Go to Market, Not the Vault for Gold Bargains: David
Source: Brian Sylvester of
The Gold Report
Baker Steel Capital trades on its analysts' "intellectual
capital and technical expertise" when it comes to knowing when
and where to invest. Right now, its funds favor equities over the
physical gold market. The lion's share of those equities are
companies exploring and producing in Africa, where careful risk
management can bring high returns, says Baker Steel Capital
Managing Partner David Baker in this exclusive
The Gold Report:
You've been quoted as saying that intellectual capital and
technical expertise set Baker Steel Capital apart. Tell us more
All six of us on our investment team have technical or financial
experience in mining, which gives us an edge. When we go onsite
at mining projects around the world, we can speak the language
and understand what the technical people are saying.
We do all our own research on the companies we invest in, and
we have a very sophisticated database modeling system, Genval,
our general valuation tool. Our database covers over 500 mining
companies and over 1,000 mining projects. The analysis enables us
to evaluate mines and mining companies on a consistent basis; we
can compare companies and mines in different jurisdictions using
common assumptions. This enables us to efficiently allocate funds
in an effort to generate the highest returns.
I noticed that Matthew Huston, one of your research analysts, has
a master's degree in mining project appraisal from Imperial
College in London. What is that qualification?
The degree is all about financing and the evaluation of projects,
relating the technical side of mining with the financial and risk
aspects. We find this is a very useful qualification when
evaluating mines and mining companies. Both James Withall and I
have similar qualifications, also from Imperial College, and
David Coates holds an MBA.
Let's talk about your Genus Dynamic Gold (GDG) fund, established
in 2003. What is its average annual return since inception?
The annual returns to the end of Q311, based on the A Share
Class, was 25.7%, compared with a benchmark return of 14.6% and a
20.3% return on gold. Our long-term performance is exceptional on
an annualized basis.
Last year we had a fantastic year, with a return for the A
Share Class after all fees of 76.6% vs. the benchmark of 29%.
This year, we have underperformed somewhat. At the end of Q311 we
are down about 23.5%. We are a bit more volatile than the index,
principally because we have a large exposure to emerging
producers, which carry higher risk.
At the end of August, Baker Steel's total assets under management
(AUM) were $1.6 billion (
). Is that Australian dollars or U.S.?
The Australian and the U.S. dollars are roughly equal. The total
now is about $1.5B.
What is your AUM goal through the end of 2015?
We have a bullish outlook on gold prices. It's not unreasonable
to say that our AUM would be maybe $2.5-3B by 2015.
We just introduced the Baker Steel Alpha Gold fund, which fits
in between the gold exchange-traded funds and gold equities and
invests a similar amount in gold via the ETF and gold via the
gold mining companies. The strategy was constructed with the aim
of outperforming physical gold by about 10% a year, yet with low
It achieves this principally in two ways. First, we run a
sentiment model that determines if we are "risk on" or "risk
off"; this is a contrarian indicator and in "risk off" mode, as
we are today, we cut our gold exposure and hedge our gold equity
exposure. Second, we aim to use our stock selection skills to
extract alpha from our equity exposure. The fund launched in the
middle of September and now has $160 million (
) under management-a very successful launch. We were up about 4%
in October outperforming gold, with considerably lower
volatility. Annualized, our volatility is 20.2%, compared to 33%
for gold in October. Steve Ellis is the portfolio manager of the
How has the market received the Alpha Gold Fund?
There is lots of interest. It was one of the best launches this
year in the UK market. It's a UCITS-compliant fund, a European
Union directive that allows collective investment schemes to
operate freely throughout the EU on the basis of a single
authorization from one member state. We have only a few months of
performance under our belt so as we build up a track record I
expect we will gain greater acceptance for this unique
Your GDG fund can consist of up to 100% equities. The percentage
of futures and precious metals could be as much as 50% and the
cash portion can account for as much as 25%. What's the current
At the moment, we see equities being undervalued relative to
gold. Our modeling indicates that it is cheaper to buy gold
through the equity market than through the physical markets; the
gold mining equities are discounting something in the order of
US$1,250/ounce gold prices. Presently the fund is fully invested
in the equities.
