Mining Markets


More pain ahead for mining investors: Michael Berry

Self-described natural resources bull and co-editor of Disruptive Discoveries Journal  (formerly Morning Notes) with his son Chris, Michael Berry is an economist, a former professor, with 25 years of experience investing in the natural...

Self-described natural resources bull and co-editor of Disruptive Discoveries Journal  (formerly Morning Notes) with his son Chris, Michael Berry is an economist, a former professor, with 25 years of experience investing in the natural resources and life sciences sectors.

In an interview with Mining Markets in late May, Berry, who is a frequent guest lecturer at the Federal Reserve, explains where the U.S. is in its economic recovery, why gold and silver will remain range bound, and what risks and opportunities await investors in the commodity and capital markets.

Mining Markets:  Let’s start off with the general state of the U.S. and global economies. Earlier this month, you wrote we are still in an economy that has not and will not achieve escape velocity – or growth – for many months or even several years. What has to happen before a recovery can take hold?

Michael Berry:  In most recoveries from a recession historically, you’ve had a 4% to 4.5% economic growth rate. Today we are barely at 2%. In most recoveries, central bankers want to generate inflation to avoid the Japanese deflationary experience: they want rising prices and wages. We’re not seeing any of these at present.

Escape velocity refers to sufficient economic growth in GDP or GNP that you can start to work off some of the debt,  put people back to work and generate real growth and wealth in the economy.

You must have real growth in the economy to escape from this debt- induced paralysis that we’re in – that the Japanese have experienced for 25 years. We’re seeing a lot of Federal Reserve currency printing. Under normal circumstances you should see inflation and gold and silver prices increase, but we’re just not seeing the kind of growth and that makes the resource markets attractive. They remain quite stagnant for the most part.

So what do we need to do? Well unfortunately, while the Fed is attempting to carry the load here, official U.S. unemployment is still 6.5%, the Congress and Administration are not proactive fiscally. We have a problem with respect to what the House and the Senate and the Obama Administration are NOT doing, and that is passing into law sound fiscal legislation. One of the potential remedies is to reduce taxes instead of increasing them, but it’s obvious there are going to be tax increases to deal with the entitlement issues that we have in this country. That’s going to restrict growth further.

Until we see a debt deleveraging – and depending on who you talk to, the average deleveraging is eight to ten years following a bust, so you could have another three or four years of slow growth, which will mean that we won’t have strong capital or commodity  markets over that time period.

MM:  Why hasn’t the Fed policy of quantitative easing worked?

MB:  Because it’s monetary policy only – there’s a concept in the Keynesian literature of “pushing on a string.”  In other words, eventually printing money is like trying to push on a string – you don’t get any impact from the additional money. If you examine the size of the Federal Reserve’s portfolio, it’s $4.5 trillion now, up from $600 billion in 2007 – that’s a huge increase – of almost seven-and-a-half times. They keep buying bonds of longer duration to keep interest rates low. At some point, they have to sell those bonds. The reason they do that is to keep interest rates low on the belief that, the economy will pick up – and it simply hasn’t happened. We have 0% interest rates at the low end of the yield curve and we have a 10-year bond at 2.5% now and declining. Two years ago the 10-year bond touched 1.4% and recently double-topped at 3%. If interest rates increase, that will shut down the economy as well. So even with very low interest rates and multiple programs of quantitative easing, we haven’t been able to stimulate the economy into a higher sustainable growth rate and what I call escape velocity.

MM:  What are the biggest risks for investors in general during this period in the next few years that you believe will be tough?

MB:  The first risk is low interest rates. Negative real rates and low nominal rates are a form of investor repression. Essentially the investor, likely senior citizens who are invested in bonds, are funding the government and losing wealth. However, I’ve seen a lot of capital market bubbles. I called the ’87 equity bubble in September of that year. Over the last five years the Fed has inflated the stock market  in printing so much currency. I think we have inflated another bubble, an equity market bubble. Bubbles always burst.

Everybody’s pretty happy with their IRAs and their 401 Ks and RRSPs because markets have been very good. (Ed note: the S&P 500 hit a record high of over 1,911 on May 27). But the markets aren’t reacting to real growth and sustainable earnings; they’re reacting to excess liquidity from the Fed. That’s the biggest risk that investors face. I believe that this year, you’ll see a significant pullback – I hope it’s not a crash, but there will be a significant pullback in the U.S. equity markets.

