Opportunities in the Small and Mid Caps: An Interview with Hans Peter Schmidlin, Precious Capital Ltd.
Source: The Gold Report††(5/30/08)
The Gold Report checks in again with Hans Peter Schmidlin, CEO of Precious Capital Ltd. in Zurich. He shares his insights on what's happening with inflation (just how accurate are those numbers?) and what he sees as an unparalleled opportunity for investing in small and mid-cap mining companies.
TGR: A lot of the buzz here is about the price of gold, currently about $927. All of our sponsors, particularly the gold mining stocks, are waiting for an increase to start funding the mines.
HPS: There are two important points about the price correction in gold. The first one is the anti-correlation with the U.S. dollar; certainly that put pressure on gold. The second one, which may be even more important, is that people really seem to believe that the financial system is safe again.
TGR: Although many people are saying that there are probably more problems to come and weíre not going to get out of it soon.
HPS: Concerning gold, I believe thatís true. Everything the Fed tries to do to save the financial system, in coordination with all other banks worldwide, has long-term effects. That means itís not coming back next week. If the sentiment of the market changes, it will keep for some weeks, if not several months. We may have a quiet time with fewer worries for some months now.
But as Mr. Bernanke warned recently, we can expect further losses in the housing market. That certainly will create additional losses for the banks. And so I personally donít think we are through with our problems. Iím pretty sure that it will come back like a boomerang, because of the money theyíve printed to save the financial system. This also created a real hidden inflation.
TGR: You mean by printing the money?
HPS: Printing more money certainly is inflationary ó and that will bring gold back to higher levels. If people realize that if inflation is going to rise, certainly that is bullish for gold. If the financial system problems come back, as I personally expect they will, and as it seems as if Bernanke himself expects, then certainly the risk premium with gold will come back as well.
TGR: Youíre not hearing a lot about the inflationary impact here in the U.S. I donít know if itís true in Europe.
HPS: If one guy says the U.S. dollar is going to recover, lots of others follow, and that brings the dollar up. That is how the U.S. dollar recovery started. I personally really have my doubts that the inflation numbers are true Ė I believe that in reality they are way higher.
TGR: Yes. They donít include fuel or food.
HPS: This is ridiculous. Everything you need daily, which really hurts your pocket, your wallet is not counted at all. So that is a really silly situation.
TGR: In the U.S. weíre obsessed about the price of gas for your car. You have reports on it every day, but they still donít put gasoline in the inflation basket.
HPS: Itís not as high as Europe, but the thing thatís important is that the U.S. changed to the so-called Hedonic inflation calculation. That means, for example, you used to barbeque tenderloin steak in your back yard. You may not buy that tenderloin any more because it is getting too expensive, so you just barbecue hamburger. But for calculating inflation, that doesnít make any difference. As long as the American gets food and gets full every day, we donít have inflation.
A washing machine is another example I like. A few years ago, they were all mechanical. Nowadays they are electronic. You have additional value of letís say 10%, but it isnít in the price and we donít feel it in the pocket. It still costs $1,000. But in the inflation basket this will be counted as 10% deflation.
TGR: So what youíre saying is weíre not measuring the true inflation because weíre switching daily foods from tenderloin to hamburger, and we have better electronic washing machines that are replacing mechanical ones. This is counted as 10% deflation even though we pay the same price.
HPS: Yes, the guys from the inflation office think that this new electronic washing machine costs the same as the mechanical one, but it should actually have more worth because itís more comfortable to use. And that theoretical 10% decrease is an example of the Hedonic inflation calculation.
TGR: So itís going to make the total inflation rate seem lower.
HPS: Thatís exactly the point. They can build in deflation using a theoretically different calculation of the inflation.
TGR: And everyoneís wondering why they donít get as much with the dollars theyíre shopping with.
HPS: Exactly. Everybodyís wondering why we donít have higher inflation numbers.
TGR: Eventually, people are going to figure this out, though. And when that occurs, are youíre saying that the price of gold could bounce back?
HPS: If people realize that how inflation is increasing in real terms, they certainly will be gold-bullish, too. But I wouldnít say that has a direct influence. What is important for gold itself is that inflation is way higher, and the financial crisis will come back. And then we will also have a renewed premium because of fears about the U.S. financial system, which will be built up in the U.S. and into gold again.
One other really important issue is the demand for metal. Others think the demand for gold is going to be lower because of the higher price. We also had the same situation with copper óthey thought, ďOkay, China will have a problem because the U.S. faces a recession.Ē That means less demand for Chinese products, so we have less demand for copper. But what happened is actually just the opposite. Copper didnít fall down in price ówhich is what everybody expected. It suddenly began to rise, and ended up at almost $4.
