Q: What is the history of the fund?
We started out as a boutique brokerage firm in the mid 80’s specializing in precious metal mining securities with a strong underlying belief in gold’s monetary attributes. In 1996, we assumed management of a Gold Fund, ultimately changing the name to the OCM Gold Fund. We added the Advisor Class of shares in 2010 to go along with the original Investor class.
Q: Why should investors consider gold?
Historically, gold has been a great asset diversifier and in general owning gold and gold mining shares diversifies a portfolio due to gold’s reciprocal behavior in periods of declining financial asset markets. An overall diversified portfolio with gold incurs less volatility than those portfolios without exposure to gold and gold related assets. In the 13-year period through 2012, gold was the best performing asset when most market indexes struggled to reach long-term averages. In our opinion, gold should have an allocation in every portfolio as insurance against the unknown and poor fiscal and monetary policy.
Today, central banks, led by the Federal Reserve, have embarked on a monetary experiment of massive balance sheet expansion in an effort to stimulate economic growth. The result has been artificially low interest rates for an extended period of time that has pushed investors in search of returns in the stock and bond markets sending those markets to all-time highs.
The market would like to believe the Fed has successfully navigated the economy to port following the Great Financial Crisis of 2008, however, past periods of monetary extremism have led to either inflation or deflation. Consequently, risk levels are high for fiat currencies to suffer a period of rapid purchasing power loss.
We believe gold is the preeminent monetary asset as gold it is not someone else’s liability. Central banks hold gold for precisely this reason. We are often asked why Central banks don’t hold commodities such as oil or copper versus gold. The simple answer is gold is produced for accumulation whereas commodities are produced for consumption. For investors looking at gold from a monetary standpoint, they are looking to us to fulfill that function in their portfolios.
Q: In what ways is investing in gold mining shares better than investing in gold bullion or an ETF?
Gold mining shares are certainly a different beast than gold bullion or bullion ETFs. We recommend that investors own bullion, but we also recommend that they own gold mining shares as a more leveraged investment to the price of gold. Although gold mining stocks are going through a re-pricing period at the moment due to past issues within the industry, this has created an opportunity for investors to accumulate positions in an out of favor industry at an attractive entry point. There are times when the share prices of the miners are undervalued versus the actual metal—for example, at the moment gold mining shares are undervalued versus gold as measured by the gold XAU ratio being at 16.8 versus being closer to 5 in past years.
The leverage inherent in gold mining shares is a result of earnings and cash flow sensitivity to rising gold prices. For instance, in a constant operating cost environment, a million-ounce gold producer would see $100 million of incremental cash flow per $100 increase in the gold price. More importantly, gold reserves in the ground become worth more. Unlike gold bullion, investors have the ability to participate in cash flow through dividends.
The risks in mining companies range from political and operating risks to Mother Nature. However, gold mining companies can create value with the help of discovery through the drill bit by turning loose pasture into a gold deposit.
Q: What phase of the gold market cycle are we in now and how are mining companies reacting to the current environment?
The price of gold has dropped nearly 40% from its peak of $1,900 in 2011, down to $1,150 an ounce. We believe this is nothing more than a correction prior to gold prices reaching new all-time highs of $3,000-$5,000. Think back to the 1970’s when gold prices went from $35 to $190 correcting back to $103 prior to its move to $800 in 1980.
The pull back in gold prices to around $1,200 is close to the “all-in” cost of production for the gold industry. The lower gold price has forced the industry to find ways to tighten its belt and look for ways to cut both operating and capital costs. We have seen capital discipline come back in vogue as management teams seeks initiatives to improve operations and balance sheets. Importantly, this gold price level doesn’t provide the cash flow necessary for the industry to replace depleting reserves and production at the current levels, which is bullish for longer term supply and demand fundamentals.
In a rising gold price environment, the gold mining industry typically pursues a production growth at all costs mentality believing that’s what the market wants. As the gold price comes down, the focus reverts to profitability per ounce. That is where we are now – focus on margin.
Over the past four years, we have seen almost 75% of the CEO’s of major companies forced out or replaced mostly due to making overpriced acquisitions. Meanwhile, the leading gold producers have all taken major write-downs to the point where none of them have any retained earnings, marginal projects have been shuttered or sold, and dividends decreased to shore up balance sheets.
The advent of gold ETFs as another product in the investing space has made gold more easily accessible to investors. Mining companies need to deliver profits rather than just be a call option on the price of gold. This means a more constant focus on margins like never before. However, in order to do that, they will have to mine higher-grade parts of the deposits, which provides the economics of strong returns allowing for a sustainable business. The optimal size of new mines will likely be smaller going forward as less material is mined at higher grades.
