Veteran investor Rick Rule reveals a unique arbitrage opportunity
One of the hardest things for a mining executive to do may be nothing. But in a market that is not rewarding companies for pulling resources out of the ground, Sprott US Holdings Inc. CEO Rick Rule would prefer to see what he calls "optionality" rather than dilution from companies looking to justify salaries. In this interview with The Gold Report, he praises innovative precious metals streams on base metal projects and one Canadian company that is adding value and being rewarded for it.
Rick Rule at the Mining & Investment Latin Americas Summit. Photo courtesy of Sprott US Holdings.
The Gold Report: In November, you called the bottom for precious metals. Do you still believe that we're in the bottom?
Rick Rule: Yes, as long as you can define a bottom gently. I said in that same interview that the most important factor in gold pricing was the fact that it was priced in U.S. dollars, and we see a topping in the U.S. dollar. In fairness, Karen, if you had asked me that same question two years ago, I would have responded in the affirmative and been quite wrong. But I do think the upside in gold is both larger and closer than the downside in gold.
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TGR: Now that the Federal Reserve has increased the key interest rate slightly, the expectation is that the value of the dollar will increase relative to other currencies. How could that be the sign of a bottom for gold?
RR: I cut my teeth in the gold business in the 1970s when the prime interest rate in the U.S. increased from 4% to 15%, and the gold price went from $35/ounce ($35/oz) to $850/oz. I also remember that the gold price increased in 2002 in a climate of increasing U.S. interest rates.
The question is more about the reason that interest rates get raised than it is about the simple fact that interest rates go up. If interest rates go up because there is an anticipation of the deterioration in the price of the dollar and, as a consequence, savers deserve more compensation for lending credit, that sort of ethos is supportive to the gold price. If, by contrast, Janet Yellen can make not just the first 25 basis point interest rate rise succeed but subsequent interest rates rise, too, in other words if she can get a positive real interest rate on the U.S. 10-year treasury that exceeds the depreciation in the purchasing power of the currency, then I think we'll see renewed dollar strength. I don't believe she's going to be able to do that, but the market will determine that.
TGR: Back in the 1970s, the international currency situation was different. Today, the euro and the yuan are part of a currency basket competing with the dollar. If gold is priced in U.S. dollars but now we have competitive currencies, is the logic used in the 1970s relevant anymore?
RR: Although we are in a multicurrency world, the dollar hegemony relative to other currencies has stayed intact. If you owned gold in almost any currency in the world in the last 18 months, gold performed its role as a store of value relative to the depreciation in currencies. It was only the strength of the U.S. dollar relative to all other media of exchange, including gold, that caused gold to perform poorly in U.S. dollar terms. To the extent that the U.S. dollar hegemony in world trade begins to be compromised in favor of other currencies, that weakening would be beneficial to the gold price.
You see, any time the denominator declines, the numerator becomes less important. That means if the dollar buys less of everything, it buys less gold, ergo, the gold price goes up at least nominally. Probably more importantly, however, the response that we've seen in the last 10 years to financial uncertainty has been an attraction for international investors into U.S. Treasuries as a store of value. If the purchasing power obtained from the real interest rate on U.S. Treasuries comes to be seen globally as negative, the attractiveness of U.S. Treasuries generally, relative to gold, will decline.
What traditionally has happened in periods of uncertainty is that investors have chosen to store some portion of their wealth in gold. The U.S. Treasuries have replaced gold to some degree over the last 10 or 15 years. My suspicion is that gold will regain some of the market share it has lost to the U.S. Treasuries as a consequence of a reduction in confidence in the U.S. dollar and U.S. Treasuries. At current interest rates, with the ongoing deterioration in the purchasing power of the dollar, U.S. Treasuries are a very flawed instrument despite their popularity.
TGR: Why are they popular?
RR: I think they are popular because people have an intrinsic sense that losing 1 or 2% a year in purchasing power beats losing 30% a year in the equities markets. People are genuinely afraid of the direction in the economy. They're afraid of a replay of 2008.
Super investor George Soros once said that you make large amounts of money by finding a popularly held public precept that's wrong and betting against it. I just last night watched the movie The Big Short, and I was reminded that it's not uncommon to have the financial services industry, the government and the populace believe something to be true that is categorically false. I'm not suggesting that the U.S. 10-year Treasuries are as stupidly overpriced as the U.S. housing market and mortgage-related securities were in the last part of the last decade, but I do suspect that we are in a bond bubble, in particular a sovereign bond bubble. I suspect that a 30-year bull market in bonds is fairly close to being over. Raising rates is very difficult for the principal value of bonds. I think we're closer to the end of the bond bull market than we are to the beginning and that's very good for gold.
