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From Barron's:

In Overdrive to $1,000 Gold

Interview with John Hathaway, Senior Managing Director,
Portfolio Manager, Toqueville Asset Management

By Sandra Ward
October 1, 2005

AS FAR BACK AS LAST OCTOBER, John Hathaway believed gold's breakaway performance from other commodities signaled rough times ahead for financial assets. That proved true -- and that's the kind of insight that has led the Manhattan-based Hathaway's $1.1 billion Tocqueville Gold Fund1 (ticker: TGLDX) to its own breakaway performance. The fund is up nearly 12% this year, versus 9% for the Standard & Poor's 500 and 17% for the XAU, the Philadelphia Exchange's Gold and Silver sector index, which has benefited from an overweight position in copper-producer Freeport-McMoRan (FCX). That follows on the heels of last year's 39% and average annual returns the past five years of 27%, versus 14% for the S&P and 20% for the XAU.

We ain't seen nothing yet if he's right about gold heading higher. Hathaway spoke with us from Colorado, where he was attending the industry-sponsored Denver Gold Forum.

Barron's: Is gold finally getting some respect?

Hathaway: There is a lot more interest, but I am not sure respect. It is still a marginal space for most investors.

What's driven the price to nearly a 30-year high?

It's associated with the liquidity squeeze and the Fed rate cuts. I was in Ireland recently, and the papers were full of news on Northern Rock, the big mortgage provider in the U.K. that essentially had a bank run. To some extent, injections of liquidity make currencies, whether the pound or euro or dollar, suspect. One obvious response is to go to gold.

A recent article in the Economist mentioned a study that concluded gold hasn't been a reliable hedge against risk or inflation. What do you make of that?

Gold has been among the best-performing asset classes since 1999, when it bottomed out. Also, gold is forward-looking. In the last several years, it has discounted a widening of credit spreads and a shift in the market to a more risk-averse posture and lower asset valuations.

But gold, as you point out, has also risen during a time of rising stock and bond markets.

There have been an anomalous couple of years where gold was viewed as a subset of hard assets and hard assets were sought after. We had a period where gold actually tracked very closely with things it normally doesn't. Maybe it is noncorrelated.

I wouldn't try to pigeon-hole gold too much, because if you look at the last four to five weeks, gold has definitely taken off because of concerns about the relaxation of the Fed's monetary policy and the expectation there will be more of that. Of course, we've seen that not just in the gold price, but in the breakdown of the dollar on a trade-weighted basis.

What about the link between a declining dollar and rising gold?

I wouldn't overweight that too much, either, because while the dollar is in a little bit of trouble here and it probably will lose some shelf space as a global reserve currency, at the end of the day, the Europeans don't want the euro/dollar rate to be at 1.50 because they will be out of business. All economies are interdependent on the dollar as an instrument of credit for cross-border trade.

Here you have an asset class that has been outperforming for some time, and yet it is still treated skeptically. What do you make of that?

Gold's bubble lies ahead. It has got a long way to inflate. So much about gold has very little to do with gold. It is more about capital-markets psychology. If we are entering a period of difficult markets, which was averted from happening earlier because the Fed pulled this 1% short-term money stunt and bought us a few more years, it is going to change psychology, and that will open the door for more people thinking about gold. What was needed to put gold in overdrive was the scent of fear.

What gets us to the magic number of a $1,000 an ounce?

I don't think it will take much. Let's not forget, in 1980 dollars, gold is less than half of its nominal price today.

The disparity between the amount of paper that has been created since 1980 and the amount of gold that has been produced since then is just enormous. The ratio of financial assets to physical gold is at the low end of a historical range. If you were to mark all the gold to market that has ever been mined, which is a very conservative approach, and then take the valuation of all the global stock markets and all the global bond markets, gold represents about 3%, compared with a figure in the mid-20% range in 1980, which was the top of the bull market in gold and the beginning of the bull market in financial assets.

Gold is a good value, certainly, at these prices, just based on the considerations we've discussed. Even if you don't think worst-case outcomes are in the cards, gold is still rare and hard to find, and believe me, these companies are having the toughest times trying to maintain production, much less build it.

Why are they having such a tough time? Because it is so expensive to produce?

There are a lot of reasons, but one is the environmental movement is so much more active and effective today. I would say the industry in general is 99% compliant with best practices and first-world standards in terms of environmental compliance. They are very responsible. But, for example, there is a project, a big new mine in Romania which could use the investment, that is being held up because of environmental opposition. That's a big, big constraint, and there are a lot of mining permits being withheld because a lot of these countries, who would like the investment, are afraid to look bad in the eyes of the global environmental movement.

What else is contributing to production problems?

Another factor is the cost of building a mine has gone up dramatically. The Fed would like to think there is no inflation, but the cost of building a mine is up by roughly 50% in the last five years. You would think if your product price went up by 100% in a five-year period, which it basically has, that the companies would be rolling in cash. But returns on equity are low. Newmont Mining's return on equity is less than 2% in the latest 12 months. Gold Fields' is 8%. Randgold Resources' is about 11%.

