The natural resources sector currently presents aspects that are good, others that are bad, and some that are just plain ugly, but it also presents opportunities, veteran investor Rick Rule said at the Hard Assets Conference in New York this week.
“More people are afraid right now than brave, so this might be an interesting time to implement contrarian strategies,” said Rule, who is founder and chairman of Global Resource Investments, a unit of the Sprott Group. One of these strategies, for Rule, involves investing in junior miners and exploration companies. But there are a host of positive and negative factors to consider when viewing this recently beaten-down sector.
Focusing first on the good, Rule maintained that the natural resource bull market remains intact, and that this is being driven by fundamentals rather than mere animal spirits among speculators or liquidity provided by banks and governments.
A global increase in living standards has been supportive for natural resources and is underpinning the fundamentals, following a 20-year bear market for the sector that finally ended in 2002, Rule continued.
As for the bad, Rule said current global debt levels remain a problem, the causes of which still have not been addressed. The resulting credit problems continue to afflict the natural resources sector, particularly where exploration juniors in need of funding are concerned.
“I’m not saying we are going to repeat 2008,” Rule said. “Much of what went wrong in commodities in 2008 was a breakdown in credit. The banks came to understand that they were broke, and figured their counterparties were too. So banks wouldn’t lend to banks,“ Rule said. The repercussions for natural resources trade and project funding were understandably negative.
“Now for the ugly. Let’s talk about the juniors,” Rule said. “There are about 4,000 of them publicly traded in various markets.”
Together in a good year the industry spends about $2 billion more than it generates in earnings and takeovers. In a bad year the industry loses $8 billion more than it generates, Rule warned, in what he termed the “price loss ratio.”
“It’s very difficult to establish values where there are none. … The sector taken as a whole is valueless,” Rule warned. He cited statistics from John Kaiser (editor of Kaiser Research Online) to the effect that 50%-60% of juniors share three negative traits: they are trading below 25 cents; they are trading at substantially less than half their 12-month highs; and they have less than six months of working capital in hand.
As if this weren’t a dire enough picture, Rule outlined other negatives for the junior miners and exploration firms. For example, he said, once every 10-15 years the market loses 90% in a market-clearing event.
Further, an undesirable trend has taken shape in the way the sector spends money. In the past three or four years there has been a significant increase in general administrative expenses that do not directly advance exploration.
“The amount of money that goes into things that don’t generate value has been rising on a fairly consistent basis,” Rule said. “It’s interesting to see the CEO of a company that’s not making money, and doesn’t have any immediate hope of making money, who feels completely comfortable awarding him- or herself a $250,000 salary and a $350,000 annual cash bonus. … This is not uncommon. “
Nevertheless, the savvy investor can find opportunities, Rule said. But this involves careful selection of companies to invest in, combined with the ability to take advantage of what he maintains is a coming wave of consolidation as competition for funding increases.
“The performance generated by the best 5% of the sector is so spectacular that it adds enough liquidity and hope to populate the whole rest of the sector with the losers,” Rule said. “What you need to know is that if you buy the sector, your results in good markets or bad are going to be ugly.”
“You need the discipline to understand that more of the stocks you pick are going to lose than are going to make you money. But… good ones are going to make you 10 or 15 times your money,” Rule said. “A 15 bagger … amortizes so much sin in the rest of your portfolio that it actually is a reasonably feasible way to speculate.”
Many of these companies will have difficulty or be unable to secure financing, however, Rule said.
“The industry as a whole gorged on capital in 2010 – they were afraid from 2009. They didn’t want to raise capital in 2011 because they thought it was dilutive. And the equity markets got soft, and then they got softer. So they’ve been 18 or 20 months without financing. But they forgot to stop spending money. As a consequence, they’ve got to raise money over the next 12 months,” Rule explained.
“We have a situation where the industry itself is afraid. People are afraid to put their own money into their companies. There are companies that are selling at half cash on the exchange – companies with $40 million in cash that are selling for $20 million in market caps,” Rule said.
Meanwhile, the recent downtrend has taken down the stocks of both good and bad companies in the sector.
“I think we’re going to have tremendous period of consolidation in this market,” Rule continued. “Prices are falling, which means that the opportunity cost for the acquirer is getting lower by the day and is going to continue to go lower. … What’s changed about this market is that the new buyer is the industry itself.”
Rule explained that established natural resource companies now have “mountains of cash,” so that the industry itself is going to be a willing and able buyer of attractive but less-established entities in the sector.
“I think there are going to be 60 to 70 takeovers in the next two years, and they aren’t going to wait for a bull market. They’re going to be price-driven and driven by the acquirers,” Rule said.
Meanwhile, the industry is at the beginnings of a discovery cycle that will add significant liquidity to the industry, he added.
“There is nothing like exploration to change things. Scattered in amongst these penny dreadfuls that are going to go to zero or close to zero in the next six to 12 months there are some companies that are going to make world class discoveries,” Rule said. He added that he is looking forward to what he said will be the best 12 months of private placements since 2002.
Chris Munford researches and writes about commodities, with an emphasis on steel raw materials and energy. He is based in the New York area.