TGR: In terms of resources, are there some widely held popular beliefs that you believe are not true?
RR: I do. Sadly, as an American, I think the hegemony of the U.S. economy relative to the rest of the world economy is a widely held precept that's untrue. Remember in 2011, the pro-gold narrative revolved around on-balance sheet liabilities of the U.S. government-just the federal government, not the state and local governments-of $16 trillion ($16T). That was considered unserviceable in an economy that generated new private savings of $500 billion a year. If $16T was unserviceable in 2011, how can $19T be serviceable today? Was $55T in off-balance sheet liabilities-Medicare, Medicaid and Social Security-in 2011 less serviceable than $90T in off-balance sheet liabilities today?
My suspicion is that the change in the interpretation of the narrative has to do with the fact that in 2011, the lessons of 2008-2009 were much closer. My observation, having been in financial services for 40 years, is that people's anticipation of the future is set by their experience in the immediate past. And the experience that we've had in the 2011-2015 time frame is that the big thinkers of the world-the Yellens, the Merkels, the Obamas-have somehow muddled through. But the liquidity they have added to the equation is not a substitute for solvency. That is the great, popularly held precept that's wrong. What I don't know is when the reckoning occurs.
TGR: Going back to Soros and a widely held popular belief and you bet against it, what's the bet against this?
RR: Gold for one thing. I think you also need to have U.S. dollars because cash gives you the courage and the means to take advantage of circumstances like 2008. But I think that if you had a set of circumstances where faith in the U.S. dollar and U.S. dollar-denominated sovereign instruments began to falter, gold would be an enormous beneficiary. History tells us that if you're using gold as an insurance policy that a very small premium-a fairly small amount of gold held in a portfolio-gives you an enormous amount of insurance. In other words, the upside volatility in the gold price is such that you can protect your portfolio against losses in other parts of your portfolio by having fairly moderate gold holdings.
TGR: Are you talking about physical gold?
RR: This would apply to physical gold or proxies like the Sprott Physical Gold Trust, the Sprott Physical Silver Trust and the Sprott Physical Platinum and Palladium Trust.
TGR: Soros has said that sometimes it takes two or three years before a bet actually comes in to the money. If we are expecting the gold price to increase as the faith in the dollar falters, what is the role of mining equities in betting against the status quo?
RR: I think it's important to segregate between the gold bet and the gold equities bet. I would say if you think that gold is going to go up, buy gold. Don't buy the gold stocks for that reason. This is particularly the case with the juniors. People ask me, "Rick, if the price of gold goes up, what will it do to the share price of my Canadian junior, Amalgamated Moose Pasture Mines?" The truth is that Amalgamated Moose Pasture doesn't have any gold. It's looking for gold.
If the price of something that you don't have goes up, it doesn't have much impact on the intrinsic value. I will say that the leverage that's inherent in the best 10% of gold stocks is superb, but you need to buy those stocks because the management team is adding relative value. You can't buy the shares hoping for a magnification of the gold price increase. That won't compensate for the risks. There have to be other ways the company is advancing.
The truth is that the gold mining industry has been an enormously efficient destroyer of capital in the last 40 years despite real increases in the gold price. You need to be an excellent stock picker to overcome drag brought on by corporate inefficiency relative to the inherent leverage that you should theoretically enjoy in equities relative to the gold price. The equities have made me an enormous amount of money in the last 40 years. It's just that as a consequence of understanding the equities for what they are, I've done a better job of picking them.
TGR: The Silver Summit was the first time I heard you explain the concept of "optionality." What is your advice in this climate for mining investors?
RR: For the right class of reader who is speculative and willing to do the work, there is a class of junior company that offers extraordinary leverage to the changing perceptions in favor of gold and gold equities. It is inherently illogical to put a mine in production because you think the price of a commodity is going to go up in the future. Let's say that there's a five-year lag between the time that you put the mine in production and the time that the commodity price goes up. What happens is that you've mined the better half of your ore body and sold that gold during periods of low gold prices in anticipation of higher gold prices. So the gold price goes up, and you have a hole in the ground where your gold used to be. Fairly silly.
A much better strategy is to buy deposits cheaply when gold prices are low. Then hold them in the ground, spending almost no money on beneficiation. Spending money at that point only causes you to issue equity, which reduces your percentage ownership in the deposit.
