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Louis James: Sharpen Those Shoppertunistic Buying Skills
Source: Interviewed by Karen Roche, Publisher, The Gold Report (2/10/10)
In this Gold Report exclusive, Louis James, Senior Editor at Casey Research, goes back to Economics 101 to argue that recovery calls for accumulating capital to invest—not amassing staggering debt and attempting to spend your way out of trouble. That said, though, sometimes buying is just what the doctor ordered. Train yourself to find opportunities to get in under market on equities when inevitable fluctuations make you say, "Wow, I can't believe what a great deal this is!"
Louis James: I think of it this way. If a patient's on the operating table and you put in an artificial heart and slap on an iron lung, blood pumps, there's oxygen and respiration and apparent life. But is that recovery? And what happens if you switch off the machines? In this case, despite massive infusions—literally trillions of dollars—one of the most critical vital signs is still faltering. We've not seen the job creation you'd logically expect.
So, yes, throwing money at the problem is having an effect. Yes, some things are working again. Yes, credit is flowing to some degree. But don't mistake this for recovery. True economic recovery takes business people making rational decisions to invest accumulated capital in new ventures and so on. That's very different from what we're seeing now. We may see a protracted plateau between troughs if the iron-lung economy continues functioning for a time. But that's a far cry from economic health and won't prevent another systemic shock when the repo-man comes for the iron lung.
TGR: To stay with your analogy, don't the positive signs—the pulse not as thready, the breathing less shallow—suggest that maybe the worst is over and we're starting to heal?
LJ: We at Casey Research are still very cautious. The Keynesian idea of government intervention was to "prime the pump," to inject a little liquidity, and with the multiplier effect turn every dollar the government spends into $6 as the money works its way through the system. In reality, that's not the case, it comes at a price, and it doesn't change the fact that you can't build anything solid without accumulated wealth to invest in the future. Some people argue that businesses borrow to fund growth all the time. That's true, but businesses usually put up real assets to back their borrowing. What the U.S. government is doing is more like a tapped-out head of household with no job asking his bank to triple the line of credit on his already maxed-out credit card. That's not a viable business plan for growth; it's a total gamble, made in desperation, against the odds. So, no, I don't see the interventions as having cured the patient in any way, shape or form.
TGR: That sounds more pessimistic than cautious.
LJ: I am extremely pessimistic mid-to-longer term on the U.S. economy but not so pessimistic over the longer term for the global economy. The shorter the timeframe, of course, the more foolish it is to say anything specific. No one knows what can happen near term. We may even see more of a semblance of health. But sooner or later, those massive injections already made by Obama and his predecessor are bound to have huge consequences. Regardless of what's done now, that's already baked in the cake. You can push prices down only so far and for only so long. You can't push below the cost of production without government subsidies, which cost more money, which has to come from somewhere. Because some people can't afford to spend reduces demand for bread, for example, but U.S. bakeries can't drop their prices to a level that would clear the market because they're obligated by minimum wage laws and other costs factors that remain high.
At the same time, money flowing and flowing and flowing from the government is real monetary inflation that eventually will show up in prices as well. It's important not to confuse price destruction in certain asset classes, like real estate, with life actually getting cheaper.
TGR: The Fed keeps saying we can grab some of that money back by increasing interest rates and slow inflation down. Do you buy that?
LJ: No. They've been keeping interest rates down to encourage economy activity, to stimulate it. We're looking at a stagflation scenario, in which they are truly damned if they do and damned if they don't. Keeping interest rates down at times of gargantuan public spending and deficits guarantees debasement of the currency—but they can't raise rates, because the voters have sent a clear message that they want JOBS NOW and those in power will spend whatever they have to in an attempt to deliver. Nevertheless, at some point higher interest rates are inevitable. The government wants foreigners to buy T-bills to fund the debt. To do that, you need to offer attractive interest rates, and an effective zero, or less, isn't terribly attractive. If they fail to interest foreigners in buying more U.S. debt, the only alternative is the printing press—the path to Mugabeville.
TGR: Let's add China and India to this mix. Their internal growth rates seem strong enough to offset reductions in exports to North America and Europe.
LJ: That's diving into some pretty murky waters. How much of China's internal growth is truly internal? The best thing about China is that the government had massive cash reserves, so when they threw a half a billion dollars at their problem a year ago, they didn't have to borrow it. But will building railroads to nowhere and ghost towns actually have any lasting positive impact? You'll find numerous hits if you Google or do a YouTube search for "empty city China."
