An Interview with Mark Johnson, USAA Precious Metals and Minerals Fund

    by Maria Crawford Scott

    USAA Precious Metals and Minerals (USAGX)

    CATEGORY: Miscellaneous Sector Stock

    PERFORMANCE* (as of 6/30/02):

      Fund Category
    1 Year 68.7 10.6
    3 Years 22.5 1.5
    5Years 6.4 3.0

    RISK: Above Average

    TOTAL ASSETS: (as of 9/02) $130 Million

    CONTACT: USAA Funds 800/531-8181

    Is gold staging a comeback? After enduring 20+ years of its worst bear market, gold may be awakening from the dead. And it’s doing so in typically volatile gold style, with some gold funds over the last year almost doubling in value. While the long-term numbers remain low, some investors appear willing to give gold another chance, particularly given the stock market’s current condition.

    One fund that has fared well over the long term compared to its peers is the USAA Precious Metals and Minerals Fund. The fund has outperformed its precious metals peers for the last year, three years and five years according to Morningstar. Currently, the fund has about $130 million in total assets. In early September, portfolio manager Mark Johnson discussed the management of the fund with Maria Crawford Scott.

    What is the investment objective of the fund?

      The primary objective is capital appreciation through the investment of precious metals in general, but as it works out it is predominantly investments in gold. Current income is a secondary objective.
    You are classified as a mid-cap fund, although you have investments also in small caps and micro caps. Is that a fair classification of your holdings?
      Yes, but you have to realize that this is a very small industry. There aren’t that many large caps out there. The largest company that I can think of has a market cap of only $11 billion. Compare that to GE, with a market cap of $269 billion. If you added up all the market caps of every gold producer in the world, you’d probably end up with a value that would be less than GE.
    What is the overall investment philosophy used to select stocks?
      The underlying premise is that for any commodity—whether it’s gold, oil or whatever—in the long-term only the quality low-cost producers will survive. In other words, the cycle is such that sooner or later, high-cost producers will at some point fail. So we start off by looking for low-cost producers with a high-quality line, strong managements, and good balance sheets. Now, all that means is that they’ll survive. But we want them to survive and prosper as well. So we also look for companies with identifiable growth profiles, either in terms of production growth or reserve growth, and we pay careful attention to valuations.
    What role does the price of the actual commodity itself play in the investment process?
      The cost of the commodity is critical, which is why we focus on low-cost producers. That means that we would prefer to invest in, say, Goldcorp, which is a Canadian producer, where their cost of production is $65 an ounce on a cash cost basis, versus Durban Roodepoort Deep, a South-African producer that is a very leveraged play, with a cash cost of well over $200 dollars an ounce. So, if gold were to fall below current levels of $250 an ounce, where we have been in the past couple years, Durban Deep is in deep trouble, so to speak. Goldcorp, on the other hand, will continue to generate positive cash flow. Goldcorp is a survivable company in any scenario, whereas Durban Deep is not.
    What determines the cost to a producer?
      It’s the quality of the ore body. The Goldcorp ore body is the highest grade line in the world in terms of value per ton of gold—the amount of gold there is per ton, whereas the Durbin Deep property is not as rich, plus it’s much deeper. When the mine gets deeper, the costs go up.
    What does “growth prospects” mean in terms of a mining company? I’m used to thinking of growth prospects in terms of markets for selling the product, but mining companies already have that.
      You’ve hit that nail right on the head—the market’s there for a commodity every single day. Growth prospects for a mining company means growing production. It could mean the availability of new mines, or the ability to grow production at current mines.

      Meridian, one of our largest holdings, has just one mine now, which they’re not going to grow. But they’re developing a new mine in a different country and that’ll cause their production to double over the next couple of years.

      For Goldcorp and Agnico-Eagle, two of our other large holdings, it’s going to be a question of growing at their existing mines.

      Goldcorp will grow primarily by discovering more ounces in the ground. They’ve got an extremely rich ore body that they haven’t fully explored yet. They’re probably not going to actually grow their production, but they’re going to grow the number of ounces that they have on their balance sheet, and the market has historically paid for ounces on the balance sheet.

      With Agnico-Eagle, that company will be expanding the capacity of their mine by about 50% over the next couple of years. That will also help to reduce their costs.

    What do you look for in the balance sheet—low debt?
      Yes, low debt. Meridian and Goldcorp have no debt at all. Plus, they are generating constant cash flow, so they can cover their capital needs with part of their cash flow. That means they’re not going to have to come to the market to raise cash when their stock price is down.

      We also prefer, but don’t require, companies that haven’t entered into derivative contracts or forwards on their production—these are known as managed producers. Companies that do that cap their upside—they run the risk of not benefiting should the price of the commodity move up and they have low price contracts. They aren’t necessarily bad: A company can make extra cash flow, and even if gold moves up dramatically, say to $400 an ounce and the firm has contracts requiring them to deliver at $300, they won’t actually lose if it is above their cost of production. But they’re selling gold at $300 while everybody else is making $400.

    How do you measure value in a gold stock?
      There are two criteria. One is the price-to-cash-flow ratio, and the other is price to net asset value. We don’t think that earnings are particularly relevant to these companies.
    How do you come up with a net asset value?
      It’s actually easier for a gold company than it would be for a technology company or probably 90% of the companies out there because you have an identifiable asset. You know approximately how many ounces of gold are in the asset, and you know approximately what it’s going to cost to produce it, so you can work out the net asset value pretty easily.
    Do you purchase companies only if they have good valuations?
      Basically, we look for companies that come closest to having the five qualities I mentioned earlier: high-quality assets, good balance sheets, strong managements, identifiable growth profiles and last, but not least, valuations.

