Investing in Gold Mining Equities

EMS:

Hi, Brian, thank you so much for being with me today.

Brian Hirschmann:

Thank you. It's great to be here. Thanks for having me.

EMS:

Absolutely, Brian. So, to kick off the conversation, tell us a little about your firm and how you got to where you are today.

BH:

Sure. My Senior Essay Adviser and Professor when I was in college was David Swensen, the legendary former head of the Yale Endowment. And one of the many things that Swensen is famous for is pointing out the many conflicts of interest that are in the investment management industry and contribute to poor returns for clients. So, when I launched Hirschmann Capital a decade ago, I wanted to create a superior fund that was consistent with the principles I had learned from Swensen and from other great investors like Warren Buffett. For example, nearly every fund in the industry is paid based on assets under management or AUM, and that, of course, incentivizes firms to focus on increasing AUM and focus on marketing. But the problem with that is that higher AUM is bad for clients because it limits the universe of securities and companies that a fund can buy, and it raises trading costs. So, as a solution, my fund is one of the very few in the world that doesn't charge any management fees, only a performance allocation above a 6% hurdle rate. We use the same fee structure that Warren Buffett used for his hedge fund before he went on to Berkshire Hathaway. So, I only do well if the client does well, and in addition, I'm the second-largest investor in the fund. So, there's very good incentive alignment. Another thing that Swensen and Buffett talked about is that the best way for an investor to outperform was by being a long-term contrarian investor. Because everybody wants to make a quick buck, so there's a lot more competition for short-term investments. But what I found is that although nearly every firm says that they are a long-term... Or many firms say they are long-term contrarian investors, in reality almost none actually are. And I think a big reason for that is a lot of firms have institutional clients that are neither long-term nor contrarian. For example, a pension fund manager might be a typical hedge fund client and the pension fund manager is often very focused on keeping his job. And the best way to do that is often to avoid long-term contrarian investments because if you invest in an out of favor undervalued security, there's always a chance that a cheap stock will get cheaper. And so, it's very easy for the pension fund manager to get fired if the investment doesn't do well initially because he stuck his neck out and did something unconventional. Whereas if the pension fund manager sticks to the same portfolio that everyone else has, even if the portfolio does very poorly, he'll probably keep his job because he was doing the same thing as everyone else. And so that kind of consensus driven short-term focused behavior carries over to the hedge funds and private equity funds that the pension fund manager hires. And therefore, pretty much everyone who's investing on behalf of the pension fund is often afraid to make the kind of long-term contrarian investments that are usually necessary to outperform. So, my solution to that is my fund only accepts capital from owners of the capital because it's very hard for a wealthy family... It can't get fired from managing its own money. And so, if the family understands why an investment strategy should deliver long-term outperformance, they can stick with that strategy through the inevitable periods of short-term underperformance. And so, I think these incentive and time horizon advantages have been a big reason why my fund has outperformed all its gold benchmarks over the last decade. And as we'll probably talk about today, I'm very confident that the best is yet to come.

EMS:

Brian, as a follow-up, given your focus on investing in gold, love to hear your high-level outlook for the space.

BH:

Sure. In short, I think this is probably the most dangerous time in U.S. financial history because it's the first time any major economy has had three bubbles, three large bubbles in equities, real estate, and bonds all at the same time. And I think there's a good chance that all three of these bubbles will burst at the same time, and that could happen soon. But the silver lining is that should be the opportunity of a lifetime for gold investors. As an example of the equity bubble, last month, U.S. equities reached their highest market capitalization to sales ratio ever, and their highest market capitalization to replacement cost ratio ever. And in the real estate market, the price to rent ratio and the price to income ratio are near all-time highs, even higher than they were during the 2000’s housing bubble. And in the bond market, we still have very low interest rates even though government debt is at levels that have always led to default in the past. And the consensus is that all of this is okay because the government will always be able to bail out the economy and lower interest rates to zero. But I think that couldn't be more wrong. If the government could always bail out the private sector and if the government could always keep interest rates at 0%, then it would've been discovered 2000 years ago, not in the last decade. So instead of a bailout, what I think we're likely to get is a government debt crisis with much higher sustained inflation and much higher interest rates because the U.S. has this toxic combination of high deficits, high government debt to GDP, elevated inflation, and high borrowing from foreigners. And the high deficits and high debt to GDP are a problem because it means our government debt is growing faster than our capacity to pay. And the elevated inflation is a problem because it means the U.S. government has already started to default through high inflation. And the high borrowing from foreigners is an issue because foreign lenders tend to be more fickle... Foreign investors tend to be more fickle and tougher to control with regulations. And so, there's many studies that show that governments that borrow a lot from foreigners tend to have crises more often and sooner. In fact, there's been 21 instances of this combination of four factors globally since 1914, and all 21 of those countries defaulted within two years. And their median average annual inflation over the subsequent four years was 18% and none of them were able to avoid sustained high inflation through a recession or some central bank policy. And what's important to remember is if a government is having a debt crisis and is defaulting through inflation, it loses its ability to bail out the private sector because if you already have high inflation and then you cut interest rates to zero, that's just going to cause more inflation. Or if investors are already worried about how much debt a government has and then it starts taking on additional debt by bailing out the private sector, then that's just going to cause more inflation and worsen the crisis. So, instead of a bailout, what we're likely to get is a doom loop where a government debt crisis torpedoes the private sector and that in turn makes the government debt crisis even worse. And that's similar to what's happened recently in countries like Argentina, Greece and Turkey. So, I agree with Jim Rogers that the next bear market may be the worst of our lifetimes, but the silver lining is that should be an incredible opportunity for gold investors.

