At Tocqueville Gold Fund, Mining Shares Glitter

New York (July 12)  Is gold poised to regain its luster? That's a fair question to ask, now that the metal has rallied 11% year to date, to a recent $1,336 per troy ounce.

Gold became a popular investment alternative in the aftermath of the 2008-09 financial crisis, amid worries that excess money creation by central banks would lead to currency debasement. The metal rallied 70% from January 2010 to Sept. 6, 2011, when it peaked at $1,921.17 an ounce. It then retreated to as low as $1,183 near the end of last year.

For some perspective on gold and the companies that mine it, Barron's turned recently to John Hathaway, co-manager of the $1.6 billion  Tocqueville Gold fund (ticker: TGLDX). A longtime gold investor, Hathaway, 73, has been helping to manage the fund since it was launched in 1998. His co-manager is Douglas Groh.

"We try to invest in the companies with the best managements, and assets that add the most value independent of what the gold price might do." —John Hathaway Photo: Ray Ng for Barron's

The fund's annualized three-year performance, minus-17.64%, belies a strong showing in 2014. Tocqueville Gold has posted a total return of 37.48% year to date, placing it in the top 12% of its Morningstar category. Its 15-year annual return of 13.86% puts it in the top 1% of its peer group. Hathaway expects gold's prospects to brighten, and he's buying shares of well-managed mining concerns.

Barron's: What do you make of the pickup in gold prices and mining stocks so far this year?

Hathaway: The gold price has discounted all of the headlines that were responsible for driving it lower, including the continuation of tapering [of the Federal Reserve's asset purchases] by the Federal Open Market Committee. After the FOMC's latest meeting in June, the price of gold actually went up. That was a departure from the previous 11 meetings, after which gold declined when tapering was discussed.

I'm also encouraged that the shares of precious-metal mining companies have been leading the gold price. That's different from what we saw in the past couple of years. The gold price outperformed the shares going into the peak in 2011 and through the remainder of that year. Now we are seeing the gold shares outperform the metal price. That typically is characteristic of better things to come.

Why is that the case?

All markets are forward looking, so if the stock market is anticipating a better gold price, the shares are going to do better than the gold price at the beginning of an upward move. In contrast, when the price of gold continued to make new highs in 2011, it was front-page news. And yet the shares lagged conspicuously. That was a sign that the move in the gold price wasn't going to be sustained.

Mining shares are highly leveraged to the gold price because of marginal economics. If the price of gold goes up 10%, that might mean the profitability of mining gold goes up 25%. Every company is a little different. In a way, mining shares are options on the gold price.

You write in your most recent letter to fund shareholders that "the catalysts for a dynamic upward shift in the direction of precious metals are numerous, but the timing remains elusive." Can you elaborate on both factors?

If I were good about timing, I'd probably be sitting in Monaco. In the letter, I tossed out a bunch of things that could be problematic at some point for the financial markets. Any one of them could be the catalyst that changes the psychology for the gold market. They include a bear market in stocks, a rise in inflation, or geopolitical issues. All three factor in to the way people look at gold. For any market, you can't really say what the flash point is. But there is a fair amount of complacency among equity investors—a feeling that we can party on until we all know when to get out.

Please sum up your case for investing in gold.

The central thesis and rationale for owning physical gold is that the radical monetary policies put into place since 2008 to rescue the financial system will become problematic. What's more, Federal Reserve officials seem to be so comfortable saying that the unwinding of quantitative easing will go smoothly. But maybe, from the point of view of someone who is thinking about investing in gold, that unwinding won't go smoothly, and will lead to disruptions in the financial markets.

We have abnormally low interest rates because that's where central banks want them. The Fed achieved that goal by buying up Treasury issues. The valuation of financial assets is based on unrealistically and unsustainably low rates. When your discounted-cash-flow model is forced to adjust to a higher level of interest rates at some point—and we don't know when that will be, but it will take place—that could be very disruptive.

Gold mining is a capital-intensive business. Mining companies often must deal with political issues, and returns haven't always been stellar, to say the least. Why bother investing in mining shares?

I share those concerns. Mining is a challenging business, and it has been notoriously badly managed for many years. At Tocqueville, however, we have the ability to pick and choose. Just because mining is a tough business doesn't mean that every mining company is a bad company. The opportunities are there. We try to invest in the companies with the best managements, and assets that add the most value independent of what the gold price might do.

Let's review the challenges facing investors in mining stocks. 

As you say, it's a capital-intensive business. The price of gold is variable. Mines are often planned based on a certain assumption in the gold price. But because the whole cycle of building a mine takes many, many years, it often happens that the gold price, when the mine starts up, is a lot different, and maybe lower, than when the mine was conceived. That's the landscape. Other issues can creep in, as well. Many host countries can go through regime changes in the blink of an eye, and so the rule of law is another big variant that you have to take into account.

What trends do you take into account when assessing the global supply of gold?

There are two different levels you have to address when you talk about gold supply and demand. The first is annual gold production globally, which is roughly 3,000 metric tons. Because of cutbacks and a more conservative approach to capital expenditures by managements of most mining companies, it looks to us like new mine supply will level off and maybe even decline after next year. You'll still have gold being mined, but the supply isn't going to rise, possibly for three or four years starting in 2016.

