Since 2003, Fundamental Research Corp. (FRC) has been focusing on companies not widely followed by brokerage firms, bringing investors and undervalued small and micro cap companies together. In this exclusive interview with The Gold Report, FRC founder Brian Tang and his crew forecast the primary driver of base metal prices in 2009, the future of gold and copper and the infinite upside of investing in finite resources.
The Gold Report: Brian, could you give us a summary of your firm and its business model? You have strong opinions about how individual investors should approach paid-for research.
Brian Tang: Sure. I founded the firm in 2003. At that time, a lot of the investment banks were being scrutinized for producing research that was tied to corporate finance and I was also in corporate finance—but more on the debt side. On the debt side, all research is paid for. Firms like Moody’s and Standard and Poor’s will charge firms money, and then issue a credit rating on them. So given that the corporate finance model was being scrutinized, I thought why not apply the debt model simply to the equity side, where we would charge a fee to issue a rating on the equity of companies?
Of course, there is the potential for a conflict in that type of situation. What we’ve done is instigate policies to mitigate those conflicts; for example, we only charge our fees flat and in advance and we don’t accept stock, so the companies have to pay in full before we get started. We sign agreements with the companies that basically relieve us from any liability for negative reports. They agree that they will not sue us for negative comments. Once we’re engaged, we have to finish the contract. They cannot prevent us from publishing further research. And, if you look at the distribution of our ratings—where 25% of our ratings are hold, sell or suspend—I think you can get an idea that our analysts are truly independent. We’ve issued sell ratings right off the bat, and that company has paid, we’ve done our due diligence, and we didn’t like the company; so we initiated coverage at a sell. So that is the business model. Also, if you look at our performance on Investars, you will see we have done quite well in the past.
In terms of our focus, we focus on small and micro cap companies that aren’t widely followed by brokerage firms. We think by focusing on companies that no other analysts are following, we can add value by discovering these undervalued companies.
Currently, a lot of our coverage is in the natural resource sector—mining, oil and gas—and the other two sectors that we cover are industrials and healthcare. From time to time, we publish special reports, industry reports, on topics of interest that we think investors would like to read about.
TGR: In this market, many people are suggesting that people avoid the micro small caps because of the shakeout in the marketplace. In essence, avoid the juniors and focus on the producers. What insights can you provide to our investors regarding that?
BT: I definitely think that, in this type of environment, the producers or the near-term producers will do better just because there’s less risk to them. Also, it really depends on what type of company you’re looking at. If the company is well financed, we don’t see that as a problem. We have downgraded some companies to sell recently because they were not well financed; we think they might run into some liquidity problems, so definitely I would avoid those kinds of companies. It also depends on what kind of commodity they’re in. I’d look for some commodities that are better than others.
But, also, small caps tend to recover first when a bull market does resume, and they also tend to do worse when a bear market starts, simply because they’re more levered in terms of operating leverage. They’re smaller, so they get affected more by swings in the economy. They recover first, but they falter first, as well. So if you avoid them totally, I would say you would miss out when the economy starts to turn again. And because nobody can predict when that will happen, I would not totally avoid them, but I would be very selective.
TGR: In the research you do and provide to subscribers, do you give specific sell-hold recommendations and pricing?
BT: Yes. We issue buy, hold or sell recommendations. We don’t call it a target price; we call it a fair value, and we also issue a risk rating from very low risk to highly speculative. We’re registered as a securities advisor with the BC Securities Commission.
TGR: Could Siddharth Rajeev, your head of research, give us your global outlook for what will happen in commodities in 2009? Specifically base metals, precious metals, and gold-silver?
Siddharth Rajeev: The primary factor that we believe is going to affect the pricing of base metals is the global GDP growth assumptions; and we believe that in 2009 we are going to see a significant drop in GDP growth. For example, the International Monetary Fund (IMF) forecasts global GDP growth of 2.2% in 2009; and that was about 5% in 2007 and 3.7% in 2008. And then most of the developed economies like the U.S., Japan, Europe and Canada are expected to be in a recession in 2009, while emerging countries like China, India, Brazil and Russia are not in a recession (but they are expected to have a significant drop in their growth rate). So we believe that these reductions in the GDP growth rates will affect demand growth for most of the base metals.
