I had the chance to connect recently with one of Canada’s rising fund managers, Jon Case, portfolio manager with Sentry Investments. Sentry manages over $10 billion in assets, representing over 300,000 Canadian clients, and has further received numerous industry distinctions.

Serving as co-portfolio manager to over $1 billion in precious metals and natural resource funds, Jon was kind enough to share some commentary on the challenging environment of the mining sector, and recent sell-offs in the price of gold.

Here are the written notes from that conversation:

TD: Jon, looking at the action over the last few weeks – anecdotally, was there anything that really shocked you guys there at Sentry?

JC: I think everyone, ourselves included, have been surprised by the magnitude of the pullback in gold, given that
 none of underlying drivers for gold have changed. With the benefit of hindsight some are attributing the sell-off in gold to ETF selling, a potential gold sale from Cyprus, and downgraded price forecasts from Goldman Sachs and SocGen. In our opinion, those events do not represent a fundamental change in the drivers of gold, and, therefore, they should have had [only] temporary price impacts.

Broad measures of liquidity (Federal Reserve Balance) show that the global balance sheet continues to trend upwards, with no end in sight (though recently it did decrease in size due to a reduction in the ECB balance from the return of LTRO funds – however, we expect this reduction to be an aberration in the rise of global central bank balances, with US and Japan poised to expand their balance sheets at a rate that will more than offset ECB losses). Economic data points such as GDP, non-farm payrolls, and retail sales continue to show an economy that is barely growing (despite massive government stimulus in the form of deficit spending). Lastly, speculative positioning in the gold futures market is at a relatively low level, in the context of the range of positioning over the last four years.

TD: What do you make of the conflicting message we’re seeing in gold – in terms of the paper markets selling off so strongly, but yet retail buyers flooding the bullion shops worldwide…what are your thoughts there? And do you see any similar institutional rush?

JC: The futures market overwhelms the physical market in value, so imbalances in the supply/demand dynamic in the latter have a tough time pushing around the former over small time periods. But over a sustained period of tightness in physical supply vs. strong demand, price would respond, and the paper market will follow suit. We track the supply/demand dynamics in the paper market by looking at the shape of the forward curve and the Commitment of Traders report; and in the physical market by looking at the physical premiums paid for gold delivered to India and China—the main sources of demand in the physical market.

On the physical front, we are seeing evidence of very strong physical demand coming from Asia, with premiums of $2 – $3/oz. in Hong Kong, which is why we believe gold bounced off its lows. Whether that demand will continue to persist as gold pushes higher is not as clear, and there is some evidence of physicals premiums dropping off at current levels with gold up $125/oz. from its lows (at time of writing). This is not surprising, given that retail demand is highly price-sensitive, especially in India.

As for an institutional rush into gold, I don’t think that’s likely until we see some price stability, or until negative changes in other asset classes drive funds into gold. We believe the recent high volatility could discourage institutional activity over the near term, and, therefore, we expect gold to consolidate in a range for a few months, before we see it resume its climb higher.

TD: And the mining shares Jon – they’ve been mutilated. Is this the end of the mining industry, or possibly one of the great markets that will be written about for years to come?

JC: There are tremendous opportunities to be found in the gold equities; however, the opportunity is not uniform across the sector, which is to say not all the gold equities are cheap. The sad reality is that weak price performance of some gold producers is justified, given that many cannot make positive free cash flow at current gold prices.

In 2012 we estimate that the four largest, publically listed gold producers on North American exchanges, which represent 41% of the total capitalization of all publically listed gold producers in North America, generated –$3.0 billion in free cash flowIn gold terms, that’s equivalent to saying the YoY change in their balance sheets reflected a cost of gold production of $1,839/oz. in a year where gold is $1,669/oz. So with gold off 12% YTD, some investors may see the drop in the broader gold equities of 35% as an opportunity, but in certain cases value has dropped by a similar or greater amount: if they weren’t profitable at $1,700, their prospects look dim at $1,450/oz.

On a more positive note, there are real businesses in the gold space that generate strong free cash flow at the current gold price. The recent pull-back in the equities has been more or less uniform – all gold equities have been painted with the same brush – and the result is an over-reaction in the share price declines of the top-quality producers, where the pull-back in price represents a gross exaggeration of the erosion to their profitability.

We are seeing valuation levels never seen before, with some gold producers now carrying free cash flow yields (implied by their current capitalization) at spot gold price in the double digits (10% – 15%) – a unique buying opportunity.

TD: As a final question Jon, you guys have some of the world’s top fund managers working there at the firm—what would you say might be the the overall fund consensus about this environment that we’re in?

JC: Kevin MacLean, my colleague, and the lead portfolio manager on Sentry Precious Metals Growth fund has been managing investments in the gold space since the 1980s, so he has seen multiple cycle peaks and crashes in gold and gold equities. His message is that he has seen this before—it’s quite common for the sector to look broken at the bottom, and that’s always the best time to buy.

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Thanks,
Tekoa Da Silva
Bull Market Thinking

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