The fund's performance in 2011 suggests that the price volatility
in gold and gold equities is translating to GDG. What is the
market volatility teaching you about this space?
The market is very conservative and obviously very worried about
the global outlook. Some in the market believe there could be a
deflationary bust and others are discounting either inflation or
the extreme hyperinflation scenario. There is a major disconnect
and that uncertainty is keeping people on the sidelines,
resulting in thinly traded markets and heightened volatility.
What do you think will happen? Will we see a spell of global
I think that is very unlikely. Inflation seems to be everywhere.
The threat of deflation will make the central banks pump more
money into the system. Deflation would be an Armageddon scenario
because there is so much debt. It is inevitable that governments
will devalue their current and future liabilities through
inflation. However, we might need to see more of a threat of
deflation to coerce the powers that be into dialing up the
In a September 2011 presentation, Baker Steel suggested that gold
production has reached its "natural limit." Nonetheless, gold
production increased in each of the four previous years. Isn't
the limit essentially whatever companies can produce?
For a company to produce gold or increase its gold production, it
really has to increase its gold inventory with new deposits.
Companies are increasing their gold inventory, but often by a
reclassification of existing deposits not new deposits.
As the gold price rises, more ore becomes economic; however,
overall grade falls as cut off grades fall. At a given throughput
gold production falls with the lower head grade; it is hard for
the industry to sustainably grow headline gold production.
To really grow gold production, companies need to increase
their inventory through exploration. Over the last 10-20 years,
the pace of finding large gold projects has fallen off
dramatically. The easy pickings have been made. If we want to
meaningfully increase gold production, we need to see a
meaningful increase in gold discovery, and I am afraid that is
not happening. Based on 2011 production, the top three gold
producers (Barrick, Newmont and AngloGold) need to come up with
17 million ounces (Moz)/year of gold to replace annual depletion.
Assuming resource to reserve conversions of 70%, this implies the
top three alone have to find 24 Moz/year-five 5 Moz deposits. The
industry is just not discovering gold at this rate or this size
The GDG fund takes positions in companies that are fully exposed
to the gold price. Does that mean you eschew positions in
companies with hedged gold production?
We tend to favor companies that are fully exposed. In our view,
very few companies have benefited from hedging gold
Hedging has overall caused grief. Eventually, most hedge books
have been bought back at shareholder expense. We are not keen on
junior companies going to the debt market; more often than not
this entails hedging future production.
That's not to say that some of the companies we invest in
don't have some modest hedging. I can give you a couple of
examples. About two years ago, Banro Corporation (BAA:TSX;
BAA:NYSE) was looking at financing projects in the Democratic
Republic of the Congo (
). The company thought about debt financing, but the cost would
have been prohibitive when you included the hedge requirements.
Further, once in production any cash flow would have been
directed toward debt repayment instead of additional growth
projects, a noose around its neck and potentially resulting in
the market not valuing Banro's growth.
Have you taken a position in Banro?
Banro is in our Top 10 holdings.
Have you heard anything about the commissioning at Banro's
Twangiza mine in the DRC?
We have not heard any more feedback on that apart from that the
mine poured its first gold in the fourth quarter of 2011. Looking
at the share price, it seems the market has been a bit cautious
following elections in the DRC. Banro's strategy is to develop a
number of high-return oxide projects it has in its inventory.
Banro didn't take on any debt to develop Twangiza, so it will
have significant cash flow to develop other projects. Without
doubt, Banro has a fantastic resource base.
Are you at all concerned about moving Twangiza from an oxide to a
sulfide mine, to an underground mine, given the trouble Avion
Gold Corp. (AVR:TSX; AVGCF:OTCQX) had going underground in West
I believe the sulfide will be delayed for a few years as the
company concentrates on the lower-risk, higher-return oxide
projects. The key to the sulfide is getting the capital for
hydroelectricity for power.
