John Kaiser: The Allure of Bottom-Fishing
Source: Interviewed by Karen Roche, Publisher, The Gold Report 01/12/2010
According to John Kaiser, creator of the Bottom-Fish Index, companies on his 2010 list are cheap because the market thinks the junior resource sector lacks the staying power it needs for their management group to guide them into significant growth. Whether the market is correct remains to be seen. John hopes to never again see a Bottom-Fishing opportunity such as that left in the wake of the crash of 2008. That said, the denizens of the deep he dredged up for his 2009 Bottom-Fish Index soared spectacularly close to 300% last year and in this exclusive Gold Report interview, he says they may double or triple in the year we've just begun. As for gold, regardless of where the price goes—up, down or sideways—John has suggestions about good places investors to be.

The Gold Report: Your 2009 Bottom-Fish Index was up a hefty 299% in the last 12 months, and you've just released your 2010 index. You say that you don't expect it to perform as well as last year's, though. What's your rationale for lowering your expectations?

John Kaiser: At the end of 2008, after the crash, I sifted the ashes and came up with about 120 companies in the junior resource sector listed on the TSX and TSX Venture Exchanges to recommend at various price ranges as Bottom Fish buys. Keep in mind that my Bottom-Fish Index is a specialized strategy of looking for companies that are not currently in favor, which may be for market cyclical reasons as was the case at the end of 2008, or because the company has an innovative story about which the market is very skeptical. What was interesting about the 2009 group was that these companies had raised money and had a lot of projects on the go during the bull market of 2003 to 2008 but were then devastated by the financial crisis.

Unfortunately, the devastation was so widespread that it took a bit of work to come up with ones that I felt still had management on board that cared, money in the treasury and projects that could still make sense. I think this group, which has done extremely well, will double or triple again as a whole in 2010.

The new list includes a group of just 63 fairly obscure companies. They still qualify as Bottom Fish, meaning they have a flat-lining or bottoming chart pattern, which most of my 2009 bottom fish no longer have. These companies did not participate in last year's rebound, and I am not very optimistic about them in the short term.

TGR: Why not?

JK: In most cases these companies are the secondary companies in the stables of the management teams that run them. These teams are still busy with the companies from that earlier cycle—including some of those on the 2009 list. When these other companies get taken over or management packs it in because the story is failing, I expect these managers to turn their attention to the secondary companies.

TGR: Why do you call the companies on this year's list "obscure?"

JK: You won't find them advertising in magazines or prominently displaying their stories at conferences. They do have structure, management, shares outstanding and some money. However, some have no stories to tell yet. With others, the stories are either still early stage or require important developments to attract the market's interest. When management finishes with their flagship companies, they'll carry on with these secondary companies. An example from last year would have been Anfield Nickel Corp. (TSX-V:ANF), which at the time was just an unknown shell. It was 35 cents per share then; today it's over $3, has a nickel asset in Guatemala, has raised $20 million and has Ross Beaty—and his Lumina Capital group—fully on board.

A comparable example from this year's Bottom Fishing list may be Highbury Projects Inc. (TSX-V:HPI), which is sitting at about $1.20 per share. It has only 10 million shares out, $1.5 million in the treasury and a mediocre project in Alaska that isn't going to get anybody excited. The same people associated with Ross Beaty and Rick Rule are present, so I imagine Highbury will one day get an advanced project and will end up significantly higher-priced. But for the time being, it's rather obscure.

TGR: Would it be safe to say that the 2009 index saw such a radical increase because it had been so beaten down? Had the markets not been hit so hard, would the situation be similar to your 2010 index?

JK: In answer to your first question, the 2009 index did indeed benefit from the 2008 crash, which knocked resource juniors down 80% to 90% from their peaks during the prior five years. It was an unprecedented situation in that the market did not discriminate between high and low quality juniors. During September–October 2008, street-smart investors started bottom fishing for the better quality stocks that were down 40% to 50%, but they were premature because the washout did not happen until December, and by then the quest for liquidity, not fundamental value, was the market's goal. Because I believed that the underlying engine driving the raw material prices during 2003–2008 was secular rather than cyclical, and had been artificially interrupted by the financial crisis, I viewed this washout in the junior resource sector as a once-in a-lifetime bottom-fishing opportunity that would not have happened in the absence of the financial meltdown.

