Frank Holmes: Gold Is for Fighting Deflation, Not Inflation

Whether out of fear or love, everyone is running to gold, says Frank Holmes, head of investment firm U.S. Global Investors. The lengthy Congressional battle to raise the debt ceiling left many investors clinging to gold for safety. But a growing world population continues to stock up on the honeyed metal for weddings and holidays. In this exclusive interview with The Gold Report, Holmes explains where our love-hate relationship with gold is headed and how to profit.

Companies Mentioned: Coeur d'Alene Mines Corp. - Franco-Nevada Corp. - Gran Colombia Gold Corp. - Randgold Resources Ltd. - Romarco Minerals Inc. - Royal Gold Inc. - Silvercorp Metals Inc.

The Gold Report: After the protracted battle in Congress over the debt ceiling and budget cuts, there were some expected consequences and some unintentional ones. What trends in precious metal equities have developed as a result of the activity in the last few days?

Frank Holmes: After the recent sell-offs, almost every equity market is in bear territory and deeply oversold. According to our mathematical models, gold is the only exception. There is a huge fear trade going on—a flight to safety.

The rhetoric surrounding the debt ceiling proved that politicians are not serious about balancing the budget. This is alarming to investors. Add to that unease the European contagion potential where many German and French banks have been selling their gold for the past five years to buy sovereign debt. Gold was not considered Tier 1 capital and was carried at a discount. These central banks sold their gold at $500, $600, $700, $1,000/ounce (oz.) to buy Greek, Portuguese, Italian and Spanish bonds in an attempt to earn a higher interest rate. If any of those countries were to default, then German and French banks would not be able to lend. This fear is very significant.

TGR: What do you see as a resolution? Or is there a resolution?

FH: The most significant factor in our capital markets is regulations, or "oppressive regulations," as Bill Gross, founder of Pacific Investment Management Co. LLC (PIMCO), calls it. The cost of regulation is so expensive; it's like injecting cholesterol into the veins of the economic system. Blood has to flow freely through an economy to get growth. Right now, all we see is an exponential growth of regulations. The Dodd-Frank Act regulations are only supposedly 10% implemented. That leaves a lot of blockage yet to come.

The financial sector, which is the second biggest sector of the S&P 500, is leveraged 12-to-1. Federal Reserve Chairman Ben Bernanke can inject capital into the market, but if it is overwhelmed with regulations, there is not going to be turnover of that money supply. We will see continued deflation.

You can see how it's creating a traffic jam. It's not just political. It's not just an issue of Democrats versus Republicans. Runaway regulations on steroids are jamming down every aspect of the economic system.

TGR: Gold stocks should have some significant positive fallout as investors clamor for safety. Are exchange-traded funds (ETFs) going to see the bump first?

FH: Gold equity bullion ETFs have made it easy for investors to get gold exposure. However, I think that gold has gone up exponentially and is due for a correction. It's up more than 36% over 12 months. Any time it makes a move like that over 12 months, there is a 90% probability of an 8% to 15% correction.

But there are themes in play that are favorable to gold, such as the "love trade." The world's population has doubled since the 1970s. Half of that population gives gold for religious holidays, weddings and birthdays. There is a high correlation of the gross domestic product of countries that follow these practices and growth to the consumption of gold. The World Gold Council said that rural housewives in India hold roughly twice the amount of gold that the U.S. has stored in Fort Knox.

We have noticed in our financial models that any time a government pays less on their Treasury bills than inflation, gold starts rising in that country's currency. Of the seven most industrialized countries in the world, only one has a positive real rate of return above inflation. China, India, Russia, the U.S., Europe—they all have negative real rates of return. They are all offering a negative real rate of return in short-term deposits and bonds. Gold will start to rise on that financial aspect. Add in the deficit spending taking place and that gold is in a secular bull market, and investors should want to add to their positions.

TGR: How do banking regulation and models like the international bank capital accords, Basel I and II, play into this?

