Mining’s old guard needs strong medicine
A new report details subpar investor returns in the mining industry over the last decade, particularly big cap diversified companies which have not adapted to new realities.
Source: The Gold Report 12/06/2010
Global Resource Investments Founder Rick Rule is always generous in sharing his wit and wisdom. In this Gold Report transcript of his Friday, Dec. 3, webcast, he covers a lot of territory and provides plenty of tips for investors as they face the extreme volatility he foresees. Despite the volatility, Rick believes the secular commodities bull market will continue its charge. Read on to find out what he says you need to stomach the highs and lows in this investment arena. This article covers the precious metals part of Rick Rule’s interview. Look for Rick’s thoughts on energy Tuesday on The Energy Report.
Jeff Howard (CEO, Global Resource Investments): Rick, let’s start with the precious metals markets because it’s been a glorious time the last three months or so, and it may be a good opportunity to get your thoughts on where we’re going from here.
So starting with gold, you know we’ve always joked over the years that when you start reading about gold in the Wall Street Journal or the Los Angeles Times and you start hearing about it on CNBC, that’s a sign of a market top, and that’s kind of what’s happening right now. It’s a popular topic out there; however, the actions of central banks and the growing distrust of paper currencies suggest that the strength in gold may continue for much longer than what we’ve seen in the past. So, what’s your take on the future direction of gold prices?
Rick Rule: Well, sadly, mixed. I know everybody wants a simple, declarative statement on gold, but I don’t have one. Jeff, I think you described the trade fairly accurately; we’re no longer lonely in the gold trade. You couldn’t describe this as a contrarian activity, and you couldn’t describe this as a low-risk activity. Trading in gold stocks, particularly the small gold stocks, in this very frothy environment is very, very, very high risk.
It’s attractive in some sense because the rewards, if you’re right, are immediate. You don’t have to wait for them, which is something that everybody likes, and, of course, this adds to the risk. Having said that, it seems that [gold] has more reasons to go higher in the near term than it does to go lower. The decision by the European Central Bank to emulate their American peers to print money to buy existent European bonds is tantamount to government counterfeiting. If they thought that counterfeiting was such a good idea, why don’t they let me do some counterfeiting? I could do as well for them as they could do for themselves.
There is a suggestion on both sides of the Atlantic that this counterfeiting is a form of quantitative easing. I disagree; I think it’s a form of fraud. I think they are printing money to buy bonds that they couldn’t otherwise sell. I think we’re in an extraordinarily dangerous period with regards to the global economy, and I think that gold’s rise is really a function of that simple fact. I do not yet think that we are in what I called in previous broadcasts “the echo market.” I think that we’re in a primary market. An echo market, you may recall, refers to a situation where the two primary motivating factors in investment-greed and fear-play off of each other.
Most financial markets are either greed markets or fear markets. The precious metals markets are interesting because when they really start to go, they are what is referred to as “echo markets.” In an echo market, the market might be kicked off by fear buying like we’re seeing in gold now, and the momentum established by the fear buyers attracts the greed buyers. The momentum associated with the greed buyers sparks more fear buying and backwards and forwards. Those of you who were in the gold market in the 1977 to 1981 period understand the hyperbolic moves associated with echo markets. I don’t think we’re in an echo market yet; I think we are in a purely fear-motivated market, with the sole exception of some of our own clients who have proven themselves to be amazingly greedy, but that doesn’t appear to the broad sector at large.
I will say to you that if you value gold stocks based on today’s gold prices, they are not astonishingly expensive. Mostly, gold stocks are valued or traditionally have been valued with other commodity stocks on a volume-average-weighted price over several years to establish a more normalized price. This is probably a more rational way of valuing the gold price because the market has demanded that gold producers not hedge their gold price. So there’s no particular guarantee that you’re going to lock in these prices on a going-forward basis to measure the cash flows.
I know you want a simple declarative statement out of me, and I don’t have one for you. Certainly, with regard to the senior producers, if you own them, when you see the VIX, the volatility index, above 30, consider calling Jeff or other brokers here and putting in place puts and calls; these things deliver tremendous volatility, and if you own these stocks, you ought to get paid for them. Also consider, on the stocks that are liquid enough, using trailing stops. Do not forget in a market like this to take profits, and never forget that in the juniors in any sector, no matter how popular the sector is, probably 80% of the companies in the sector have no net present value.
