Source: The Gold Report 01/09/2009
A 40-year, spectacularly successful veteran of the investment industry, Eric Sprott (the "Energy Guru") needs no introduction. Sprott's steady stream of strategic, entrepreneurial and global performance awards often end in the words: "of the year." Sprott's investment abilities and knack for seeing opportunities where others don't have earned him a spot among the most successful investors in the country. Managing $4.8 billion worth of hedge and mutual funds for Sprott Asset Management, the financial sage is also an esteemed art collector. Referring to his color-blindness in a recent interview, Eric Sprott said: "It's not the color that does it for me. It's probably the contrast in the colors." One might say the same of his investment strategy.
The Gold Report: Eric, what's your viewpoint on what’s happening in the stock market and, specifically, why is gold a good investment at this time because we’re looking at a deflationary (some would even call it a depressionary) market?
Eric Sprott: Since 2000, I’ve believed we are in a secular bear market. We had a modest cyclical bull from ’03 to ’07, which was brought on by the lending mania. That’s obviously over, despite the fact that we’re another leg down in the secular bear market.
We essentially remained bearish throughout that period. The concerns that we expressed back then and our reasons to own gold are the same now except that there has been greater play-out in the meantime. This would suggest that having owned gold, and continuing to own gold, looks even more propitious today than, perhaps, in 2000 when we first got involved in the gold area.
First of all, I think we’re in a depression today. All data points suggest we are. The fundamental problem of the world’s financial system is an over-leveraging of the banking system. The average bank is probably leveraged 25 or 30:1. As you look at these banks’ balance sheets, the liabilities never go down. They must be paid despite the corresponding volatility in assets. We have seen so many of the asset classes come under incredible evaluation adjustments. It is hard to imagine that, in a true mark-to-market, any banks would have any tangible capital left.
Consequently, they either have to raise capital (which a lot of them are quickly doing) or replenish their capital through earnings. This would imply the discontinuance of dividends, and they must then shed assets. It is very difficult to shed assets in a market where there are no asset buyers. However, we have this awful situation where everyone would like to be a seller in the banking business. The reality is that there are no buyers.
For a long time I have believed fundamentally that we never should have allowed the banks to get leveraged to this extent. I don’t know what the proper level of leverage should be. Even 10:1 scares me. Moreover, if you have to go from 25:1 to 10:1, that is going to take a long time to manifest itself. By implication, it means there will be no net new loans any year for a long time. The effect this will have on the economy, of course, is excruciatingly bad.
That is what we are seeing today. There is no credit available and all asset values are in collapse. The biggest fear is that weakness begets weakness, which is what we’re seeing here. We are going to continue in this negative vortex. So far, nothing that the authorities, governments or central banks have done seems to have made any difference. One might argue that the only difference is that when they started directly buying paper mortgages recently, yes, it did move the rates down, but there is a lot to buy and the system is too big to bail.
TGR: Eric, you said that you believe we’ve been in a secular bear market since 2000 with a little bull blip between ’03 and ’07. What were the fundamentals in 2000 that caused you to believe that (obviously, I’m sure they’ve exponentially increased with this financial crisis)?
ES: Of course, back in 2000 it was a different view in the sense that you saw how ridiculous people were becoming in valuing stocks. We had stocks that were trading at multiples of sales; you could see that there was a stock mania going on. When you have a stock mania, it has to come to an end; it did come to an end—we had the NASDAQ fall by 80%. It was only logical that we had to work through the problems of declining values at that time. But, really, the authorities didn’t want us to have to work through it, so they created this other mania—the lending mania. Now, of course, that’s an even bigger problem than we had back then, and it’s a bigger problem by many, many dimensions. So we have just gone from what was sort of a modest secular decline to what will now probably be a major secular decline and a market that acts more like the Great Depression than just having a long secular decline.
TGR: So do you see, as we’re looking at 2009, a continued financial market decline?
ES: Yes. That’s what we’re expecting.
TGR: For the entire year or will it bottom out, say, in Q2?
ES: I have no idea when it will bottom out. If you look at what we think the fundamental reasons are, you can foresee negative forces on the economy (i.e., no loans) happening for a long time. So I don’t see this as a one-month or one-half or one-year phenomenon. It will be much longer lasting than that.
TGR: You stated earlier you think that we’re already in a depression and that eventually the government will figure this out. Gold, typically, is an investment when you’re looking at an inflationary environment. How will it act in a depressionary environment?