About 27% of the assets in the GDG portfolio are in Africa, with
only 17% in North America. Some might consider that risky. What
is your position on the risk-reward balance for companies
operating in Africa?
The issue for gold mining is you have to go where the gold is and
where new projects are. Africa has a lot of fairly virgin country
in terms of exploration, areas which are very prospective.
In terms of risk, we invested early in Nevsun Resources Ltd.
(NSU:TSX; NSU:NYSE.A). It has an exceptionally high-return
project in Eritria in East Africa. The market views Eritria as
high risk in that the company was unable to debt finance its
development. We weighed the risk against the potential returns
and became a cornerstone investor in its equity raise last year.
The company recently brought the project into production and has
already built up more cash on its balance sheet than the mine
cost to build.
We're looking at other projects with similar high returns and
believe La Mancha Resources Inc.'s (LMA:TSX) Hassai project in
Sudan is similar to Nevsun's Bisha project, both being volcanic
massive sulphides (VMS) with both copper and gold. In the case of
La Mancha's asset, part of the gold has already been mined out.
But overall the scale of the La Mancha asset is potentially four
times the size of Bisha. La Mancha is in Northern Sudan; we
believe the returns compensate for the risks.
La Mancha acquired a number of assets in a reverse takeover by
the French firm AREVA (
). It now has mines in Cote d'Ivoire, Sudan and Australia. Why
haven't more people, at least in North America, heard about this
That is a good question. I think there is a perception that
AREVA, which has a controlling stake, is quite conservative. The
company has promoted itself and has delivered amazingly. It's
been one of the best performers since the lows in 2008.
When we first looked at La Mancha, it was valued at $8M yet
generating cash out of its mine in Australia. Now three years
later it has $98M cash on the balance sheet and a market
capitalization approaching $400M. The quality of its assets
suggests that it should be valued at least double where it is
La Mancha's Hassai development project in the Sudan is very
exciting and it has the balance sheet to finance it. There are
two stages. The first stage is to convert the project to a carbon
in leach, requiring capital of around $190M. La Mancha is
negotiating to increase its interest in this project in return
for funding the government's share of capital. Right now, the
government has 60% and La Mancha has 40%. In the short term,
there is some uncertainty as to how much the Sudanese government
will end up giving up in exchange for this finance.
Is the Hassai VMS project in Sudan La Mancha's most advanced
The Hassai project is the most exciting and probably the most
advanced. It certainly has the most upside. Brokers calculate the
valuation of the company is covered on its Australian assets;
investors get the African assets for free.
Of course, the market could be saying, "Sudan is so high risk
that all the cash La Mancha is generating in Australia will be
poured down the drain so to speak in Sudan." I don't see that
happening. Hassai is a proven operation already.
Like Nevsun's Bisha mine, Hassai is a very high-return
project. The value per ton of rock at Hassai is around $150 at
today's metal prices. The cost of extracting the rock will
probably be in the region of $20-30/ton, so you can see this will
be a very high return project.
As of September, the bottom three performers in the GDG fund were
OceanaGold Corp. (OGC:TSX; OGC:ASX), Allied Gold Mining Plc
(ALD:TSX; ALD:ASX) and Lake Shore Gold Corp. (LSG:TSX). Why are
you holding onto them?
They are all cheap. Unfortunately all three have disappointed the
market, but that is why we run a diversified fund, not all our
seeds germinate at once. Oceana had a profit downgrade;
production wasn't quite what the market expected in New Zealand
and costs were higher. Oceana has producing assets in New
Zealand; the New Zealand gold price is making new highs, which
should flow to the bottom line. Oceana is also developing a
copper-gold project in the Philippines, which the market has yet
to factor in, yet this is fully funded to production. We are
effectively buying the company at an ex-growth multiple at a 4-5
times earnings before interest, taxes, depreciation, amortization
The same applies to Allied Gold, which had a few delays and
cost increases in its Papua New Guinea assets and the Solomon
Islands. The stock is cheap. Next year it should generate $100M
of free cash flow on a $600M market cap.
