GEOFF CANDY: Welcome to this week's edition of Mineweb.com's Gold Weekly podcast. To help us navigate the torrent of market news at the moment is Frank Holmes - he's the CEO and CIO at US Global Investors. Frank there's a great deal happening at the moment and a lot of headlines focussing on whats going on in the US, but you speak often about the fear trade and the love trade in the gold market. Clearly I would assume that the fear trade is dominating - whats happening with both of them?
FRANK HOLMES: There's no doubt about it - the fear trade dominates the marketplace and Wall Street has been calling it a gold bubble since 2005 when gold prices hit $500/oz - and gold's continued 30% rise to record levels in 2010 has given media naysayers added ammunition to downplay the yellow metal's intrinsic values. Right now with the debt problems and issues in America, along with Greece, it continues to dominate the media. But on the backdrop on that, which is so important, is the love trade and that love trade is significant and unique to gold. People buying gold out of love and demand for jewellery was the biggest contributor to gold demand in 2010, accounting for 54% of the total. When we look at the fear trade, what we have found in our research are two drivers for gold to rise in a country that has negative real interest rates and deficit spending. So when we look at the world and we try to simplify it, we see continued negative real interest rates in most of the G7 countries, in Europe and in particular we see them in the US. So there is no inflation per se, its deflation is why you have negative real interest rates, but the thought process is that there's always this inflation that's going to be coming next year and it's ignoring history. Whats so important this fear trade is that these countries - and that's most of the G7 and what we track is the E7 - the seven most populated countries in the world - they also have negative real interest rates. So gold has been rising in their currencies and this is probably going to continue for the next five years. I could easily see based on money supply growth and negative real interest rates, gold to grow at a 13% compounded rate of return
GEOFF CANDY: And is that both the G7 and the E7 or only the E7?
FRANK HOLMES: In countries currency - if I take a look in dollar terms, in other countries' currencies, it would fluctuate differently against the dollar. But if I do it in dollar terms, gold could double over the next five years, and a big reason for that is that most of the emerging market countries - which is 50% of the world's population - have money supply growing at 18%. When you have negative real interest rates and money supply growing at 18% coupled with that love trade, you have that caring nature to give gold as a sustainable gift - you're going to see gold prices be volatile but double over the next five years.
GEOFF CANDY: And I suppose at the other end of that spectrum you're likely to see the dollar devalue as well to some extent.
FRANK HOLMES: I think there's no doubt that the mature societies of Europe and America are headed towards the lowest they've ever been as a dependence on debt that enables excessive consumption is forced upon to reduce and I also think their social engineering ambitions of Obama on a class warfare targeting the rich with his socialist biases to be a real significant factor in hurting the currency and trying to create jobs.
GEOFF CANDY: If we look at that love trade and clearly its centred around Asia - around China and India in particular - you have a fascinating graph that shows a clear correlation between the level of income in those countries and demand for gold - why is that?
FRANK HOLMES: Its emotional, its cultural - 50% of the world's population in the 1970s had no global footprint. Today China has the second largest GDP in the world. Gold is going to be an incredible investment, and at the same time jewellery barometer for the next five years. In countries such as China where they've embraced the free market principles has ushered in economic growth and gold demand levels should remain strong because they have policies now - going back 30 years since Deng Xiaoping took office in China, have been instilling concepts of free markets. And the country has grown with very well defined infrastructure spending and that's contributed to a sustainable growth. This is what happened in America in the 1950s under Eisenhower, so in countries such as today, China and India continue to grow and 7% and 9% and there's an emotional commitment to gold for the loved ones, coupled with a discipline for central bankers. That's truly shown up in this past couple of years with India basically putting a floor of $1,000/oz - buying mostly IMF gold. Then we have recently, Korea and Mexico - you're seeing that their socialist governments have been net sellers of gold whereas the capitalistic and more of a free market emerging countries with low debt levels as a percentage, have been buyers of gold. So you have these twin engines coming at you of love trade and this fear trade.
GEOFF CANDY: How important is the central bank buying going forward and what patterns are likely to emerge - or is this the pattern that is going to continue to emerge?
