During a time in which downward volatility of the junior resource sector has resumed in force, Rick Rule, Chairman of Sprott U.S. Holdings was asked if we’ve seen the ultimate capitulation in junior resource markets yet. Rick noted that, “We haven’t had a capitulation yet… we’re beginning to see the types of market volatility, rabid moves up and down on no volume, that are normally the “rattle” of the rattlesnake of capitulation. But the market hasn’t followed through yet, and I think that’s a consequence of the recent strength in the gold price.”
With regard to the recent political and social turbulence associated with West Africa, Rick commented that, “With regards to what happened in Burkina Faso, the probability of that set of events being unpleasant for mining is very small, and so it’s pretty obvious to me that the sell-off engendered an opportunity.”
Rick further added that when investing in politically turbulent markets, “Having the cash and the courage
to make a binary bet in an extraordinarily bad situation where the risk to reward is $.20 cents on the downside and $10.00 on the upside, is a set of circumstances that everybody should be lucky enough to have once or twice in their career.”
Here are his full interview comments with Sprott Global Resource Investment’s Tekoa Da Silva:
Tekoa Da Silva: Rick, you published a commentary on October 16th in which you said, “It’s my belief now that we have a 50% chance of entering a capitulation phase in this bear market. If that’s true, in the next few weeks, we will see two or three weeks of fairly dramatic, fairly ugly, but fairly short term of a sell-off. This is consistent with what we saw in ’92 as well as the bear market bottom in 2000.”
Given the sell-off we’ve seen in the resource sector over last two weeks of October, do you have any updated thoughts?
Rick Rule: We haven’t had a capitulation yet. I think the increase in the gold price forestalled a capitulation. I also think there are more psychological forces in the market, which could take it lower in the short term.
We’re in a very interesting situation from a valuation viewpoint. The best 300 of the juniors out of the 3000-junior universe are not merely cheap; they’re very, very, very cheap. So while the stage is set for a move to the upside from an empirical point of view, in the near term, markets aren’t driven by empirical data. They’re driven by emotion.
So any further weakness we could see in commodity prices, in particular weakness as a consequence of a strengthening US dollar, could push us over the edge again into a capitulation, which I think is a condition for a higher market.
At the point in time in which we’re talking, we’re beginning to see the types of market volatility, rabid moves up and down on no volume, that are normally the “rattle” of the rattlesnake of capitulation. But the market hasn’t followed through yet, and I think that’s a consequence of the recent strength in the gold price.
TD: Do you still feel there is a 50% chance of a major market capitulation?
RR: I think so. I think the next excuse for the market to go one way or another is tax-loss selling, and any move to the downside would likely promote an emotional as opposed to a rational response.
Understand that capitulation is a completely emotional event and decision. It’s not an empirical decision. An empirical decision would be to sell the 2700 poor-quality juniors that pollute the universe and buy the best 300—a transfer of weak investments to strong investments. We’ve already seen a transition from weak hands to strong hands, but we need one more emotional sell-off I think in order for the market to clear and move higher.
TD: Rick, during that last week of October I saw four newsletter writers hit the sell button on the junior resource sector for various reasons. Is there a capitulation that occurs there too, among the wholesale buyers and sellers of stocks?
RR: Very unhappy outcome for their subscribers, but of course very good for the market as a whole because we need market clearing events. What I think needs to be remembered is that newsletter writers are human beings too, and every human being is subject to the same emotional response unless one can employ real, real discipline.
The most important factor to note is that people’s expectation of the future is set by their experience in the immediate past, and if all of your experience in the immediate past is negative, the expectation you have for the future is that you’re going to get spanked again.
In particular, if you’re a caring newsletter writer responsible for the fortunes of other people, the trauma you feel coming up with good ideas and seeing your subscribers lose 25% in response to your good ideas is incalculably unpleasant. The consequence is that the emotional turmoil you feel is multiplied. Many newsletter writers are like politicians in that they have the desire to be loved, when in fact despite their best efforts they’re doing harm.
So the psychological impact on them is multiplied, and it causes the reaction you see in the market. It contributes to the spasmodic selling of a market already down by 83%.
TD: Rick, we also saw a political event unfold in Burkina Faso at the end of October, in which the segment of junior resource stocks with operations in that country were down 20% to 50% percent in a matter of a day or two on various sell recommendations. What are your thoughts when you see those types of events unfold?
