Discovery Investing for 2014

To say 2013 was a tough year for just about all commodities would be an understatement

With deflationary forces still predominant, in my opinion, a challenging environment awaits the metals sector in 2014

That said, every environment provides opportunities and 2014 is no different. In this article, I will outline the opportunities I see in 2014

Signs of life?

Despite the headlines and our bias towards deflation in the global economy, things are in a better place than they were at the start of 2013. The economy in the US is slowly improving, the Euro Zone has emerged from a multi-quarter recession, and the emerging markets have generally found a bottom. China growing at slightly above 7% is thought to be the new “cruising speed” for the world’s second largest economy.

A look at the performance of PMI and ISM surveys – one of my preferred methods of gauging manufacturing strength – is clearly on the upswing as per the chart in Fig. 1.

I have said in the past, and continue to believe, that we are at the bottom of the cycle. The only questions now are when will it turn and what are the catalysts to ignite a new rally in metals that can hopefully filter down to the junior sector?

The 800 pound gorilla – Quantitative Easing

True, there are myriad issues hindering growth, including a tanking velocity of money and huge slack in the labour market which cannot and should not be ignored. That said, with developed economies on the mend, the potential for the Federal Reserve to begin tapering asset purchases is becoming a real possibility. I am of the opinion that we will not see a taper in December and I think odds of a tapering in March at the Federal Reserve’s first meeting in 2014 are at 50/50.

The reason? Inflation, or rather a lack of inflation. This is the proverbial “dog that hasn’t barked”. Until we start to see more inflationary data emerge, any sort of a halt to QE or a major tapering seems unlikely. 

To be clear, there is inflation out there, but it is predominantly asset price inflation. Fig. 2 shows various price increases since 2000.

A taper would most certainly put upward pressure on interest rates, and I view it as doubtful that anyone at the Federal Reserve or in the halls of Congress wants to deal with the issue of higher interest payments on US$17 trillion of debt.

Economic strength is a good thing, though, and the ultimate goal of Fed policy makers, so any sustained economic strength and subsequent higher interest rates will be watched closely. Just how high interest rates can rise in the US without causing lasting economic harm will be one of the main issues I will watch in 2014. This balancing act on the part of the Fed is sure to be crucial to sustainable economic growth and incoming Federal Reserve Chairwoman Yellen has her work cut out for her.

The irony in all of this is that the effect of QE is arguably deflationary and likely harming the recovery. Looked at this way, the recent strength we’ve seen in various economies is even more impressive than first thought.

Adding to all of the confusion are news headlines that appear to be completely contradictory. Cases in point are the headlines below from Bloomberg within one day of each other:

December 11th 2013:  “IBM Says Economy Remains Discouraging”

December 12th 2013: “World Led by US Poised for Fastest Growth Since 2010”

Whom to believe? I’d prefer to side with the latter statement, but comments from one of the largest technology companies on the planet about a sour macro environment cannot be dismissed.

Where I am focused in 2014

So with a 50/50 chance of a taper next year (in my opinion) based on a strengthening, but still sluggish, global economy and broadly deflationary forces still in control, is there any value in the metals sector? I believe the answer is yes, and I’ll be focused on specific opportunities in the following metals and minerals:

Phosphate – Food security has been, and will continue to be, a theme I watch closely. With the majority of the world’s phosphate coming from a politically unstable part of the world in Northwestern Africa, a supply of phosphate from a geopolitically stable part of the world will become increasingly important against the backdrop of shrinking arable land and growing populations.

One example is Arianne Resources (TSX-V: DAN, OTCBB: DRRSF) which boasts a high-grade phosphate deposit in Quebec (Fig. 3). The story is substantially de-risked to the point of having a prefeasibility study published demonstrating strong economics. We will be publishing more on this in 2014. I own shares in DRRSF.

Cobalt – Cobalt is a relatively small market and often produced as a by-product. A majority of cobalt production comes from central Africa and cobalt is critical in battery production and as a super alloy – two markets exhibiting above normal growth. Given these facts, the price of cobalt could be poised to appreciate in 2014. A clear understanding of cobalt producers and battery production statistics is a must here. I am currently watching several cobalt juniors to find the one(s) with the greatest ability to take advantage of any upswing in the cobalt price. One company I am reviewing currently is Global Cobalt (TSX-V: GCO). The company is rare in that it is a pure play on cobalt exploration and development with a number of strengths and catalysts ahead of it. I particularly like the pure play aspect here as many cobalt deposits are by-product stories and cobalt production is subject to the production of other metals like copper.

