Interviewed By Karen Roche, Publisher, The Gold Report | 3 February 2010
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The Gold Report: President Obama recently came out with proposals to limit profit taking in the banking industry, impose salary caps and restrict banking investments. Then in his State of the Union address, he called for a freeze on spending for discretionary government programs. Any comments about that?
Frank Holmes: Wherever it is in the world, it's important to recognize the tremendous impact of governmental policies. Look at Hugo Chavez in Venezuela as opposed to Álvaro Uribe in Colombia. Chavez destroyed Venezuela's economy and judicial system to maintain his power. Bolivia is heading in the same direction, but Colombia and Panama are booming. Policies in those two countries are completely different from Venezuela's.
Basically, government policies break out to either monetary or fiscal. Of course, money supply is on the monetary side, along with real interest rates, while fiscal policies involve taxing and spending. We try to distill the G-7 versus what we call the E-7— the seven most populated emerging-market countries— and look at money supply. We see something very, very important when we create macro models to compare the E-7 to the G-7.
What we see with the E-7 countries is a very different set of policies for capitalism and job creation and social stability. In the G-7, in contrast, we see a sort of socialism being pushed. How it's being done is very significant, too, in part because one of the consequences of such policies is higher unemployment. What starts out as anti-money laundering expands to the point that it becomes anti-money.
Good government policies came to China after Deng Xiaoping came to power in 1978. He started a model based on the old saying that "it doesn't matter if a cat is black or white as long as it catches the mouse". People need a means of getting jobs and achieving prosperity. That's what drives China now. There was a lot of talk about a broker being shot by order of a Chinese court for stealing $19 million because of government concern over the gulf between rich and poor. That wasn't the reason. Chinese policies are designed to produce social stability. Stealing creates social instability. They need social stability and ways for people to realize economic independence.
The big wrestling in the world is to really appreciate urbanization and understand globalization, which— along with access to information— has changed the world dramatically.
TGR: It seems that urbanizing is inevitable whether government policies are good or bad. As populations grow, a society cannot remain agrarian.
FH: Correct. There's no doubt that you get these tipping points in the population, but good government policies adapt to changes as they realize what's taking place. The planet had 1 billion people 200 years ago; 100 years later there were 2 billion people; 50 years after that, it was 3 billion people. The world's population has more than doubled since 1970, when gold became free-trading and there were 3 billion people. Now, 40 years later, we have more than 6 billion people. The number of people on earth becomes very significant and so government policies become very important. In China, India, Thailand, it's all about job creation.
Political parties talk about policies for managing this big sea change and about the urbanization and the information highways around the world changing things dramatically. The movie Slumdog Millionaire, which was filmed in India and won so many awards, starts off with kids living in a slum. At the end the slum is filled with huge high-rises and even though there's so much poverty in India, it's filled with hope too.
Sudan is poor, just like India, but there's no hope in Sudan— only fear. That same type of fear is here, in policies to deal with terrorists, and in Europe, where fear rather than hope drives policies. I think that's really key in looking at how governments deal with huge demographic change. It's not just the fact that the world population is moving toward 7 billion people. What is really important is the rise in the emerging-market middle class, whose needs are not the same as in middle-class America or Canada.
Look at China again. As many as 25% of Chinese— more people than the entire U.S. population— fall into the 'middle-class' category or above now, with a doubling possible by 2020. While most dramatic in China, it is also underway in India and elsewhere. People in this emerging middle class just want a nice home with running water. When they turn on the switch, they want the light to come on. That means massive commodity consumption.
TGR: But isn't the rise in the middle class an outcome of urbanization?
FH: It's a result of good government policy, too. As an investment person, I'm a big believer in what are called "complex adaptive systems". There are complex adaptive systems all around us— our body's brain and immune system, the ecosystem, ant colonies, the stock market and many others. In this sense, the immune system is very similar to the stock market and very similar to how bees swarm. It has a lot to do with the capacity to learn from a new experience and change in response to that experience.
A lot of people— or organizations or governments— can learn something, but they don't necessarily change their behavior. Remember when the Encyclopedia Britannica was sold in malls? Microsoft's Encarta came along and they were wiped out. The Britannica people knew what was happening, but failed to adapt fast enough. A classic example.