FRANK HOLMES: If you go back in history, and you look at what percentage of gold assets in the marketplace at this price level versus the amount of paper money that's out in the marketplace, gold still represents a very small percentage historically. It's off its lows with this price appreciation, but I think that most of the gold has been owned by central bankers and they've been basically net sellers of gold and now they've turned. For the past couple of years you've seen net buying - real policy changes - they're supposed to be coming in the fall with Basel III for banking regulations where gold is treated as tier one capital and not at a discount. Well this is very significant because it will basically create discipline for bankers in Europe, not to be buying high yielding Greek or Italian bonds which are sovereign - all sovereign debt is treated as tier one capital. All of a sudden gold is also going to be treated as a tier one capital. You would probably be seeing net buying by central bankers and you couple that with the love trade, gold could easily double over the next five years.
GEOFF CANDY: I want to get your views on gold stocks in a second, but just coming back to the fear trade - in terms of the situation in the US, how do you see this deal unfolding and if anything, how do you see the US progressing from here?
FRANK HOLMES: Ian McAvity summarises it well - "enjoy eating sausages, don't ever visit a sausage factory to see how they're made" - you really don't want to see the ingredients or process so watching the legislative process in Washington - how its performed is embarrassing. A lot of stuff is done behind closed doors - I don't think it's any real change. The policies in the US and particularly the government are very pro-union. Unions are pro-regulations and we're seeing this ramp-up like Dot Frank etcetera is having serious ramifications. It's like shooting cholesterol - even though the government of the US has put so much money into the banking system, the regulatory rulemaking as Bill Gross has said for Pimco and the CEO of JP Morgan has made several comments that its basically oppressive government regulations and that's Jimmy Dines along with the biggest bond money manager. So what is that like - it's like putting an injection into your system and saying "don't worry, go run a marathon". I just don't think it's going to happen and we're seeing the ramifications show up everywhere. So this social engineering doesn't appear to have stopped in any form or fashion and this will change the landscape dramatically over the next five years.
GEOFF CANDY: Moving to what seems to be a conundrum really, between gold stock prices - they have lagged over the price of bullion for some time now - what macro factors if there are any particular ones have been driving this, and does this mean that they're undervalued or should we be watching for other flags or signs of risk?
FRANK HOLMES: The most important shot in the gold market, the US dollar remains that gold is rising above its 60-day moving average which has been above its 200 day since February to $2009. At the beginning of it we had a huge run in gold stocks along with price of gold - gold against all currencies, against the yen, the euro and the dollar - and we're seeing times when gold stocks do a rotation between big cap versus small cap and mid cap and we're seeing rotations where gold outperforms gold stocks and gold stocks outperforming gold. Through one of those periods - one of the things we have noticed is that when there's an aggressive attack on the financial sector - anti-money, anti-banking regulations - a lot of envy regulations coming up. What that does is it seems to stifle all equities and the gold stocks themselves have been pulled down and against this backdrop - but their profit margins should be exploding here and I think many CEOs of these major gold mining companies have changed their strategy but are increasing their dividends. We've seen this take place with Goldcorp - the idea of just acquiring companies for the sake of building up reserves - now there's much greater discipline on cash flow and this is a really significant change. I like to look at Newmont - the biggest US producer and the only gold stock in the S&P500 has done nothing for six years while gold has gone from $732 to $1620. And if you take a look at five out of the 12 major gold stocks, they're trading below the levels reached when gold was topping at $732 in May 2006 - and this is amazing. Those stocks that haven't performed is because they diluted the revenue or production per share of those companies with poor acquisitions and I think that's going to change. So gold stocks are most undervalued on a price to cash flow or price to book and you're going to see that they're much more disciplined when they go acquire companies - so that they're accretive on both the production and a cash flow basis. With that, we still hear these euro bears believe that the euro will disappear and structural volubility will most likely lead to I think a two-tier euro. But I don't think it's going to totally implode but gold will rise - it's been showing great strides in euro terms. Then the euro bears believe that the Federal Reserve is determined to debase the debt by putting money under the cover of fighting potential deflationary forces. So you get bulls see that the dollar is the best looking house in the glue factory. You look at all these factors and say what are the government policies and there'll be a battle between balancing fiscal and monetary policies and right now the G7 countries haven't got their act together regarding balancing fiscal and monetary policies. So gold will trade higher, based on that and the gold stocks that are going to remain attractive, are companies like Franco Nevada - it's amazing to look at this company versus Newmont. Franco Nevada was spun out of Newmont in 2007 and Newmont has basically gone sideways, but Franco Nevada has grown at a 31% compound rate of return. Management owns a big slug of the company. Pierre Lassonde, the chairman of the company has done a spectacular job - the stock is up since 2007 almost 300% and it pays a monthly dividend of four cents a share. So high profit margin companies like this - that's where people must focus on. Silver Wheaton has also been a spectacular performer - they'll be paying dividends - that's another one of those great companies to take a look at. When you go down the food chain, one of the interesting companies that has taken a big position, is called Grand Columbia - that's got over ten million ounces producing 100 ,000 ounces of high grade gold - they'll expand their gold production to 500,000 ounces but there'll be massive dilution because it's so undervalued. What has the company recently done - its floated a debenture backed by silver at $15.00/oz and you get a 5% coupon so therefore there's no dilution to the Grand Columbia shareholders. However when you look at valuation models, silver was never given any value for this company as a by-product. So I think that the royalty companies that I mentioned - you need products like the Grand Columbia debenture, silver-backed debenture - this is where investors will see opportunities over the next five years,.