So, whatís the problem here? The problem is that everybody looks at the demand side, and nobody looks at the supply side. If people would check the supply side, they would realize that the supply of metals is going to decrease a lot, and this is exactly what all the big guys from the big companies are always saying. And recently at the Denver Gold Show, Peter Munk of Barrick Gold said that nobody realizes how serious the supply situation is because there are fewer and fewer discoveries. In the last 10 years there haven't been any really big discoveries.
The only big one actually was Aurelian Resources' (TSX: ARU). But then you have the next problemóitís in a politically insecure country. So, it looks as if the only really big discovery is not going to be built, because the Ecuadorians stopped all the mining in that country. You have the same in Venezuela, and you have the royalty discussions in Ghana, Guyana, or the taxes in Mongolia.
So you have fewer and fewer possibilities to make a discovery. That means the supply will decrease a lot over the next years.
And we just had that same situation with copper. With copper, certainly there is less demand in America because more goods are produced in China. But also China may have a bit less demand because of the possible U.S. recession. The problem is that everybody overestimates the influence of the U.S. imports from China. But the real point is the balance between supply and demand in copper is very tight.
TGR: So the underlying fundamentals of supply and demand, which we should all be remembering from our Econ 101 classes, say that all these metals have much higher to go.
HPS: Absolutely, because there are no new discoveries. You still have existing mines, but their mine life will be over within the next few years. And then you have new discoveries over the last years, but the contracts for production over the next three to five years are mostly already sold. So, itís really difficult to catch the metal on the market.
TGR: The demand wonít decrease enough to equalize the supply.
HPS: I donít think so, and weíre talking about the next five or maybe 10 years. But certainly this is a really important point for the ongoing bull markets, which will last not only two to five years, but maybe even longer, five to 10 years.
TGR: When last we spoke you said your fund just focuses on metals. You gave a portfolio balance of 60% gold, 25% silver, 5% uranium, and some copper. Is that changing now that youíre seeing fluctuations in the gold market? A lot of the buzz here is the uraniumís really devalued.
HPS: First of all, as I say, the ongoing correction in gold might go a little bit further. I always check the 300-day moving average. Everybody else, it seems, looks at the 200-day or another moving average, but I check the 300-day moving average. And this one has worked really well since the beginning of the bull market.
At the moment, the 300-day moving average is $785. We could have a short panic selling day, but I do not expect it. I would say that $785 is a maximum, because I donít think that the price is going lower. If that happened, a lot of mining companies would immediately close their doors because the cash costs of production costs have risen so much over the last few years. It would immediately decrease supply a lot again. That is the worst-case scenario.
I expect actually that gold will go to around $860, and then down to $830 and then thatís it. But we see already that the big-caps Ė letís say all mining stocks Ė are already discounting such a decrease in gold. The big-caps are pretty low; they have showed big surprises in the first quarter 2008 results.
So our fund is now at 41% gold, silver at 18%, and copper at almost 13% because of the big rise lately. But we may decrease copper a little bit because it is so high at the moment, and increase our stakes in gold and silver again because we think the mining stocks already are discounted.
TGR: Are you increasing uranium in the fund?
HPS: We just put in place some more uranium investments, because we believe long term about climate effects and thatís uranium-positive.
TGR: When you say long-term, are we looking at five years or 10 years?
HPS: Letís say the next 12 to 18 months. But maybe the recovery in gold is a bit more urgent, so thatís where weíre focused at the moment. And then we will look more and more at mid- and small-caps again.
TGR: When we spoke before, you were not that bullish on the juniors.
HPS: Yes, and they have decreased even more in the meantime. Now you have lots of mining companies in the small-caps or mid-caps that are priced at ridiculous levels; they have a market cap that's as much as the cash in their pockets. That doesnít make much sense.
The real exploration companies without cash flow will have problems raising money in the future to finance, but if they have a really good project, which the professionals believe in, they wonít have a big problem raising money. So, itís very important that you have a really good property if you donít have a cash flow yet. These guys certainly will have way less trouble raising money, but still it will be tough, and it certainly will sort out all the bad quality exploration companies.
TGR: How does an individual investor really understand if itís a really good property or not?
HPS: You need to be a really good geologist, and most investors are certainly not geologists. So thatís where you have to go into specialized fund investments. A fund that is investing in resources should have a geologist at least as an advisor, if not as an employee. These guys understand where they can invest and where not.
But it could be that mid- and especially small-caps mining companies will take off again, because I see a similar situation to 2002. In 2002, many small companies, with prices at really low levels, as is the situation now, exploded over 12 to 18 months. We certainly are in a similar situation, and I cannot say it isn't possible. But where Iím focusing now is in the mid- and small-caps because they have to be bought out by the big-caps. Big-caps will try to catch more reserves and resources through buying up mid-caps. They will also try to profit from the low market cap at the moment, because of the really, really cheap levels right now.
TGR: Back to your comment about 2002, when people were really buying small-caps and really running the price up. What was causing individuals to buy in the small-caps after the sell off in 2002?