MM:  If we’re in a low or no-growth scenario for the next few years, what’s the case for investing in mining stocks?

MB:  That’s a great question. The key at this stage is to find a mining and exploration companies that can sustain themselves. I believe that a lot of TSX Venture companies are not going to survive. They’re having a lot of problems doing financings.

On the other hand some great properties are going to free up. And when the cycle bounces back, whenever that is, these properties will reward you.

We’ve seen a lot of private equity investors starting to acquire good properties. Investors in Canadian resource stocks have a very different market today than they’ve had in the past. It’s interesting that most of them haven’t yet realized where we are in this cycle. They think that we’re just going to bounce back. But that bounce back is going to take some time.

What we’re seeing in hard and soft asset markets that leads me to believe we have a potential for a deflationary, or at least disinflationary world, until we deal with the excess debt that’s sitting out there and has been largely pushed down the road. Once we deal with the debt we will start a new credit cycle.

In a deflationary environment, you’re going to have excess supply and deficient demand. We’re already seeing that in a lot of the metals that we’re dealing with – also in a lot of the junior miners that are now penny stocks.  It’s going to take some time for these valuations to work their way out of the system.

So if you’re going to buy a junior mining stock, you’ve got to buy one that can sustain itself, keep its properties, do whatever minimal amount of work required, and one that has some access to either a joint venture or to the capital markets. Of course the real issue is how long does that company have to last. I don’t have an answer for that. It could be six months or it could be three years, it all depends on how quickly we’re able to deleverage and get the new credit cycle moving.

MM:  So you’re looking potentially a three-year time horizon when you’re looking at investments?

MB:  In
my mind yes, because historically the average deleveraging sequence after a bust has been eight years, so we’re five years down the road from the 2008-2009 break and if this is an average break that we’ve just gone through – and I’m not sure it is – then you’ve got another three or four years of treading water before you get to where the capital markets start allocating to these companies again and investors recognize the values.

I’m out there in the capital markets a lot and in the U.S., it’s very, very tough right now. So I hope I’m wrong, but I’m preparing for my portfolio and for my clients to be buying assets that we can hold for a longer period of time and maintain them. We will come back from this and many properties right now are selling for pennies on the dollar. There’s great value out there if you have the liquidity and the patience.

MM:  You’re still looking at juniors then, rather than intermediates or majors?

MB:  I own some gold producers. But I’m much more interested in the company that discovers the porphyry that has 2% copper in it or the 6 gram gold resource, so yes, I’m at that end of the discovery cycle which is a very difficult place to be in right now.

But even companies that are generating revenue right now – I can think of a bunch of silver companies that I like; they’re not getting any love from the capital markets either. And juniors that are purely in exploration are mostly selling for pennies. These are the ones that you seek and analyze carefully to make sure that they can sustain themselves until the cycle recovers.

Where I’m different from most people that are saying, ‘now is the time (to buy),’ is I think we’re a ways off from that point. I think it’s going to take a while longer before we start to see things move up.

MM:  Tell me a little bit about how you make investing decisions.

MB:  We focus on discovery. Discoveries that is essential to increasing Quality of Life worldwide. Natural resoruces are certainly part of this investment philosophy. Disruptive discoveries are especially interesting to us.

When I really got into natural resource investing, I developed 10 factors that required evaluation to attain understanding of 80% of the variability in share price movements. So I developed a 10-point “grid” that has worked great over time; it tells you what and when to get in and when to get out.

One of the most important of my 10 factors is the excellence and capability of the management team.  That  breaks down into many different aspects – what is the experience of the team, how good is the CEO, where does he come from, can he create value and track record. Have they done this successfully before?

The second factor that I look at is to determine if this is a world-class asset? What is the grade, tonnage, metallurgy, where is it located geographically, how close is it to other producing mines, and so on.