ES: One of the beautiful things about gold is that it can show its relative value in both an inflationary and a deflationary environment. Some people argue that if they just keep printing, we’ll end up with some kind of hyperinflation anyway. However even in a deflationary environment, where people concern themselves with the banking system, lending and where they have assets, it is a very powerful force for people to own gold. We’ve seen that manifesting itself this year and it probably won’t take much more (particularly now that the interest rate is almost down to zero) for people see the wisdom of gold as an asset class.
It wasn’t too long ago that if you said people should have 5% gold in their portfolio, they thought you were a quack. Now people are certainly willing to go to 10% of their portfolio and they’re not seemingly crazy. In my portfolio I have 40% in gold and I think that’s the safest, and probably the most rewarding investment that I could have. If people come to that conclusion, even at 5%, the demand for gold would be outrageous and who knows where the price would go. I believe no matter what environment you’re in—deflation or inflation—people will run to gold. Gold is proving exactly what we all would have expected, that in almost any environment, it’s a go-to asset.
TGR: You mentioned that 40% of your portfolio is in gold. Is that physical gold or a combination of physical and equities?
ES: For the most part, I always own physical gold. When I say gold, I really mean gold and silver; and I am probably about equal in each. I always take delivery. I want to own the physical—I don’t want an owner’s certificate, I don’t want to own an ETF. I believe that it’s really the only security you have, and you don’t want any counter-party between you and your gold, so I take delivery. Forty percent is in bullion. Probably 10% of my assets would be in gold equities or precious metal equities.
TGR: Many are saying that the real leverage in gold right now is the equities because they got slammed initially by the gold price going down along with the market going down. So, leverage-wise, as you’re looking at any rebound as the price of gold goes up, the equities will have an even larger multiplier effect. What’s your viewpoint on that?
ES: For sure that’s true. However it depends on exactly what equity we’re dealing with and the status of, let’s say, some gold miner’s project, whether it’s in production, in the exploration stage, high-grade or low-grade, open pit, underground. There are many reasons to want one class over another; if gold goes up, the equities go up faster. And, as you know, since October 24th, from the bottom to the top, the HUI Index was almost up 100% in that short time period.
So, to get to your point, it’s obvious that there’s leverage in owning the securities rather than gold. However it cuts both ways. When we see gold go down, say, 2% or 3% today, we see the stocks go down a lot more. I guess people would say we’re being pretty defensive owning gold instead of the shares, but we’re happy to make a steady return per year. We don’t need to knock the ball out of the park and, in essence, take on some risk of owning a piece of paper that might not ultimately prove its value. We do own gold shares and we like gold shares, and I’m buying gold shares now. The most important thing is gold has got to go first, and then the gold shares will get going. We believe in both. It’s not going to bother me if gold under performs gold shares in the environment we’re in. We’re in such an ugly environment that any time you can make a gain, that’s a good thing.
TGR: You mentioned you’re buying gold equities right now. Any names you’d like to give to our readers of stocks that you’d recommend they be buying, as well?
ES: To name a few, amongst my largest holdings are Kinross Gold Corporation (K.TO) (NYSE:KGC), Alamos Gold Inc. (TSX:AGI), Dynasty Metals & Mining (TSX:DMM), Kirkland Lake Gold Inc. (TSX:KGI), El Dorado Gold Corporation (ELD.TO) (AMEX:EGO) and Ramelius Resources (ASX:RMS) in Australia. I probably have 100 other smaller companies that I own.
I typically don’t buy the larger-cap gold companies. I want to find smaller gold companies that are slightly off the radar screen that are in, or near, production, where the value of ounce—either in the ground or annual production—is way less than what they’re paying for the bigger companies. Ultimately, gold lifts all boats equally. It has to. So I’m trying to find small- to mid-size companies where the market has inappropriately valued them. Now that we’ve seen the majors have this huge run up, people are going to start poking around at the mid and smaller-cap companies to provide a little torque to their portfolios.
TGR: Are you avoiding the exploration companies?
ES: It depends on where they are in exploration and the sort of quality of the ore body. I’m somewhat hesitant on low-grade big open pits because of the financing issues in the world. I’d much rather find a high-grade underground where the development is not nearly as expensive per ounce as a big low grade open pit. You certainly don’t want an ore body with a base metal component in it in the kind of situation we’re looking at. If somebody has a reasonable high-grade open pit, then obviously that would suit the bill, too.
TGR: Any areas of the world that you’re focusing on or avoiding?
