"We don't have real capitulation yet..."
THREE SPEAKERS at a recent Casey Research summit tell The Gold Report why they are looking forward to a buyer's market. They are: Global Resource Investments Founder and Chairman Rick Rule, Casey Research Senior Editor Louis James and Casey Energy Opportunities Senior Editor Marin Katusa.
The Gold Report: When we talked last fall after the When Money Dies summit, Rick, you were looking forward to the volatility preceding the decline of paper currencies as an opportunity to take advantage of the liquidity crisis.
Rick Rule: The volatility I anticipated didn't happen because the amount of quantitative easing—I would call it counterfeiting—was extraordinary. That cash coming into the system acted as a soporific, so the volatility I had hoped for did not in fact come to pass. People whose portfolios declined probably felt they experienced volatility, but I think it was the weight of the chronically overvalued junior resources sector. Probably 80% of the sector is nonviable and in a state of permanent decline, with the market occasionally punctuated by up moves driven by performance among the best companies.
TGR: So, you were disappointed.
Rick Rule: I was very disappointed. I expected a Volatility S&P 500 (^VIX) in the range of 30. For somebody who makes a living basically as a pawnbroker, there are no better circumstances than extraordinary volatility. I didn't get to practice my trade.
TGR: Do you think it will change in the second half of 2012?
Rick Rule: I don't know, but the disconnect between the way we in the West live and the way we can afford to live will be problematic, particularly because the productive part of society—the so-called one percenters—is being vilified. The conflict between good and bad news will create incredible volatility at some point, but I'd be pressed to tell you when.
TGR: That sounds like more social than economic volatility.
Rick Rule: Social volatility manifests itself in the economy. We'll see less productive investing if the politics of envy drive increasing taxes on capital. To raise workers' real wages, the workers must employ more capital, and you can't do that if the capital isn't finding its way into the economy.
TGR: Last fall, Marin, you said quantitative easing was deflating equity valuations. "He who has cash will be king," you said, "because he can afford to buy discounted stocks. If you do your homework and be sharp you'll make a fortune in the next three years." Is that still the case? Are we too late?
Marin Katusa: Not too late at all, and I still believe we're in deflating equity prices. I'd say it's going to get a lot worse, especially for the junior resource companies. Less money is flowing into the sector and it's now a buyer's market. This is the riskiest investment segment on the planet. Risk mitigation is the key to succeed, and any opportunity to reduce risk is the most important thing moving forward. By mitigating risk, being strategic, if you do your homework and buy good companies, you can do well.
TGR: Louis, you said "the secret is to figure out what real stuff people need because it will retain value. When prices on valuable stuff go down ridiculously it's a godsend because you can buy when it's cheap and sell when it's expensive." Is the stuff people need cheap now?
Louis James: Stuff is not really cheaper. There is deflation in some asset classes and some equities, but life for the average Joe is not cheaper and commodities in general are not cheaper. Copper is at what looks like maybe reasonable long-term prices, but short term, they're ridiculously high. I can't believe the way copper has defied gravity in the face of all the economic turmoil the world is in. It says something about the supply destruction industry is seeing and the supply pinches coming.
It's actually fantastic if you have high, driving prices in the commodities, find good companies with good management, money in the bank and the wherewithal to weather the storms, buy them cheap and profit from some of the volatility Rick is looking for.
But I agree with what he said. I also think we'll see more volatility, and the chances of seeing much lower prices are pretty good. When a bear sentiment grabs the market, it takes everybody down, both the best and the worst players. If you have the courage to face it, that's very good news. There's a good chance we'll see much more of that over this summer and I'm looking forward to it.
TGR: Rick, you've said a reconnoitering is inevitable. But how do you tell the difference between a correction or retrenchment in a supercycle and the start of a bear cycle?
Rick Rule: I don't know how to know. I'm not a student of markets. My response to a market is simply to try and figure out what I think a company's worth and buy or sell based on that. I think the resource equities markets are headed lower this year. I also think we're going to see increased merger and acquisition (M&A) activity simply as a consequence of the fact that the entry points are going lower. Although I think the overall market is going down, I'm writing more buy than sell tickets today. When the luster is off the sector, it's off all parts of the sector, so in bad markets the best companies are cheap. When the best come cheap, you have to play.