FH: Now we are going to Basel III, which is basically banking requirements for how much capital they have to lend against. If a bank has $1 billion (B) in capital, that means that it can take deposits and have a debt portfolio of $12B, or 12 times that. But what do they put up for $1B of capital? Gold was always classified as a lower tier asset class, meaning it had to be carried at a discount. It was never treated as money. Basel III, coming out in the fall, will treat it as sovereign debt.

Central bankers sold their gold to buy junk debt. Now there is going to be a shift in central bank buying. During the past eight years, emerging markets have been buying gold. India bought $6.7B in gold in 2009 from the International Money Fund. Recently, South Korea and Mexico bought tons of gold. Once Basel III goes through, central bankers in Europe along with commercial banks will likely become net buyers of gold. That will change the landscape as gold will be treated equally with sovereign debt.

Along with the backdrop of rising GDP-per-capita in emerging countries, gold has a probability of doubling over the next five years. The last bit of math that has a high correlation to gold from a financial point of view is money supply growth. The G7 countries have money supply growth on a year-over-year basis of around 4%. Emerging countries have slowed down to 18%. I think that money supply in these emerging economies will continue to be strong. They haven't been cancelling huge infrastructure projects such as the mega-railway project in China. The country earmarked $300B to connect 700 million people with high-speed trains. I think that will add to the gold consumption because this is highly correlated to rising GDP-per-capita.

TGR: Wouldn't new construction also have a positive effect on base metals?

FH: Yes, it will. There is no doubt. Fear of a slowdown and a recession could cause copper prices and other metals to correct 10% or more, but they won't collapse like in 2008. This build-out will continue. Investors should use this type of correction to their advantage. We tell investors that volatility is only dangerous if you are borrowing against it.

In any 12-month period during that past 10 years, it has been a non-event for gold to go up or down 15%. Any time it goes up twice that then there is a 90% probability of a correction. During the last nine months, gold stocks have been underperforming bullion. I think the greatest opportunities are picking gold stocks where investors can get dividends that are higher than a five-year government note. Franco-Nevada Corp. (TSX:FNV) is a classic example. It pays a monthly dividend. The yield is higher than any government debt. It has no debt on its balance sheet and management owns a big piece of the company. Since 2007, it has a growth rate of more than 30%.

TGR: Franco provides good diversification and a kind of mutual fund approach through various royalty interests.

FH: It's a brilliant model with high profit margins. Since it went public as a spin-out from Newmont Mining Corp. (NYSE:NEM), Franco-Nevada is up about 300%, while Newmont is up about 6%. It just goes to show that having growth, revenue-per-share and high profit margins and returns in capital do work for any long-term investment theme.

Royal Gold Inc. (TSX:RGL; NASDAQ:RGLD) has grown about 25% compounded during this time. Even through the crash of 2008 and back up, some of these stocks have done spectacularly well.

The most important aspects of a gold-producing company are production-per-share and reserves-per-share. Underperforming gold stocks destroyed their production-per-share with acquisitions. Even though gold has gone up to over $1,700/oz., these gold stocks have not participated in the upside because they kept issuing stock and diluting production-per-share.

TGR: Normally companies get better movement in the shares than in gold. Yet it seems most stocks are underperforming. Some of them are down much further than you would expect. Why?

FH: There are two reasons for that. One is this fear of owning any equities. I think the real bubble is putting your money into CDs where investors are going to lose money on interest. Investors will get an interest payment below the inflationary rate and their money is locked up. It just shocks me. Right now, Mellon Bank charges to park cash with them. It's charging investors a fee. It's not paying. It's charging.

It is just bizarre that people are so fearful when you can turn around and buy gold. I think there will be a wakeup call and the companies that will be the beneficiaries of that cash will be the gold mining companies that have not diluted the share-of-production factor. When there is a banking scare, equities as a whole get punished and gold equities as a whole get dragged into that market. Secondly, there is a failure to appreciate the importance of protecting the reserve-per-share and the production-per-share in acquisitions and building out mines.

Randgold Resources Ltd. (NASDAQ:GOLD) was a huge winner for us, then it had a slow down. Its production-per-share dropped because its production dropped. Immediately, the stock went into the penalty box, but now it has reversed that. The stock has been a spectacular performer this past week.

TGR: Would you say that the mid caps are a better shot at this point than the smaller caps?