Unless you're dealing with a dictator, I believe that the majority of government policies, especially in democracies, begin with good intentions. But they have to adapt. In terms of investments, some of our biggest wins will come from policy change in Colombia versus Mexico, for example.
TGR: So as we look at countries such as India and China, with immense populations and growing middle classes, is it simply the nature of the middle class or are government policies promoting consumerism?
FH: I think it's a combination of three things— population density plus rational, intelligent government plus resources. Cities need proper infrastructure to function. Otherwise, you get slums. You get chaos. You're wiped out if an earthquake or a hurricane hits.
TGR: But China still imports a lot of the resources required to build the infrastructure.
FH: China is a very pragmatic country with long-term thinking along the lines of, "Okay, we're going to need all this copper and steel and oil." So they go out and acquire. Not long ago, I read that China's December imports of unwrought and semi-finished copper products were up 27% over November's, while scrap copper imports were up 46%, and that there's a strong expectation that China would be buying a lot of copper from international markets early this year. I also saw where China's reserve targets are said to be one million tons of aluminum, 400,000 tons of copper and zinc and 20,000 tons of nickel.
TGR: Nouriel Roubini, the economist credited with having seen the economic meltdown coming, says a lot of people are talking about investing in China because they expect China to pull the world out of recession. He argues that China isn't the panacea that people think it is. He claims that the government needs to implement certain social programs that motivate people to stop saving and start spending. He's talking about unemployment insurance and other safeguards against lost income. From your viewpoint, looking at these policies, how much of the growth in China will come from consumerism evolving naturally or must the government intervene?
FH: It'll come and it won't be because Roubini wants to give it a European-style socialist perspective. It's going to come because the government does not give the free health care. China has basic health care and the technology to do all the x-rays and MRIs, but if people want anything special, they have to pay for it. China also offers basic education, but if people want the better schools, they have to pay.
The high savings rates in China are predominantly so people can take care of their families if something happens to them physically. At this stage, the government is not much worried about that; they're worried about job creation. They don't want a bunch of people on unemployment insurance and food stamps. They'd prefer to have them cleaning up dirt on the highways and debris on the streets. They recognize 800 million people still live in rural areas, so they have to manage urbanization and employment methodically and rationally. They can't force consumer spending. But they've found, for example, that when they gave farmers tax credits and made schooling easier, the farmers used their higher disposable incomes to acquire more products made in China.
TGR: In your recent article, "The Case for Commodities in 2010 (and Beyond)," you say that an investment in natural resources is a vote of confidence in global economic growth. You also talk about how demand and growth of the middle class in emerging countries will fuel the commodity supercycle. Is the commodity supercycle dependent on the emerging countries' growth exclusively? Or does continued demand in developed countries dictate a big part of that?
FH: We've created a matrix to try to explain it. There's never a single factor; it's a summation of several factors. A big one is the last supercycle's pattern of infrastructure spending. It started in 1955 with Eisenhower building up America's interstate highway system— a job that had the U.S. consuming 55% of all the world's commodities at the time. Then Japan, Taiwan and Korea had significant buildouts. Then the Vietnam War put heavy demand on resources. So this supercycle that started out from deflation and ended with inflation lasted 25 years.
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Then we went through a 20-year drought from 1980 until 2000. During this period there was significant underinvestment in schools for engineers and geologists. Kids were going to become electrical or technology engineers, not go into mining or into the resources. There was minimal investment in the technology of energy or in raw resources. Right now in America all the kids want to go into CSI or Law & Order. But 10 years from now they will be taking degrees in petroleum engineering and mining engineering. We'll see that shift when they start to see that they can make much more money that way.
In the meantime, General Electric Company (NYSE:GE) has a huge new R&D center in Bangalore. I recently visited this center, which almost doubles GE's global research and development staff. GE went to India because U.S. colleges produce more sports trainers (75,000 of them a year) and lawyers than engineers— while India's producing 400,000 scientists and engineers.
TGR: Wow.
FH: Financial Times recently reported that China is the leader now in filing for patents. If you go to grad school in America, you'll see it dominated by Indians and Chinese.
TGR: Although technology seems to be getting more attention in North America nowadays, the resources industry here seems to be struggling more and more with environmental issues.
