Go to Market, Not the Vault, for Gold Bargains: David Baker
Interview

The Gold Report: You've been quoted as saying that intellectual capital and technical expertise set Baker Steel Capital apart. Tell us more about that.

David Baker: All six of us on our investment team have technical or financial experience in mining, which gives us an edge. When we go onsite at mining projects around the world, we can speak the language and understand what the technical people are saying.

We do all our own research on the companies we invest in, and we have a very sophisticated database modeling system, Genval, our general valuation tool. Our database covers over 500 mining companies and over 1,000 mining projects. The analysis enables us to evaluate mines and mining companies on a consistent basis; we can compare companies and mines in different jurisdictions using common assumptions. This enables us to efficiently allocate funds in an effort to generate the highest returns.

TGR: I noticed that Matthew Huston, one of your research analysts, has a master's degree in mining project appraisal from Imperial College in London. What is that qualification?

DB: The degree is all about financing and the evaluation of projects, relating the technical side of mining with the financial and risk aspects. We find this is a very useful qualification when evaluating mines and mining companies. Both James Withall and I have similar qualifications, also from Imperial College, and David Coates holds an MBA.

TGR: Let's talk about your Genus Dynamic Gold (GDG) fund, established in 2003. What is its average annual return since inception?

DB: The annual returns to the end of Q311, based on the A Share Class, was 25.7%, compared with a benchmark return of 14.6% and a 20.3% return on gold. Our long-term performance is exceptional on an annualized basis.

Last year we had a fantastic year, with a return for the A Share Class after all fees of 76.6% vs. the benchmark of 29%. This year, we have underperformed somewhat. At the end of Q311 we are down about 23.5%. We are a bit more volatile than the index, principally because we have a large exposure to emerging producers, which carry higher risk.

TGR: At the end of August, Baker Steel's total assets under management (AUM) were $1.6 billion (B). Is that Australian dollars or U.S.?

DB: The Australian and the U.S. dollars are roughly equal. The total now is about $1.5B.

TGR: What is your AUM goal through the end of 2015?

DB: We have a bullish outlook on gold prices. It's not unreasonable to say that our AUM would be maybe $2.5–3B by 2015.

We just introduced the Baker Steel Alpha Gold fund, which fits in between the gold exchange-traded funds and gold equities and invests a similar amount in gold via the ETF and gold via the gold mining companies. The strategy was constructed with the aim of outperforming physical gold by about 10% a year, yet with low volatility.

It achieves this principally in two ways. First, we run a sentiment model that determines if we are "risk on" or "risk off"; this is a contrarian indicator and in "risk off" mode, as we are today, we cut our gold exposure and hedge our gold equity exposure. Second, we aim to use our stock selection skills to extract alpha from our equity exposure. The fund launched in the middle of September and now has $160 million (M) under management—a very successful launch. We were up about 4% in October outperforming gold, with considerably lower volatility. Annualized, our volatility is 20.2%, compared to 33% for gold in October. Steve Ellis is the portfolio manager of the Fund.

TGR: How has the market received the Alpha Gold Fund?

DB: There is lots of interest. It was one of the best launches this year in the UK market. It's a UCITS-compliant fund, a European Union directive that allows collective investment schemes to operate freely throughout the EU on the basis of a single authorization from one member state. We have only a few months of performance under our belt so as we build up a track record I expect we will gain greater acceptance for this unique product.

TGR: Your GDG fund can consist of up to 100% equities. The percentage of futures and precious metals could be as much as 50% and the cash portion can account for as much as 25%. What's the current mix?

DB: At the moment, we see equities being undervalued relative to gold. Our modeling indicates that it is cheaper to buy gold through the equity market than through the physical markets; the gold mining equities are discounting something in the order of US$1,250/ounce gold prices. Presently the fund is fully invested in the equities.

TGR: The fund's performance in 2011 suggests that the price volatility in gold and gold equities is translating to GDG. What is the market volatility teaching you about this space?

