RE: speaking of shorts...
Market Malaise Signals Opportunity: Rick Rule on Getting Back in the Markets
Source: The Gold Report 07/25/2008
Legendary investor Rick Rule, founder of GlobalResource Investments, began his career in the securities business in1974, and has been principally involved in natural resource securityinvestments ever since. In this extensive interview with The GoldReport, Rule gives his thoughts on everything from why he's consideringre-entering the market for junior miners to why he thinks thedisconnect between equities markets’ performance and the metals willcontinue.
TGR: You've been out of juniors for the last couple of years?
RR: Yes.
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 thetable. I was frozen out of the financing market because I just didn’tlike the pricing, and that’s changed.
There were large numbersof companies created in the last two to three years that receivedinitial financings on terms that were ludicrously generous. And theseguys are coming back to market now, having spent that money, and themarket is much less generous, which means you are going to have somenumber of failed companies.
I suspect that that outcome will makethe market, as a whole, pessimistic. And when those sets ofcircumstances occur, it is usually beneficial for more prudentspeculators.
TGR: Are these good companies that arefailing because the market has moved away from them, or are theycompanies that really shouldn’t have gotten financing to begin with?
RR:Ninety percent of the companies that got financed should never havebeen 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. Whatone does to survive a situation like that is try to do qualitativedifferentiation. Of course, buy the best, even though they’re goinglower with the overall market. . .thinking, wishing, praying—whateverthe 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 havetarget prices, and when the market comes to our target prices, we beginto buy.
We have what we call the "nibble-gobble" rule. We havea typical company — let’s call it "Moose Pasture Exploration." Let'ssay we have determined internally that Moose Pasture Exploration issomething that we will begin to buy—in other words, we will nibbleat—when it has, say, a $30 million market capitalization, and we willgobble—that is buy aggressively—when it has a $22 million marketcapitalization.
We’re actually starting to nibble now, and wewould expect ourselves to become gobblers around August, when all theinstitutional buyers in Canada go on vacation, and when someone is aseller, and the market has gone “no bid" in the depths of the summerdoldrums. We’re usually reasonably good buyers.
The other thingthat we see ourselves doing is providing financing to companies thatare intelligently run, but not well promoted. We believe that therewill be a good appetite for capital in the exploration business in thenext 12 months and that capital supplies will be much less generousthan 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 silverprice have gone up while the price of gold and silver equities has gonedown.
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 goldor silver. They’re looking for it, and the fact that the commodity thatthey don’t have any of goes up in price is really irrelevant in thecontext of their value.
It is my own belief that the preciousmetals prices will tend to go higher over the next few years forreasons that you’re very familiar with —softer U.S. dollar, domesticdeficits —both in terms of trade deficit and government deficit. Nextyear I suspect will be dominated by bad news in the U.S. economy ratherthan good news, which for real reasons and psychological reasons takethe U.S. dollar down, and take the gold and silver prices up.Traditionally in the U.S., a new president in his or her first year inoffice has tended to make us sick so they can make us well later in thecycle and get reelected.
I think that the disconnect betweenshare prices and metals will persist, and I think it will persist for avariety of reasons. In the first instance, at the senior producer levelwe have not seen the increases in margin that you would have expectedto see relative to the increase in the gold price. Much was made overNewmont’s last quarter, but if you look at Newmont’s last quarter, netof sustaining capital investments, it was not that grand a quarter,particularly in view of the fact that the gold price has gone from $300to $900. The only companies that seem to have benefited on an operatingbasis from this increase are Barrick and Agnico Eagle, and that’sproblematic for me.
The second thing is, it would appear that atacceptable price steps, the senior gold mining stocks are trading at1.6 to 1.8 times the net present value of their cash flows, at thesegold prices. That’s problematic; you have a business priced at a hugepremium to net asset value that’s in a depleting business.
Theidea that you’re buying a business in liquidation at a premium inrelation to its inventory suggests that you believe that they canreplace that inventory on an efficient basis, which they haven’t shownthemselves to be able to do.
And, partially in their defense,the costs of all of their inputs have risen as high as the gold priceshave. At the same time that the gold price is up 300%, 400%, there arelabor shortages and the price of diesel, steel, and cement are up. Andthe price of theft, which is what I call taxation and governmentroyalty, is up dramatically as well.
So, although the goldprice is higher, you have cost-pushed inflation in the inputs, whichhas caused the margins—let’s be charitable and say—to not expand asrapidly as one might have expected.
I think the third factorthat we have to look at, and people in our industry always tend tooverlook this, is pricing. Pricing adjustments are due to the fact thatgold and silver are denominated in U.S. dollars, with the dollarheading lower, in my opinion. That means gold prices will be headedhigher, at least in nominal terms.
I think that gold andsilver prices may go higher in real terms if the economic recovery inSouth Asia — India, Pakistan, Bangladesh, Sri Lanka, and Nepal —continues, because those areas have had traditionally high demand forgold and silver as stores of wealth among the peasantry, and withrelatively strong agricultural prices. With relatively strong economicconditions in those countries, it would be reasonable to suspect thatthe peasantry in South Asia will have some access to liquidity andtraditionally, 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 verydifferent. The first has been paper issuance. Many of your subscribersand many of the speculators generally are concerned by the issuance ofphony paper money by organizations like the U.S. Fed.
I amalways fond of saying the private sector can do anything moreefficiently than the public sector, and that includes inflation. Theissuance of phony paper by the Canadian Dealer Network; that is, thephony gold and silver shares, has greatly outpaced the issuance of U.S.and Canadian dollars.
While the individual share priceshaven’t escalated over the last two or three years, the marketcapitalization of the sector has increased spectacularly because thereare many more small public companies purporting to look for gold andsilver, and the existing companies have issued so much paper to raisecash.
This will be exacerbated in the near future, as we saidearlier, because the companies that were formed two years or threeyears ago were formed in an environment of freely available capital.They haven’t husbanded the capital they raised particularly well, andthey will be returning to market to raise more capital with absolutelynothing to show for the capital that they raised the first go round.With any luck at all, the markets will look at the performance thesecompanies have exhibited and will be somewhat stingy going forward.
So,I think that the disconnect between the equities markets’ performanceand the metals will continue. I believe that sets up an absolutelyideal stockpicker’s market for people who can differentiate fromdeserving juniors and the mass of juniors.
TGR: If themarket in general is going to go down, when will these deservingjuniors be able to disconnect from the general malaise?
RR:What has been successful for me in the past 20 years is having aportfolio of companies who deliver positive surprises on an individual,rather than a market-, based basis. In other words, what has worked forme is backing intelligent people who employ capital well long enoughthat they make a discovery, and I get a 20-bagger out of it.
Lookback, as an example, at the success of Arequipa Resources It occurredin a strong market rally, but it didn’t go from 35 cents to $30 becauseof a market rally. It went because they discovered 8 million ounces ofgold.
What I will use this market malaise to do is buy companiesthat are threatening to or have the capability of making majordiscoveries at a big, big, big discount to the surrounding market. Ithink it will be an easy time for educated people to outperform themarket, partly because the market as a whole won’t perform well, andpartly because as the market underperforms, the competition from otherinvestors to buy shares of the best of the best will be very low.
RickRule, founder of Global Resource Investments, began his career in thesecurities business in 1974, and has been principally involved innatural resource security investments ever since. He is a leadingAmerican retail broker specializing in mining, energy, water utilities,forest products and agriculture. Rule's company has built a nationalreputation for its specialist expertise in taking advantage of globalopportunities in the oil and gas, mining, alternative energy,agriculture, forestry, and water industries.