Editor's note: In yesterday's edition of our weekend Masters Series, we featured our friend and expert resource financier Rick Rule's insight on the junior resource sector.
Today, we're featuring another piece from Rick... a timeless educational interview on one of the most powerful ideas you'll ever encounter – resource "hoarding."
This interview was conducted with Rick last year by our news and insight aggregator, The Daily Crux. And we featured it in the Masters Series at the time. It's not really an "urgent" or "current" piece. But with the recent volatility in precious-metals stocks, we think now is a good time to revisit one of our favorite strategies for producing 5-to-1, 10-to-1, even 100-to-1 returns on your money...
The Daily Crux: Rick, of all the ways to invest in resources, the strategy of "hoarding" may be the simplest... But it can also be extremely profitable – and relatively safe – when done correctly. Before we get into how this idea works, can you define what hoarding is?
Rick Rule: Sure. Hoarding is simply buying resources in the ground and holding them, rather than mining or extracting them. Companies that do this are known as "hoarders."
Crux: What is the benefit of hoarding?
Rule: To fully appreciate the beauty of the strategy, you must first understand a fact about the mining business: It's a terrible business.
It's a business where your asset base – the resources in the mine – is declining consistently over time. You have huge capital costs for building the mines and maintaining expensive equipment. And you're often exposed to huge political risks because you can't just pack up a mine and move it. On top of all that, many mining executives are less than shareholder-friendly.
So when you buy a mining stock, you must understand that is the business you're buying into.
Now imagine if you could get many of the positives of owning the resources in a mine, but without the negatives associated with mining. That is the benefit of hoarding.
Hoarders accumulate mines and undeveloped resource deposits, and basically just sit on them. Because they don't operate mines, they don't have the huge capital costs and risks of traditional mining companies.
Their share price is simply a leveraged play on the price of the underlying resource. When prices rise, the value of the company's deposits increases as well.
Crux: You've been intimately involved with this strategy... Can you give us some examples of how profitable it can be?
Rule: Certainly. During the last secular bear market in resources during the 1990s and early 2000s, we were able to employ this strategy with great success.
At the time, there was no constituency for resource stocks at all. A group of us in the business came to the realization that exploring for things like heavy oil, natural gas, copper, uranium, and even gold and silver made no sense at the time. But we could buy the successful efforts of prior explorers – where the deposits weren't profitable at the then-prevailing prices – often for pennies on the dollar. Because we believed that commodity prices had nowhere to go but up, this made perfect sense.
As an example, during that time, we financed Silver Standard – one of the world's biggest owners of silver mines – at $0.72 a share, or about $2 million. But instead of mining the deposits, we just held them. As other proven mines became available, we bought them, too. When silver soared in the bull market of the 2000s, it became a $1 billion-plus company.
Another great example was Paladin Resources, a uranium hoarder. It was buying uranium when absolutely nobody cared about it. We bought it at $0.10 a share, and I remember selling some of that stock at $10 a share.
As you can see, the leverage these companies can provide to rising commodity prices is just incredible.
Crux: What are the guidelines for hoarding stocks?
Rule: The ideal time to buy these stocks is at the bottom of a resource cycle or during times of great pessimism. When the price of a particular commodity is low, mining companies in the sector can't produce a profit, and most investors are completely uninterested.
It's at these times when the hoarder stocks are at their cheapest, safest, and most attractive. Take uranium after the Fukushima disaster as a great example.
Of course, because hoarders are so leveraged to the price of the underlying resource, they can be a good speculation on rising prices and a hedge against inflation. Just remember that leverage is a double-edged sword, so the volatility will typically be much greater than that of the actual commodity.
I should also mention that successfully owning these stocks requires a great deal of discipline and patience. These stocks can return hundreds and hundreds of times your money, but they often require several years to do so.
Are you prepared to wait five, 10, or more years for those kinds of returns? Most investors would impulsively say yes. But in practice, many have trouble holding a stock for 10 weeks, never mind 10 years. People want immediate gratification. But in my experience, immediate gratification is very seldom on offer in the financial markets.
Crux: That's a great point... Are there any significant risks to owning these stocks?
Rule: Because they aren't involved in the mining business, these stocks are generally less risky than the miners... But there are still some risks.
While they don't have to pay the huge capital costs of mining, they do still have to pay for expenses like property taxes, fees, and overhead. They don't mine, so they're typically cash flow negative. This means they can get into trouble and be extraordinarily volatile during times when access to capital becomes difficult. You must be prepared for that.
Also, because these companies' resource estimates are usually based on drilling and assays rather than actual production, the stocks trade at a significant discount to active mining companies. This isn't necessarily a risk, but it's another good reason to concentrate your purchases at times of great pessimism.
As I frequently say, you have to be a contrarian or you will be a victim.
Crux: Thanks for the insight, Rick.
Rule: My pleasure. Thanks for having me.
Editor's note: Rick and his team at Sprott Global Resource Investments invite all S&A readers to receive a no-obligation portfolio consultation. You can reach them on the web at www.sprottglobal.com or by phone at 800-477-7853 or 760-444-5254. You can also send them questions through e-mail at contact@sprottglobal.com.