Rick Rule: Mathematics of a resource portfolio

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Tekoa Da Silva recently spoke with Rick Rule, Chairman of Sprott U.S. Holdings, on video for our readers.

In this discussion, Tekoa and Rick get into the ‘nuts and bolts’ of speculating in exploration stocks. What’s the right amount to have in these stocks? What should a resource portfolio look like in different market cycles?

You need to be careful as an investor, but you don’t always have to be right, said Rick. In one of his greatest investment successes, owners of the stock turned out to be wrong about the merits of the company’s project.

It wasn’t an economic discovery after all, even after years of exploration. But it still made investors money along the way because the potential value creation was high.

TD: Hi. I’m Tekoa Da Silva with Sprott Global Resource Investments and I’m sitting down here again today with Rick Rule, Chairman of Sprott US Holdings. Rick, good to see you.

RR: Thanks for the opportunity Tekoa.

TD: What are the ‘mathematics’ of a resource portfolio starting with the math behind discovery probabilities?  How would you define a discovery and what are a few of the most significant discoveries that you have participated in throughout your career?

RR: Well, there are different definitions of discovery depending on whether you’re an investor or a speculator. There are some traders as an example who can make money on one drill hole, which of course does not make a mine.

Working with Sprott, with much larger accounts, my definition of the discovery would be the delineation of enough ore of sufficient quality that it could be put into commercial production.

Mercifully, we’ve participated in numerous of those in the last 30 years in Sprott’s predecessors. Some of the ones that come to mind is of course the famous Arequipa discovery in Peru. But there have been probably 20, 25 that we’ve participated in the last three decades in here.

TD: Rick, sometimes I speak with people on the phone and I’m sure you’ve been asked all throughout your career for advice for someone who has maybe $10,000 or $20,000 and wants to buy four or five exploration stocks and make a discovery. But I also heard you note that in one of the earlier partnerships you participated in 108 private placements but only six produced the type of stellar gains that newsletter writers talk about as a result of discovery. Can talk about the probability of success?

RR: Well, I think that’s accurate. That isn’t to say that I only made money on six stocks of 108 in that portfolio. I made money on more than that but it’s important to note that very large discoveries — the types of discoveries that make you 20 fold, 30 fold or even 100 fold returns are fairly scarce and speculators need to understand that they’re going to have to move through a lot of opportunities to make those types of discoveries. To put it in context Tekoa, economic geologists will tell you that somewhere between 1 in 1000 or 1 in 5000 mineralized anomalies becomes a mine.

You can shift the odds in your favor by participating in exploration efforts that are run by absolutely A-quality explorations or participating in exploration activities that take place in areas that are unpopular, like the Congo, and haven’t been studied much.

But the truth is that the odds are long against success. People need to understand that exploration speculation is a process. It can take a substantial amount of time.

TD: Is the process a ‘shotgun approach’ of buying a whole bunch of explorers or is it extremely diligent due diligence on each one of them?

RR: Very, very, very focused. The truth is that a limited number of people enjoy most of the success and so focusing on people who have enjoyed success in the past is important. Another thing that’s very important is focusing on potentially large discoveries. A small discovery has all the risk of a large discovery but yields a small gain.

The most difficult thing for most people who wrap their heads around is that most of the easy-to-find discoveries in places that we’re comfortable with like the United States, Canada and Australia have been made. You have to go farther afield to have the probability of large discoveries. Many speculators are uncomfortable with places they can’t find on a map or if they could, places that would scare them.

TD: Rick, you’ve been credited with coining a term in the mineral space, which is the “prospect generator model,” which from what I understand comes from the energy space. Can you talk about the prospect generator model and the sole risk exploration model? What are the differences between them?

RR: The prospect generator is the process of discovery that I favor. It involves a group of geoscientists and businesspeople who use their specific acumen to develop exploration theories and stake ground and then bring in third parties to do the heavy lifting of exploration — at least the heavy lifting of exploration funding.

The downside of this approach is that the prospect generator gives up some or most of the project in return for obtaining the funding. The upside is that most of the value in small exploration companies is actually in the human capital of the people that make up the company. Given that the chance of success on any one exploration property is small, maintaining your equity in the intellectual capital rather than having that diluted away to raise money to explore an individual property is the process of financing exploration which has worked for me.

