Rick Rule – prospect generators, uranium, deep value
Rick Rule of Sprott US Holdings sits down with Maurice Jackson of Proven and Probable to discuss the deep value proposition that he foresee’s with Prospect Generators and Uranium. Mr. Rule provides listeners with a list of virtues of proven management germane to the task, with the right business model, in the right sector. Great educational tool for value investors.
Maurice Jackson: Welcome to Proven and Probable where we focus on metals, mining, and more. I’m your host, Maurice Jackson.
Joining us for a conversation is Rick Rule, the President and CEO of Sprott U.S. Holdings. For our listeners, we want to share that Sprott Inc. trades on the TSX symbol SII and on the OTC symbol SPOXF.
Rick, thank you for joining us today.
Rick Rule: Pleasure, Maurice. Thank you having me.
Maurice Jackson: Rick, in our last conversation, we highlighted how imperative the people aspect is as a part of your security analysis thesis on selecting and identifying the value propositions that the market cap does not recognize. I’d like to discuss that a little bit further today in highlighting an ETF recently that was market cap-driven.
Rick Rule: Sure. The earlier discussion we had paraphrase Warren Buffett’s old thing about the fact that there’s lots of good basketball players in the world but to win the title, you had to have a couple of 7 footers. The fact is, that we’ve been lucky over time at Sprott being able to align ourselves with the Bob Quartermain’s and the Robert Friedland’s, the Ross Beaty’s and the Lukas Lundin’s of the world. And ironically in bear markets in particular, you can buy the best of the best people in the business with no premium over anybody else.
We talked also about how the business has regarded as being asset-intensive. But really, it’s people beneficiating an asset is what makes you money. And the fact that the intangibles involved in the company aren’t often reflected in the market cap or rather are often not reflected in the market cap is something that has helped us outperform industries who are less picky than we are.
Your question with regards to the ETF I guess goes to the fact that a market cap that’s quantitative, that is, it only takes in statistics particularly when those statistics only refer to market capitalization and liquidity, by definition miss the best companies in a qualitative sense.
If you have an earlier stage company that’s very high caliber that’s run by one of these 7 footers, that company may not be well-represented in the ETF relative to a larger but more poorly run company.
Specifically, I guess the issue really is the rebalancing of the GDXJ. The VanEck junior gold miners index, it has become such an enormously successful financial product that rather than having the sector ETF be driven up or down by the sector, the sector in fact has been driven up and down by the ETF. The analogy would be the tail wagging the dog.
And the consequence of the enormous success of that ETF and their own guidelines has meant that more and more money has poured into fewer and fewer names, juniors allegedly but juniors with a median market capital $3.8 to $4 billion dollars. And the consequence of that is that the so-called small juniors, the ones under $2 billion or a billion and a half market cap has suffered as they have been sold off by the ETF.
While, the select few juniors, things like El Dorado Gold with a $4.2 billion market cap or New Gold have in fact done very well. And to belabor the point, I guess the opportunity that I see in front of us is look to the companies that have unusually high GDXJ ownership, companies that will be driven higher on a momentum basis by flow of funds. But don’t buy those despite the fact they had been in the short term. There’s going to be more buyers and sellers for them.
But rather, look at companies who are out of favor, who are strategically important to them and who will be taken over by those favored few at 35% or 40% or 45% premiums to market.
Maurice Jackson: Let’s discuss how the ETF’s with Sprott, how they are different and unique because to me, I think there’s a deep value proposition within the ETF’s that Sprott has.
Rick Rule: Ours are so-called factors-based. Now remember that an ETF must by necessity be rules-based and not actively managed. But some ETFs limit the number of factors that go into their selection to things like market capitalization and market liquidity.
At Sprott, what we decided to look at was liquidity of course to be sure but also, beta to the gold price. We wanted companies that were responsive to increase in gold prices because we and our clients believe that gold is fundamentally undervalued. So we think that people buy gold stocks for leverage to gold. So we had looked historically at companies that exhibit high beta or leverage to those in the gold price.
We also look at companies that would not go broke, companies with low debt and with good cash flow to enterprise value.
And finally, we look at companies that are growing their revenues. One of the risks that you run as a mining investor is to buy a company that isn’t adding to reserves and resources because every day that you mine, your business gets smaller. You can’t pour water and fertilizer into gold mine and have it grow gold. You have to have a company that is either organically that is by exploration or in terms of capital markets efficiently acquiring more ounces.
