Editor's note: With the recent volatility in precious-metal and commodity stocks… we thought it was time to feature the insights of one of the world's leading experts in resource investing.
Rick Rule, founder of Sprott Global Resources Investing, has spent decades in the resource markets, making a fortune for himself and his clients in the process. He has also financed several of the most important resource companies in the world.
In the following interview – which originally appeared in February on the financial news and analysis website SmallCapPower – Rick describes his outlook for small resource stocks… where he's seeing opportunities… and why he expects the market to go through a period of "cleansing"…
SmallCapPower: Markets have recently made a comeback with big board indexes like the Dow Jones currently at very good levels. Where do you see the broader markets going from here?
Rick Rule: I'm mixed in terms of my approach to the broader markets. On the one hand, I love the balance sheets and income statements among larger-cap U.S. companies, the management in the S&P 500 as an example. What I'm nervous about is the general direction of the American economy. I don't think that we're out of the woods yet. And I think that the economic conditions that we're in is part of the response to artificial stimulus, i.e. counterfeiting. I'm nervous about what would happen with the return to normal interest rates. I'm nervous about a lot of things.
So I'm decidedly mixed with regards to the major markets. We're seeing a trend right now that might be described by the financial media as "risk-on" as opposed to "risk-off." People are feeling fairly ebullient as a consequence of the money flooding the system. My nagging doubt is what would happen if the stimulus cap began to be turned off or if investors began to be nervous again about the blow-up in debt on the federal government's balance sheet.
SmallCapPower: Economies like China seem to have achieved a soft landing and now look like they are back to a growth mode. What is your commodities outlook for the next 12 months in this scenario?
Rule: I share that point of view. I think what's happened in China is that people are nervous about the fact that China is growing at 6.5% or 7% per annum. People need to know that the aggregate growth associated with building a large economy, like the Chinese economy, now at 6.5% or 7%, is greater as a sum than growing a much smaller economy like China's was 10 years ago at 10%. The internal rate of growth in China, and in particular the things that the money is being spent on, things like infrastructure, as opposed to U.S. expenditures which are spent on consumables, leads to first of all a healthier overall economy. But importantly, an increased demand for commodities.
It's very important for your listeners and readers to understand a fairly subtle thing about economics. And that is that increased disposable income at the bottom of the demographic pyramid, that is among poor people in places… in frontier markets like India and China and Indonesia and Mexico, is much more important from a commodity consumption point of view than increases in disposable income in developed economies. Rich people already have a lot of stuff. When they get more money they don't spend it on stuff. They spend it on services. When poor people get more stuff, they increase the calorie consumption of their household. They increase energy consumption. They might switch from an adobe house to a cement-block house. They might try to upgrade a thatched roof for a steel roof. So it's very, very, very important for your listeners and your readers to know that increased disposable income in frontier market economies leads to a disproportionate increase in commodity consumption.
And because of the credit conditions that have existed in the last 20 years, these same frontier markets are paradoxically much less indebted than the developed nations that they compete against. So from my point of view, economic leadership is switching from the sclerotic Western economies like the North American economy, the western European economy, the Japanese economy, to frontier market economies. And this has a really, really, really dramatic impact on commodities business. And I think another thing that's important for you or your listeners and readers to know, is that the impact isn't just a 12-month impact. It's a 10-year or 12-year impact. That's very, very, very important in terms of your listeners' speculative investment plan.
SmallCapPower: Wow, great answer. Thank you. How do you see gold performing in this current environment of low macro growth in the U.S., sluggish job growth, the U.S. Fed continuing to print money with no signs of inflation and deficits still high?
Rule: I think the gold market is going to be volatile. I think it's going to trend higher. Remember that gold, silver, and platinum bullion prices, all precious-metals prices, are denominated in the U.S. dollar. And you don't make something more valuable by making it less scarce. They're printing dollars like crazy. We are involved in a worldwide war of competitive devaluation. The Japanese are trying to take the yen down. The European community has to respond. And if they respond, the U.S. has to respond.
