This is the 12th piece in our Positioning for 2012
series. Readers can find the entire Positioning For 2012
David A. Nadel is a Portfolio Manager and Director of
International Research for Royce & Associates, LLC,
investment adviser to The Royce Funds.
Seeking Alpha's Leland Montgomery recently spoke with David
to learn more about his rather unique views on international
investing and where he sees the best opportunities for 2012.
How would you generally describe your investing
We are buy-and-hold investors in global companies with market caps
up to $5 billion. We invest with a 3-5 year horizon in businesses
with defensible market positioning, strong balance sheets, and
sustainable high returns on capital.
Within equities, are there any particular sectors or themes you are
currently overweight or underweight? If so, why?
We are benchmark agnostic, but are functionally overweight
materials, including precious metals mining and energy services
companies. Meanwhile, we tend to avoid any industry that relies
substantially on debt financing, including banks, utilities,
telecoms, insurance companies and utilities.
Our investments in materials stocks are focused on companies
which produce commodities that are in finite, and in some cases
declining, supply. We think this creates a positive pricing dynamic
in an investment context of essentially infinite supply of fiat
currency in the developed world. As the U.S. dollar, euro and
Japanese yen "race to debase" via aggressive money-printing, we
expect the price of some commodities to continue to show an upward
bias. Consider that the world has already passed "peak-oil"
production on a per-capita basis, or consider that gold production
adds merely 1.4% to supplies per year, or consider that more than
90% of the silver ever mined has functionally disappeared by being
consumed or discarded.
For gold, I like Medusa Mining (MDSMF.PK). Trading at just 7-8x
forward earnings, Medusa is among the cheapest mid-tier
gold-producers we know, and they have executed very well. The
company produces gold at an all-in cash-cost of less than $200 per
ounce, and the Philippines which is home to their mines is becoming
a hotspot of activity among the gold majors, meaning Medusa might
attract suitors. Medusa's current production profile of 100,000
ounces/year is on its way to 400,000 per year in the next few
years, but the stock has recently been cut in half on commodity and
gold jitters. Medusa has a very solid balance sheet, and is
massively cash-generative: their profit per ounce is $1,400 at
today's gold price so even at say 90,000 annual production, you're
talking $125 million of cash flow for a company with an $850
million market cap. They return some of that cash to shareholders
with a dividend yielding 2.5% now, and will deploy some more cash
for exploration and development.
For silver, I am invested in Hochschild Mining (HCHDF.PK) across
a number of my funds. Hochshild has 3 of the world's top 12 silver
mines, and produces about 22 million ounces of silver-equivalent
per year (2/3 silver, 1/3 gold). Plus they've got a nice pipeline
of mines coming on stream, including one potential blockbuster in
Argentina.With its $2.2 billion market cap, Hochshild trades at
just 3 and ½ times operating income, net of an investment in
another mining company, and is generating so much cash that they
recently increased by 50% each both their dividend and their
exploration budget. We like the fundamentals of silver, including
new applications in healthcare and energy, and the price
inelasticity of its industrial demand; no wonder Warren Buffett
controlled about 1/3 of the global silver market for 10 years! We
actually just penned a seven-page
on why silver is under-owned and should do well.
Name one investment that exceeded your expectations in 2011, and
one you had high hopes for that didn't pan out. Do you see any
particular investment surprising investors over the next year?
In March, we visited Japan for a week to see companies for the
second time in a year, and actually got caught at Narita Airport in
the tremors of the Tohoku earthquake/tsunami as we were attempting
to leave the country on that Friday afternoon. As challenged as
Japan's economy is in terms of sovereign debt and its homogenous
and aging population, it is also home to some pretty decent
companies offering growth via exports to emerging Asia, and
comparatively decent corporate governance, at least by Asian
standards. Three of our best-performing stocks in 2011 have ties to
the Japanese market: Nu Skin (
) (35% of revs from Japan, 35% non-Japan Asia) benefited from a
strong product cycle and improving margins; FamilyMart (FYRTF.PK)
(90% of operating income from Japan) continued to leverage its
pricing power and expand its network of convenience stores
geographically; and USS (USSJF.PK) (100% revenues from Japan) rode
a healthy used-car market in Japan while deploying some of its
copious cash flow to buy back shares and hike its dividend.