RR: Well, that brings up several topics of discussion. One is that utilizing newsletter writers and analysts for the market response they generate as opposed to their advice is a very good thing.
If you own stock that is recommended by a newsletter writer, and the editor (or an investment conference) generates a response in the stock, you’re wise to sell. Very often a newsletter recommendation can cause a stock to trade up by 25%. We call it “newsletter syndrome.”
Using that response to sell the stock and then waiting five or six weeks until the response intended by the newsletter writer subsides, before buying back the stock can be a very good way to trade. I did that for years when my business was small enough that I had the time to do it. I can’t do it anymore but there’s nothing to stop our clients from doing that.
Conversely, a position in a company that has been held for a long time by newsletter subscribers who are suddenly advised to sell can cause a stock to move down by 25% or 30%.
What has really changed is simply the editor’s opinion of the company. It doesn’t necessarily mean that the company has changed. So utilizing sell recommendations by newsletter writers is still a technique that I employ to the extent that I see a stock come off a lot that is on my acquisition list. Certainly you should study the reason for the recommendation and test it against your thesis. But if you believe you are right and they are wrong, they may be giving you a 25%-off-sale, which is very, very good.
With regards to Burkina Faso, you need to be very careful about changes in political conditions in frontier markets. The reason is that they’re very poor and absurdly political. Political risk is smaller in very large countries like the United States only because the advanced countries are less political. The reason frontier markets are poor is precisely because they’re so political and the importance of their political events takes on an outsized character.
With regards to what happened in Burkina Faso, the probability of that set of events being unpleasant for mining is very small, and so it’s pretty obvious to me that the sell-off engendered an opportunity.
TD: Rick, I spoke with a client this morning about the Burkina Faso issue, and he noted to me that he was reminded of the phrase, “You can’t read the score card” during situations like that. What has been your experience investing in emerging countries that have what look like obvious political problems at the surface?
RR: My experience has been superb. That doesn’t mean I haven’t been hurt politically before, I have. As examples, in 1996 or 1997, the situation in Congo would have been comical had it not been so tragic for the Congolese. The chaos that engulfed the Congo was absurd. You had as headlines; AIDS, Ebola, malaria, and an internecine conflict that killed 2 million people.
The sub-surface mineralization in the Congo however, didn’t care about the human tragedy that was taking place at the surface. Congo’s copper was put in place 35 to 45 million years ago by a complex series of geological events, and it didn’t care much who killed who.
While that sounds heartless, I was powerless to stop AIDS, Ebola, malaria, or internecine conflict in the Congo. I came to understand that in the Congo, the price of some of the best mineral deposits in the world following those tragedies—Kolwezi, Kipushi, Tenke and Fungurume — was so cheap that I could afford to speculate on a binary outcome.
I’m reminded that Tenke Mining which was under the stewardship of the Lundin family (the finest mining entrepreneurs on the planet) held the best undeveloped copper deposit in the world, and was selling at $.20 cents per share with $.30 cents per share cash. So you had the opportunity to buy the best copper deposit in the world, managed by the best stewards of wealth in the world at a discount to cash.
It occurred to me at the time that I could take a risk with money I could afford to lose all of because there were going to be two circumstances. Either Tenke mining was going to go to zero or it was going to go to from $.20 per share to some number like $10.00 per share.
Having the cash and the courage to make a binary bet in an extraordinarily bad situation where the juxtaposition of risk to reward is $.20 cents on the downside and $10.00 on the upside, is a set of circumstances that everybody should be lucky enough to have once or twice in their career.
I have made bets like that successfully in places like Congo, the Ivory Coast, Sudan, Ethiopia, and Eritrea. I made a bet in Afghanistan and had the other kind of experience—I lost all the money I put up.
One of the things I’ve also been lucky enough to figure out is that part of the reality of political risk is perception, and in my 35 years of investing in natural resources I’ve learned that the most dangerous politicians are not the ones who appear the most odious on the evening news. They’re the ones who are closest to you because they’re the people that have the ability to get at your wealth.
The greatest political risk I’ve suffered personally was here in the People’s Republic of California. We somehow believe that money stolen from us by people in North America according to the rule of law is somehow “less gone.”
An example would be when the Alberta legislature doubled the natural gas royalty in Alberta in response to rising natural gas prices 10 years ago. Having extracted the front-end rents based on an old fiscal regime, they then changed the fiscal regime.