DB: The market is very conservative and obviously very worried about the global outlook. Some in the market believe there could be a deflationary bust and others are discounting either inflation or the extreme hyperinflation scenario. There is a major disconnect and that uncertainty is keeping people on the sidelines, resulting in thinly traded markets and heightened volatility.

TGR: What do you think will happen? Will we see a spell of global deflation?

DB: I think that is very unlikely. Inflation seems to be everywhere. The threat of deflation will make the central banks pump more money into the system. Deflation would be an Armageddon scenario because there is so much debt. It is inevitable that governments will devalue their current and future liabilities through inflation. However, we might need to see more of a threat of deflation to coerce the powers that be into dialing up the printing presses.

TGR: In a September 2011 presentation, Baker Steel suggested that gold production has reached its "natural limit." Nonetheless, gold production increased in each of the four previous years. Isn't the limit essentially whatever companies can produce?

DB: For a company to produce gold or increase its gold production, it really has to increase its gold inventory with new deposits. Companies are increasing their gold inventory, but often by a reclassification of existing deposits not new deposits.

As the gold price rises, more ore becomes economic; however, overall grade falls as cut off grades fall. At a given throughput gold production falls with the lower head grade; it is hard for the industry to sustainably grow headline gold production.

To really grow gold production, companies need to increase their inventory through exploration. Over the last 10–20 years, the pace of finding large gold projects has fallen off dramatically. The easy pickings have been made. If we want to meaningfully increase gold production, we need to see a meaningful increase in gold discovery, and I am afraid that is not happening. Based on 2011 production, the top three gold producers (Barrick, Newmont and AngloGold) need to come up with 17 million ounces (Moz)/year of gold to replace annual depletion. Assuming resource to reserve conversions of 70%, this implies the top three alone have to find 24 Moz/year—five 5 Moz deposits. The industry is just not discovering gold at this rate or this size of deposit.

TGR: The GDG fund takes positions in companies that are fully exposed to the gold price. Does that mean you eschew positions in companies with hedged gold production?

DB: We tend to favor companies that are fully exposed. In our view, very few companies have benefited from hedging gold production.

Hedging has overall caused grief. Eventually, most hedge books have been bought back at shareholder expense. We are not keen on junior companies going to the debt market; more often than not this entails hedging future production.

That's not to say that some of the companies we invest in don't have some modest hedging. I can give you a couple of examples. About two years ago, Banro Corporation (BAA:TSX; BAA:NYSE) was looking at financing projects in the Democratic Republic of the Congo (DRC). The company thought about debt financing, but the cost would have been prohibitive when you included the hedge requirements. Further, once in production any cash flow would have been directed toward debt repayment instead of additional growth projects, a noose around its neck and potentially resulting in the market not valuing Banro's growth.

TGR: Have you taken a position in Banro?

DB: Banro is in our Top 10 holdings.

TGR: Have you heard anything about the commissioning at Banro's Twangiza mine in the DRC?

DB: We have not heard any more feedback on that apart from that the mine poured its first gold in the fourth quarter of 2011. Looking at the share price, it seems the market has been a bit cautious following elections in the DRC. Banro's strategy is to develop a number of high-return oxide projects it has in its inventory. Banro didn't take on any debt to develop Twangiza, so it will have significant cash flow to develop other projects. Without doubt, Banro has a fantastic resource base.

TGR: Are you at all concerned about moving Twangiza from an oxide to a sulfide mine, to an underground mine, given the trouble Avion Gold Corp. (AVR:TSX; AVGCF:OTCQX) had going underground in West Africa?

DB: I believe the sulfide will be delayed for a few years as the company concentrates on the lower-risk, higher-return oxide projects. The key to the sulfide is getting the capital for hydroelectricity for power.

TGR: About 27% of the assets in the GDG portfolio are in Africa, with only 17% in North America. Some might consider that risky. What is your position on the risk-reward balance for companies operating in Africa?

