While physical gold is not in our buy zone, many gold mining companies are selling as if the price of gold is currently $800 to $900 per ounce, which is 28% to 36% lower than gold's closing price on January 31, 2014, and well within our buy zone.

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"There are two ways to conquer and enslave a country. One is by the sword. The other is by debt."

- John Adams, 1735 - 1826

Overview:

  • We continue to be concerned about the increasing levels of federal debt, Fed policy and quantitative easing, and the overall lack of political will to change the present course. As a result, we believe that the probability of elevated inflation over the next 5 years has dramatically increased and have been reviewing gold as a potential investment for our portfolios.
  • During our study of gold, we arrived at a methodology that prices the commodity from five different viewpoints. Currently trading at $1,220 to $1,300 per ounce, we believe gold is selling in a fair value range.
  • While physical gold is not in our buy zone, many gold mining companies are selling as if the price of gold is currently $800 to $900 per ounce, which is 28% to 36% lower than gold's closing price on January 31, 2014, and well within our buy zone.
  • With or without high inflation in the future, we believe many gold mining companies have been selling at bargain prices and have added them to our portfolios.

 


 

The Century Management Newsletter, The Value Investor™, December 2004

"Corporate debt, while high, is improving. However, consumer and federal debt are at record levels and very troubling. These debt levels would be of even greater concern if a financial mishap were to occur, as there would be fewer options available to prevent the economy from declining. To continue on this path of high or increasing debt is simply unsustainable over the long run."- Arnold Van Den Berg

From 2009 through 2013, the U.S. government's unfunded liabilities have increased at an average rate of $6.8 trillion per year. This increase is not counted in the annual budget deficit. In fact, Social Security and Medicare are simply listed as a footnote. We project the unfunded liabilities to total approximately $90 trillion at the end of 2014.

We have been concerned about debt levels and the possibility of inflation or deflation for the past 10 years. We first wrote about these issues in our 70-page newsletter in December 2004, where we outlined the risks and concerns we had about various over-valued markets and the unsustainable direction of our country's finances. Chart 1 shows there is currently $17.2 trillion in total public (federal) debt outstanding. Divided by the U.S. population, the amount of public debt translates to $54,335 worth of debt for every person in America. However, these figures do not include unfunded liabilities, such as Social Security, Medicare, Medicaid, Veteran Health Care Benefits, the Medicare Prescription Drug Bill, and the Affordable Health Care Act. These liabilities increase the total U.S. public debt outstanding to $82 trillion, or $258,254 per person. This is up from $100,000 per person just 10 years ago!

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When you consider the rate at which public debt is increasing, along with the fact that so many countries around the world instituted their own versions of quantitative easing (i.e. printing money) while increasing debt levels, these conditions are unprecedented. We have found no historical example of so many major countries simultaneously engaged in quantitative easing. Just ten years ago we would not have thought such an economic environment was even possible.

We believe this debt combined with artificially low interest rates has already created distortions in the financial markets. If not corrected, these conditions may lead to another financial crisis. Today, we see only two ways that the Federal Reserve can work its way out of these problems.

Option 1: The Fed can continue to stimulate the economy through quantitative easing and, if it does, we will likely see higher inflation or a currency crisis at some point. The reason we have not had inflation so far is because most of the quantitative easing has gone into the banks. Chart 2 shows that most of this money has remained on the banks' balance sheets and has not yet circulated throughout the economy. Banks earn a small but risk-free return by holding government bonds and thus have had little incentive to lend. When incentives do increase and banks begin to lend in earnest, we will likely see higher inflation. When inflation takes hold, it can happen quickly, as seen in the 1970's when inflation increased from 2% to 12% in just two years.

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Japan provides us a good example of what can happen to an economy when central banks reverse quantitative easing on a large scale within a short period of time.

Chart 3 shows that in 2001, the Japanese government provided tremendous quantitative easing to stimulate growth in their economy. Five years later, in 2006, they turned around and pulled the money out.

