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May 29, 2002

O Brother Homestake, Where Art Thou?
by John Hathaway

"If I buy a gold stock, it's because I expect the gold price to go up. Why then would I buy shares of a company that hedges the gold price?" Such concerns are the subject of frequent e-mails to the Tocqueville web page asking what exposure The Tocqueville Gold Fund portfolio (TGLDX) has to hedged producers.

Do investor preferences make any difference to the performance and valuation of gold equities? It has seemed indisputable to me for years that exposure to a rising gold price creates value while hedging detracts. It is clear that the top performing shares of the last two years have been the unhedged producers, while the laggards have generally been lugging a hedge book. Over the past two years, the Amex Gold Bugs Index (HUI) rose 137% versus 49% for the Philadelphia Gold & Silver Index (XAU). The HUI index consists of unhedged gold equities, while the XAU is dominated by Barrick Gold, Placer Dome and Anglogold, three of the leading hedgers.

A recent prize winning (International Precious Metals Institute) thesis written by Matthew Callahan, a second year business school student at the Leonard Stern School of Business, substantiates these views. Titled "To Hedge or Not to Hedge", Callahan states, "gold mining firms that aggressively hedge gold price risk are not maximizing shareholder value. These results provide empirical ammunition to the argument against hedging in the gold mining industry." He goes on to say that "the reduction of the volatility in cash flows (from hedging) may not translate into a reduction in volatility of the stock price. In any case, it appears that while Barrick's hedging efforts make the firm's revenues more predictable and may lower risk, this is counter to any shareholder wealth maximization strategy…"

In Callahan's paper, which is published this month in the NYU Salomon Stern Center Working Papers, a firm's alpha is the proxy for value creation. Alpha, a measure of a firm's excess returns relative to the market, is the intercept of the linear regression of a stock's returns against the market's returns. The fact that the period studied was 1996-2000, a time when gold was locked in a twenty-year downtrend, renders these findings even more compelling. Callahan also noted a positive correlation between volatility and alpha in the gold sector. Conversely, there was a negative correlation between hedging and volatility, as one might expect.

It is fair to say that gold mining shares in this respect differ from other market sectors, where the predictability of outcomes has historically been highly valued. It suggests that the attempt by gold hedgers to introduce predictability, while well intentioned, has failed because it ignores the bedrock principal of all gold investors, stated at the outset: "I buy a gold stock because I expect gold to go up". The desire is for exposure to a rising gold price, whether or not that turns out to be the case.

In a February 1, 2002 research study, Barry Cooper, a veteran gold mining analyst at CIBC World Markets, asserts "the market appears to ascribe a bullion option value to gold equities in addition to their NAV (net asset value). Our methodology has predicted share prices to within 10% of market values 78% of the time within the last six months…" He goes on to say "that the largest component of the option value is the right to participate in future gold price swings. In congruence with option fundamentals, these are long-dated, in-the-money options that carry significant option value in excess of the NAV."

Value investors often have difficulty coming to terms with gold shares because they usually seem expensive based on the traditional metrics of P/E multiples, price to cash flow, price to sales, etc. The valuation method most widely used by many gold research analysts is the discount or premium to NAV, which in turn is calculated as the present value of cash flows from reported mine reserves at some specific gold price assumption and some specific discount rate. More often than not, shares trade at a premium to NAV and the premium itself implies some level of expectation as to future gold prices. The NAV methodology and its variations have value in that they incorporate published financial information, inputs which cannot be ignored. However, they do not directly address the option component of valuation, which is the central explanation of where the shares are trading. Regardless of methodology, gold equity valuation metrics have light years to travel before they approach the absurdity best captured in the notion of "clicks per eyeball" at the height of the dot com craze. Gold shares will trade where they will based on investor expectations of future gold prices. Right now, those expectations are for significantly higher prices. Hedging, at the very least, detracts from that exposure. At the very worst, it threatens corporate viability, as exemplified by Cambior and Ashanti in 1999.