Don't get me wrong. I've been to China numerous times and see a lot to be bullish about there. I've seen the enormous accumulation of wealth, and I've met individual Chinese people who have savings—but that doesn't mean that there won't be any bumps in the road. In time, as corrections have their necessary consequences, China and India will spur global growth going forward—to a degree. Meanwhile, it's dangerous to assume they will save the world. To think they can just step in and keep the party going single-handedly is naively optimistic.
TGR: With all of the things you've been talking about as a backdrop, where are investors supposed to put their money if they're trying to build personal wealth?
LJ: I think it makes a lot of sense to continue to be cautious, to keep your powder dry, have a significant cash holding, and of course we're very bullish on gold—regardless of short-term fluctuations. We had quite a year in 2009, a lot of gains. Not as great as they might have been if we had left all the money on the table, but we slept a lot better because whenever we got a double, we recovered our initial investment. So we have all our capital back plus large positions in highly prospective companies. And having cash is not a bad thing.
In terms of the bigger picture, sitting on cash ready to deploy into good opportunities and maintaining a significant position in gold (and silver, of course) are smart things.
TGR: And you say you remain very bullish on the precious metals.
LJ: Absolutely. We like precious metals a lot. We can see gold going down if the dollar remains strong near-term, because gold still varies inversely with the dollar. But that's a buying opportunity. It's nothing to cry about; it's something to take advantage of.
As for silver, we'd predicted that it would outperform gold by a wide margin in 2009, and it did; that was an easy one to spot, because the price was out of whack. The natural ratio of silver to gold in the world is something like 16:1 in terms of the frequency of the element in the earth's crust. The trading ratio between the two has resembled the natural scarcity ratio for most of history. Over the bull cycle of the aughts (2000s), the ratio went to about 50:1 by and large, but in the crash of 2008, it dropped to about 100:1. That was just silly. Silver is not 100 times more common than gold.
Still, silver is an industrial metal as well as a precious metal. It actually gets used up. If business demand goes down with the economy, it stands to reason that there are fewer silver buyers. But with that precious metal component, if there's a big economic scare and gold makes a major move up, silver will climb too, regardless of the industrial demand. So when the economy got whacked, silver got whacked. It made a lot of sense to look for silver and silver plays. That gap narrowed significantly over 2009, but it's still a gap. Silver is still relatively cheap.
So we like silver a lot. Even if economic conditions reduce industrial demand, the precious metals demand would increase for the same reasons. Meanwhile, we still have supply destruction. Most silver is a byproduct of base metal mining, so if copper or lead prices fall and companies cut back production, that would constrain silver supply at a tie when demand may rise.
TGR: Where should our investment focus be in the near term?
LJ: In economic environment that remains so uncertain, you should run the other way if someone tries to tell you what's going to happen next month. In these circumstances, you should respond like a value shopper—with a feeling of "Wow, I can't believe what a great deal this is!"—before taking advantage of an opportunity. Don't buy anything because it's cheap relative to comparable deals – most of them are probably overvalued. Relative valuation should never be confused with real value, meaning, a company trading for less than NAV, or even less than cash. There are times when speculating on relative value can work out—as in hot area plays— but when you can buy real value at a discount, that's always better.
TGR: That strategy worked for a lot of people after the crash.
LJ: It sure did. When things went south in the fall of 2008, a number of really good companies—companies that had been extraordinarily successful, had no discovery risk and little technical risk—went down with everything else. Savvy investors were able to buy high quality at a huge discount. When I saw some of the prices on the tickers, I thought, "Wow, I can't believe I can buy this company for this little." One example of that was when Teck dropped to the C$3-range. Sure, the company had serious debt problems, but this was Teck, a major mining powerhouse, off from $50 a share to $3 a share. That was "stupid cheap" and an obvious buy, regardless of whether or not the market had hit bottom. I have to admit that we did not make this recommendation to subscribers, because we were not sure base metals would recover, but I did bring it to the team, and the stock rose by more than 1000% in 2009. When you see those kinds of opportunities, that's a good time to deploy some of your cash.
TGR: But incredible returns on the market in 2009 brought equities up across the board. Have we missed out on those value shopper opportunities?
