Interview with Rick Rule: Prepare for when the dam breaks

I called up the 61-year-old Carlsbad, California, based executive recently to discuss speculation, Sprott’s due diligence process, Rick’s outlook for the junior resource sector, and the conference he’s hosting in Vancouver next month.

“Most of the junior mining sector’s injuries were self-inflicted,” Mr. Rule said.

A recent internal study by Sprott of 75 sub-$10 million market cap junior mining companies showed that 57-58% of the capital raised went to general and administrative expenses over a 5 year period. Meanwhile, major mining companies, such as Teck Resources, typically allocate 12-15% of project expenditures to G&A, according to Mr. Rule.

“The delta between what the industry allows and what the capital markets allow is a full 40%, which goes a long way to explain the chronic underperformance of the junior mining industry.”

I wanted to pick Rick’s brain about Sprott’s due diligence process.

Rule himself says he monitors about 45 companies closely, and that the Sprott organization determinedly follows and models approximately 400 companies, which is 200 too many, in Mr. Rule’s opinion.

“With 3,000-4,000 junior issuers on a global basis, you absolutely positively are going to miss something,” Mr. Rule said.

Rule estimates that the entire Sprott team takes 2,500 meetings a year with companies, “some of which are going to be dupes,” and conducts 150 site visits per year.

Although he enjoys them, Rule said he takes few site visits personally these days, insisting that the technical professionals within Sprott have an unfair advantage over him in evaluating early stage projects.

I asked Rick if any new discoveries were getting him excited; however, he was only comfortable in discussing broad strokes.

“We are monitoring a couple of indicated discoveries that we don’t own yet but I would be loath to talk about those.”

“The sector that interests me the most is the sector that’s the most out of favor and that would seem to be the emerging and frontier markets oil and gas and prospect generator sector.”

“All of the oil and gas money is going to development stage unconventional oil and gas plays, and the conventional third world wildcatting exploration plays are getting absolutely no love whatsoever… In particular the African prospect generators, and not the sole risk guys, that’s too risky for me, but the guys who use capital to obtain on and offshore concessions, shoot the seismic, and develop the target which they farm out generally to a major or super major… That sector is getting no love at all.”

“The move in Africa Oil’s share price from $0.70 to $8 is a graphic reminder of what happens when you enjoy exploration success in frontier markets.”

Note, speculating in exploration is high-risk. For instance, Africa Oil stock subsequently rose above $10 in late 2012, and stood at less than $8.00 earlier this year.

We spoke about investment newsletters. Rule subscribes to and pays for numerous investment letters and has made scores of money with them, commenting that they make his prospecting more efficient. “But the buck stops with me, it’s always up to me to see if I agree with the assessment of the letter writer.”

Brent Cook of Exploration Insights is clearly Mr. Rule’s favorite. “Brent Cook has forgotten more [about mineral exploration] than I’ll ever know.”

He praised Bob Bishop of the Gold Mining Stock Report, now retired, for having a unique sense of the impact of a story on market psychology. “As a consequence Bob’s readers, on occasion, enjoyed some 10-15 fold gains on companies that had a wonderful exploration concept and some measure of success short of full success because he understood the market response that results were likely to generate.”

With that said, Rule complained that value creation in the junior resource sector is perverted to the extent that issuers try to create a story, and not a discovery.

“This is a market that will move with a genuine discovery but we haven’t given it many.”

I pressed Rule on his investing strategy.

“What I am trying to do is determine an important unanswered question, that could in and of itself give me an 18 month double, but has the follow on potential if I get a yes answer on the first question to generate a second question that could give me a double or triple. What I am really looking for is the possibility of an 18 month double and further possibility of a 5 year 10 bagger. That’s what I’m about and I try where I can to exploit that opportunity by offering the company money in a private placement that comes with a full warrant because a ten bagger with a full warrant isn’t a 10 bagger it’s a 17 or 18 bagger.