And so, we give special weight to companies that are growing rather than shrinking their revenues. Our ETF is a factors-based ETF, which means that we try and make qualitative as well as quantitative decisions.
Maurice Jackson: And speaking of deep value propositions here and also sticking with the Sprott theme here on the 25th through the 28th of July at the Fairmont Hotel in Vancouver, British Columbia, we will have the Sprott Natural Resource Symposium.
And Rick, these are a number of issuers that you have hand selected and this is my third year attending. It is an amazing, an amazing conference for anyone to attend. Let’s talk about in my opinion, there are two categories of issuers that I believe get neglected. I’d like to talk about the prospect generators. Why do you like them so much?
Rick Rule: Well, the prospect generators are simply put, arithmetically the best way to speculate in the exploration business. We said earlier on this interview in fact that the business isn’t as much an asset-intensive business as it is an intellectual property business.
If you think about the exploration business as a research and development business which is really what it is, you will understand the business more. And the prospect generators are people who recognize that intellectual capital in the business is more important than physical capital. They are generally amalgamations of scientists who have some specialized expertise that is recognized by the markets.
They maybe experienced in Peru, that is regional specialist or they may be specialist in porphyries or volcanogenic massive sulfides, geological terrains. Whatever their specialty is, they employ their intellectual capital to generate investment thesis around mineral exploration properties that they suggest. But rather than exploit the thesis themselves, they farm out or joint venture the thesis to other mining companies who then do the heavy lifting of the exploration expenditure to earn an interest in the property.
The consequence of that is that I don’t dilute myself by issuing more shares at the intellectual capital level, the level that I want to be invested in. I dilute rather in the property level. And I don’t spend all of my time or all of my risk on one property. But rather, I diversify my risks on a portfolio basis that is an example with Eurasian Minerals probably includes 150 properties, those properties all being explored by other people.
And Maurice, one other thing that I love in this case, a lot of the due diligence burden falls on somebody else. When I look at most junior mining companies, the research on it might be done by a consultant who bills me to review the company or it might be done by a brokerage firm that has a conflict of interest because they want to get my commission.
The due diligence that I rely with a prospect generator is done by the joint venture partner, somebody like Teck or BHP or Rio Tinto or Barrick. And they don’t send me a bill. Rather, they do due diligence with a view of spending a million or two million or ten million dollars to earn an interest in the property.
And believe me, Maurice, there’s no more honest appraisal than the appraisal that precedes spending $5 million earning an interest in the property. So I love the fact that the due diligence burden becomes partially the burden of a deep pocketed, highly sophisticated, world-class mining company.
Maurice Jackson: And I think you and I were discussing this prior to the interview. I think you’ve owned what is it, 60 prospect generators over the years?
Rick Rule: Yeah. As I told you in the earlier discussion, Maurice, sadly I’m becoming old enough that I don’t remember the exact number. But I think it’s somewhere like 65 or 66 prospect generators in my life. I have participated in I believe, depends on how Cascabel works out for Cornerstone, but I believe I’ve participated in 24 economic discoveries. And the consequence of that is that thus far ending the Mariana takeover by Sandstorm.
I have been involved in 22 takeovers. Now, if you think about 22 successful conclusions to 65 starts and you juxtapose that with the fact that one in 3,000 mineralized anomalies becomes a mine, I’m told by people smarter than I that the success that I’m enjoying with prospect generations is about three standard deviations better than one would have experienced in the junior resource sector as a whole. That’s truly astonishing, three standard deviations of outperformance.
Maurice Jackson: It truly is. And for our listeners, our sponsors of Proven and Probable will be there in attendance which is EMX Royalties, Riverside Resources, Millrock Resources, and Fission 3.0. We encourage you to stop by the booth, speak with representatives there, and discover the deep value propositions that not just myself but you’re hearing it from the legend himself, Rick Rule, why he enjoys these companies and sees the merit in being a shareholder.
Rick, let’s change discussion now to another group of issuers that get neglected in my opinion at the conference, and those are the uranium-based companies.
Rick Rule: Well, you maybe early on the uranium, Maurice. Now of course, you’ll have reasonable company, that’s me. The beginning of the discussion of uranium I think you and I have maybe four interviews ago, which is the fact that uranium is being sold for less than production cost. That’s normally a good sign except that you have to be patient. We have to be willing to accept a lot of pain.
