The following market commentary is excerpted from a presentation at last months’ Prospectors and Developers Association of Canada conference in Toronto. Rick Rule will give a keynote address on “Natural Resource Investing in a Financial Meltdown” on May 14 and also give free workshop and participate in a “Bulls and Bears Panel” on May 15 during the New York Hard Assets Investment Conference.
This year the junior resource sector will present investors and speculators with both unparalleled opportunity and risk. I see a year where unwary sector investors underperform in painful fashion, while discriminating stock pickers perform very well. The following is an overview to put these comments into perspective and to explain our expectations.
Let’s start with the good news for the sector.
The Good
In the U.S. alone, private sector institutions and individuals are estimated to hold in excess of US $8,000,000,000,000 (that’s trillion, with a “T”) in investable cash. Further, as a consequence of artificially low interest rates and rising inflation, savers are turning into speculators as a defense against negative real interest rates. To merely save is to lose money. This is very bullish for speculative equity markets.
Some of this cash should find its way into the resource sector because the resource bull market is still very much intact. In my opinion, we are in a resource super-cycle. Resource supplies are constrained. We are currently witnessing the lingering effects of a twenty-year bear market. Thanks to limited investment in a capital-intensive industry, ongoing dysfunctional credit markets restricting the available project debt needed for large scale resource development, escalating public demand for taxes, royalties, project equity and other forms of social costs, increasing regulatory and political uncertainties, and inflation in wages, energy costs and other inputs, resource supplies are constrained. In the face of tighter supplies, demand is increasing as a consequence of increasing population, rising real incomes and hence rising living standards in emerging and frontier markets. Constrained supply meeting rising demand equals a bull market!
This bull market has generated excellent operating margins for existing participants in most extractive sectors. These margins allow existing participants to reinvest capital to expand operations without diluting current equity holders. Major producers have been depleting their reserves and will need to acquire other companies’ deposits to grow. Issuers are returning capital to shareholders through dividend streams and equity buy-backs, and are also expanding their activities with mergers and acquisitions, all of which are beneficial to resource equity markets. Thanks to volatility and fear, the natural resource sector has lost its luster for the broad investing public. There is lower volume and less buying pressure in many of the stocks, meaning that many stocks are now acceptably priced, and some of them are arguably cheap. The over-valuations that were evident, particularly in the precious metals equity sector have collapsed. Finally, after funding the exploration sector generously for eight years now, I believe that we are at the dawn of a discovery cycle, where new discoveries drive the acquisitions markets and inspire further excitement and investment in the sector as a whole.
The Bad
Despite positive circumstances for the macro resource market trends, the overall economic outlook is poor. The developed markets, especially the US, Japan and Europe, are coming to a “reckoning period,” where they must come to grips with the fact that they have lived beyond their means for three decades, mortgaging their futures. I believe there is precious little unpledged future left to mortgage. As private sector capital becomes unavailable, the government’s response to circumvent a credit crunch has been to engage in what can only be called “counterfeiting.” No matter what it’s titled, (Quantitative Easing, Operation Twist and foreign currency swaps among others) it is the act of printing money, hoping to inflate away the currently unsustainable debt levels and increase interim liquidity. In the US we are taking in less than 40% of what we are spending, borrowing about half the balance, and counterfeiting the rest. Don’t try this at home! The US has in excess of US $12 trillion in on-balance sheet liabilities and an estimated US$65 trillion in off-balance sheet liabilities. It is suggested by the CBO (Congressional Budget Office) that the private (i.e. productive) sector will save approximately US$420 billion or 3% of GDP (GDP estimated at US$14 trillion). Servicing the on-balance sheet liabilities with our saved surplus would be tough enough; servicing the off-balance sheet liabilities is not mathematically possible. And these numbers assume we balance the budget next year…
I find it unlikely that we can grow our way out of this mess. If you accept the Keynesian prescription (I obviously don’t) that government stimulus will create conditions where the economy expands fast enough to service the accrued liabilities, then you would have to conclude that we are seeing that more stimulus (counterfeiting) yields less and less GDP growth on a per-dollar basis. We have entered a period where even fraud yields diminished internal rates of return. As Ambrose Bierce warned, the root word of confidence is “con,” and I’m afraid that as the liquidity “con” is exposed, economic confidence could be shattered.