“I would suspect we get involved in 25 or 30 new names a year, and I would suspect that we would delete 75% of those in the first year, because the exploration data makes it increasingly less likely that we are going to get the yes answer that we are looking for. We aren’t traders, we are people who speculate on risk adjusted net present value and as the probabilities as suggested by exploration data give us a better and better picture of net present value we will either buy and sell based on that.”

I wanted to know how many different companies a speculator should own, in Rick’s opinion.

“The speculator can have as many positions as he or she is willing to spend one serious hour per month on. Investors who don’t read and think about the press releases, who don’t follow up with a call to the company’s IR, who don’t read the proxies, the management information circulars, who don’t at least read the cover page of the Preliminary Economic Assessment, if there is one, shouldn’t be in the business. There’s a ton of publicly available information on these companies that’s very good but one needs to take the time to utilize it. The way that you employ competitive advantage over your peers is by working harder and more thoroughly than they do and most people don’t even think about that.”

“Most people’s technique is “Got a hunch, bet a bunch,” Rule quipped.

Sticking around for the long term, saving capital, and working harder than others are the keys to success, in Mr. Rule’s experience.

“A lot of my success is due to the fact that for years I worked harder than guys. The compounding of working through good markets and bad markets. And the most important thing is I truly wanted to be rich. For years I made money and didn’t spend it. That allowed me to have a tool, capital, that’s essential for a capitalist. I like to think I have the correct perception in terms of time. When I look at a theme now like uranium, I am perfectly comfortable with the fact that it might take 5 years to be right. I have come to learn that asking myself investment questions where the answer begins with when, not if, is a very good trade.”

When, not if

“In the uranium business now, industry costs including cost of capital is about $70, so you produce for $70 and sell it for $30 and lose $40. You cannibalize existing capital in corporate vehicles and that goes on until they go broke, and then the price shoots just like it did last decade. That’s a question that begins with when. When does the dam break? It’s not if. Does the price of uranium go up or do the lights go out?”

Rule admitted that he had been early on his uranium call last year but that he has no problem waiting it out.

“The nature of the business from my point of view is that if you make 10 investments, you probably lose money on 6-7, break even on 1-2, and you’re trying to whack the ball out of the park on 1. So you’ve got to have a lot of starts, you’ve got to trim your losses aggressively so you can re-cycle intro new starts, and you’ve got to try and get warrants so your starts are magnified.”

“For the last 30 years I have sized my investments correctly relative to my means.”

“I assume as a speculator that any individual speculative idea that I have could go down 30% before I would be smart enough or quick enough to sell it, and 50% in a considered mistake. So I don’t use more money than I could easily afford to lose 50% of in any one particular name. We are always trying to re-assess fundamental value.”

“I believe that making money in speculation is a function of getting yes answers to unanswered questions. If I buy a stock at $1 because I think it could go to $2.50 and the stock gets to $2.50 without the question getting answered, I sell at least half, if not all. That has cost me some forgone profits, but I am okay with that. For me if you take away all my downside, you can take away a bunch of my upside, I am okay with that.”

We then got to the reason for my call, Sprott’s upcoming Vancouver July 22-25, 2014 conference: the Sprott Vancouver Natural Resource Symposium.

The event, formerly put on by financial publisher, Agora, and now adopted by Sprott, “Because for 16 years it has been the finest high end natural resources conference in the world,” in Rick’s words, is shaping up to be extremely exclusive.

More than 170 companies have applied to exhibit and only 55 made the cut, I learned.

Robert Friedland, the dynamic billionaire entrepreneur, has his Ivanhoe Mines presenting.

Even the Lundin Group, considered the world’s top natural resources developers, will be there.

The speakers list is the best I have ever seen for a conference like this: Robert Friedland, Bill Bonner, Frank Holmes, Doug Casey, Brent Cook, Keith Schaefer, Paul van Eeden, Mr. Rule, and many others.

There’s even a panel with Pat Di Capo, managing director of Power One Capital Markets. Pat is one of the most influential financiers in Canada and rarely speaks at conferences.

So what Sprott has shaping up with this conference is the absolute best financiers and management teams from the natural resources sector, along with a few hundred individual investors willing to buck up $699 here (registration fee escalates soon).

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