ES: I can probably better answer that by what I might avoid rather than where I might focus because you’ve got to go wherever the ore body is. I do have some concerns in regards to some countries in Africa. Likewise, I do have some concerns about some Eastern European countries. So, really, North and South America seem like the more logical places to go. Australia would certainly be on our screen if there was something interesting down there, and we own some gold stocks in Australia. You want to find a country where things are relatively stable. We realize that even in our own country things are never entirely stable. You really want to try to minimize the political risk.
TGR: Eric, you’ve been espousing the value of gold since 2000; and, in 2008, you opened up Sprott Money, which is selling both gold and silver?
ES: Yes, about three years ago I was in the fortunate position where I happened to own a lot of gold. Somebody that owned a mint asked if I’d like to convert the bars to coins. I said I would, as they’re somewhat more fungible.
Then I thought, there’s a reasonable premium on coins. We’ll make our coins available for sale and, as people buy the coins, I’ll buy a bar and, ultimately, convert it back to coins again and just facilitate people owning gold. For the reason that if there is one thing I believe in—and I’m thinking as a Canadian here—it’s that I would love people in Canada to own gold as I think it’s the safest asset they can own.
So if you can make it a little bit easier for them by breaking it down to a smaller unit, then they have a chance to get in. For us, it’s a reasonably profitable business because the premiums are quite high, as you know.
TGR: It’s pretty hard to get gold coins right now. There’s a real shortage. What’s the source of your coins, and are you experiencing the same shortages?
ES: I converted a lot of bars to coins, so I have no shortage of coins. It would take some pretty big buyers to buy me out of the coins. Obviously, as we sell them, I do buy the 400-ounce bars and, somewhere along the line I’m going to have to go to some mint and say, okay, we need to punch out more Maple Leafs. Now maybe when I go there, their capacity will all be utilized. I may not even be able to get in the queue, but there will be a time when we will somewhere. I’d prefer to sell Maple Leafs, but maybe we’ll have to find some other source.
TGR: So you’re converting bullion bars into Canadian Maple Leafs?
ES: Yes.
TGR: I thought that was only done by the government.
ES: It is. It’s done at the Royal Canadian Mint.
TGR: So you are providing them with the gold to create the Canadian Maple Leaf?
ES: This happened about three years ago. So I did that—I converted a lot of bars over to coins and sat on the coins for a couple of years. Finally, it dawned on us that there’s a market for these. I can certainly go buy the 400-ounce bars and, ultimately, convert them back. We have lots of inventory; we’re not seeing any signs that we’re going to eat through our inventory of coins. But I always do worry that I’ve got to be able to buy the bars back, too. So we’ll see. If it happens that I can’t buy the bars back, I don’t think I’ll be selling the coins.
TGR: Can you compare for us how your Sprott Money site works for buying coins, compared to Kitco, which is also selling Maple Leafs, or other online sites?
ES: Gold coin premiums are generally between 7% and 9%. In this regard we are comparable with the other online sellers. Additionally, Sprott Money Ltd. is competitive on shipping and insurance. We ship worldwide, whereas other online retailers will only ship certain bullion products to certain destinations. Lastly, we do not sell inventory we do not have; we ship right away as soon as we receive payment.
TGR: You mentioned earlier that you are also investing in silver. Can you speak briefly on your viewpoints of silver? We hear that it’s a much more volatile industrial metal and, therefore, it’s more risky.
ES: We almost own as much dollars of silver as we own in gold. I personally did not convert silver bars into coins. Our supply of silver coins is somewhat limited and, of course, the supply of silver coins in the world is very limited; the premiums that we charge are much higher than those charged on gold coins. So, in that sense, a gold coin is a better value vís a vís the premium.
And, yes, silver has the quality of being considered an industrial metal, but I think what’s most interesting about silver is that there’s not a lot of above-ground silver in the world. It wouldn’t take many buyers for there to be no silver around. We’re talking a very small amount of money.
That’s one of the unique aspects of silver. If it really catches a bid here, it can move pretty fast and I happen to be in the Ted Butler camp that—when you look at the goings on and the commodity exchange, it just looks so perverted with the size of short positions that are going on—I think the quoted values, ultimately, will not prove to be relevant.
TGR: Eric, what do you see as a potential event to be a tipping point to get investors to begin migrating to gold? We’ve seen a gradual migration, but do we need a country to go bankrupt? Do we need the State of California to go bankrupt? Is there something you can envision that would be the tipping point?
