Inflation, deflation and why management remains key for mining equities - Berry
Michael Berry looks at the factors that are now driving valuation in the mining sector and why he believes silver is undervalued relative to gold. An interview with the Gold Report.
Posted: Thursday , 22 Nov 2012
PETALUMA, CA (The Gold Report) -
Michael Berry believes the declining dollar is the real driver behind the gains in gold and silver and that silver is undervalued relative to gold. In this interview with The Gold Report, Berry, the co-founder of Discovery Investing and the pioneer of the Discovery Investing Scoreboard, discusses the factors that are now driving valuation.
The Gold Report: When you look at the PHLX Gold/Silver Index (XAU) between mid-May and mid-July, there's a perfectly beautiful double bottom. It looked like a big W. Since the beginning of October all commodities have broken down a bit, but that double bottom was so pronounced. Do you attach any significance to it?
Michael Berry: George, when we used to see a "W" pattern we would say "WOW" and when we identified a double top "M" we would say "Mother"! There is a dominant secular quality-of-life cycle in the world, a very long-term cycle, so in the short run, we're going to have runs up and then declines. The Federal Reserve is going to continue to attempt to inflate and devalue the dollar value relative to other currencies and relative to gold and silver. And it is going to do it for the next three to five years, for however long it takes. Just take a look at Japan for a view of the future. My sense is that there's a very firm bottom on both gold and silver that has been identified by the double bottom you are referring to.
TGR: Quantitative Easing (QE) 3 is gearing up. We know that central banks are now buyers of gold and not sellers as they were in the 1990s. How much inflation do you anticipate we could see in North America?
MB: The Fed wants to see asset inflation, particularly in housing; we're seeing a little bit of that now. A housing recovery is the big bet by the Fed. But we're also seeing inflation in food and energy, though that is not considered in the statistics. We're going to see more of it because ultimately as we go through this process of quantitative easing, demand is going to increase, as are prices. However, make no mistake, we're still on the knife's edge. The reason why Fed Chairman Ben Bernanke has said the Fed is going to keep short interest rates at zero for the next two to three years and is going to print $40–80 billion (B)/month is because he sees that the deflation possibility is not yet off the table. This financial repression not only punishes seniors who have bond portfolios but also life insurance companies and pension funds who are becoming more underfunded with the low rates. Recently several of the Federal Open Market Committee governors have even opined for even more QE.
The Fed wants to stimulate inflation to avoid a deflation at any cost. Printing money debases the currency. It's not so much that gold or silver have gone up in price, in spite of apparent downward manipulation in the futures markets. It's that the dollar has declined in value relative to other assets and currencies. We will see this inflation affect all hard assets and real money. Whether or not it will actually inflate the economy and create jobs—the new focus of the Fed—is another issue, of course.
TGR: Could we be looking at stagflation?
MB: Yes, we could be. We could also be looking at deflation. The more work I do, the more I see the Fed beating its head against the wall in an apparent liquidity trap. The more I see the economy moving sideways with growth that doesn't replace jobs, the more I'm worried about actual deflation. Remember that when you must de-lever (extinguish bad debts) in a no-growth or negative-growth economy, it is a very dangerous situation.
Deflation is a phenomenon that the Fed doesn't really know how to deal with because when you're in a deflation, you're trapped in a downward spiral and you have to create a new credit cycle, so you have to wipe out all the old credit or the markets will do it for you. We're not even close to that situation yet. Stagflation would be better than deflation. We will surely have some kind of inflation along with it. Investors are going to have to protect themselves, and that's why I think having claims on some of these hard assets, particularly gold and silver, is important.
TGR: With President Obama re-elected, is anything different going to happen in our economy?
MB: From an economic perspective, it wouldn't have made any difference if Romney had won rather than Obama, in terms of the ability to fire up this economy, to erase the bad debt and to move forward. Neither of them had or has a plan to move us forward to a new sustainable credit cycle. So in that respect, no.
On the other hand, I do believe that President Obama views the economy as an entitlement economy and that tax rates must increase. In my opinion, Nov. 6 effectively marked the formal beginnings of the U.S. economy as an "entitlement economy" where wealth transfers will be the dominant economic flows for years.
That is a very serious negative for U.S. investors at this time. I do think there will be a 12th-hour reconciliation on the fiscal cliff in which the Republican House will concede on higher tax rates. I recently spoke on the topic at the Hard Assets Conference in San Francisco; my presentation was titled "Fiscal Cliff, Sequestration and Discovery Investing." It's worth a read. President Obama wins on this issue whether we go over this "cliff" or he gets his increased taxation on the "wealthy." I am very much concerned that it will be hurtful in terms of stalling the U.S. economy.
The Congressional Budget Office estimates that an encounter with the Fiscal Cliff will cost the economy between 0.5% and 1% of GDP. I don't look for a very high-growth economy as we go down the road. There are trillions of dollars that must be taken out of it at this stage. In 2013, the Fiscal Cliff would remove $500B and the Alternative Minimum Tax (AMT) would cost another $200B for 28 million new AMT taxpayers.
TGR: Mike, I want to ask you about your 10-point discovery model for emerging companies. Have you revised anything about your model since the downturn of 2008?
