A 40-year, spectacularly successful veteran of the investment industry, Eric Sprott (the "Energy Guru") needs no introduction. Sprott's steady stream of strategic, entrepreneurial and global performance awards often end in the words: "of the year." Sprott's investment abilities and knack for seeing opportunities where others don't have earned him a spot among the most successful investors in the country. Managing $4.8 billion worth of hedge and mutual funds for Sprott Asset Management, the financial sage is also an esteemed art collector. Referring to his color-blindness in a recent interview, Eric Sprott said: "It's not the color that does it for me. It's probably the contrast in the colors." One might say the same of his investment strategy.
The Gold Report: Eric, what's your viewpoint on what’s happening in the stock market and, specifically, why is gold a good investment at this time because we’re looking at a deflationary (some would even call it a depressionary) market?
Eric Sprott: Since 2000, I’ve believed we are in a secular bear market. We had a modest cyclical bull from ’03 to ’07, which was brought on by the lending mania. That’s obviously over, despite the fact that we’re another leg down in the secular bear market.
We essentially remained bearish throughout that period. The concerns that we expressed back then and our reasons to own gold are the same now except that there has been greater play-out in the meantime. This would suggest that having owned gold, and continuing to own gold, looks even more propitious today than, perhaps, in 2000 when we first got involved in the gold area.
First of all, I think we’re in a depression today. All data points suggest we are. The fundamental problem of the world’s financial system is an over-leveraging of the banking system. The average bank is probably leveraged 25 or 30:1. As you look at these banks’ balance sheets, the liabilities never go down. They must be paid despite the corresponding volatility in assets. We have seen so many of the asset classes come under incredible evaluation adjustments. It is hard to imagine that, in a true mark-to-market, any banks would have any tangible capital left.
Consequently, they either have to raise capital (which a lot of them are quickly doing) or replenish their capital through earnings. This would imply the discontinuance of dividends, and they must then shed assets. It is very difficult to shed assets in a market where there are no asset buyers. However, we have this awful situation where everyone would like to be a seller in the banking business. The reality is that there are no buyers.
For a long time I have believed fundamentally that we never should have allowed the banks to get leveraged to this extent. I don’t know what the proper level of leverage should be. Even 10:1 scares me. Moreover, if you have to go from 25:1 to 10:1, that is going to take a long time to manifest itself. By implication, it means there will be no net new loans any year for a long time. The effect this will have on the economy, of course, is excruciatingly bad.
That is what we are seeing today. There is no credit available and all asset values are in collapse. The biggest fear is that weakness begets weakness, which is what we’re seeing here. We are going to continue in this negative vortex. So far, nothing that the authorities, governments or central banks have done seems to have made any difference. One might argue that the only difference is that when they started directly buying paper mortgages recently, yes, it did move the rates down, but there is a lot to buy and the system is too big to bail.
TGR: Eric, you said that you believe we’ve been in a secular bear market since 2000 with a little bull blip between ’03 and ’07. What were the fundamentals in 2000 that caused you to believe that (obviously, I’m sure they’ve exponentially increased with this financial crisis)?
ES: Of course, back in 2000 it was a different view in the sense that you saw how ridiculous people were becoming in valuing stocks. We had stocks that were trading at multiples of sales; you could see that there was a stock mania going on. When you have a stock mania, it has to come to an end; it did come to an end—we had the NASDAQ fall by 80%. It was only logical that we had to work through the problems of declining values at that time. But, really, the authorities didn’t want us to have to work through it, so they created this other mania—the lending mania. Now, of course, that’s an even bigger problem than we had back then, and it’s a bigger problem by many, many dimensions. So we have just gone from what was sort of a modest secular decline to what will now probably be a major secular decline and a market that acts more like the Great Depression than just having a long secular decline.
TGR: So do you see, as we’re looking at 2009, a continued financial market decline?
ES: Yes. That’s what we’re expecting.
TGR: For the entire year or will it bottom out, say, in Q2?
ES: I have no idea when it will bottom out. If you look at what we think the fundamental reasons are, you can foresee negative forces on the economy (i.e., no loans) happening for a long time. So I don’t see this as a one-month or one-half or one-year phenomenon. It will be much longer lasting than that.
TGR: You stated earlier you think that we’re already in a depression and that eventually the government will figure this out. Gold, typically, is an investment when you’re looking at an inflationary environment. How will it act in a depressionary environment?
ES: One of the beautiful things about gold is that it can show its relative value in both an inflationary and a deflationary environment. Some people argue that if they just keep printing, we’ll end up with some kind of hyperinflation anyway. However even in a deflationary environment, where people concern themselves with the banking system, lending and where they have assets, it is a very powerful force for people to own gold. We’ve seen that manifesting itself this year and it probably won’t take much more (particularly now that the interest rate is almost down to zero) for people see the wisdom of gold as an asset class.
It wasn’t too long ago that if you said people should have 5% gold in their portfolio, they thought you were a quack. Now people are certainly willing to go to 10% of their portfolio and they’re not seemingly crazy. In my portfolio I have 40% in gold and I think that’s the safest, and probably the most rewarding investment that I could have. If people come to that conclusion, even at 5%, the demand for gold would be outrageous and who knows where the price would go. I believe no matter what environment you’re in—deflation or inflation—people will run to gold. Gold is proving exactly what we all would have expected, that in almost any environment, it’s a go-to asset.
TGR: You mentioned that 40% of your portfolio is in gold. Is that physical gold or a combination of physical and equities?