Our worst-performing stocks outside of materials were largely in
technology, such as Aixtron (
) which lost about 70% of its value over the year.In the beginning
of the year, we were attracted to the valuation discount of
technology equipment and "plumbing" companies versus the sky-high
multiples of cloud-computing and social-networking companies. But
we miscalculated the brutal cyclicality of the former group. Longer
term, we like the fact that the industry is overdue for an upgrade
cycle - the average corporate PC is more than six years old - that
pricing is becoming more disciplined, and that about one-third of
last year's M&A activity was in tech. So we are sticking with a
bet that in retrospect we committed to prematurely.
We think precious metals mining companies will finally surprise
investors on the upside next year. The industry has a long and
somewhat sordid history of value-destruction in the form of
dilutive share offerings, poor execution, environmental and
labor-related dysfunction, and even outright fraud, so it's no
surprise that mining companies have markedly underperformed the
metals, particularly in 2011.But we're convinced that the better
managed precious metals mining companies now stand on the cusp of
being recognized as reliable and cash-generative business models,
much as oil exploration and production companies gained mainstream
attention following the spike in oil prices at the start of the
To us, mining companies also resemble pharmaceutical companies:
they are under continual pressure (and shareholder skepticism) with
regard to discovering their next "blockbuster" (i.e. mine) as the
productive life runs down on their existing assets, but all the
while they are producing their product with fat profit margins
while returning money to shareholders in the form of dividends,
like Medusa and Hochshild, above.
Some describe the current era as "The Great Deleveraging". Do you
agree/disagree, and does this macro consideration affect your
investment planning process?
Considering the facts, I think one would be hard-pressed to
disagree with this statement. In fact we feel that debt has today
become the great divide between the healthy "creditor" world
(comprised chiefly of emerging economic champions) and the
struggling "debtor" world (U.S., Europe, Japan).
We are in a global credit crisis, of which Europe is only the
tip of the iceberg. For all of Europe's debt woes, don't forget its
consumers are by and large not that levered. Unfortunately, the
American consumer is levered to the hilt. In fact, aggregate debt
in the U.S. - and I mean federal, state, local, consumer and
financial debt - is a mind-boggling six times the size of our GDP.
Think about that for a minute! Global credit, including the U.S.,
is a very disturbing three times global GDP, and U.S. debt alone is
twice as bad as that average. To me, the U.S. debt is more alarming
than that of much-maligned Japan: their sovereign debt exceeds
twice their GDP but most of it is held internally by the Japanese
themselves so they are not at the mercy of foreigners as we are,
and Japan has also armed itself with the world's largest foreign
Historically, when countries have had debt at just two times
GDP, the resulting dislocation has led to wars, typically once the
usual policy of currency debasement has run out of steam. As Ernest
Hemingway said, "The first panacea for a mismanaged nation is
inflation of the currency; the second is war."
Personally, I do believe we're already at war, by which I mean
the currency war with Europe, China, etc., but these absurd debt
levels unfortunately increase the likelihood of civil unrest and
traditional war as well. We do think that despite assurances to the
contrary, the U.S. is actually pursuing a weak-dollar policy. When
our government commits as it did last year to doubling exports
within 5 years, what they really mean is they're going to trash the
dollar, because how else can a mature economy like ours double
Do you believe gold is a genuine hedge in uncertain markets? If so,
how much exposure to it or other precious metals do you have? If
not, where are you turning for potential downside
Gold has proven itself not only an effective hedge, but a highly
effective stand-alone investment too, and not just since the global
economic crisis, but for the last 10 years, and really for the last
40. Since 1970, gold has outperformed the S&P 500 and U.S.
Treasuries by a factor of three, with even more dramatic
outperformance as of late. While the talking heads on business TV
may fixate on the latest "$80 one-day drop!" in the gold price when
levered investors dump gold in a panic to meet margin calls, the
metal is actually less volatile than most equity indexes and has
generally exhibited an upward bias over time.
I think we are at an interesting inflection point with gold.
Despite the endless speculation of a bubble in the gold price, gold
is today a severely under-owned asset, very much unlike bubble-era
real estate and dotcom stocks. Gold today comprises less than 1% of
global financial assets versus 20%-plus during various other times
of crisis in the 20th century, i.e., 1921, 1932, 1948 and 1982.