We have a long-term positive outlook on copper, primarily because we still believe in the Brazil, Russia, India and China (BRIC) countries' growth; so we believe that, in the long term, they will achieve growth. Those countries will drive the demand for base metals.
BT: Also, if you look at current commodity prices, they have declined a lot from the peaks—but those peaks were not necessarily based on fundamentals. I think they were based more on speculation. If you look at where the price is today compared to historical averages, the prices are still much higher. For example, we have a long-term forecast (2012+) for gold of $600 per ounce. Even though that’s lower than today’s prices, it’s still double the historical average. Gold has historically averaged only about $300 per ounce, and that’s the same with oil prices.
SR: For gold we expect prices to converge to $600 per ounce in the long term. But in the near term, we are bullish on gold, especially because we expect the U.S. dollar to depreciate due to the slowdown in the U.S. and the negative real interest rates in the U.S. And we expect inflation to creep in once the effects of the large stimulus package are felt. So, it’s because we expect the U.S. dollar to depreciate and we have seen in the past that gold prices have had a negative correlation with the U.S. dollar. Other reasons that we’re bullish include higher cash costs, as well as relatively flat supply. So we’re bullish on gold in the near term; but in the long term, we expect prices to converge to $600 once the global economy improves and the U.S. dollar recovers.
TGR: Do you have some specific companies you can share with us that you feel are getting some good financing and are close to production, which you feel our investors should know about?
SR: One of our top picks is called SilverCrest Mines Inc. (TSX.V:SVL). They have three silver-gold projects in Mexico with 43-101 compliant resources, and then they are planning to put their main project, the Santa Elena project, into production later this year. Based on our evaluation, our valuation of the company is $1.98 per share while the shares are trading at 45 cents.
In terms of comparables, their enterprise value (EV) to resource ratio is just 25 cents per ounce, while our estimate of the average ratio of its peers is over $2. So we like the company, number one, because we have a positive outlook on both silver and gold; number two, they’re closer to production; number three they have a favorable valuation; number four, and most important now, is that they are in a decent cash position. The second company I want to talk about, that we’re currently doing due diligence on, is called Gold Resource Corp. (OTCBB:GORO) (FSE:GIH). They have four high-grade silver-gold projects in Mexico.
They’re planning to put their main project in Mexico into production mid-2009, and their plans are to produce 70,000 ounces of gold in the first 12 months of production. And the best part is that management estimates that their cash cost is going to be just $100 per ounce.
TGR: Wow. For gold?
SR: Yes. So they’re aiming to be one of the lowest-cost producers around. That’s one of the companies that we think investors could track.
TGR: Do they have the management team or the production team to start producing gold there, or will they be joint venturing?
SR: No, no. They have the management team, and they are arranging the financing now. Recently, they had announced a strategic alliance with Hochschild Mining (LSE:HOC). They hold 5% of equity in them and they are planning to do another 10%. So, even though they have to raise capital, we don’t think it will be that tough compared to a lot of companies. Management is also expecting a payback of less than a year, which is pretty good.
TGR: I know one of the companies you’re following is Commerce Resources Corp. (TSX.V:CCE) (PK SHEETS:CMRZF). Can you comment on them?
BT: Vincent, our geologist, will discuss Commerce.
Vincent Weber: With regard to Commerce, they’re focusing largely on their Upper Fir project. They did 131 HQ diameter drill holes totaling just over 26,000 meters in their last phase of drilling, and they’re targeting carbonatites that host tantalum and niobium mineralization. Tantalum is used for capacitors, like those used in cell phones; niobium is used for special alloys for steels. They just put together a 2,000-ton bulk sample on the Upper Fir Carbonatite, which they’re sending to a company in Richmond, B.C., for sampling to characterize the deposit. They’re also going to put together a flow sheet and a pilot test plant to try and determine the appropriate recovery method.