So let’s do the math. First of all, uranium currently provides, I believe the number is 16% of base load electrical generation in the United States. That means pretty simply, if we stop having uranium, we would stop having electricity which I don’t reckon is going to happen. So that’s the first part of the equation.
The second part of the equation is that a couple of experts, Cameco, the world’s largest uranium producer and the International Energy Agency, estimate that the total cost to produce a pound of uranium, I mean total cost now not just cash cost but total cost, is about $60 a pound. So the industry makes the stuff for 60 and they sell it for 23. They lose what? $37 a pound. And of course, the miners are trying to make our volume.
Now, what I’m trying to tell your listeners, Maurice, is at some point in time in the future, six years from now, seven years from now, seven years from now, one or two things is going to happen. Either the price of the uranium is going to go up to $60 or the lights is going to go up. And I would suggest that if you ask your listeners whether it was more probable that the price of uranium went up or the lights went up, they would say it’s more likely that the price of uranium is going to go up. And here is why.
To operate a new nuclear power plant, well, first of all, to build the thing is $6 or $7 billion. To fuel it, you got to have a million pounds of uranium a year. So to amortize the $7 billion investment, you only have to buy at $60 a pound, $60 million worth of uranium.
The truth is that the uranium price is almost irrelevant to the total cost of producing energy. So the price has to go up because of selling for less than production cost. And it can go up because the price doesn’t matter to the price of the finished product.
My belief is this, Maurice, is something has to happen and it can happen. It will happen. The problem is it doesn’t have to happen in a timeframe that suits you or I or your listeners or my clients. The price of uranium will go up when the pace of Japanese nuclear reactor restarts increases. And I can’t tell you when that’s going to occur. Likely, not in time for my conference.
Maurice Jackson: And we also encourage our listeners to please stop by and visit Fission Uranium. They will also be in attendance at the Sprott Natural Resource Symposium.
Now, the last company which is Sprott Inc., talk to us about Sprott Inc. because this to me is the preeminentin the natural resource space, it gets overlooked.
Rick Rule: Well, I think we do get overlooked. And I think we get overlooked because the “sexy story” isn’t understood. People buy junior resource stocks because they want leverage to a commodity. And they only think of leverage to commodity in the context of a mine. And it’s certainly true that if you are making a little bit of money producing gold at $1,200 an ounce and the price of gold goes to let’s say as an example, at $1,200 an ounce, you’re making $100 an ounce.
And let’s say that the price of gold goes to $2,000 an ounce. That likely means that your earnings while the price of gold didn’t double, your earnings go up tenfold. And so, everybody looks at the leverage increase earnings you could have with the gold price.
It’s interesting though that people don’t look at the leverage increase in earnings that you can have in a precious metals-oriented, resource-oriented money manager because we think the leverage is just as great. We believe as you said that Sprott in terms of small cap natural resource equities is probably the preeminent investment brand worldwide. Nobody puts a premium on that brand because those markets had been in such a terrible bear market.
The truth is that the index that we’re measured against, the TSX: V fell by 90% in real terms so people don’t hold us in high stead. But my experience and yours too is that a bear market like that is the author go a good bull market. And in that circumstance, our assets under management and hence our revenues, and hence our earnings could soar, could absolutely soar.
And the truth is, at the beginning of the exercise, we are fundamentally a very cheap stock. Our market capitalization is now less than $600 million. We have $345 million in cash. No debt. So in terms of downside risk, it’s kind of hard to go broke when you have no debt and $345 million in cash. And all through the bear market, we generated free cash. In other words, we made money.
Importantly, and people don’t understand this, our mine is our brand. We manage in excess of $8 billion on behalf of a couple of hundred thousand retail investors worldwide. And it’s my belief, Maurice, as this bull market begins to take hold, those people will associate the positive experience they’re having in the sector with Sprott and they will increase their exposure to us and it also increase the depth of their exposure. This is important because those are two hundred thousand customers that we don’t have to go out and get. We already have them. We made the investment to obtain them in a bear market. And now, they are ours and we are theirs.
And if past is prologue, the upside in assets under management we could have is very dramatic. If you dial us back in an imaginary fashion to the year 2000, we had about $120 million in performance fee generating assets at the bottom of the last bear market. At the top of the last market, the top of the bull market in early 2011, we had $5.6 billion in performance fee generating assets.