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Option 2: The Fed can reverse the quantitative easing by pulling the money back out of the banks. However, in the short run, this action could possibly cause a recession and even deflation. The Fed tapered its quantitative easing by $10 billion per month in December 2013 and by another $10 billion per month in January 2014, which has caused increased volatility in U.S. markets, as well as casualties in various foreign markets. Even after this reduction, the Fed is still buying $65 billion per month of bonds and mortgage-backed securities. Should the Fed begin a larger scale reversal of the quantitative easing within a short period of time, we would likely see material disruptions in the U.S. economy and in international markets, perhaps a recession or a bout of deflation.

As a result, from 2006 through 2013, Japan experienced a deflationary environment as its GDP shrank at an annualized rate of 0.80%. See Chart 4.

This negative growth was not good news for Japan's stock market.

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Chart 5 shows that as the Bank of Japan reversed its quantitative easing in February 2006, the Nikkei 225 Index began a decline, finally hitting bottom in 2009. Stuck in a low trading range with no sustained market improvement, the Bank of Japan reinstituted its quantitative easing program in February 2011. However, it was not until early 2013 that the central bank's asset purchase program significantly increased in an effort to materially reverse two decades of deflation. This increased stimulus was a major reason why the Nikkei 225 Index appreciated roughly 50% by the end of 2013.You can see the Fed's dilemma: Leave the money in too long and risk inflation; pull the money out too quickly and risk recession and possible deflation.

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There is one more possible scenario. If American businesses grow fast enough, they could provide enough stimuli to the economy to offset the impact that a reversal of the quantitative easing would have on economic growth.

In part, this is what the Fed is trying to encourage by employing quantitative easing and keeping interest rates low. However, while the Fed can create liquidity and heavily influence nominal GDP(1) growth by defining the value of the dollar, it does not control the Real GDP(2).

As money managers, we are challenged by not knowing which way the Fed will handle the quantitative easing or the record low interest rates, and how the economy will play out as a result. However, after careful analysis, a review of history, and following the Fed closely, we believe the Fed is going to err on the side of inflation. We have come to this conclusion because we do not believe there is enough political will to materially reduce the country's record debt levels and curtail quantitative easing. To do so would mean eliminating or reducing a variety of government programs and expenditures, as well as potentially causing a prolonged period of slow growth or deflation. On February 13, 2014, Congress showed this lack of political will by approving an increase in the debt-ceiling through March 2015. To add insult to injury, the approval was based on a "clean" debt-ceiling bill with no deficit reduction provisions. This legislative act is unbelievable given the unsustainable rate of federal spending. Unfortunately, few people realize that the "light at the end of the tunnel" is not the light of the horizon, but that of an oncoming train.We believe that the probability of elevated inflation over the next 5 years has dramatically increased, and we have sought ways to invest our portfolios in this environment that will protect their purchasing power while maintaining our traditional valuation discipline. Specifically, gold and mining stocks look promising. We have used gold successfully in the past when we had similar economic concerns. In fact, investing in gold provided our portfolios tremendous protection in the early part of our company's history, 1974 through 1980, when inflation reached as high as 12%.

After completing an in-depth study(3), we developed a methodology that values gold from five different viewpoints. Chart 6 highlights the summary of our work. We believe gold, which has recently been trading between $1,225 and $1,300 per ounce, is in a fair value zone. We believe the downside risk to gold is approximately $650 to $700 per ounce, and the extreme upside is between $1,800 and $2,200 per ounce. At present, we believe gold is likely to go lower than its current $1,225 to $1,300 trading range and therefore do not believe it is an attractive time to buy gold as a commodity.

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However, we believe that gold mining companies are trading as if the price of gold is currently $800 to $900 per ounce, which is approximately 28% to 36% lower than the closing price of gold on January 31, 2014, and well within our buy zone. Even if the price of gold continues to drop, we do not believe that these mining companies will decline much further given that their prices are already deeply discounted.

Chart 7 highlights that while gold fell roughly 37% from its September 2011 peak of $1,895 per ounce to a low of $1,195 in December 2013, shares of gold mining companies fell even more. The middle line on Chart 7 is the Market Vectors Gold Miners ETF, which is a basket of large- and mid-size mining companies. This ETF declined 69% from its September 2011 peak to its December 2013 low. The Market Vectors Junior Gold Miners ETF, which represents the small miners, declined 83% from its December 2010 peak to its December 2013 low. At these prices, we believe owning the miners, large or small, will provide much more upside relative to owning the commodity.

