Richard Pomboy has seen, and done, it all. Very well.
In bull markets and bear. Brokerage in the '60s, research boutique in the '70s, hedge funds in the '80s and '90s. Small wonder that, even retired to ski and golf in the Rockies, he can't resist keeping a very active hand in the markets, albeit these days shepherding only his own (considerable) assets. Which are largely in gold shares. And which he was way early in going into, as Dick is the first to admit.
A tech stock maven when I first met him in the '70s, Dick closed down his first, highly successful hedge fund at the end of the '80s and took a couple-year hiatus from the market, returning in '92 convinced that gold was about to end what was then a 13-year bear market. Oops. But gold did rally in '93, and Dick actually generated fancy returns for his investors for several years before running into grinding frustration as golds sank and techs went ballistic. As gold shares climbed this year, while most others sank, I often wondered what Dick was thinking and doing. Well, I finally tracked him down around the 4th of July and asked. It was worth the effort. -KMW
What do you make of market's latest slide?
We've just lived through a 20-year bull market in stocks and a 20-year bear market in gold and these things are not easily overcome. People are still hanging onto the hope stage in the stock market. I know, CNBC says you don't need to have a capitulation phase, but they are the cheerleaders of the stock market. Experience tells me that you do. You have to go from hope to fear and then to panic. And I don't think we are anywhere near that-though we're closer than we were a few weeks ago. But there are so many other forces affecting these markets-such as the dollar. One of the real risks here is competitive currency devaluations. Eventually, people are going to recognize that they aren't making any real returns in stocks-or, that if they are, those returns are going to be very low. Meanwhile, gold has traditionally done very well in periods of low real returns in the stock market. Gold has been the strongest currency in the world in the last two years.
If it's a currency.
That's true. But a currency is what it traditionally has been, except in the last few decades. Historically, for 5,000 years, it was a currency. We have seen some protectionism lately, but the true issues here are no real returns on assets, and the risk of competitive currency devaluations. Meanwhile, pressure on manufacturers here, I think, is going to dictate that we not get too worried about a declining dollar. Meanwhile, as foreign economies start to recover somewhat-those economies have fewer excesses than the U.S. – they are going to withdraw money on the margin, or at least send less money over here. But we need something like $1 billion a day to fund our deficits.
Only something like 75 percent of all the world's money flows everyday.
Yes. We can't keep absorbing that amount of capital. Eventually, we'll get some inflation. The dollar decline is obviously going to have some inflationary impact and we also have additional federal spending to combat terrorism, etc. But I think the big issue on the inflation front-and we will just have to see how it shakes out-is Japan. To solve its problems, Japan is eventually going to have reflate. There is a theory that the reflation could be so severe that it would really trash the yen to a degree that is unacceptable to the rest of the world. If so, the solution would be for the rest of the central banks to buy the paper issued by the Japanese government. But in so doing, Japan would export its reflation to the rest of the world. I don't think any of this bodes too well for the stock market, which still is levitating on some fancy multiples. And that's before we even consider the loss of confidence in corporate reporting and the U.S. market. All of this, in short, bodes well for a move back into tangibles, which eventually takes place at the end of all paper bull markets.
Before we mine your favorite topic, let's chat more about stocks. One of the great benefits of talking to someone who has been active in Wall Street since the 'Sixties is that you've seen a full cycle or two-
Inevitably, I guess, over 35 or 40 years.
Many investors think a bear market is a couple of weeks of unpleasantness like they experienced in '98, when Russia and LTCM defaulted.
As you know, I lived through the bear markets of '69, '72, '73-very unpleasant times-and was even heavily involved in buying tech stocks, way back when, so I have some sense of what they should sell at. But in the dot.com mania, I was completely lost. I really could not understand it at all. As a matter of fact, two years ago I was skiing with a friend who was bragging about his stake in Intel, which at the time was trading at upwards of $70. I told him that I thought Intel was one of the finest companies in the U.S. and that I was going to be very happy to buy it in single digits-at which point he almost crashed into a tree!
No doubt. Hope he sold, too.