Tin – With China now a net importer of tin as opposed to a net exporter, and global stocks running low, there exists a very real possibility of higher tin prices in 2014. Increasing demand for lead-free solder, used in electronics, should also provide a tailwind for the metal in 2014. Demand is forecast to outstrip supply to 2016, offering ample opportunities in the space. I am currently reviewing the universe of tin production stories, as well as development and exploration plays, and will be publishing ideas on those stories most undervalued in due course. As with cobalt, a lack of true pure plays in the space makes this a challenging exercise. 

Silver – This is a play on economic growth and manufacturing strength. Silver had a terrible year in 2013 and is viewed by many as a contrarian’s dream. In addition, any USD weakness should help the price of silver as a hedge against currency debasement. However, I am more optimistic for the prospects of silver based on an improving global economic picture and silver’s crucial role in a multitude of manufacturing processes. Specifically, each new car contains between ½ and 1 ounce of silver. China alone is forecast to produce 30 million automobiles per year by 2020.

Uranium – I continue to believe that uranium investment is a three-year proposition. I have written many times on uranium in 2013 and won’t rehash the arguments here. That said, the most profitable niche in this space currently is near-term uranium production. This offers leverage to any increase in uranium prices between now and 2016 and a more immediate return via cash flow generation.

Uranerz Energy (TSX: URZ, NYSE AMEX: URZ) is an example of one such company and I anticipate cash flow for the company later in 2014 (Fig. 4). Due to its mining method (in-situ recovery), uranium can be extracted at a much lower cost versus conventional hard rock mining methods. As a believer that the lowest cost producer “always wins”, URZ can count itself in this class and offers investors an opportunity to gain from what I think will be an improving outlook for uranium in 2014 and beyond. I own shares in URZ.

Special situations – As the junior sector continues to contract, this has encouraged me to look at other opportunities – mainly outside of the resource sector and all unorthodox. I am currently doing due diligence on several potential opportunities and will be writing on them in 2014 when and where appropriate. These include wearable technology and hydroponic farming.

Gold?

You may have noticed that I have not mentioned gold yet. Successive rounds of QE have pushed gold to the point where it doesn’t appear to be responding to risk as it should. This is a mystery to me and all I can surmise is that the weak inflationary environment has put a lid on substantially higher gold prices for the foreseeable future.

Given a strengthening global economy and near-term USD strength, this leaves me neutral on the prospects for gold in 2014. While in Germany last month, a Morning Notes subscriber asked me what I thought the price of gold would do in 2014. With the spot price at the time of US$1,288.50 per ounce, I said I thought gold would likely remain within 10% of where it was currently trading (Fig. 5). This gives an admittedly wide range of $1,417 and $1,159 and so until I start to see more evidence of inflation (a rebound in the velocity of money, for example), I stand by this estimate and am biased to the downside. I own a small number of gold-focused equities and bullion as insurance.

The takeaway

The bottom line is that with so much uncertainty, you must embrace risk and educate yourself about the myriad opportunities that are evidenced no matter what the macro environment. The resource sector continues to offer incredible values, but as China slowly shifts to a consumer-driven model of economic growth and we in the West grapple with deleveraging and sluggish growth, finding specific pockets of opportunity among sustainable resource companies is the best way to profit in 2014.

I hope I have been able to provide some ideas for you as we head into 2014. 

Disclaimer: The material herein is for informational purposes only and is not intended to and does not constitute the rendering of investment advice or the solicitation of an offer to buy securities. The foregoing discussion contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995 (The Act).  In particular when used in the preceding discussion the words “plan,” confident that, believe, scheduled, expect, or intend to, and similar conditional expressions are intended to identify forward-looking statements subject to the safe harbor created by the ACT.  Such statements are subject to certain risks and uncertainties and actual results could differ materially from those expressed in any of the forward looking statements.  Such risks and uncertainties include, but are not limited to future events and financial performance of the company which are inherently uncertain and actual events and / or results may differ materially.  In addition we may review investments that are not registered in the U.S. We cannot attest to nor certify the correctness of any information in this note. Please consult your financial advisor and perform your own due diligence before considering any companies mentioned in this informational bulletin.

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By Chris Berry

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