“You only need one bull market to build life-changing wealth. And a new bull market may be knocking at the door…” – Rick Rule
Compiled by Ellsworth Dickson
At the recent fifth annual Sprott Natural Resource Symposium in Vancouver, British Columbia, Rick Rule, Director, President and CEO of Sprott U.S. Holdings Inc., gave his usual compelling presentation to a packed auditorium.
I want to talk to you about this market a little bit in general and then talk to you specifically about what I am doing with my own money, with the understanding that what I do with my own money, may or may not be appropriate to you. It represents the most honest interpretation of how I see taking advantage of the market conditions that I see.
But understand that my own perceptions, my own need, my own time frames are going to vary from yours, so the fact that I did it may or may not mean that it’s appropriate for you. It’s important when we look at a market we look at each subject in context.
One of the things that have interested me about this conference is that although you as attendees are battle scarred veterans that have stood the test of time and understand intuitively a lot about markets and cycles, we’ve demonstrated that markets take five or six years to turn. Exploration success takes four or five years to occur.
People are more interested in trade fluctuations and in pricing information than they are in value information which I think is to everyone’s detriment. So I want to talk to you about this market in a much broader context.
Somebody was talking yesterday about the fact that gold had broken down to $1,228 an ounce. I was watching the consternation that the crowd was expressing about this 4 and a half dollar decline in gold and I’m thinking: what impact does 4 and a half dollars have on the net present value of an exploration project? This is about as irrelevant as a mosquito is to a blue whale and it commands all kinds of attention and hand wringing. So I want to draw you away from that.
There are 7.3 billion of us. People do what people do and, as a consequence, the population grows and all those people want to eat and want the lifestyle that you have. One truism I’ve seen in 40 years of the resource business is that, mercifully, the bottom of the demographic pyramid, while still desperately poor, is demonstrably richer than they were 40 years ago.
An example is Malawi, Africa. Thirty-five years ago in Malawi, the largest public health issue was starvation. Now that’s an issue! The largest public health issue now is obesity! This talks about what you could call the ascent of man.
It’s important to note that when the 2 billion people that occupy the bottom of the demographic pyramid, get richer, richer is relevant. They’re not rich like you, but richer than they were before. When poor people get more money, they feed their kids better. They might replace a thatched roof with a steel roof. They might replace walking barefoot with walking with shoes, replace the shoes with a bicycle, replace the bicycle with a motorcycle and replace that with a Honda. Their consumption patterns involve resources, and the ascent of man is something that is at the root of natural resource and commodity businesses.
So while the price trend in commodities can vary substantially, what you have to think about ultimately is the ascent of man [and the need for natural resources]. The key thing that you have to think about is the relationship between the price that the commodity sells for on a global basis and the cost of producing it. One thing that works spectacularly well for me has been to find commodities where I think the demand is going to be steady or increasing. Because the material itself is critical to humans beings where the price of that commodity is less than the global cost of production, means that the industry itself is in liquidation. This means that either the price goes up or our material standard of living declines.
If you look at the example of the price of oil going from $45 to $75 because it had to and you take that same calculus across the rest of your natural resource portfolio, you have accomplished the most important investment task that faces you. The price of something that has to go up will go up. The cure for low prices is low prices.
It may not happen in the time frame that might suit you, but it’s not the job of the market to have the time frame that suits you. The function of the market is to balance over time the supply and demand. So remember it in this context – markets work. If you are not a contrarian, you will be a victim.
Commodity prices in the last two years have held up or increased relatively well. We talked about oil – $45 to $75. Zinc – off a little bit lately but basically almost a double in two years. The copper price has done well. The gold price has held up relatively well. Do we wish it was higher? Yes.
In other words, the commodity producer equity prices have declined at the same time that the prices of the commodities that they produce and enhance the company’s operating margins have done fairly well. It’s interesting then that the companies equity prices to value are better, much better than they were two years ago and people find that a problem.