Gold, or rather precious metals, are the only generally accepted medium of exchange that does not have the domestic political constituency for devaluation. And if you devalue the denominator, that is the U.S. dollar, the numerator, that is the nominal price, becomes less important. Gold is denominated in U.S. dollars terms. The U.S. dollar is a slow-motion train wreck. And so at least in nominal terms, gold will do better.
I think gold will do better in real terms, too. Because I think the confidence that exists in today's market is a confidence born of U.S. dollar liquidity. I think people are comfortable with the fact that central bankers and governments around the world are treating as if it were a liquidity issue. They are adding liquidity and at the same time exacerbating the solvency issue. And I suspect that over time, people who are capable of doing the mathematics will understand the root word of the confidence that we feel in the west is "con." And when that occurs, people will increasingly favor the precious-metals complex, not merely gold, but gold, silver, platinum, and palladium over fiat currencies. I think an important theme of the next five years is "Buy something that they can't print."
SmallCapPower: Great. The Canadian junior market and the resource juniors continue to struggle as investors shy away from them despite the TSX and Dow Jones trading at very good levels. When do you see the junior markets starting to perform again?
Rule: That's a very tricky question. I have to give a nuanced answer. Most of the companies on the [Toronto Venture Exchange (TSX V)] are worth nothing. They have no net present value. And we need to have a cleansing on the exchange. We need to have a period like, 1991, 1992, and 1993, where dozens of companies got delisted every month. We need for the bottom half of the exchange at least to go to its intrinsic value, which is zero. So we are going to feel like we're in a bear market in the TSX V for probably 18 months.
What that will disguise is that the best 10% of the companies on the TSX V have probably already bottomed. The market is going to start to bifurcate and the bifurcation will be those companies that can raise enough money to continue to add value and those companies that can't.
You're starting to see a plethora of financing of companies doing nickel deals and raising $300,000. The ability that company has to employ the $300,000, to add value and exploration, is nil. These guys are raising money to pay for working capital deficits and salaries with no hope of generating any benefit to shareholders.
So we need to wash this irrational activity out of the market. What you are going to see in 2013 is that some of the better market participants, some of the people who understand the nature of exploration and are good at stock picking, are going to have absolutely stellar performance years. My own performance in the period 1998, 1999, 2000, 2001, 2002 – that is the last truly ugly bear market that we saw in resources – was absolutely superb. The old vets are going to do very, very, very well in 2013 because they can separate the wheat from the chaff.
And as I say, my suspicion is that the best 10% of this market has already bottomed and is going to head up from low levels. This is going to occur for three reasons. One, we are starting from a cheap base. Some of the better companies that are listed on the exchange are down by 90% from their 2010 highs. So they're simply oversold. They will come back because the sellers are exhausted and the buyers will dominate.
The second reason is, in the oil and gas and mining space, between them, there are probably 50 companies that will be taken over by larger companies. There will be consolidation, and this consolidation will add both cash and hope in the system. There will also be amalgamation, that is, horizontal amalgamations where three or four companies merge, reduce their combined G&A by 75%, and become viable rather than nonviable entities.
But the third thing that's going to happen that people aren't counting on right now is that because we have funded exploration very well for 10 years and because that's what it takes, we're coming into a discovery cycle. We talk about the fact that this market hasn't performed, but the industry hasn't given the market very many reasons to perform. There haven't been very many discoveries. If you look at 2012, which was a dismal market from anybody's point of view, and you look at companies like Reservoir Minerals, $0.26 to $3; Gold Quest, $0.06 to $2; Africa Oil, $0.80 to $10; you will see that the market performs when the industry gives it an excuse to perform. And as a consequence of having spent 10 years in the exploration cycle and being well-funded from 2003 to 2013, the industry is, I believe, on the cusp of a discovery cycle that will really, truly surprise people.
