Submitted by Jeff Clarke of Casey Research
Source: Karen Roche and JT Long of The Gold Report
When the currency system as we know it dies, some people will become very wealthy. In this special report from the Casey Research/Sprott Inc. Summit "When Money Dies," The Gold Report cornered Global Resource Investments Founder and Chairman Rick Rule, Casey Research Senior Editor Louis James and Casey Energy Opportunities Senior Editor Marin Katusa for a roundtable discussion on the best strategies for thriving during the coming economic transition.
Companies Mentioned: Extorre Gold Mines Ltd.
The Gold Report: Since we are at a conference called "When Money Dies," please explain who killed money and how, after all these years of governments around the world trying everything from quantitative easing to bank bailouts, we are still in the midst of the weakest global economy in this generation's history?
Rick Rule: The answer is in an old Pogo Cartoon that reads: "I have seen the enemy and he is us." Collectively in the West, we have lived beyond our means for a substantial amount of time. We rely on a government that we have paid to steal from our neighbors. Money is how we deal with transfers. Dealing with transfers dishonestly by making more of the medium that isn't backed by any value is the process by which money dies.
Louis James: The problem is that you are asking the guardian who has stolen the goods to recover them. Government has been in charge of money for hundreds of years. When it is debased, you have to ask: "Who was watching the hens in the hen house?" When you discover who the fox is, you don't want to put him back in charge.
TGR: We are looking at quantitative easing 3 (QE3) in the U.S. Europe is considering the same thing. Even China is doing its version. Will money actually die or will it all inflate together?
Marin Katusa: I am going to take the contrarian view. With all this quantitative easing, there is actually asset deflation occurring right now if you look at the valuations from an equity standpoint. Trillions will be printed, but look at the deflation in the assets. He who has cash will be king because he can afford to buy these discounted stocks. If you do your homework and be sharp, you will make a fortune in the next three years.
TGR: But money is an asset; cash is an asset. If you are holding your wealth in money wouldn't it all deflate?
MK: It's all about purchasing power. Look at Canada's largest oil company. It is just as good of a company as it was three months ago, but it has lost half its market cap, which means your dollar will buy more of a great company. It isn't inflationary all across the board. It's an asset deflationary market. That is a current example of equity asset deflation in the market right now.
TGR: So cash will deflate less rapidly than physical equities?
MK: Yes, right now.
RR: It is likely that the purchasing power of Western currencies will lose 5%–7% compounded for a long while, maybe until they go extinct. But in the interim, when you are experiencing incredible volatility, that is demonstrably better than losing 30% per anum in assets that are illiquid. Despite the fact that money is going to die, perversely you have to have lots of it to take advantage of the liquidity crisis.
LJ: You see, inflation figures are averages. Asset price destruction in a certain area doesn't negate monetary inflation, nor its impact on other prices. Tremendous money creation is going on. This has economic consequences. The guy at the supermarket can see it even if his house is worth less. It is the worst of all possible models. Necessities cost more, but once trusted assets—the store of wealth in real estate and pensions—are depreciating. This has investment and economic consequences. The government is creating all this money and blowing it out the window. You have to figure out where to stand with a net.
TGR: How do you know what way the wind is blowing so you know where to place your net?
LJ: It's all about stuff. Stuff people need is, in general, good when paper or theoretical money is bad. In certain asset classes, including real stuff, there will be price destruction. Real estate, for instance, still has a speculative side to it and has not yet bottomed. But fundamentally, real stuff that has value can't just blow away. The world will go forward. People will need food and raw materials. Gold is another vehicle with intrinsic value. These things can't be inflated out of existence. When prices on valuable stuff goes down ridiculously, that should be seen as a godsend. People will still need copper, steel and timber. Buy when that stuff is priced low and wait for it to go high, then sell.
TGR: Oil is priced in dollars. Is there a dollar price above which demand stops?