HPS: The bull market in gold just started then, exploded in summer 2003, and at the beginning we had a similar situation with fear about the markets. At that time it was because of Enron, WorldCom, and other big companies, but this time it has happened because of the overall financial system. There are currently huge losses, and thatís why people think the juniors will have a lot of trouble raising money.
But as we are having a big, ongoing bull market in the metals, why shouldnít they get financed if they have a really good property? If you know you have one million or two million ounces of gold in the earth, you can make an easy calculation how much it will cost to get it out and at what price you can sell it and how much profit there will beÖ if you have almost a guaranteed profit, you always will find financing. And thatís a very important point.
TGR: What are some of the companies you are following in the juniors or the small-caps?
HPS: GoldQuest Mining Company (CDNX:GQC.V) made a really nice discovery in June. They even had a second discovery, and the stock price went even lowerÖwhich is really ridiculous. I expect they will release a 43-101 compliant resource and finally get recognition for their efforts.
TGR: Gold Quest is really perplexing. They have had a second discovery since we talked in February, and the stock price is still bouncing around.
HPS: Still down because the investors donít really understand the geological results and so donít follow any new discoveries. No one wants to be in the juniors because of the fear that theyíre going to be bankrupt and will have problems raising money. Thereís even talk about hedge funds shorting the juniors. So itís all these things.
But one of my favorites is still Miranda Gold Corp. (MAD:TSX-V), because of their team. Forty percent of the geologists nowadays have gray hair and are going to retire over the next five to 10 years, and there aren't more qualified ones in the next generation. Teck Cominco estimates that as many as half of its workers in British Columbia will retire in the next five years!
Then comes the question up: who is going to make the next discoveries? I've heard a geologist can now earn more money than an MBA, and that shows how huge the demand is and how small the supply is.
TGR: Whatís so special about the Miranda team?
HPS: The geologists: Joe Hebert, Steven Koehler and their boss, Ken Cunningham. Itís an amazing team with a lot of experience; they have a really good nose to discover something. They just haven't had luck lately. And for me thatís just a matter of time until they get lucky again, because they haven't lost their knowledge about mining or about finding a deposit.
What I try to do in the real world is to buy low and sell high. Thatís what everybody tries to do, of course, but nobody has the courage right now to buy low. I think if you have a company that has more cash in the pocket than their market cap, then something is really wrong; it's a ďno-brainer,Ē actually. You really have a huge opportunity to buy low now.
What we need is a trigger to make the ball go forward again. It can be a takeover by a big company. When a big company suddenly comes and buys up a small-cap with big resources or even reserves, then they immediately begin to look around to see what other small-cap company has lots of resources and reserves that also may become a target of a takeover. And that could kick off the next rally.
But certainly, you never catch the real low. I personally expected that were at a very low level when we talked in February. Now itís even lower and itís even more ridiculous. But what else can you say? I am just trying to pick out the small-cap companies with really good, promising discoveries. I am also looking especially at mid-caps with lots of resources and reserves. They certainly will be a takeover target for the big companies because they have lots of cash. They generate cash now because their balance sheet is clean.
Goldcorp Inc. (GG-NYSE; G-TSX), Newmont Mining Corp. (NYSE:NEM), and Barrick Gold Corp. (ABX) are suddenly coming out with big, positive surprises, which shows that they can handle the rising costs, and they also can finally profit from the high gold prices.
TGR: In terms of these mid-caps, do you have any mid-caps that youíre watching for potential consolidation with the large-caps?
HPS: I really like MAG Silver Corp. (TSX:MAG; AMEX:MVG); it has a huge discovery in Mexico. They have already proven 350 million ounces. They are in a really secure country, and thatís what counts at the moment. They have an astonishing geology team with a proven record. So the possibility that their discovery could become even bigger is pretty high. MAG Silver is not a producer yet, but they have a big discovery, proven discovery. The discovery liess just beside the biggest mill in Mexico from PeŮoles, which is the biggest silver company in Mexico. And we have early indications that one of their other properties, Cinco de Mayo, could be another homerun.
TGR: Are any others in that mid-cap range youíre looking at?
HPS: I also look at Moto Goldmines Ltd. (TSX:MGL), which is in the Congo. This is a country with a huge amount of reserves and resources Ė Moto Gold could reach more than 20 million of resources. The political situation is certainly not that secure, but they just fixed all agreements new, and that could be a takeover candidate sooner or later.
Otherwise, Petaquilla Minerals LTD. (PTQ.T) in Panama, which is politically pretty secure. I was amazed Teck Cominco just guaranteed part of the financing a short time ago, and theyíre talking of financing of almost $3.5 billion, which is actually huge. Thatís a positive thing.
I have to say that I have investments in all the companies Iíve mentioned. And I have to repeat, the small-cap I like most is Miranda Gold. The team of geologists is the most important asset of a company, until they have a big discovery certainly.
TGR: Yes, thatís the way it is. Well, Hans Peter, thank you very much for the time that you have spent with us.