LJ: Maybe, but that doesn't make it right to rush into the market now if you've been on the sidelines. If you're not feeling that something is extraordinarily cheap, you're taking a risk because otherwise it can correct in a big way and stay lower than your entry point for a long time. All it takes is one bit of really scary economic news to bring the whole house of cards tumbling down.
TGR: Could you update us on some of the companies you've mentioned before?
LJ: Sure. You've asked me about Lara Exploration Ltd. (TSX-V:LRA) and Reservoir Capital Corp. (TSX-V:REO).
I really, really like Lara's management. They are people I trust and know to be extremely competent, which is, sad to say, not so common in this business. They have had some interesting developments, including the deal with Sprott Resource Corp. (TSX:SCP). I don't follow Lara closely, but I like those people a lot.
The same people are involved with Reservoir. Again, I have the greatest respect for their management, and since Reservoir started out as a gold play in Serbia, I know them well. Marin Katusa, my counterpart in the Casey Energy Division, follows REO now that it's no longer really a gold play. But I can say that Reservoir has shown that can create deal flow and operate in a hot sector (green energy in Eastern Europe) where it's been difficult for others to maneuver. They've landed significant renewable energy concessions, green-friendly energy that commands a premium price. They know how many megawatts they can generate at some projects. All they have to do is connect the dots. Once they get a power purchase agreement with a green-energy price bonus, the numbers will line up and the market will be able to calculate a value for what they have. That hasn't happened yet, but they're working on it. And when they are re-valued, the potential is enormous. This is a little company and these energy contracts are big business—it's a stock I own, personally.
Then there's Inter-Citic Minerals Inc. (TSX:ICI) (ICI.TO), which has had its ups and downs, but we've always held on. That's because ICI's Dachang Gold Project really is extraordinary. With many projects, figuring out where to even look for gold is worse than the proverbial needle in a haystack. You start with a gold-in-soil anomaly, which all gold projects have. Just because you find gold at the surface, of course, doesn't mean there's gold below. The surface traces could be the bottom of a system that's been eroded away, leaving nothing at depth. But where Inter-Citic's done detailed trenching—digging through the dirt and scraping the bedrock to see what's actually there—they've had great success. The correlation has been unusually high with the soil anomalies. And when they've drilled, that correlation has again been unusually high between gold on surface and volumes of gold underground—in excess of 90% of the time. As I said: extraordinary.
Better yet, the company has tested only a few of the known areas on their property thus far. So there's a lot of blue sky in that play, and with this unusually high correlation between exploration targets and drill results, that blue sky is more real than in most gold exploration plays. The news lately is that they've started an initial round of drilling in a new zone that's a significant distance from the existing zones. Already they have holes a couple hundred meters apart, and both hit. That isn't enough to outline new volume of potentially economic mineralization, but the odds look very good that a new zone will shape up there. That would add substantially to the company's already significant resources, and that's very bullish. Inter-Citic still has to prove that all of this is economic, but it has clear and imminent discovery potential of significance. I like that a lot.
TGR: Excellent. Any others?
LJ: AuEx Ventures Inc. (TSX:XAU) is one of our very favorite companies. Drill results since the last resource estimate make it clear that those resources will get much larger, which is part of the reason AuEx is trading at a premium. The main thing, though, is that its flagship project, the Long Canyon joint venture—49% AuEx and 51% Fronteer Development Group (TSX:FRG) (NYSE.A:FRG)—shows almost ideal characteristics for becoming a mine. These are very competent companies, and they are doing a great job of advancing this project.
TGR: What makes it so ideal?
LJ: It's an open-pit target, the cheapest kind of mine. Open pits are usually low-grade, bulk tonnage projects; but this is relatively high-grade. It runs 2.4 grams per ton gold in its Indicated resources, 1.6 g/t for its Inferred resources, and in some places up to a half-ounce per ton over significant widths—and this is in heap-leachable oxide ore (i.e. cheap to process). That makes for very robust margins. AuEx came out with a preliminary study that showed and internal rate of return of something like a 66%. That's pre-tax, so you have to take that with quite a grain of salt, but even cut it in half, that would be a great IRR. And that's just getting going. No optimization of the mine design has been done yet. Plus, the resources are still getting bigger, and size does matter. It's just a great project.
