Nobel Laureate Neils Bohr once quipped:
“Prediction is very difficult, especially if it’s about the future.”
In a world filled with different predictions from dozens of news outlets and hundreds of commentators, Bohr has been proven pretty much spot on in his assessment of predictions.
That’s not to say predictions are useless. They are not useless. Predictions (or most of them, at least) are based on a fundamental picture including many variables. In the financial world, they often incorporate economic growth, unemployment, supply and demand, governmental policy changes and a host of other factors.
So rather than look at the predictions at face value, as analysts, we can take the end prediction and work backwards. We look at all the inputs and see if we’re missing something in our own expectations. From there, we analyze risks, rewards, and probabilities of potential outcomes. Those are the keys to successful investing.
That’s why I rarely write anyone off when it comes to a seemingly contrarian or outlandish prediction. They may be right. They may be wrong. What I’m concerned with is how they arrived at their conclusion.
That’s why when I had the opportunity to talk with Brian Tang, CFA, I wasn’t too surprised to hear him talk about how his firm’s models showed the potential for gold to revert back to $600 an ounce in the long term and copper to rise to $2 a pound and stay there by 2010 (incidentally, copper has moved up towards his forecast level since we spoke).
Tang is the President of Fundamental Research Corporation. He has been featured in CFA Magazine, The Globe & Mail, and Buyside Magazine among many others. His research firm has ranked in the top 10 of investment research firms by Investars, a firm which provides research on the track records of equity research firms.
Needless to say, his ideas and research are worth listening to. He just might have found a seemingly small piece of data or new idea which you may have not considered yet. Because, in a financial world as volatile as the one we’re in, any extra edge you can glean could make you or, more easily, save you a lot of money.
Interview with Brian Tang, President/Analyst, Fundamental Research Corp.
Andrew Mickey: At Q1 Publishing, we are searching out where the opportunities are and also what to avoid. At Fundamental Research, what do you foresee that really isn’t priced in the market yet, in other words, what’s not known out there by the markets yet? Where do the opportunities lie?
Brian Tang: All right, so I will start by giving you just a broad overview and then what our opinion is.
For the next two years, at least until 2010, we don’t see any sort of recovery. We are pretty much in a global recession. So we think that will have a negative impact on most commodities in 2009 with the exception of gold.
Gold kind of works opposite to most everything else; wherein, during economic hardship or just uncertain political and economic future people tend to rush towards gold. So our short-term outlook for gold is actually different from everything else.
We are positive on gold in the short term. In the short term we are negative on oil. We think oil will hover up around the $50 level for 2009-2010. Slowly move up to $65, then forecast a long term equilibrium price of $85.
Copper, is pretty much the bellwether for the economy and is highly correlated to GDP. We think the short-term outlook is not that good.
In the longer term, we have the opposite outlook as OPEC supply cuts come into play. Other companies are cutting production because they are just not economical at today’s prices.
I am most bullish on oil prices. I would be buying oil today and just holding on to it. What most people don’t realize, or always think about when it comes to investing in oil, is that oil is a commodity that’s finite. There is only a certain amount on earth. We burn oil daily and so the supply is getting lower.
If you look at a commodity like gold, for example, it’s not really consumed and it doesn’t have much industrial uses. So pretty much whatever has been mined for the past 100 years is probably still around in some form or another.
But in terms of oil, that’s number one. It’s a finite resource and it’s being used up.
Number two, refining and development costs increase every year. People have to dig deeper, go to more remote locations and I believe that creates a floor for oil prices. In my opinion, oil has no radical let up. So I would be buying oil at these levels.
One of our analysts has actually built statistical models to come up with our own long-term price forecast for gold and copper.
Andrew: Statistical models…interesting. What are your models showing you for copper and gold…if we’re headed into a depression, recession, or a near-term recovery?
Brian: I’ll start with copper. We expect the slowdown in the global GDP growth to affect the demand for base metals, including copper. So we expect copper to stay soft in 2009 and 2010, but expect prices to move up closer to our target price of $2 in the long-term, that’s beyond 2011-12.
Using a similar regression model that we did for zinc gave a long-term price forecast of $0.75 per pound.
Then we did a regression model for gold which gave us $600 per ounce long term. We expect gold prices will start to converge to this level starting in 2011.
Andrew: Gold…$600? That’s certainly a contrarian call at the moment. So I have to ask, with respect to copper, what are the factors that go into your model.
Brian: We tried out different factors that could potentially have impacted the price.
Ultimately, what we found was, there are three factors that had a significant correlation with copper.
One was GDP growth rate. Global GDP growth rate had a positive correlation with copper prices in the past.
Number two was copper mine production growth. We found that it had a negative correlation.
It makes sense…increase supply and copper prices should go down. So, GDP growth rate had a positive correlation and mine production growth rate had a negative correlation.
The third factor was the U.S. dollar.
Andrew: So, right now, you foresee mine supply in copper declining?
Brian: Right – in 2009-10 we are expecting prices to stay around levels of $1.50 and slowly moving onto a sustainable level at $1.75.