So the up move over the course of the sector when we were less well-known and smaller was from $120 million to $5.6 billion. Will our assets under management grow 50-fold in this bull market? I don’t think so. But if they triple or quadruple, the impact of that on our management fee income and hence on our profits could be absolutely dramatic. And I actually think this is an expectation, not a possibility.
Importantly, unlike many opportunities that have pretty dramatic leverage upside, we don’t have an awful lot of downside because at the bottom of a bear market, we generated free cash and we have $345 million worth of cushion. And to make it easier for investors to wait to bridge the gap between inevitable and imminent, we pay a 5.6% cash dividend.
Maurice Jackson: When someone wants to invest in bonds, the first question I say is, “Have you heard of Sprott Inc.? This is a company that has zero debt, provide 5%, as you just referenced, dividend.” And most investors are not aware of the name and it just – it startles me because they’re willing to invest in a government that has debt obligations it cannot meet and they’re willing to put their future into that. But here, you have Sprott Inc., 5% dividend, undervalued, you mentioned bridge.
For someone who is not familiar with the story, talk to us about bridge and mezzanine financing, how that works into the philosophy of Sprott Inc.
Rick Rule: Well, one of the principal investment products that we have and one that we invest a lot of money in ourselves is in effect, bonds. But we’re private lenders. We’re not lending to governments. We are lending to companies.
Bridge lending means that we are providing temporary capital which will be replaced by the issuer later on with lower cost permanent capital.
Mezzanine level is like it would appear in real estate. The mezzanine level is the one above the ground floor where we might be subordinated to a senior lender. And increasingly, Sprott is in the project lending business where we are doing what would in real estate be called the construction finance. This is a business that we’ve been at for a very long time. And it’s a business where we have a big advantage over our competitors. Because we’re so active in the equity side of the business, our origination cost for lending is zero. We’ve already established a relationship with the lenders earlier in their history as a public company. So that’s an important durable competitive advantage.
And in fact, it’s the income that we have made on our lending activities that have allowed us to pay a dividend all the way through the bear market in the mining stocks. If you think about our lending activity, Maurice, going back over the last bear market, at the same time that the junior resource equities as measured by the Toronto Stock Exchange Venture Board, fell by 90% over five years, we made 19% per annum cumulative and compound in our lending business.
In other words, they lost 90%. We made 19% per annum in that business. It was a wonderful, wonderful business.
Earlier in your statement, you alluded to us as being a bond-like investment. That isn’t actually true in the sense that although we’re both income –oriented, of course, a bond is a call on cash that may or may not be there depending on the entity’ willingness to pay.
The advantage that we have over a bond is that unlike a bond, we can go up. If somebody borrows a thousand dollars from you, they pay you the interest plus the thousand dollars back. In our case, we pay you the dividend and there’s a chance, in fact, I think a probability that the share price goes up.
The truth is, there are a couple of structural advantages too to a government bond over us. The first is that the government’s asset is you. You think you are a citizen but you’re not. You’re a chattel. And they have the ability to come with a gun and make Maurice pay. And even if you borrow money from me, Maurice, sadly, I can’t do that.
The other thing a government can do that we can’t do is print. The US 10-year treasury is backed by the full faith in credit of you and me and if that isn’t enough, they can just whip up a couple of digits on the computer and make it so.
Now, you believe and I believe that the net present value of that payment stream in the future will be de facto compensated because they’ll find a way to print or inflate a way the premium. The advantage that Sprott has is that same set of circumstances that causes your bond to become worth less money probably causes Sprott to be worth more money because we’re in the hard asset business.
But I would caution people that sometimes the reason you buy a bond and the reason why you ought to buy a Sprott are different. We say to people, our value proposition is you want yield, you want growth, why not both? Sprott is yield and growth.
Maurice Jackson: Very well said. Switching gears, let’s discuss Sprott Global Resource Investments and the virtues of being a customer or having a brokerage account with a full service broker that is germane to the natural resource space.
Rick Rule: Well, the last part of your statement is a critical part. There are several fine brokerage firms both in the United States and worldwide. My definition of a fine brokerage firm is a brokerage firm that serves its customers’ interest. I believe that we are the finest firm in the world with regards to natural resources. That’s all we do. If you want to buy supermarket stocks, if you want to buy bank stocks, if you want to buy municipal bonds, God bless. But you should not do it with us.