Why do we participate in a sector where 80% of the participants have no net present value? Because you can make so much money concentrating in 5% of the sector that does, which is what we’ve enjoyed. But this would be an absolutely lovely time if you have any precious metals stocks that you have any doubts about whatsoever to sell them. I think that’s it on gold for the time being, Jeff.
JH: Okay. And by the way, we don’t really know who’s listening on this call, but if there are any security regulators happening to be listening, Rick Rule was just joking about counterfeiting. Right?
RR: Of course, of course.
JH: I am sure most of you know we’re being merged in with Sprott, Inc. (View news release.) Our soon-to-be-boss, Sprott, is a big, big believer that the silver markets are very tight right now and that silver prices should continue to rise until it achieves a more historical relationship to gold prices. Yet, it appears that although the Silver Trust ETF (SLV) adds several million ounces every week, the Sprott Physical Silver Trust (NYSE.A:PSLV) bought 22 million ounces without trouble. How do you explain the contradiction?
RR: Well, I think one explanation is that Eric (Eric Sprott, CEO/CIO of Sprott Asset Management) understood something about the nature of the amount of silver he was going to buy and had at least informally contracted for several months in advance. I think we have seen an up move in the silver price, and I think part of that is a consequence of tightness in the physical markets associated with both Sprott Physical Silver and the ETF. Eric points out-and I don’t know how true this is-that in terms of accumulation of silver by the ETF, not all of that is physical silver. Some of that is silver depository receipts or other forms of paper silver where the ETF has title but not good possession of silver, which is something that he points out is quite dangerous.
The other thing that might impact the silver market in the near term is that if Sprott Physical Silver continues to sell at a substantial premium to the silver price, it wouldn’t be unreasonable for Sprott Physical Silver to do a secondary offering in public markets and buy yet more silver. There is a lot of evidence to suggest that in at least the very short term that the physical silver market is not very well supplied, and as demands for coins increase from investors attracted by the increase in the silver price, it could be that those spot shortages are exacerbated.
What is interesting to me about the silver market is that higher silver prices do not necessarily result in increased production of primary silver because so much of the production of silver comes from base metals mines. And what is interesting about that is despite the fact that copper prices, lead prices and zinc prices are very high, there are not very many new mines getting built. As a consequence, I suspect, of the ongoing weakness in the debt markets, while there is a lot of debt finance available for very short-term activities-margin debt is an example-there is still not very much debt available for long-term project finance. As a consequence of that, copper mines are not getting built; lead mines aren’t getting built; zinc mines aren’t getting built and increases in by-product silver are not occurring in the manner one would suspect with these very, very high metals prices.
In the two-year to three-year timeframe, there is probably a lot of physical silver available from personal holdings in South Asia; people who store their wealth in physical silver, rather than in Bangladeshi, Pakistani, Indian or Sri Lankan currency. But this silver finds its way onto the market fairly slowly, and isn’t normally as related to world events as it is to local events like strong harvests in India, which cause people to buy more silver as a form of holding or floods or droughts in India, which cause people to dishoard it in order to feed their families.
So, the silver market is going to be a true conundrum; all I can say about most of these markets, frankly, is that they’re going to be extraordinarily volatile and extraordinarily interesting. Whether interest manifests itself in a pleasant or an unpleasant form is something I am not prepared to speculate on as we speak.
JH: Okay, you mentioned base metals; let’s talk about them. Since the 2008 selloff, copper prices have tripled; nickel and zinc have more than doubled. This is partially due to the decline of the U.S. dollar, partially to economic expansion in China. Are we approaching price levels where the downside risk is too great to justify investing in base metals stocks?
RR: The short answer there is yes, I think. The bullish news on base metals is that there is continued strong demand from emerging markets, which is perversely a consequence of their being such bad credit risks 10 years ago that nobody would lend them, so they don’t have much debt. Places like Brazil, India, Russia and China really have pretty good balance sheets and are doing a relatively good job of growing.
The other bullish part of the base metals markets we covered earlier. Because of the ongoing debt crisis, it’s very, very difficult to increase supplies in a meaningful way, but that’s beginning to work itself out. The fact is that base metal trades are no-risk trades when there’s no margin in base metals mining industries and mines are shutting down. It becomes a fairly high-risk trade where the median cash margin in the industry is above 50%, where it is now. In the exploration sector, of course, none of this matters; it’s whether or not your company is going to find copper or lead or zinc that matters to you rather than the relative pricing associated with these metals.