With regard to your second question, had the meltdown not happened, we would not have had a situation that would have favored a bottom-fishing opportunity such as represented by the 2010 list. The 2003–2008 period was not a good bottom-fishing window for complex structural reasons. After that horrific metals bear market from 1997 to 2002, the exchange consisted of a sea of shells. It was pounds or ounces in the ground that attracted the market as we got into the 2003–2008 commodity-based bull market. It was no longer a matter of hoping some exploration target might turn into a multi-billion dollar discovery, but more a case of hoping that the higher metal prices represented a new long-term reality. For the juniors it became a question of how to acquire deposits discovered decades ago and never developed due to marginal economics.

In that environment, companies were transformed overnight from shells into companies with financings in place, active projects and fairly high stock prices. The structural change that made this possible was the reduction of the private placement hold period from 12 months to 4 months. This was important because the stories of the 2003–2008 cycle involved funding the advanced portion of the exploration-development cycle. From 1982–2002 the junior market had been focused on the grassroots, target drilling and discovery delineation part of the development cycle. From 2003 onwards, the focus was on infill drilling, metallurgy and feasibility studies leading to production decisions and mine permitting activity. This was capital intensive, but it did allow number crunching, and this is what attracted so much institutional and hedge fund capital. It was, of course, the liquidity crisis that forced these entities to dump their positions, which is why we ended up with such a bottom-fishing opportunity at the end of 2008. During this window it was hard to pick bottom fish because you did not know which company would suddenly acquire an advanced project and launch a funding cycle. Had the 2008 crash not happened, the identifiable secondary companies management groups had in their stables would have had high prices reflecting market optimism that these companies would soon also get an advanced project and head sharply higher. Today we have a situation where management is still busy taking care of unfinished business from the 2003–2008 cycle, in a market setting where there is concern that the financial crisis is far from over and that metal prices may yet give up their 2009 rebounds. The 2010 bottom-fish list is cheap because the market does not believe the junior resource sector has the staying power needed for management groups to launch their secondary companies with new projects. It is my view, however, that the secular bull market for raw materials that began in 2003 remains intact.

TGR: What leads you to believe that?

JK: I believe that China and India are on a long-term development track that will continue to suck up raw materials. At some point the OECD (Organisation for Economic Cooperation and Development) also will get back on a growth curve. Mining supply infrastructure had just started to adapt to the rise of Asia but was interrupted by the crash in 2008.

The supply response interruption left the original problem that began to emerge in 2003 intact, so the raw material supply needed to keep Asia growing were not in place. That's why metal prices bounced back so significantly in 2009. In fact, even when prices collapsed during 2008, none reverted to the 2002 levels that prevailed at the end of that metals bear market.

So while those 2008 lows were very painful, from a Bottom Fisher's perspective it was a opportunity to buy companies at very, very cheap valuations. I hope we never have to see such a Bottom-Fishing opportunity again.

TGR: Raw material prices and related companies dropped in 2008, and while both have since bounced back, the precious metals market has risen more dramatically. Can you explain that?

JK: Gold lagged copper, zinc, nickel and other base metals during 2003–2008 because the world doesn't need gold for any industrial purpose. The base metals are used to fabricate things, to change the world. So when demand rose for those base metals, their prices went up. Gold started going up significantly in the past couple of years because the market became worried that the foundation of the rise of Asia was very fragile. That fear, in fact, proved to be correct because the U.S. policy of easy credit, which was imitated around the world, led to the securitization of debt and selling debt as a structured product to the financial community. The enormous real estate bubble that also resulted fueled consumption and helped China grow. Gold started to rise when the market began to understand there could be severe consequences for the whole financial system. And then things did fall apart.

TGR: People worry now about either inflation or a collapse of fiat currencies, and on that basis, many project that gold will get up into the several thousands of dollars. Do you see that scenario as you look forward?

JK: The idea of gold going to thousands of dollars in response to currency debasement—in essence, printing far more dollars than economic growth can support—is a risk. Just look to Zimbabwe to see how this can happen. If such a scenario does come to pass, my interest in companies that are developing ounces in the ground would be a complete waste of time because the higher gold price would be accompanied by a rising cost structure that does nothing to boost profit margins.

What I think is far more important is that there are major, major changes happening in the power structure of the world. We are nearing the end of an empire, several centuries where first Europe and then the United States dominated the world. We're entering a transition period where power is going to end up being shared between Asia and the old European-American complex and there is uncertainty about how this will all unfold.