ES: For the most part, I always own physical gold. When I say gold, I really mean gold and silver; and I am probably about equal in each. I always take delivery. I want to own the physical—I don’t want an owner’s certificate, I don’t want to own an ETF. I believe that it’s really the only security you have, and you don’t want any counter-party between you and your gold, so I take delivery. Forty percent is in bullion. Probably 10% of my assets would be in gold equities or precious metal equities.
TGR: Many are saying that the real leverage in gold right now is the equities because they got slammed initially by the gold price going down along with the market going down. So, leverage-wise, as you’re looking at any rebound as the price of gold goes up, the equities will have an even larger multiplier effect. What’s your viewpoint on that?
ES: For sure that’s true. However it depends on exactly what equity we’re dealing with and the status of, let’s say, some gold miner’s project, whether it’s in production, in the exploration stage, high-grade or low-grade, open pit, underground. There are many reasons to want one class over another; if gold goes up, the equities go up faster. And, as you know, since October 24th, from the bottom to the top, the HUI Index was almost up 100% in that short time period.
So, to get to your point, it’s obvious that there’s leverage in owning the securities rather than gold. However it cuts both ways. When we see gold go down, say, 2% or 3% today, we see the stocks go down a lot more. I guess people would say we’re being pretty defensive owning gold instead of the shares, but we’re happy to make a steady return per year. We don’t need to knock the ball out of the park and, in essence, take on some risk of owning a piece of paper that might not ultimately prove its value. We do own gold shares and we like gold shares, and I’m buying gold shares now. The most important thing is gold has got to go first, and then the gold shares will get going. We believe in both. It’s not going to bother me if gold under performs gold shares in the environment we’re in. We’re in such an ugly environment that any time you can make a gain, that’s a good thing.
TGR: You mentioned you’re buying gold equities right now. Any names you’d like to give to our readers of stocks that you’d recommend they be buying, as well?
ES: To name a few, amongst my largest holdings are Kinross Gold Corporation (TSX: T.K, Stock Forum), Alamos Gold Inc. (TSX: T.AGI, Stock Forum), Dynasty Metals & Mining (TSX: T.DMM, Stock Forum), Kirkland Lake Gold Inc. (TSX: T.KGI, Stock Forum), El Dorado Gold Corporation (TSX: T.ELD, Stock Forum) and Ramelius Resources (ASX: RMS) in Australia. I probably have 100 other smaller companies that I own.
I typically don’t buy the larger-cap gold companies. I want to find smaller gold companies that are slightly off the radar screen that are in, or near, production, where the value of ounce—either in the ground or annual production—is way less than what they’re paying for the bigger companies. Ultimately, gold lifts all boats equally. It has to. So I’m trying to find small- to mid-size companies where the market has inappropriately valued them. Now that we’ve seen the majors have this huge run up, people are going to start poking around at the mid and smaller-cap companies to provide a little torque to their portfolios.
TGR: Are you avoiding the exploration companies?
ES: It depends on where they are in exploration and the sort of quality of the ore body. I’m somewhat hesitant on low-grade big open pits because of the financing issues in the world. I’d much rather find a high-grade underground where the development is not nearly as expensive per ounce as a big low grade open pit. You certainly don’t want an ore body with a base metal component in it in the kind of situation we’re looking at. If somebody has a reasonable high-grade open pit, then obviously that would suit the bill, too.
TGR: Any areas of the world that you’re focusing on or avoiding?
ES: I can probably better answer that by what I might avoid rather than where I might focus because you’ve got to go wherever the ore body is. I do have some concerns in regards to some countries in Africa. Likewise, I do have some concerns about some Eastern European countries. So, really, North and South America seem like the more logical places to go. Australia would certainly be on our screen if there was something interesting down there, and we own some gold stocks in Australia. You want to find a country where things are relatively stable. We realize that even in our own country things are never entirely stable. You really want to try to minimize the political risk.
Please stay tuned tomorrow for Part 2 of this article
Eric Sprott has accumulated 35 years of experience in the investment industry. After earning his designation as a chartered accountant, Eric entered the investment industry as a research analyst at Merrill Lynch. In 1981, he founded Sprott Securities, which today is one of Canada's largest independently owned securities firms with offices in Toronto, Calgary and Montreal. After establishing Sprott Asset Management Inc. in December 2001 as a separate entity, Eric divested his entire ownership of Sprott Securities to its employees.
Eric's investment abilities are well represented in his track record in managing the Sprott Hedge Fund L.P., Sprott Hedge Fund L.P. II, Sprott Offshore Fund, Sprott Canadian Equity Fund, Sprott Energy Fund and Sprott Managed Accounts. In December 2004, the Sprott Hedge Fund L.P. was the winner of the Opportunistic Strategy Hedge Fund Award at the Canadian Investment Awards. In addition, the Sprott Offshore Fund, Ltd., won the 2006 MarHedge Annual Performance Award under the Canada-Based Manager category. Furthermore, in October 2006, Eric was the recipient of the 2006 Ernst & Young Entrepreneur of the Year Award (Financial Services) and the 2006 Ernst & Young Entrepreneur of the Year for Ontario. In December 2007, Eric was named Fund Manager of the Year by Investment Executive, a widely circulated publication for Canadian financial advisors.
Sprott Money Ltd. is one of Eric’s newest ventures. As one of Canada’s largest owners of gold and silver bullion the company’s goal is to facilitate ownership of precious metals to the general public.