please note, since the interview was conducted with Barry Allan, there has been significant news on WGI. Here are excerpts of Barry's update from his research note, "On March 4, WGI and New Gold (NGD) agreed to merge share-for-share (and a nominal payment of $0.0001 to WGI), and the surviving entity is to be NGD. . .WGI will l require 2/3 shareholder approval , and NGD will require a majority of shareholder approval. Target date for completion of the merger is the end of May 2009. . . The merger would move New Gold into the lower end of the production range for intermediate gold producers (average valuation multiple is ~1.4x NAV). IMPACT – A STEP IN THE RIGHT DIRECTION AND SHOULD GET A RERATING, BUT ASSET QUALITY IS NOT ENHANCED. . .We always argued that WGI would “do something” beyond the Mesquite mine. While the combination of the Mesquite, Cerro San Pedro, and Peak mines should provide cash flow in the range of ~US$150 million per year, the quality of the combined production will be at the high end for operating costs (~US$500/oz). In addition, development of the New Afton mine as an underground, block-cave mine is not without its operating challenges. . .VALUATION – SHOULD IMPROVE ONCE DEAL IS DONE. . .RECOMMENDATION – BUY We remain a BUY due to valuation.
Barry Allan joined Research Capital's Investment Banking Department in 1998 as a mining specialist, and transferred to the Research Department as a Mining Analyst in 2001. Barry has over 15 years of experience in the mining sector. Prior to joining Research Capital, Barry was a Gold and Precious Metals Mining Analyst with Gordon Capital, BZW, and Prudential Bache. Prior to equity research, Barry was a member of the specialist finance group at CIBC, one of Canada's largest financiers of mining projects. Barry earned his B.Sc. (Geology) and MBA degrees from Dalhousie University.
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