Performance Review 2008Georges Lequime: "The Earth Gold Fund UI outperformed its peer group in late 2008, as the market started to recover from a major sell-off from July 2008 through October 2008. During the sell-off phase, which quickly developed into panic selling, there was very little differentiation between good quality companies and poorer quality companies. We continued to conduct in-depth fundamental research on all the companies in the sector and found a number of significantly undervalued small, mid cap and large cap stocks.
We initially focused on primarily investing in large cap stocks in the Fund, which offered similar returns to mid cap and smaller stocks without the added risk, especially balance sheet risk. The larger market cap stocks also offered increased liquidity in the event of significant withdrawals from the Fund. Traditionally, the share prices of the larger market cap companies recover first after a major sell-off, and this was proved again in late 2008."
Performance Review 2009
Georges Lequime: "2009 marked a return of value investing in the sector and the fund could significantly outperform the shown benchmark (+121% vs. +23,65%).
The performance was aided by subsector allocation, with emphasis on gold rather than platinum group metals, which are heavily influenced by its industrial use characteristics. We were also overweight silver companies at the beginning of the year, which were sold aggressively in late 2008."
Performance Review 2010 - Year-to-Date
Georges Lequime: "During the first half of 2010 the fund matched the index as new investors chased “market themes” rather than value – companies who demonstrated growth in reserves/resources and growth in production were favoured over “value” stocks in the sector. During this period, we took profits on a number of companies where valuations became extreme given the risk of the companies in achieving the growth profiles. Given the relatively small size of precious metals sector, good quality companies can become extremely expensive on a relative basis from time to time.
We reinvested the proceeds into companies where we recognised significant relative value. During the latter half of 2010, we were able to outperform the market as the market shifted its attention away from overvalued growth stocks to undervalued small, mid cap and larger market cap stocks. A number of companies in the portfolio were also involved in M&A activities, which supported the fund performance."
Performance Review since 2008
Georges Lequime: "The fund performance graph since inception shows the benefits of solid bottom-up fundamental analysis and the returns that we could achieve by constantly switching out of overvalued stocks into value stocks or stocks where the market did not fully understand the issues at hand. Apart from the panic sell-off period immediately following the inception of the fund, the performance has been steady and consistent. Since inception, we have focused on absolute returns rather than relative performance and we are pleased that we could achieve superior returns given that we are value investors in a very strong market for precious metals. This demonstrates the benefits of fundamental analysis in both a rising and falling market (where it is extremely important).
Due to its long-only character (UCITS III) the fund cannot “go short”. We have remained fully invested since late 2008. However, we have the option to hold up to 30% in cash, including gold, silver, platinum and palladium Exchange Traded Funds (ETFs), where we cannot fund sufficient equity investments that will outperform the expected performance of the various commodity prices over a 12 month period. We were invested in gold and platinum ETFs during the panic selling phase in July-October 2008. However, since late 2008, the implied valuation of gold and silver equities have continued to discount significantly lower prices than spot, justifying the investment in equities above cash and ETFs."
Investment Process and Strategy – How does the Fund Manager Invest?
The Earth Gold Fund UI is a “long-only” fund. The management strategy focuses on the active management of the portfolio, i.e. the aim is to provide a portfolio return that exceeds a fixed return (7%). The decision process consists of two parts: macro and micro portfolio construction.
1.1 Macro component
Top-down inputs for commodity prices, currencies and inflation rates will be derived from a centralized database. Commodity price forecasts are divided into two sections: short/medium-term (5 years). The database is adjusted regularly (at a minimum on quarterly basis). A wide network of highly ranked brokers and commodity analysts provides guidance in the top-down approach.
The macro component of the portfolio compares market capitalizations, outlook and liquidities for the various commodity sub-sectors, aiding the definition of weightings of these sectors in the portfolio. Further consideration in the weighting process is given to geographical distribution, liquidities, and market capitalization of the sectors. In the weighting of sub-sectors, special consideration will be given to the correlation of different sub-asset classes (e.g. the correlation between gold price and oil price).
