Four-Digit Gold?

CFA, Senior Managing Director, Co-Portfolio Manager
November 23, 2005

For Tocqueville Gold Fund's John Hathaway, gold shares "give you more octane than the metal itself."

If it's gold you're after, Hathaway, who runs about $550 million in the Tocqueville Gold Fund and another $400 million in separate client accounts, is the man for you. Year in and year out, Hathaway has delivered glittering returns, outperforming the benchmark Philadelphia Exchange Gold and Silver Index at every step. This year his fund (ticker: TGLDX) is up 15.3%, compared with a gain of 14.84% in the index, even though the performance of gold stocks has lagged behind the appreciation of the metal. Focusing on what he considers to be undervalued gems with good growth potential has paid handsome dividends for Hathaway and his investors. If, as he believes, the price of the precious metal is heading toward four-digit territory, expect that streak to continue.

Barron's: Gold seems to be trying to make another run here. What's your outlook for the price?

Hathaway: In the very near term, I have no idea. But it is still a bull-market trend, and there are a lot of reasons for that, and we will see higher prices. People shouldn't be surprised to see gold trade in the four digits.

Q: What's behind the move higher?

A: There is so much paper around, there are so many financial assets, and it only takes a small diversion from financial assets into gold to push the price higher.

Q: But what would lead to that diversion?

A: People are buying tangible assets, and gold is tangible and probably one of the most liquid and, in some ways, the least risky of all the tangible assets.

Q: There doesn't seem to be a lot of it around.

A: There is not a lot of it around. If you took one-tenth of one percent of global financial assets and stuck them in gold, you would wind up with a couple of years of mine supply. It is a trade you can't do. But it still gets back to the question as to why people would get more interested in gold, and it's not all based on bearishness. India is getting more prosperous, and Indians like gold. China is getting more prosperous, and the Chinese like gold. More disposable income in Asia definitely helps gold.

Q: Yet there are bearish factors behind the bull case for gold.

A: There is an ongoing currency debasing. Look at all the people who were bearish on the dollar a couple of years ago -- they've been slammed because they put their money into the euro. They should have put it in gold. Warren Buffett just took a loss on part of his position in the euro. He was famous for being bearish on the dollar. How did he activate that? He took a 22 billion euro position because the euro was liquid and gold isn't.

Q: Are you surprised at the behavior of the euro?

A: Not really. It is a piece of garbage, really. There is no national treasury that stands behind it, but a committee of bureaucrats. Then there's the politics and social issues in Europe. There's a big difference in the growth rate between the U.S. and Europe, and there's a big differential in interest rates between the U.S. and Europe. Gold is going to rise against the dollar and the euro and the yen, which it has been doing for quite a while, but it has been doing it quietly, so most people aren't even aware of it.

Q: There are still a lot of skeptics on gold.

A: It's been five years since it's been in a bull market.

Q: Before that it had been in a bear market for about 20.

A: These days, the generations are much shorter. Residual skepticism is all over the place, and it is terrific because it gives the bull case longevity. If everybody were on board the way they are with energy, I would have to think of a new investment theme to work on.

Q: You have written about gold benefiting from a bubble in the U.S. Treasuries market.

A: The bubble is a reflection of the lack of investment alternatives. It is also a reflection of the perceptions of risk and the notion that Treasuries are a safe haven so they should be priced in a different way. There is so much money sloshing around the system, to the extent it is risk-averse it goes into Treasuries. On the other hand, you have negative real rates throughout the yield curve. Latest 12-month inflation is running about 4.7%. An investor has to go out almost 30 years on the yield curve just to get even. There is so much paper around and returns on assets are so hard to come by that it is driving money in this direction, and that's created the bubble. But these conditions are very favorable for gold.

Q: So what will focus people's attention on gold?

A: Hitting $500. That will fixate attention. This has been a stealth bull market. Only years after a bottom has been made do people realize it.

Q: Hasn't there been a disconnect between the price of gold and gold shares?

A: Day by day, tick by tick, they don't do the same thing. But if you go back to 1999, which was the bottom of the bear market in gold, gold has gone from $250 an ounce to nearly double that. And the XAU, a benchmark for gold shares that most people use, has gone from the low 40s to around 115. For the last year or so, the shares have underperformed the metal to some extent, but over a period of time and on a historical basis, the shares give you more octane then the metal itself.

Q: Why are the shares underperforming?

