Rick Rule: Coming natural resource market will ‘elate or terrify you’

See below for his most recent comments.

Photo credit: Cambridge House International

Sprott Global: Rick, you’ve predicted an impending bear-market bottom in precious metals and natural resources. Are we there now?

Rick Rule: I believe we are. We’ll see a rising market with higher highs and higher lows. We’ll also see high volatility — which one day will elate you and another day will terrify you. That’s the way this works.

As we’ve discussed before, bear markets lead to bull markets; and this bear market will end at some point. Let’s take a look back to 2003. The first third of the year was truly terrifying. Buyers were exhausted and a lot of people were selling. The price charts of both commodities and equities looked like ski hills, falling rapidly from the upper left to the lower right of the page.

In the middle part of the year, we had a ‘flat-line’ experience. Sellers were exhausted but buyers were exhausted too. So the stock charts were horizontal.

At the end of the year, we began to see ‘bifurcation.’ The best of the issuers and some of the commodities caught bids. In the absence of sellers this caused dramatic price moves upwards on relatively small volume. Some of the juniors — like Eurasian Minerals Inc., Almaden Minerals Inc., or B2Gold Corp. — went up by double-digits with only minor buying.

That was a classic sign that the bear market bottom had been passed.  Today, we have seen this ‘flat-line’ period in 2013. To signal a start of a new bull market, we should see rising volumes and higher prices.

In the past, a new bull market was preceded by ‘issuer capitulation.’ The better players among small exploration and mining companies – ‘juniors’ — understand that you cannot simply survive. You have to advance your project and grow. You need to deliver value to investors. And for that you must raise money.

In July of 2000, the very best of the exploration companies, which were run by such mining legends today as Ross Beatty, Bob Quartermain, or Lukas Lundin, said:

“We need to raise money. We need to advance our projects, whatever it takes.”

When that decision was made in 2000, it kicked off a spectacular rally in some of the juniors – mainly those that received financing.

Meanwhile, the ‘worst’ of the juniors continued downwards. But the best of the juniors produced high returns during this period. And that is ultimately what kicked off the bull market.

Rick, back in October you mentioned that investors should reorganize their portfolios at the bottom. What is it they need to do?

People – including me — don’t want to admit defeat.

Somebody who bought a stock at $4 that is selling at 40 cents today will often think: “I can’t sell this stock at 40 cents. If I do, I’ll lose $3.60.” The truth is you’ve already lost the $3.60.

All that matters is what you do with the 40 cents. It doesn’t matter that you paid $4 for this stock. If you believe it’s selling for 40 cents and it’s worth 90 cents, that’s OK. You have made a decision with the 40 cents you have left in the stock. But don’t hold on because it’s too painful to sell.

Getting rid of such a stock is difficult. But the price you paid for a stock is irrelevant to your decision today.

Today, what asset classes do you think will lead a natural resource recovery?

The safest commodities to buy are those that are selling below what it costs to produce them. In these cases, the commodity price must go up or the industry that produces them will go out of business.

For example, platinum and palladium are priced below production cost, so the industry will likely start to decrease production. But platinum and palladium are highly valuable, for one reason because they purify the air coming out of cars’ exhaust pipes.

Uranium is another example. It cost us $70 a pound to mine. It sells for $35 a pound. Either the price goes up or nuclear power plants shut down – and the lights go out. It’s that simple.

With commodities like platinum, palladium, and uranium, if the prices do not go up, we will stop enjoying the benefits they produce.

15 years ago, I made a similar call on copper. It cost the industry a buck and a quarter to make a pound of copper, but copper was selling for 80 cents a pound. Either the price of copper had to go up or we would run out of copper. Copper is essential to modern life – especially in providing electricity. Sure enough, the price of copper went up.

To me, these are ‘comfortable’ speculations. But the exploration stocks, where you take a lot more risks, is where you can also make much higher returns – if you are right.

In this ‘ragged edge’ of the speculation spectrum, there is one critical task: to identify the best of the companies – those with real assets, proven management expertise, and solid prospects. I believe even the worst of these will probably triple in price over three or four years. The best may generate tenfold or fifteen fold returns.

But you’re going to have to take a lot of risk to get those big returns. In order to get these 10 or 15-fold returns, you’re going to have to take several individual losses to your portfolio.

And you’re going to contend with a lot of volatility that is beyond your control. I believe the decline in the gold price from $1,900 to $1,200, for instance, was not the end of a secular bull market. I think it was a cyclical decline within a secular bull market.

The great bull market of my youth, in the 1970s and 1980s, was truly an epic bull market. The gold price rose from $351 an ounce to $850 per ounce2. Natural gas prices rose from 25 cents a thousand cubic feet to over $2.53.

In that 10 or 12-year bull market, there were probably 10 or 12 price declines in gold of 20 percent or more — cyclical declines in a secular bull market.