Finally, with the important exception of artificial liquidity, I don’t think that any of the root causes of the liquidity panic we enjoyed in 2008 have been addressed; at best, they were postponed. Calling the involuntary write down of the Greek debt “voluntary” does not mean that Greece did not default, nor does it lessen measurably the strains inherent in other structurally challenged economies like Italy, Spain, Portugal, or the US.
In short, “black swan” spotters like me have observed flocks on the horizon.
The Ugly
Junior resource markets rival, and often best, the government as mis-allocators of capital. If every public junior-minerals company on the planet was merged into one “Junior Explorco” and one subtracted
global gross expenditures from gross realizations (takeover premiums, operating profits etc.) the resulting entity would lose US$2 billion in an extremely good year and US$5 billion in a normal year. How then should we value the industry? Should it be a “bargain” at five times losses, a “normal” inverted market multiple of fourteen times losses, or should we assign it a “glamorous” multiple of twenty or better as a consequence of its financial consistency, and the fact that resources are in favor?
Remember that the private sector does everything better than government, including counterfeiting. The natural resources financial services industry can print “phony” equities as fast as the US government can print phony dollars, and they can get them bought without force or threat! The issuance of valueless equity (never mind merely over-valued equity) is the worst I’ve seen in a 35-year career.
Even in legitimate companies, the non-project related expenditures (in particular, general and administrative expenditures) as a percentage of total expenditures are rising rapidly.
The Result
Volatility. One can expect extraordinary volatility as a consequence of this collision between the good, the bad and the ugly. Volatility is not the same as risk, but your own reaction to it can put you at great risk. Speculators’ reactions to it usually involve terror, which is not good for general market pricing, but is great for “check writers” like us. With few financings last year, we are going to see more companies desperate for cash and fewer financiers with the means to give it to them.
The Strategy
One theme to keep in mind is that the buyers of our assets in these markets are unlikely to be the traditional bull market buyers like other speculators or institutions, and more likely to be cashed-up aggressive mining companies. Tailor your purchases accordingly. Always think, “Who is my buyer, and why?“ Many junior securities issuers, including the “good” ones, refused to issue equity and raise money last year, in the face of what they hoped were temporarily depressed equities prices, but they continued to spend money on projects and administration. I call this “financial roulette.” They have been spending money to generate news, to stimulate excitement, to raise money; this behavior is both circular and dangerous. Make no mistake; these companies will have to raise money this year. The terms they have to accept will be a function of market conditions at the time they have to go to market. If volatility causes redemptions at the small institutions that have funded the financing frenzy the issuers have enjoyed the last five years, meaning these same institutions have no more cash to spend, our terms could be very favorable indeed.
Despite the deserved criticisms I have leveled at the industry in this rant, there is a lot of hidden value. We may be able, as we were ten years ago, to supply interim equity at great discounts to intrinsic value and prior equity pricing and enjoy the takeover premiums that are the almost certain circumstance of the conditions we described in the good portion of this essay.
We have invested prudently for the last few years. With cash on hand, the technical experience and sector expertise, we have the means to distinguish the most promising companies and to negotiate the most accretive deals with the best management teams. My suspicion is that this will be a pretty good year for private placement investors with knowledge, discipline, cash and courage. I believe we enjoy all of those characteristics.
Yours truly,
Rick Rule
We hope these remarks are helpful to you this year, and we also hope that they highlight the difference between Sprott and many of its generalist competitors in natural resource financial services. As well as being a broker dealer for thousands of retail clients, we believe that we are the preeminent source of natural resource private placement opportunities for American investors. Our Canadian parent, Sprott Inc., participated in over 200 financing transactions last year, giving us unparalleled deal flow. If you agree with the thesis Rick proposes and defends in the remarks, and if you are an accredited investor who would like to discuss participating in the types of opportunities that Rick is talking about, we would like to talk to you. Please respond contact us at (800) 477-7853.
Disclaimers
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