MK: Yes, that is why you have to put the price into perspective when considering an investment. Are you valuing a company at $60, $70 or $80/barrel (bbl.) oil? If a company isn't making money at $60/bbl. oil, you don't want to own that stock.
TGR: The market in the last six months has been volatile, but it seems to be like a roller coaster coming back to where it started. Is there a bigger trend moving daily prices?
RR: Dramatic volatility will lead to higher highs and lower lows. Despite the fact that it may look like a mean on a chart, people who experience it don't experience a mean. They experience extraordinary discomfort. The fact that a $10 stock becomes a $7 stock in a few days causes people to speculate less frequently. It tames the animal spirits. The volatility will act as a depressant on the market.
That is why it is important to understand the causes of these fluctuations. QE is a polite way of saying counterfeiting. If you debase the denominator, the numerator doesn't seem to matter much. You are actively debasing the currency by making it less rare. In the process, the government has declared a war on savers, reducing the utility they could get through traditional savings, forcing them to make more speculative investments.
The problem is even deeper than that, however. At the same time you have plentiful money, you have restrictive credit. People assume prices get set across the whole spectrum, but they get set on the margin and dramatically on the margin based on the psychology of the participants. It makes no sense. Look at the downdrafts in commodities. Nothing about the utility of copper caused it to fall. But interdraft lending dried up and when credit goes away, fabricators, traders and shippers can buy. Economic dislocations like this cause the market to be really volatile for substantial periods of time, which will unnerve many market participants.
I am actually fairly excited about it. I believe if it is going to happen anyway, find a way to enjoy it.
TGR: Marin, you are skilled at mathematics. Your models help assess equities. In a market driven by psychology and government policies, how relevant are your models and have you changed the factors you use to value companies?
MK: Since so many people are investing on emotion in the resource sector, you have to take your profits in a bull market and have lots of cash on hand to take advantage of deals in a bear market. In the program I created, there are literally thousands of variables you can analyze and interpret, but one of my favorite metrics for the junior exploration sector is the Casey Cash Box Indicator. One year ago, three companies were trading for less than cash on hand. Now I know of a little over 30. But, we are no where near the low of March 2009 when over one-third of all the companies on the TSX and TSX-V were trading less than cash. The Cash Box Indicator is what I use to give me a "feel" of the psychological sentiment in the market. When there are lots of companies trading under cash, people are fearful, and that is good if you're looking for value.
For the junior exploration companies that do not have any tangible assets, the models I use for producing projects with cash flow are not as relevant.
TGR: Louis, you are out there visiting companies all over the world. In this market, how important is management?
LJ: It is and it isn't. Having competent people to run the show is imperative. The alternative is non-competent people. Who wants that? Incompetence shows up quickly in performance. But just because a company has good people and a good project doesn't mean it will do well; nature may not cooperate with exploration, or it could run out of money. When fear is in the driver's seat, people are less willing to take chances, even on good people.
In the end, volatility is your best friend because you know that a market that's down will go up again. When your favorite wine or something you value goes on sale, you don't complain. You celebrate and buy two. We have that opportunity now. Wall Street hates volatility, Howe Street loves volatility—or it should, even on the downside, because that is a sign that it's shopping season.
TGR: In the 1970s, we saw a bullish precious metals market, followed by a big upside. This time we had a big upside and now extreme volatility. Have we already experienced the extent of the bull side?
RR: You have to acknowledge the fact that despite volatility's unpleasantness, it can be an opportunity. Gold and silver still have a long way to go although it may not be straight up. Even if it were to go to $2,500/ounce (oz.) eventually, it could test $1,000/oz. first. You have to have an understanding of history in order to understand what you might face. Keep cash on hand to take advantage of the volatility. Prepare yourself to have the courage to take advantage of the dips. A lot of people have been responsible investors and studied everything about the market except themselves. They haven't prepared themselves. You need the cash and courage to use volatility.