In addition, on the other side of the mountain from Long Canyon, AuEx has another project called West Pequop where another JV partner, Agnico-Eagle Mines (TSX:AEM) is spending all the exploration money. That will have a first-pass resource estimate this year. West Pequop is a little bit trickier than Long Canyon. Some of it is deeper; in different areas; it's not one fairly continuous length of mineralization. But Agnico-Eagle seems to like it, and they're no dummies.
Beyond Long Canyon and West Pequop, AuEx has other projects in Nevada plus generative work in Spain and Argentina. While they've shown extraordinary degree of success already, there's plenty of blue sky, too.
TGR: Those sound like pretty strong endorsements.
LJ: There's still a chance of correction with everything we're talking about, so as enthusiastic as I may sound about any company, my general take is you should buy on weakness. Look for chances to get in under market. In January, the gold correction hit a lot of companies pretty hard, so across the board many companies were off 25% or more. That made some stocks relatively cheap and it was a good time to buy, if you didn't own any already. But by time I was starting to see some attractive deals, gold went on a tear again at the beginning of this month.
TGR: C'est la vie. Or que será, sera.
LJ: Indeed. That's the reality of our business. I encourage anybody who's interested in any of these companies to remember that such fluctuations make for good buying opportunities.
TGR: A side effect of the last downturn was a significant seize-up in capital, which prevented lots of juniors, in particular, from pressing projects forward. As you look at upside potential now, how much weight are you giving the balance sheet factors that were so critical a year ago?
LJ: It's a red flag when a company doesn't have at least a year's operations money on hand—preferably two years'—and I am much more hesitant to recommend it. I am far more likely to put it on my watch list for a private placement. If I really like the story and the only thing missing is cash, I'd most likely recommend that subscribers who are qualified investors, like most of those who subscribe to our Casey Investment Alert service, watch for seats at the private placement table, so they can get warrants and add leverage to their investments.
TGR: So the balance sheet is still critical even though the capital markets are loosening up.
LJ: The money is flowing again, but it could freeze up again in an instant, given the right shock.
TGR: Earlier on you were saying that you still really like silver. What are some of the companies in that arena that interest you these days?
LJ: The big ones that we've liked for a long time would be Silver Wheaton Corp. (NYSE:SLW, TSX:SLW), which is really a silver royalty company, Silver Standard Resources Inc. (NASDAQ:SSRI), which is a big emerging production story, and Silvercorp Metals Inc. (TSX:SVM), which is a super high-grade Chinese silver producer.
Silver Standard does have huge resources, almost 2 billion ounces of silver and very substantial gold resources as well. It is making the transition from explorer to producer, which typically gets a company's ounces revalued. So Silver Standard has enormous potential, but we are concerned about the transition and are not recommending new buying at this time. The company's founder and long-time CEO, Bob Quartermain, departed last month in a very sudden way. You have to think that if it was just due to a strategic shift, maybe he'd have stayed on until they found a new CEO.
TGR: What about Silver Wheaton?
LJ: As long as you see a bull market in metals, you've got to love Silver Wheaton. They have no mining costs, nor any of the headaches that go with actually wresting precious metals out of the earth. They purchase byproduct at low prices and sell it at spot prices, and that's just a great business.
TGR: And Silvercorp?
LJ: Silvercorp has such a high-grade ore operation in China that they can make money almost regardless of any market fluctuations, and turn that money into shareholder value in other ways. They pay dividends. I like that company a lot.
One of the smaller juniors that we like a lot is Fortuna Silver Mines Inc. (TSX.V:FVI), the Simon Ridgeway company. It's a profitable little company that makes money in Peru, where its Caylloma silver-lead-zinc operation is growing. They've just announced discovering a new high-grade silver-gold mineralization zone there. That's great in itself, but it's much better at a producing mine such as Caylloma because it turns into cash flow quickly.
Fortuna ran into a spot of political trouble in Oaxaca, Mexico a while ago, which made us nervous because that can stop a project cold, and most of the company's near-term growth ties into their San Jose project in Oaxaca. But that problem seems to have blown away. The project is fully permitted now and they're building the mine. So Fortuna is a great little story. With the large upside potential from the San Jose Project in Oaxaca moving forward, it looks very good.
TGR: We've been hearing some buzz about Alexco Resource Corp. (NYSE/AMEX:AXU; TSX:AXR). What do you know about them?