In other words, they stole $2 billion from shareholders. But stealing the money in a legislative sense according to the rule of law, somehow made it less odious than had it occurred in Africa by traditional methods.
TD: Earlier in the month Rick, I visited a local hospital and saw a map of Western Africa at the information desk. Liberia was highlighted in red. When I drove home, I turned on NPR, and Liberia, Ebola, and West Africa was being talked about. It was also the buzz around the Sprott Global offices all that week as well.
Is there a bubble of “fear” in regards to West Africa and the West African segment of the junior resource sector?
RR: There is and it will get worse. Ebola would appear to be a fairly erasable medical and social challenge, but those are fragile countries, ill-suited to deal with the challenge.
We’ve seen Ebola spread to Mali and it will likely spread further in West Africa, and as a consequence, fear of Ebola which is already high will continue strong.
We will find a way to deal with Ebola but it might take two or three years. The commercial rubber industry in West Africa implemented social changes among their labor force and as a consequence of that, shielded their labor force from Ebola. That example is instructive of two things; it’s instructive of the fact that private solutions to social problems are always better than public solutions to social problems—meaning that the private sector protects workers better than the government protects its citizens.
The second thing it points out is that in rural areas where you can control the local population because they work for you, the Ebola challenge doesn’t have to be as problematic as it is in urban areas in West Africa where there are complete breakdowns in social order.
A third thing is that if gold in ancient Archaean terrains in West Africa was in place 300 million years ago and it takes three years to solve the Ebola problem—the gold will still be there.
If the company that holds the gold concession is well enough positioned that it can survive three years, the truth is that the fiscal regime in countries that are increasingly in need of cash from gold mining will become better to operate in over the next three years.
So people who have the cash and courage to stay the trade need to understand Ebola in its entire context; a social tragedy and a political reality, a risk to the gold mining industry, but certainly an opportunity for a speculator.
TD: What are your thoughts on the junior streaming and royalty sector after observing the recent combination of Virginia Mines and Osisko?
RR: Well, I think the junior sector is going to be stressed. The junior royalty and streaming companies are going to continue to have challenges competing with the bigger royalty companies. I would suggest that the resultant combination of Osisko and Virginia isn’t a junior given that there’s a $1.3 billion market cap, $275 million in cash, and a substantial free cash flow.
The big opportunity in streaming and royalty as I see it is the delta between the market valuations and free cash flow.
The market values precious metals streams at something like 15 times EBITDA, which is another way of saying that the market is willing to accept a 4.5% to 5% yield on current investments with the hope of upside from either a precious metals price increases or further discoveries.
That same EBITDA, if it’s on the income statement of a base metals producer, is priced at 5-7 times EBITDA. So cash flow in one corporate circumstance is valued at 15 times EBITDA, and in a different circumstance, is valued at six times EBITDA. That means there’s a $20 billion opportunity in the market right now for big streaming companies that can afford to do $2-$3 billion sized transactions; to buy streams from base metals producers of byproduct precious metals production, in transactions that simultaneously lower the cost of capital.
For base metals producers, it allows them to put mines into production at a lower cost while enhancing the visibility of free cash flow on a per share basis.
This is a $20 billion opportunity and I see it being realized over the next two or three years. This is a catalyst to change the affairs and valuations of the senior streaming companies. The junior streamers will have to inhabit a different place in the landscape. They’ll have to be more aggressive, they’ll have to fund definitive feasibility studies and development, and they’ll have to take on smaller but attractive opportunities. They also won’t be able to avail themselves of the single greatest opportunity in the streaming trade that exists today, which is the arbitrage of the insane delta between the valuations of free cash flow as a precious metal stream or as base metals free cash flow.
TD: Rick I heard someone ask the other day, “How do I make money here?” It caused me to think about the process of making money. Do you make it when you buy or do you make it when you sell? What are the ingredients required to make money as an investor based on your experience?
RR: I think you start by examining yourself and the environment in which you’d like to make the money. There’s a bunch of ways to make money in the markets. I myself am not particularly suited to trading. There was a point in time where I did more trading because I had less capital.
But I am by nature a capitalist, which means I employ capital for the long term, and I’m a speculator. I have also learned techniques that are suited to my personality.