In the middle of that bull market, at the end of 1975, and in 1976, the gold price had run from $35 an ounce to $200 an ounce, and fell by fully 50 percent — from $200 an ounce to $100 an ounce. Many people lost their courage or their conviction and got shaken out of the gold trade — missing the move in gold from $100 an ounce to $850 an ounce over the next five and half years.

In the current recovery, we will see higher highs and higher lows. We will see 20 percent perturbations in price that will either elate or terrify you depending on your individual positions.

Rick, will we then see higher volatility from here on out?

Well, I was surprised by the lack of volatility since the events of 2008. I had expected the market to experience much more volatility than it has.

What happened is that the market was sedated — injected with substances in the form of quantitative easing and short-term credits. But artificial benefits of short-term credit will be less and less effective in the market just as increasing doses of heroin are less and less felt by the addict. One of the results of this addiction will be volatility.

You have said that investors must be willing to do the work to understand their investments. What if they entrust this task to someone else, like a financial advisor? What would you tell an investor to ask their financial adviser?

First of all, ask “Why you?”

There are hundreds of thousands of people who are willing to tell you what to do with your money and make a commission.

The answer had better include a specific focus on whatever sector you want to invest in.

If you are interested in financial services stocks, then your adviser had better know something about the financial services sector. The institution that he or she works for had better have a specific focus on these stocks as well.

In an investment world as diverse as it is today, no institution — let alone any individual — has sufficient expertise across the length and breadth of the market.

If your adviser doesn’t have specific expertise with regards to the topic that you are asking him or her to address, fire them.

The second thing to ask your adviser is to describe their view of current market conditions. What circumstances do they believe are driving the market? What are the correct strategic moves for an investor? If the adviser can’t give a good response, fire the adviser.

The third thing is you need to ask is: “What specific support do you get from your institution that makes you competitive?”

Take Sprott as an example. We are probably the world’s largest investor in micro-cap natural resource equities. We have the ability to address these companies either as investors or as lenders. But our size and scale mean that we are able to focus more on evaluating resources by employing geologists, geophysicists and engineers than any of our competitors.

Our strategic advantage is simply that we are a $7-billion institution in terms of assets under management and largely focus on natural resources.

But if somebody came to Sprott and asked us, “Should I buy a thousand shares of General Electric?” they shouldn’t listen to our response because we have no experience or focus pertaining to General Electric.

On the other hand, if somebody asks us a question about small-cap or micro-cap oil and gas or mining shares, we are probably better prepared than any competitor in the world to answer those questions.

You mentioned that in the earlier years of the firm, you would spend around 20 percent of the company’s revenues on research – for example analyzing the geology of deposits or the economics of a mine. Why is this research so important?

In the natural resource exploration business, it’s not really about physical assets. I would call these companies the research and development businesses of the natural resource sector. They are trying to answer research questions that will create value to someone – like determining the nature of a geological anomaly, the size of an ore body, or whether a deposit is economic to mine.

The human resources of these small companies are their most important assets.

How do you evaluate the potential of a project and a research team?

First, you want to know what question they are trying to answer.

Is it the question that will add the most value, when answered? What thesis do they currently have, and is it supported by the facts that are available? Is their process to prove or disprove their theory valid? How will they know that they have answered the question pursued in their research?

In other words, if a company raises $10 million for a drilling program, will they have the good sense after spending $3 million dollars to understand that their thesis isn’t valid? Will they save the $7 million dollars left for some other useful purpose? Or will they spend the whole $10 million dollars because they raised it?

The success that I have enjoyed in natural resources has really come from a fairly small number of extremely good decisions that yielded extraordinary returns.

Getting an answer to the research question requires 18 months. A project as a whole, where there are multiple questions that must be answered, can take half a decade.

This is why we devote so many resources to acquiring knowledge about projects and management teams. We need to determine what management teams actually know their stuff; what their plan is; how well they stick with their plan; and what the value of their research might be.

Ben Graham pointed out that in the short term the market is a voting machine. It’s a source of noise. It represents people’s intuition and feelings. In the long term, it’s a weighing machine. It values what things are worth. You make money in the market by exploiting the gap between how people feel about things in the short term, and what they are really worth.

You need to establish a basis for evaluating these projects in order to decide whether the market’s current price is cheap or expensive. For me, that involves spending lots of money on geologists and engineers to help figure that out.

Rick, when we look at the broad stock market today, represented by the Dow Jones and the S&P 500, are you seeing an impending bear market? How will that impact the nascent recovery in natural resources?

When I look at the balance sheets and income statements of the largest industrial and financial companies in United States, I am struck by what great companies they are.

They responded to the 2008 collapse by strengthening their balance sheets. They are holding excess cash. Their operating margins are very strong.

But is this strength sustainable? Are their margins at all-time highs because they have become better businesses? Or is this because interest rates are artificially low, so demand is higher and their cost of borrowing is lower?

