What's Wrong with Gold Stocks?

JOHN: Well, it is no secret that gold prices have been heading higher. In March, gold prices headed north of $1000 an ounce; and since then of course, as could be expected, they pulled back. Today they?re close to 900 an ounce ? in the high 800s there ? which is up from last year; bullion prices of gold and silver equities rose in tandem. However last year, precious metals equities lagged bullion as they have this year. So people are wondering what is behind this divergence? Does this spell either a) trouble or b) opportunity? And that?s our first conversation here on the Big Picture today.

JIM: Looking at bullion prices, we commented actually that performance is starting to change because right now, year to date, we?ve got bullion prices up a little over 3% and you?ve got the HUI up about 2.8% and the XAU up about 2.6%, so they?re getting closer. This divergence which was widespread last year is narrowing this year and I think we?re at that tipping point where you?re going to see gold equities and silver equities start to outperform the bullion.

But anyway, there were probably three or four factors that were behind this divergence. One was costs that were rising faster than bullion prices; 2), with the emergence of the credit crisis last year there was an aversion to risk; 3) the credit crunch, which made it more difficult for some companies to get financing; and 4) is a reversal of hedge fund activity from being long to going short because there were only a handful of five or six stocks within the HUI that made money (a good majority were either neutral or they lost money.) And of course, if you look at the junior sector, juniors were down last year as they are this year.

So one thing that stands out - and I think the reason for this underperformance as it relates to producers is that costs in the mining sector were rising faster than the price of bullion. Remember, up until last August, gold prices were at 650 an ounce and it wasn't until this credit crisis burst upon the scene that bullion prices really rose at double-digit levels and above the rate of costs. Mining costs have been rising at an annual rate over the last two years between 25 and 30% a year; and it's attributable to a number of factors. You had rising labor costs; you had the rising cost of energy - look at energy costs where oil went from $50 a barrel to $100 a barrel; material costs - everything from steel to plastic pipe; and also government take - governments began demanding a higher share of mining profits. So as recently as the fourth quarter of last year, margins were hurt as costs were going up faster than the price.

For example, if we take a look globally last year, in the fourth quarter you had costs were up 30% in South Africa, they were up 23% in Australia; Canadian mining companies saw their costs rise 23%; in the US costs rose close to 20%; in the UK, costs were up 23%. So if you take the average of global prices, they were up 28%. Now, if we boil that down to companies, the large producers: Newmont saw its costs rise 19%; Barrick's costs rose 31%; if you take the South African producers such Anglo, Gold Fields and Harmony - their costs rose anywhere from 31 to 40%. Globally we've seen average costs rise from about $175 an ounce in 2001 to around $390 an ounce for 2007. So costs are up over 120% over the last six years and more importantly, they have skyrocketed over the last two years. In 2007 alone, the average cost for producers went from 300 to around $400 an ounce, so that cut into margins which is why a lot of the gold stocks - especially the large caps - underperformed bullion. [4:39]

JOHN: So looking at it from a pragmatic standpoint, if you were an investor should you avoid the stocks and just buy the bullion ? I know we see these questions come into the Q-Lines a lot and emails ? or what should the strategy be here?

JIM: We have always advocated on this program that you start your base building in precious metals [with] bullion and some people like to recommend at least a 5% position in bullion. So you start out with your bullion base. But now right now, if you take a look at where the value lies in the market, and I think we are seeing this change before our eyes even on this day that you and I are talking - but the real value lies in the precious metals stocks versus the bullion. But as a consequence, also the risk is higher. But I believe if you look at the markets today, the opportunity lies with the equities. Prices have finally risen - on the day you and I are talking the price of gold is at 886 - so the price has finally risen high enough now that margins are also rising for the producers.

A good example is the recent earnings report for Newmont which reported first quarter earnings of 82 cents a share; that?s up from 15 cents a share a year ago and a loss 63 share in 2006. So if prices remain high as they are now at close to $900 and head higher as I expect - I expect we will retest 1000 and then eventually we?re going to go beyond 1000 - so the producers are going to be minting money if prices of gold bullion stay at this [level]. And remember they are very leveraged to the price of bullion if they?re unhedged and that to me represents a better opportunity in my opinion than bullion. [6:31]

JOHN: I know you favor the growth producers who are building resources and growing production but if we do some comparison, how have they fared up against the super majors?