An example of this Tekoa is to take the low range of the probabilities that I said with regards to exploration success, 1 in 1000, and you juxtapose that to the success that I’ve had backing prospect generators. We’ve had something over 20 discoveries in 55 or 56 attempts (of course, past experience is not necessarily predictive of future results). You will see that the probabilities of success, at least in my experience with prospect generators, are almost immeasurably greater than they are with sole-risk exploration.

That doesn’t mean sole-risk exploration can’t work. Sole-risk explorations speculation in bear markets like these can work fairly well because the competition that you face in trying to buy a company after they’ve made the initial discovery, after they’ve had a successful drill hole, can be very low.

If you practice this technique in bull markets when you’re competing with tens of thousands of speculators, you’re almost certain to lose.

TD: Rick, I think I’ve heard you use the analogy of a ‘cover charge’ when it comes to investing in exploration companies (the cost of shares is an opportunity’s ‘cover charge’). Does paying attention to the cover charge help amortize investment mistakes or speculations that don’t result in discovery?

RR: Absolutely. It magnifies the upside. This morning I was negotiating an investment with a small Australian company that has a $700,000 Australian market cap. That’s about US $550,000. That same company would have had a $6 million or $7 million market capitalization in the bull market.

Two things. Your money can go further in markets where the market capitalizations are miniscule like this. But much more importantly, when the sector returns the favor, not only will the small company be worth more but a discovery will be more valuable.

So the idea that you would diversify your risk among small companies now and enjoy their return to favor is one that has worked for me in prior cycles.

TD: Rick, in the prospect generator model, do they apply the option approach to one or two or three properties? Do you define them generally having large volumes of properties?

RR: One company that we own a lot of here as an example, Eurasian Minerals, I think has probably put 120 properties in its life span through the exploration process. That’s 120 properties that were explored with other people’s money (money also came from investors in the prospect generators, but costs were shared with joint venture partners).

They have enjoyed merchant banking-style success where they have enjoyed some exploration success and sold it to one company, then sold it to another company, and driven on, which is the way that they have managed to continue to explore over time.

So I think what you’re looking for is to own a portfolio, sort of five to ten prospect generators, that originate four or five projects a year, farm out two or three projects a year and get two or three projects a year drilled.

The idea with that is that in your portfolio, you are exploring 15 to 20 projects a year mostly using other people’s money.

TD: Looking at your success in doing the 108 private placements while having great success with just six, can a person do that with two, three, four or five project generators?

RR: That’s the idea. We’ve discussed before, Tekoa, financing the prospect generators –taking private placements in prospect generators.

They don’t often need money. But they need money more often in poor markets where it’s tough to find joint venture partners than in good markets. So for accredited investors that have the opportunity to participate in prospect generators and can magnify their wins with warrants — particularly long term warrants — this is probably the best way to participate in exploration speculation statistically.

TD: Rick, I’ve also heard you speak about good starts or decent starts. When we move down the pyramid of speculation towards the advanced-stage development companies, how do the probabilities of success change there when you’re dealing with a company that looks like they have something decent in the ground?

RR: It gets much better. Again, this is a game that you have to play in bad markets because in good markets, the competition for successful efforts and exploration gets very high. But making money in exploration, Tekoa, involves speculating on the answers to unanswered questions.

It might be in the context of an exploration company that they have discovered, if you will, a surface expression of mineralization and they need to trench it down to a couple of meters to see if that expression continues at depth. It might be that having determined that it continues at depth, that they want to see that it extends along strike and find the widths, so they run a grid of trenches. That might be the second unanswered question.

Let’s assume that that’s successful too and now they have a legitimate drill-hole target. They have potentially economic exploration over potentially good widths with a lot of strike length. But they want to see the third dimension. They want to put a drill hole into it.

If you’re in a market where you get a discovery-grade drill hole, that is economic widths of potentially economic grade, one of the wonderful things that can happen in a bear market is that the discovery is greeted by the market with a yawn and you have the ability to analyze the information.

Think about the information in the context of the other geological information available to you. Peruse the management. Look at the income statement. Look at the balance sheet. You have the time to make up your mind as to whether you want to accept that speculation, a luxury that certainly isn’t available in good markets.