The second level, which is even more important to the gold price, is the above-ground supply of gold. This is more of an apocryphal number, but it supposedly is around 170,000 metric tons. In theory, all the gold that's ever been mined has stayed above ground. It isn't all in play, because a lot of it is in museums and other places. So the supply of gold is basically fixed, and it changes very slowly, based on increments from mine production. It grows by maybe 1% to 2% a year. There is a lot of demand for jewelry.

Where is most of the above-ground gold?

A lot of the physical gold that's above ground has migrated to Asia. Imports into China have been at record levels, and India is a big buyer of gold, as well. There is less gold in Western vaults than there was a couple of years ago. But because Asian investors tend to hold their gold—they don't view it so much as a trading vehicle—it may not be available, should there be a rise in investment demand in the West.

What does all of this mean for investors?

If, for whatever reason, people who hold financial assets want to go into gold, the supply of it doesn't expand rapidly. In fact, it might not expand at all during a period of high financial-market demand, and that's why you get these extreme moves in the price. If we're at a stage where, for whatever reason, Western demand for gold awakes from a 2½-year nap, there is probably going to be less of it to go around, and we could get dynamic moves on the upside. That would probably surprise just about everyone, as was the case when gold moved up from 2008 to 2011.

Which of your portfolio holdings best illustrate the types of companies you like to invest in?

 Detour Gold  [DGC.Canada] is based in Canada, and is focused on ramping up its flagship asset, the wholly owned Detour Lake mine in Ontario. The mine has about 15.5 million ounces of gold reserves and is expected to have annual gold production of 660,000 ounces over its 21-year mine life. The mine is unique because of its size—it will become Canada's largest operating gold mine—and longevity, both of which are rare in the gold industry. In addition, Ontario is politically stable. The company is still going through the start-up phase, so the full extent of confidence that the market would have in terms of its profitability is subject to start-up issues. But the stock is highly leveraged to the gold price.

Detour's shares have risen 250% so far this year, to a recent 14.43 Canadian dollars [US$13.54]. What will push them higher?

The stock has had a big run, in part because  Osisko Mining [OSK.Canada], a big holding for us, was acquired earlier this year. When you have a big takeover in an industry, investors look around for the next obvious candidate. I'm not saying Detour is going to get taken over anytime soon, but if you are looking for takeover candidates, Detour would be front and center.

Which other companies are well positioned?

When we initially invested in  B2Gold  [BTO.Canada] in 2011, it had two gold mines in Nicaragua that produced a total of 140,000 ounces a year. The company is targeting overall production of 400,000 ounces in 2014. The increase in production came mostly through the acquisition of CGA Mining, which had a big mining operation in the Philippines that produces about 200,000 ounces a year. B2Gold's global production in 2015 is expected to be 550,000 ounces, once the company's operation in Namibia comes on line. B2Gold has managed to grow from an exploration company in 2008 to a producer of an expected 550,000-plus ounces in 2015, an impressive turnaround in eight years. It has done a good job of buying assets opportunistically, advancing them, and executing on production.

The company's management, which is entrepreneurial, has done something that makes a lot of sense. It has been adding and acquiring mines during this period of devastation in the market value of gold-mining equities. Unlike the big mining companies that have been gun-shy, B2Gold has taken advantage of weak markets and added some attractive assets all over the world. Value is being created by astute acquisitions by an opportunistic management group.

What will get these stocks moving higher?

The catalyst for all of these companies will be higher gold prices. But in the case of B2Gold, it would be a demonstration that the assets they've acquired will produce the ounces and the cash flow that management expects they will.

I'll finish with  Torex Gold Resources  [TXG.Canada], another company based in Canada, although it is focused on Mexico, specifically its Morelos Gold Property. Torex is completing a major gold mine that will produce gold very profitably. But the process of raising capital to do that is an overhang on the stock. But we believe that the company is sufficiently funded through its start-up phase. The financing risks have been mitigated, but I'm not sure that the market fully accepts that. Also, the mine hasn't started producing yet, but it is very close, probably within a year.

Like many companies at this stage of operations, Torex isn't profitable. Is that a concern?

No, because they're not producing anything. But this is a great asset, and we think highly of the company's management. The mine has all kinds of upside potential in terms of further discoveries. And, again, this is an asset that will be coveted by the majors.

Let's finish up with a few closing thoughts about gold.

Gold is not mainstream. It is considered to be a niche strategy, and it has always been viewed as a marginal discussion. It is partly because it is so out of favor right now, and it is probably because that's just traditionally the way investors in the Western financial markets have looked at gold. While one could speculate on all kinds of things that would drive the gold price higher, you don't need to know what they are today.

All you need to know—as was the case in 1998, when we launched this fund—is that gold is a quality asset that is completely out of favor. You didn't know in 1998 or 1999 what was going to happen over the next 10 years. I never want to be categorized as a doomsayer, as I'm basically optimistic. But just try to be as objective as possible and say, "Gold is a quality asset that nobody likes." Everybody hates it, frankly, but that can change based on future developments.

Thanks, John. 

Source:  BARRONS