GEOFF CANDY: Just finally to close off with, and clearly if I understand you correctly, its management that now plays a big role in getting these companies to the type of profits that they expected, especially given all the cost pressures for example, that they're likely to deal with. But I wanted to ask you about Barrick just quickly because the Australian had recently said that copper is definitely a major direction for them now given the deal with Equinox and although it won't be a major focus it will still be a useful cash generator. What did you make of that deal and is this a deal perhaps that's likely to continue?
FRANK HOLMES: You know, Barrick is so sad - Peter Munk has been an incredible visionary very early in this whole cycle and it's been an incredible stewardship, but this is a company that did not cover their hedge book until gold was $1000. They buy an oil company when oil is $147 a barrel. They hedged their biggest cost which is fuel and now they're not buying copper. You want to have to scratch your head and say maybe their strategy has become a Rio Tinto and try to get a gold multiple but they're really diversifying their portfolio to become that. Copper will remain attractive as a commodity, as an asset class and yes it will help with the revenue etcetera, but I just don't think it's that pure gold stock. When you go buy a company like Franco Nevada you get much better performance - you get higher profit margins. And that's what I like at both the loyalty companies - they're paying dividends like that. Royal Gold is another one which since 2007 has grown at a 25% compounded rate of return - it doesn't have the discipline of paying the monthly dividends. Goldcorp has increased their monthly dividends and many of these big cap gold stocks are going to have to compete with the bullion ETF in a low interest rate scenario - they're going to have to start increasing their dividends back to the shareholders and all of a sudden that will wake up as being an attractive asset class for the general fund manager that's looking for gold, that's looking for also yield with it because money rates are so low. You'll start to see money going into those gold stocks that are paying dividends.
FRANK HOLMES: There's no doubt about it - the fear trade dominates the marketplace and Wall Street has been calling it a gold bubble since 2005 when gold prices hit $500/oz - and gold's continued 30% rise to record levels in 2010 has given media naysayers added ammunition to downplay the yellow metal's intrinsic values. Right now with the debt problems and issues in America, along with Greece, it continues to dominate the media. But on the backdrop on that, which is so important, is the love trade and that love trade is significant and unique to gold. People buying gold out of love and demand for jewellery was the biggest contributor to gold demand in 2010, accounting for 54% of the total. When we look at the fear trade, what we have found in our research are two drivers for gold to rise in a country that has negative real interest rates and deficit spending. So when we look at the world and we try to simplify it, we see continued negative real interest rates in most of the G7 countries, in Europe and in particular we see them in the US. So there is no inflation per se, its deflation is why you have negative real interest rates, but the thought process is that there's always this inflation that's going to be coming next year and it's ignoring history. Whats so important this fear trade is that these countries - and that's most of the G7 and what we track is the E7 - the seven most populated countries in the world - they also have negative real interest rates. So gold has been rising in their currencies and this is probably going to continue for the next five years. I could easily see based on money supply growth and negative real interest rates, gold to grow at a 13% compounded rate of return
GEOFF CANDY: And is that both the G7 and the E7 or only the E7?