SR: We believe that Commerce is one of the companies that raised capital at the best time-when the market was at a peak, so based on their latest financial statements, they had about $22 million in cash at the end of July 2008 and that's like 20 cents per share. Share prices are currently 24 cents per share, so the market value is very little for their projects.
TGR: What's the burn rate?
SR: Based on the last financial statement, it was around $700,000 per month in the second half of 2008. The company, though, was in the midst of the biggest program that they had ever done, which was in total 157 drill holes and the extraction of the 2,000 tonne sample we just mentioned, and after speaking to management, the expectation is that their burn rate for 2009 should be a lot lower. I am certainly looking forward to seeing those results. I expect that they have about $15 million in cash at this time.
TGR: You just issued an update on Castle Gold Corporation (TSX.V:CSG). Can you share with us any insights on that company?
SR: Yes, they have two producing projects; and, in our valuation, we actually raised our fair value estimate to $1.67. Currently shares are trading at 46 cents. We like the company because it's currently producing, generating cash flows and is expecting to reduce operating costs next year. In 2008, the company had very high operating costs; but they expect to reduce costs through 2009 and realize much lower costs in 2010 and beyond, which will help them generate stronger cash flows starting in '09.
BT: The El Castillo mine experienced operating costs of $685 per ounce, which was higher than expected, and the reason for that was they incurred a high strip ratio of 1.55 versus the expected mine life average of 0.6 which is expected to come into effect by 2010. This strip ratio is waste to ore. When we spoke to management, the company said that they expect operating costs to decrease in 2009 by improving mine efficiencies, which would include utilizing larger equipment and also using that larger equipment to increase their gold production from the mine.
TGR: Where are they currently producing, and do you expect them to spend a lot on capital investments in ’09?
BT: Guatemala and Mexico. In our models for ’09, we estimated a capex budget of $2.15 million. Our models are showing that, in 2008 and 2009, they should be cash flow positive.
TGR: Are there any other base or minor metals or gold or silver companies that you currently like?
VW: Another project that I’m currently doing some due diligence on, which is an intriguing deposit, is West High Yield Resources (TSX.V:WHY). They have a large magnesium deposit that they’re exploring in British Columbia; that’s a different type of metal from all the other companies.
TGR: What is magnesium used for?
VW: It’s used for lightweight alloys. That’s one of the main uses.
TGR: What is the outlook for minor metals in 2009?
SR: In terms of minor metals, I can give a general idea on where those metals will perform in 2009 - 2010. Basically, for several minor metals, including molybdenum, manganese, chromium, vanadium, these companies serve the steel sector and most of these metals had a good run in 2007 primarily because of a significant increase in steel production in China; and, of course, their forecast at that time of steel production was very optimistic, which is why we believe that those metals had a good run in 2007.
But now, as we expect the global GDP growth to slow down, we expect steel production also to slow down, which will affect the demand side of all these metals. So we are expecting all these metal prices to stay soft in 2009 and 2010, just like our outlook for base metals.
TGR: Do you think the stimulus package that Barack Obama is proposing will have an impact on that?
SR: It will have a positive impact on it, but then we think that in 2009 - 2010 the GDP growth drop will have a stronger effect, which will push down the prices or soften the prices. Beyond that point, once the infrastructure and the BRIC country GDP growth starts to improve, we expect the demand for these metals to improve then.
TGR: Thanks so much for your time today. We really appreciate it.
Brian Tang, BBA, CFA, founded Fundamental Research Corp. in 2003, and has successfully led the firm to be recognized as on of the fastest growing companies in the province of B.C. Prior to Fundamental Research Corp., Brian was an analyst in the corporate banking group of one of the world's largest international banks where he performed fundamental analysis on Financial Post 500 companies (the Canadian equivalent of the Fortune 500). Prior to this, he worked at a financial advisory firm where he analyzed and published research on Canadian equity mutual funds.
Fundamental Research provides institutional quality equity research coverage on small and micro cap companies through its extensive distribution network. Its major institutional delivery channels include institutional sites such as Reuters, retail sites such as Stockhouse, and subscribers. Fundamental Research’s performance has been highly ranked in the past by Investors.
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