FH: That's right. The EPA, which was created in 1973, became a force around the world for clean air and clean water, which I'm a big believer in. But if you're not exploring and developing, and barriers to entry grow while the populations also continue to grow, where does that put you? In a situation where you have insufficient supply to meet the demands of a population that's doubled— and a growing middle class. Based on previous cycles of 20 years, I think we're halfway through the current increase in growth of the middle class, and I don't think the big inflation will hit for another five years.
TGR: So five more years before inflation becomes problematic?
FH: Everyone keeps talking about big inflation. So why are real interest rates negative? Interest rates have been negative, not positive, in E-7 and G-7 countries 80% of the time since the year 2000. Governments are trying to ensure cheap cost of capital to create jobs and spur economic activity. After our recent credit crisis, year-over-year money supply (M-2) in the U.S. is up only 3%, and down dramatically from its peak. But the monetary base has increased massively. That's supposedly money that's gone to the banks for lending, but in fact they're not using it for loans because it's not showing up in the velocity of money supply.
At the end of the day, we're still wrestling with deflation. It's something we're going to live with. We'll get pockets of inflation, commodity by commodity. Zinc will rise and fall. Then copper will rise and correct, and so on. But we won't see the across-the-board inflation we had from 1975 to 1980 until probably 2015 to 2020.
Bear in mind, too, that natural resources are one of the few asset classes that benefit from inflation. If prices for fuel or other commodities rise, one way to hedge against the impact of those price increases is to invest in those commodities, or commodity-based equities, either through an actively managed natural resources fund or a passive vehicle such as an indexed fund or exchange-traded fund (ETF).
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TGR: Will that big inflation that's five or so years away be worldwide or isolated to specific countries or regions?
FH: Historically it's gone worldwide, and most countries are part of the economic engine. I think there's going to be food inflation. We'll see unions striking for higher income to deal with the food inflation. During the Christmas holidays I was in Sri Lanka. It's one of the best performing stock exchanges since its long civil war ended. The stock market took off. Why did I go there? Plantations. Food. The world will keep having babies and its middle class will keep growing. It makes me sort of bullish on commodities long term; we're going to get these spikes because we're not able to supply.
Demographics aren't the only factor influencing commodities, either. You get a strike in Chile, copper goes up dramatically. A strike in Mexico drives zinc and copper up dramatically. We're going to have to deal with this. More money has to be put in exploration and development. We were shocked to see the dimensions of cuts in exploration last year, talking to general mining and drilling companies. It was like a 90% cut overnight. It takes a lot longer to kick that resource back into production to meet the needs of urbanization and globalization in the age of information. But today's technologies allow these companies to just pull the plug on exploration and development as soon as the commodity price falls below its marginal cost of production.
TGR: Do you expect some commodities to fare better than others? Near term and longer term?
FH: I don't know that. The complex adaptive system involves trying to adapt. Will the supply disruptions be sustainable? Will the amount of dollars that we spend for this $20 billion project be enough to secure supplies? Where are the commodities going to come from? There are real patterns here. When car sales come off, it affects zinc and aluminum. We see a domino effect of related commodities. It's just a matter of recognizing the need and adapting to those changes.
In fact, that's what active money management is all about. What I think is a real bubble is all this money going to ETFs. It's not the best way to play one of these commodities. Do you know that if you buy a gold equity ETF on the big up days, it usually trades at a premium to its underlying stocks? And on big down days it can trade at a big discount, so if you're selling, you lose even more. Bloomberg has a function every 15 seconds to tell you that. We compared active gold funds to the big gold equity and bullion funds, and we far, far, far out performed it.
TGR: Is that true of all ETFs versus managed funds? Or just with gold?
FH: Either the Wall Street Journal or Bloomberg had an article saying that actively managed funds outperformed the ETFs. And it wasn't a little bit. It was pretty healthy.
TGR: Back to the commodities, what looks good these days?
FH: Right now, the hot commodities are platinum and palladium. You can probably make some money at the beginning owning the commodity itself, but some of those stocks are picking up. You're betting on car sales remaining healthy and strong.
TGR: Isn't the growing middle class you were talking about an indicator that car sales will remain strong?