LJ: I like Alexco a lot. It's had some vicious ups and downs and it's taken a beating from lots of sides. Originally it was closely allied with NovaGold Resources Inc. (NYSE/AMEX, TSX:NG), which was one of the market darlings earlier on, with several very large gold projects in British Columbia and Alaska. Then their Galore Creek project ran into cost overruns and resulted in huge problem for that stock.
This was significant for Alexco—this is just my take on it—because a lot of people thought that Alexco would discover a lot of silver with its historic super high-grade ore in the Keno Hill district in the Yukon and then sell the project to NovaGold, which would build the mine. So when NovaGold hit trouble, the end game went away for Alexco, and a lot of investors doubted that AXR's explorers could actually become profitable miners.
TGR: And the good news?
LJ: The real watershed event for Alexco was when Silver Wheaton stepped up to the plate with the money to build the first mine in the Keno Hill district in exchange for a slice of the production. That provided outside validation. It's not just the money to build the mine; some very sharp people—some of the best in our business, particularly in the silver sector—said, "This can really work and we're going to put $50 million into it." This is not chump change.
That was months ago, and we're now looking at production starting up in July. So, it's getting close. This is a company that has yet to show that it can produce profitably, but the grade is so high, I think they will. This isn't one of these slender-margin projects where getting the chemistry slightly wrong can make difference between profits and losses. This is high-grade; kilos-per-ton stuff. It's a sweet little project; they have the money; they're building it, and they would really have to screw up to avoid nice cash flow starting in the second half of this year.
LJ: And there's more. The whole concept has never been just to go after this one small mine they are starting with, the Bellekeno silver mine. The market seems to have overlooked the fact that the first start-up project is just the beginning. Alexco has the program on tap this year to remind the market that it not only has other targets, but has had success drilling some of them. They're going to produce a first-pass resource estimate on the Lucky Queen mine, the highest-grade past-producer in that whole district. And then there's the Silver King area where they've had relatively high gold numbers as well as silver in their drill results. Because this place has been mined for 100-plus years, they also have pretty rich tailings. They're going to have a resource estimate on that, too.
So, you've got a combination here where the company's going to be getting to cash flow and showing the market it has other assets on tap, as well as an ambitious exploration program to look for new finds. They aren't just re-heating old stuff. They have a geological theory as to why the high-grade deposits have been found where they are, and they're looking to test similar places for totally new discoveries. Very exciting story for 2010.
TGR: Any last thoughts?
LJ: I want to stress that I don't have a crystal ball, but the longer-term "baked in the cake" reality of what the U.S. and other countries have already done is very clear to me. Whether there's near-term deflation or not doesn't matter, except in that it may create great buying opportunities. What's already been done is so huge, it's going to have seriously bad consequences for the dollar, and other paper currencies, and therefore seriously positive consequences for gold.
So look at the reality, grab hold of your courage and have faith in your analysis. If you believe all the massive money supply that has been created will affect the dollar and the price of gold, don't sweat the near-term fluctuations. Look at them as buying opportunities if you can. If you can't, just hold on because this gold bull cycle has a long way to go to the top.
Always on the lookout for the next double-your-money winner, Louis James is the master of metals at Casey Research, where he's the widely read and well-respected senior editor of the International Speculator and Conversations with Casey. Fluent in English, Spanish and French—and conversant in German and Russian to boot—Louis (aka Lobo Tiggre) regularly takes his skills on the road, evaluating highly prospective geological targets, visiting explorers and producers in the far corners of the globe, and getting to know their management teams. In addition to subject matter expertise, he's built a following on the basis of a dynamic combination of investment savvy, practical advice, experience in physics and economics and a gift for comprehensible technical writing.
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1) Karen Roche of The Gold Report conducted this interview. She personally and/or her family own none of the companies mentioned in this interview.
2) The following companies mentioned in the interview are sponsors of The Gold Report or The Energy Report: Lara Exploration, Reservoir Capital, Inter-Citic Minerals, AuEx Ventures and Fortuna Silver Mines.
3) Louis James: I personally and/or my family own the following companies mentioned in this interview: I own shares in Reservoir Capital. At this time, and at the time of the interview, I own shares in no other company mentioned in the interview. However, most of these companies have been recommended to Casey Research subscribers in the past, and some funds operated by Casey Research may own shares in some of these companies. Neither I nor any member of my family is paid by any of these companies. Some of them may have placed paid advertisements on the Casey Research web site, but I have no involvement in that, and have no idea which, if any, those might be.