A: Costs are up so much, particularly for open-pit mines, which use a lot of energy pushing dirt around and hauling it. The cost of building a new mine is up a good 30% over what it was five years ago. So the economics of the industry, even though the price of the commodity is up quite a bit, are essentially just as crappy as they were when gold was at its lows.

Q: Will consolidation in the industry help that?

A: Not really. They might help a particular company's business, but it is not going to change the economics. What would change the economics would be a $200-$300 price increase so that gold would then outperform commodities. Gold has underperformed other commodities by about 50% for quite a few years. That tells you oil, copper and a lot of these inputs that gold producers need to get gold out of the ground have outpaced the price of gold. That is a fairly straightforward explanation of why margins have been poor. But there is another factor, and that is it is so easy for a gold company to get money. They have abused their ability to access what has been very low-cost capital by over-issuing shares. The stocks might be 20% higher if so many didn't declare open season on investors by issuing so much new stock.

Q: Do you take an activist role in that sense?

A: I'm very vocal about how investor-unfriendly the success of share issuance is. I'm particularly upset with the Canadian investment banks that do these deals.

Q: What's their defense?

A: The other side of it is that small companies, particularly the ones that are true exploration companies, are analogous to biotech stocks. They have properties that have potential value, but it takes a lot of money for drilling and exploration and metallurgical testing and feasibility before you actually generate revenues. Basically, they have to pass the hat all the time. Issuing shares is a quick and dirty way to get money, and for smaller companies, it's OK. But I object to any company that has a listing here in the U.S. on the New York Exchange or American Stock Exchange doing "bought" deals [in such a deal, a new-share issue is bought entirely by one underwriter to resell to investors].

Q: Is there any evidence that raising money has boosted production?

A: No. We just had a company in yesterday that is a particularly good example of this practice, and if you look at benchmarks like resources per share or ounces of production per share, they have been flat at this company for the last four years. So getting back to your question on why the shares have been sluggish in an environment in which the gold price is going up, it's because costs are way up and these companies issue stock without discipline.

Q: Haven't some gold stocks been hurt by strength in local currencies?

A: Certainly the South Africans were hurt because the rand went from something like 13 to the dollar to six to the dollar over a period of a year and a half or two years. That's like cutting the gold price in half. Even though the dollar price of gold has gone up, the rand price of gold is just now getting back to where it was a few years ago. To a lesser extent, strength in the Australian dollar and the Canadian dollar until recently squeezed margins for operations in those countries. But you get around that problem if gold is rising in all those currencies, which it is doing. But we have reached a point where gold isn't really linked to foreign-exchange rates because a lot of people are concerned about paper currencies in general.

Q: Yet Central Banks have been selling gold.

A: Central-bank selling fills the gap between supply and demand. They have been selling at steady pace. What they have is an arrangement so their selling is orderly and doesn't spook the market. Under that arrangement, there is a quota system of 500 metric tons a year for five years. The selling is transparent, the market knows it is there, and if the program wasn't in place, gold could easily be $200 or $300 higher. We are in the second year of that five-year agreement, and it is hard to imagine where all that gold is going to come from.

Q: Who's buying?

A: They sell it into the market. We keep some of our gold in Switzerland, and I went to the facility where we keep it and basically it was a large refining company. They were melting down bars from the Swiss Central Bank, and at the other end of the production line there were semi-finished gold watch cases and jewelry for China, the Persian Gulf and India. That's where it is going. Central bankers are selling their best asset into the markets and it is going into non-monetary forms, and they will never get it back. They are just bureaucrats and not even held accountable for what they do on a financial basis. It has been such a bad trade for the last five years, you would think that at some point they would begin to say maybe we should hang on to what we have. But again, their general agenda is not to have gold as a monetary asset or at least not talk about it if they have it, because what is still true is that a rising price of gold is not a favorable reflection on public financial policies, monetary and fiscal.

Q: What's the impact of gold exchange-traded funds on the market?

A: It is potentially huge. Right now there's about $3.5 billion in gold ETFs, which isn't bad considering the first one came out a little over a year ago. As we discussed, gold shares can be risky, yet gold is not necessarily an investment for those who are risk-seeking or risk-tolerant. Gold is essentially financial insurance. It is non-correlated. It has hundreds of years of history of being non-correlated with financial assets, which means that when financial assets are doing well gold doesn't do well. From 1980 to 2000, that was the case, but in the 1970s and 1930s, gold did very well. What the ETF does is open the door for people who should have exposure to gold. It makes it easy for a college endowment that would never typically open up a commodities account or open up an arrangement with a bullion dealer to own gold. The ETF paves the way for an entirely different class of investors to come into gold, not gun slingers looking for huge returns but people who just want to protect capital, which gold does very well. Eventually, this will do a tremendous amount for the gold price. The more money that comes into the ETFs, the more it is going to create momentum for the underlying commodity. Barclays is trying to bring out a silver ETF, and the Silver Users Association, which includes companies such as Kodak and Dow Chemical, are opposed to it because of concern it is going to take the price up.