I don't know. But there is a time to buy these things and a time to sell. Bear markets can be very painful, yet because we had a bull market basically for 20 years, most investors have no idea how bad a bear market can be. Unless, of course, you have been involved in gold for the last 20 years-or in Japan for the last 10-plus. In which case, you are fully acquainted with bear markets.
Let's dip into ancient history. Back before you started your first hedge fund, in 1980, you ran a research boutique-
I actually ran a brokerage firm. We were members of the Exchange and specialized in researching high techs. That was in the heyday of research boutiques-which look like they could make a comeback.
That's clearly my hope.
I think that is really the trend and that is going to be terrific. It eventually will give investors some more confidence in Wall Street.
It's just too bad there's no overnight cure. You alluded to Japan. Many investors reject those comparisons because Japanese society is so very different from ours. "They can't get out of their own way." But American investors were just as hapless in the 'Seventies bear market.
Yes. That was our world back then. Some of the Fidelity high-tech funds fell something like 80 percent in the early 1970s. Which implies we have some more room to go on the downside if this is going to be similar to that. It is a very painful experience. We really have to get to the point where people don't ever want to hear about the stock market again-and we are nowhere near that.
Even if outrage at corporate shenanigans is finally being vented.
We have had a decade or two of real greed, during which the reward system that corporate executives operated under was pretty clear: You got a lot of stock options and you did whatever you could to get your stock up. You exercised your stock options; sold simultaneously and you retired. You didn't worry about what was underlying the numbers or about the future of the company. One thing that could be done to correct the situation would be- since exercising a stock option produces ordinary income and the recipient has to pay taxes-let them sell just enough of their position to pay the taxes but then require corporate officials to hold the remainder of their positions for, say, three years. Then they'd be in the same boat as any pension fund or other long-term investor-and they probably would run the business very differently.
Assuming they were also prohibited from using loans or derivatives or any of the other clever methods that have been devised for corporate insiders to effectively (not to mention quietly) monetize those shares earlier.
Absolutely. But I have not seen that proposed yet and I assume the lobbying against any such proposal would be pretty significant. As you know Wall Street benefits from volume-and public offerings and higher prices make all of that possible. So the Street is going to lobby against any real reforms despite what they may say. The only thing that could even dent the Street's thought process on that might be the judicial losses that they are going to face-which could become very significant.
As I wrote just after the market peaked [w@w, April 20, 2000], I only wish there were a way to invest in the class-action law firms-without actually becoming a lawyer, that is.
Very clever. But I guess there really is no way to do that.
No, but unfortunately the lawyers are the only ones who will walk away from this winners.
That is right. Eventually we are going to have a wonderful opportunity in the stock market, but that is well down the road. In the meantime, you will have erosion in the equities markets, erosion in the dollar and eventually a give-up. Only then will we will have some kind of basis on which real investors can get involved again.
Which is why you've liked gold, for a long time?
Gold's story is actually getting more and more compelling.
A lot of serious people argue that gold is really not an investment alternative at all-
Well, gold has been discredited in the last 20 years because no one needed gold. Everything else worked. But in this environment, there are very few things to invest in. And gold has historically had a very high inverse correlation with the Dow and a very strong inverse correlation with the dollar.
The metal's price, relative to the Dow, has fallen off the charts.
That is true. Relative to the Dow, gold's price is about as extreme as it's been in history. And there are other things working in gold's favor. The central banks a couple of years ago signed what was called the Washington Agreement-it was signed by the British and European central banks and the U.S. went along with it-under which they limited their annual sales to 400 tons. Considering that there is probably a supply-demand deficit in the market of 1,000 tons annually, that is really not a huge amount of central bank selling. So that took a little pressure off of the market. Talking about central banks, the central banks that have been sellers of gold were typically taking those proceeds and investing it in U.S. dollars. But since the U.S. dollar has started depreciating, the question is are they going to pursue that avenue as vigorously as they did before. The answer is probably not. If they sell their gold, what are they going to buy? The Bank of England has been selling gold for the last couple of years and so far they have left something like $500 million on the table. The Bank of England has notoriously, throughout history, marked the bottom with their gold sales. They did it with the London gold pool in the early 1970s. On the central bank side, you also have the Asians under-owning gold. The question is what are they going to do with their reserves? Are the Chinese going to continue to buy dollars? Are the Japanese going to continue to buy dollars or will they start to build up their gold reserves, which are very small? Those are interesting supporting aspects of the case of gold. But its basis is the regular supply/demand situation. Mine supply is decreasing. There has been very little exploration in the last five years and it takes a long time, after finding a deposit, to actually bring it into production.