These are the market conditions where speculation on sole-risk exploration — particularly for more advanced projects, what I call “successful efforts” — works.

TD: Getting back to the idea of investing in the sole-risk explorers, what is the ideal portfolio size to play in that arena? Can you do that with $10,000, $20,000, $30,000 or do you really need a few hundred thousand?

RR: Again, in a market like this, you can do it with $10,000 or $20,000 or $30,000. One of the things that happens if you’re doing “successful efforts” exploration rather than generative or “grassroots” exploration (on prospective targets that have seen almost no prior exploration) is that you have a lower probability of failure. The magnitude of your win is also reduced though.

Employing $25,000 as an example, with five bets of $5000 each, is perfectly feasible in the type of market we’re in today. The upside that you’re going to enjoy with any individual success will be less than the upside that you would enjoy with a grassroots virgin discovery with a smaller market capitalization. But it’s a very viable speculative technique.

TD: In the advanced-stage project space, when you’re looking at companies that have  identified a few million ounces of gold or 50-100 million ounces of silver as an example, say we have 10 or 15 of those companies, are all 10 or 15 going to make it?

RR: Certainly not. Understand that all ounces aren’t created equal. A four-million-ounce gold deposit of very low grade in remote terrain with bad metallurgy is a science project. A one-million-ounce deposit that’s accessible, that’s fairly high-grade and is mineable might turn out to be extremely viable.

The truth is, again, you need to remember that most money is made in exploration through the answering of unanswered questions. In a circumstance like today where the expectation for the market is failure, the probability that a portfolio of 10 fairly advanced-stage projects is going to pay off for you is higher, simply because the probability of higher mineral prices and the better market is greater in bear market bottoms than it is in bull market tops.

You get to add in to this investment “stew,” if you will, optionality. That’s the idea that a deposit that isn’t economic in today’s prices could be economic at higher prices.

TD: And that type of bet has nothing to do with whether or not all those deposits will be put into production at some point down the road, correct?

RR: That’s true. You can make money with a deposit that returns to favor even though it’s uneconomic. I remember very well at the beginning of the last cycle being instrumental in spinning Allied Nevada out of Vista Gold. If my memory serves me correctly Vista Gold shareholders got their Allied Nevada shares for free.

Those people who participated in the first financing with us, I think paid $2.25 for those shares. As the gold price rose and as the exploration efforts of Allied Nevada proved the deposit to be larger and larger and larger, the share price ran from $2.25 to $45. At today’s gold price, that deposit is probably uneconomic.

But the move in gold that the original speculators enjoyed from the $300 price level1 to the $19002 price level made the effort successful in the context of the market that existed at the time. People, while ultimately wrong, made fortunes.

TD: Rick, I’ve thought about the exploration segment as having– with well-chosen options — a three to five percent success rate, whether it be with your prospect generator model companies or a big portfolio of the sole-risk exploration stocks.

When we look at a well-selected portfolio of advanced-stage projects, what could be the chances percentage-wise of those going into production and themselves being a success?

RR: Well, I certainly think that there are four or five opportunities that are in front of us today that have 75 or 80 percent chances each of going into production.

If you get me beyond four or five in the portfolio, then the portfolio becomes decidedly more speculative. But there are certainly deposits that are in our wheelhouse, if you will — deposits that our geologists have visited and where we’ve interviewed managements, where we know the companies fairly thoroughly — where I would suggest that there’s a 75 or 80 percent chance of each of them becoming a mine.

This again is a situation that only happens in very, very, very poor markets. Usually in a good market if you have a deposit that is likely to be a mine, the market capitalization of the company assumes that it already is a mine and all of the economic gain is taken out by the frothiness of the market. It’s only in markets like these where you can find high-probability advanced-stage exploration deposits that would appear to be reasonable economic speculations too.

TD: When you look around the world today, how many deposits like that are out there that have a 70, 80 percent chance of going into production worldwide?

RR: Very few at today’s mineral price points. There are probably 15 or 20 that in the course of exploration over the next five years will be upgraded to that status. But we of course don’t know which they are until they’ve accomplished it. But I would say that there are five or so in our wheelhouse now. These are junior companies that have done enough exploration that we believe they’re economic and they will be built in the upcoming cycle.

