The Gold Report: You started your career, Dave, in the fixed income securities division of Goldman Sachs. And you worked as a junk bond trader before founding Golden Returns Capital. What prompted you to move into precious metals?
Dave Kranzler: After working as a bond trader on Wall Street, I was day trading. A friend suggested that I look at gold and silver. I initially poo-pooed that idea, as I was more interested in shorting technology stocks during the Internet bubble. I thought the tech valuations were based on nothing more than hopes and dreams, not on real wealth. The enormous growth in paper investments was driven by the incredible amount of money supply thrown into the system by Alan Greenspan’s Federal Reserve.
But in late 2001, my friend finally convinced me to get serious about mining stocks. So I investigated the reasons why there had been a 20-year bear market in precious metals and why a long-term bull market was in the offing.
TGR: Why should we invest in gold instead of, say, Facebook?
DK: People like Warren Buffett, Charlie Munger and Bill Gates characterize gold as an investment. It’s really not. It’s a monetary metal. Gold represents the embodiment of real wealth. By contrast, Facebook has a sustainable business model based on revenues derived from advertising. But there’s an extreme differentiation between what Facebook might be worth on the basis of long-term historical market capitalization measures versus what the market was willing to pay at its IPO. It quickly dropped in value, and it has a lot further to fall. Gold is more real.
TGR: How does gold as money differ from paper currency?
DK: Paper currency can be created at the whim of a central bank. The “fiat” currencies are politicized and based only upon the issuing entity’s promise to pay. Gold is the world’s oldest currency; it was used as a medium of exchange before the Roman Empire. Historically, gold replaced barter by providing the fungibility to enable widespread trade and commerce. Gold is very hard to produce, let alone counterfeit. It represents a true measure of wealth exchange.
TGR: You mentioned that gold is a medium of exchange, so it’s a repository of value. It embodies a standard of value that represents the usefulness of other commodities, like a bushel of wheat. But if the gold itself is not the source of value, then what is the ultimate source of the value that it represents?
DK: Globally, the value of gold is rooted in supply. The supply of aboveground gold represents economic wealth, which is embodied in the price of gold, when there is a gold standard in place. A gold standard fixes the price of gold. Therefore, under a gold standard, the money supply can be increased by pulling more gold out of the ground. But if the price of gold is not fixed, then the price must rise and fall as new wealth is created or destroyed-regardless of the amount of aboveground gold in existence.
Unlike gold as money, paper currency is easy to reproduce. If the government wants to spend more money, it doesn’t have to base that increase in spending upon incremental economic output. It can just decide to issue bonds and print money to pay for those bonds. Inflation occurs when the paper money supply is increased over and above marginal economic output.
TGR: So why is the price of gold volatile?
DK: The price of gold has steadily gone up every single year for 11 years. That’s not really volatile; its one way, to the upside. The gold market is small and not very liquid. When someone wants to sell a lot of paper gold, and there are not many buyers, the price goes down, and vice versa to the upside. So we see large swings in price over short periods, but over the last 11 years, the price has only gone up. It has been less volatile than the S&P 500 over the last 10 years.
TGR: Large and institutional investors are showing some interest in gold. For example, George Soros has significantly increased his position. J.P. Morgan and other banks are investing in junior gold and silver mining companies, as are large mutual funds. Is this a significant change?
DK: A very, very small percentage of the institutional investment world is in gold-less than 1% of institutional funds globally. Very few of those institutions have taken physical delivery of gold. There are exceptions: Northwest Mutual took delivery of 400 million ounces (Moz) gold a few years ago; Texas Teachers Retirement keeps physical gold. If you look at the three cycles of a bull market-smart money, the institutions and then the public-there is potentially a huge wave of institutional investing in gold yet to come.
TGR: What metrics do you use to assess the value of junior mining stocks?