I'll give you a couple of examples. One would be an optionality play from the last cycle called Paladin Resources Inc. that advanced from $0.01/share to $10/share in four and a half years. Another example would be Lumina Copper Corp. (LCC:TSX), which, if my memory serves me correctly, we financed at $0.50, and it was liquidated at $200/share over eight years. Pan American Silver Corp. (PAA:TSX; PAAS:NASDAQ) and Silver Standard Resources Inc. (SSO:TSX; SSRI:NASDAQ) similarly advanced from $0.50 and $0.72, respectively, to in excess of $40, respectively. That doesn't suggest that any of these companies slavishly followed the hording strategies, but what they did early on in their incarnation was buy reserves. When the price of the commodities increased and their share prices increased much more rapidly and their cost of capital decreased, they were able to beneficiate the projects as the market demanded but with a lower cost of capital.
TGR: How does someone who is not a geologist know what the relative cost of getting that gold is if the company hasn't done some work like drilling and publishing a preliminary economic assessment to educate me?
RR: One thing investors can do is subscribe to publications like Brent Cook's newsletter or visit the free educational material at www.sprottglobal.com. The truth is that nobody, even the best investor in the world, is going to get it right all the time. All you have to do is get closer than your competition. Given the fact that most of your competition isn't doing any work whatsoever, the bar isn't very high.
TGR: Another investment strategy that you have been a fan of is streaming companies. How would you compare their optionality given where the gold price is now?
RR: I love the streaming business. It's regarded as an extremely conservative strategy, and maybe that's why I like it. In the streaming business, the contracting company buys the rights to a certain amount of gold or silver from a mine for a fixed price over a given period of time. The company receives the gold in return for a pre-negotiated payment irrespective of the gold price at the time that the gold is received. The company that contracts for the gold isn't responsible for the capital cost required to build the mine, so any cost overrun associated with the mine is irrelevant to the streamer. Similarly, it is not responsible for the operating cost of the mine. It has already locked in its costs. Commonly, those are about $400/oz. The margin between $400/oz and $1,000/oz-$700/oz-is substantially greater than the margins enjoyed by the mining industry in general, which are, in fact, negative.
What I really like about the streamers right now is the arbitrage in cash flow valuation between the streaming companies and the base metals mining companies. Precious metals-derived revenues in a streaming company, because of the success of streamers in the last 20 years, have been capitalized at about 15 times cash flow. That same precious metals revenue as a byproduct revenue in a base metals mine is capitalized at about six times cash flow. That means that a streaming company could buy that cash flow from a base metals mining company at $10M, and it would be wildly accretive to the streaming company at the same time as it would materially decrease the cost of capital for the base metals mining companies.
Base metals mining companies are in truly dire circumstance right now, with the price that they're being paid for their base metals commodities being substantially lower than their all-in sustaining capital costs for producing it. This means that the base metals mining companies need to do whatever they can do to lower their cost of capital. My suspicion is that you will see many billions of dollars of precious metals byproduct streams from base metals mines being sold from the major base metals mining companies around the world to the streaming companies. My suspicion is that these transactions will simultaneously save the base metals mining company billions of dollars in capital while being accretive to the precious metals streamers by billions, too. I think this is a transformative event for the streamers.
TGR: If a base metals company is essentially losing money for every pound pulled out of the ground, why wouldn't the management leave the commodity in the ground until prices increase? Why don't they practice optionality?
RR: One of the challenges with the optionality strategy is it is very tough to get a management team to do nothing. It's tougher yet to get them to be paid appropriately for doing nothing. Not mining is an awful lot cheaper and an awful lot easier than mining, but the truth is that there's a bias to produce, and there may be a need to produce. Your all-in cost to produce 1 pound of copper may be $2.75, but your cash cost to produce that pound may be $1.70, and if you sell it for $2/lb, you are generating $0.25 to service debt and cover the all-important CEO salary.
TGR: Frank Holmes agreed with you when he said that while the price of gold seems to have languished in the U.S. dollar terms, in other currencies it has been doing quite well. Particularly, he pointed to Australian mining companies as standing out. Do you agree?
RR: Australian gold stocks have performed incredibly well this year, so part of that thesis has been used up by the share price escalation of those companies. Given that Australian gold mining companies sell their product in U.S. dollars but pay their costs in Australian dollars, they had a de facto 40% decrease in their operating costs, which is extraordinary. In fact, the decrease was deeper than that because a major component of their variable costs is the price of energy, and the price of energy fell 50% in U.S. dollar terms at the same time that the Australian dollar fell further. That means that the operating performance of gold mining companies in Australia relative to gold mining companies whose costs are denominated in U.S. dollars with U.S. operations has been extraordinarily good.
We don't see any near- or immediate-term strength in the Australian dollar so this cost competitiveness could continue. Additionally, the iron and the coal industry, which compete for workers and inputs directly with the gold industry, have experienced continued distress, which means that the cost push even in Australian dollar terms will diminish.