The yields on certificates of deposits and long-term bonds are artificially low now. This drives more people into stocks, which may explain these companies’ performance.

If interest rates rise, it will raise costs for companies that rely on debt to run their businesses. At the same time, it will lower their attractiveness to investors because bonds and savings will pay higher yields.

The impact that a rise in interest rates could have on these markets makes me nervous to think about. I expect it would either be very negative or catastrophic.

Rick, how do you view water as an investment opportunity?

You need to know a few things about the water market. You don’t have a water market in places like British Columbia where the challenge is to make it go away.

You have a water market in places like the west and southwest United States. For water markets to emerge water must be scarce and the society must be rich enough to pay for water.

There’s a shortage of water in Djibouti but it doesn’t matter because you can’t sell it to anybody. You want to focus on a place like California or Texas where water’s value is highest because it is most scarce, and the population can afford to pay for it.

Throughout most of our history, water has been cheap because there was more supply than there were uses. But that reality is coming to an end.

Water’s cheapness has caused it to be used inefficiently. As a result, here in California for example, 85 percent of the water that we use contributes to 3.5 percent of GDP — in agriculture.

Only 15 percent of the water in the State of California contributes to the other 96.5 percent of GDP.

Why such an imbalance? Water has been allocated by voters rather than the market. 80 years ago, when farmers and the State held the political power, they created a water rights system that kept water cheap for farming. Today, the political fight necessary to reverse these decisions and to deregulate the price of water hasn’t happened in California, because of the political cost of going against the rural constituents. Meanwhile, there has been ample water.

The last time we had a big drought in California was in 1977. It was an enormously disruptive event. People had to do things like ration how many times they flushed their toilets. A considerable inconvenience!

And in 1977, there were almost 12 million fewer people in the state. In other words, there were 12 million fewer straws in the barrel. We offset the shortage of water in the state by overdrawing our allotment of Colorado River water. But that was before lots of people lived in places like Las Vegas or Phoenix.

When we finally get a full-blown water shortage in California – probably sometime in the next decade — water will change in price dramatically. I believe it could go up ten-fold.

Rick, you have said this will be your last big cycle in natural resources. As a Director of Sprott Inc., how do you hope to shape the organization for the future?

Financial companies like Sprott are really just made up of people. Sure, you can look at our balance sheet, at our physical addresses, and at our wonderful art collection. But when the last person goes home, all we have left are desks and phones.

Our investment in the future involves recruiting and training new people. We need to grow our human resources because they’re the only real resources we have.

Yes, we have a potent balance sheet. We have important mandates from individual investors, institutions and even nations. Our real hope is to nurture the next generation and the subsequent generation of investors who will take the mantle from investment leaders like Marc Faber, Eric Sprott, John Embry, or me.

Our outreach programs aim to convey the paradigm gained by 35 years of investment experience at Sprott to investors who can employ it profitably and enhance the reputation of this firm.

Sprott will aim to continue the critical contrarian thinking that has led to the success of investors in my generation, and took Sprott from being one man to a multi-billion-dollar organization. We want to arm the second and third generation with the knowledge and the attitudes that are part of the Sprott franchise. And it’s going to be a lot of fun.

One of the huge benefits I’ve gotten from my affiliation with Sprott was unintended. I have received great personal joy from mentoring younger talent. I didn’t realize the psychological and intellectual benefit that I would get from that.

It is at least equal to the gratification that I’ve gotten from analyzing stocks. And the benefit that I have enjoyed from that has been tremendous in the last 35 years.

I am one of those guys who never really worked a day in his life. I get up and I am eager to go to work. I now have the opportunity to imbue other people with that advantage, while profiting monetarily in my declining years as a large shareholder of Sprott. It is almost fictionally good fortune for me.

Rick Rule, Chairman of Sprott US Holdings Inc. Thanks for your comments.

Thank you for the opportunity.

Rick Rule has devoted over 35 years to natural resource investing.  His involvement in the sector is as broad as it is long; his background includes mineral exploration, oil & gas exploration and production, water, agriculture, and hydro-electric and geothermal energy. Mr. Rule is a sought-after speaker at industry conferences, and a frequent contributor to numerous media outlets including CNBC, Fox Business News, and BNN. He founded Global Resource Investments in 1993 and is now a Director of Sprott Inc., a Toronto-based investment manager with over $7 billion in assets under management, and CEO and President of Sprott US Holdings Inc., where he leads a team of skilled earth science and finance professionals who enjoy a worldwide reputation for resource investing.

1 www.kitco.com

2 http://www.cbsnews.com/news/is-golds-price-drop-just-the-beginning/

3 http://www.eia.gov/dnav/ng/hist/n9190us3m.htm

The video recording of our talk with Rick will be published shortly.

You can also view Rick’s recent take on the market with smallcappower.com here.