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The
Gold Report met up with Rick Rule, founder and chairman of Sprott Global Resource Investments Ltd, at the Hard Assets
Conference in San Francisco. In this interview with The Gold Report,
he shares his belief in the power of gold as both "catastrophe
insurance" and an investment vehicle. As to equities, he sees a new
discovery cycle lifting the prospects of majors and juniors alike, as long as
they act like "rational" businesses.
The
Gold Report: Rick, you believe the natural resources sector is
experiencing a cyclical decline in a secular bull market similar to the
1970s. Is that true for other sectors as well?
Rick
Rule: I learned the hard way not to assume that my
success in the natural resource business was transferable to other sectors,
so I am going to stick with resources.
However,
there are parallels with the gold market. In the 1970s, we had a spectacular
resource market, in particular for gold. Its price soared from $35/ounce (oz) to $850/oz. By 1975, in the middle of that secular
bull market, gold had fallen to $100/oz. Those who sold at the bottom missed
an 800% move in six years.
It
is important to understand that in cyclical markets like resources, declines
in secular markets are to be expected. From my point of view, you need to
understand cyclical declines for what they are—sales.
TGR: Is
it fair to think that the prices of natural resources will bounce back as
they did in 1970s, when the recession was much shorter and not as global?
RR:
That depends on the resource. For gold, the answer is yes because the
parallels between the 1970s and today are striking.
The
U.S. dollar has stayed fairly strong, not because of the strength of the
economy but as a function of the dollar's liquidity. As the U.S. dollar
appreciates relative to frontier and emerging market currencies, we are
causing very real inflation in places like India, Vietnam and South Africa.
In the
U.S. however, we are seeing inflation in two places: in the liabilities that
we are leaving for our heirs and in a tremendous bond bubble. The prices of
U.S. Treasury securities, the inverse function of the yields, suggest that we
are in the biggest economic bubble in history.
When
the U.S. went through the economic turmoil of the 1970s, we went into it with
a much stronger national balance sheet than we have today. Then, we had the
ability to capitalize our reconstruction while we serviced our debts. I am
not sure we have that ability anymore. Our federal on-balance sheet and
off-balance sheet liabilities, relative to our ability to service those
obligations, are much lower. The alternative is to inflate our obligations
away, which would be good for bullion.
Finally,
in a demographic sense, our needs will continue to outpace our means. In the
1970s, you and I were coming into our productive years. Today, you and I are
at the opposite end of our productive years, no matter how much we want to
forestall it. The demographic implications of that are profound. If a country
cannot produce its way out of its deficit, it has to default.
TGR: Or
quantitative ease.
RR:
That is a form of default. There are two ways to default. You can renounce your
obligations or you can lie. Quantitative easing (QE) is the lying part. You
depreciate the currency that your obligation is in.
TGR: But
with the entire world in that situation, are we in a cyclical decline or is
the bull market over, specifically for gold?
RR: The
West is in for a period of muted demand for commodities. As the advanced
economies become less free and poorer, and frontier markets become more free
and richer, it will lead to volatile demand characteristics for many
industrial commodities.
Overall,
I am afraid that the circumstances ahead of us will be very good for all
precious metals. Traditionally, gold has been a great way to avoid the impact
of chaos. When other exchange mechanisms—yen, renminbi,
euros, dollars—are engaged in competitive
devaluation while managing a staged default, people will look for a medium of
exchange that is also a store of value: gold. It is not a promise to pay; it
is payment.
TGR:
Does more QE portend that gold or equities will be a better return?
RR:
They are very different asset classes.
Rationally,
I might not be well advised to own any gold at all because I have so much of
my net worth tied up in my business, which reacts to the gold market.
Nonetheless, I own a lot of gold, silver and platinum bullion. I own it the
way that I own life, auto or homeowner insurance. I regard it as catastrophe
insurance.
I
would suggest that your readers establish a core or insurance position in
bullion and hope to God that later on they can regard that investment as a waste
of time and money.
