How contrarians play bear markets in resources: Rick Rule

The slump in the early 90s’ had occurred because of too much debt and excitement leading to a peak in the business cycle. In turn, the bull market turned to a bear market. That led to an oversold market, which certain investors were able to profit from substantially when a recovery came by 1992.

“Buy low, sell high,” Rick admonished readers in the April issue of the year 1990. In retrospect, considering the vigor of the recovery that came later, this was extremely prescient. The following discussion of buying low and selling high should be familiar to investors who have heard Rick speak about investing over the years…

“As Benjamin Graham has taught us, be brave when all around are afraid, and afraid when all around are brave. Always buy straw hats in the winter. The phrases seem so simple and logical, and yet most investors act so differently.

“Financial assets are among the few commodities that increase in popularity as the price increases. Imagine being encouraged at the grocery store, as you are at the checkout stand, seeing your bill increase significantly week after week. Imagine cheering your service station owner for increasing the price you pay for gasoline. Imagine complaining to a plumber because he lowered his rates. Think about this phenomenon as you analyze potential investments.”

A reasonable reader might take issue with Rick here… Is he comparing apples to oranges? After all, we consume goods and services whereas investments are usually held in the expectation of selling later at a higher price.

The point is that your willingness to buy a stock should not be diminished by the fact that it has fallen in price. In everyday purchases, we want to buy things that are selling at discounts. In investing, people tend to prefer stocks when they are expensive and hate them when they are cheap. Rick continues…

“In the stock market, the fact that shares are increasing rapidly somehow makes them more desirable. But as more capital is attracted to a certain economic activity, its relative usefulness diminishes, and the investors inevitably pay more and more to get less and less.

“Let’s follow this cycle from trough to crest and back again. The bottom of the cycle is characterized by product prices below the industry’s average productions cost. With prices this low, no productive capacity is added; in fact, production declines as high cost and marginal productive capacity disappears, and even low cost producers constrain capital spending.

“These low product prices increase the utility of the product to its users, and they begin to consume more. As declining supply collides with increasing demand, prices begin to increase. Product users often begin to hoard product in anticipation of further price rises or to guard against shortages, so some price rises have a near term result of actually increasing demand.

“These events allow producer profit margins to widen, and this improved financial performance enhances the sector’s investment image.

“The higher product prices and enhanced industry image set the stage for the cycle’s crest. Investment capital floods into the industry attracted by high operating margins and the industry utilizes that capital to build more productive capacity to supply increased demand. Meanwhile, higher product prices have lowered the product’s utility to its users, so demand begins to falter.

“This time, increasing supply collides with decreasing demand and product prices begin to fall. Product users, sensing price softness, may begin to ‘dishoard,’ reversing the earlier paradox. The industry’s profit margins decline and its investment image erodes. Now investment capital declines, prices fall further and productive capacity declines; but with lower product prices, product utility begins to increase.”

“Share prices fall below what would be rational given the expectation for an eventual recovery. Only a few investors have the interest to notice; fewer still have the courage to act. Most investors call us twice during this cycle: once in a panic to buy at the top of the cycle and again in a panic to sell at the bottom.

“We aim that through our exclusive focus on natural resources we will notice sectors that are inefficiently priced by the market. Hopefully, you will have the foresight and courage to buy straw hats in winter.

“’The time to take hors d’oeuvres is when they are passing them out.’ In other words, when summer comes, sell those straw hats. Sell the stock and find another one that is underpriced. We believe that these industry cycles will always repeat.”

Today, resource stocks are suffering one of the harshest declines in decades. Can buying resource stocks when they are ‘on sale’ work today? An 80 percent decline in resource stocks certainly creates a situation reminiscent of the resource market in the lows of 1990 and 2000.

As Rick explains, “Natural resource companies are capital intensive businesses with long development cycles and extreme short term price elasticity. Understanding the basic cycle of extractive industries and investing using the contrarian approach are essential elements of successful natural resource investing.”

If you follow Rick’s media and public speaking appearances, you know that this 3-year slump has not deterred his belief in contrarian investing. Will the contrarian approach work again in the current bear market? Well, if the cyclical nature of resource markets is intact, we should expect that bear markets should eventually lead to bull markets which may compensate investors for their willingness to build or maintain their position in times of depressed market prices.

P.S.: As part of our commitment to helping you be a successful natural resource investor, we would like to offer you a free, no-obligation portfolio consultation from Rick Rule. Click here to take advantage of this offer.

P.P.S.: Many of you attempted to contact Mishka Vom Dorp in response to our piece, “Where Is Gold Headed in 2014? – Mishka Vom Dorp”, but most were not delivered due to a misprint of his contact information. To follow up with Mishka about inflation risk and precious metals in 2014, please e-mail him at [email protected].