Key lessons in hard-work for gold mining stock buyers...
RICK RULE, CEO of Sprott US Holdings Inc., began his career in the securities business in 1974.
A leading American retail broker specializing in mining, energy, water utilities, forest products and agriculture, Rule has built a national reputation on taking advantage of global opportunities in the oil and gas, mining, alternative energy, agriculture, forestry and water industries.
Now he tells The Gold Report here how he is looking for "optionality" in natural resource stocks, rather than dilution from companies looking to justify salaries. Because the natural resources market is not rewarding companies for pulling resources out of the ground, but one of the hardest things for a mining executive to do may be nothing.
TGR: The Silver Summit was the first time I heard you explain the concept of "optionality". What is your advice in this climate for mining investors?
Rick Rule: For the right class of reader who is speculative and willing to do the work, there is a class of junior company that offers extraordinary leverage to the changing perceptions in favor of gold and gold equities.
It is inherently illogical to put a mine in production because you think the price of a commodity is going to go up in the future. Let's say that there's a five-year lag between the time that you put the mine in production and the time that the commodity price goes up. What happens is that you've mined the better half of your ore body and sold that gold during periods of low gold prices in anticipation of higher gold prices. So the gold price goes up, and you have a hole in the ground where your gold used to be. Fairly silly.
A much better strategy is to buy deposits cheaply when gold prices are low. Then hold them in the ground, spending almost no money on beneficiation. Spending money at that point only causes you to issue equity, which reduces your percentage ownership in the deposit.
TGR: How does someone who is not a geologist know what the relative cost of getting that gold is if the company hasn't done some work like drilling and publishing a preliminary economic assessment to educate me?
Rick Rule: One thing investors can do is subscribe to publications like Brent Cook's newsletter or visit the free educational material at Sprottglobal.com. The truth is that nobody, even the best investor in the world, is going to get it right all the time. All you have to do is get closer than your competition. Given the fact that most of your competition isn't doing any work whatsoever, the bar isn't very high.
TGR: Another investment strategy that you have been a fan of is streaming companies. How would you compare their optionality given where the gold price is now?
Rick Rule: I love the streaming business. It's regarded as an extremely conservative strategy, and maybe that's why I like it. In the streaming business, the contracting company buys the rights to a certain amount of gold or silver from a mine for a fixed price over a given period of time. The company receives the gold in return for a pre-negotiated payment irrespective of the gold price at the time that the gold is received. The company that contracts for the gold isn't responsible for the capital cost required to build the mine, so any cost overrun associated with the mine is irrelevant to the streamer. Similarly, it is not responsible for the operating cost of the mine. It has already locked in its costs. Commonly, those are about $400 per ounce. The margin between $400 per ounce and $1000 per ounce – $700 per ounce – is substantially greater than the margins enjoyed by the mining industry in general, which are, in fact, negative.
What I really like about the streamers right now is the arbitrage in cash flow valuation between the streaming companies and the base metals mining companies. Precious metals-derived revenues in a streaming company, because of the success of streamers in the last 20 years, have been capitalized at about 15 times cash flow. That same precious metals revenue as a byproduct revenue in a base metals mine is capitalized at about six times cash flow. That means that a streaming company could buy that cash flow from a base metals mining company at $10 million, and it would be wildly accretive to the streaming company at the same time as it would materially decrease the cost of capital for the base metals mining companies.
Base metals mining companies are in truly dire circumstance right now, with the price that they're being paid for their base metals commodities being substantially lower than their all-in sustaining capital costs for producing it. This means that the base metals mining companies need to do whatever they can do to lower their cost of capital. My suspicion is that you will see many billions of Dollars of precious metals by-product streams from base metals mines being sold from the major base metals mining companies around the world to the streaming companies. My suspicion is that these transactions will simultaneously save the base metals mining company billions of Dollars in capital while being accretive to the precious metals streamers by billions, too. I think this is a transformative event for the streamers.
TGR: If a base metals company is essentially losing money for every pound pulled out of the ground, why wouldn't the management leave the commodity in the ground until prices increase? Why don't they practice optionality?
Rick Rule: One of the challenges with the optionality strategy is it is very tough to get a management team to do nothing. It's tougher yet to get them to be paid appropriately for doing nothing. Not mining is an awful lot cheaper and an awful lot easier than mining, but the truth is that there's a bias to produce, and there may be a need to produce. Your all-in cost to produce 1 pound of copper may be $2.75, but your cash cost to produce that pound may be $1.70, and if you sell it for $2 per pound, you are generating $0.25 to service debt and cover the all-important CEO salary.
TGR: Frank Holmes agreed with you when he said that while the price of gold seems to have languished in the US Dollar terms, in other currencies it has been doing quite well. Particularly, he pointed to Australian mining companies as standing out. Do you agree?
Rick Rule: Australian gold stocks have performed incredibly well this year, so part of that thesis has been used up by the share price escalation of those companies. Given that Australian gold mining companies sell their product in US Dollars but pay their costs in Australian Dollars, they had a de facto 40% decrease in their operating costs, which is extraordinary.
In fact, the decrease was deeper than that because a major component of their variable costs is the price of energy, and the price of energy fell 50% in US Dollar terms at the same time that the Australian Dollar fell further. That means that the operating performance of gold mining companies in Australia relative to gold mining companies whose costs are denominated in US Dollars with US operations has been extraordinarily good.
We don't see any near- or immediate-term strength in the Australian Dollar, so this cost competitiveness could continue. Additionally, the iron and the coal industry, which compete for workers and inputs directly with the gold industry, have experienced continued distress, which means that the cost push even in Australian Dollar terms will diminish.
Plus, we see the Australian market as more honest than the Canadian or the London market in the sense that the mining industry in North America and Europe became increasingly securities-oriented where the value proposition became rocks to stocks and stocks to money. In Australia, the ethos is more a direct drive, more a sense that you want to make money from mining and that the stock ought to take care of itself. We see that as a competitive advantage that will continue for five or six years while the North American and European industries reform their expectations.
TGR: The value of the Canadian stocks has been decimated over the last three years. If the management teams are not focusing now on making money now, what's going to make them change?
Rick Rule: Hopefully, bankruptcy. There are 500 or 600 listings on the TSX Venture Exchange that are zombie companies with negative working capital. They're in a capital-intensive business, but they have no capital, so they aren't really in businesses. These companies need to be extinct. It's an ugly thing to say to the people who own stock in these cockroaches and uglier still to the people who work for the cockroaches, but it has to happen.
TGR: You'll be speaking at the Vancouver Resource Investment Conference at the end of January. What are you hoping that investors take away from that conference?
Rick Rule: This conference is in Vancouver, so it's easy and cheap for companies to exhibit there. The first thing that I hope that people do is understand that if the narrative that existed with regard to resources and precious metals in 2011 was true then, it's more true now. Only the price has changed. Investors need to recognize that a market that's fallen by 88% in nominal terms and 90% in real terms is precisely 90% more attractive now than it was then. The mistakes that people made then were mistakes of overvaluation. The mistakes that people make now are mistakes of undervaluation.
It's important, however, not to make the mistakes that we made in the past. The truth is that you need to temper your expectation of wonderful stories with hard core reality, with securities analysis, which people are unwilling to do. At that conference, you will have the ability to learn lessons in equity market valuations if you are willing to work and absorb them. And you have the ability, with 200 exhibitors present, to practice the lessons that you've learned in real time, 20 or 30 meters away from where you learned the lesson itself. So it's a wonderful opportunity for people who come to work rather than people who come to be entertained.
TGR: Thank you, Rick, for your insights.