With all the write-downs having seemingly taken place and the cost structures coming down, there has been a nice tailwind for mining companies over the past few months. With the U.S. dollar strengthening, the local currencies of commodity producing countries have come down dramatically, helping in turn improve operating margins. Additionally, for big open pit mines, or mines in secluded areas that use diesel generators for power, lower fuel prices have provided another big tailwind on the cost side.
We are currently at a stage where a lot of hard work has been done for these mining companies. They have taken the write-offs and lowered their cost structures as the gold price comes down. And, now these miners are in a position to reap the rewards from a rise in gold prices.
Still, in order to move forward on a sustainable basis, miners need projects that will allow investors to understand the cash flow and capital will be there for the next generation of mines. Naturally, we want to participate in future cash flows. Looking at the peak gold scenario, we take into account the number of mines that are going to meet those criteria. We hedge that with the fact that higher gold prices will also attract new capital into the industry. At that point, we have to see whether management remains disciplined or not.
Q: What is the rationale for the gold price to rebound?
In the run up to $1,900 there was basically a street sweep of all the available gold through the “We Buy Gold” campaigns. Much of that gold was absorbed by ETF’s. As investors in the West, disinvested their gold holdings over the past couple of years to allocate additional capital to the equity markets gold has found its way into the Asian markets. Asian investors tend to be more strategic in nature and longer term holders. This uninterrupted flow from the West to the East continues even at the current price.
Developed economies consume about 1.2 grams per person, whereas developing economies in Asia consume about 0.8 grams per person. The demand in Asian markets is still rising as the middle class develops and the consumption inches towards the level in developed economies because of the new wealth effect.
According to the latest estimate available from the ANZ Bank in Australia, Asian demand is likely to exceed 5,000 tons annually. However, the supply is still constrained. We estimate gold supply to stay near 3,100 and at $1,200 price the supply will drop to 2,000 tons annually.
While the supply and demand fundamentals are positive for gold going forward, the absorption of Western gold by the East sets the stage for higher gold prices upon fallout of the Fed’s extreme monetary policies whether it be deflation or inflation.
oreover, geopolitics also plays a positive role for the gold price shift. Unrest in the Middle East is a constant, but the most significant geopolitical event is the Chinese and Russians moving away from dollar. China and Russia are actively looking to diversify their reserve base and increase gold exposure as they attempt to move away from US dollar influence.
With the increase in demand coming out of Asia, the long-term outlook is very bullish. We expect the supply to be constrained because of different dynamics in the mining industry.
Q: How are mining company shares trading in relation to the broader market?
Presently, mining company shares are trading at their cheapest historical levels. Just to review the last cycle, at the beginning of 2000, the ratio of the S&P 500 Index to the Philadelphia Gold/Silver Sector Index of mining stocks, or XAU, was 32.6. Since then, gold mining shares began to outperform gold in anticipation of the gold price increase that lasted nearly a decade.
Currently, the ratio is just above 30 and nearing its historic high. We believe that gold mining stocks will begin to outperform the gold price in the next cycle again. In order to get the ratio back down, the mining companies need to deliver on operating earnings and the capital allocation needs to be more disciplined.
From a contrarian standpoint, gold shares are one of the most unloved asset classes presently. It is time for investors to diversify their portfolios with gold assets and to look for value in gold mining stocks.
Q: What is your investment strategy and process?
We adjust the portfolio depending on where we are in the gold cycle. To this end, we have a database of approximately 110 mining companies including a number of gold explorers and mine developers. We want to see if management can perform with quality assets. They need to be in jurisdictions that we believe are manageable and that management has experience dealing in. All mining companies have individual issues, such as rising costs or replacing reserves.
There is a lot that goes into the mining industry and it takes time and experience to understand. Management plays a key role in any company and any industry and this is especially true in the gold mining business. We are constantly looking for gold mining assets that create shareholder value.
We are looking for management teams with demonstrated capabilities. Not only do they need to grow their portfolio, but they should also have tangible returns on their portfolio. At the same time, we are looking at opportunities where the market has written down capital that has already been sunk. If we can get that at a discount, we believe that is a potential value opportunity.
With our current fund size, we have enough flexibility to move within various sectors of the industry with limited restrictions from a liquidity standpoint. We do not want to be in an illiquid position with the Fund that is greater than a couple of percent.
One of the benefits of being in a mutual fund rather than an ETF is that the mutual fund will be able to act on situations as they arise even counter to rebalancing periods. Our Fund does not have to deal with trying to track any index for the purpose of casting a wide net over the entire industry. Instead, we can focus on companies that are executing and delivering.
In the coming environment, we believe there will be a number of gold mining companies in the gold space that fail to replace reserves or fail to maintain the financial discipline necessary to operate a sustainable business model that has value. A broad ETF would have to invest in those companies according to its mandate.