DB: The issue for gold mining is you have to go where the gold is and where new projects are. Africa has a lot of fairly virgin country in terms of exploration, areas which are very prospective.

In terms of risk, we invested early in Nevsun Resources Ltd. (NSU:TSX; NSU:NYSE.A). It has an exceptionally high-return project in Eritria in East Africa. The market views Eritria as high risk in that the company was unable to debt finance its development. We weighed the risk against the potential returns and became a cornerstone investor in its equity raise last year. The company recently brought the project into production and has already built up more cash on its balance sheet than the mine cost to build.

We're looking at other projects with similar high returns and believe La Mancha Resources Inc.'s (LMA:TSX) Hassai project in Sudan is similar to Nevsun's Bisha project, both being volcanic massive sulphides (VMS) with both copper and gold. In the case of La Mancha's asset, part of the gold has already been mined out. But overall the scale of the La Mancha asset is potentially four times the size of Bisha. La Mancha is in Northern Sudan; we believe the returns compensate for the risks.

TGR: La Mancha acquired a number of assets in a reverse takeover by the French firm AREVA (AREVA:NYX). It now has mines in Cote d'Ivoire, Sudan and Australia. Why haven't more people, at least in North America, heard about this story?

DB: That is a good question. I think there is a perception that AREVA, which has a controlling stake, is quite conservative. The company has promoted itself and has delivered amazingly. It's been one of the best performers since the lows in 2008.

When we first looked at La Mancha, it was valued at $8M yet generating cash out of its mine in Australia. Now three years later it has $98M cash on the balance sheet and a market capitalization approaching $400M. The quality of its assets suggests that it should be valued at least double where it is now.

La Mancha's Hassai development project in the Sudan is very exciting and it has the balance sheet to finance it. There are two stages. The first stage is to convert the project to a carbon in leach, requiring capital of around $190M. La Mancha is negotiating to increase its interest in this project in return for funding the government's share of capital. Right now, the government has 60% and La Mancha has 40%. In the short term, there is some uncertainty as to how much the Sudanese government will end up giving up in exchange for this finance.

TGR: Is the Hassai VMS project in Sudan La Mancha's most advanced project?

DB: The Hassai project is the most exciting and probably the most advanced. It certainly has the most upside. Brokers calculate the valuation of the company is covered on its Australian assets; investors get the African assets for free.

Of course, the market could be saying, "Sudan is so high risk that all the cash La Mancha is generating in Australia will be poured down the drain so to speak in Sudan." I don't see that happening. Hassai is a proven operation already.

Like Nevsun's Bisha mine, Hassai is a very high-return project. The value per ton of rock at Hassai is around $150 at today's metal prices. The cost of extracting the rock will probably be in the region of $20–30/ton, so you can see this will be a very high return project.

TGR: As of September, the bottom three performers in the GDG fund were OceanaGold Corp. (OGC:TSX; OGC:ASX), Allied Gold Mining Plc (ALD:TSX; ALD:ASX) and Lake Shore Gold Corp. (LSG:TSX). Why are you holding onto them?

DB: They are all cheap. Unfortunately all three have disappointed the market, but that is why we run a diversified fund, not all our seeds germinate at once. Oceana had a profit downgrade; production wasn't quite what the market expected in New Zealand and costs were higher. Oceana has producing assets in New Zealand; the New Zealand gold price is making new highs, which should flow to the bottom line. Oceana is also developing a copper-gold project in the Philippines, which the market has yet to factor in, yet this is fully funded to production. We are effectively buying the company at an ex-growth multiple at a 4–5 times earnings before interest, taxes, depreciation, amortization (EDITBA) multiple.

The same applies to Allied Gold, which had a few delays and cost increases in its Papua New Guinea assets and the Solomon Islands. The stock is cheap. Next year it should generate $100M of free cash flow on a $600M market cap.

