Precious metals
stocks are shining again, after a period of rising interest rates in the U.S. dulled their sparkle. But fund managers are convinced that bullion is poised to go much higher than its recent US$470 an ounce, and conditions are ripe for a resumption of the stock rally that began in late 2000.

“The gold sector peaked in January 2004, about six months before the Federal Reserve Board started raising interest rates,” says Kevin MacLean, manager of Sentry Select Precious Metals Growth Fund and senior portfolio manager at Toronto-based Sentry Select Capital Corp. “The gold sector does not like a tightening policy — it’s a huge weight on the sector. Gold is money without yield and has to compete with money that has yield.”

This past June, however, MacLean became more bullish as benchmark 10-year U.S.
treasury bonds fell below 4%. “The 10-year note acts as a ceiling on how high the Fed can raise rates; it does not want to go that high because it would flatten the yield curve and could lead to a slowdown. This gave the market confidence that the end was in sight,” adds MacLean, a gold specialist with 17 years of experience in the sector.
Although the Federal Reserve Board raised short-term rates in September to 3.75%, he argues that most of the tightening appears to be over.

At that point, MacLean, who doesn’t try to forecast the price of gold, went on the offensive and lowered the fund’s cash holding to 5% from 30%. “For the moment, the fundamentals are much more positive,” he says. As well as pointing to the near-end of U.S. rate hikes, he argues that the link between gold and the euro-dollar exchange rate has been severed, thanks to France’s rejection of the European constitution. As the euro has stumbled badly, investors have been moving into gold. That move also ended the traditional inverse correlation with the U.S. dollar, as gold’s rise has paralleled the climb of the greenback.

Principally a bottom-up investor, MacLean has only one large-cap holding, a 6% stake in Kinross Gold Corp. “I prefer to make money whether gold goes up or not. I can’t say that with the senior shares,” he says. Large-cap gold stocks tend to trade at valuations that are extremely unattractive. When he bought Kinross at $6.70 a share, or one times net asset value, accounting issues had affected its second quarter. The stock recently traded at $8.82 a share.

About 10% of the fund is in intermediate gold stocks (which produce 250,000 ounces and more), such as Agnico-Eagle Mines Ltd., Cambior Inc. and Iamgold Corp.

But the bulk of the fund is weighted toward smaller companies that MacLean believes have greater upside. There is about 30% in junior gold and silver producers and 31% in exploration companies, as well as 14% in base metals and 4% in diamond exploration.

One of his favourites is Semafo Inc. Semafo is active in Guinea and Niger, where it produces 180,000 ounces a year, but it is about to boost output with the Mana project in Burkina Faso. “It’s cheap but generates cash flow of about US20¢ a share,” says MacLean. Bought last spring at an average cost of $1.40 a share, Semafo recently traded at $1.80 or 0.80 times its NAV. “Based on fundamentals alone, the stock should be $2,” he says, noting it is trading at a small discount.

In a similar vein, he likes Alamos Gold Inc., which has a new mine in Mexico that will produce about 150,000 ounces a year. Once production is expanded to 250,000 ounces, it should boost cash flow per share. Bought a year ago at about $2.50 a share, it recently trading around $4.85. MacLean’s upside target over the next 12 months is $5.60 a share, assuming gold stays where it is.

John Embry, manager of Sprott Gold and Precious Minerals Fund and chief investment strategist at Toronto-based Sprott Asset Management Inc. , is also focused on the small- and mid-cap segment of the gold sector. “We have very little exposure to large caps,” he says, noting a 1.6% weighting in Newmont Mining Corp., as well some intermediate players such as Iamgold Inc. “Beyond that, the vast majority is in emerging companies that are small producers, or companies that are turning resources into reserves. At this stage, greater opportunities lie in those companies.”

@page_break@A veteran of the gold sector, Embry has watched the ebb and flow of the price of gold and gold shares. While bullion has gone through a soft patch, he now expects gold will reach US$500 an ounce within five or six months, and US$1,000 within two to three years. “Gold doesn’t really move; it’s the underlying paper currencies that move,” he says, adding that the colossal U.S. trade and account deficit will force down the US$ and competitive pressure could lead to the debasement of many currencies.