Again, if you’re owning the real stocks in the sector, the New York Stock Exchange-listed stocks or the senior international producers, consider using stop losses. If you’re focused on the juniors, I would suggest if you have, as so many people have, enjoyed doubles or triples in the near term, that you at least consider taking your capital out of the position and selling enough in addition to pay the capital gains tax and perhaps sell a little more to buy yourself a Christmas present for having had the courage to buy copper when it was cheap.
JH: Okay. Let’s talk about rare earth metals. Most of us probably haven’t visited rare earth metals since we were in 8th grade when we were forced to memorize the periodic chart by our science teachers, but a few years ago some writers started to introduce investors to companies that were exploring for those metals, claiming that there was going to be increased demand from China and there were going to be shortages. Some of these stocks have done very, very well, although maybe for the wrong reasons. What is your take on the rare earth companies?
RR: I think rare earth equity prices will probably do well for the next year or two. I don’t think as an industry that the industry will do very well in one year, two years, five years or ten years. The reason for that is really twofold; in the first instance, rare earths aren’t particularly rare. We haven’t been looking for them because they have been so cheap for the last 10-12 years. There was a global rare earths business 20 years ago, but discoveries by the Chinese in far Western China and very low Chinese operating costs decimated the rest of the rare earths industry. That doesn’t mean the rare earths went away; remember they aren’t rare. There are places like the Western U.S., like the Canadian Shield, like Brazil, like Australia, like central Africa-great big old Protozoic and Pre-Cambrian rock formations called pegmatites that have lots and lots of rare earths.
We haven’t been looking for them because it hasn’t paid us to do so. Suddenly, as a consequence of rare earths use in so-called technological applications and as a consequence of China’s flirtation with restricting exports of raw rare earths so that the materials that are made from rare earths could be produced in China, there is a rare earths panic.
Let’s observe the panic. In the first instance, the global market for rare earths at today’s rare earth prices is about $2.2 billion. That means the gross sales of all this stuff that ends in ium-all these unpronounceable materials-gallium, germanium, iridium, blah, blah, blah-is $2.2 billion. China produces most of that, and most of that was state-associated companies; so, perhaps 60% of those gross sales don’t matter to the market because the market will never see it. About half the rest or 20% of the market is controlled by major mining companies that produce all this stuff that ends with ium in the context of their exploration for things like nickel, copper, cobalt, things like that. So, about 20% of this $2.2 billion market is attributable to rare earths-focused companies.
So, if we look at gross lines as the top line in the $400 or $450 million range and we assume that because of very low Chinese production costs the rest of today’s margins at today’s prices are 20% or 25%, we are talking about EBITDA (earnings before interest, tax depreciation, amortization, blah, blah, blah) of around $100-$150 million a year. If you assigned a 10X multiple to that EBITDA, which is generous, by the way, in a busines
Let’s not let facts get in the way of a good story-and this is s a tremendous story; it’s one of these few things where you can have a booth in an investment conference and not have to talk about your reserves because everybody acknowledges that you don’t have any but you get to talk about batteries. You get to have a car in the booth and have a pretty girl talking about things, always the makings of a good story.
I think the story is going to continue. For those of you who have confidence in your ability to do psychological analysis of markets, along the sort of Jim Dines’ lines, who talks about the mass psychologies, this will be a spectacular market to trade. Don’t try and do much by way of fundamental analysis because there is no fundamental analysis to do. The net present value of the cash flows of the producers are worth a third of the market cap of the consolidation of the companies that will never produce. So don’t confuse yourself too much with the facts.
If you’re going to play this game, understand the nature of the trade.
JH: Okay. That’s kind of it for the different sectors. You mentioned volatility earlier. Let’s kind of talk about your feel for this market. It’s been a wonderful time over the last three months. What do you think? Where are we?
RR: Well, volatility is the most important part of today’s discussion. I can’t guarantee anything with regards to energy prices; I have my superstitions. I can’t guarantee anything about oil prices. I can’t guarantee anything about gold prices. I can guarantee this: the next two years we’re going to experience unbelievable volatility-unbelievable volatility. I believe-to lay my cards out on the table-that we are half or two-thirds of the way through a commodities supercycle. I think we are in a secular bull market; I think the broad economy is in a secular bear market. I think the collision between a secular bull market and a secular bear market is going to resemble the collision of two very large weather systems. And I believe we are in for a period of just absolutely unbelievable turbulence.