When goods that you want to consume are on sale, that is not a problem, it’s an opportunity. If you were shopping for something and it was on sale, you’d be delighted. What I am trying to say is twice before in my career that I can remember, commodity producer prices have lagged commodity prices and, both times, that was reconciled in favour of share prices.
Moving further down the thesis, I think it’s fair to say that there has been for 20 years an under-investment by society in natural resource equities – oil and gas equities and mining. Secondly, and this is a more subtle fact, there has been mis-investment as well as under-investment.
When I came into the business over 40 years ago, the value driver in the business was rocks, meaning geology-to-money. The idea was that you would discover a deposit, develop a deposit, you would produce a deposit and you would make money in the context of geology and operations.
The value creation matrix has changed. There’s a third dynamic. Now it is rocks-to-stocks and stocks-to-money. As an industry, we have spent 20 years exploring for a stock market narrative rather than exploring to make a discovery. There are other parts of the world where their value drivers are still rocks-to-money. Australia is one which is one of the reasons why Australia’s resource equity market has so dramatically outpaced the American market.
I would suggest to you as investors, you pay less attention to the share prices and more attention to the perceived value and your perception of value. Pay more attention to what has to go up, rather than what has gone up.
Right now the rage is cannabis stocks and cryptos. Sprott has looked at lending to both sectors. Now as a lender, you don’t get the upside. You just get the downside and so you tend to look at things differently. We looked at a cannabis stock the other day with a market capitalization well in excess of a billion dollars. We couldn’t find $20 million in collateral and a $1.4 billion market capitalization. But everybody likes it because the price has gone up. Now think about that.
If you went to buy a coat or a pair of shoes, would you be delighted that something that used to be $250 was now $600? How would that make you feel? But if you take that same narrative to a stock, you’re delighted! The price has gone up so it must be a good stock. I think that we need to adjust these expectations.
The expectations around mining are so low that the industry can’t help but outperform. In fact, people in the industry have been so badly beaten that they have low expectations of themselves. At the same time, I’m beginning for the first time in the 40 years of my career to see mining companies acting rationally.
We’ve [mistakenly] asked them for many years to be proxies for commodity prices and not good businesses. Boy, did they comply! Now they have become extremely efficient businesses. Now I’m on conference calls and hear stuff I’ve never heard in mining before – free cash yields, rational expectations, rational allocations, companies being run as real businesses.
These companies after 40 years are now being run as businesses just at the time that investors expect them to continue being stupid. I expect that this year you’re going to see companies materially outperform expectations, not just because the businesses are becoming more rationally run but because the expectations are so low.
While expectations are low, companies are suddenly mean and lean – something that we haven’t seen for a long time. The current perception of the industry is a five year old perception. In fact, the reality is very different and there’s another reality too.
They’re mean and lean because they’ve under-invested. Some would say for six years, others would say for 20 years. And there’s an opportunity in that too! The industry knows that they have to grow now. There’s no development pipeline in the industry as a whole. There’s no exploration pipeline in the industry as a whole. Every day that you mine, your business gets smaller. If you aren’t replenishing, pretty soon you don’t have a business and we’re coming into a massive investment cycle in mining. If we don’t, we’ll starve in the dark. That’s the way the world works.
We need these things whether we like them or not and that’s the opportunity for you. This is something that has to happen if we as a species want to maintain our material standard of living. Something that has to happen will happen.
How am I playing the game? I’m playing the game in three ways. The first is that we are now really well and truly in a mergers and acquisitions [M&A] cycle. This hasn’t happened for a long time because we as investors remember how stupid the mining business was in the last cycle with mergers and acquisitions. They were insane the last time!
The consequence of that insanity was that about 70% of the team of the major mining companies were allowed to pursue other employment opportunities. Now mining companies have to buy good deposits and merge laterally even without deposits because they need to lower the general administrative expenses relative to assets under management.