For a cogent explanation of the rationale for hedging, look no further than the 2001 Barrick Gold annual report. Within the footnote on derivative instruments (page 81), it states: "The Company's risk-management program focuses on the unpredictability of commodity and financial markets and seeks to reduce the potentially adverse effects that the volatility of these markets may have on its operating results." In other words, Barrick management prefers to be agnostic on the subject of gold prices. Fine, but that's not what investors want.

For an explanation of this apparent divergence between management actions and shareholder interests, refer to the Barrick 2001 proxy statement. It shows that corporate management has a very small personal financial commitment and stake in the performance of the shares. Commitment is evidenced in shares held outright. An option position, which costs the manager nothing but entails potential dilution risk for the shareholders, invites opportunism. For example, the Barrick CEO owns outright only 10,200 shares, worth approximately $200,000 at today's market price. For an executive earning US $1.4 million a year, this miniscule share position does not pass muster as an incentive. Barrick is not the only example of a divergence between management and shareholder interests. A similar pattern can be discerned in the proxies of other hedgers.

One could infer as a possible and charitable explanation for this disconnect that the managers equate stable, predictable cash flows, which might translate into the financial strength necessary to build a bigger enterprise from which all stakeholders might benefit, including shareholders. An important reason for the rise of gold hedging during the 1990's was the generational transition in senior management. Hard-core gold bugs, who failed to generate returns on capital within a declining gold price environment, were replaced by no-nonsense apparatchiks who saw gold as just another commodity. The 1990's culture in which both financial engineering and stock option packages thrived goes a long way to explaining both why the new breed of management cared little about gold as money and their willingness to pursue dilutive acquisitions (Homestake-Acacia, Anglogold- Normandy, and now, Placer Dome-Aurion, for example).

Contrast the Barrick example to the manager-shareholders of Franco Nevada who hold a substantial personal stake in the enterprise. Having tried once only to fall short of achieving a merger with Goldfields of South Africa, Seymour Schulich and Pierre Lassonde engineered the three-way merger between Newmont, Normandy, and Franco. The stated objective was to convert their personal wealth in Franco into an unhedged entity with full upside exposure to gold. This strategy and vision was, in my opinion, an important reason why Normandy shareholders preferred the Newmont proposal to that of Anglogold, a prominent hedger. Other examples of pro gold, staunch anti-hedging managements with significant equity commitments are Harmony, Goldfields, Iamgold, Goldcorp and Agnico Eagle. (This is not an all-inclusive list and I apologize to the many I failed to include.)

At the end of the day, hedging was nothing more than an devious and complicated way to finance a declining business. Complexity in monetary matters, in the words of John Kenneth Galbraith, " is used to disguise truth or to evade truth, not to reveal it." The truth about gold hedging is that it is a short sale, which can be covered in only two ways. First, it can be covered as gold produced by mines is repaid to the bullion dealers, who in turn repay the original central bank lenders. However, this method of repayment takes time, often years. Such a delay might be excruciating in a rapidly rising price trend. What is also interesting about this method of repayment is that it actually reduces the supply of gold because gold earmarked for repayment never hits the market. The second method of repayment is outright purchase of physical gold on the open market. If done in an orderly, measured fashion, open market purchases are probably feasible. However, if all the shorts get the idea at the same time, it would be very difficult to cover because the amount of this short interest is at the very least 4,000 tonnes, or more than 1.5 years of new mine supply.