I'm keeping powder dry, too, because I think we're going to have the best private placement market in 2012 since 2002, when it was truly spectacular, when management thought they either had to raise money or forego their salaries. It made them reasonable about things like warrants.
Marin Katusa: There are already more private placement opportunities on the buyers' terms, with full warrants, three years minimum. We'll also see management teams participating in the private placements. New terms will specify a certain amount that must go in the ground. A lot has unraveled and the mergers have started.
A lot of the easy money has been blown up. Half the companies listed on the Venture Exchange have less than $5 million (M) in the till. They cannot do a serious exploration program. Drilling 4,000 meters in the Yukon costs a minimum of $2M. But the good companies will do very well, better than any bull market because there are more willing buyers for those few superb companies.
Louis James: Because a rising tide lifts all ships, during part of a frothy bull cycle you have a reasonable chance of making money on the greater fool theory: buying something in the hopes somebody else will come along and pay more for it simply because the market goes up—not because any value has been added or the company has achieved any of its goals. But that's a pretty risky proposition; the greater fool theory is exceptionally dangerous. You never know if the market will go up, or whether a dip is a bottom or an increase is a top. Nobody in his right mind tries to time the market.
A much better procedure is to buy value. A rising tide will raise all ships but it should raise those with real value higher. The people who know the quality players certainly know what they're looking for, and they will buy the successful exploration companies.
TGR: Do you also anticipate increased M&A activity?
Louis James: We've always had an eye out for the takeovers and kept them on the radar, but we started to focus on them more when the liquidity issue became very serious, because, frankly, as the number of subscribers grew we became market movers. We moved toward more liquid shares in the newsletter, and takeovers are among the best liquidity events.
As Rick says, M&As aren't an "if" but a "when" question for the larger mining companies, because if they don't buy the successful exploration efforts, they will no longer be larger companies. There's no way a mine can be anything but a depleting asset, so if these companies don't spend money replacing reserves through their own grassroots efforts, they have only one choice.
TGR: Bud Conrad, Casey Research's chief economist, pointed out during the summit that gold stocks have never been lower compared to the Gold Price. When will this change?
Louis James: My gut says that we don't have real capitulation yet—just price destruction and desperation that has Rick rubbing his hands together gleefully. Companies are hoping for the next round of drill results to raise their stock price so they can raise money at a better price and so forth. They aren't yet saying, "Forget it. Name your terms." When we start hearing that, it's a good sign of bottoming.
I'm quite happy for the bottom to pass and then say, "Clearly that was a bottom and now we have upward momentum," particularly in the context of a supercycle, which I don't believe is over. Looking at supply and demand and political factors, I have a high level of confidence that this major bull cycle for metals has a longer way to go. Until the fundamentals change, any retrenchments along the way, no matter how major, are buying opportunities. It's just a matter of when and how much to deploy.
Rick Rule: The gap between gold and gold equity prices came about for several reasons. In the first place, before 2010, gold stocks increased in price very rapidly, more rapidly than gold itself. As a result, gold stocks simply overshot and needed a rest. The second factor was partly a function of the first—the explosion of Gold ETFs. People who hadn't traditionally been gold buyers but bought gold stocks for leverage to gold could buy bullion-like instruments in retirement accounts and hoard gold in some fashion more efficiently than buying it and burying it in the backyard.
The third factor was the gold industry's extraordinarily poor performance. Between 2000 and 2010, the price of gold advanced from $250/oz to $1,200+/oz. One would have expected a meteoric rise in the free cash generation of the gold companies, but the industry's cash-generating and earnings response was pathetic. Worse, while cash didn't explode, equity issuances did, so they diluted the cash they already had. That led to disgust with the gold companies, which carried over into their stock valuations.