A third factor is that some of the locales where gold is being found are not all that hospitable to private enterprises. Most noteworthy is Venezuela. Its president, Hugo Chavez, has a certain cultural and ideological view that is gaining influence in other South American countries, such as Bolivia and Ecuador and Peru. The risk premiums are going up for putting a lot of money into places that are otherwise geologically very attractive. Russia has great geology, but it is dicey in terms of its rule of law and the sanctity of contracts.

What, then, is attractive about these stocks?

Only one thing, and that is if the gold price goes up a lot, they go almost overnight from being mediocre businesses to being really great businesses for a while. The potential for a reversal of fortune is enormous.

How high does the gold price have to go before it results in meaningful change at these companies?

We are in the area: The $700s or maybe $800.

What companies are you recommending in this environment?

Newmont Mining [NEM], which has been a laggard. They've been through a transition in senior management, and the new CEO is talking about optimizing returns on capital.

The industry has been managed to a net- present-value standard, which means that if it could make a dollar producing an ounce of gold, it would produce it. The analysts promote it and the bankers promote it, but the industry has to get away from net present value as the Holy Grail of success or failure.

And adopt what in its place?

An honest accounting of return on investment. They should also show the connection between the shares they have issued and whether or not it has been accretive or dilutive in terms of troy ounces. When you buy a gold share, you buy it with one thought in mind, and that is because you think the gold price is going to go up. If there are twice as many shares behind each ounce of gold as you thought you had, it cuts the upside in half.

Why isn't the industry more shareholder-friendly?

It isn't true across the board, but many of the managements are not shareholders.

Newmont just warned of higher costs and dwindling reserves.

That wasn't particularly news. The new CEO, Rich O'Brien, is trying to establish credibility by being aggressively forthright. Newmont's core Nevada assets may be more worn out than we realized, but even so, they have a pipeline of new projects. Again, you buy these stocks based on the commodity price going up, not because costs are better contained.

Where is Newmont stock headed?

If gold were trading at, say, $800, Newmont with today's number of shares might be trading at $70 or $80. It is now 45.

How about another pick?

Gold Fields [GFI] is one I like. It is in the doghouse along with Newmont, and both are big-cap, blue-chip names.

Why is Gold Fields out of favor?

They went through a protracted takeover battle with Harmony Gold [HMY], which is another South African gold company, that didn't succeed. Harmony has had all kinds of problems since then. But more importantly for Gold Fields, the takeover attempt was a huge distraction and took away their focus. I don't think they did anything particularly badly during that time, but investors were also distracted by the whole sequence.

Another factor was that South Africa's currency, the rand, was strong for a period of years. So the company's margins were squeezed. Then, too, it is always penalized because it is a South African company, because of concerns about political issues. Most recently, there are concerns about an asset Gold Fields purchased from Barrick Gold [ABX]. The South Deep mine is very, very deep, and there are worries about the costs of extracting the gold. But what it gives to Gold Fields is longevity, which few other companies have. These reserves will be produced 30, 40, 50 years from now, and so it gives them a certain sustainability.

Any others?

One would be Ivanhoe Mines [IVN]. It is very controversial because the chairman and biggest shareholder, Robert Friedland, carries a lot of baggage. The common perception of him is that he is a promoter. But that's based on ancient history.

His biggest score was selling Voisey's Bay to Inco. That was a $4 billion deal, and anybody who went along with him made a lot of money. Ivanhoe is a copper-gold mine in Mongolia and probably the biggest new copper-gold mine in the world. It has cost more money to build than anyone thought. The validation of Ivanhoe's position there was the fact that Rio Tinto [RTP], one of the world's leading mining conglomerates, has invested in Ivanhoe shares and has an agreement to buy more as certain milestones are met.

It is one of the more interesting development stories. Ivanhoe doesn't produce a nickel of earnings right now, but this is a very, very big important asset that will be built and will produce enormous cash flow for Ivanhoe and for Rio Tinto.

How about one more idea?

Randgold Resources [GOLD]. It's run by a very smart guy, Mark Bristow. Randgold has been a good stock, unlike Newmont and Gold Fields. It has got a market-cap of roughly $2 billion. It is based in the Channel Islands and its assets are mainly in West Africa, in Mali and Tanzania and the Ivory Coast. They actually make money, which is unusual for most of these companies. Even though I don't believe gold is a growth business, this company has a growth profile, because it has a smaller base to build on. West Africa is a very good place to be in terms of the geology, and Randgold is the dominant player there. They are in a position to be an aggregator and do some accretive deals.

What are the big issues being talked about at the conference in Denver?

Some of the things I've mentioned, including the steadily increasing costs of production. It is a very energy-intensive business. It is capital intensive. A lot of the inputs have gone up more than the gold price. That explains why their profitability has been so disappointing, despite the rise in the gold price.

Deals and takeovers are also being talked about, which to me is sickening. I'm very opposed to most of these deals. Very few of these combinations have added value for shareholders. They have added shares outstanding and they have certainly made the bankers rich. But I'm not sure they have really added value for shareholders.

Thanks, John.

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