TGR: Will that big inflation that's five or so years away be worldwide or isolated to specific countries or regions?

FH: Historically it's gone worldwide, and most countries are part of the economic engine. I think there's going to be food inflation. We'll see unions striking for higher income to deal with the food inflation. During the Christmas holidays I was in Sri Lanka. It's one of the best performing stock exchanges since its long civil war ended. The stock market took off. Why did I go there? Plantations. Food. The world will keep having babies and its middle class will keep growing. It makes me sort of bullish on commodities long term; we're going to get these spikes because we're not able to supply.

Demographics aren't the only factor influencing commodities, either. You get a strike in Chile, copper goes up dramatically. A strike in Mexico drives zinc and copper up dramatically. We're going to have to deal with this. More money has to be put in exploration and development. We were shocked to see the dimensions of cuts in exploration last year, talking to general mining and drilling companies. It was like a 90% cut overnight. It takes a lot longer to kick that resource back into production to meet the needs of urbanization and globalization in the age of information. But today's technologies allow these companies to just pull the plug on exploration and development as soon as the commodity price falls below its marginal cost of production.

TGR: Do you expect some commodities to fare better than others? Near term and longer term?

FH: I don't know that. The complex adaptive system involves trying to adapt. Will the supply disruptions be sustainable? Will the amount of dollars that we spend for this $20 billion project be enough to secure supplies? Where are the commodities going to come from? There are real patterns here. When car sales come off, it affects zinc and aluminum. We see a domino effect of related commodities. It's just a matter of recognizing the need and adapting to those changes.

In fact, that's what active money management is all about. What I think is a real bubble is all this money going to ETFs. It's not the best way to play one of these commodities. Do you know that if you buy a gold equity ETF on the big up days, it usually trades at a premium to its underlying stocks? And on big down days it can trade at a big discount, so if you're selling, you lose even more. Bloomberg has a function every 15 seconds to tell you that. We compared active gold funds to the big gold equity and bullion funds, and we far, far, far out performed it.

TGR: Is that true of all ETFs versus managed funds? Or just with gold?

FH: Either the Wall Street Journal or Bloomberg had an article saying that actively managed funds outperformed the ETFs. And it wasn't a little bit. It was pretty healthy.

TGR: Back to the commodities, what looks good these days?

FH: Right now, the hot commodities are platinum and palladium. You can probably make some money at the beginning owning the commodity itself, but some of those stocks are picking up. You're betting on car sales remaining healthy and strong.

TGR: Isn't the growing middle class you were talking about an indicator that car sales will remain strong?

FH: They will grow. China has picked up the slack of America. But what happens when America turns and China remains robust? Holy jumping. Strap on your seatbelt.

TGR: You showed an oil seasonality graph at the Vancouver Conference. What are some other significant commodity seasons?

FH: Life's all about managing expectations and keeping an eye on the big picture. Every year has a seasonal cycle that affects supply and demand of commodities. We compare gold to copper to silver to platinum and to oil, and can see defined patterns. For more than 150 years, the patterns have a 70% accuracy of forecasting economic activity. Copper is usually best bought in November and sold in March. It fell off dramatically between March and November for many, many years until China's economic engine fired up and started altering that pattern 15 years ago. It still falls off, but not nearly so dramatically now.

Usually gold bottoms in August and charges back in September as part of a seasonal pattern that kicks off with religious observances and holidays in countries where it's very common to give gold as a gift and a representation of love—from Ramadan through the Diwali season of lights in India through Christmas and the Chinese New Year. We try to manage expectations by watching these patterns.

TGR: Does that imply that you move in and out of stocks depending on seasonality?

FH: It's more for managing our cash levels. Money coming in; money coming out and making the cash part of a tactical strategy. Understanding inherent volatility within seasonal patterns helps you manage your cash as an active money manager.

When it comes to picking stocks, that's a different set of fundamentals. The most important thing we look at is management that respects and protects the value per share. There are three drivers for value per share: your producer's per-share production, cash flow and reserves. It excludes the price of gold because while the price of gold's gone up dramatically, these companies' cash flow per share has not because they've issued so much paper.

I like the little junior stocks. Give me the junior stock that has the most rock per share and I'll buy it if management's got discipline not to keep doing financings. And guess what? They're the ones are taken over by bigger mining companies. The rock per share, reserves per share drives the net present value of the deposit along with the price of the commodity, but it's value on a per-share basis that matters.

We've seen gold-mining companies issue more shares than they've been finding reserves. It's unbelievable. And the production grade has been falling. The supply of gold per mine continues to fall and the mill costs continue to rise. That bodes well for higher gold prices.

TGR: In terms of those three drivers—production, cash flow and reserves or rocks per share—could you name some companies whose ratios you find appealing?

FH: Yes. Production on a per-share basis for Red Back Mining Inc. (TSX-V:RBI) is up. Its stock has outperformed. Since Goldcorp (TSX:G) (NYSE:GG) bought Glamis Gold, Goldcorp's per-share production is down. So you take a look at the past three years where a major acquisition has taken place, it has diluted value. Those that increased the production or reserves per share in a rising gold market have far outperformed. When gold was at all-time highs in November, some of these other stocks were up, too, because of the production per share and the reserves per share. So that's the key factor.

TGR: Any more?

FH: We like Medoro Resources Ltd. (TSX-V:MRS) , which basically has a whole mountain in Colombia. There's a lot of money to be spent on engineering and so on to prove out reserves, but this is the region that has, according to some back-of-the-envelope calculations, the potential of 30 million ounces, at one gram per ton. There's a 50% probability that they'll get 15 million ounces. There's a 30% probability for 10 million ounces. So Medoro consolidated this property, Marmato Mountain. This region's basically been mined for hundreds of years, back to the time when the Spaniards first came in and shipped gold from there down to Cartagena and over to Spain.

Medoro is small for now, but it's going to grow rapidly and they're going to bring in the best of technology and the best of practices and its stock will be re-rated. If they get 10 million ounces of gold and it's valued at $100 per ounce—one-tenth of what gold is trading at if it's $1,000 an ounce—that makes the stock worth more. And even more if they have 20 million ounces.

TGR: But at this stage, we're talking potential reserves.

FH: Not proven, but potential. Very important, the risk being whether they prove out that potential. But the fact that it's been a prolific region for hundreds of years suggests it just needs to be consolidated and fixed up. It's not about looking for it and finding it; it's about proving it up. Completely different risk line. We like stocks with such huge potential.

TGR: Any parting comments?

FH: To end on a bright note, the secular bull market for commodities and natural resources stocks remains intact. Depending on the extent of economic recovery in developed nations, it could even intensify this year. Either way—although we have more conflict in the world than anybody needs, I think it's just great that peace and prosperity are driving the cycle in these emerging countries.

By arrangement with: www.theaureport.com

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