Gold & Miners Diverge
Does the current malaise hitting junior gold miners signal opportunity...?
LEGENDARY INVESTOR Rick Rule, founder of Global Resource Investments, began his career in the securities business in 1974, and has been principally involved in natural resource security investments ever since.
In this extensive interview with The Gold Report, Rule gives his thoughts on everything from why he's considering re-entering the market for junior miners to why he thinks the disconnect between equities markets' performance and the metals will continue.
TGR: You've been out of junior miners for the last couple of years?
TGR: But at these prices, you're beginning to think about re-entering?
RR: I am definitely looking to re-enter. I think I have a place at the table. I was frozen out of the financing market because I just didn't like the pricing, and that's changed.
There were large numbers of companies created in the last two to three years that received initial financings on terms that were ludicrously generous. And these guys are coming back to market now, having spent that money, and the market is much less generous, which means you are going to have some number of failed companies.
I suspect that that outcome will make the market, as a whole, pessimistic. And when those sets of circumstances occur, it is usually beneficial for more prudent speculators.
TGR: Are these good companies that are failing because the market has moved away from them, or are they companies that really shouldn't have gotten financing to begin with?
RR: Ninety percent of the companies that got financed should never have been financed. The market took the good, the bad, and the ugly all up, and the market will take the good, the bad, and the ugly all down. What one does to survive a situation like that is try to do qualitative differentiation. Of course, buy the best, even though they're going lower with the overall market...thinking, wishing, praying – whatever the right word is – that you have chosen correctly.
TGR: Can you give an idea of what your strategy is?
RR: We have a focus list here of about 60 exploration stocks, and we have target prices, and when the market comes to our target prices, we begin to buy.
We have what we call the "nibble-gobble" rule. We have a typical company – let's call it "Moose Pasture Exploration." Let's say we have determined internally that Moose Pasture Exploration is something that we will begin to buy – in other words, we will nibble at – when it has, say, a $30 million market capitalization, and we will gobble – that is buy aggressively – when it has a $22 million market capitalization.
We're actually starting to nibble now, and we would expect ourselves to become gobblers around August, when all the institutional buyers in Canada go on vacation, and when someone is a seller, and the market has gone "no bid" in the depths of the summer doldrums. We're usually reasonably good buyers.
The other thing that we see ourselves doing is providing financing to companies that are intelligently run, but not well promoted. We believe that there will be a good appetite for capital in the exploration business in the next 12 months and that capital supplies will be much less generous than they've been the last three years.
TGR: What's your current take on the market and the divergence between the Gold Price and equities?
RR: People have made a lot of the fact that the Gold Price and the silver price have gone up while the price of gold miners and silver equities has gone down.
I would point out in the first instance that about 90% of the companies that investors believe are gold and silver stocks are, in fact, not gold and silver stocks, because they don't have any gold or silver. They're looking for it, and the fact that the commodity that they don't have any of goes up in price is really irrelevant in the context of their value.
It is my own belief that the precious metals prices will tend to go higher over the next few years for reasons that you're very familiar with – softer US dollar, domestic deficits – both in terms of trade deficit and government deficit. Next year I suspect will be dominated by bad news in the US economy rather than good news, which for real reasons and psychological reasons take the US dollar down, and take the gold and silver prices up.
Traditionally in the US, a new president in his or her first year in office has tended to make us sick so they can make us well later in the cycle and get reelected.
I think that the disconnect between share prices and metals will persist, and I think it will persist for a variety of reasons. In the first instance, at the senior producer level we have not seen the increases in margin that you would have expected to see relative to the increase in the gold price. Much was made over Newmont's last quarter, but if you look at Newmont's last quarter, net of sustaining capital investments, it was not that grand a quarter, particularly in view of the fact that the Gold Price has gone from $300 to $900. The only companies that seem to have benefited on an operating basis from this increase are Barrick and Agnico Eagle, and that's problematic for me.
The second thing is, it would appear that at acceptable price steps, the senior gold mining stocks are trading at 1.6 to 1.8 times the net present value of their cash flows, at these Gold Prices. That's problematic; you have a business priced at a huge premium to net asset value that's in a depleting business.
The idea that you're buying a business in liquidation at a premium in relation to its inventory suggests that you believe that they can replace that inventory on an efficient basis, which they haven't shown themselves to be able to do.
And, partially in their defense, the costs of all of their inputs have risen as high as the gold prices have. At the same time that the gold price is up 300%, 400%, there are labor shortages and the price of diesel, steel, and cement are up. And the price of theft, which is what I call taxation and government royalty, is up dramatically as well.
So, although the Gold is higher, you have cost-pushed inflation in the inputs, which has caused the margins – let's be charitable and say – to not expand as rapidly as one might have expected.
I think the third factor that we have to look at, and people in our industry always tend to overlook this, is pricing. Pricing adjustments are due to the fact that gold and silver are denominated in US dollars, with the dollar heading lower, in my opinion. That means gold prices will be headed higher, at least in nominal terms.
I think that Gold and silver prices may go higher in real terms if the economic recovery in South Asia – India, Pakistan, Bangladesh, Sri Lanka, and Nepal – continues, because those areas have had traditionally high demand for gold and silver as stores of wealth among the peasantry, and with relatively strong agricultural prices. With relatively strong economic conditions in those countries, it would be reasonable to suspect that the peasantry in South Asia will have some access to liquidity and traditionally, they have stored that in precious metals.
TGR: To what do you attribute the poor performance in the juniors?
RR: The reason for the poor performance in the juniors has been very different. The first has been paper issuance. Many of your subscribers and many of the speculators generally are concerned by the issuance of phony paper money by organizations like the US Fed.
I am always fond of saying the private sector can do anything more efficiently than the public sector, and that includes inflation. The issuance of phony paper by the Canadian Dealer Network; that is, the phony gold and silver shares, has greatly outpaced the issuance of US and Canadian dollars.
While the individual share prices haven't escalated over the last two or three years, the market capitalization of the sector has increased spectacularly because there are many more small public companies purporting to look for gold and silver, and the existing companies have issued so much paper to raise cash.
This will be exacerbated in the near future, as we said earlier, because the companies that were formed two years or three years ago were formed in an environment of freely available capital. They haven't husbanded the capital they raised particularly well, and they will be returning to market to raise more capital with absolutely nothing to show for the capital that they raised the first go round. With any luck at all, the markets will look at the performance these companies have exhibited and will be somewhat stingy going forward.
So, I think that the disconnect between the equities markets' performance and the metals will continue. I believe that sets up an absolutely ideal stockpicker's market for people who can differentiate from deserving juniors and the mass of juniors.
TGR: If the market in general is going to go down, when will these deserving juniors be able to disconnect from the general malaise?
RR: What has been successful for me in the past 20 years is having a portfolio of companies who deliver positive surprises on an individual, rather than a market-, based basis. In other words, what has worked for me is backing intelligent people who employ capital well long enough that they make a discovery, and I get a 20-bagger out of it.
Look back, as an example, at the success of Arequipa Resources It occurred in a strong market rally, but it didn't go from 35 cents to $30 because of a market rally. It went because they discovered 8 million ounces of Gold.
What I will use this market malaise to do is buy companies that are threatening to or have the capability of making major discoveries at a big, big, big discount to the surrounding market. I think it will be an easy time for educated people to outperform the market, partly because the market as a whole won't perform well, and partly because as the market underperforms, the competition from other investors to buy shares of the best of the best will be very low.