We don't use price targets for gold internally, but my estimate
would be that the implied price of gold today using the Bretton
Woods standard (i.e. backing the U.S. monetary base with gold) is
around $10,000 per ounce, and as the circus of money-printing
continues to erode faith in paper currency, we would predict there
will be calls for re-linking gold in some manner to currencies.
The U.S. dollar has lost 80% of its purchasing power over the
last 40 years; I struggle to grasp why it is still viewed by many
as a safe haven and a store of value. Gold's appeal, by contrast,
seems more readily apparent. We have a detailed
on gold investing for those who are interested.
Royce does not invest directly in gold bullion, but rather has
invested for more than 10 years in gold-mining companies. We have a
10-14% weighting in precious-metals mining companies in most of the
portfolios that I manage, chiefly linked to gold or silver.
Global Macro considerations dominated the headlines in 2011. Do you
see 2012 unfolding differently? If so, how?
Headlines are a funny thing.What passes for investing in today's
markets looks to me more like headline-driven speculation: a
simplistic choice between a "risk-on" or "risk-off" day.
At some point, the European sovereign debt crisis will be
essentially resolved, and the daily battery of negativity on Europe
will ease. Perhaps it will dissipate through a stubborn adherence
to the euro, or perhaps peripheral Europe will break ranks with the
currency and default. This latter scenario, by the way, would
likely be very constructive for those home-market equities-just
look what stocks did in Brazil, Mexico or Russia after their
sovereign debt defaults! Today's European sovereign debt crisis
isn't really all that different from the Asian Crisis of 1997-98 -
currency pegs, unsustainable exchange rates, over-indebtedness -
and consider that in the decade after that got resolved, Indonesia
gave equity investors a 1,400% return.
In our European investments, we are biased towards the classic
but overlooked Germanic and UK exporters, which have successfully
managed through decades of currency and political turmoil. Among
our holdings are Semperit (SEIGF.PK), which has grown revenues and
operating income organically for 19 of the last 20 years,
vacuum-pump maker Pfeiffer Vacuum (PFFVF.PK), and Spirax-Sarco
(SPXSF.PK), the global leader in steam systems which has increased
its dividend for 42 straight years.
Likewise, despite the air of hopelessness and uncertainty in
North Africa and parts of the Middle East, negative headlines from
this part of the world will also probably fade at some point.
Bloody protests make headlines; the more mundane nation-building
does not.The region's countries are slowly but surely dividing
between a burgeoning group of quasi-democracies on the one hand
(Iraq, Egypt, Tunisia, Libya), and a smaller group of failed states
on the other (Yemen, Somalia), with only a few of the core
autocratic regimes remaining (Syria, Iran, Saudi Arabia), which of
course was until recently the dominant form of government in the
Among the factors that we think will become prominent global
macro considerations in 2012 is the latent but still insidious
global currency war. And accordingly, we've positioned our
portfolio with those proven exporters, which are structured to
manage successfully through this fast-changing landscape. Many
people incorrectly assume that small-caps are not geographically
diversified, and pigeonholing for example a European-headquartered
company as being 100% dependent on the euro and the European
consumer. But this could not be further from the truth with the
European exporters we've selected: not only does their revenue base
stretch way beyond Europe, but so does their manufacturing and cost
base, meaning they are not overly dependent on either the European
consumer or the euro.
2010-11 saw a notable rush for the exits from equities and equity
vehicles. Is this a cyclical, or secular shift? What would it take
to bring them back?
I think it's largely cyclical. The money that has been exiting
equities in a reactionary manner has piled belatedly into the
perceived safety of fixed income, and we are witnessing the making
of a massive bond bubble, which I believe is not going to end well
for investors. Personally I think folks are taking serious career
risk now by hiding their clients in fixed income. Investors who
fled equities at the bottom after the global economic crisis hit in
late 2008, and then fled en masse into fixed income, are likely to
be carried out when the bond bubble bursts. Investors cannot afford
to accept negative real rates of return forever. When you take
inflation into account, much of the bonds out there are just
certificates of confiscation!
Royce Funds are long MDSMF.PK, HCHDF.PK, NUS, FYRTF.PK and
Dissecting Today's Bull Market