Aren't those supply/demand numbers very controversial?
Well, there is no way that producers can replace the amount of gold they are producing-2,500 tons a year. They are finding only a small fraction of that. As a matter of fact, you have seen a lot of acquisitions to mask the fact that their longer term production profiles are declining. The upshot is that there is no doubt that mine supply is decreasing. As a matter of fact, the whole bear market in gold-this is an interesting point-would have been shortened substantially had real economics come into play. But because of the derivative markets, gold mining companies were able to sell forward production at higher prices as the market was declining. If they would have had to sell at spot, they would have closed down the mines a long time ago. But because they could sell at higher prices in the futures market, they did that very aggressively-which enabled them to keep some production open. The Bank for International Settlements just released some statistics on the worldwide derivatives position in gold, putting it at $230 billion in total. JP Morgan Chase alone has a gold derivatives position of $45 billion. Now, consider that total annual mine production is about $25 billion. I am sure that the BIS or Morgan would tell you that somehow it is all market neutral -which of course is what we heard from LTCM. My guess is that there is a significant short position out in the market-in addition to the producer forward sales-and that it is somehow hedged in a manner that these institutions believe neutralizes the position. But these markets don't always work the way some mathematician projects them to work. What we do know is that the derivatives market in gold is enormous compared with the size of the market.
I'll say, representing almost 10 years' worth of production.
Exactly. And as I say, the volatility in gold can be such, or the counterparty risks can be such, that those hedges won't work.
There also is another influence working on gold's supply/demand situation that I think is still pretty much unknown. There is an effort afoot to introduce later this year a gold trust certificate that will trade on the NYSE like a stock.
Like the exchange-traded sector funds?
As I understand it, what would happen is that every time someone bought one of these trust certificates, someone-a financial institution or bank-would actually buy an underlying amount of physical gold. So you would have a trust certificate which actually represented ownership of physical gold. It is a very interesting concept being sponsored by the World Gold Council. I expect a full registration statement to be filed with the SEC over the next couple of months. One of the issues that currently deters individuals from buying gold is that the process is rather complex. You have to open up a commodities account, which involves more logistics than people typically want to get involved in. Likewise, many equity funds are not registered as commodities-pool operators and therefore are not allowed to buy gold. But these trust certificates would represent something that everyone could buy very easily. If other alternative investments are not doing well, I would imagine that just about every broker in the country would decide, "Why not buy some?" There is also the possibility that, if and when those trust certificates come into being, they will take a lot of physical gold out of the market. Remember, the physical gold market is already in a deficit position because mine supply is probably 1,000 tons per year less than demand for jewelry and industrial use. Up until recently that gap has been filled by central bank sales of let's say 400 or 500 tons a year and by all of the forward sales by the producers and from some other forms of shorts. But now, as the producers are no longer selling forward -and are actually buying back (virtually every producer except Barrick (ABX) and Placer Dome (PDG) among the North Americans, has been buying its hedges back) those forward sales are actually being reversed. Plus you've got a cap on central bank sales-from European central banks, at least-so there probably isn't too much appetite for shorting something that is starting to go up. In other words, all of the supply/demand dynamics have changed rather dramatically over the last six months. Which is why gold has been going up.