For Lake Shore, there is a debate in the market as to the production outlook. We visited the site recently and are comfortable with the mine, the production ramp-up has been stretched but in terms of delivering resource growth, the company is meeting our expectations. The company is going through typical growth pains, exacerbated by the fact it is developing three mines over 40km of prospective ground. We see some good upside there; as with the others, we are holding on to these positions.

We also are buying Great Basin Gold Ltd. (GBG:TSX; GBG:NYSE.A). Great Basin has really fallen out of favor. Its market capitalization is just under CA$500M, and it probably spent more than CA$550M on its Burnstone gold mine in South Africa. Yes, there have been some delays, but we think a ramp up of the asset in South Africa will still happen. It has just been pushed back 12–18 months. Burnstone is relatively different in the South African context, being shallow mechanized mining, which has safety as well as cost advantages. The company looks like an exceptional value right now, trading at less than book cost.

TGR: Let's look at the other end of the spectrum. Your top three performers, as of September, were First Majestic Silver Corp. (FR:TSX; AG:NYSE; FMV:FSE), Gold One International Ltd. (GDO:ASX; GDO:JSE; GLDZY:OTCQX) and Archipelago Resources Plc (AR:LSE). Did you take some profits on those names? Do they have any upside left?

DB: We sold down First Majestic, which we think is fully discounted by the market. We have been reducing Gold One, which has a project in South Africa called Modder East, a shallow reef gold mine similar to Burnstone, which is owned by Great Basin.

A Chinese consortium is acquiring a stake in Gold One, at $0.55/share, so we have taken this as an opportunity to reduce Gold One and switch into Great Basin, because we believe it would make sense for Gold One to own the Burnstone mine, which is owned by Great Basin. At this price and with the backing of the Chinese, that would make a lot of sense.

TGR: How about Archipelago?

DB: We have reduced our position, but we think Archipelago, which has recently commissioned a gold mine in Indonesia, will now be able to spend more on exploration to extend the project's life. This is a very prospective region and at these prices still relatively good value. It's not in our Top 10 positions, but we like the company.

The main point to note about these three investments is that we bought early, we took a view on the assets based on our technical appraisal and the risk-reward leverage supported the companies; all have been significantly rerated in the past 18 months. As they approached our valuation metrics, we have rotated into new stories; this is a good example of how the fund can and is delivering long-term performance.

TGR: What should the average investor expect from the gold market heading into 2012?

DB: Gold shares are very, very cheap. At some point, they'll become expensive. When you buy something that is cheap and is paying good dividend yields, you are being paid to hold the shares. We think it's going to be a very exciting market next year.

TGR: Excellent. David, thank you for your time and insights.

David Baker is a managing partner at Baker Steel Capital Managers and heads the company's Sydney office. Prior to founding Baker Steel in 2001, Baker was part of the award-winning Merrill Lynch Investment Management (MLIM) natural resources team, successfully managing the Mercury Gold Metal Open Fund, the largest precious metals fund in Japan, from its launch in 1995 until his departure in 2001. Prior to joining MLIM in 1992, he was a gold and mining analyst for James Capel Stockbrokers in London from 1988 and held a similar role at Capel Court Powell in Sydney from 1986 to 1988. Baker started his career in 1981 as a metallurgist at CRA Broken Hill, Australia. He holds a degree in mineral processing and a master's in mineral production management from Imperial College, London.

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DISCLOSURE:
1) Brian Sylvester of The Gold Report conducted this interview. He personally and/or his family own shares of the following companies mentioned in this interview: None.
2) The following companies mentioned in the interview are sponsors of The Gold Report: Banro Corporation, La Mancha Resources Inc., Avion Gold Corp. Streetwise Reports does not accept stock in exchange for services.
3) David Baker has interest in his fund, which was discussed in the interview. David Baker personally and/or his family were not paid by any company mentioned in this interview. David Baker was not paid by Streetwise for participating in this story.