Understand the big picture. Profit from the details

It was Jared Dillian’s The 10^th Man newsletter. He mused about how we are all formed by our experiences – in particular, how the state of affairs during our first few years in the business determines our investing outlooks and biases.

Dillian started working in finance in late 1999, just before the top. For the first three years of his career stocks went down relentlessly. As a result, he is pervasively bearish.

He offered a couple other good examples.
“One of my bosses at Lehman was an options trader back in the ‘90s. What he liked best was to just buy naked call options on stuff. Why not? It sure worked in the ‘90s. Volatility was underpriced, and markets only went up. Not so much in the 2000s, when markets went sideways and vol was more challenging. But he kept buying naked upside calls—it was what he knew how to do…
“Guys who got rich trading tech stocks in 1996-1999 are still trading tech stocks. Never mind that the world has moved on and we have since had bull markets in things like steel, railroads, chemicals, and emerging markets. They are still punting around profitless dot-coms.”

I tend to agree. I see it around me. Those now mid-career, who started out in the mostly bearish years between 1996 and 2003, responded to the latest bear market in an Eeyore-like fashion: downtowns are expected so just accept it, and don’t be surprised it this one lasts a really long time.

On the other hand, those who got their feet wet in a bull market got through these bear years by keeping one hopeful eye trained on the horizon, awaiting the next upswing.

That’s particularly true of all those who started out in the sector’s epic bull run of 2004 to 2007, many of whom are now driving their own vehicles in anticipation of big returns during the next bull. One acquaintance, formerly in IR and now heading an exploration pubco, told me the other day he expects to “get bought within a year.” That’s his business plan. If that isn’t an outlook founded in a bullish first few years, I don’t know what is.

I too am guilty as charged. Luckily for me, in my first few years the mining markets shot up, plummeted down, bounced back, got a reality check, and then settled into a long bear – in other words, I saw everything the resource sector had to offer in fast forward.

I started in the sector, as a staff writer for the Northern Miner, in 2007. In my first year I experienced life at the peak of a mining boom. Then came the shock and despair of a global financial crisis, incredible share price collapses, and major miners nearly drowning under massive debts. That rapidly shifted to a bounce far bigger than most expected, highlighting the payoff that can come with contrarian investing.

Then gold started to crumble, pushed downward by US QE3, and majors started writing off billions and billions of dollars in bad investments as, meanwhile, the rest of North America’s stock markets soared. Generalist investors abandoned gold and mining in general. A long, cold bear market set in.

So what kind of investor has that made of me?

One who plays the cards that are on the table.

It would be great if the resource sector were always rising. In bull markets good bets regularly return multiples and even bad bets generally don’t lose a lot. But there is no point wishing for what is not, and the resource sector is definitely not always hot.

Instead, as my formative years showed me, it is very changeable.

Cyclical is the word we always use, but mining’s cycles vary dramatically in length. Some bull markets last only a year or two, like the rally from early 1993 to mid-1994, which lost almost all its gains by late 1995 only to cycle even higher in 1996. Others are far longer, like the raging bull that ran from 2003 to 2007 or the recent bear that has dragged on since 2011.

What should investors do? There is much talk of taking advantage of cycles, but how exactly do you treat something so unreliable?

There are several answers.
First and foremost, understand where the sector sits within the big cyclical picture. If the market is rising, be very aware that bull markets are unpredictable in terms of where and when they top. Never assume the climb will simply continue. Constantly manage that risk by taking profits off the table. It is always better to lock in a small or medium gain and miss out on additional upside than to see a gain of any size turn into a loss.

If the market is declining, do not try to catch a falling knife. Unlike bull markets, bear markets are fairly predictable in terms of how far they fall.

This chart, courtesy of TheDailyGold.com, charts the Barron’s Gold Miners Index over gold bear markets back to 1939. Note that, while durations vary, gold bear markets have pretty similar bottoms. I’m generally an optimistic person but I didn’t expect the recent bear market to end until we got down to this level.

And what about right now?

Both of the above charts outline pretty clearly where we are right now: at a bottom. The bear market has been almost as long as any before it and has fallen as far as most bear markets fall. It has run its course.

I wish bears turned bull overnight, but (excepting 2009, which was highly unusual) they do not. Instead the market generally needs a year to stabilize. Investors need to gain confidence that gold is done declining. Funds need to convince themselves that gold is setting up for a bull run. Major companies need to see gold inching up before they start moving on underpriced assets.

When all these things do start to happen, the bull becomes established. While we aren’t there yet, we are in that stabilization year between bear and bull.

And as with all parts of mining’s cycles, there are opportunities. Those opportunities – the details of direction, as opposed to the overall picture – are the second answer.

A sideways market is made up of some companies gaining and others declining; if you can differentiate between those groups, you can profit during the lull. Along with that are market moments: times when the sector goes on a mini-run, as though practicing for the impending real deal.

How to capitalize? Be prepared to play opportunities.
• Timing. For example, the first few months of the year regularly outperform the rest for resource stocks, as I outlined in this article. January followed this pattern to a T. So make sure you’re aware of seasonal patterns and take advantage. Buy based on timing. Once you’re up 25 or 30%, either sell some to lower your cost base or sell all and lock in your gain, in the knowledge that 30% is great in a sideways year.
• Look beyond the mainstream metals. Certain metals go on runs despite an otherwise bear market because of metal-specific fundamental reasons, like palladium did for much of last year.
• Position in takeout candidates. Figure out what major miners want in new projects today. Find the best examples of those and buy. In sideways years, very few announcements create significant and sustained share price spikes – but take-outs top that short list. And if you choose well, even if the company or project does not attract an offer then you still have a low-cost position in a vehicle with upside that will carry into the real rebound.

I have my opinions and picks around those three opportunities. And I do believe the next year offers both the chance to make some money and the final opportunity to establish low-cost positions in companies that will outperform the market even as it runs away in the next bull.

But these opportunities only exist if you play the cards on the table. Investors who buy based on the same principles whether the overall picture is bull, bear, or lull will lose.

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