A fifth factor, of course, is that the junior sector is perpetually overpriced. The sector itself is valueless and always will be. Added to that, these little companies incredibly inflated the number of shares they issued. The private sector is always more efficient than the public sector, even in counterfeiting, and the Canadian dealer network printed more phony share certificates than the Fed printed phony Dollar bills. So although share prices didn't escalate, the market capitalization of the sector escalated dramatically.
If you step back and look at all those factors, you'll see the stage set for a rebound in the better gold companies. The performance of the senior and intermediate gold companies has been much better over the last 18 months. The cash is really starting to come out. Strip the tax gobbledygook from the accounting and look simply at cash at the beginning and end of period and capital expenditures, and you'll see how much cash these companies are generating.
That's good in a bunch of ways. It allows them to grow organically so they don't have to issue equity. It allows them to do takeovers, which adds capital and liquidity and hope to the sector. And increasingly the companies are sharing some of that capital with their shareholders either as dividends or equity buybacks. That's making the gold equities more attractive.
Ironically, the stage is set for a rebound just as gold share investors have conditioned themselves to expect the worst. Does that mean it's going to happen anytime soon? I'm long past confusing inevitable with imminent. And I would caution against reading too much bullishness into what I say with regard to juniors because you have to remember that most of them have no value.
That said, we're in a discovery cycle. Although the industry has all kinds of flimflam artists, every year we get a few better people and over the past 10 years we've empowered them with lots of capital. We now have some great people using great tools to make discoveries in many places that have never before been prospected by means more sophisticated than a pick and a mule.
So I expect an increasing cycle of discoveries that will really surprise people, and more money may be made farther down the value chain than at the very top. If I'm ever right about volatility—if the volatility index gets up to 25 or 30 again—one of the easiest ways in the world to make money is to buy very good companies and sell short-dated puts and calls against them. Being particularly volatile, gold stocks are especially appropriate for put and call ratings. So for the next year, I'd suggest buying a couple of majors if you're so inclined—they may not be cheap but they're reasonably priced—and sell puts and calls against them, particularly when the volatility goes nuts.
TGR: How about explorers versus producers?
Rick Rule: If you're willing to play the game, nothing makes money like successful exploration. Most speculators don't have the patience to speculate on a process, which is what anticipating exploration takes, but that's what's made me the money I have. So for people willing to take the risk and the time, the exploration sector is a nice place to be.
TGR: In conclusion, tell us about the best investing advice you have ever received or given.
Rick Rule: I think the best investing advice I've ever received I read in Ben Graham's Intelligent Investor—the chapter on Mr. Market. On the whole, he's your manic-depressive business partner. If you trade against his mania and depression, he's the best partner you could possibly have. By the same token, probably the best investing advice I've given was merely paraphrasing Ben Graham. I've told people for years that in an extremely cyclical business such as natural resources, you can either be a contrarian or a victim.
Marin Katusa: My best advice came from two people. Doug Casey always said to focus on people, and Rick told me to focus on people of my generation to reap the rewards for the next 30 years. The main advice I'd give anyone is you're not going to succeed if you don't enjoy learning about it and enjoy the people in it. If you follow your passion, whatever that may be, you will succeed.
Louis James: Back to what Rick said—and he continues to be one of my mentors—is the critical concept of being either a contrarian or a victim. It's certainly proved true. Of course, Doug Casey is the quintessential contrarian. Maybe I'll go one further and add Bill Bonner's quip that a bull market is a random market movement that causes average investors to mistake themselves for financial geniuses. I've done a number of things wrong and there are things I might do differently, but I'm pretty sure I haven't made the mistake of assuming that the beneficial results of a bull market had anything to do with my particular genius. I've been cautious and the bull market has made me disciplined.
I think the advice I have given—and it's not mine but reiterating things that I've heard that have worked—is about discipline. You have to know yourself. As Marin said, you have to do something you care enough about to do the hard work, and learn what you need to learn. Rick said something about staying in the play until you get to the end game. That takes a lot of discipline. A good speculator is not just lucky. A good speculator is very disciplined.
TGR: That's a wonderful note to end on. Thank you all for your time.
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