      If you look at the three largest holdings we have, Meridian Gold, Goldcorp and Agnico-Eagle Mines, those are probably three of the more expensive stocks out there, quite frankly. However, they all have really great assets, they are all well managed, two out of three have really clean balance sheets, and all three of them have strong, identifiable growth profiles. So they meet four out of the five criteria. It’s pretty rare to get one that meets all five criteria.

    What do you look for in a company’s management?
      Basically, three things. First, we want managers who can articulate where they want the company to go—they have a strategic vision. There’s a tendency for people in this industry to think myopically about their most recent project, they aren’t able to think strategically in longer terms as to where they want to position the company.

      The second thing I look for is operational excellence—they’ve got to be able to have the engineers and the geologists on the ground, and they should deliver good operational performance at the mine level. The third thing I look for in management is a strong sense of ethics. I want honest people who aren’t going to play games with us.

    How do you judge that?
      There are two ways you can go about it. One is simply checking the financial statements and the accounting—especially the accounting. Generally, companies that will play around ethically will also play around ethically with their accounting standing. The second way is through industry scuttlebutt. If you know the people in the industry, you eventually learn about these things. And the third way is simply talking to the managers, particularly on management projects, to see if they really know what they’re talking about.
    It seems that ethics issues plague the industry.
      Absolute and outright fraud? That’s a problem. And that’s a hard one to get around, particularly in the exploration area because you’re only talking about a piece of ground and some exploration results that the company has come up with. So we limit our exploration holdings.

      The fund is roughly 80% in gold, but it also holds platinum and diamonds. What role do platinum and diamond investments play in the portfolio?

      The cycles are different. If gold is having a major run, the other two might lag and the reverse is true as well. They stabilize the performance, making the fund less volatile.

      For instance, currently we have diverging views on the outlook for gold and platinum. We feel we can make a very good case for a rising gold price in the future, based primarily on the U.S. dollar. Gold is inversely correlated with the U.S. dollar.

      As far as platinum goes, should we have a double-dip recession—I’m not expecting one, but it’s a possibility—that would hurt platinum more than it would hurt gold, largely because with platinum, over 50% of demand is related to auto catalysts for environmental control purposes.

    What would cause you to sell a particular holding?
      It’s the inverse of the five criteria that I mentioned before. We won’t want the companies to the extent that they don’t meet those five criteria. It’s a mirror.
    The fund appears to have relatively low turnover.
      This is a far more stable industry than, say, technology, where one quarter a company may be going through the roof and the next it is contemplating Chapter 11. And these mines tend to have multiple-year mine lives and fairly well-defined economics, barring geo-political problems—they generally don’t change over night.
    Your fund has done better compared to other gold funds. What would you attribute that to?
      One part of it is good stock selection. We benefited from a number of stocks that did quite well both because the company did well and because of consolidation, where a couple of names got bought out. We also bought some cheap stocks, where we benefited from rising valuations.

      I think owning growth firms helped us, because with growth companies, time is your friend. Some gold companies, especially in South Africa, are looking at declining production levels. Their mines are getting deeper, the grades dropping over time, and it just becomes increasingly difficult year after year to produce the same number of ounces.

      In a flat gold price environment, Meridian’s earnings are likely to go up over the next several years, whereas the older producers are more likely to go down.

    The long-term performance of gold—the last 20 years—really hasn’t been very good. What would you attribute that to, and what’s your long-term outlook going forward for gold?
      Why did gold do so poorly? With gold, back in the days of inflation in the late 1970s and early 1980s, it got up to $800 an ounce or something like that. Everybody and their brother went out and sunk money into new mining projects. That’s a lot of mines. And there were some technological breakthroughs in terms of how to produce gold more cheaply. That was it—the explosion of supply, coupled with the elimination of inflation. And of course the bull market in stocks.

      In terms of our outlook, we’re positive both in the short term and long term.

      In the short to intermediate term, our outlook is positive based on the declining U.S. dollar.

      Longer term it’s positive based on supply and demand characteristics. There’s been very little done in the past several years in terms of exploration because of low gold prices. As a result, there isn’t much out there in terms of new gold mines coming on the train to replace old mines going off the train. So supply over the next several years in the mines is likely to drop. And there are some people who make the case for significant drops. At the same time, we see the demand continuing to rise with rising world GDP [gross domestic product], which it historically has.

    Why should individual investors include gold in their portfolio holdings?
      We think that holding gold serves two purposes in an investor’s portfolio.

      One is to make money, since we think that the gold price will rise from here as the U.S. dollar declines. But that’s more of a short-term reason.

      The second reason is even more important than the first, and that is that gold actually reduces portfolio risk. Even though gold stocks are themselves very volatile securities, they are inversely correlated with other financial assets—they tend to go in the opposite direction, and that reduces overall portfolio volatility. In the situation that we have had in the last couple of years, when the S&P 500’s been dropping like a rock, the odds are in that environment that your gold position’s going to be doing fairly well—which it is. And that would serve to moderate and stabilize overall portfolio returns in an otherwise miserable environment. And it doesn’t take that much gold to do it either—a 4% position is sufficient. So, that’s the longer-term reason to hold gold.

→ Maria Crawford Scott