What is happening in the gold market currently is that the hedged mining companies, after having taken a pasting in the form of share underperformance and vocal criticism from the investment community, are beginning to capitulate. Recently, Durban Roodeport, a South African mining company, recently raised cash through a new share issue. The use of proceeds was to purchase gold on the open market in order to close out its hedge book. Other miners have been quietly writing puts at strike prices below the market, in the hopes that they will become long gold on pullbacks. However, the proliferation of puts only serves to put a floor beneath the market. Several prominent hedgers, including Anglogold, have reduced their hedge books and numerous others have stated that, at the very least, they will not increase their hedge books and are in the process of reviewing their hedge exposure. The intellectual case for hedging appears to be in tatters and there appear to be very few who would advocate it vociferously. The recent rise in the gold price has all the appearance of a slow motion short squeeze, which could well get out of hand if too many rush for the exits.

To say that hedging has become a bad word is hardly news, even to those who had never heard about the 1999 tribulations of Ashanti and Cambior. The very existence of these two companies was jeopardized by the spike in gold prices caused by the announcement of the Washington Agreement in 1999. At the recent Berkshire Hathaway annual meeting, Warren Buffet predicted that derivatives, "a major business for Enron, would also trip up other firms. There's no place with as much potential for phony numbers as derivatives." Buffet probably did not have the gold market in mind when making this dire forecast, as the profile is far more obscure to the general public than Enron. Nevertheless, the heavy use of derivatives, off balance sheet financial commitments, and poor disclosure characteristic of the Enron debacle are also present in the gold market.

In Barrick's first quarter financial release, footnote # 5 on derivative instruments takes up 6 pages of a 34-page document. This sort of extensive disclosure, while admirable in many ways, reflects the influence of the post Enron financial markets as well as investor concerns on the matter. I have no doubt that the Barrick management is as professional and competent as any in the matter of hedging. There is nothing to suggest that Barrick's exposure is of the same risk magnitude as 1999 version of Ashanti and Cambior, or the 2001 version of Centaur, or the current version of some of the heavily hedged Australian mines. Clearly, Barrick's considerable percentage of unhedged ounces will provide substantial upside to a higher gold price and strengthen their already strong credit position. Still, as an investor these days, I yearn for simplicity. Why try to decipher what is nearly indecipherable?

On May 8, Barrick issued an interesting postscript to its first quarter press release, just seven days earlier. The company stated that it would be "simplifying" its "Premium Gold Sales Program", i.e. hedging operation. First, it would not renew certain call and variable price sales contracts, and expected this position to decline by 3 million ounces in '02. Second, "the company will no longer invest a portion of its spot deferred contracts in corporate bond funds, and will instead leave all proceeds invested with its average AA-rated bank counterparties" (emphasis obviously added). What is this all about? What are the counterparties nervous about? Is this a sort of margin call or just a tighter leash? There are undoubtedly many good answers and explanations, but as an investor, I am not interested.

In the fourth quarter Office of Comptroller & Currency's (OCC) report on derivatives, it is interesting to note that the JP Morgan Chase gold derivatives exposure rose slightly over the previous quarter. The increase is curious in light of the fact that gold producer hedge books declined by 75-100 tonnes in 2001, the first such decline since 1982 based on GFMS data (Goldfields Mineral Service). This is not to single out JP Morgan Chase. However there is no public information on two other major gold derivatives players, J. Aron (Goldman Sachs) and Morgan Stanley. In addition, a number of non-US institutions retain gold derivative exposure. In a previous report, The Investment Case For Gold, I commented on the shrinking number of institutional players within the bullion dealer community, a reflection of the increasingly unappealing economic and risk profile of facilitating new or servicing existing hedge positions for the gold mining industry. I speculated that the remaining bullion dealer gold derivative positions were like toxic waste dumps, a stale short position, with a dwindling number of proponents or members of management willing to take responsibility.

Without mentioning names, some of the most prominent architects of the gold derivatives trade, in which financial institutions act as intermediaries between central banks and mining companies to effect a short sale of gold, are no longer in a position to act as cheerleaders. As with all corporate write offs, disappearance of original sponsors for any cause clears the way for successors to reclassify a sacred cow as the white elephant it always was. Usually this transition leads quickly to a "let the chips fall where they may" mode, which allows full loss recognition. There is, however, one big difference between a corporate write off and covering a short position. The first instance involves an immediate accounting write down, with physical transactions such as layoffs, shutdowns, or asset dispositions to follow at an orderly pace. The second instance allows for no such interlude. In fact, the simultaneous recognition of being significantly offside in financial markets is probably the single most powerful force underlying volatility. I believe that the gold market is approaching this juncture.

