Adrian Day: Gold Prices Due for a Correction

Source: Brian Sylvester of The Gold Report (5/6/11)

As Adrian Day, of Adrian Day Asset Management, plays the current gold market "for all it's worth," he isn't happy about the political decisions fueling it. Read in this exclusive Gold Report interview how he would fix the federal deficit, what he looks for in gold stocks and why his gut tells him the gold price is headed for a fall.

The Gold Report: Adrian, in your 2011 first quarter edition of Portfolio Review, you wrote that President Obama’s budget "shows he doesn't understand the problem or is not serious about it." How would you solve the problem?

Adrian Day: Low taxes didn't cause the problem and high taxes won't solve it. High spending caused the problem, therefore we have to tackle it by spending less. If you want to cut the deficit, you have to cut spending. If you want to cut spending, you have to go where the money is. You could eliminate every single discretionary item in the budget and hardly make a budge in the deficit. You need to cut entitlement spending—Social Security, Medicare and Medicaid—and defense.

TGR: How is the deficit problem affecting the gold price?

AD: It's affecting the gold price significantly. The U.S. is borrowing tremendous amounts of money to meet its deficit. Over the last four to six years, China and Japan have been the largest buyers of U.S. debt. For the last six months, China has been a seller. Japan is likely to be a seller when the latest numbers come out.

The Federal Reserve has boosted the adjusted monetary base by over 27% from January to March 2011. It's printing money to help the economy and to monetize the debt. It is buying Treasuries from the government because nobody else will. The Federal Reserve is buying over 80% of the new Treasuries being issued.

I think the situation is almost hopeless. About 10% of the federal budget is servicing debt. Since the credit crisis in 2008, the government has been doing more funding at the short end. The average yield on 30-year bonds is 2.2%. That’s extraordinarily low. On the new bonds, the average is even lower; I would venture to say well under 1%.

TGR: Standard & Poor's warned that the U.S. would lose its credit rating should the White House and GOP lawmakers fail to reach a long-term solution to America's mounting debt load. Is there a way out of this that isn't good for gold?

AD: I don't think so. They can't immediately cut spending enough without putting the country into an enormous depression because so many people are dependent on government paychecks. They can't raise taxes enough. They can't raise interest rates.

The only answer is to print money and let the dollar go. The Fed can inflate or default. I don't think they want to default. So, the Fed will continue deflating and printing money. The more that happens, the less attractive U.S. bonds become to foreigners.

TGR: Where do you see gold stocks and the gold price headed?

AD: I think we're going to get meaningfully lower prices between now and the end of September. It's partly a gut feeling, partly the fact that markets don't go in straight lines for two years without corrections. We're overdue for a correction in both the dollar and gold. I don't think a correction in gold will be long and deep. I think gold stocks are going to correct much more than gold itself.

We've had some enormous runs in gold stocks in the last year or two. When people see gold start to correct, they will be ruthless in locking in their profits. I think some of the thinly traded juniors could come up significantly. Some of them have come off dramatically—20%, 25%—just in the last month.

In addition, May is often a seasonal peak for gold. So, weakness in July and August would be more typical than not. We just need to be a little bit patient and cautious in adding to positions. But there are some good buys.

TGR: Your firm specializes in gold plays, which appreciated more than 60% last year. Isn't this a boom for you?

AD: Oh, absolutely. We're going to play it for all it's worth.

TGR: What's the typical asset mix in your gold accounts?

AD: We have gold accounts and resource accounts. In the gold accounts, we have around 25% in the seniors. We have 10% to 12% in non-gold resources, which would include silver and more diversified companies. Then we have about 35% to 40% in exploration. We have about 10% in emerging producers, second-tier companies, like Allied Nevada Gold Corp. (TSX:ANV; NYSE.A:ANV). The rest are companies affiliated with the gold business like investment banks.