1.2 Micro component and Ranking
The stock selection process within the portfolio construction process focuses on a bottom-up analysis (see below) and the subsequent ranking of stocks. The ranking process is crucial in this regard and will be integrated within the EARTH GOLD FUND UI database, taking into account the following valuation parameters:
• Near-term NAV growth
• Price to cash flow multiples
• Price to free cash flow multiples
• Country and management risk
• Project Financing
• Market cap
• And, ultimately, the expected return for the stock over a 12 month and a three year basis.
2 The EARTH GOLD FUND UI value approach
The EARTH GOLD FUND UI invests “away from the benchmark”. Investments will only be guided by the company valuations. Focus will be on relatively undervalued large and mid-sized companies, as well as “undiscovered” companies and projects. The value approach should offer potential for capital gain, regardless of the long term increase of underlying commodity prices. Underlying the capital gain estimate is the “valuation curve” of resources companies.
3 Portfolio construction
The portfolio will consist of 35-40 stocks. Although stocks with market caps below US$300m will be considered, liquidity constraints will limit the number and weighting of such stocks. Such companies do not present more than 10-20% of the portfolio. Targeted fund size is expected at €400m-€500m, at which level the fund will be capped in order to continue to give investors adequate exposure to junior and mid-cap companies.
The portfolio is actively managed, i.e. a stock will be sold, if a company’s share price exceeds its determined target price. Target prices will also include a take-over premium (in general 30-40%).
Georges Lequime: "In our opinion, the global macro economic outlook still strongly favours a higher rather than lower gold price in the short-to-medium term. Although we are seeing signs of economic recovery in the USA and Europe, concerns over global debt levels and the actual pace of the global economic recovery remain. We are witnessing a modest rising of interest rates in certain emerging markets. However, in the US, we expect real interest rates to remain low or negative over the next few years as the Fed continues to adopt policies aimed at stimulating growth, seemingly at the expense of the relative value of the dollar and at the risk of hyper-inflation in the medium-term.
Source: Deutsche Bank
We find the above graph very powerful in its ability to explain the rally in gold and silver prices since 2000. Following a long period of very high inflation in the late 1970’s, the US Fed (Volkner) raised rates substantially after the spike in the gold price in 1981. This effectively curtailed inflation and the Western World went through a prolonged period (1981-2000) of high real interest rates. The attractiveness of gold as a currency diversifier diminishes significantly during this period since it offers no yield to investors. Significantly, this period (1981-2000) coincided with record gold production as the US, Canadian and Australian gold fields were aggressively developed. Looking back, it is not difficult to explain the record low of US$258 per ounce that we witnessed in 2000.
We find ourselves in a completely different environment today. Despite record low interest rates in the US, the economic recovery seems fragile and vulnerable to any increase in interest rates. With the Fed unable to cut interest rates any further to stimulate the economy, a second round of quantitative easing ($600 billion) was recently announced. The actual effectiveness of quantitative easing on the economy remains uncertain and the risk remains that a third or fourth round of quantitative easing will be announced before the US economy recovers to a satisfactory level. The current Fed Chairman, Ben Bernanke, recently clarified the Fed’s position that the Central Bank will do “all that it can” to foster growth. This is supported by the US government’s suggestion, that a longer than expected period of quantitative easing measures may be used to induce inflation and stimulate growth.
The actual sizes of the quantitative packages are substantial. $1.2 trillion dollars of securities were purchased under the QE1 programme with another $600 billion earmarked for the purchase of securities in QE2. Although, we have yet to witness a material increase in money supply and inflation (since banks have used to proceeds to repair balance sheets), the US dollar is being effectively debased through these packages, very much in the same way that gold was debased through the late 1980’s and early 1990’s. These figures (US$1.8 trillion dollars in total) dwarf the total investment in gold ETFs to date ($92 billion) and the total size of all gold investments by the private sector and the official sector ($900 billion).
With global capital chasing superior returns, gold is increasingly being seen as a steadily performing asset with low volatility (~7% volatility). This is attracting the attention of global asset management institutions, looking for diversification and high returns couple with low volatility.
Despite gold strong performance as an asset class over the past ten years, it’s weighting in generalist portfolios remains very low compared to previous decades.