One thing I understand well is that the process of speculation involves accepting failure. It involves accepting the fact that six or seven out of ten of my decisions will end up being bad. I am willing to accept 20% to 30% losses on 60% to 70% percent of my positions. Conversely, one or two out of ten may provide returns that more than make up for these losses.
I’ve also come to understand the admonition I’ve told you so often Tekoa, which is that you have to be a contrarian or you will be a victim.
Another truth in resource markets—at least if you’re Rick Rule—is that you will not sell as much at the top as you should.
A rational person would look at the fact as I did in 2011—that there wasn’t much to buy, and that in itself should mean they ought to be selling.
Did I sell enough? No, I didn’t. Hubris set in, and it will again for sure. My thinking was that, I’m a better analyst than the other guy, and I am. I think that I back better management teams with more discipline, and I do. I think the balance sheets of companies I invest in are better than others, and they are. I think the projects my analytical team helps me choose are better than the competition’s, which is also true. But none of that matters when the market goes down.
When the market goes down, everything goes off the bridge. The fact that I sold 30% or 40% of my positions at the market top doesn’t excuse the fact that I held 60% or 70%. The 60% or 70% I held lost me 50% or 60%.
But the interesting part of being a contrarian is this: Once every 10 years you experience a 50% decline in the value of your speculative holdings. I believe that’s followed four or five years later by an inevitable up cycle where you make a five or tenfold return.
So let’s think about the arithmetic associated with that. Let’s assume that you start the exercise with $100,000 and you draw it down to $50,000. Then you turn the $50,000 into $250,000 or $500,000, which means what you ultimately did was turn $100,000 into some amount of money between $250,000 or $500,000 or better.
Now what part of this bargain don’t I like? Of course the part I don’t like is the fact that it goes down. But the fact is that it’s going to go down and you have to accept that. The other arithmetic people need to take into account if they’re going to be speculators — not investors but speculators — is that most of the investment decisions they’re going to make will be wrong.
They have to understand that you need to “court” risk in order to generate alpha because it’s the risk that generates reward.
TD: Rick, you mentioned to me one day the importance of the phrase, “You never ever, ever get it right.” For the reader considering discussing this market with their financial adviser or broker—is this a good time to consider taking bite-sized pieces of high-quality companies?
RR: I think so, but I know what I always get wrong. What I get wrong is that I’m entirely empirical and entirely rational. My fault is this: I confuse two words, which are “inevitable” and “imminent”. So I’m always too early on the buy side; it can also lead to being too early on the sell-side, though, as the example of 2011 illustrates, not always.
When I say you can’t get everything right, I mean that if you are a good buyer, sometimes you can get a market bottom. But if your psychological makeup is that you’re going to catch a market bottom, you’re not going to catch a market top on the sell side. That’s just the way it works.
If you’re a good trader, you’re going to cut your wins before they’ve fully matured. You’ll cut your losses too probably, which is a good thing. What’s more important is for people to understand their own emotional makeup and how that makeup is going to govern their actions in the market.
It’s important for one to compensate as best as they can for their psychological makeup by a disciplined plan of speculation, which will enable them to use their own skill sets and prejudices to their advantage as opposed to being disadvantaged by who they are.
TD: Rick, we’ve talked about this before but if the reader is joining us for the first time—what’s the biggest risk an investor faces and how can they mitigate that risk?
RR: Simple. The biggest risk is to the left of your right ear and to the right of your left ear. It’s not Obama, not the gold price, nothing like that. The biggest risk is not being able to work hard. The biggest risk is “got a hunch, bet a bunch”. The biggest risk is going into a speculation without a plan, not knowing why you made the investment, not knowing what would cause you to sell, both in terms of success or failure.
Indiscipline is a big risk. If a stock goes down, does that mean you sell it reflexively or does it mean you reexamine your premise and buy more if you think you are right and the market is wrong—because the market is frequently wrong.
Remember that making money in speculation is done by taking advantage of the delta between opinion and fact. It has been said by many knowledgeable observers that the market in the near term is a voting machine. In the long term it’s a weighing machine. Speculative profits are the delta between the way people vote (which is always stupid) and what stuff weighs.
TD: Rick Rule, Chairman of Sprott US Holdings, thanks for sharing your comments.
RR: Thanks for the opportunity.
For questions or comments regarding this article, or on investing in the precious metals & resource space, you can reach the author, Tekoa Da Silva, by phone 800-477-7853 or email firstname.lastname@example.org.
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