With the last 50 years of economic growth, the wealth of the world has expanded tremendously. The 5 billion ounces of gold that exist are worth only about $6 trillion now, a drop in the bucket relative to the total wealth of the world. On a widespread incremental basis, investors around the world are simply adding some gold to their portfolio of assets as a long-term hedge against currency volatility and the possibility that certain debt instruments will simply evaporate as a result of counterparty risk falling apart on them. This is all adding up after a 30-year bear market for gold.

An important thing to keep in mind is that if you take gold at $400 in 1980 and apply the American inflation index, it should be at $1,009 right now. So gold at $1,111 has actually added about $100 to the real price. In my view, that's far more meaningful than the nominal gain from $260 to $1,100 during the past decade. Are we now at a threshold, where gold can continue to go up without massive inflation and currency debasement accompanying it? If so, we are looking at a tremendous bull market in the junior and even senior resource sectors because all of a sudden ounces in the ground become worth a lot more than during the last five or 10 years. When I talk about "worth," I am, of course, referring to difference between what it costs to produce an ounce and what you get selling it.

TGR: What will be the significant plays to look at if gold continues to climb?

JK: Companies that have fairly low-grade deposits would do extremely well. Brett Resources Inc. (TSX-V:BBR), for instance, has a 6.7-million-ounce deposit below one gram per ton at Hammond Reef in Ontario. The market is pricing Brett at a fraction of what it should be worth if it makes it into production. Because of the uncertainty that gold will hold at current levels, this stock has not jumped up to the $4 to $5 range where one would expect it to be. But if gold starts to trend up in $100 increments without obvious inflation rampaging through the global system or the U.S. dollar tanking against all other currencies, a Brett-type stock will have tremendous leverage.

We did some number-crunching on Brett, looking at the after-tax present value at $800 gold. If Brett were in production at that price, the stock would be worth about $7. If gold went to $2,000, the target price would jump to $38, assuming no dilution. At $1,100, it would conceivably be worth about $15 a share. But right now it's priced at $1.70. The important thing to keep in mind about such figures is that we assume the cost structure will remain unchanged as we increase the price of gold. This you cannot do in your typical collapsing fiat currency scenario. If we get a trend in place in which the real price of gold is increasing, money would flood into companies like Brett.

TGR: Are other companies sitting in the same similar situation?

JK: Yes. Another one is Skygold Ventures Ltd. (TSX-V:SLV). At the moment it's only about 3 million ounces at its Spanish Mountain deposit in British Columbia, but the market's assigning it a very low $35 million market cap because it's not sure of the cost to produce those ounces. The company is planning a scoping study such as Brett did to find out the cost to build this mine and then to produce each ounce of gold. The results of that study will then become the basis for speculators to decide where gold has to be priced without changes in the cost structure for the Spanish Mountain project to have a positive net present value. After crunching the numbers, they may decide that this stock is a bargain at 35 cents, that it could have a $3 or $4 price target down the road gold if continues to trend up in real terms, or perhaps even if it stays flat. I emphasize again, we are looking at gold juniors' ounces in the ground—their cash flow generating potential as the key to their future market valuation.

If my scenario of a rising real gold price continues to unfold, big companies like IAMGOLD (TSX:IMG), producers that have a strategy of acquiring companies that look marginal or are in some sort of financial stress, will become very aggressive in expanding their resource bases through mergers and acquisition activity.

TGR: If an investor feels that gold will inflate mildly because of continued fears of what's going to happen over the next couple of years, should they look at gold producers or pre-production companies such as Brett and Skygold, which have low market caps?

JK: If you're optimistic that gold will trend up gradually, I think the leverage is in the companies like Brett and Skygold. Modest increases in the price of gold and growing confidence that current nominal prices are here to stay will pull capital into such projects. It also will allow them to be priced in terms where people believe the discounted cash flow numbers they can generate right now with their Excel spreadsheets are real. Under those circumstances, owning gold wouldn't make you much profit in the short to medium term, but you could make multiples of your investment in a fairly short time period owning companies like these. The other side of the coin, of course, is if gold starts to develop a downtrend, these companies go even lower than they are now and you'd end up losing much more money than you would just owning gold.

TGR: You told us what we can expect if gold continues to go up without inflation or currency debasement. But what if it stays flat?