JIM: I actually think the growth producers are doing much better. Some of my favorites actually have negative costs. If you take a look at Agnico-Eagle, their cash costs are a negative $184; Yamana's costs are a negative $9 per ounce; and the numbers are even looking better as you look at the firs quarter of this year. So these growth producers continue to be the low costs producers, meaning they are making a lot more money per ounce of gold or silver sold and I think that situation is only going to get better going forward. [7:16]

JOHN: Up until recently costs were rising faster than prices and as a result you would expect that would hurt profits which it did, which in turn damaged stock performance. But can anything else be factored in here to explain this divergence between stocks and bullion?

JIM: Sure. I think there is a broad aversion to risk which came in last August with the credit crisis. When that crisis erupted, investors basically said "where did this come from?" and everybody rushed for safety. And what happened is in terms of asset allocation there was a shift to safe haven type investments. And those two safe havens were Treasuries and bullion. Gold and Treasuries became the safe haven of choice and if investors went into precious metals equities - which they did because they did rally in the fourth quarter - it was mainly the large cap producers; the rest of the sector, from junior producers to junior development companies did very poorly since May of last year. And even in the case of some of the majors, investors have been mainly trading in and out of them. When gold pulled from 1000, you saw companies like Agnico whose share price went from 83 and dropped all the way down to $59 a share. So even the shares of majors have pulled back sharply as bullion prices pulled back. [8:41]

JOHN: And what about juniors? I mean I know you favor them - that's been no secret here on the program.

JIM: Oh my goodness, I mean they have taken these companies out to the woodshed and beaten them up severely. In many cases, you can take a look across a broad spectrum ? they?re practically being given away. But juniors sort of travel to their own individual cycle. I know a junior that I've been involved in was beaten up severely last year due to management problems; there was heavy shortselling that came in to the stock - in fact, a naked short position came in due to financing. But this year the stock is up almost 130%. What I find I think remarkable is even as things have gotten better for a lot of these companies and especially this one in particular the short position has actually increased. But what is happening to this company I see happening all across the sector. Companies announce spectacular drill results, they increase their reserves and the stocks go down, the short positions go up. [9:42]

JOHN: We've done shows before on shortselling. What is behind this anyway?

JIM: I think that part of this explanation is due to hedging, especially with the markets becoming more volatile; a lot more uncertainty was injected into the markets with the credit crisis last year. So, with hedging let's say you take a long position in bullion which has been the dominant trade, then you hedge against bullion going down by shorting the gold stocks; Or, if you're long the majors you short the juniors.

Gosh, going back to the turn of the Century, I've been involved in this sector since 2000 and 2001, when we got heavily involved in this sector and John, I've never seen short positions like I?ve seen today. They short the majors, they short the intermediates, they?re shorting the juniors. [10:35]

JOHN: What would really help here is some examples of what you?re talking about.

JIM: I'm not going to get into specific names but I'm just going to give some examples. One of the companies we own just reported that their sales were up 172%, their profits were up 400-something percent and John, this is a company whose stock is down 19% this year. And the short position went from nothing to almost 5 or 6% of the outstanding stock - and this company is very tightly held. So management is a key holder as well as certain other respectable firms that own this company, but you know, they reported these results and yet the stock got hammered.

Another company that reported spectacular drill results: They reported for example, 8 meters of gold averaging 55 grams of gold; they had 10 meters of 46 gram gold; they had 32 meters of 15 gram gold. You're talking about an Aurelian-type deposit here and it was amazing because when they announced these results the stock went up and then all of a sudden the stock got hammered and it was actually reported - it went on the naked short position that came into this stock; and short positions just multiplied.

Another company reported drill results: 16 meters of 4.6 grams of gold; 1300 grams of silver; 7000 grams of silver, 28 grams of gold. And this is a company that within a three month period of time reported drill results with these kind of results and each time they reported this, what happened is the short position increased in the stock. So a lot of people are saying, "what's wrong with juniors!?" There's nothing wrong. A lot of these companies are either if they're junior producers are reporting almost in one case, 200 to 300% increase in sales; 4 or 500% increase in profits; drill results that we haven't seen; or for example they increased their reserves or their resources by 20 to 30%. And what has happened, instead of the stocks going up or if they do go up on the results immediately heavy short selling comes in to drive these stocks down because that's been the dominant trade - you go long the bullion, you short the stocks. And this is all across the whole spectrum. [13:06]

JOHN: Is this whole process legal or is there something fishy here?