But one of the most important factors is the sustainability of this company? Of the 10 factors, in today’s market sustainability is crucial today. I weight these factors differently based upon where we are in the cycle. Because when you are dealing with junior mining companies, they usually don’t have revenue, so they have to access capital markets or do a joint venture. They take their dilution in the stock or in the ground.  So I want to look at how much cash they have on the balance sheet, what’s their burn rate and estimate their sustainability. If I am correct about the time we have to tread water in these markets, sustainability will be by far the most important factor in buying junior miners.

Then I re–estimate a numerical score for all 10 factors and add them up to rank stocks accordingly from best to worst. Sustainability right now is critically important. Companies that have sustainability are going to make it.

MM:  You’re a fan of gold and silver. What’s your outlook for them over the next year to three years?

MB:  You know it’s really interesting, that’s a great question because usually gold and silver move together, but gold and silver are really quite separate now in my mind. Obviously gold is down US$600-plus dollars from its top in 2011, and I think it has a bottom of about US$1,180. I follow the big gold mining companies. Gold has now retraced about 80% because if it declines a lot more, the gold mining industry is going to be in a lot of trouble. Gold exploration is already declining.

So I think we’re much closer to the bottom than we are to the top and I see it vibrating between US$1285 and US$1,320. However I think there’s more downside: Gold could not rally above US$1400 with what’s happening in the Ukraine – that ought to have been a major catalyst for gold. I know that central banks are buying it. I know that the Chinese are now buying it through Shanghai, so there’s a reason for gold to be down here for a while and I think there’s a reason for it to probably test lower. I will be buying gold at US$1,250, and buying a lot of gold at US$1,200. Both are possible.

Until we get things settled with the current economic malaise, until we see escape velocity in economic growth, I think gold is going to have a tough time.

Silver is much more volatile, it’s a smaller market and it’s more industrial, so if I’m right in the fact that industrial growth is not yet high enough for escape velocity, even though I think silver is extremely  important, I think it has a tough time breaking out as well. Many people disagree with me, but I think that until we start to see real growth and real Fed-induced inflation in the economy, silver and gold are pretty much range bound down here. So it’s an opportunity to buy some of the gold and especially silver mining stocks at very low prices.

MM:  Do you see more potential for other metals in the next little while?

MB:  Selectively, yes I do. We saw some of the uranium companies levitate – we haven’t seen the price of uranium come up yet. However the Chinese are building nuclear reactors, the Indians are building reactors so ultimately, you have to believe uranium is cheap.

Obviously lithium-ion batteries are going to be important, I think lithium is going to be a really important metal and ultimately there’ll be excess demand there.

Nickel looks like it has some real opportunity, and tungsten, so some of the industrial metals, very selectively, have some potential. But it’s a very selective thing, not a broad super-commodity wave that’s going to wash over us – at least not for the next couple of years.

MM:  Lastly, can you give us two or three examples of junior mining stocks that you like right now?

MB:  Yes, and I’ll disclose that I own them all. I like Terraco Gold (TSXV: TEN) because CEO Todd Hilditch is running that show, I think he’s a great executive. He has, in addition to exploring for gold at Moonlight, north of Spring Valley in Nevada, and also in Idaho, purchased royalties on Spring Valley which Barrick Gold (TSX: ABX; NYSE: ABX) has with Midway Gold (TSX: MDW) in a 70%-30% joint venture. I think this was a really innovative effort on his part. Terraco is a company that’s quite sustainable, again it’s a 12 or 13 cent stock, but it will make it through because of its royalty wealth – it’s not being valued properly. I am also an advisor to Terraco Gold.

Another discovery focus is Arianne Phosphate (TSXV: DAN), which is in Quebec. It has a very high-grade phosphate deposit and the world needs fertilizers. This stock is down from $1.50 to around $1.10 &
ndash; it’s a cheap stock. Again, we own the stock, we’re consultants to them, and I think this has got great potential and very good sustainability.

The third disruptive discovery is Allana Potash (TSX: AAA) and that’s the potash play in Ethiopia. They have an 80% offtake from ICL, an Israeli fertilizer company. Allana will get into production. They are sustainable. I am a consultant to Allana.

So we’re looking at a lot of investments a little bit different from gold and copper and silver that would involve food production – fertilizers for example, potable water and things like that.  In some sense these may be disruptive in their impact.

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