FH: I think that the mid caps are the most overvalued. The Market Vectors Junior Gold Miners (GDXJ) ETF has over $2.5B in mid caps and it just jams up all these silver and gold stocks. One reason you've seen money going into these products is that gold analysts can't recommend a junior gold stock without research coverage on the company, however, they can recommend an ETF like the GDXJ without research on all of the companies it holds.

I think any big-cap company is going to have to end up looking for those companies that have 10 million ounces (Moz.) in reserves and acquire them. One of the companies that we have taken a big position in is Gran Colombia Gold Corp. (TSX.V:GCM), which has over 10 Moz. of reserves and one of the best valuations. You are only paying $45/oz. of gold in the ground. Gold producers trade at six to seven times that level. That makes it a takeover candidate. It has a higher grade and is producing over 100 thousand ounces (Koz.), with plans to ramp up to 400 Koz. of gold production. We like to buy where we get a big bang for our buck—lots of gold-per-share.

To increase production and not dilute the shareholders, the company just raised $80M by issuing a 5% silver note. It is convertible at $15/oz. of silver, which allows you to buy silver at a massive discount. That gives them the cash to ramp up production for the final build out phase. This is brand new and very interesting. We like to invest in those types of companies. We like those companies that are very protective of themselves on a value-per-share basis.

The other one that we think is very exciting is Romarco Minerals Inc. (TSX:R) in the Carolinas. It continues to have a high grade. It likes to spend its dollars on increasing its reserve profile. That is always beneficial for shareholders.

TGR: People forget that gold mining in this country started on the East Coast and in the Appalachians in pre-Revolutionary War days. Romarco's in an area where there has been gold production for 300 years.

FH: Yes, for centuries. We like to look at how much bang for a dollar we are getting for a ton of rock. When we look at silver companies, we look at Silvercorp Metals Inc. (TSX:SVM; NYSE:SVM) to get the most dollar-value/ton of rock moved. That makes Silvercorp an attractive silver play. It also pays a dividend. It is a fascinating way to play the silver market and get a dividend. When I compare it to the Coeur d'Alene Mines Corp.s (TSX:CDM; NYSE:CDE) of the world, it just has more value.

TGR: Any final thoughts you would like to share with us?

FH: We are in a secular bull market in gold. It's like the 1930s—fighting deflation, not inflation. It will eventually become inflationary, but right now there are negative real interest rates and deficit spending, and that always bodes well for gold. When the love trade and the fear trade show up together—bingo! Higher highs. I don't think it is like 2008. Governments have shown they are going to print money when push comes to shove. That's important for investors to recognize and gold should be a key component in a diversified portfolio.

TGR: Greatly appreciate your time, Mr. Holmes.

Frank Holmes is CEO and chief investment officer at U.S. Global Investors Inc., a registered investment adviser with $3.1B in assets under management for the quarter ended March 31, 2011. Its 13 no-load mutual funds, which offer a variety of investment options, have won more than two dozen Lipper Fund Awards and certificates over the last 10 years. The company's World Precious Minerals Fund was the top-performing gold fund in the U.S. in 2009–it was the second time in four years that the fund has achieved this distinction. Frank has been CEO since purchasing a controlling interest in the company in 1989. He co-authored The Goldwatcher: Demystifying Gold Investing, which was published in 2008. A regular contributor to a number of investor-education websites and speaker at investment conferences around the world, he maintains an investment blog called Frank Talk, writes articles for investment-focused publications and appears as a commentator on business channels such as CNBC, Bloomberg Television, Fox Business Channel and CNN's Your Money. Frank, who has been profiled in Barron's, Fortune, the Financial Times and other publications, was named Mining Fund Manager of the Year by The Mining Journal, a London-based publication for the global natural resources industry, in 2006. The World Affairs Council's chapter in San Antonio, Texas—where U.S. Global Investors is based—named him 2009 International Citizen of the Year. In addition to achievements as an investor in international markets, the award recognized his involvement with the William J. Clinton Foundation to provide sustainable development in emerging nations and with the International Crisis Group to avoid and resolve armed conflicts around the world.