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Chart 8 shows that relative to the price of gold, gold mining stocks are basically as cheap today as they were 13 years ago.

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The below examples of two individual mining companies further highlight the potential of mining companies vs. the commodity.

Example 1: Seabridge Gold Inc. (Symbol: SA)

Seabridge Gold is a development stage company engaged in the acquisition and exploration of gold properties located in North America. In other words, it has no sales or earnings which can fluctuate widely as the price of gold moves up and down. Because of this, Seabridge trades relative to its proven reserves in the ground.

By taking the total market cap and dividing it by the amount of its reserves, we can get a good idea of how much Seabridge's price is currently discounting its gold in the ground.

Chart 9 shows that in the 2008 market decline, Seabridge fell to a low of $7.03 per share, while at the same time gold was near its low of $712.50 per ounce. During the first six weeks of 2014, gold prices averaged $1,244 per ounce while Seabridge traded mostly between $7.50 and $8.50 per share, roughly the same price as when gold was $712.50 (i.e. 42% lower)! In other words, our analysis indicates that Seabridge is selling at bargain levels relative to reserves. (As a side note, the quality of the company's reserves also improved. See reserve details in Exhibit 1 at the end of this report).

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Chart 10 also confirms that Seabridge is a value today, as it highlights a price-to-book value lower today, at roughly $1,250 gold, than the company's price-to-book value was in 2008 when gold traded at a low of $712.50.

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Example 2: Agnico-Eagle Mines Limited (Symbol: AEM)

Agnico-Eagle Mines is a gold mining company with mining operations in Canada, Mexico and

Finland, as well as exploration activities in Canada, Europe, Latin America and the United States.

Chart 11 shows the price history of Agnico-Eagle. You can see at the bottom of 2008, around the time when gold hit a low of $712.50 per ounce, the price of Agnico-Eagle dropped to a low of $21.70 per share. However, in December 2013, Agnico-Eagle traded as low as $25.13 per share while gold traded at roughly $1,200 per ounce. In other words, even though gold is roughly 68% higher in December 2013 than it was at the bottom of 2008, Agnico-Eagle's share price is just 19.5% higher at the end of January 2014, which leads us to believe the stock is significantly undervalued relative to gold.

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Chart 12 highlights that when gold traded at $712.50 per ounce in 2008, Agnico-Eagle's stock price traded at 1.3 times book value. Now, at the end of January 2014, with gold trading at $1,251 per ounce, Agnico-Eagle's price-to-book is actually lower at 1.2 times. Again, we believe this illustrates an undervalued share price relative to gold.

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Chart 13 shows that while gold closed at $1,251 per ounce at the end of January 2014, Agnico-Eagle's share price sold at 1.3 times sales. This is lower than when gold traded at $712.50 per ounce. Again, we believe this ratio highlights that its share price is undervalued relative to gold.

By analyzing the gold mining companies on an individual basis using price-to-book and price-to-sales ratios, as well as our proprietary resource valuation models, we see many of the gold mining companies trading as if the price of gold is $800 to $900 per ounce rather than its current trading range of $1,225 to $1,300 per ounce. Relative to the price of gold, we believe the miners offer a tremendous value today.

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CM Investment Strategy For Metal/Mining

We are using a basket approach to implement our investment strategy for these mining companies. To date, we have analyzed more than 40 gold (and silver) mining companies and have invested in approximately 10 to 12 (depending on the individual client's portfolios), which represent roughly 10% of our typical CM Value I (All-Cap Value) client portfolio. If prices get cheap enough, we plan on increasing our exposure and would consider going upwards of 15% to 20% of the total portfolio.