By contrast, if you’re interested in mining, oil and gas, farming, forestry, water, stuff like that, it’s what we do. It’s the only thing that we’ve done for 30 years. We have a team of professionals around the world and all we do day in, day out is natural resources.
Importantly, our largest clients are our employees, myself included. So while we’re telling you what we think you ought to do with your money, we are doing that very same thing with our money. We manage on behalf of two hundred thousand investors worldwide in excess of $8 billion of natural resources.
So the research that you see from Sprott isn’t research that’s primarily generated to get a commission out of you. It is research that is oriented towards providing a return on capital for Sprott Inc. for its own account, for its employees who are its largest customers, and for money that it manages on a performance-basis. That’s very different from the agency commissions that you would see at other full service brokers.
And as to the discount brokers, you will need to decide whether or not information is worth something. If information isn’t worth anything to you then by all means, go to Schwab. But what you ought to do is you ought to compare and contrast ourselves with Schwab.
I would offer any of your listeners, any of your readers, any of your subscribers the opportunity to send me their natural resource portfolio. Send it to me in an email [email protected] with the name of the company and the symbol. And I will send you back an absolutely no obligation review of those companies backed up by all the professionals at Sprott.
Send that same list to Schwab and to E-Trade and to Interactive Brokers and see if you even get a responding email or see and compare their analysis of your stocks, it will be nonexistent with mine. And if you think that your portfolio would benefit from information and if you care about the natural resource business then you need to think about Sprott.
If you believe that your account is meaningless enough that you can put it on autopilot. In other words, that information doesn’t matter, by all means, stay with your discount broker.
Maurice Jackson: And for our listeners and Rick first of all, thank you so much for that opportunity. For those listeners that are going to take advantage of this opportunity, please to help streamline the emails, put in the subject line: Proven and Probable. No attachments. Please make sure you just put the subject line Proven and Probable and in the body of the email, include your natural resource portfolio.
And Rick, before we close here, for someone listening, they have an account with one of your competitors, they can purchase the OTC, let’s discuss the merits of an account with Sprott and why that would not be an issue or why they should even consider the OTC’s aspect versus actually going on the exchange of the stock that they’re trying to purchase.
Rick Rule: Well, that’s very important. That’s a very good question. Most natural resource stocks worldwide aren’t American domiciled. Most of them are domiciled in Great Britain or South Africa or Canada or Australia. Many of those stocks trade in the US over-the-counter market in the pink sheets. But in that case, you weren’t buying a stock on its full and exchange. A market maker is buying it on the home exchange and marking it up and selling to you.
So the first thing is that you have the dealer markup. The second thing you have is a foreign exchange fee which maybe as much as 200 bases points. It is important if you’re going to be in this business to be able to compare both the U..S dollar price and the US over-the-counter market and US dollar net price on the stocks home exchange, be it South Africa, Australia, New Zealand, Canada, or Great Britain.
If your broker can’t do that, your broker is doing you a disservice. Many people have quoted to me the commission that they paid on a stock that they bought in the U.S. over-the-counter market and forgot about the fact that they were paying 2.5 or 3% in markups and for an exchange fees. In other words, their total cost was substantially higher. They were paying as much as a thousand dollars more for a stock that there was even $35 in commission on, a false savings to be sure.
Maurice Jackson: And just to add to that, what a lot of investors are not aware of is that when you purchase the OTC, there’s very little volume and there’s no correlation in the movement with the actual stock say, the company that you’re looking at is on the TSX. Would you expand on that a little bit further as well?
Rick Rule: Yeah, absolutely. Remember, it’s a dealer or a market makers market. You aren’t buying the stock from another investor on an exchange. You’re buying stock for facilitor]. Many of the discount firms in the United States will refer your order into a market maker. Generally, Knight Securities and they will get paid a fee.
If you get paid a fee for routing an order, it’s pretty obvious that the person paying the fee is not the United Way or the Red Cross. They are doing it so they can trade against your order and mark it up and make money on the spread. It’s very important that you examine the total cost and the transaction.
Maurice Jackson: And last but not the least, please visit our website, www.ProvenandProbable.comwhere we interview the most respected names in the natural resource space. The website again is www.ProvenandProbable.com. You may reach us at [email protected].
Rick Rule of Sprott Global Resource Investments, thank you for joining us today on Proven and Probable.
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