TD: Rick, what about the producing segments — the single or multi-source junior producer or the major? How do you view probability and success when you look at those groups?

RR: Well, there you’re less concerned with probability and more concerned with net present value and commodity price, adjusted for optionality and process. There are teams like the Rio Alto team or the Mandalay team that, while small, seem to have the ability to either discover or buy deposits and build them and operate them profitably.

It’s important that you buy those companies at reasonable valuations using reasonable commodity price assumptions because there’s a reasonable chance that you are wrong. You should get the icing on the cake from higher commodity prices for free for taking the risk associated in what is a risky sector.

TD: What in your mind represents a reasonable discount to net present value on a per share basis for those companies and what are some reasonable numbers that we should use for assumptions on these projects?

RR: Well, I think the assumption has to be the current gold price. If you want to be more aggressive, which I do, you use the forward strip: gold is about $1200 today and the forward strip three years out is $1300. The price assumption that you would use would be somewhere between $1200 and $1300.

The discount in today’s market that I would use personally is probably zero. This is a very, very, very un-frothy market and rather than being so concerned arithmetically with the discount, what I would be much more concerned with personally would be insider ownership — that is whether or not the people running the company acted as my partners or my ‘employees’ (because their only stake in the company was their salary). Parenthetically, I prefer partners.

I also look at their track record of success and what their undeveloped project pipeline is and what the brown field’s exploration potential around their existing deposit is. In other words, I’m fine not to get a spectacular bargain on their existing operations, but I want to get a fair bit of upside baked in the cake for free.

TD: When we look at those segments Rick, how many companies would you say are out there today that have those features?

RR: That’s an interesting question that I hadn’t thought of Tekoa. My suspicion is that there are 10 or 12 that are reasonably-priced junior producers or intermediate-sized producers where you get the upside for free.

I have to caution you that at least half of them are in the copper business. My own personal nervousness with regards to copper in the absence of any demonstrably sustainable economic recovery is that my bias for copper is to go lower rather than higher. I gave you my prior answer in the context of the gold price where I think the probability is higher as opposed to lower.

TD: Rick, in some of your earlier interview materials, video recordings and things, I’ve seen you label expected-return percentages for each of the different segments, with speculation being the highest and moving downwards as you move towards cash. Could you go through those here for the person watching?

RR: Yeah, I’ve done that primarily as a tool for prospective or existing customers to give themselves a risk-reward audit. What I’ve told customers is to look at the rate of return that you’re hoping to achieve and assign an arbitrary risk factor to the rate of return that you’re trying to achieve that’s 1.5 or 2 times greater.

So an example would be if you were going to buy 10-year US treasury bonds today that would yield you a 2.3 or 2.4 percent internal rate of return, I think it’s reasonable to assume that in the wrong side of circumstances, that you could lose at least five percent of your money.

By contrast, let’ say you’re looking at an S&P 500-style investment, like one of the big industrial companies in the United States, and you had an eight percent annual internal rate of return expectation. I’d say you ought to think in the context of prior bear markets and that it would be fairly easy for you to have a 15 percent loss if the market went in a different direction.

Say you were taking more risk than that, like if you wanted to buy the small-cap and mid-cap growth companies and your rate of return expectation was 15 percent, a number you got from the Wilshire Index perhaps. I think that you need to be prepared to lose in that set of circumstances 25 or 30 percent of your money if things don’t go your way.

It’s very important that you put your return expectations in the context of your capacity for risk. How much can you afford to lose both financially and psychologically? That will give you some idea of the orientation and distribution of assets by risk in your portfolio.

TD: Rick, is there anything else that you think that we may have missed?

RR: I think we’ve given it a pretty good go this time. I think it’s a useful instructional video for customers that have a life, or people who are thinking about investing but spending most of their time thinking about their family, or thinking about their jobs. These are the types of issues that one has to consider when thinking about investments or speculation.

TD: Rick Rule, Chairman of Sprott US Holdings, thanks for sharing your comments with us.

RR: Always a pleasure Tekoa. Thank you for facilitating this.

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 760-444-5262 or email [email protected].

1 http://www.theguardian.com/business/2009/oct/06/gold-price-dollar-decline

2 http://www.theguardian.com/business/2012/jan/17/gold-to-hit-2000-dollars-an-ounce

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