FRANK HOLMES: In countries currency - if I take a look in dollar terms, in other countries' currencies, it would fluctuate differently against the dollar. But if I do it in dollar terms, gold could double over the next five years, and a big reason for that is that most of the emerging market countries - which is 50% of the world's population - have money supply growing at 18%. When you have negative real interest rates and money supply growing at 18% coupled with that love trade, you have that caring nature to give gold as a sustainable gift - you're going to see gold prices be volatile but double over the next five years.
GEOFF CANDY: And I suppose at the other end of that spectrum you're likely to see the dollar devalue as well to some extent.
FRANK HOLMES: I think there's no doubt that the mature societies of Europe and America are headed towards the lowest they've ever been as a dependence on debt that enables excessive consumption is forced upon to reduce and I also think their social engineering ambitions of Obama on a class warfare targeting the rich with his socialist biases to be a real significant factor in hurting the currency and trying to create jobs.
GEOFF CANDY: If we look at that love trade and clearly its centred around Asia - around China and India in particular - you have a fascinating graph that shows a clear correlation between the level of income in those countries and demand for gold - why is that?
FRANK HOLMES: Its emotional, its cultural - 50% of the world's population in the 1970s had no global footprint. Today China has the second largest GDP in the world. Gold is going to be an incredible investment, and at the same time jewellery barometer for the next five years. In countries such as China where they've embraced the free market principles has ushered in economic growth and gold demand levels should remain strong because they have policies now - going back 30 years since Deng Xiaoping took office in China, have been instilling concepts of free markets. And the country has grown with very well defined infrastructure spending and that's contributed to a sustainable growth. This is what happened in America in the 1950s under Eisenhower, so in countries such as today, China and India continue to grow and 7% and 9% and there's an emotional commitment to gold for the loved ones, coupled with a discipline for central bankers. That's truly shown up in this past couple of years with India basically putting a floor of $1,000/oz - buying mostly IMF gold. Then we have recently, Korea and Mexico - you're seeing that their socialist governments have been net sellers of gold whereas the capitalistic and more of a free market emerging countries with low debt levels as a percentage, have been buyers of gold. So you have these twin engines coming at you of love trade and this fear trade.
GEOFF CANDY: How important is the central bank buying going forward and what patterns are likely to emerge - or is this the pattern that is going to continue to emerge?
FRANK HOLMES: If you go back in history, and you look at what percentage of gold assets in the marketplace at this price level versus the amount of paper money that's out in the marketplace, gold still represents a very small percentage historically. It's off its lows with this price appreciation, but I think that most of the gold has been owned by central bankers and they've been basically net sellers of gold and now they've turned. For the past couple of years you've seen net buying - real policy changes - they're supposed to be coming in the fall with Basel III for banking regulations where gold is treated as tier one capital and not at a discount. Well this is very significant because it will basically create discipline for bankers in Europe, not to be buying high yielding Greek or Italian bonds which are sovereign - all sovereign debt is treated as tier one capital. All of a sudden gold is also going to be treated as a tier one capital. You would probably be seeing net buying by central bankers and you couple that with the love trade, gold could easily double over the next five years.
GEOFF CANDY: I want to get your views on gold stocks in a second, but just coming back to the fear trade - in terms of the situation in the US, how do you see this deal unfolding and if anything, how do you see the US progressing from here?
GEOFF CANDY: Moving to what seems to be a conundrum really, between gold stock prices - they have lagged over the price of bullion for some time now - what macro factors if there are any particular ones have been driving this, and does this mean that they're undervalued or should we be watching for other flags or signs of risk?