Source: World Gold Council, 2010
It is estimated that less than 1% of global assets under management is currently allocated to physical gold or gold equities. Any meaningful weighting of gold in asset management portfolios is almost exclusive to high net worth portfolios and hedge funds with the large financial institutions and emerging market Central banks increasingly looking for opportunities to invest in gold. China and Russia have openly stated their intent to increase the weighting of gold in their foreign exchange reserve portfolios. According to the IMF, central bank holdings currently stand at 34,400 tonnes (Q2-2010) and represent 13% of overall forex reserves, or in industrialized countries, gold represents 23% of forex reserves. In contrast, China’s reported gold holding of 1,054 tonnes represent just 2% of its overall forex reserves, which is well below the global and industrialized countries’ averages.
Source: Company Reports, ERIG
Unlike the 1980’s and 1990’s, we are not seeing a supply side response to record gold prices. World gold production has been flat for a number of years despite constantly rising prices. Although global gold production is expected to be higher (1-2%) for the first time in five years in 2010, the downtrend in global gold output is set to continue from 2011 onwards as reserves at high volume operations are depleted and grades continue to fall.
The principal reason for the lack of any meaningful supply-side response is the increase in total cost of producing gold (see above graph). Total costs have risen by an average of 16% per year over the past five years and continue to rise at 10-11% per year due to inflationary pressures and the mining of lower grades. The average cost of production currently stands at $981 per ounce. This effectively puts a floor to the gold price at around $1,000 per ounce and we can argue that the incentive gold price to drive any meaningful change in global gold output is probably closer to $2,000 per ounce rather than the current price of $1,350 per ounce.
Over the next 1 to 2 years, we believe that the upside risks to the gold price far outweigh the downside risks:
1. Gold performs well in low to negative real interest rate environments, since it is ultimately a zero-yield currently – we expect real interest rates in the US to remain low in the short-to-medium term.
2. As an asset class, gold is consistently outperforming other asset classes, which is attracting the attention of large financial institution with little or no exposure to gold. Given the size of total assets under management globally, any material investment by large institutions in gold could lead to a material spike in gold and send gold into “bubble territory”, as highlighted by George Soros in a speech earlier this year. “Bubble territory” would imply gold prices of around $4-5,000/oz and higher, which is not inconceivable given the relatively small size of the total gold market and the inability of any meaningful supply side response to higher prices.
3. The downside risk is protected by the high cost of production, which effectively places a floor on the gold price at around $1,000 per ounce.
4. In addition, Central Banks in the emerging markets, particularly China, India and Russia are buyers of gold in any weakness, effectively creating another floor to the gold price.
The downside risk over the next couple of years hinges on the global economic recovery. As worst case scenario for gold is a strong economic recovery coupled with very low inflation, thereby enabling the US and Europe to raise interest rates to levels that penalise investors and Central Banks holding gold, instead of US dollars and Euros - back to real interest rates of 3-4% or higher. In the very short-term, gold could also weaken in the event of a material pullback in stock markets around the world given the fact that gold is a very liquid asset to dispose of in times of stress. The latter scenario is more likely than the former, in our opinion and concerns about both scenarios is expected to lead to continued volatility in the gold price over the coming months.
Silver and the platinum group metals have a higher industrial use component to them than gold, which is really driven almost exclusively by investment demand and jewellery demand.
We find silver very interesting and more vulnerable to developing into a “bubble” than gold, given its tight supply and demand fundamentals. Silver has struggled to keep up with gold since 2000 and has recently started to play catch-up. The recent rally in the silver price is being driven by investment demand as gold is seen as a cheaper alternative to gold for retail investors. In addition, since two-thirds of global production is sourced as by-product production, the supply-side response to rising silver prices is even more muted than is the case for gold.
The platinum and palladium markets look very interesting. Both are closely tied to the global economic recovery, particularly motor vehicle sales, since platinum (predominantly in diesel engines) and palladium (predominantly in gasoline engines) are used in auto-catalysts, required by ever-tightening legislation to reduce carbon emissions.
The short-term concern about the platinum group metals (PGM) market is the high degree of hedge fund activity in both markets, particularly palladium. If global growth estimates prove too optimistic, PGM prices could collapse in the short-term. Unlike gold equities, which are discounting gold prices of $1,100 per ounce, or almost 20% below spot prices, PGM-related equities are discounting PGM prices 10-20% higher than spot prices, making it difficult to invest in the sector as a value investor.
We remain fully invested at the moment with an 85-88% weighting in gold equities and a 10-15% weighting in silver equities."