But in the longer term, we believe that higher cash costs and all the supply disruptions that we just talked about, and long-term growth especially from the big countries, will be the major long-term price drivers of copper.
So many projects had been abandoned or suspended because current prices do not make them feasible or both supply disruptions and higher cash costs.
Andrew: While we are on the topic of copper, one thing that I think most people don’t know about is the actual costs involved. As all these mines shutdown, the basic theory is, they’re back up within six months once copper, if copper it gets back to $2?
Your long-term forecast is $2. Do you expect to see the return to $4 copper?
Brian: No, we do not think that’s going to happen. $4 is, to say the least, highly unlikely.
Andrew: Agreed. $4 copper was a bit unsustainable. Oil though, that’s a different matter. What kind of model do you use to predict oil prices?
Brian: Basically, for oil prices, we look at consensus estimates and supply and demand. We look for divergences between expectations and reality. That’s where opportunity lies.
We did a study from 1973-2008 and our research shows that OPEC is still very influential in affecting oil prices. We tried to determine the correlation between the price of oil as pricing by WTI (West Texas Intermediate) and we compare that to OPEC and non-OPEC production. What we saw is from 1973 to 2008, the correlation between OPEC production and WTI was negative 0.13. Versus non-OPEC production and WTI the correlation was negative 0.04, which is basically zero.
This means there is no impact from non-OPEC production on WTI; whereas, the correlation were strongly negative between OPEC production and WTI which indicates to us that OPEC does have a big impact on oil prices. And when you look at the graph of the data that I just talked about you can clearly see. For example, from 1973 to about mid-1983, OPEC cut production quite aggressively and there was a result in spike in the price of oil around that time. And when you look at non-OPEC production it’s clearly trending upward which means they don’t really collude very well, the production just rises every time.
Andrew: So when you look at the model, it’s just the way you guys invest or analyze commodity stocks? It sounds like you have developed a forecast for the actual commodity first and then work your way back?
Andrew: So after you determine a commodity price target, what’s the next step you normally take in order to relate back to commodity stocks? So, with mining, $2 copper is priced in?
Brian: No, basically, what we do depends on whether the company is in production or not. If the company is not in production then the price really has to do with when we expect it to go into production.
So let’s say we look at the company, and we don’t expect them to go into production ‘til 2012, and we really don’t care what the price is today, we want to know what the price is in 2012. That’s where we start looking at the model.
The other thing is, we usually run a statistical analysis of just how sensitive the price is to that commodity. Say we’re looking at a copper company, we will compare the changes in the daily stock price to the changes in the daily copper price and try to see what the strength of the relationship is.
If the company is in production, then the price forecast is a crucial part of the valuation of the company; because, that’s where you would start the valuation process.
In our model we would start to build the revenue line first, which is production times price, and then look at the cost estimates and then move on from there…
Basically, we use more than one evaluation model to evaluate companies. We use the Discounted Cash Flow model (DCF model). Then we also use a proprietary real options evaluation model. So basically, early stage mining companies, early stage oil and gas companies, they can be evaluated using the real options model which is based on the Black-Scholes model for pricing stock options. This model is proprietary to our firm. We haven’t seen any other analysts publish valuations based on this option pricing model.
Yes, so firstly DCF, secondly real options, and third we use a comparables valuation model. So we typically use a ratio called enterprise value to resource. We compare a specific company to its peers and see if they are over valued compared to peers or not. So once we do all these pre-evaluations models, we take an average after that and then that’s how we come to a fair value estimate.
Andrew: Now, what do you see as the opportunities out there right now or are you just kind of waiting? With your more bullish forecast, for the commodities, do you think the best opportunity is next year? And what are you looking at now?
Brian: Yeah, I did say it’s impossible to predict so we don’t try to time the market. Our philosophy is basically if the fair value is higher than what the stock is trading at now, we would be buying it. So it could go lower and we would be able to get it cheaper, but as long as we are confident that the value is higher than what we can get it at, and then we are happy to just sit on it.
We don’t trade in the stocks we cover, but in general, that’s how we look at the stocks that we are rating. The same rule applies to our own in-house trading. Our general philosophy is to buy stocks if they are trading for less than what we think they are worth.
Andrew: You have covered a lot in the junior sector. What kind of advice would you give to the average investor in that space?
Brian: First of all its very high risk. So you have to have a certain amount of good patience and be prepared to lose all the money. I would put a portion of the portfolio into that sector; it’s good to diversify into that sector. But I would not input the majority.
The thing about small and micro caps is they tend to be the first to improve when situations do improve, but they also tend to be the first to go down when the economy starts to turn. So, I would suggest that if investors are trying to time the market using small caps, they would miss out. Because small caps tend to do well early on in recovery and they tend to do poorly at the start of a recession and that’s just because of the nature of the small caps. They are more leveraged to day-to-day swings in the economic condition.