At least until running into some recent headwinds. But I can't imagine that someone isn't trying to dream up a way to back those proposed gold certificates with derivatives instead of the real thing-
Actually, the whole concept is that these certificates would represent physical gold and get it away from the derivative market. The derivative market is really not what you want to be backstopping this now because that is not real safety. Who knows what is going to happen in the derivatives market? My impression is that this is a very interesting overture by the World Gold Council, which has typically not been very aggressive. But here they have come up with a very good program; gone about this very professionally. I have seen their presentation and it looks like a first-class program that should work. Anyway, all these dynamics, plus the underlying factors of poor alternative investments and depreciating currencies all present a pretty compelling backdrop for gold-something we haven't had all coming together for 20 years.
What golds do you like?
Well, if you eliminate the big hedgers, Barrick and Place, as attractive candidates to buy, with all the consolidations and the shrinkage in capitalizations of these companies (because their stock prices have been in the doghouse just until recently), you really are looking at probably $70 billion of market cap in the whole gold industry, combined. This is not like 1993, when gold had a big run-up even though gold stocks were competing with a lot of other good alternative investments. You could have bought Intel or whatever else you wanted back then-and the market capitalization of the gold stocks still got to be a higher number. There were many more gold companies then, too. The South African industry has consolidated basically down to three companies from over 20. So now you have a much smaller universe. That tells me that in this run-up, the gold stocks should certainly do as well and will probably do better, relative to gold bullion, than they did in 1993.
Which wasn't badly, as I dimly recall.
In 1993 gold got to $400, more or less, and the XAU, the Philadelphia Gold Index, got to somewhere around 150. And that is pretty much the way, traditionally, the pricing has worked. For every one percent move in gold, you typically had a three percent move in the gold shares. So if gold went up to $400 dollars here-let's call it a 30 percent move in bullion-you would get a 100 percent move in the gold stocks. And that would move the XAU index from 73 to say 150. That is just about right. Except that in this environment, you might do a little better since there is more of a scarcity of gold shares and there are fewer attractive alternatives than there were in '93.
Of course, the market has a way of supplying enough shares to meet rising demand-
That is right. But if you assume that every single company that makes up that $70 billion of gold market value issues 10 percent more equity, which is not a bad guess, you are simply moving the gold market's capitalization to $77 billion-which is still just a fraction of the value of many of the leading Dow components.
Which brings up something I hear repeatedly. There simply isn't enough liquidity in the gold shares to attract serious institutional interest. After all, there are 65 companies now in what Steve Leuthold has dubbed "the billion shares outstanding club," but not a gold among them-
In fact one of things motivating its acquisitions, Newmont Mining Co. (NEM) claims, was its desire to reach a capitalization that would be attractive to institutions. Newmont has a capitalization now of $11 billion and it is a strong advocate of being unhedged. So Newmont actually, among the majors, is going to be the hands-down favorite for institutions-and everyone-to go into. And Newmont is actually a very compelling story, when you look at the numbers, Newmont's cash flow at $325 gold is about $2.60 and the stock is selling today at $26. So it is trading at 10 times cash flow. But one of the important aspects of valuing a gold stock is the option value for the potential increase in the price of gold. At the bottoms of cycles, there is basically no option value and as gold prices rise, the option value obviously increases. And the option value relates to (1) the price of gold going up and also to (2) currently uneconomic projects that these companies have that become economic at higher gold prices. That gives you a lot of leverage. Especially because as gold price goes up, production in many of these companies can increase without commensurate increases in costs. For every $25 increase in the gold price, Newmont's cash flow increases by $200 million. That is pretty substantial leverage. And the multiples tend to expand. So at $350 gold, a good number for cash flow at Newmont would be $3 a share. At that point I would think that your multiple would start to expand to maybe 15. The highest multiple on Newmont that I have seen historically is 25. But let's say it goes to 15. That means that on a 10 percent move in the price of gold, you probably have a 50 percent rise in the stock price. So considering the market cap that they have, producing eight million ounces a year and having 90 million ounces of reserves, I think that Newmont is a very interesting stock. While they have a reasonably high amount of debt, that debt is coming down fast due to their cash flow. At current gold prices, in three years, they will have no debt. The only negative in Newmont is that they acquired Normandy-and Normandy had a hedge position. But it is primarily in Australian dollars and every time the Australian dollar moves up one cent, that reduces the negative position in the hedge book by $50 million. I would guess that their negative hedge book right now is probably about $300 million so if you had a six-cent move here in the Australian dollar, which is very possible, that hedge book would be neutralized and make it easy for Newmont to close it out. So it is also a currency bet. Looking at gold as having a very good inverse correlation to the U.S. dollar, in theory, should work. Plus, Newmont has closed out two or three million ounces of their hedge already this year. They are taking every opportunity they can to either deliver into the hedge or close it down, and the hedge is equal to less than one year of Newmont's production. So I think it will not be an issue.