For Lake Shore, there is a debate in the market as to the
production outlook. We visited the site recently and are
comfortable with the mine, the production ramp-up has been
stretched but in terms of delivering resource growth, the company
is meeting our expectations. The company is going through typical
growth pains, exacerbated by the fact it is developing three
mines over 40km of prospective ground. We see some good upside
there; as with the others, we are holding on to these
We also are buying Great Basin Gold Ltd. (GBG:TSX;
GBG:NYSE.A). Great Basin has really fallen out of favor. Its
market capitalization is just under CA$500M, and it probably
spent more than CA$550M on its Burnstone gold mine in South
Africa. Yes, there have been some delays, but we think a ramp up
of the asset in South Africa will still happen. It has just been
pushed back 12-18 months. Burnstone is relatively different in
the South African context, being shallow mechanized mining, which
has safety as well as cost advantages. The company looks like an
exceptional value right now, trading at less than book cost.
Let's look at the other end of the spectrum. Your top three
performers, as of September, were First Majestic Silver Corp.
(FR:TSX; AG:NYSE; FMV:FSE), Gold One International Ltd. (GDO:ASX;
GDO:JSE; GLDZY:OTCQX) and Archipelago Resources Plc (AR:LSE). Did
you take some profits on those names? Do they have any upside
We sold down First Majestic, which we think is fully discounted
by the market. We have been reducing Gold One, which has a
project in South Africa called Modder East, a shallow reef gold
mine similar to Burnstone, which is owned by Great Basin.
A Chinese consortium is acquiring a stake in Gold One, at
$0.55/share, so we have taken this as an opportunity to reduce
Gold One and switch into Great Basin, because we believe it would
make sense for Gold One to own the Burnstone mine, which is owned
by Great Basin. At this price and with the backing of the
Chinese, that would make a lot of sense.
How about Archipelago?
We have reduced our position, but we think Archipelago, which has
recently commissioned a gold mine in Indonesia, will now be able
to spend more on exploration to extend the project's life. This
is a very prospective region and at these prices still relatively
good value. It's not in our Top 10 positions, but we like the
The main point to note about these three investments is that
we bought early, we took a view on the assets based on our
technical appraisal and the risk-reward leverage supported the
companies; all have been significantly rerated in the past 18
months. As they approached our valuation metrics, we have rotated
into new stories; this is a good example of how the fund can and
is delivering long-term performance.
What should the average investor expect from the gold market
heading into 2012?
Gold shares are very, very cheap. At some point, they'll become
expensive. When you buy something that is cheap and is paying
good dividend yields, you are being paid to hold the shares.
We may see more mergers and acquisitions. There are rumors
that Eldorado Gold Corp. (ELD:TSX; EGO:NYSE) will bid for
European Goldfields Ltd. (TSX:EGU; AIM:EGU). These large
companies need to increase their inventories of gold. So we think
it's going to be a very exciting market next year.
Excellent. David, thank you for your time and insights.
David Baker is a managing partner at Baker Steel Capital
Managers and heads the company's Sydney office. Prior to
founding Baker Steel in 2001, Baker was part of the
award-winning Merrill Lynch Investment Management (MLIM)
natural resources team, successfully managing the Mercury Gold
Metal Open Fund, the largest precious metals fund in Japan,
from its launch in 1995 until his departure in 2001. Prior to
joining MLIM in 1992, he was a gold and mining analyst for
James Capel Stockbrokers in London from 1988 and held a similar
role at Capel Court Powell in Sydney from 1986 to 1988. Baker
started his career in 1981 as a metallurgist at CRA Broken
Hill, Australia. He holds a degree in mineral processing and a
master's in mineral production management from Imperial
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1) Brian Sylvester of
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2) The following companies mentioned in the interview are
The Gold Report:
Banro Corporation, La Mancha Resources Inc., Avion Gold Corp.
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