TGR:
Over the last several years, if you bought gold for its investment return,
you would have done better in bullion than in equities. Why do we keep
telling people not to look at physical gold for investment return when it has
outperformed equities?
RR: I
would not discourage that either. It is implied at the Hard Assets Conference
that rising gold prices will affect the share prices of the exhibitors, most
of whom have no gold; they are looking for gold. If the price of something
you do not have goes up, it should not have any impact on your share price.
As
for the companies that do have gold, their performance over the last 10 or 12
years has been pathetic relative to the increase in the price of the
commodity that they produce. That said, I believe we
are through the worst of that. We should see the senior and intermediate gold
companies begin to perform surprisingly well at the corporate level.
TGR:
Why?
RR: The
companies have learned lessons. Investors asked mining companies to exhibit,
as an investment characteristic, leverage to the commodity price. In other
words, we asked them to be marginal. Marginal producers enjoy the most
outsized gains in an escalating commodity price environment. The industry
gave us exactly what we asked. They became extraordinarily marginal and
inefficient.
Four
years ago, an irrational metric appeared that sticks in investors' minds:
ounces of gold in the ground per dollar of enterprise value. You divide the
enterprise value into the number of ounces, without taking into account the
capital cost of bringing the ounces into production, the cost of extracting
the gold or the time value of money. Ounces were valued irrespective of
whether or when they would be recovered.
Increasingly,
investors are telling management teams to be rational. They are telling
managements, "In addition to giving us some leverage to the gold price,
it would be nice if you made money. We do not want to see you buy 20 million
ounces at 5,000 meters (m) in the Andes, only to have to spend $7 billion to
bring the deposit on and generate an 8% internal rate of return (IRR) with a
7-year payback. We would rather see you do something that generated a 30% IRR
with reasonable amounts of capital where you pay back the capital in three
years.
Investors
are asking the gold mining business to become a business. That is not too
much to ask.
TGR: But
in your opening remarks at the Geo Tips seminar, you noted how many of the
publicly held mining companies have no gold. That seems contradictory.
RR:
There is no contradiction. We want the producing companies to be rational.
With regard to the juniors, 80% of them have no net present value (NPV).
The
attractiveness of the juniors is twofold. The junior share prices have all
been taken down, the good companies along with the bad. There are probably 20
developmental-stage juniors selling at substantial discounts to the NPV of
their existing deposits, even though those deposits will grow through
exploration. The major mining companies know it will be easier to buy that
resource than to discover it. So the first point of attraction for juniors is
that the major mining companies, in order to stay steady—much less
grow—will have to acquire deposits.
The
second thing, and it is somewhat hidden, is that we are coming into a
discovery cycle. In the next 12 to 24 months, we are going to see reasonable,
maybe spectacular, discoveries with increasing frequency. This is a market
that rewards tangible results. There is nothing like discoveries to add hope and
liquidity in the junior market.
TGR: How
does an investor know when to jump into a junior exploration market?
RR:
That is a big topic. In brief, the dynamic changes from market to market. You
need to figure out which parts of the market are unloved and, hence,
available. You have to pay attention to where the values are and set your
strategies not by what you wish would happen but by the facts represented by
pricing in the market.
The
most common mistake I see speculators make is regarding the market as a
source of information. It is not. It is a mechanism for buying and selling
fractional ownership of businesses. Getting your information from the market
is the same as getting your information from the expectations of 10,000
people who probably know less about the topic than you do.
TGR: But
can an investor use catalyst events like a preliminary economic assessment
(PEA) or a drill result to minimize the risk?
RR: The
beauty of a bear market is that people's expectations are so low that many
companies sell off on news, even news that is not truly spectacular. For the
first time in my career, I see developmental-stage juniors with PEAs selling
at substantial discounts to the admittedly speculative values established in
the PEA.
We
look for three things in a company: One, the sum of the enterprise value of
the issuer and the front-end capital costs are lower than the NPV at today's
gold prices. Two, IRRs above 25% but preferably about 30%. Three, capital
payback within three years. I have not seen these three things come together
very often in my career, but they are occurring right now.
