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Michael Berry: Discovery Investing's Stellar Potential

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Dec 16 2009 10:58AM Investing pioneer Dr. Michael Berry's number-one hedging strategy against the struggling U.S. dollar is to simply own currencies of the commodity countries—of which Canada is his favorite. When Michael grew up in Canada, he recalls its currency— now fondly known as the loonie because of the image of the loon used on the die for the back of the C$1 coin—always being worth more than the U.S. dollar. We'll be revisiting those good ol' days within the next year, he predicts, as the Canadian dollar reaches parity with the greenback and then goes beyond. In addition to holding loonies and their C$2 counterparts, the toonies, Michael tells The Gold Report, in this exclusive interview that he believes in "some exposure to the physical" in every investor's portfolio, maybe as little as 1%. He's also a staunch believer in keeping a place in the portfolio for discovery investments, ideally in a mixture of incubator, mature and legacy companies, to partake in the bonanzas that can come when promising discoveries make it to the world-class stage.

The Gold Report: Gold is in the news. You've been talking about investing in gold for years, and now all of the investment programs are talking about it. In one of your recent Morning Notes, you said, "Today, you must own and hold gold bullion or coins." But how much more can an investor expect on the heels of a 215% increase in the gold price over the past four years?

Michael Berry: In the first place, I said "coins and bullion" to differentiate from buying shares in the gold companies. I think it's important for discovery investors, in particular, to hold the physical gold. And I said "you must hold it" because I think bad things are going to happen to our currency, even though right now we're having a covering of the short dollar position and commodities are getting hit a little bit.

I am not suggesting that they necessarily need to buy a lot more of the physical metals. I am certainly very happy that gold came off $66 the first week in December and another $66 or so during the following week. So this is correction great; this is wonderful.

TGR: A pullback is wonderful?

MB: Yes. Gold was overbought; I kept watching it ascend and began to realize, "Hey, wait a minute, there's too much froth here." We knew we had to have a correction; there was a bit of a bubble forming. This correction is very good for gold, and it will allow people to come back in at a lower level. We will find the bottom—this is just a correction. It is not the beginning of a bear market in gold.

TGR: And when you say, "hold bullion or coins," would you include ETFs, GoldMoney and so on, or do you want people actually hold the physical items?

MB: To answer your question directly, I exclude ETFs from the "bullion and coins" category. But I am not saying you shouldn't also own an ETF, nor am I saying you shouldn't also own a discovery company. I am talking about having physical gold in your possession, however. As far as I am concerned, you need some exposure to the physical in your portfolio and at your disposal.

TGR: Given the turmoil in the markets and the economy, what percentage in physical silver or gold would you suggest people own?

MB: A relatively small portion, depending on your proclivity for risk and your view of the marketplace—maybe 1% to 5% of your portfolio. For some people that would be quite a bit, but not 10% or 15% or 20%. You always must feel comfortable with your position, so allocations toward the physical metals are going to be different for everyone.

TGR: In another one of your recent Morning Notes, you wrote that investors who are U.S. dollar based MUST (in all capital letters) develop an active investment-in-hedging strategy. Can you suggest some ways for our readers to look at hedging against the dollar?

MB: Hedging is a very specific term that usually connotes the use of options or futures contracts, where you can implement "delta hedging" to dynamically change your position over time. There's always that, but I think you can also hedge by buying currencies; you can buy access to other currencies such as the Canadian dollar or the Aussie dollar that have more upside relative to the U.S. dollar.

My main hedging vehicle for the past six or seven years, when the Canadian dollar was at 62 cents, has always been to buy Canada. I like Canada because not only was I raised there and know the country very well, but it's tied to the U.S. geographically and culturally and I think the Canadian dollar will benefit relative to the U.S. dollar. My number-one hedging strategy is to simply own those currencies of the commodity countries, basically, and Canada would be my recommended currency.

TGR: To what extent are you incorporating an inflationary scenario into your suggestions to buy gold and buy Canadian dollars? Because as you say, Canada is tied to the U.S. and since the U.S. is obviously going through an economic recession right now it eventually will hit inflation.

MB: I wish I had a very specific answer. When we talked in June, I said there was no inflation, and there's still no inflation—no matter what anybody says. My sense is that we have a year or two of debt and excess capacity liquidation, so I'm not much of an inflationist for the next 18 to 24 months.

I think gold will be much, much higher when we do get to that point where all the excess money that's been printed and shoveled into the economy starts to make itself felt. But right now, if you look at the velocity of money, the MZM money multiplier published by the St Louis Fed is less than one and is at an all-time low of .81 and heading south.

TGR: Yes, I think you've said that even with a substantially expanded money base the money multiplier has dropped to Depression levels.

