By Tekoa Da Silva
I had the chance to visit once again with Rick Rule, Chairman of Sprott US Holdings.
It was a great conversation, focusing on the state of metals and mining, a $20 billion opportunity now available due to market chaos, and ‘multiples of potential return’ in mining equities, should historical measures reassert themselves.
“I’ve seen this four times before in my career,” Rick noted. “These periods of deep despair are the necessary component, the necessary factor to turn a bear market into a bull market.”
Here are his full interview comments:
Tekoa Da Silva: Rick, it has been a while since we’ve sat down for an updated market commentary. I thought this could be a very interesting time. It’s late 2015. We’ve seen a lot of volatility this year in the resource and mining share market, as well as the overall markets. The S&P 500 experienced about a 10% correction in late August.
There are also interesting developments occurring internally within the mining and resource space. But to start with–where do you think we are in terms of a market bottom in resources and mining? Are we emerging from the bear market?
Rick Rule: With regards to precious metals and precious metals equities, I’m going to go out on a limb and say I think we’ve bottomed. I will probably be rewarded for that with another smack down.
But it appears to me like the precious metals markets in terms of both commodities and the equities markets that underlie them are in recovery. My friend Steve Sjuggerud says to make money, you have to find a sector that’s undervalued, despised, and that isn’t in an uptrend.
If you look technically at the precious metals equities, they certainly qualify in all three of those categories. We saw in the juniors that after an absolutely brutal start to 2015, a true bifurcation occurred. Money is available to the best junior companies and share prices are recovering in some cases by as much as 100%, but in most cases by less than that.
You also saw the XAU gold/silver index up recently. You’ve seen all of the indexes up, particularly of course about two or three weeks ago. But I think the really strong tone began in July, albeit from a beat-up bottom.
Now with regards to industrial materials—base metals, coal, iron—my suspicion is that the bear market lasts longer there, perhaps a lot longer. There is overcapacity to work through. And by a lot longer, I mean two years or three years.
The truth is (as we’ve talked about before), is there seems to be a lack of demand globally for everything. The extraordinarily poor quarter put in last quarter by Caterpillar would suggest that the world’s demand for ‘stuff’ is non-existent. That doesn’t portend well of course for copper, zinc, lead, iron, or coal demand.
Now, if you have a five, six, or seven-year view point, it’s precisely at times when there is ‘no hope’ in terms of the outlook for the sector that you buy the best names in the sector.
So if you are a long term investor in high quality names, you can use this opportunity to buy the best of the best in base metals, companies like BHP; or the best of the best in the oil business, companies like Exxon. But understand that you’re going to go through some fairly turbulent waters over the next year and a half.
In the oil and gas business in particular, and in the part of the oil and gas business that we inhabit—the sub $700 million market space—I think it has lower to go. But that doesn’t mean that you don’t take advantage of special binary exploration situations that aren’t connected to the oil price.
But the truth is that the issuers and the regulators are allowing the industry to in effect perpetuate securities fraud by using unrealistic price assumptions to set net present value guidelines for loan valuation parameters. I think that will last until next year’s annual reports because these companies, although they aren’t getting their credit lines called this year, aren’t being given any more money.
They’re producing out reserves without adding any new reserves and their loan bases are staying the same. I suspect we’re going to see a world of hurt next year in the junior oil sector. It will be one of those once in a decade opportunities to provide capital for the sector on terms that are very advantageous to investors.
So all in all, I’m fairly hopeful. Right now as we speak, the discussion pipeline Sprott has in front of it, the people we’re talking to about financing exploration or development opportunities is as deep as it has ever been in terms both of number and quality.
That isn’t to suggest that we don’t have competition in the space. One of the themes we talked about the last time you and I visited was the amount of real money—heavy, deep money, circling the sector and that’s starting to come home to roost.
The recent Pretium Resources financing is an example. It featured Blackstone, a huge private equity group, coming into a $500 million financing in the resource sector and they were one of four competitors to finance Pretium.
So the idea that there isn’t capital available in the sector is silly. There is lots of capital available for good deals. But there aren’t very many good deals.
Another example of capital availability is something you and I have talked about in interviews before, which is the capital available for large base metal mining companies (despite the gloomy outlook for their commodities) by selling the byproduct precious metal streams.
It’s a really unique opportunity that people need to pay attention to. The truth is that precious metals cash flow, structured as a stream, trades for sort of 15x cash flow. That same cash flow within a base metals company is valued at a base metals multiple of about 6x-7x EBITDA.
So a big base metals company that needs cash can sell a byproduct precious metals stream to a company like Franco-Nevada or Silver Wheaton at 10 times EBITDA. They simultaneously lower their cost of capital while they’re being accretive to the streamer. There are $15-$20 billion worth of these transactions that can take place in the next year and a half and I suspect they will. They will benefit the investor, they will benefit the streamer, and they will benefit the base metals company.
This is just an example of one of the opportunities that’s available during market chaos because during market chaos, people don’t look for opportunities. They look for excuses to justify their fears.
TD: Rick, I’m glad you mentioned the royalty opportunity with base metal producers because about a year ago we put together a commentary in which you noted that a $20 billion opportunity existed to pull out byproduct precious metal streams from the base metal producers.
It seems kind of like buying an orange let’s say for $.60 cents in Florida—and driving up to New York and selling it for $1.20. You can afford to overpay in Florida by paying $.80 cents, because you can turn around and sell it for $1.20 in New York.