Plus, we see the Australian market as more honest than the Canadian or the London market in the sense that the mining industry in North America and Europe became increasingly securities-oriented where the value proposition became rocks to stocks and stocks to money. In Australia, the ethos is more a direct drive, more a sense that you want to make money mining and that the stock ought to take care of itself. We see that as a competitive advantage that will continue for five or six years while the North American and European industries reform their expectations.
TGR: The value of the Canadian stocks has been decimated over the last three years. If the management teams are not focusing now on making money now, what's going to make them change?
RR: Hopefully, bankruptcy. There are 500 or 600 listings on the TSX Venture Exchange that are zombie companies with negative working capital. They're in a capital-intensive business, but they have no capital, so they aren't really in businesses. These companies need to be extinct. It's an ugly thing to say to the people who own stock in these cockroaches and uglier still to the people who work for the cockroaches, but it has to happen.
TGR: I'd like to get your impression on something that's happened up in the Athabasca region recently. The Chinese company CGN Mining Co. Ltd. injected $82 million into Fission Uranium Corp. (FCU:TSX). Was that a positive development for investors and Canadian mining in general?
RR: Fission Uranium did something highly unusual-it created value. It made what appears to be a world-class uranium discovery. The market was looking for near-term share price performance and didn't properly appreciate the value. But a Chinese investor who understood that the current malaise in uranium prices can't continue and was looking for security of supply came in at a substantial premium to market and provided the company with sufficient working capital to move the project forward.
There are a whole bunch of instructive lessons here. First of all, that the market in very good times or very bad times is a bad arbiter of value. In very good markets, investors overvalue reserves, resources, narratives and potential, and in very bad markets they undervalue the very same thing.
The second lesson is that the time frames investors, in particular speculators, limit themselves to are farcical. It will take probably five years for the southwestern part of the Athabasca Basin to deliver enough certainty with regard to the net present value (NPV) of those resources that they could be appropriately valued, but investors have trauma holding stock over a long weekend. Their expectations of value are unrealistic. The Chinese investor, by contrast, understood that the malaise in uranium prices is temporary because it knows how much uranium it is going to need. It realizes that it could come in to a deposit paying a premium to market but at the same time obtaining a substantial discount on its estimation of the NPV.
It's truly a win-win for all concerned. I don't think that the Canadian body politic is as reflexively distrustful of the Chinese as Americans are. If you live in Western Canada, Vancouver as an example, the reality of Chinese investment is all around you, in home and condo prices. So I think the Canadian investor and the Canadian voter are much less ethnocentric.
TGR: Will we see more deals like this when other big investors see these lessons?
RR: I think there's a shortage of high-quality projects, so the opportunities for smart investors to arbitrage the public markets are much smaller than the mining industry would cause you to believe. But I do think the absolute values in the market on selective projects are great. I think you will see more transactions.
TGR: You'll be speaking at the Vancouver Resource Investment Conference at the end of January. What are you hoping that investors take away from that conference?
RR: This conference is in Vancouver, so it's easy and cheap for companies to exhibit there. The first thing that I hope that people do is understand that if the narrative that existed with regard to resources and precious metals in 2011 was true then, it's more true now. Only the price has changed. Investors need to recognize that a market that's fallen by 88% in nominal terms and 90% in real terms is precisely 90% more attractive now than it was then. The mistakes that people made then were mistakes of overvaluation. The mistakes that people make now are mistakes of undervaluation.
It's important, however, not to make the mistakes that we made in the past. The truth is that you need to temper your expectation of wonderful stories with hard core reality, with securities analysis, which people are unwilling to do. At that conference, you will have the ability to learn lessons in equity market valuations if you are willing to work and absorb them. And you have the ability, with 200 exhibitors present, to practice the lessons that you've learned in real time, 20 or 30 meters away from where you learned the lesson itself. So it's a wonderful opportunity for people who come to work rather than people who come to be entertained.
TGR: Thank you, Rick, for your insights.
Rick Rule, CEO of Sprott US Holdings Inc., began his career in the securities business in 1974. He is a leading American retail broker specializing in mining, energy, water utilities, forest products and agriculture. His company has built a national reputation on taking advantage of global opportunities in the oil and gas, mining, alternative energy, agriculture, forestry and water industries. Rule writes a free, thrice-weekly e-letter, Sprott's Thoughts.
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Source: Karen Roche of The Gold Report
http://www.theaureport.com/pub/na/veteran-investor-rick-rule-reveals-a-unique-arbitrage-opportunity
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