So from my point of view, while 2013 and part of 2014 will feel dismal to market participants who as a whole don't know how to segregate between the good, the bad, and the ugly – the part of the market that matters, the best 10% of the juniors, has already bottomed and is going to be heading up. And some of the upside move in some of the companies that make discoveries will be as explosive as the moves that we've just talked about, 10-fold or 15-fold. What could be really, really, really pleasant is participating in 2013 in private placements with some of the better issuers that have to issue full warrants to attract capital… and then experiencing the 15-bagger that comes from exploration success, not only with the underlying stock but with the full warrant. Because that turns a 15-bagger into a 25-bagger and that's the thing that people will experience, the same way they experienced it in 2003 and 2004.
SmallCapPower: Great. In today's environment, when you are looking for new investment opportunities in resource companies, what do you look for before putting money in?
Rule: People. You want people who have been successful or serially successful and you want them to have been successful at an activity that's very similar to the activity that they're undertaking for you.
It's not enough that somebody has been successful in mining. We said many times that somebody who comes to you and says that he's a good mining man because he operated a gold mine in archean terrain in French-speaking Quebec [isn't] going to be successful exploring for copper in tertiary volcanics, young rock, in Spanish-speaking Peru. The exploration process is different, the production process... archean terrains are different than tertiary volcanics. And certainly there are cultural difference between French-speaking Quebec and Spanish-speaking Peru. You need to back people who are engaged in activities that they have specific success relating to. That's important.
The second thing is that this is a capital-intensive business. Companies that don't have rational balance sheets relative to their expenditures – in other words, people who don't have capital – can't succeed in a capital-intensive business.
And the last thing that's important is scale. There are seductive stories. Stories in particular appeal to entrepreneurial business-building investors that have to do with, as an example, discovering small mines and using the cash flow from small mines to avoid dilution, building a major mine from humble beginnings. It's a wonderful, seductive story. The problem is it doesn't work. Everything that can go wrong with a big mine can go wrong with a small mine, but a small mine can never make you big money. And taking risks that one has to take in exploration speculation, one needs to take those risks in anticipation of very, very large targets. So what you need in summary is management with technical skills that are specific to the task at hand. Either capital in the treasury or capital readily available to them, to undertake the task at hand. And you need scale in terms of the task that the company's assigned itself.
SmallCapPower: Great. And finally, what are you doing with your own money right now in the microcap world and why?
Rule: We're aggressive right now. Sprott-wide on behalf of clients and on behalf of ourselves, we are being very aggressive. Particularly we're aggressive in the private-placement space. We would like to provide the capital to people to finish dreams that they started during the last decade, but are undercapitalized to continue it now.
Particular sectors, we love the platinum and palladium space. We believe that the price of platinum and palladium has to go up. And importantly because of the utility associated with the commodity, we believe it can go up. We're very specific in terms of the platinum and palladium companies that we're investing in. But we like the space physically, and we like the space in terms of exploration, production. If we're involved in exploration activities, production activities, that could be mechanized. The labor-intensive South African model is broken, so we like that space.
We like the gold and silver space. In particular, unusually for us, we like the preliminary economic assessment phase or the pre-feasibility phase. We see five projects – which we're unwilling to name for competitive reasons of course – where the net asset values established in the pre-feasibility study are substantially larger than the sum of enterprise value. And front-end capital costs where internal rates of return are in the 30% range and where payoffs are three years or less. In each of these particular cases, we are highly confident that either the market will return to rationality in terms of the pricing associated with these or the names will be acquired. In either case we'll make good money.
We are also attracted to sub-$300 million or sub-$400 million market cap Canadian oil and gas resource plays where you have large numbers of proved, undeveloped resources on the books and the ability to invest fairly large amounts of money with very repeatable and very acceptable internal rates of return.
And finally, we're very attracted to an exploration model among the juniors that we refer to as the prospect generator/joint venture model… where companies assemble intellectual capital teams that have definable, specific technical or regional skills, develop targets, and farm those targets out to other mining companies who do the heavy capital-intensive listing... where our companies recognize that their true asset is their knowledge base rather than the properties.
We're attracted to those four sectors and we expect each of them to materially reward Sprott and materially reward the Sprott clients on both sides of the border.
Editor's note: As we said, the investment-focused website SmallCapPower originally published this interview with Rick back in February. To see more of the site's financial news and analysis, you can visit its website: www.SmallCapPower.com.