FRANK HOLMES: The most important shot in the gold market, the US dollar remains that gold is rising above its 60-day moving average which has been above its 200 day since February to $2009. At the beginning of it we had a huge run in gold stocks along with price of gold - gold against all currencies, against the yen, the euro and the dollar - and we're seeing times when gold stocks do a rotation between big cap versus small cap and mid cap and we're seeing rotations where gold outperforms gold stocks and gold stocks outperforming gold. Through one of those periods - one of the things we have noticed is that when there's an aggressive attack on the financial sector - anti-money, anti-banking regulations - a lot of envy regulations coming up. What that does is it seems to stifle all equities and the gold stocks themselves have been pulled down and against this backdrop - but their profit margins should be exploding here and I think many CEOs of these major gold mining companies have changed their strategy but are increasing their dividends. We've seen this take place with Goldcorp - the idea of just acquiring companies for the sake of building up reserves - now there's much greater discipline on cash flow and this is a really significant change. I like to look at Newmont - the biggest US producer and the only gold stock in the S&P500 has done nothing for six years while gold has gone from $732 to $1620. And if you take a look at five out of the 12 major gold stocks, they're trading below the levels reached when gold was topping at $732 in May 2006 - and this is amazing. Those stocks that haven't performed is because they diluted the revenue or production per share of those companies with poor acquisitions and I think that's going to change. So gold stocks are most undervalued on a price to cash flow or price to book and you're going to see that they're much more disciplined when they go acquire companies - so that they're accretive on both the production and a cash flow basis. With that, we still hear these euro bears believe that the euro will disappear and structural volubility will most likely lead to I think a two-tier euro. But I don't think it's going to totally implode but gold will rise - it's been showing great strides in euro terms. Then the euro bears believe that the Federal Reserve is determined to debase the debt by putting money under the cover of fighting potential deflationary forces. So you get bulls see that the dollar is the best looking house in the glue factory. You look at all these factors and say what are the government policies and there'll be a battle between balancing fiscal and monetary policies and right now the G7 countries haven't got their act together regarding balancing fiscal and monetary policies. So gold will trade higher, based on that and the gold stocks that are going to remain attractive, are companies like Franco Nevada - it's amazing to look at this company versus Newmont. Franco Nevada was spun out of Newmont in 2007 and Newmont has basically gone sideways, but Franco Nevada has grown at a 31% compound rate of return. Management owns a big slug of the company. Pierre Lassonde, the chairman of the company has done a spectacular job - the stock is up since 2007 almost 300% and it pays a monthly dividend of four cents a share. So high profit margin companies like this - that's where people must focus on. Silver Wheaton has also been a spectacular performer - they'll be paying dividends - that's another one of those great companies to take a look at. When you go down the food chain, one of the interesting companies that has taken a big position, is called Grand Columbia - that's got over ten million ounces producing 100 ,000 ounces of high grade gold - they'll expand their gold production to 500,000 ounces but there'll be massive dilution because it's so undervalued. What has the company recently done - its floated a debenture backed by silver at $15.00/oz and you get a 5% coupon so therefore there's no dilution to the Grand Columbia shareholders. However when you look at valuation models, silver was never given any value for this company as a by-product. So I think that the royalty companies that I mentioned - you need products like the Grand Columbia debenture, silver-backed debenture - this is where investors will see opportunities over the next five years,.
GEOFF CANDY: Just finally to close off with, and clearly if I understand you correctly, its management that now plays a big role in getting these companies to the type of profits that they expected, especially given all the cost pressures for example, that they're likely to deal with. But I wanted to ask you about Barrick just quickly because the Australian had recently said that copper is definitely a major direction for them now given the deal with Equinox and although it won't be a major focus it will still be a useful cash generator. What did you make of that deal and is this a deal perhaps that's likely to continue?
FRANK HOLMES: You know, Barrick is so sad - Peter Munk has been an incredible visionary very early in this whole cycle and it's been an incredible stewardship, but this is a company that did not cover their hedge book until gold was $1000. They buy an oil company when oil is $147 a barrel. They hedged their biggest cost which is fuel and now they're not buying copper. You want to have to scratch your head and say maybe their strategy has become a Rio Tinto and try to get a gold multiple but they're really diversifying their portfolio to become that. Copper will remain attractive as a commodity, as an asset class and yes it will help with the revenue etcetera, but I just don't think it's that pure gold stock. When you go buy a company like Franco Nevada you get much better performance - you get higher profit margins. And that's what I like at both the loyalty companies - they're paying dividends like that. Royal Gold is another one which since 2007 has grown at a 25% compounded rate of return - it doesn't have the discipline of paying the monthly dividends. Goldcorp has increased their monthly dividends and many of these big cap gold stocks are going to have to compete with the bullion ETF in a low interest rate scenario - they're going to have to start increasing their dividends back to the shareholders and all of a sudden that will wake up as being an attractive asset class for the general fund manager that's looking for gold, that's looking for also yield with it because money rates are so low. You'll start to see money going into those gold stocks that are paying dividends.