With
a good deposit, a couple of things will happen between the PEA and the
bankable feasibility study. In the two years it takes to get from PEA to
bankable feasibility study, the deposit is likely to be bigger and higher
grade. More important, the bankable feasibility study gives legal cover to
the outside directors of an acquirer. It takes courage to take over a company
based on a PEA; with a bankable feasibility study in hand, you are covered.
TGR: You
mentioned earlier that the majors have to acquire. How much does proximity to
a major increase the likelihood of a junior being acquired?
RR:
Being next door to an existing operation lowers the total cost associated with
the acquisition. Because the infrastructure costs have already been paid, the
major can afford to pay more for you.
TGR: But
there also is no bidding.
RR:
That is the bad news. It is tough to have an auction with one bidder.
There
are two positives in this market. First, compared to 2010 at least, it is
cheap. And cheap is good. Second, some of those cheap companies are also good
companies. Granted, investors may not get huge premiums in a takeover, but a
probable 40% or a 50% premium today is better than a mere possibility 12 to
24 months out.
The
wild card that few people are focusing on is this discovery cycle. Having a
low-cost entry point in 2012 is preferable to a high-cost entry point in
2010, in particular because we are two years further into the exploration
cycle and the payoff is closer. People are going to make tenbaggers
or fifteenbaggers.
TGR:
Rick, I know you like the prospect-generator model. Would you advise
investors just coming into this market to start by investing in prospect generators?
RR:
Because prospect generation is such a rational approach, most people cannot
do it. Most people come into the exploration sector for emotional reasons.
They want to believe the newsletter propaganda, "I made 603% in seven
trading days."
If
you want to take emotion out of the exploration business and focus on cash
and cash returns over time, you can pursue a portfolio strategy that will
give you three standard deviations of superior performance over a decade. You
have to manage your hope and be willing to watch your portfolio decline 30%
or 35% in a bad year.
TGR: It
really comes down to a risk-appetite decision.
RR: You
just put your finger on the most important part of the equation. If you are
engaging in a high-risk, high-return activity, returns take care of
themselves. You have to manage risk.
The
expectation of exploration has to be failure. When most of your investment
decisions are unsuccessful, your winners have to amortize your losers. Every
step that you take in building a speculative portfolio has to be a step taken
with the view to minimizing portfolio risk in an extremely risky activity.
Most
speculators are reward chasers not risk managers, which is why most people
who come into the sector fail.
TGR: You
have long been involved in debt financing. Is that on the increase?
RR:
Yes, for a couple of reasons. First, we have had 10 years of extraordinary
equity investment in resources. That builds up collateral for a lender.
Today's collateral values in the mining business are orders of magnitude
better than they were 10 or 15 years ago.
Second,
equity costs companies money now. In 2009 and 2010, underwriters and
speculators were throwing equity at companies. Now, equity issuers believe,
rightly or wrongly, that they are selling at 30 or 40% of net asset value,
which makes issuing equity very expensive. Companies realize that coming to
us as bridge or mezzanine lenders is substantially cheaper than equity
financing.
Oddly
enough, the market often sees that these companies need capital and prices
the equity down in anticipation of an offering. If the company borrows
$30–35 million from us, the pressure comes off and its market increases
by 25% or 30%. The company can then raise what it
needs to pay us back in the equity markets.
Now
is the best set of circumstances to be a bridge or mezzanine lender that I
have seen in 30 years in the natural resource markets.
TGR: Do
bridge and mezzanine financing carry less risk with slightly less yield?
RR:
Yes. In effect, it is junk debt, but not the kind that Wall Street offers up.
As lenders, we will not make a tenfold return, but we have a probability
rather than a possibility of 15% compounded annual returns with much less
risk.
TGR: How
does one get involved in debt financing?
RR: You
can own shares in us or participate with us in private lending syndicates.
