Rick Rule: Are some mining stocks heading up?

“Twice before, I have been in a market this gloomy,” Rick continues, “in 1991 and 2000. Within a year and a half of both periods, the market went much higher. In 1991, the benefits to me were spectacular. And the recovery off the 2000 low was even better by a large margin.

“Now, after three years of pain, I suggest it is in your interest to hang around for the gain,” he says.

What Goes Around Comes Around…

“In a conversation with Eric Sprott about four or five weeks ago, I was lamenting my own behavior at the peak in 2010. I observed at the time that it was hard to buy – which probably meant it was time to sell. I even communicated this to clients at the time. And we did sell some at the time – but not our entire position. Why did I hold on when I believed the market would go lower?

“What I learned from Eric was that you never sell everything at the top. This is a consequence of our own confidence and simple hubris. We believe ourselves to be better investors and analysts than the rest. We believe our management teams are smarter than others, and that our properties are of higher quality. We believe our companies have better balance sheets. What happens is that we ride our stocks over the top and then, with some of them, back down to the bottom.”

Were we wrong to think that we owned better stocks than most investors?

“The truth is that the market does not care whether you do or not. And that is true on the way down — and on the way up.

“In the context of very rapid and very violent market moves – particularly on the way down – having the best is very little consolation when your position has declined by 50%.”

So why stay in the sector when the market ignores our expertise at analyzing stocks?

“Once in a decade, natural resource markets fall by at least 50%,” says Rick. “The best investors lose half their money even though they have the best positions. At the bottom the best investors sell the worst of their stocks and redeploy the money among the remaining companies. When markets recover, those portfolios can be up dramatically, compensating them more than handsomely for their courage in the bear market days.”

“Closet Bull Market” May Be Under Way…

Has the market bottomed yet? Rick says the better stocks may have already turned around.

“In my last market update, I said the market would begin to ‘bifurcate’ – meaning the top 10 to 20 percent of issuers would start moving higher, while the rest of the issuers continued to trend lower. This ‘bifurcation’ may already be three or four months old at this point.

“These types of moves may leave behind investors looking for a broad-based recovery in the resource sector, because the overall market will continue to decline, dragged down by the majority of stocks.”

This type of phenomenon is nothing new, says Rick. “As with prior bear market bottoms, buyers are exhausted, which is the reason for lower and lower prices – but sellers are exhausted too. As an example, one stock that we follow closely was recently up 50% on only $300,000 of buying.

“So at this point, we should see some of the better companies begin to receive higher bids, because sellers are scarcer than before. It can take a small amount of buying to change a market cap substantially.”

Beware, nonetheless, that there could be more rounds of selling, even in the better companies, specifically because of tax-loss selling in December, Rick warns.

Why Can’t We Call a Broad Market Bottom?

“A lot of companies simply do not have the balance sheets to survive in the absence of a change in underlying market conditions. While the best companies get better, the worst companies – which are much more numerous – are going to keep going lower.”

Do not expect a quick recovery of the broad market before these deadbeat stocks disappear, he says: “This cleansing period could last another 18 to 24 months. This will be a ‘closet’ bull market because only the best will be moving up or going sideways.

“Despite overall deteriorating market conditions, companies that offer real value from the best management teams exploring in areas with the highest chance of success should start to receive higher bids.”

‘Cleansing’ of bad companies will likely accompany similar developments among professionals and investors in natural resources, Rick expects: “We haven’t seen professional capitulation yet among mining industry experts. We would expect many CEOs and administrative staff to leave the sector as mergers and acquisitions reduce the number of professionals needed within the space.

“We also still expect to see capitulation among issuers, where they come to us for capital offering terms similar to those we obtained in 1991 and 2000, when new capital was as scarce as today. Instead, issuers expect the terms they got at a market peak in 2010, when companies could easily find financing.”

This “gloomy” market may already be moving up for the best names. If you believe Rick, this is a move that the broad market could fail to recognize because of deadweight from companies still ‘on the way out.’ While specific stocks recover, the broad junior space could continue to clean slate with more professional capitulation and fewer junior companies able to maintain their operations – let alone their salaries.

Rick Rule founded Global Resource Investments in 1994. Global provides brokerage and investment banking services to high net worth individuals, institutional investors, and corporate entities worldwide. In 2011, Global was acquired by Sprott, Inc., a public company based in Toronto, Canada, which has in excess of $7.3 billion in assets under administration in the resource and commodity sectors.

¹http://www.marketwatch.com/investing/stock/sii