In the last couple of months, we have seen 20% or 25% upsurge in precious metals prices. For those of you who are predisposed to believe that precious metals prices were going to go up, this doesn’t feel like volatility to you. It feels like a rational or justified response to your brilliance; believe me, some of this is volatility. For some reason, people aren’t so sanguine about 20% down moves as they were about 20% up moves, but we’re going to get a lot of both of these, and I suspect that over the next two years that 20% moves are going to be considered “tame” moves.
I think we are going to see 30% moves and 40% moves and 50% moves that are attributable solely to volatility, not to underlying events. The underlying events are already baked in the cake. Specifically, I think we’re going to see moves in the junior market up and down of 20% for no reason whatsoever simply because in the near term there are more buyers than there are sellers or more sellers than buyers. I think the probability of 50% moves in both directions-let’s put it differently; I think 50% moves are probable rather than possible.
Now what does this mean for you? Given that volatility is going to occur-in my mind-you have two choices: You can accept it, you can embrace and you can use it or you can get waxed. Those are your two choices. Our theme here has been contrary or victim, the choice is yours, and that’s the way it works with volatility.
What is volatility? Well, in markets, what volatility is is a series of repeated sales. Buying goods on sale is always preferable to buying goods at retail. Volatility will give you precisely the opportunity to do that. Volatility does something else for you, too; it gives you the ability to mark up the goods you bought on sale and sell them to other people for a price that is substantially dearer than the price that you had to pay.
But in order to do that you have to manage your own temperament; you have to be disciplined; you have to pay attention to the reality, not the noise of the market. It’s human nature when you buy a stock for $2 and see it go to $4 that a couple of pleasant circumstances occur. In the first instance, you feel smart; that’s nicer than feeling stupid. In the second instance, when you see it on your statement, you like that stock, it went up, that stock gives you pleasure. It is fighting that instinct that causes you to make money. If a stock goes up, if a stock doubles, for any other than truly spectacular reasons, you need to understand as a consequence of doubling, the stock is precisely half as attractive as before it went up. The fact that it went up makes it less attractive on a going-forward basis. It is dearer, and you have to fight your tendency to like the stock that’s gone up. You have to make yourself take profits.
At the same time, the stock that you liked at $1 falls to $0.50; when you look at that stock on your statement, it makes you feel stupid. It’s more pleasant to feel smart than stupid. Feeling stupid is unpleasant. You see this stock on your statement, which may be a bargain, but to you it’s a dog. It’s a mistake; evidence of your own failings and frailty. Never mind my failings and frailty. Although, if nothing else has changed, it is precisely twice as attractive at $0.50 than it was at a $1. Most people’s temptation will be to sell the stock that’s twice as attractive rather than hold the stock that’s twice as attractive.
The nature of profiting from volatility is being on the other side of the trade. When panic is in the market and good companies are priced down, you have to have the courage not only to stay the trade, but in fact, increase the bet. During periods of time when you are completely sanguine and really aggressive, you need to sort of shake yourself by the throat and say I need to take some profits here. Everybody remembers how bullish they felt in 2006; everybody has to remember that we all confused the bull market for brains, and everybody has to remember how they felt in September, October, November of 2007 when the market went no bid. We didn’t feel so smart then. Had we simply felt a little less smug in 2006 and a little more aggressive in 2007, we would all be substantially wealthier than we are today.
Bear that in mind because this market is going to be extraordinarily turbulent and extraordinarily volatile, and it will give you extraordinary opportunities as a consequence either to make or lose money. Whether you make or lose money will not be a function of the market. Volatility is not a risk; it is a tool. The risk is located east of one of your ears and west of the other. It will be a function of your response to the volatility whether the next two years are extremely pleasant for you or extremely unpleasant for you.
JH: Okay, Rick, thanks. We have to go back to work.
Note: This article covers the precious metals part of Rick Rule’s interview. Look for Rick’s thoughts on energy Tuesday on The Energy Report.
Rick Rule, founder and CEO of Global Resource Investments, began his career in the securities business in 1974, and has been principally involved in natural resource security investments ever since. He is a leading American retail broker specializing in mining, energy, water utilities, forest products and agriculture. Rick’s company has built a national reputation for its specialist expertise in taking advantage of global opportunities in the oil and gas, mining, alternative energy, agriculture, forestry, and water industries. This article is based on his Global Resource Investments webcast, Friday, December 3.
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