At Sprott, we’ve compiled a list of 23 probable M&A targets and we are going through the process of trying to narrow those down to five or six.
If you look at the prices paid recently in a bad market for good M&A targets – I’m thinking about Arizona Mining, for example – the premiums that are being paid for these targets are very attractive. There are a reasonable number of companies out there that are viable targets, and so the first part of my portfolio is going to be establishing positions in companies that I think are undervalued and are increasing their values fairly rapidly and will likely be attractive targets for either amalgamation into larger companies or sideways amalgamations.
Buying acquisition targets is not something that’s going to yield you a 10-bagger. That’s not the way it works. But getting 35% or 40% internal rates of return with relatively limited downside risk is a consequence of buying companies that are fundamentally sound companies is a good way to try and make money.
The second theme that is important to me and the second way I’m going to invest my money is that we’re coming into a massive capital spending cycle in mining. And paying attention to the dynamics on how capital gets raised and spent and allocated in mining is the next important theme.
Several important trends have happened in mining finance that most people are not aware of, particularly in the smaller sector and that is that issuers no longer have access to the project banks to finance things.
It used to be is that if you looked for a construction loan to build a mine, you went to one of the biggest projects banks in the world; the Royal Bank of Canada, for example. Now those banks are basically forbidden by the governments from participating in non-investment grade credits which opened sort of a $15 billion space. This is one of the reasons why Sprott has earned so much money. We came into that space not because we could out-compete the big banks but because big banks were prohibited from competing with us.
The subject of this part of my speech is that the royalty and streaming companies – although they are richly priced relative to their producing peers – still represent more compelling representations. I believe these companies will have the ability to allocate capital across the capital structure of companies and participate in the financial needs of the mining brokers for a very long time. The customers need them and they will be able to allocate capital efficiently. And, as a consequence, earning very good returns. And so I am going to buy and continue to be buying personally, the royalty and streaming space.
Will I buy the oil and gas streamers? I’m going to buy them too. Good operation margins, good balance sheets and really robust businesses with the wind at their back for at least five years. We’ve been able to identify about 20 viable public royalty streaming companies worldwide.
If you want to be in the space and you want to sleep nights and stay calm, I think you’re going to make good money on the biggest and the best of the best.
You won’t need to go into smaller companies. I also believe that some of the smaller companies are much more likely than not to double over two or three years. If you think about a probable double in three years, if you think about internal rates of returns that are probable as opposed to impossible and are 30 or 40% annual with much less downturn, that’s not a bad risk reward acquisition. I think it’s extremely attractive and I’m going to take advantage of it.
However, the most important thing I’m going to do is what I know and like the best. Nobody is paying attention to the exploration sector. It is knocked down, dragged out, stomped, smashed and cheap. We are coming into a real exploration cycle. We are coming into the absolute heyday of prospect generators and they’ll be able to generate targets and sell them to majors. They’ll be able to generate targets and sell them to juniors. The market opportunity in front of them is amazing. This industry, like any other industry, is beginning to outsource. Big companies don’t do exploration as well as they used to. They’re headed by finance guys, not exploration guys, coming to the point of the cycle where exploration isn’t a discretionary expenditure anymore. It’s a normal and natural way of replenishing the reserves that they’ve been living on – cannibalizing for 20 years.
You need to focus on exploration and we’ve talk about this for years. You need to focus on the best people and often the best technical people are found in prospect generators. They have to be good people because it’s their reputation that sells a project. You also need great geology.
As an investor, you have to find a circumstance where great people are involved in projects that are permissive for large discoveries because large discoveries are something where the reward justifies the risk and is the intersection of where money is made.
I think the three things that I’m going to play are: M&A candidates, people involved in the financing boom for resources in the next five years, and particularly because of the risk and reward, the prospect generators.
Those of you who remember the decade of the 1990s and those who remember the early part of the last decade will know that when they move, exploration stocks will express more upside volatility than almost any other sector. You all have been through the pain; get ready to participate in the gain.
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