Investment Universe, Process, Strategy and Benchmark – How does the Fund Manager invest? (ISIN: DE000A0Q2SD8)The Earth Gold Fund UI is a “long-only” fund which invests in gold, silver, platinum group metals and diamond company equities listed on major exchanges around the world. The Fund also invests in physical gold, silver, PGM* through Exchange Traded Funds (ETFs) when appropriate. 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.
Top-down inputs for commodity prices, currencies and inflation rates is derived from a centralized database. The database is adjusted regularly with the assumptions approximating the prevalent spot prices at the time and applying further conservatism to our price deck and assumptions. A wide network of highly ranked brokers and commodity analysts provides guidance in the top-down approach.
Micro component and Ranking
The stock selection process within the portfolio construction process focuses on a bottom-up analysis and the subsequent ranking of stocks. The ranking process is crucial in this regard and is integrated within the EARTH GOLD FUND UI database containing financial models for all companies in our research universe.
The bottom-up analysis is based on discounted cash flow (DCF) analysis, where the future expected free cash flows are discounted at 5% (real terms). Where we believe that the company will materially add to its reserve base over the coming 12 months, this will be incorporated into the financial model. We then apply discount or premium multiples to our analysis based on the downside or upside risk that we recognise in the company’s ability to meet future projections. Typically, a factor of 0.7x is applied to a development company where management have not sufficiently demonstrated to the market its ability to meet its development plan and/or mitigate project risks.
The DCF analysis and the application of the discount (or premium) multiples are used to determine the expected return for any particular stock over the next 12 months. Finally, the ranking model sources important figures and metrics of all modelled companies from a central database within our universe and this drives our investment process within the various sectors.
Our current investment strategy is to have an appropriate and risk managed exposure to: 1) large established producers; 2) medium sized-medium risk producers with significant development project/s pipeline (or exploration upside at existing operations); and 3) small sized, higher-risk companies, which are typically single asset projects or late stage exploration projects.
As a guideline in executing our strategy, the EARTH GOLD FUND UI invests “away from the benchmark”. Investments are guided by the company valuations and typical gold index weightings (such as the FTSE Gold Miners) do not play a role in the decision process. Focus is on discovering value within companies and projects that is not yet reflected in the share price and before the market becomes aware. The value approach offers potential for capital gain, regardless of the long term increase of underlying commodity prices.
For comparative purposes when asked by current and potential investors, the EARTH GOLD FUND UI is often compared to the FTSE World Gold Index, which consists primarily of large and established gold producing companies, where the value is driven by commodity price movements (beta) rather than by growth creation (alpha).
* PGM – Platinum Group Metals
Performance Review 2008
Georges 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
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 (but not necessarily creating value) were favoured over true “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 not achieving their projected growth plans. Given the relatively small size of the precious metals sector, good quality companies can become quickly expensive on a relative basis, from time to time.
We reinvested the proceeds into companies where we recognised significant value relative to company peers within the sector. 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 2011
Figure 1: US Equity Risk Premium
Source: Goldman Sachs Global ECS Research Edition 02/35
Georges Lequime: "2011 proved to be a difficult year for all investors in the precious metals sector. Risk was taken off the table in 2011 as evidenced by the surge in the US Equity Risk Premium over the year (see Figure 1). Value stocks and developing companies were out of favour throughout the year and multiples (such as P/NAV)* fell to the lowest level seen in recent memory by year-end. There was a clear separation between certain larger capitalisation stocks that did not disappoint the market and the rest of the sector.
We marginally underperformed the FTSE Gold Miners Index which, as mentioned above, is dominated by low-risk larger market capitalisation stocks, but we strongly outperformed the mid-cap and smaller-cap indexes within our sector."
* P/NAV – Price to Net Asset Value
Performance Review 2012 - Year-to-Date
Georges Lequime: "To date, the investment pattern in 2012 has proved to be very similar to 2011 with Equity Risk Premiums remaining at all-time highs (see Figure 1). Smaller market cap stocks are starting to rebound although any company missing production targets or cost guidance are still being severely sold off.
Figure 2: Senior and Intermediate Gold Producers Historical P/NAV
Source: Canaccord Genuity
We believe that the market is starting to stabilise and value companies are being looked at more closely given the levels to which they have sold off to and the attractive entry points presented. However, the global economic uncertainty is weighing heavily on the market’s attitude towards the gold price, especially with regards to the continuation of expansive monetary policy. Valuations on a P/NAV*, or on a P/CF** basis, remain at all-time lows but we are seeing the contraction of these metrics shows signs of levelling off and a slight improvement in some cases (See Figure 2)."
* P/NAV – Price to Net Asset Value
** P/CF – Price to Cash Flow
Performance since 2008
Georges Lequime: "The fund performance graph since inception shows the benefits of solid bottom-up fundamental analysis and the returns that we achieved by switching out of overvalued stocks into value stocks or stocks where the market did not fully understand the operational issues at hand (and thus oversold the stocks). Apart from the panic sell-off period immediately following the inception of the fund (GFC), the fund performance has demonstrated to be 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 by executing our fund strategy. This demonstrates the benefits of fundamental analysis, portfolio risk management, stock ranking and selection, and implementing conservative macro assumptions, in both a rising and falling market (where it is extremely important).
Due to its long-only character (UCITS IV) the fund cannot short stocks. We have remained fully invested since late 2008. However, we do have the option of holding up to 30% cash, including gold, silver, platinum and palladium Exchange Traded Funds (ETFs), where we cannot find sufficient equity investments that will outperform the expected performance of the various physical commodities 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 has continued to discount significantly lower commodity prices than prevailing spot prices at the time, justifying the investment in equities as opposed to holding cash or investing in ETFs. Since early 2011, equities have been significantly underperforming the physical commodity price due to increased equity risk in general and increasing capital and operating cost inflation, which have negatively impacted operating margins as well as the expected internal rate of returns, payback periods and NPV of many development projects."