MB: Exactly. If we had any hint of inflation, Ben Bernanke at the Fed would not be saying we're going to keep rates low for a long time. Believe me. So I don't see inflation as a problem in the immediate future. It's interesting that we're seeing this tremendous move to gold—the 200 tons that India bought, the 40 tons the Russians recently bought, China allowing its citizens to make their own homemade dollar currency hedges, buying physical silver and physical gold—and yet there really are no inflationary expectations out there whatsoever. If anything, whiffs of deflation remain in the air because we still have to eliminate a lot of debt and excess capacity that's been built up over these last two bubbles.

TGR: You say there is no inflation now and maybe still some whiffs of deflation. Yet countries such as India and China are not only moving gold into their own banking system but also encouraging their citizens in that direction. What's causing that? And have the Western countries read too much into it?

MB: I don't think we've read too much into it. They're hedging their dollar exposure. Period. That's exactly what they're doing. They're trading their excess dollars for whatever they can. The IMF is selling 400 tons of gold to liquefy themselves. Even George Soros has suggested having the IMF use its remaining gold to as collateral for loans to developing countries. Many countries will pick up the IMF gold in a heartbeat, and it's a hedge, a dollar hedge. Even though the dollar has been much stronger of late, that's a short covering on the dollar similar to what we had in July 2008. It's not a long-term phenomenon. There's a strong sense out there that the dollar is going south.

Sri Lanka bought 10 tons of gold and India 200 tons—that's what you're seeing around the rest of the world, and even though there's no real inflation there, they aren't buying it for inflation protection. They're buying it to hedge their dollar exposure.

TGR: For people who aren't familiar with your "discovery investing" strategy, would you give us a brief description?

MB: When I was a fund manager for Heartland Advisors, I wanted to make sure that I was never out of the market regardless of the cycles—never in value when growth was the place to be, never in growth when value was the place to be, and never in small cap when large cap was the place to be, and so on. I wanted to develop a strategy, a discipline, a way of investing that would always enable the creation of wealth. That's what discovery investing is based on.

If you make a great discovery of a mine, you create tremendous value. So if you have some kind of discovery exposure in your portfolio—and it doesn't have to be a lot—you're going to have a hedge to the rest of the market. And even in a recession, a great discovery will create value.

I developed discovery investing as a discipline, and it has caught on with a lot of people. I use 10 rules to evaluate every company against their peer group, and then I rank the companies. Their discoveries are the natural catalysts for value creation that the market usually recognizes when a great discovery is made.

TGR: When you're investing before the discovery proves out seems to be somewhat risky. So would a discovery investment go in the speculative part of the portfolio? Where would you put it if you want a balanced portfolio?

MB: I would definitely want to maintain it completely separately. You're absolutely right; this is a high-risk environment, but it's also a very high-reward environment. I always use the baseball analogy. The best hitters bat .300, so they strike out, fly out or fail seven times out of 10. Likewise, if one or two discovery investments out of ten say, work for you, you'll do very, very well. My sense is you have a small allocation, and that allocation is whatever you feel comfortable with. Again, it's similar to what we talked about with gold—maybe you put 1% or 5% or 10% of your portfolio into discovery investments, and you monitor them closely. You use the 10-point grid you keep them separate from your other investments because they're quite different. They're riskier, and you may have to be prepared to stay with them for quite a long time. It's a very different investing discipline.

TGR: Would you recommend that investors keep their discovery investments in a single sector, like a basket of discovery companies in one sector? Or should they have a balance across sectors?

MB: That's really up to the individual. Some people love natural resources. Some people love oil and gas. Some people are focused on mining. Some are focused on gold only. I do recommend diversifying across sectors, but frankly most people don't do that because most people have an interest in one sector and invest in that sector of the discovery space.

In fact, I like to diversify across not only those industries but also get into some biotech and high tech companies. Essentially, the risk-reward ratios are exactly the same irrespective of the sector. The discoveries that pan out are going to create wealth, and it's not going to be dependent upon industry sector, inflation or deflation or the cycle of the economy.

TGR: Why not?

MB: If we go into a deflationary scenario for a long time, it's possible that copper companies aren't going to do well, for instance. But in that same time period if you are in biotech sector as well as copper, and one of your companies happens to have a discovery to improve cancer treatment, for instance, its wealth creation would be independent of the fact that you're in a deflationary environment.

TGR: So discovery investing may be independent of inflation or deflation, but small companies would still be dependent upon some type of capital or cash flow.

MB: You're right. Smaller companies have had a very hard time getting financed for the last year or so. This is one of the primary risks at the first level of discovery investing, the incubator level. These are the micro-cap stocks that may trade for pennies. In these cases, you have to make sure that management knows how to control their income statement and balance sheet and that they know how to raise money and employ it effectively. Micro cap stocks demand a different strategy that I learned that from Bill Nasgovitz, with whom I worked for several years on micro caps at Heartland Advisors.