The major mining companies have a problem in that gold is a depleting asset. When Newmont Mining Corp. (NYSE:NEM) produces an ounce of gold, it has to go out and find another ounce of gold. When you're producing 5 to 7 million ounces (Moz.) annually like Newmont or Barrick Gold Corp. (TSX:ABX; NYSE:ABX), it’s not that easy to find another 7 Moz. every year. That forces these companies to make acquisitions just to stay in place.

For the juniors and the exploration companies, the problem is that the odds are so long against them. The often-quoted statistic is that only 1 in 3,000 anomalies ever becomes a mine. Those are extraordinarily long odds.

TGR: But if the speculative interest in junior mining stocks were only to get to the point where the deposits were actually mined, there wouldn't be any speculative interest, right? You can still make money on stocks that never get into production.

AD: Oh, absolutely. But a company raising millions of dollars from the market, pouring the money into holes in the ground, and not coming up with anything has to have a speculative move at some point.

It is the triumph of hope over experience that we keep giving money to companies when the odds are so long. We try to overcome that by looking at companies where the business risk is minimized or mitigated to the extent that it can be.

With seniors, for example, we're very big on royalty companies like Franco-Nevada Corp. (TSX:FNV) and Royal Gold, Inc. (TSX:RGL; NASDAQ:RGLD). These companies have business plans that mitigate mining risk. They have plenty of upside, but they don't have the same downside as producers who have the heavy curse of replacing ounces.

We very much favor the prospect-generator model where a company generates prospects and joint ventures production so other people spend the money. In return for giving away the majority of a particular property, the prospect generator retains its balance sheet. A good prospect generator can do this 5, 10, or 15 times.

TGR: What are some of the prospect generators that have been successful for you?

AD: One of the first was Virginia Mines Inc. (TSX:VGQ), which started out as a pure prospect generator. The model is that as you build a company, build a balance sheet, build the number of prospects where other people are spending money, and build the number of joint ventures, then you are in a position to afford a little more risk with a given property without destroying your balance sheet. Virginia did that with a discovery up in James Bay called the Eleonore Project. Eventually, Virginia sold the Eleonore Project to Goldcorp Inc. (TSX:G; NYSE:GG), which is putting it into production in 2014. It's going to be one of Canada's largest mines, with a mine life of 17 or 18 years. It has about 9.5 Moz. of reserves at the moment and is still growing.

TGR: Virginia also gets a royalty in advance of production.

AD: Yes, a very attractive advance royalty of about US$100,000/month. It's also a variable royalty that goes up along with the price of gold as the cumulative number of ounces produced increases, with a 3.5% cap. Virginia will receive the cap in the second full year of production. Starting in 2015, Virginia, a US$280M market cap company, will receive about US$40M a year of free cash flow for 17 years. That is just remarkable.

TGR: If Goldcorp is going to pay Virginia US$40 M for 17 years, wouldn't Goldcorp be better off just buying it?

AD: Goldcorp is the obvious buyer since it is probably worth more to Goldcorp, the company paying the royalty, than it would be to a third-party. Virginia also has a lot of land in the Eleonore area. Some of it has already had some attractive early stage exploration. Goldcorp is likely to want that as well.

TGR: Any other names?

AD: I like Vista Gold Corp. (NYSE.A:VGZ; TSX:VGZ) as an asset play. The current stock price is US$3. The company has 15 or 16 Moz. of gold at projects around the world. The company just did a joint venture on a property in Idaho. My guess is that after doing more exploration and building up reserves, Vista will spin that off into a separate public company.

Almaden Minerals Ltd. (TSX:AMM; NYSE:AAU) is very strong, with good management and a good balance sheet. They have a couple of exploration projects in Mexico that are returning strong results. Almaden is at US$4. At that price I’d probably not chase it, but it's one we like a lot.

Eurasian Minerals Inc. (TSX.V:EMX) is selling at US$2.90. This is a prospect generator, so in return for low risk you have to be patient. Eurasian is a very strong company with a good balance sheet, good management, and a lot of projects around the world, including a joint venture with Newmont in Haiti. The whole company is selling for only US$150 M, a very low price.