FH: They will grow. China has picked up the slack of America. But what happens when America turns and China remains robust? Holy jumping. Strap on your seatbelt.
TGR: You showed an oil seasonality graph at the Vancouver Conference. What are some other significant commodity seasons?
FH: Life's all about managing expectations and keeping an eye on the big picture. Every year has a seasonal cycle that affects supply and demand of commodities. We compare gold to copper to silver to platinum and to oil, and can see defined patterns. For more than 150 years, the patterns have a 70% accuracy of forecasting economic activity. Copper is usually best bought in November and sold in March. It fell off dramatically between March and November for many, many years until China's economic engine fired up and started altering that pattern 15 years ago. It still falls off, but not nearly so dramatically now.
Usually gold bottoms in August and charges back in September as part of a seasonal pattern that kicks off with religious observances and holidays in countries where it's very common to give gold as a gift and a representation of love— from Ramadan through the Diwali season of lights in India through Christmas and the Chinese New Year. We try to manage expectations by watching these patterns.
TGR: Does that imply that you move in and out of stocks depending on seasonality?
FH: It's more for managing our cash levels. Money coming in; money coming out and making the cash part of a tactical strategy. Understanding inherent volatility within seasonal patterns helps you manage your cash as an active money manager.
When it comes to picking stocks, that's a different set of fundamentals. The most important thing we look at is management that respects and protects the value per share. There are three drivers for value per share: your producer's per-share production, cash flow and reserves. It excludes the price of gold because while the price of gold's gone up dramatically, these companies' cash flow per share has not because they've issued so much paper.
I like the little junior stocks. Give me the junior stock that has the most rock per share and I'll buy it if management's got discipline not to keep doing financings. And guess what? They're the ones are taken over by bigger mining companies. The rock per share, reserves per share drives the net present value of the deposit along with the price of the commodity, but it's value on a per-share basis that matters.
We've seen gold-mining companies issue more shares than they've been finding reserves. It's unbelievable. And the production grade has been falling. The supply of gold per mine continues to fall and the mill costs continue to rise. That bodes well for higher gold prices.
TGR: In terms of those three drivers— production, cash flow and reserves or rocks per share— could you name some companies whose ratios you find appealing?
FH: Yes. Production on a per-share basis for Red Back Mining Inc. (TSX-V:RBI) is up. Its stock has outperformed. Since Goldcorp (TSX:G)(NYSE:GG) bought Glamis Gold, Goldcorp's per-share production is down. So you take a look at the past three years where a major acquisition has taken place, it has diluted value. Those that increased the production or reserves per share in a rising gold market have far outperformed. When gold was at all-time highs in November, some of these other stocks were up, too, because of the production per share and the reserves per share. So that's the key factor.
TGR: Any more?
FH: We like Medoro Resources Ltd. (TSX-V:MRS), which basically has a whole mountain in Colombia. There's a lot of money to be spent on engineering and so on to prove out reserves, but this is the region that has, according to some back-of-the-envelope calculations, the potential of 30 million ounces, at one gram per ton. There's a 50% probability that they'll get 15 million ounces. There's a 30% probability for 10 million ounces. So Medoro consolidated this property, Marmato Mountain. This region's basically been mined for hundreds of years, back to the time when the Spaniards first came in and shipped gold from there down to Cartagena and over to Spain.
Medoro is small for now, but it's going to grow rapidly and they're going to bring in the best of technology and the best of practices and its stock will be re-rated. If they get 10 million ounces of gold and it's valued at $100 per ounce— one-tenth of what gold is trading at if it's $1,000 an ounce— that makes the stock worth more. And even more if they have 20 million ounces.
TGR: But at this stage, we're talking potential reserves.
FH: Not proven, but potential. Very important, the risk being whether they prove out that potential. But the fact that it's been a prolific region for hundreds of years suggests it just needs to be consolidated and fixed up. It's not about looking for it and finding it; it's about proving it up. Completely different risk line. We like stocks with such huge potential.
TGR: Any parting comments?
FH: To end on a bright note, the secular bull market for commodities and natural resources stocks remains intact. Depending on the extent of economic recovery in developed nations, it could even intensify this year. Either way— although we have more conflict in the world than anybody needs, I think it's just great that peace and prosperity are driving the cycle in these emerging countries.
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