Q: What risks are working in gold's favor?

A: There is a lot of financial risk in the system. The level of household debt, the housing bubble, the amount of U.S. Treasuries held by foreign central banks, the valuation of the stock market, the overvaluation of the bond market, are all legitimate reasons to be concerned, not that I wish for worst-case outcomes. Secular credit expansions, which is what we had from 1982 through 2000, are often accompanied by an ever-decreasing perception of risk. Frankly, we've been in a bear market since 2000, and people still don't realize it. Yet bear markets have a life of their own, and they really don't end until a certain psychology takes hold and people just hate financial assets.

Q: Are gold stocks attractive at this point?

A: One of the problems I have is that a lot of my positions are merging, so I'm forced to go down the food chain and look elsewhere for other things to own more of. Among the big producers, companies such as Newmont Mining [NEM], Gold Fields [GFI], Barrick [ABX] and, to some extent, Goldcorp [GG], aren't really growth vehicles. They can get a little bit bigger, perhaps, but if this Barrick merger with Placer Dome [PDG] goes through, for instance, the company will produce 10 million ounces of gold, and that's more than 10% of the market's annual global production. How much bigger can they really get? This is not a business that lends itself to size in the sense that one company could ultimately become 30% or 40% of the market.

When you are mining that much gold, you have to replace it every year, and if these guys can just replace what they produce and replace it with high-quality ounces, and keep their costs in line, they are doing a great job. They become perpetual options on the gold price. Newmont, for instance, should just say it will be a seven-million-ounce producer for the next 15 years, and that would create a certain instrument in the market- place, which is a long-dated option on the gold price with a very low cost of capital.

Q: What about the smaller companies?

A: On the other end of the spectrum are the pure exploration companies that are out there trying to find new reserves, and as the gold price goes higher, the Newmonts and Barricks of the world will be compelled to buy the junior names. We manage our portfolios by owning the best of the large companies that have this long-option characteristic to their shares and the best of the small-cap names where value can be created without the price of gold rising necessarily.

Q: What junior producers are attractive?

A: I want to be careful to list companies that are reasonably liquid. We own something called Yamana Gold [AVY], which has a very nice growth profile. They are in Brazil and have a great land package. It's got 190 million shares trading at 4.

Q: Are you expecting more upside?

A: Yes. They have a fairly well-defined ramp-up of growth in the next five years, and that is something that we look for. We also like Ivanhoe Mines [IVN] a lot. There are 300 million shares outstanding, so it has a $2.4 billion market cap. They have a huge discovery in Mongolia. Ivanhoe has a world-class copper discovery that just keeps getting bigger and has the potential to match Freeport McMoran's [FCX] big copper property in Indonesia in terms of its size. It is right near the Chinese markets, and it is economically very significant.

Q: Any others?

A: A third one is Eldorado [EGO]. It's an emerging producer with assets primarily in Turkey, which is geologically a very good place to be. It hasn't been picked over the way some areas have. It is not really a Third World country in that it has got First World infrastructure.

It's got a billion-dollar market cap. Basically, what we look for is production ramping up so there is some growth component and prospective acreage and land packages allowing for more discoveries.

Q: Thanks, John.

John Hathaway, CFA, Senior Managing Director, Co-Portfolio Manager

Mr. Hathaway is a co-portfolio manager of the Tocqueville Gold Fund, as well as other investment vehicles in the Gold Equity Strategy. Mr. Hathaway also manages separately managed accounts for individual and institutional clients.  He is a member of the Investment Committee and a limited partner of Tocqueville Asset Management ( Mr. Hathaway began his career in 1970 as an Equity Analyst with Spencer Trask & Co. In 1976, he joined investment advisory firm David J. Greene & Co., where he became a partner. In 1986, he founded Hudson Capital Advisors and in 1988 became Chief Investment Officer of Oak Hall Advisors. He joined Tocqueville as a Senior Partner in 1998. Mr. Hathaway has a BA degree from Harvard College and an MBA from the University of Virginia.  

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