Rick Rule: Volatility will present unprecedented opportunity
Renowned resource investor Rick Rule talked with SmallCapPower.com about the ongoing market volatility and how to position yourself to take advantage of it.
SmallCapPower.com: Rick, we’re coming up to the one-year anniversary of Canadian investment firm SprottInc., helmed by renowned resource investor Eric Sprott, acquiring your brokerage firm, U.S.-based Global Resource Investments Ltd., along with your money management firms Terra Resource Investment Management and Resource Capital Investments. The merged entity has been called the world’s largest microcap resource investment company. Almost a year later, has the merger proven to be what you expected?
Rick Rule: I had high hopes and I have to say that the merger exceeded my expectations. Sprott is a very well-run company, and it’s a company extremely deep in bench strength, with a lot of talented people in a lot of roles. And, particularly exciting to me, Sprott has a lot of talented young people. They’re clearly very, very good at hiring and mentoring, which is a skill that, with their help, we have begun to emulate successfully in the United States.
SmallCapPower.com: One of the things you talked about around the time the merger was taking place was the ability of this new company to buy research and then create data from that data that would ultimately influence your investment decisions. Is that taking place as you envisioned?
Rick Rule: Rather than buy research what we tend to do is create research. Rather than take research from the sell side on the Street, and although some of the sell-side research is very good, it’s broadly available. Managing $12 billion in assets, which is what we manage now in the resource sector, we can amortize our own research budget over a fairly large capital base and generate research specific to our needs that’s also proprietary in terms of competing with our peers in the money management business. The access to proprietary research – that non-sell-side driven research – is what we think will be the crucial determinant in our ability to continue to outperform our peers.
SmallCapPower.com: We’re seeing a lot of volatility in the markets, especially over the last month or so. When you look at that data, what are you seeing at a macro level?Are there some pictures forming?
Rick Rule: I think you put your finger on it. What I have been calling for – specifically in the last 12 months – is volatility on steroids. In a resource market you are going to see markets driven by what they’ve been driven by in the past: frontier market demand. And you’re going to see supply continually constrained as a consequence of the bear market in raw materials that lasted from the early 1980s to the beginning of the last decade. So you have a classic bull market in commodities driven by reduced supply and expanding demand. At the same time that’s happening, you have very bad economic conditions in the developed world. I see a high probability of black swan events. Black swan events are supposed to be asymptomatic, but I see so many black swans on the horizon it feels like a flock of black swans. So I think you’re going to have volatility as these two big trends collide. I think you’ll have liquidity seize-ups, inter-bank lending seize-ups as a consequence of any number of sets of circumstances. I think the volatility that you’ve seen in the last three or four weeks is just a down payment. I think that you’re going to see extended periods of heightened volatility and I think that will be unnerving for most market participants. Given that my own style is event-driven rather than market-driven, I would suspect that while the next 12 months will be unnerving, it will be as good a 12 months in terms of opportunities sets in pricing as I’ve ever observed in my career.
SmallCapPower.com: Given that information, should investors sit with a significant portion of their portfolio in cash so that they will be ready to take advantage of some of those opportunities?
Rick Rule: Cash or bullion, absolutely. I think liquidity is absolutely critical. Liquidity gives you the ability to take advantage of situations that the market delivers to you. But just as importantly it gives you the courage. It is difficult for somebody to sell out of a losing position, to buy a position that has more promise. It’s less difficult to switch out of cash into a position that has more promise. So having liquidity in the form of cash and/or bullion, ready to commit when the market makes a pricing mistake is going to be absolutely critical to performance in the next 12 months.
SmallCapPower.com: Eric Sprott’s Sprott Foundation recently sold two million units of theSprott Physical Gold Trust (NYSE: PHYS) at around $1,800/oz. gold and then invested that cash in the silver market. EricSprott then proclaimed that the investment of the “next decade” would be silver. Do you agree with his assertion?
Rick Rule: I don’t know. Eric is a student of markets. I would point out that precious metals markets are driven by the two primary investment motivations: greed and fear. When it comes to bullion purchases, I am primarily a fear buyer. I am trying to preserve my purchasing power. Eric is profoundly a greed buyer. Eric is a wonderful student of markets and Eric has the point of view that gold will outperform most things, but silver will outperform gold. I’m buying because I’d like to sleep nights and he’s buying because he’s intensely competitive, a student of markets. I’m not trying to dance around the question, but rather explain our relative viewpoints.
SmallCapPower.com: Is that something that you’ve learned from Eric in terms of investing?
Rick Rule: When Eric was asked to describe my chief investing fault, he said, “Sometimes Rick is afraid to be right.” I’m so cynical and so much a pawnbroker, that when I have an idea that’s an extremely good idea, and I have the idea when the rest of the market doesn’t have it, I tend to sort of tiptoe in. Eric’s belief is that studying a question to perfection is a form of procrastination. And he’s been enormously successful by really, really crowding into an idea aggressively that he has studied thoroughly. I would say that that’s what I’ve learned from Eric. It’s a lesson that I knew academically, if you will, but he’s taught me to be more instinctually aggressive in these markets.