You can also buy shares in Dundee Bank Corp. or Macquarie, the Australian
bank. There are also public markets for high-yield or junk debt, primarily in
Canada. There are some very nice bond issuances in the mining and the oil and
gas sectors with returns in the 7.75–8% range.
TGR: At
the conference, you are talking about The 9 Nosy Questions to Ask Mining
Experts. What is the one fatal question investors do not ask?
RR: Can
I have two?
First,
you must ask a management team to describe its track record of success. For
example, a promoter might tell you he operated a gold mine in Precambrian
rocks in French-speaking Québec but his new project is exploring for
gold in tertiary volcanics in Spanish-speaking
Peru. It is important to understand management's track record of success in
an endeavor that is relevant to the current situation. Investors are not
discerning enough with regard to the specific expertise needed in every task.
The
second thing that's critical is to ask management how funding will be
obtained. Reward chasers will sit at a booth and the promoter will say we
have 800,000 oz (800 Koz),
we're going to drill 50,000m, there's going to be this new flow, we're going
to do this and we're going to do that. What the investor has to say is, hmm,
interesting, so how much money is this going to take over 18 months? How much
general and administrative (G&A) expense do you have? What's the
relationship between G&A expense and exploration expense? If you don't
have the money, why am I listening to you? Many times I'll be on the exhibit
floor and somebody will have a $10M exploration budget and a $3M G&A
budget, so there's $13M to answer my unanswered question. And they have $2M
in the bank. I say to them that I don't really have to listen to you anymore
because you're $11M away from giving me the answer that's going to get me an
increased share price.
TGR: But
isn't that what you do in your private financings?
RR:
Sure. If I can answer the question as to where the capital is coming from,
then I've removed the risk. But if I can't, I won't.
TGR: So
absent the ability to go into private financings, you need to have the money
to answer the questions.
RR:
Yes, absolutely. I'm not suggesting this is a recommendation. If you talk to
a prospect generator, its exploration budget this year may be $20M, and joint
venture partners are going to spend $17M of that. So its net exploration
expenditure is $3M. Its G&A budget is $2M. So it needs to find $5M and it
has $180M in cash and securities. The question is answered. You have a yes.
You see another company, however, that is operating on its own nickel, whose
budget is five or six times the cash it has, and if it can't give you a very,
very, very good answer as to where it is going to get the money, you get to
walk away.
About
20 years ago probably, I gave a speech at one of the predecessors of this
conference, the Boston Gold Show. After I got offstage and changed into casual
clothes, I was wandering around the exhibit hall. A particularly aggressive
salesman tackled me, brought me in the booth and went on and on about all the
stuff he was going to do. I said that's very interesting. It's going to cost
a lot of money. How much money do you have? He said, well, that doesn't
really matter; I said tell me more. I didn't have my nametag on. He said that
there's a really, really hot California stockbroker named Rick Rule. I said
that I have heard of that guy, he spoke here. He said that he's going to
finance us. I said, is that so? He said the opportunity really is that Rick
doesn't like to finance things below $2/share, and our stock is at
$0.60/share. When we get it up to $2/share, he'll finance us and, in effect,
you can leverage off his money. I asked why would he do that?
He said that's just the way he is. So at that point, I got out my driver's
license and I said I know this Rick Rule guy really well.
TGR:
Rick, any final words of wisdom for our readers?
RR:
It's important to understand that part of this business involves painting
dreams on a piece of paper and marking up the paper based on the dream. With
4,000 companies out there, the game is not finding something to invest in.
The game is throwing away stuff quickly so that you are not wasting time on
the dross.
TGR:
Rick, thank you for painting a rational approach to gold investing for us
today.
Rick
Rule, founder and chairman of Sprott Global
Resource Investments Ltd., began his career in the securities business in 1974.
He is a leading American retail broker specializing in mining, energy, water
utilities, forest products and agriculture. His company has built a national
reputation on taking advantage of global opportunities in the oil and gas,
mining, alternative energy, agriculture, forestry and water industries.
Source: Karen Roche of The Gold Report
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