We've long been interested in the thinking of Rick Rule, a founder of US-based Sprott Global, and something of an expert on the resource sector Sprott runs $10bn worth of resource investments. Given the huge declines in commodity equities in recent months, I was keen to talk to Rick myself. However, as our schedules didn't match up (and I loathe phone interviews), we contracted out the talk to Henry Bonner (if you guessed a connection here to Bill, you guessed right). What follows here is my summary of Rick's answers to the questions Henry put to him.
The key questions were about where we are in the cycle for commodity stocks. Are we perhaps at the capitulation stage the bit in every bear market that marks the point at which investors throw in the towel and sell at any price? Rule thinks that, in the junior resource sector at least, we are. "This is my fourth major market cycle and in every previous bear market, the bear market ended in a sort of a crescendo, capitulation downdraft." This tends to be followed by "nine to 18 months of sideways, choppy movement on very low volumes" with a recovery that just doesn't feel like a recovery to anyone "except to stock-pickers".
Clean up your portfolio
That means that anyone speculating on smaller mining and resource stocks needs to "aggressively high-grade their portfolio". Most portfolios, like the market as a whole, probably contain "lots of flotsam and jetsam". During the bull market in resources of 2000 to 2010, perhaps 1,000 to 2,000 new firms were founded that in the end will be non-viable, says Rule. The price of shares in these companies has to "go toward their intrinsic value which is zero". So for the next two years or so you are going to see the junior market "cleaning out the excesses of the last bull market".
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However, that will hide the fact that the best 5%-10% of the juniors are likely to start seeing their prices rise this autumn. This market still rewards the companies that get it right, and it will keep doing so. For example, Colorado Resources recently discovered a new porphyry deposit, and saw its price rise ten times in ten weeks. Shares in companies such as Reservoir Minerals and Africa Oil have also seen huge moves. So the best thing to do is to sell mistakes fast, "however painful" that is, and upgrade to better-quality companies.
One interesting thing to note is that this "is a market with a downward bias". One of its outstanding features "and one of the reasons why here at Sprott Global we were able to make so much money" is that stocks have often sold off on good news. That, says Rule, meant "we never had to buy in anticipation of a drill hole, in anticipation of a feasibility study, or in anticipation of any news at all". Instead, Sprott could wait for the news and then "look for discrepancies between our interpretation of the value of company and the market's interpretation of the value". That generated "spectacular two, three and five-year returns".
The other key point is that management teams at junior companies have resisted raising new money over the last two or three years as their share prices have fallen sharply. Soon many of them currently in "dire straits" will need refinancing. Anyone who really wants to be "in this market through the next up-cycle should begin to participate now in financing these companies", as long as you can get the right deals: "capital is scarce and you get to charge for it".
It is also worth noting that in "three prior cataclysmic market bottoms... the duration and severity of the decline was matched by at least the aggressive nature of the recovery the truth is you have to be a contrarian in this business".
Go for platinum and palladium
So where is Rule most focused now? In precious metals. These are "very seldom fairly priced". Thanks to the fact that there is a sub-set of the population ("including me", says Rule) that is biased towards believing in higher precious metals prices, there is almost always "a premium attached to precious metals exploration companies relative to the value of their potential cash flow", because investors expect the price of precious metals to keep rising.
But today, Sprott's research suggests that the "the opportunity cost in precious metals is the lowest it has been since 1992". Premium exploration assets in the precious metals mining sector are rarely even fairly priced. But right now in certain cases they are "flat-out cheap".
Rule is particularly interested in platinum and palladium, where "we see a market where we think the market has to, and can, go higher for fundamental production reasons" (ie, demand is higher than supply). But he remains keen on gold and silver as well, with the pricing drivers there simply being "the debasement of currency and their traditional roles as inflation hedges".
Outside precious metals, uranium seems a good spot for the contrarian. The sector raised a lot of money seven or eight years ago, but since then "most of the 500 firms that regarded themselves as uranium explorers have failed". The sector is "deeply out of favour", to the extent that "there are companies that have been reasonably successful that are selling for market capitalisations that are less than 20% of the money that they have spent on their projects".
That's attractive: at $40, the uranium price is currently half of what it needs to be "to maintain the supply of uranium that global reactors will be consuming three years' hence". Nobody likes the commodity and nobody likes the sector, but "we do".
Think long-term on base metals
What of the base metals? Rule expects credit constriction in China to put pressure on the steel, copper, lead and zinc producers. "As a consequence there will be literally no money available for base metals juniors." But this too will pass. The discoveries that will be made this year and next in base metals are discoveries that will be put into production five or seven years from now. So "it isn't today's price of copper or zinc that you focus on it's whether or not you can find the copper or zinc that matters, because the prices and credit and market conditions that exist five or seven years from now are the prices that are germane relative to the activity". You need to think long-term to be in this sector.
On to junior energy. This, says Rule, is the "really fascinating sector right now". People tend to think of oil and gas as one big market. It isn't. There is a huge discrepancy between oil prices and gas prices on an energy equivalent basis in the US, and between the US and global natural gas prices, for example. But there will be a gradual convergence.
In America, natural gas is rapidly replacing coal as a baseline fuel for power generation. "It's also a little- known fact that without cheap natural gas, the solar industry and the wind industry as alternative energies in Europe and North America wouldn't work." Natural gas is what makes current available at night for solar. Natural gas is also finally "making the conversion to a motor fuel", starting with the continent's long-haul trucking fleet. "Natural gas prices will rise as a consequence of utilisation, and competition from natural gas will begin to moderate the upside in the oil price."
The best plays in the energy sector
How do you play this? In the juniors "you buy balanced oil and gas producers that generate good cash flow out of oil today, but have gas-rich lands proved, undeveloped gas that will serve as a three-to five-year warrant on what I believe to be absolutely inevitable upside to natural gas prices I would suggest that the more speculatively inclined readers focus on the Canadian oil and gas sector the C$1bn market cap, and preferably the sub-$500m market cap, a sector that has absolutely no market interest... but is absolutely cheap". Investors who pay attention to junior producers whose balance sheets are solvent at today's energy prices, and also have large proved, undeveloped resource inventories of natural gas, should do extremely well over two to three years.
But there is something else going on in the junior oil and gas sector that should be of interest to all financially repressed investors today very high dividend yields. There is an expectation in the market "that the dividend-paying juniors will not be able to continue to pay their yields". That pessimism means you now see some in the market at 18%. But "how would you feel if that yield got cut in half and you only got 9%"?
Aggressive income-seekers, says Rule, need to look at putting together a package of oil and gas income producers. Don't worry too much about the share price. Pay attention "to the sustainability of the dividend yield that you can get from those producers". You should be able to put together a portfolio of five juniors paying between 8% and 11% over at least three to five years, reckons Rule. We'll be looking at this sector in more detail in a future issue. For some ideas on how to invest in the mining sector right now, take a look at our cover story: As China slumps and inflation rises, it's time to go digging for bargains.
Who is Rick Rule?
Rick Rule has been working in commodity investment since 1974. In 1975, a five-year bull market in gold suddenly collapsed, yet Rule kept faith in the yellow metal and was rewarded when it rose 800% in a subsequent bull market. Thanks to that and other investments, by 1992 he was able to set up his own, commodity-focused, asset-management firm, Global Resource Investments. The firm endured a commodity bear market for much of its early years, which, while unpleasant, gave Rule the chance to snap up stakes in struggling miners. Again he was rewarded with a bull market, which boosted the firm's assets under management from $10m to $10bn.
Now chairman of Sprott US Holdings, Rule oversees a wealth manager and broker that specialises in investing across commodities, from fish farms to coal mines.