SmallCapPower.com: And what, may I ask, do you think he has learned from you?
Rick Rule: I think we’ve contributed a bit to Eric in terms of our focus more on companies and less on markets. For us, a market is merely a facility for buying and selling fractional ownership in a business rather than a source of information. My own point of view is that markets are really places to catch discrepancies and I think that Eric has always agreed with our deeply seated instinct toward fundamental analysis. But I think when he looked at the level to which fundamental analysis had contributed to the companies’ investment performance over the last 20 years, and particularly to the fact that we were already paying for all that fundamental analysis so that he got it for free, I think our joint hope is that our focus on the micro and his skills in the macro will reinforce our joint performance relative to our competitors.
SmallCapPower.com: Over the years, you have made a lot of money in the precious metals space. But we’re seeing a somewhat unprecedented phenomenon where precious metals are vastly outperforming precious metals equities. Do you think equities will close the performance gap before the end of 2011? And, if not, how long will that lag last?
Rick Rule: I have to give you a nuanced answer to that. I think the better precious metals companies will, in fact, close the lag. And I think we need to spend a bit of time on that question.
The lag, I think, occurred for several reasons. The first being that the precious metals stocks, three, four and five years ago, performed extremely well in anticipation of some of the gold and silver price escalation that we’ve enjoyed. So some of the move was already priced into stocks.
The second thing that happened was despite that the price move in commodities, the companies didn’t enjoy increases in free cash flow that were commensurate with what one would expect as a consequence of the commodity price moving. In other words, the companies as entities didn’t perform anywhere near as well as the market thought they should have; they disappointed in terms of their performance.
The third thing was that although the individual share prices of the juniors and seniors didn’t escalate as much as people had expected over five years, the market cap of the sector exploded as a consequence of a capital raising and new company formation. So, we’ve gone from having many fewer participants with smaller share counts to many more participants with much larger share counts. And what happened, in effect, was inflation, private inflation, where the amount of paper that was issued to represent the wealth associated with the companies expanded just as surely as the U.S. government expanded paper circulation in our country.
I would say the fourth thing is that in the junior population, probably 90% of the issuers are absolutely valueless. And I think the incredible profusion of valueless paper has constrained the market.
On a going-forward basis, I think that’s about to change or some of those factors are about to change. In the first instance, the free cash generation by the senior and intermediate gold mining companies is absolutely exploding. In other words, they are generating the free cash that we all expected them to begin to generate four years ago. They’re finally starting to perform. And this free cash gives them the ability to acquire smaller companies and expand organically rather than expand via equity issuances.
The second thing is that we’re now 10 years into an exploration cycle. I think the exploration cycle in gold began in 2002 when the financing window opened up for the juniors. And 10 years of exploration has begun to generate enough results that you’re starting to see exciting exploration successes take place around the world. I think that this combination of corporate performance and exploration success and the acquisition of juniors and intermediate companies by seniors will ignite a pretty ferocious gold equities rally among the best of the issuers.
Finally, the availability of exchange-traded investments in the form of physicals, trusts and exchange-traded funds has given equity investors other alternatives in the precious metals arena.
SmallCapPower.com: Basically, you’re saying consolidation will bring the performance of precious metals equities back in line with the performance of their underlying commodities.
Rick Rule: Consolidation and discovery. It’s important to add “and discovery”. There is nothing that adds hope and excitement to the sector like an Arequipa making a 5-million ounce discovery and going from 30 cents to 30 dollars in 19 months. And I think past is prologue in that regard. I think that we’re going to see some of those extraordinary successes in the next two years. It isn’t always going to feel like it because the extraordinary volatility that we’re going to face is going to make people really, really, really uncomfortable while these underlying trends play themselves out.
SmallCapPower.com: In an interview on www.gril.net dated Oct. 4, 2010, you suggested that of the 5,000 or so junior mining companies that are publicly traded, you are actively involved in about 300 to 400 of those, or a little less than 10%. I realize you can’t discuss specific companies but what are some themes you’re looking for in those 300 or 400 companies that are actually worth investing in?
Rick Rule: The most important theme, at least in the juniors, is management. You need a management team that has been successful in the past and they need to have a skill set that’s very much suited to the task at hand. You can’t, as an example, have somebody who is successful operating a gold mine in French-speaking rural Quebec claim that those skill sets are appropriate to looking for gold and copper in Spanish-speaking rural Peru. The skill sets have to be immediately adapted to the task at hand.
In terms of the non-human attributes that are attractive to us in the larger companies, we are looking for both organic production growth and declining costs in the three- to five-year time period. We’re looking for companies that have development-stage projects and internal exploration, in-field exploration, that will more than replace the ounces they produce. And where their production five years from now will be 40 or 50% higher than it is today, at lower costs. That’s absolutely critical from our point of view, among the seniors. We want the financial flexibility that will get them through the sort of credit constraints that existed in 2008 and fund their growth internally or organically.