We are using a basket approach to invest in the mining companies for two reasons. First, we want to diversify the size of companies we are buying. Liquidity and the volume of shares we can obtain are part of our consideration when building a portfolio. Therefore, while many of the smaller companies offer significant upside relative to some of the larger miners, we do not want to own too much of any one company. Second, we want to diversify the geographical locations. While some of the miners we have purchased are based in the U.S, others are in Canada, Africa, Asia, Latin America, and Europe. Each of these locations has different laws, regulations, and varying levels of political risks/uncertainties. Thus, we believe it is prudent to diversify to protect against geopolitical changes that may affect production.

The stocks in our basket also adhere to our basic principal of choosing companies with strong fundamentals: 1) we have chosen companies that we have identified as efficient producers or that have reserves that are less costly to mine, and 2) we are primarily sticking with companies that we believe have good balance sheets. While we may still use an ETF for part of our exposure, we believe developing our own basket of mining companies gives us the best reward-to-risk opportunities.

 


 

Summary

Even if we do not experience higher inflation or a currency crisis in the future, we believe the gold mining industry is providing many good values today. If physical gold were to drop to $900 per ounce or lower, we would consider owning the commodity as we feel it would be a good value and in our buy zone. While we do not own physical gold today, for those who do own it in this fair value zone, we think it can serve as a very good insurance policy against higher inflation or a currency crisis should these conditions occur.

 


 

Exhibit 1

Seabridge Gold Inc. Reserve Breakdown

Seabridge Gold is a development stage company engaged in the acquisition and exploration of gold properties located in North America. In other words, it has no sales or earnings which can fluctuate widely as the price of gold moves up and down. Because of this, Seabridge trades relative to its proven reserves in the ground.

By taking the company's enterprise value (i.e. stock value + debt - minus cash = total worth) and dividing it by the reserve volume in ounces, we can determine how much investors are valuing Seabridge's reserves. Our math is below.

ex1a

The chart shows that when comparing the enterprise value per reserve ounce of $3.66 in 2013 vs. $3.74 in 2008, we can see the reserves are valued lower than in 2008. However, we believe it is important to highlight Seabridge's gold reserves are now more sellable than in 2008, as its proven and probable reserves have dramatically increased from 0% to 56%.

Proven and probable reserves are typically more bankable than measured and indicated reserves or inferred reserves as they are more likely to be extracted in the near term, have to go through more extensive feasibility tests, and show that they can be economically extracted.

ex1b

Disclosures:

The gold pricing in this report is measured using the London PM Fixing price, quoted in U.S. dollars per ounce.

Past performance is not indicative of future results. Century Management reserves the right to modify its current investment strategies and techniques based on changing market dynamics or client needs.

The content of this report/letter should not be deemed, nor is it intended to be considered an investment recommendation to purchase or sell any particular security or an offer to sell any product.

Certain statements included herein contain forward-looking statements, comments, beliefs, assumptions, and opinions that are based on Century Management's current expectations, estimates, projections, assumptions and beliefs. Words such as "expects," "anticipates," "believes," "estimates," and any variations of such words or other similar expressions are intended to identify such forward-looking statements.

These statements, beliefs, comments, opinions and assumptions are not guarantees of future performance and involve certain risks, uncertainties and assumptions which are difficult to predict. Therefore, actual outcomes and results may differ materially from what is expressed or forecasted in, or implied by, such forward-looking statements.

Viewers are cautioned not to place undue reliance on these forward-looking statements, which reflect Century Management's judgment only as of the date of this report/letter. Century Management disclaims any responsibility to update its views, as well as any of these forward-looking statements, to reflect new information, future events or otherwise.

Factual material referenced in this report/letter is obtained from sources believed to be reliable and is provided without warranties of any kind, including, without limitation, no warranties regarding the accuracy or completeness of the material.

Century Management is a registered investment adviser. More information about Century Management, including its advisory services and fee schedules, can be found in its Form ADV Part 2 which is available upon request or you can download from our website at www.centman.com.

 


 

(1) Nominal GDP is a gross domestic product (GDP) figure that has not been adjusted for inflation.

(2) Real GDP is an inflation-adjusted measure that reflects the value of all goods and services produced in a given year, expressed in base-year prices. It can account for change in price levels of inflation.

(3) Detailed CM Gold Valuation report available here.