Kiska Metals Corp. (TSX.V:KSK) used to be Rimfire, a pure prospect generator. Then it merged with Geoinformatics and obtained a project called Whistler. That's when they started changing their strategy to focus on exploring. It's a huge project with lots of upside.

TGR: Kiska has a lot of money on the balance sheet . . .

AD: Yes, but Kiska is spending money. I think they're going to have a very good resource. I'm suggesting the project is too big for them to develop and bring into production on their own. There's just enormous upside there before bringing in a partner.

TGR: Didn't Kiska just find some copper/gold targets?

AD: Just last night (May 2, 2011). The results look very attractive. Assuming the results continue strong, the real key will be financing. Success depends on how quickly the company goes through money and how soon and how often it has to refinance before bringing in a partner.

TGR: The company just did a US$17M financing, so they should be cashed up and good for a while.

AD: They should be fine for a while. But it's an expensive project. It's at US$0.83 and there are 100 M shares out. So, you’re paying US$86 M for a lot of upside.

TGR: Another prospect generator that you have said you like is Midland Exploration Inc. (TSX.V:MD).

AD: Yes, we hold 5% in Midland, one of my favorite companies. It's a smaller company with a market cap. The CEO, Gino Roger, runs the company in a very methodical manner without spending a lot of money. The company has about US$5 M on the balance sheet. It has two gold ventures with Agnico-Eagle Mines Ltd. (TSX:AEM; NYSE:AEM). Agnico just re-upped in one of those ventures for the third time. The other one is a regional joint venture in the James Bay area, where Goldcorp's Eleonore project is. Midland also has a JV with Copper One Inc. (TSX:CUO) and an attractive JV with a Japanese national oil company on a rare earth project in the northern part of Québec called JOGMEC.

I think Midland is going to be the next Virginia. I would definitely buy it, but it doesn't trade very much. So, this is not one that you buy at your discount broker. This is an astonishing buy. You're getting an awful lot of value.

TGR: Any other companies you want to talk about?

AD: Miranda Gold Corp. (TSX.V:MAD) is another prospect generator in Nevada and Colombia. The market got a little bit tired of Miranda because it doesn't seem to have much success. I don’t know when Miranda will succeed, but I would bet that it will have a discovery. In the meantime, you're paying less than US$25 M for 12 joint ventures. I think the company is very cheap.

TGR: You have a long-term investment philosophy.

AD: Absolutely. We buy parts of companies, not pieces of paper. I am a ruthless seller. If I change my mind on a company or the company deviates from its business plan, I look at it very carefully. But I'm also very patient in holding throughout stock price volatility.

TGR: You will be at the New York Hard Assets Investment Conference on May 9 and 10 to talk about your new book, Investing in Resources: How to Profit from the Outsized Potential and Avoid the Risks. Can you give us a preview?

AD: I'm going to talk about four long-term trends in the world. First is the shift in economic power from the U.S. and the industrialized nations over to China and the emerging East. Second is the helpless financial situation of the U.S. Third is the ongoing decline of the dollar. The last is the growing shortage in resources across the board.

All four are interconnected. That's where I want to be positioned. Even in my global managed accounts, we have 40% of our assets in resources. There will be growing shortages of platinum, copper and uranium; those prices are just going higher. That is where you want to be for the next several years.

TGR: Adrian, thank you for your time and insights.

Adrian Day is a British-born writer and money manager, a graduate of the London School of Economics, who has made a name for himself searching out unusual opportunities around the world. At his money management firm, Adrian Day Asset Management, he specializes in global diversification and gold equities for individual and institutional clients. Adrian is a frequent speaker at international seminars, a frequent guest on CNBC and The Wall Street Journal Radio network and has been interviewed by Money, Straits Times, Good Morning America and others.