What about the central banks who in the past were famous for their willingness to stuff any significant price rally with an "injection of liquidity?" Central bankers are only human. Once, they were only to happy to pile on to the downtrend in the dollar gold price by outright selling and lending of gold reserves in order to accumulate more paper assets. Now, they find themselves in the position where their principal reserve asset, the US dollar (representing 76% of world central bank reserves) is declining in value against the gold they were dumping as well as their holdings of other paper currencies. What they are loaded with is their worst asset. Since they are only human, it would be most surprising if they decided to sell what little (proportionately) remains of their best asset into a rising market. It would not be surprising if net sales of central bank gold have already seen their high water mark. The discussions between bullion dealers and central bankers on rollover of existing loans should become extremely interesting following a sharp rise in the gold price.

It has been about a year since Homestake management agreed to be taken over by Barrick Gold. Since then, much has happened in the gold world, most of it good. As candidate Ronald Reagan once asked rhetorically, are the shareholders better or worse off today given what has happened? Homestake, once a household name in the gold sector, was the purist's gold stock. It was a refuge for assorted curmudgeons such as myself who had no desire to view the world through the rose colored lens of CNBC. Staunchly conservative accounting, a strong balance sheet, and a perceived antipathy to hedging created the sort of mystique appealing to gold investors. It is ironic that Barrick, the gold stock for agnostics, became its merger partner. According to Barry Cooper's analysis, Homestake shareholders are about as well off as part of Barrick as they might have been had the company remained independent. However, that is not the real issue. How will they fare once gold exceeds $400? In that instance, it seems fair to say that they will have lost out.

Running the shorts is only a small aspect of the investment case for gold. Much more important are the overvaluation of the over-owned US dollar and the prospect for a continuation of poor returns on financial assets. Wherever the gold price settles after this current squeeze remains to be seen. In my estimate, however, it will be at levels high enough to make the remaining shorts uncomfortable. It will not retreat to a level where they can make good on their bad bets. Undoubtedly, there will be bone-rattling corrections designed to shake out latecomers, momentum investors, and other weak holders. The gold sector is notorious for volatility and huge swings in sentiment. On the other hand, will mining companies attempt to rebuild their hedge books and once again try to outsmart the gold market? I suspect that such a prospect will require a new generation of management.

John Hathaway
© Tocqueville Asset Management L.P.

This commentary is not an advertisement or solicitation to subscribe to The Tocqueville Gold Fund, which may only be made by prospectus.

The Gold Fund is subject to the special risks associated with investing in gold and other precious metals, including: the price of gold/precious metals may be subject to wide fluctuation; the market for gold /precious metals is relatively limited; the sources of gold/precious metals are concentrated in countries that have the potential for instability; and the market for gold/precious metals is unregulated. In addition, there are special risks associated with investing in foreign securities, including: the value of foreign currencies may decline relative to the US dollar; a foreign government may expropriate the Fund's assets; and political, social or economic instability in a foreign county in which the Fund invests may cause the value of the Fund's investments to decline.

Nothing herein constitutes investment or any other advice and should not be relied upon as such. This document has been prepared solely for information purposes and does not constitute an offer or an invitation to buy or sell securities. Tocqueville Asset Management L.P., their affiliates and their officers, directors, employees, advisors or members of their families as well as the clients for whom they manage portfolios; 1) May have positions in securities or options of issuers mentioned herein and may make purchases or sales of the securities or options while this publication is in circulation; 2) May hold directorships in corporations discussed in this publication.

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