We look one step below the seniors at companies similar to Red Back Mining (which was purchased by Kinross Gold in September 2010), companies that have done such a good job with a drill bit that they absolutely must and will be acquired by the seniors. And we look very specifically for companies that have properties that have operating synergies with existing deposits already operated by the majors.
Coming down the quality chain into the intermediates, we look at feasibility- or prefeasibility-stage deposits that are underpriced on a net-present-value basis or are misunderstood by the markets in that they have more exploration upside than the market is according them. By the way,looking at companies on a net-present value basis is a much stricter test than market cap by reserve and resource ounce.
And then all the way down at the bottom of the spectrum we look at exploration projects that have a third dimension, have a drill hole in them that we think has the size characteristics and the terrain characteristics that will allow them to build wealth very rapidly through the drill bit.
And finally, on this side of the border at least, we are active providers of working capital for the prospect generators, people who do early stage grassroots exploration and market their successful efforts through joint ventures with larger mining companies.
SmallCapPower.com: So you favour the prospect-generator model?
Rick Rule: Absolutely. The prospect generator has several advantages. The first advantage is that in the real micro junior – the sub-$50 million market cap companies – the most important asset that most of these companies have is the intellectual capital of the management team. Most of the other assets they have actually only convey the right to spend the money; they are obligations as opposed to assets. The prospect generator preserves your interest in the intellectual capital by not issuing shares and funds exploration via third-party expenditures. The other advantage that the investor gets from that is that the project due diligence that you otherwise have to do yourself, is done by other mining companies. The most sincere form of flattery is when a good geologist decides that your ideas are good enough relative to his or hers that they commit to spending $5 or $6 million on your ideas. That’s much better than getting a consultant who charges you $5,000 for an opinion. We really like the prospect generator model. And it’s been extremely good to us over the last 30 years.
SmallCapPower.com: Beyond gold, what are some other commodities that you’re zeroing in on?
Rick Rule: I love the whole energy complex. I think oil prices will be much higher five years from now than they are now. I think natural gas prices, both in terms of the U.S. and Canada and then internationally will be higher than they are now. I think the uranium sector is cheap after having been ludicrously expensive. And I think the alternative energy sector is truly washed out. And given that I think that all energy is going to trade higher, we will be aggressive buyers of some of the microcap alternative energy stocks.
SmallCapPower.com: In the same interview that I referenced earlier, you touched on a number of investment themes, but one was alternative energy. At the time you said that no one was buying geothermal equities and that you were going to convince the big thinkers at Sprott that alternative energy was the place to be. Did you succeed?
Rick Rule: No, mercifully for Sprott, I was wrong. One of the things about me is that I’m normally very early. I’m a highly linear thinker. If I’m confronted with an equation where if “a” is true and “b” is true and “c” is true and “d” is true and “e” is true, then “f” is the likely result. My difficulty is that I often confuse the word “imminent” with “inevitable” in that set of circumstances. And I think the success of the geothermal power companies is inevitable but surely it is not imminent. Further to the geothermal theme, if I may, I’ve been asked by numerous speculators what’s wrong with geothermal, and I’ve pondered this at length. The answer I have is that nothing is wrong with geothermal. What has gone wrong is that the management teams that we have pursued the geothermal business with have been highly flawed. The problems with the junior geothermal sector have been implementation problems, not a problem of the sector necessarily. I think we’re halfway through the process of fixing that, so I’m attracted to the geothermal sector. That isn’t to say that I would advise your readers to rush out and buy geothermal equities now. I suspect that in November and December – tax-loss selling season this year – if you combine tax-loss selling season with the volatility in all markets that I expect between now and then, you might have a once in a generation opportunity this November or December.
SmallCapPower.com: Is there one specific investing strategy that you can impart to the readers of SmallCapPower.com?
Rick Rule: My technique has been to be very value oriented and very contrarian. And those two attributes have made me successful. One must pay attention to the value inherent in stocks, particularly what Ben Graham would have called your margin of safety. And one needs to be contrarian, paying attention to what Ben Graham described as Mr. Market, the manic-depressive, that’s on the other side of the market from you every day. And I’ve been very good at that for 30 years, that’s how I made my living. I have occasionally forgotten - well, more than occasionally, unfortunately - I have forgotten that in development-stage projects, it isn’t the project but rather the people developing it. In the junior side of the market, an even more slavish attention to people is what will improve my investment performance over the next decade.
SmallCapPower.com: Do you have some parting thoughts for our readers?
Rick Rule: Yes, simply this: strap on your seatbelts and keep a lot of powder dry. You are going to see markets gap up 20% and gap down 30% for almost no reason whatsoever. The volatility that we are going to go through is going to be unprecedented in the memories of even experienced investors like me. And it will be absolutely unnerving for novice investors.
If you look back to 2008, there was a point in time when 19 of the companies that we followed were selling at one-half cash in the treasury. Saying no to a trade like that is like walking down the street and having somebody offer you a dollar bill for two twenty-five cent pieces. If you have the ability and you have the courage, this volatility is going to offer you absolutely unprecedented opportunity. But if you aren’t prepared to take advantage of the volatility, the market will, in fact, take advantage of you.