Q: What is your research process and how do you look for opportunities?
We feel we have a pretty good pulse of the gold mining industry through our years of building up relationships in the sector. This allows us to see new opportunities early on. Key to our process is meeting with the management team of each company we look to own in the portfolio. After 30 years in the business, it is pretty easy to determine if management is just promoting or actually has the combination of talent and quality assets.
Site visits to mine operations are also part of our research process in order to get a sense of what the asset is and what the merits and potential upside and downside scenarios might be. For example, one important upside that can come through on a site visit is the potential for additional reserve life that is not being valued in the market. On the flip side, a site visit may also expose future environmental liabilities or mine boundary constraints.
After we have met with management and conducted a site visit if necessary, we then look at the assets of the company objectively on a relative value basis versus other assets within the industry, the level of returns on capital the company is generating or has the potential generate and then the jurisdiction of the assets for geopolitical risk.
If it is a multi-mine portfolio with operations, for example, in Brazil, Australia and Africa, we break down those locations in the portfolio of all of our holdings to see how much exposure we have in any one jurisdiction. This allows us to manage our jurisdictional and geopolitical risk profile.
A good example of a portfolio company would be Mandalay Resources Corp., whose management has been acquiring new assets. The company has mines in politically stable jurisdictions such as Australia, Chile, and Sweden. They have also shown an ability to extend reserve life and provide shareholders participation in cash flow through a 6% dividend policy on gross revenue.
When buying assets, Mandalay looks to get an after-tax return of 25% to 30% after they have made some improvements to operations. Such discipline allows the company to continue to grow its asset base — something that gives us comfort that there will be growth in shareholder value over time.
Our largest holding, Randgold Resources Limited has financially conservative management, which has been able to deliver positive cash flow even in declining gold markets. For planning purposes, Randgold has utilized $1,000 gold price in order to achieve 20% plus returns on capital. It has held equity dear and utilized debt judiciously. Furthermore, Randgold has been able to successfully grow its reserve base organically through exploration. Its operations are located in Africa, so we still have to balance that off with having other portfolio positions in less risky jurisdictions.
At OCM, we evaluate projects on a 10-year trailing average gold price, currently around $1,130. Once again, my 30 years of experience in the business gives me a fairly good idea of what works and what doesn’t work.
Q: Would you describe your portfolio construction process?
Our number one goal is to provide investors with a portfolio that provides leverage to rising gold prices while also delivering value and growth.
We start off with major producers responsible for production of over a million ounces. Then, we move progressively down in percentage to intermediate producers, or companies producing between 250,000 to a million ounces, before eventually reaching junior producers.
We are looking for 30% after-tax returns. From a historical point of view, that is a high number, but that is what we need in order to compensate for the level of operational political risk, to allow for shareholders to participate in cash flow, and allow for the capital necessary to build or find the next mine.
We have a select number of developers and explorers that make up the portfolio along with an allocation to royalty companies, which tend to be a bit more of a defensive play. Royalty companies do not have the operating cost inflation risks, but they still participate in growing reserves and upside in the gold price. These companies have outperformed traditional gold mining companies over the past 10 years due to the lack of operating risk perceived in the marketplace.
At present, we hold 38 names in the portfolio and we change our allocation among the subgroups of the industry as the gold price trend evolves and values change.
Historically, we have outperformed our portfolio benchmark index, the Philadelphia Gold/Silver Index, and for the most part we have outperformed the Market Vectors Gold Miners ETF (GDX).
The metrics we consider when analyzing silver producers, which form 10% of our allocation, are similar to how we analyze gold producers in terms of valuation and upside to the company’s stock and management’s capability of performing and executing. It comes down to how much exposure to silver we want to have in the portfolio. Silver has more volatility than gold and has more industrial characteristics. Overall, we want to provide the gold asset hedge that investors are looking for. If we have too much silver in the portfolio that can infringe on our core function.
As patient investors, we have had a very low turnover rate in our portfolio of less than 10%. With regard to our sell discipline, we will move away from a position if management does not act according to their strategic plans.
Q: How do you define and manage risk?
There are numerous risk factors in the gold mining business. The number one being volatility in the gold price. We manage this risk by constructing a portfolio that consists mostly of companies with operating costs in the lower quartile of the industry and having the flexibility of adjusting the portfolio amongst the various sectors of the industry. Our investors want exposure to the gold price, but we have to understand which companies are going to be susceptible, from a balance sheet standpoint, to lower gold prices and which companies will have leverage to higher gold prices.
The inherent risks in the gold mining industry range from operational risks, depletion of reserves without replacement, geopolitical risks, Mother Nature, cost inflation, and changing government regulations and taxations. As you can see, it takes a lot of time and energy to stay on top of the risks that are presented. This is where our experience comes into play.