MB: No, we just sharpened our focus since 2008. The system worked beautifully. There are no changes, just enhancements. There are 10 basic factors in the Discovery Investing Scoreboard (www.discoveryboard.com) (DiS) that address very different issues. We really wanted to better define those issues, so we worked on that. We have about 1,200 users on the system now. We cover about 840 companies—some biotech, quite a few mining and resource companies and some high-tech and infrastructure companies. We can access all companies on the Canadian, American, Australian and Hong Kong exchanges.
We still look for world-class assets, but most important, even critical, we look for world-class management. With emerging companies, mediocre management is anathema.
We break all these factors down into multiple sub-components. For example, a world-class asset would have sub-factors such as grade, tonnage, infrastructure and location and these may be further broken into components.
We look for catalysts for value change, either creation or destruction. We look for sustainability of operations—cash flow, royalties, etc. About a year and a half ago, we began to talk about the most important factor not being world-class asset availability but sustainability. Can a company sustain itself as the market for funds went dry? That is where we are today. Rather than changing the factors, in the DiS we simply allow the user to change the emphasis on the current factors to reflect what is really driving the market now.
TGR: In picking mineral stocks, what is the most important fundamental factor?
MB: It depends where you are in the economic cycle, but almost always, management, management, management—is the most important factor. A great management team can create value in a mediocre project. A lousy management team—there are a lot of them out there—can destroy value in a great project by diluting recklessly, by wasting money on overhead, by chasing the flavor of the day, by giving $0.05 stock to friends and family and by too much diversification with properties. So management expertise and track record are almost always the most important factors.
TGR: Does the market pay any attention to drill core results anymore, especially in micro-cap stocks?
MB: Yes and no. In some sectors drill results work today, and in some sectors they don't matter. We've gone through cycles in the '90s: There was the diamond bubble in the Northwest Territories, there was a bubble in uranium in 2004, followed by lithium, rare earths and now graphite. Part of this is a natural shift in technology, lithium ion batteries, for example, and part is an attempt by the junior space to capitalize on an opportunity. At any given point when we're in one of these technology sub-cycles, if a company gets good drill results, the stock appreciates and then recedes.
My son Chris Berry, who works with me, tracks industrial minerals and notes there are now 75 companies in the burgeoning graphite space. At the beginning of the year there were about seven. We will end 2012 with 10 times the number of junior graphite exploration companies than we began the year with. This is clearly not sustainable. He will be presenting on the very topic at the Mines and Money Conference in London on Dec. 4 and the Industrial Minerals Graphite Conference on Dec. 5, also in London.
In other sectors, the copper sector, for example, this is not happening. A great copper drill result? Who cares, even though copper is really becoming scarcer every day and it's more difficult to find a world-class copper deposit. Even gold—with great drill results, a company still has to go out there and explain it and sell the world-class potential.
TGR: One thing on copper. It's around $3.46 or $3.50/pound (lb) right now. It appears to have solid support around $3/lb. Is that a profitable level for copper miners?
MB: It all depends. Is it oxide copper? Is it open pit? Is it underground? Are there by-products like molybdenum and gold? Is it a porphyry or a massive sulphide? What country is it in? Peru, Indonesia and some other countries right now are not very welcoming to copper miners. While $3.50/lb ought to work, it all depends on the grade and the factors mentioned above.
Normally, companies produce what we call a preliminary economic assessment that tries to do an early discounted cash flow with as much as we know about the deposit.
TGR: In the late summer, you commented that the market was scared, especially of the mineral mining micro caps. You said that you thought the TSX Venture Exchange, which is full of resources stocks, had put in a bottom. Even though these mineral stocks and commodity stocks have given back some over the past six weeks, do you believe this positive uptrend is going to continue?
MB: In the long run, yes. You want to be in a position where you have studied your companies, studied your commodities, and picked great management teams that will acquire great assets and you're ready. Most of these TSX Venture companies are all still extraordinarily cheap. I don't think they're going to get much cheaper. I do think the TSX Venture Index has put in pretty close to a bottom, but it could be a long time, a year or two, before we see the emerging world start to build out again. A lot will depend upon resolution of the Fiscal Cliff drama and Europe. I'm certainly a long-term investor. I'm prepared to wait, and I'm looking around for great values now. If a company can sustain itself through a year or two, I'm a big buyer at this stage.
TGR: Let's talk about industrial minerals.
MB: Chris Berry covers industrial minerals. Many of these metals or minerals have increased in price based on Chinese demand and also because they control production of much of these markets. There is a lot of opportunity but you have to find the right management team, find the right deposit and you have to be prepared to hang in there with it. This is especially true given the gloomy near-term outlook for economic growth (and hence industrial demand) in much of the world today.
TGR: What about silver?
MB: I like the silver producers. Silver is quite undervalued relative to gold. Ultimately, silver has more utility than gold because in a good market, silver is an important industrial mineral. It's a high-tech mineral. In a bad market, it's money. The gold/silver ratio is around 51:1, well out of whack.
TGR: Thank you so much for your time. It's been a pleasure, as it always is.
MB: Thank you.
From 1982–1990, Michael Berry served as a professor of investments at the Colgate Darden Graduate School of Business Administration at the University of Virginia, during which time he published the book "Managing Investments: A Case Approach." He has managed small- and mid-cap value portfolios for Heartland Advisors and Kemper Scudder. His publication, Morning Notes, analyzes emerging geopolitical, technological and economic trends. He is a guest lecturer at the Federal Reserve Bank. Berry travels the world with his son, Chris, looking for discovery opportunities for his readers.