They obviously figured that Normandy was worth the trouble.
Normandy had a lot of good assets. Newmont also at the same time acquired Franco Nevada, which is a very interesting Canadian company, along with some of the Franco management, which was widely considered the best in the gold industry, and is now in senior management at Newmont. So they got good assets, they dramatically improved their balance sheet and they got good management. It was an all-around win, which makes Newmont the most attractive of the majors. But the real explosion in gold shares earlier this year was in some of the leading unhedged South Africans. They will continue to be the leveraged bets because of the fact that they have enormous reserves that are very easy to bring on as the gold price rises.
Such as?
For some of these companies, the numbers are very attractive. Harmony Gold Mining Ltd. (HGMCY) is the leading unhedged company-well, it and Gold Fields (GFI) are unhedged but Harmony has been an outspoken "un-hedger" for many years. They have 170 million shares outstanding and they are selling at around $16, which gives them a reasonable market cap. They trade a couple of million shares a day in the U.S. They do about 3.4 million ounces of production. Currently they have a cash flow of $1.40 a share, so they are also selling at a little over 10 times cash flow. But at $350 gold, they have a cash flow of about $2.50 and at $400 gold, they have a cash flow of somewhere between $4.50 and $5. So just to look at the higher number, at $400 gold, which would be a 30 percent rise in the price of gold, you could have Harmony selling somewhere between $50 and $60, meaning you would make 300 percent to 400 percent, if everything held true, on Harmony versus 30 percent in gold bullion. And it has virtually no debt. They have 40 million ounces of reserves. Their resources are enormous. Could be as high as 200 million ounces-including its 40 million ounces of reserves. And as the gold price rises, as I said, they would find it easy to increase their production. So I think you will see a steady increase in production.
What about Gold Fields?
That is also true of Gold Fields, the other outspoken "un-hedger" and a larger company. They have 470 million shares outstanding, trading around $13. They have about $1 a share of cash flow at the current gold price. At $350 gold, they'd have probably about $1.50 of cash flow. They have an excellent balance sheet. They have 85 million ounces of reserves and 150 million ounces of resources. Both stocks have done extremely well. Harmony went from $4-$4.50 in October to about $18 recently. It backed off to around $14 before rebounding some. The action in Goldfields has been somewhat similar because the cash flow generation of these companies is just enormous as the gold price goes up. So while the XAU has risen roughly from 50 to 75-a 50 percent increase, you could have, if you had been in the right stocks, done substantially better than that. And these two South Africans-Gold Fields and Harmony-are your two leading unhedged most-leveraged producers.
Are there other gold mining stocks you can't resist?
Among the larger ones, I also think Freeport-McMoRan Copper & Gold (FCX), another unhedged producer, is very interesting. Unfortunately, its reserves are in Indonesia. They produce 2.5 million ounces of gold a year. It sells at a very low multiple of cash flow. Its cash flow is now about $3.50 and the stock trades around $18. What the company always says is that if someone were to buy them and pay the same multiple that Barrick paid for Homestake, the price for Freeport would be $40 a share. Now, Freeport probably will get acquired at some point, but it probably won't be at $40. But it will be at a substantial premium from where Freeport is trading.
Thanks, Dick.
Kathryn M. Welling is the editor and publi-sher of welling@weeden, an independent research service of Weeden & Co. L.P., Greenwich, Conn. http://welling.weedenco.com