JK: If gold stays around $1,000, a number of companies will go into production or be taken over by bigger companies, but will not reward shareholders with appreciably higher stock prices, because at $1,000 the market is still skeptical that even this price will hold, and that we may end up with an even lower price sometime in the next few years. On the plus side, $1,000 gold as the new reality would set the stage for renewed interest in exploration plays. Nobody has been interested in gold exploration plays since 1997 when the Bre-X discovery turned out to be a fraud. There have been only a handful of major discoveries like Aurelian Resources' Fruta del Norte discovery in the past five, six, seven years.

If gold stays flat, the small number of deposits with decent ounces in the ground will quickly disappear and people will look at companies that would get a lot of value if promising gold zones expand. For instance, ATAC Resources Ltd. (TSX-V:ATC) has made what is turning out to be a very significant discovery in the Yukon with the Rau deposit. They have found some very good grades over good intersections and the geological setting is such that the initial target of a million ounces could grow into multi-million ounces in multiple deposits within this large land package that they have secured over the past year. This type of play, which nobody cared about before, would start to dominate center stage in a scenario where gold does not rise significantly above the current levels.

TGR: So supposing that gold settles in somewhere around $900, what would be a good place to be in gold equities?

JK: At that stage I would start looking for earlier-stage exploration-style companies. One that I have a fairly significant position in is Nevada Exploration, Inc. (TSX-V:NGE), which has a strategy of looking for the gold deposits hidden in Nevada's gravel-covered basins using a technique that they spent a decade developing and which will take others a while to catch up with. If companies like this with fairly small market caps of $10 million to $20 million drilling blind holes on conceptually generated targets all of a sudden get a hit, speculators will jump in. That shift toward exploration discovery-type stories will be where the market will go if gold retreats to $900 and bounces around at that level.

TGR: And what's the strategy if gold begins to climb toward $1,600 in the next 12 to 18 months?

JK: Even amidst signs of weakening currencies and inflation making a comeback, that would create a mania in the gold sector, and advanced gold juniors with ounces in the ground would move up dramatically. Companies with exploration targets and teams in place to explore them would get attention. We would see a major influx into the gold stocks. We would also see a lot of money going into the gold ETF because now it is very easy for ordinary people to pick up the phone and become an indirect owner of gold and have that as part of their retirement portfolio. Once somebody is an ETF gold owner it is a natural progression to become curious about gold producers and developers. Such a dramatic price move would create an enormous inflow of capital into this sector. Turkeys and pigs would learn to fly again.

TGR: When the inflow comes in, won't the exploration plays as well as companies like Brett and Skygold also benefit?

JK: Absolutely. The market always wanders down the "food chain" in a mania. But before that the place to be is in the companies that have advanced-stage gold projects with ounces in the ground but where the valuation is still fairly pessimistic mainly due to questions about the economics of mining such deposits. A sharply higher gold price would put all these deposits into the money instantly, and never mind that three to five years down the road gold might be back at $1,000. Nobody will think about that when gold is charging into a new high territory.

TGR: If gold charges into the new high territory, won't the fear that it will fall below $1,000 be even more exaggerated?

JK: If gold jumps up to $1,600, it probably won't stay there. But if there's been no massive cost inflation and it pulls back to $1,200, we'd have the confidence that deposits like Brett's and Skygold's are not going to be undermined by gold collapsing back to, say, $400.

To give an example, consider what happened during the '70s. In 1972, gold was unleashed from its $35 fixed price. It really started to escalate in '78, and by 1980, it had charged as high as $850. Everybody went crazy and started talking about $2,000 gold and so on. During that transition period there was a lot of uncertainty about what the long-term price for gold would be and the mining industry was slow to respond.

Then gold settled back at $400 and that became the new long-term base. That's when the mining industry really kicked in. Starting in about 1984, the mining industry ramped up new gold production, adding 1.9 billion ounces to the total above-ground stock of gold from 1980–2010. By 1984 the mining industry understood the cost structure for developing and mining a gold deposit and had become comfortable with $400 gold as the new price reality. They were not confident initially about the sustainability of a gold price ten times higher in real terms than what it had been for most of the 20th century. That was understandable because the problem with gold is it's not used for anything. In that sense, its price is completely arbitrary.