EMS:

And Brian, more specifically, where do you see some of the greatest opportunities in your space and why?

BH:

Sure. As these bubbles implode and the U.S. government defaults through inflation, I think the gold price should soar dramatically. And why is that? Well, the first reason is that inflation reduces the value of fixed dollar amounts, of fixed payments in the future, which is why inflation is a disaster for bonds. But gold doesn't depend on fixed payments in the future. And so, when you have an inflation crisis, investors often shift from debt such as bonds to gold, and that causes the gold price to soar. We saw an example of that in the 1970s when gold's valuation reached an all-time high. And it's important to remember that right now, the value of all the world's debt is about 20 times the value of the world's gold. So only a small shift in investors' allocation from debt in bonds to gold could potentially cause a huge increase in the gold price. The second reason gold would do well in a crisis is that in a crisis defaults of both governments and corporations would increase. And as the cliche goes, gold is the one asset that is no one's liability and is thus immune from default risk. And so, when you have a big increase in defaults and a big increase in risk aversion, investors tend to shift from gold. And so right now gold's valuation is around its 50-year average, despite all these risks and despite this looming inflation crisis. And so, if gold returns to its peak valuation in 1980 at the tail end of the last inflation crisis, then its price should go to more than $7,000, a huge increase. And to answer your question more directly, I think the best opportunity is in the sorts of small gold mining equities that my fund owns because for one, they should go up even more than the gold price when the crisis inevitably occurs. And one simple reason for that is operating leverage. For example, if you have a gold mine with a 50% profit margin and then the gold price goes up 10%, then the profits of the gold mine would go up around 20%. And so, the stock price should go up much more than the price of gold. And that operating leverage effect can be very powerful. For instance, we currently own a company that's trading for $5 per gold resource ounce, which means gold in the ground that they own, but they haven't yet mined yet. And if the gold price returns to its 1980 peak valuation, that company could go from trading for $5 per ounce to more than $500 per ounce, so potentially more than a 100x return. And then at current gold prices, our companies are still trading at a fraction of their present value. So, if gold prices don't go anywhere, I would expect our portfolio to continue to appreciate as valuations improve. For example, this year, the fund is up around 60% year-to-date, even though the crises haven't yet started and even though it seems as though the U.S. economy hasn't yet entered a recession. And if the gold price dips temporarily, I think any impact on the small gold mining equities that we own will be temporary, again, due their low valuations, their low production costs, and also since they have no debt. And so regardless of what happens with the gold price in the short term, I would expect our portfolio to outperform dramatically over the long term. And an important reason for that is that my fund has total flexibility in the sorts of gold projects that it invests in. Whereas if you invest in the gold mining index or the gold mining ETF, which many investors do, then the index is restricted to only companies over a certain market cap and to only companies that are already producing gold. And so what my fund can often do is buy high quality companies that have been orphaned and are trading at a low valuation simply because they're not eligible, they're a little too small for the index, or we can invest in high quality deposits that are trading at a big discount because they're not yet producing, and then we can sell them at a much higher price once they start producing and a flood of index buying has driven up their valuation. And examples of that would be when we invested in Atlantic Gold in Canada or Capricorn Metals in Australia.

EMS:

Brian, on the other hand, what are some of the greatest challenges you face and why?

BH:

Sure. So, one challenge is that in the short term, gold mining equities can fluctuate in value due to changes in the gold price and production results and exploration results. So, I think they're only appropriate for a long-term investor. And another challenge is that these bubbles have lasted for a very long time, and they could last longer, but I think all bubbles eventually break, and the bigger a bubble gets and the longer it lasts, the more we should profit when they inevitably do burst. And so, I don't think it matters a whole lot whether a crisis happens in 2024 or 2026, inevitably gold should skyrocket, and in the meantime, our gold mining equities should continue to appreciate by producing cash and finding more gold. And so that's a big difference between other bearish strategies such as buying put options where you tend to lose money over time if a crisis doesn't happen.

EMS:

Brian, we've covered a lot of ground today and wanted to see if there are any final thoughts you'd like to share with us.

BH:

Yeah. When a crisis happens, as I mentioned, I expect gold to skyrocket, and I think the valuation of the S&P 500 will probably get crushed, but that'll create incredible opportunities in sectors such as health care, consumer goods or industrial equipment. So, if I'm on the show again, perhaps I'll be talking about investing in small technology companies rather than gold mining equities.

EMS:

Brian, I want to thank you so much for sharing your perspective with our listeners.

BH:

Thank you. Thanks for having me.

EMS:

And thank you for listening to the EisnerAmper podcast series. Visit EisnerAmper.com for more information on this and a host of other topics. And join us for our next EisnerAmper podcast when we get down to business.

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