JIM: Shorting is legal and is actually quite bullish, if you think about it, because eventually short sales have to be covered. What is illegal is naked short selling and that is actually equivalent to what we call counterfeiting stocks. And there is a lot of that going on right now and the regulators, just as they were asleep with the accounting and scams of the Enrons and just as they were asleep with this credit problem going on with these CDOs, they're also asleep now with this naked short selling. In fact, the SEC probably opened the door to this kind of activity when last year they got rid of the uptick rule to accommodate the hedge funds. So there are a lot more shares sold short than shares that are registered.

So part of the problem is the regulators are allowing this to occur because if they really pressed a lot of the funds to come in and cover their naked short positions because its so widespread they would actually trigger another major financial crisis and I think that's what they're dealing with right now. This sort of lying underneath and nobody is giving recognition to this in terms of how widespread [it is.] I read a report on a New York Stock Exchange - I think it was like 25 billion shares sold short and it goes way beyond the number of shares that were registered in the companies that were sold short. So it?s a widespread problem right now, not just with the juniors but all across the board. [14:43]

JOHN: It's something like you said that can't be unraveled because if they did unravel everything really would unravel if they tried to deal with that issue. You know, speaking of crises: What about the credit crisis because banks are tightening their lending standards, they?re deleveraging their balance sheets so this would seem to be presenting a problem for juniors with credit conditions that are really, really tight right now compared to what they were a couple of years ago?

JIM: Well, look, if you look at the junior sector there are probably about 2,000 juniors out there; and out of those 2,000 probably less than 5% of them will ever turn into a mine or go into production. So for many of these companies times are going to get tough. However, if you have a project that has a defined resource of? I don't know ? anything over a million to two million ounces or more, is in a friendly jurisdiction (especially with political problems of nationalization on the rise), with good mining economics, with good management that is probably equivalent to like having a FICO score of 800. And companies with 800 FICO scores are having no problems getting financing. We've been involved in three different financings this year and all three were oversubscribed with money waiting in line to get in. So like the real economy, if a company has a viable project, a defined resource with plenty of blue sky, you're having no problem getting money. [16:13]

JOHN: So if shares haven't been performing as well as bullion and hedge fund shorting, then who is buying? I mean for every seller there has to be a buyer in this deal, so who is on the other side of these trades?

JIM: If you take a look a look at what's happened, probably going back to summer of last year, most of the day-traders and the momentum traders have exited this sector. What I see now is a lot of big, smart money moving into the sector. You see this almost daily. In fact, on the day that you and I are talking, John, I'm looking at my screen of majors, intermediates, and juniors - you have the HUI, the XAU is down and a wide swath of juniors are in the green. Several of these juniors are up 7, 8%. So I think what has happened is there a widespread recognition, I think this short in this sector is in the process of reversing itself.

And if you think about it, "buy low, sell high" we've always been told that's how you make money in the market. Well, when gold was at 1000, everybody was high-fiving going into the major gold stocks. Look at where we are today. The sector is beaten down, it's ignored; pessimism runs rampant in the junior sector. It reminds me a lot of what I saw in the year 2000 and 2001 when I first began to accumulate juniors. I mean the tech bubble was bursting, the economy was heading into a recession, you remember all the scandals with the Enrons, the WorldComs. Investors were putting their money in cash. Nobody wanted to invest in gold. It was unloved, undervalued and underowned. But gold and gold stocks were being given away during that period of time.

A similar story by the way for oil because nobody was buying oil between let's say the years 2000 and 2003 when oil went from $30 a barrel; and it wasn't until oil prices got over 40 and headed towards 50 that money began moving into the oil sector. Even on a day that we are talking where our forecasts for $125 oil was reached on this Friday and the oil prices closed at just a few cents below 125, you know what, they were selling off the oil stocks. And it's like people are saying, "well, you know, this can't last - this is not going to be there."

So if you take a look the fundamentals for gold have never been stronger, especially as we head into that crisis window that you and I have been talking about that begins in 2009 and goes to 2012. In respect to gold equities, the situation has never been better. And as Warren Buffett likes to say, you?re being given a perfect pitch. [19:07]

JOHN: Well, the role of patience or the lack of it in this situation?