Like MacLean, Embry notes the traditional inverse correlation between the greenback and the gold price is over. “It’s been broken now, because the gold price has been getting much stronger in euro terms — we have had a major break-out,” he says. “But I’m watching the gold price in all currencies and I like what I see. Gold is beginning to move upward — in all currencies — and that is when a true bull market is underway.”

Running a 60-name fund of which the top 20 account for 60% of the portfolio, Embry likes up-and-coming play Southwestern Resources Corp. It is developing the Boka project in China and the Liam project in Peru. “It could have 20 million ounces in total under its control, yet it is valued as if it had next to nothing,” he says. The firm is making the critical shift from resource status to reserve status (in which there is a greater certainty of the extent of recoverable gold).

Although production is not slated for a few years, Embry values the company because of its takeover potential. Bought in mid-2003 at about $3 a share, it recently traded at $11.75 on a split-adjusted basis. He has a notional upside target of $25 a share, but much depends on where gold ends up in the next few years. “There is so much going on; they could prove up more ounces, for instance. Regardless, the stock is undervalued based on what we know today.”

Another favourite is Greystar Resources Ltd. “It has a very large resource that is being converted into a reserve in Colombia,” he says. The Latin American country has become a safer place to invest than in the past, he adds: “You will have a revaluation of assets such as Greystar, as this becomes apparent.” Another potential takeover candidate, Greystar has about eight million ounces in resources. Embry bought the stock two years ago at about $2 a share and it recently traded at $8.50, with much of the upward move coming in the past few months. His target is about $15 but, he says, “It will need further proving up of reserves, a higher gold price and improvement in the perception of Colombia.”

Similarly bullish on the gold price, Charles Oliver, co-manager of AGF Precious Metals Fund , and vice president at Toronto-based AGF Funds Inc. , is avoiding companies with large hedge books.

“Barrick Gold Corp., for instance, does not necessarily fill the bill,” says Oliver, who manages the fund with Bob Farquharson, vice chairman of AGF. “We believe our investors want to get the full price when the firm sells bullion into the market. But with the hedge book they only get the value of the book. In this environment, we want to be in unhedged companies, for the most part.”

Although there is a 3% holding in Placer Dome Inc., which has a partial hedge, the stock is there for diversification purposes and to lower volatility.

Like Embry, Oliver expects the gold price to escalate to US$1,000 within three to five years, largely driven by falling currencies. He argues there are similarities to the 1985 Plaza Accord that saw the rapid devaluation of the US$ to stem the U.S. trade deficit.
Last summer’s Chinese revaluation of the renminbi, he says, could be a precursor to a similar situation that evolved from the Plaza Accord.

“If you look back, 1985 was the early stage of a 20-year secular bear market for gold, whereas today we believe we are in the first leg of a secular bull market,” he says.
Inflationary pressure, in the form of rising oil prices, is another factor that will support a significantly higher price for gold.

Running a 125-name fund, Oliver has allocated less than 20% of the portfolio to senior producers such as Kinross Gold Inc. and Meridian Gold Inc. There is also about 10%-12% of the portfolio in exploration companies that are poised to become producers.

Like MacLean, he likes Alamos Gold Inc., which began with a resource base of about one million ounces about four years ago. But Oliver, who paid on average $1.67 a share for the stock over the past few years, believes the firm could have up to five million ounces today. The stock recently traded at $4.85 a share.

Another favourite is Virginia Gold Mines Inc., which runs the Eléonore Lake project in Quebec. “It could have the same type of growth as Alamos,” he says. He expects the firm could have more than one million ounces in resources. Bought at an average price of $1.67 a share, it recently traded at $7.50.

The bulk of the fund, however, is in mid-cap names, including Bema Gold Corp. Oliver has held the stock for five years and watched as management struggled to develop its projects in Russia. Now it is poised to bring on the Kupol project there, which could produce about 500,000 ounces a year within two years.

“It’s easy to mine and has one of the nicest veins to be found in recent times,” he says. “A geologist’s dream.” Bought at an average price of $2.28 a share, it recently traded at $3.15 a share. IE