RR: And that’s a wonderful image you’ve just presented. You described the arbitrage very well. The market is willing to pay a premium for long term precious metal streams because the market overall has a better outlook for precious metals prices than for base metals prices.
The market is willing to pay for high quality precious metals streams, and large base metals mines often have 20-25 year mine lives. That means there’s a lot of certainty as to the amount of metal that will come out of the stream.
The final thing is these very big base metal deposits almost always surprise you to the upside in terms of discovery. That means a company that’s buying a stream on what appears to be 3 million ounces of gold is very often buying a stream on what turns out to be 3.6 or 3.8 million ounces of gold, because the exploration surprises on very large high quality deposits are invariably pleasant.
TD: Rick, I want to ask about the ‘waters’ of the general equity market. We saw the S&P 500 come off by about 10% in August. I understand you’re more of a credit analyst than an economist—but what are your thoughts on general equities over the next two, three years?
If we see a severe selloff in the overall market, how is that going to impact metals and mining equities?
RR: Well, the first thing that will happen if we see something really severe in terms of a contraction in the stock market is that natural resource stocks are stocks, and they will react negatively. But it’s my point of view that natural resource stocks have already had their bear market.
So while they may decline, the decline won’t be as steep as it will be for general market securities, and the recovery will be quicker. History is on my side with regards to that observation.
The truth is that in the very short term, the markets are voting machines, and it’s only in the long term that it’s a weighing machine. That means in the short term, the market measures people’s emotions. Over the long term, markets measure value.
The natural resource markets are in a very deep cyclical bear market which means they’re already cheap. I don’t believe the same can be said for the general market.
So my suspicion is that value will win out in the case of a decline in resource equities that’s linked to a major market decline.
But make no mistake—if we see a major liquidity squeeze and downside in the market similar to what we saw in 2008, initially the resource stocks will sell off with all the others because the sell decisions often aren’t made by the investors. They’re made by margin clerks and the margin clerks sell what they can, not what investors want them to.
TD: Rick, where do you see resources fitting today in terms of a person’s portfolio in the context of looking at the broad market as a whole?
RR: That’s the $64 billion question Tekoa. After a four-year bear market (or a two-year bear market in oil), investor expectations with regards to natural resources are very low, which means the proportion of investor’s portfolios devoted to natural resources is very low. That means the room for recovery is very high.
We’ve done some internal preliminary work at Sprott, talking about the resource allocation in generalist mutual funds now as compared to over time.
In Canada over time, the median and mean apparently is in the mid-teens, meaning the generalist mutual funds in Canada generally have sort of 15% to 20% of their allocations in natural resources and right now as we understand, they are at about 4.5%.
A similar statistic I think came from Morgan Stanley. It had to do with precious metals and precious metals equities. The high point in concentration in precious metals and precious metals equities occurred between 1980 and 1981, at the top of that great super cycle in precious metals.
About 8% of investible assets in the United States at that time were in precious metals or precious metals equity.
The same measurement today is .3%. The median and mean over the last three decades is between 1.5% and 2%. So in order for precious metals and precious metals equities allocations to get to the three-decade mean, they would have to go up 6-fold as a percentage of the total investible assets in the United States. So there is an awful lot of room to the upside.
Now that allocation isn’t necessarily true with regards to our own client base. They are much more natural-resource-centric. But the truth is even in our client base (particularly the more speculative parts of our client base) the disintermediation—the move away from natural resources to other speculative sectors like technology has been extraordinary.
I’ve seen this four times before in my career. These periods of deep despair are the necessary component, the necessary factor to turn a bear market into a bull market. The expectation is so low that you can’t help but to exceed it and markets move up when you exceed expectation.
TD: Rick, in winding down, is there anything you think we may have missed?
RR: I think with regards to investors, they need to ask themselves some questions about where they fit on the risk-reward spectrum. In natural resources this is a wonderful time to be a value investor in large cap natural resource stocks.
It’s also a wonderful time to be a speculator. But if you’re a speculator, you have to understand the risks and the volatility. In speculation, you become your own largest risk.
For myself, all the money I invest prudently now, I made by speculation and I am moving into the part of the cycle where I’m going to become much more aggressive in terms of speculation.
That’s a consequence of the fact that I have the psychological and financial ability to withstand the risk, but our clients need to ask themselves whether they have those two capacities themselves.
If the answer is yes (and I know I sound like a broken record on this Tekoa), then the best way to do it if you can afford the risk, is to build yourself a private placement portfolio—one that includes warrants, which amplify the possibility of success.
But for customers who don’t have the financial or psychological wherewithal to withstand both the risk and volatility inherent in speculation, look towards the very high quality seniors. We could of course help in that process.
TD: What’s the best way a person can participate and have that conversation with us?
RR: Well, I would suggest of course they contact their Sprott Global broker. For those people who are listening to this and don’t have a Sprott Global broker—they should address that.
They can visit our website or email [email protected] and make arrangements to interview a Sprott Global broker.
Another thing that everybody who is reading should do is subscribe to the Sprott’s Thoughts blog which is very easy to do on the cover page of our website.
TD: Rick Rule, Chairman of Sprott US Holdings. Thanks for sharing your comments.
RR: Always a pleasure Tekoa. Thank you for facilitating the opportunity.
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