DK: We look at a range of firms: from companies poking holes in mineral lease claims to companies that have proved resources and are on the verge of becoming producers. I define a junior as a mining exploration company that’s not producing and is depending upon the market for financing. I do not invest in evergreen companies. I look for a company that has a track record of drilling results. And, I want those results to come from areas that are proven producing areas, such as the Carlin trend in Nevada or the Durango silver belt in Mexico. Ideally, I like to see an NI 43-101-compliant mineralization report showing some Proved or, at least, Measured resources. I want a company to have on hand at least a year’s worth of cash under normal operating and capital expenditure scenarios. Ideally, I want to see a large mining company as a sponsor. I want management to hold 5-10% of the equity. And the company must be operating in areas of relatively low political risk.
TGR: What happens if we have Qualitative Easing (QE) 3?
DK: Some people would argue that the market’s already pricing that in, and that’s why the entire stock market hasn’t gone lower right now. But there’s a high expectation that the Fed will not do a QE3. If it does do it, gold and silver and the mining stocks will explode as they did when QE1 was announced in 2008 and QE2 in late 2010.
TGR: China, Russia, India and the Gulf States are accumulating massive amounts of bullion. How is that affecting the market?
DK: The Western central banks have been selling off bullion for the last 15 years. What I like to call the “Eastern Hemisphere central banks” have been accumulating that bullion. There has been a transfer of bullion from the Bank of England, the European Central Bank and the Fed to central banks in China, Russia and India. A lot of people don’t realize that Vietnam is the fifth largest gold-importing country in the world. Obviously, the Gulf States have started accumulating it pretty aggressively. Recently, Mexico and some of the South American countries are showing up as large accumulators of physical gold, not through ETFs or any of the other paper forms, but actual physical gold.
TGR: How does that affect pricing?
DK: The steady climb of gold over the last 11 years reflects this accumulation by very wealthy interests in Europe and Asia. China has been voraciously accumulating gold. The International Monetary Fund sold 400 tons of gold a couple of years ago. But a lot of these central banks, instead of selling gold, are leasing it out. They rent their bullion to banks like J.P. Morgan and Deutsche Bank that turn around and sell it into the marketplace. That gold is going somewhere. It is going to these quiet accumulators of physical bullion. At some point and, again, it’s impossible to measure when, the central banks and investors that have been buying physical gold will have to get more aggressive with what they are willing to pay. That will be the next stage in the bull market.
TGR: When you talk about leasing, these companies that lease the gold aren’t actually taking physical possession of it?
DK: They’re borrowing it. Then they go onto the London Bullion Market Association and sell it. It’s a legal transaction, but it’s a paper transaction.
TGR: Is it a form of derivative?
DK: That’s correct. Say that you are J.P. Morgan and you’ve sold me some gold that you leased from a central bank. If I ask for delivery of the metal, you will have to find it and deliver it. That’s where the problems are going to start.
TGR: That certainly could be a problem. You have described yourself as an investment contrarian. What is your parting advice on mining stocks?
DK: Mining stocks are at an extraordinarily cheap level vis-à-vis their historical valuations, especially when you measure them versus the price of gold. Large and small companies are basically trading at the same valuation levels in relationship to gold that they were when gold was at $400/oz back in 2003-2004. To me, it’s the ultimate contrarian and value play to hold your breath and invest in these companies now. I think if you do it now, you’re going to be rewarded with a lot of money down the road, especially if the fundamentals for supporting gold and silver only get stronger.
TGR: OK, Dave. Thanks for your time.
DK: Thank you, Peter.
Dave Kranzler spent many years working in various analytic jobs and trading on Wall Street. For nine of those years, he traded junk bonds for Bankers Trust. He has a Master of Business Administration from the University of Chicago, with a concentration in accounting and finance. Currently he co-manages Golden Returns Capital, a precious metals and mining stock investment fund based in Denver. He writes a blog to help people understand and analyze what is really going on in our financial system and economy: www.truthingold.blogspot.com
Article published courtesy of The Gold Report