TGR: You just mentioned micro caps as discovery investments. Earlier, you gave a different example of a discovery investment. How do you define that category?

MB: There are three levels of discovery investing depending upon your proclivity to risk, not the market capitalization—incubator stocks, mature discovery stocks and legacy stocks. Incubator companies are the riskiest because they don't have any tangible discovery yet, except hope. Then when a discovery is made and you start to pile up resources in the resource sector, or if you're in the biotech, you're going into the cancer clinic, you have a mature discovery company. Shares normally appreciate, you have a larger market cap, and you're closer to making a real world-class discovery.

And then the third area is a legacy stock. A major company still making discoveries, increasingly wonderful assets, etc. Every time a company like that makes a discovery, it solidifies the base and tends to create value, even if it doesn't add quite as much as you'd get with an incubator stock making a discovery.

I really like to be able to buy an incubator stock and follow it through all of the elements of its discovery life, but that doesn't often happen. Normally these stocks are taken out long before you get to that level. This is really the event that discovery investors are looking for.

We were talking earlier about diversification. That applies here, too. If somebody says, "Gee, I'm in all these tiny and illiquid incubator stocks, and I am not sure," they can stay in the discovery space but allocate to a safer level. They could get into companies such as Goldcorp and even receive dividend payments.

TGR: What are some of the other sectors that have good potential for discovery investing?

MB: I already mentioned biotech, and I focus a lot on gene technology. The gene therapies, the biotherapies, are going to be really, really important in the next decade for treatment of chronic diseases like cancer, arthritis and transplantation of organs—things like that. In chemotherapeutics, for instance, the small- and large-molecule drugs work to a degree but they've really been hurtful with side effects, so cancer research is now going in the direction of gene therapy.

I'm also focused on high tech—battery technology and new solar developments, for instance. Some of the things that are coming on are a decade or so away, but now is the time to start looking at these discovery technologies as well.

TGR: You're talking here about battery technology and looking into the future, and a moment ago you mentioned earlier that the U.S. will need domestic copper if it's going to rebuild the infrastructure. Do legislators appreciate the need to become domestically oriented?

MB: They're beginning to. Traditionally they haven't appreciated it at all, and that's why I prepare a biweekly piece that goes to several members of Congress describing potential discovery assets such as rare earth elements. China produces about 95% of all rare earth elements. There are some mines in this country, but not many, and of course rare earth elements are so important for so many of the new technologies. All of a sudden, that's raised the level of understanding and concern for extractive industries in Washington.

So the wind is starting to blow the other way a little bit, and legislators from various states are concerned. Senator Lisa Murkowski (R-Alaska), for instance, is very interested in this issue of U.S. resource dependence.

Here's a good example. The U.S. has plenty of uranium, and it's clear that we're going to have to go nuclear sooner rather than later. Yet here we are producing only 5% of the uranium that we use domestically and we're going to buy more from the Russians. That doesn't make any sense to a lot of the people in Washington. They're catching on, and we're trying to educate them as quickly as we can.

TGR: What else interests you in resources?

MB: There's a very interesting fund, the 49 North Fund, which is run by Tom MacNeill out of Saskatoon. It has a lot of exposure to Saskatchewan assets, including uranium, gold, coal and phosphates. This fund is a sleeper, and it's certainly worth looking at, I think.

One of the great things about discovery investing is that you don't have to spend a lot of money on it. The risk-reward ratio on some of these companies, before they're discovered, is excellent. That's why I like discovery investing because if you do it the right way, you really have an opportunity to create good wealth with great leverage.

TGR: On that note, Michael, thank you. And all the best to you in the new year.

Michael Berry has lived in the U.S. for 36 years but born and raised in Canada. A math major at the University of Waterloo in Ontario, he earned an MBA at the University of Connecticut and obtained a PhD specializing in quantitative analysis and investment finance from Arizona State University. He has specialized in the study of behavioral strategies for investing and has been published in a number of academic and practitioner journals. His definitive work on earnings surprise, with David Dreman, was published in the Financial Analysts Journal. While he was a professor of investments at the Colgate Darden Graduate School of Business Administration at the University of Virginia (1982-1990), Michael spent considerable time with some world-renowned geologists on the Carlin Trend. While a professor, he published a case book, Managing Investments: A Case Approach.

Michael also held the Wheat First Endowed Chair at James Madison University in Virginia, and managed small- and mid-cap value portfolios for Milwaukee-based Heartland Advisors and Chicago-based Kemper Scudder. His Morning Notes publication, distributed worldwide, provides analyses of emerging geopolitical, technological and economic trends, as well as identifying opportunities for the Discovery Investing strategy he developed.

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