We are most bullish on gold and silver. So we would like to see gold and silver companies that are closer to production, so closer to cash flows…those kind of companies we like to see and another thing that has resulted from all the financial crisis and slowdown is that so many companies are trading below cash. So those kind of companies you will need in your portfolio and investors really have to look at their commodity or project to make proper evaluations first.
Andrew: Okay, that makes sense. You must be projecting some sort of economic recovery. From a global perspective, in the next couple of years, do you think with all the manufacturing out of China that a downtrend could grow even stronger?
Brian: Yes, we believe that China, India…they are not immune to the global economic slowdown. Slowdown in the U.S. and the developed countries is going to affect all these emerging countries. But the one thing you should always look at is that China’s export was 15% to 20% of their GDP.
So the slowdown in the developed country is going to bring down their other exports, but then in terms of the GDP, it’s only 15% to 20% of the GDP, all right. So even though it’s going to affect the Chinese economy, it’s not going to be as significant as people normally think.
Andrew: Obviously we read lot of stuff everyday…the headlines out there. What do you really kind of disagree with or see happening in the other way than is being talked about, from a more contrarian kind of perspective?
Brian: One thing – I mentioned that just while ago. It’s basically overselling. If a company is trading below cash no way it makes any sense in terms of valuation because in terms of valuation a company has to be valued based on their projects plus cash minus debt, right? So, if a company is trading below cash then you see a straight arbitrage opportunity and that kind of thing should never happen in the market. So we think that it basically shows how risk adverse investors have become.
And also, what I think is, a lot of the stocks out there had been oversold not based on fundamentals but for other reasons. For example, a lot of mutual funds have had to liquidate positions…it’s what they call a ‘fire sale’ not necessarily at the best times, but just because tons of people had to redeem units to raise cash to pay the bills. So there is forced selling by mutual funds. There is deleveraging by hedge funds again for selling. So a lot of assets become depressed and I would say that a good time to buy is when things go on sale like that.
So actually, I don’t think the situation out there is all bad. There are fundamental problems with the economy in terms of housing, banks but I think there is a lot of good buys out there. So that’s one thing that I think the media tends to over emphasize the negatives.
Andrew: Okay. Where do you then get the most requests or demand for research information? What do people want to know most about?
Brian: Investors want to know definitely about the two commodities uranium and gold. When we get people sign up for a subscription that’s one of the key requests. From the past few weeks what I am seeing is they want to see anything about uranium or gold.
Andrew: Oh, uranium. It always seems to me there’s always demand for uranium information, but since the bubble burst there hasn’t been much demand for stocks. What is your take on the political situation in the U.S. what – is that going to matter for uranium? Is it Obama kind of pro-nuclear no one really knows yet that’s the feeling I kind of get?
Brian: I don’t think we have a real opinion about that yet. I guess, policy does matter especially for mining projects. We come across a lot of mining projects that are not in politically favorable areas and they just, you know, they turn into disaster even though they have a good project, but I haven’t thought too much about the Obama situation.
In terms of uranium demand I think over 100 reactors are proposed and 25 are under construction and most of them are outside the U.S. even though a few of them are from U.S., but most of them are outside the U.S. So in terms of global demand for uranium those factors make it more significant.
Andrew: Okay and your primary customers, like I mean, if people are demanding research on gold and uranium do you guys primarily sell to a retail audience or an institutional type of audience?
Brian: We got both. Our research is available on all the major institutional portals like Reuters and FactSet, etcetera. So we will get demand from both sides, from institutional as well as retail.
Another thing you had asked about maybe things people haven’t thought about. One thing that I like to always discuss is using oil and gas or oil and gas stocks as a risks management tool and not just to make money on investing in it. But I think what people don’t think about very often is when gas prices are high a lot of people complain and I think it can offset that risk by owning oil or oil and gas stocks that are highly correlated to oil and gas prices.
So when you lose money at the pump it’s offset by gains in your portfolio on the oil side. So the definition of a hedge is to remove risks, so if you are available to find an oil and gas asset that move perfectly with gas prices which I don’t think you could find, but in general you can offset your risks somewhat and I think that’s one thing that people don’t think about enough.
Andrew: Okay. What else do you guys see as the #1 opportunity in the commodity world? Brian, you projected zinc at 74 so nothing really too exciting there?
Brian: Well, we also, use $11 per ounce for silver. One thing is that, silver we believe that is another commodity that’s just like gold. People move to silver during trouble times, we price gold as if it’s a currency and not as a commodity.
Silver acts partially as a currency, and partially as a commodity because 50% of the demand for silver is coming from industrial applications – and the demand from that side was hit because of the slowdown. So that is why we believe that silver has not really followed gold prices in the last six months.
So although investment demand for silver has increased because of, you know, for capital preservation reasons, but then it was offset by a slowdown in demand from the industrial side.
Andrew: Okay, makes sense. Do you guys have anything else you are looking into next or anything along those lines?
Brian: We’re just taking it as it comes. That’s the nature of our value-oriented approach.
Andrew: Thanks for taking the time to sit down with us today. I think you provided a different perspective, which is always helpful.
Brian: Thanks and we’re happy to do it.