JIM: We have talked about this over the years. If you're not a long term investor, if you don't understand the fundamentals that are behind gold, and especially gold equities, then you know what, quite frankly you don't belong in this sector. Keep your money in a Treasury bill or a bank CD. However, if you're a long term investor and have a long term horizon when you make investments, it just doesn't get any better than this. [19:41]

JOHN: Okay, but let's create a theoretical scenario here. What if prices don?t go back above the $1000 mark. I mean gold prices are usually soft during the summer months, so what if the conditions you've named that keep juniors from performing, what if they persist now?

JIM: Quite honestly, my ideal scenario I would love for these conditions to stay at these levels for the rest of the summer and early fall. But you know what, I'm in the accumulation mode so I hope they keep prices low because that enables me to buy more shares at much lower prices. And you know, that's all I care about right now because I know that gold prices are heading much higher. I know that oil prices are heading much higher, commodity prices are heading much higher. And John, when price are going to recognize that - will it be this month, will it be next month, will it be by the end of summer? I would say by the end of summer the price of silver, the price of gold is heading higher. By summer, we're going to be looking at much higher natural gas prices and as we get into fall, as we'll get into the next segment I have now revised my price forecasts where we're going to be looking at 145, $150 oil and certainly by the end of next year, $200 oil. So I don't care what the price is now - if they want to short the stocks, drive the prices down - I'm in the accumulation mode just as I was in 2000 and 2001. And all I care about is how many shares I'm going to be able to buy and I think that is what is more important. So I hope they keep this down. But you know what, if you take a look at these conditions, they will not last much longer. They never do. In fact, I wouldn't be buying bullion here as prices at close to $900, I would be buying shares because that's where I think the value is in this market right now. [21:38]

JOHN: I have to admit that as long as I've know you you've been a long term investor, but that's in many cases sort of a contrarian position from what I would call the knee-jerk day to day of what's been going on out there. It's a whole different mind-set, let's face it.

JIM: I've always looked at long term investing - I've been in this business over 30 years and you know what, the long term thinking or long term investing is the only way I've ever figured out to make money. I'm more comfortable getting on board a long term trend early and riding it until it plays itself out. And in my opinion - it's not just mine but others that I respect - I believe that this commodity bull market will move on well into the next decade. And I certainly believe that because we don't have excess supply, we don't have excess inventories and we're living in an age that I would describe as an age of scarcity. So that's what's worked for me. Other people may be better at trading in and out of this sector than I am - I'm not a trader so I don't subscribe to that view because as I mentioned I''m a terrible trader.

But if you look at this market, so either you enter this market as a long term investor, buying on weakness, building your positions or you trade this sector. But when it comes to juniors, you make more money by buying quality companies, holding, building your position on weakness and when it comes to juniors, John, this is as good as it gets. [23:08]

JOHN: So if we have to summarize the whole thing, we basically believe that gold and silver prices are heading much higher - that's pretty much given where everything is going right now as far as the economy and oil and everything else; precious metals equities have underperformed due to a series of factors - rising costs, there is risk aversion, and the short selling that goes on. But, that whole process is in the act of reversing itself right now. Prices are higher today so mining companies are back in the black and good quality companies are having no trouble getting financed and short positions will eventually - I mean they have to be covered sooner or later. So of course the question to all of this is just one of timing.

JIM: Yes, and it becomes a question of patience and taking advantage of opportunities. Does anyone really think that the credit crisis is over, the dollar is going to get stronger, central banks will stop printing money or that inflation rates are heading lower or that the gold industry will expand and discover elephant-sized projects that will flood the markets with excess supply? That is not happening. If you take a look at it I've never seen a period where all the stars are lining up for a higher bullion, and what I believe is going to be an explosive run in precious metal equities. In fact, I think we're at that tipping point where things are beginning to reverse themselves. Like I said, on this day, we're seeing the price of many juniors move up and I think it's going to be a process that's going to reverse itself. And when these short positions have to covered, it's going to be explosive because the liquidity - I mean if you're short 5, 6% or 8% of a company and a lot of these companies are held in strong hands, where in the heck are you going to get the shares? The only way you're going to get those shares is actually by coming in, paying a higher price for it and that's what I expect to happen. [24:58]