ES: Needless to say, if we had another major bank failure, or if you had some failed government auctions in the developed world, people will realize that even the government can’t get the money that they want to get and that would be very disconcerting to the financial system. The other thing, which you already referred to, is if there was some currency mishap where some currency just plunged. We already had the Icelandic króna do what it did.
TGR: Brazil.
ES: We’ve had Brazil or Argentina and Hungary and a few others. The currencies are falling sharply. If we started to see a slight unraveling in the currency business of a few countries, then you might surmise it will spread to others; they always start going up the food chain. That would be a bit of a tipoff that the real rush might be on for gold.
TGR: What’s your view of the U.S. dollar? What do you see in ’09 for the dollar?
ES: The rally in the dollar, in my mind, was totally anomalous and totally had to do with repatriation. In fact, we can even see it in global offshore funds. These offshore hedge funds, which are owned by international financial institutions, have their own issues. So there have been redemption issues in hedge funds. I can tell you from experience, if we had X dollars of redemptions in November, we have one half of X in December, .1 of X in January, and none in February. In the business we’re in, the repatriation is done.
Anything we might have had to do—in other words, sell a Canadian resource stock, convert it to U.S. —it’s over. So the worst of that might be done. The dollar really, in my mind, shouldn’t have rallied; in fact, it should have done the reverse because the obligations that the U.S. government’s taken on here have been immense and I think beyond the scope of what they obviously can pay for, even though most people haven’t gone there yet. So I don’t hold out a lot of hope for further dollar strength.
TGR: But isn’t the dollar the best of the worst?
ES: You might have a point there. It might be the best of the worst and that’s a very challenging discussion. To know what is the best of the worst—and I don’t pretend to know exactly how strong the UK economy is or the EU or the Canadian (I guess the Canadian government I have some sense of)—but for me to analyze each one of those countries and decide who’s the worst? That’s a tough thing to do and it is sort of ironic that that would be the discussion. If that’s the discussion, just buy gold and forget it.
TGR: We've heard from other newsletter writers that they think we could have a big break in the Dow mid-second quarter or third quarter of ’09, where the Dow could go to 5,000 or 6,000. Any comment on that as to how low the Dow could go or how high gold could go?
ES: I easily believe the Dow can go to those levels and I think it can go lower, obviously, because of the situation we find ourselves in, which is a credit fiasco. Depending on how they attempt to resolve it, who knows where the price of gold is going. It could go to many thousands of dollars, as we would expect it would do. But I can’t tell you the number because it really depends on how irresponsible all the governments are and that’s a tough thing to measure at this point. It certainly seems like they’re quite irresponsible, so the more irresponsible they get, the higher you expect the price of gold to go. I don’t have a specific number that I think it’s going to.
Gold has been such an incredible investment for the last eight years, including this year—we’re finally up in the year. I think it’s up by at least 25% in the Canadian currency; so it’s done exactly what we wanted it to do. Here the markets of the world on average are down about 40% and gold up substantially or flat in every currency, so it’s been perfect.
TGR: Eric, this has been very insightful and informative. We appreciate your insights.
Eric Sprott has accumulated 35 years of experience in the investment industry. After earning his designation as a chartered accountant, Eric entered the investment industry as a research analyst at Merrill Lynch. In 1981, he founded Sprott Securities, which today is one of Canada's largest independently owned securities firms with offices in Toronto, Calgary and Montreal. After establishing Sprott Asset Management Inc. in December 2001 as a separate entity, Eric divested his entire ownership of Sprott Securities to its employees.
Eric's investment abilities are well represented in his track record in managing the Sprott Hedge Fund L.P., Sprott Hedge Fund L.P. II, Sprott Offshore Fund, Sprott Canadian Equity Fund, Sprott Energy Fund and Sprott Managed Accounts. In December 2004, the Sprott Hedge Fund L.P. was the winner of the Opportunistic Strategy Hedge Fund Award at the Canadian Investment Awards. In addition, the Sprott Offshore Fund, Ltd., won the 2006 MarHedge Annual Performance Award under the Canada-Based Manager category. Furthermore, in October 2006, Eric was the recipient of the 2006 Ernst & Young Entrepreneur of the Year Award (Financial Services) and the 2006 Ernst & Young Entrepreneur of the Year for Ontario. In December 2007, Eric was named Fund Manager of the Year by Investment Executive, a widely circulated publication for Canadian financial advisors.
Sprott Money Ltd. is one of Eric’s newest ventures. As one of Canada’s largest owners of gold and silver bullion the company’s goal is to facilitate ownership of precious metals to the general public.
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