With copper, nickel and other raw materials, you can do macro-economic projections about how much will be needed, what the current mine supply infrastructure is capable of delivering and which currently inventoried deposits could be brought on stream. But with gold you have no idea what the future demand will be because gold has no utility. The situation is similar now. It's not as dramatic as in the '70s when we had 1,000% increase in the real price of gold. But because there has been a significant nominal price increase and because the price is arbitrary, the mining industry and the capital markets are reluctant to really throw a lot of money at undeveloped deposits until they are confident that the gold price will hold.

TGR: As you were putting together your index, what were your assumptions regarding whether the current gold price will hold?

JK: If gold settles back down to $900, we're hedged because management groups will give up on companies that have far too many shares out and whose projects are hopelessly marginal at that gold price. They will instead go to work on those secondary companies I mentioned before—where there's some money still in the treasury and incentive to try again to create new wealth. But those secondary companies also will be pushed into service if we have a scenario where gold goes to $1,500 or even $2,000, so we're hedged for that situation too.

I think people should be prepared for a scenario where the gold price is going up and interest in gold stocks is rising—and not because the world is coming to an end. That would catch a lot of people by surprise because so many are predicting gold to go up and the stocks to go up because the world's going to have another financial meltdown.

In my view, if that meltdown comes to pass, it will result in a severe curtailment of economic activity and there will be no appetite for gold. People will, in fact, be trying to sell it to get some currency to get food, shelter and clothing to take care of their fundamental needs. If there's any interest in assets, it will be assets that represent power and productive capacity.

TGR: That brings us to base metals. Could you give us a broad overview from your perspective?

JK: China continues to have a strong interest in acquiring raw material assets in various locations around the world. Over the past decade, China has accumulated significant foreign reserves, denominated to a large degree in U.S. currency. There are serious concerns as to how long the imbalance in trade between the United States and China can be maintained, not to mention concerns about the stability of the dollar. Consequently, China is trying to figure out ways to convert its U.S. paper assets into hard assets. They are doing deals in Africa, South America, Australia and other parts of Asia, acquiring deposits in the ground often at valuations that we shake our heads at in the western world. But when you consider that they're using a currency that in their long-range thinking terms may not be worth much, it makes a lot of sense for them to do these types of transactions. Most importantly, they are securing title to these deposits through business transactions rather than the coercive colonialism used by Europe prior to the 20th century, or the "strategic alliances" used by the United States and the Soviet Union during the Cold War.

So juniors with base metal deposits in various parts of the world may not be getting the kind of top dollar that they got in 2005 to 2007, but they are still getting pretty good valuations for these properties. I expect we will see more of this activity over the next couple of years, which will allow a lot of these companies with these projects to be taken over at premiums to the current levels. An example would be the recent takeover bid of Corriente Resources Inc. (NYSE/AMEX:ETQ; TSX-CTQ) by a Chinese group which, after spending almost a year doing due diligence, has a definitive agreement to buy Corriente at a price of about $8 a share, better than a 25% premium to Corriente's average trading price in December.

With deals like this, China is accomplishing two goals at once—converting their U.S. dollar reserves into hard assets while securing their supplies of raw materials. In fact, the big theme that underlines the base metals market and, for that matter, all the specialty metals, is the concept of security of supply.

TGR: On that note, John, let's refer our readers to our sister website The Energy Report, where we can follow some of these same threads this coming Thursday. We'll pretty much pick up there where we're leaving off, getting more of your thoughts about the specialty metals, the security of supply issue and what to expect in China.

John Kaiser, a mining analyst with over 25 years experience, is editor of the Kaiser Bottom-Fishing Report. He specializes in high-risk speculative Canadian securities and the resource sector is the primary focus for an investment approach he developed that combines his "bottom-fishing strategy" with his "rational speculation model." Kaiser began work in January 1983 as a research assistant with Continental Carlisle Douglas, a Vancouver brokerage firm that specialized in Vancouver Stock Exchange listed securities. In 1989 he moved to Pacific International Securities Inc where he was research director until April 1994 when he moved to the United States with his family. From 1989 until 1994 he was also a registered investment advisor. He worked six months as a researcher for Bob Bishop's Gold Mining Stock Report before branching out on his own with the publication of the first issue of the Kaiser Bottom-Fishing Report in October 1994. He has written extensively about speculative Canadian issues, is frequently quoted by the media, and is a regular speaker at investment conferences.