Be careful, however. Don't get your information from the market. The market is a mob. It is a facility to buy fractional ownership of businesses. But you have to get a sense of the value of the business to make good decisions. Take advantage of the idiocy of the other players. Other players only drive value of the stock in the short term. In the long term, the company fundamentals will determine the value of the business. What the three people in this room have become good at is buying companies that will be taken over by the industry at higher prices later. Playing foolishness is fun, but that is less important than the fundamentals associated with the valuations of the companies. The safest and most consistent money is made when you find discrepancies in the valuation of a company and the market valuation and play the arbitrage.
TGR: How can you value gold in a volatile market like this where the price of gold can vary between $1,000/oz. and $1,900/oz. Do those lows wipe out some companies?
LJ: The average cost of production for most companies is $600/oz. Even at $1,000/oz. gold, a 40% margin in any industry is considered pretty good. A lot of mining companies are making lots of money right now, which means they are fundamentally strong. In the face of that, when the market fluctuates, it's a good thing; it brings opportunity. I have stocks in my portfolio that we have been able to take profits on when they were high and buy again when they were stupid cheap. We have been able to make doubles this way multiple times—on the same stock.
But not all gold stocks are production stories. How do you value an exploration play where there is no particular asset? That is difficult. You can use peers, or speculate about what the company might have in the ground if it is successful and try to estimate a value. Whatever path you choose, you should have some kind of metric, a sense of what is reasonable.
A great example of how volatility can create opportunity and profits is Extorre Gold Mines Ltd. (XG:TSX; XG:NYSE.A; E1R:Fkft), the spin out from Exeter Resource Corp. (XRC:TSX; XRA:NYSE.A; EXB:Fkft), operating mostly in Santa Cruz, Argentina. I have been there and looked at the main asset. I have no doubt the flagship Cerro Moro project is going to be a highly profitable mine, unless the government goes completely insane. Extorre had good exploration success there and has started getting very positive results from a second project. Based on this work, Extorre went from CAD$2 to CAD$14, so naturally we took profits along the way. I love Extorre, but at CAD$12, its market cap was greater than some profitable producers with cash flow and it was still just exploring. Now, with no bad news from the company, the market correction has the stock down to CAD$7. We know more about its assets now than we did when the shares were higher, but it's selling cheaper, so it's a better value now. We don't know when things will go up and down, we just know they will. We know when they are cheap it is a good time to buy; when they are expensive, it's a good time to take profits.
TGR: It seems like investors have to be more active now, going in and out of stocks. They can't just buy and sit on them.
MK: You have to be careful in this volatile market. An investor needs to understand what type of investor he/she is. If you are a day trader, this is your type of market, because the volatility and big swings are present. I don't believe relative valuation. I think it is important to distinguish between intrinsic valuation and relative valuation. But the answer to your question really depends on what type of investor you are and why you bought the specific stock. In my experience, my biggest gains have been buying big positions in companies where I believed in management and the projects, and bought more when the stock was down, and held the stock for more than a few years.
LJ: There is a distinction between resource investing and mainstream investing. Tried and true Graham-Dodd analysis was never applicable to our industry because the underlying commodities change too quickly, making even the biggest companies too fickle for that sort of securities analysis. However, I would posit that Wall Street is becoming more like Howe Street in a post-Lehman Brothers world. Everyone is taking more risk. There is no safe place anywhere in the world where you can buy a stock and forget about it.
RR: The two central tenets of Ben Graham's book The Intelligent Investor deal with evaluating the margin of safety and management. You have to speculate in companies that have the financial wherewithal to weather the most immediate risks. In today's volatile market, you are competing against manic-depressive traders who show up one day wanting to pay more than what you have is worth and the next day willing to sell for less than their assets are worth. In a devotion to net-nets, one of the best indicators of when you ought to be all-in is when it is full of people so disgusted in the market they are selling for less than they are worth. It's a great time to be an investor.
TGR: If a lot of these companies are worthless, how does the average investor know which companies can go the distance?
LJ: You have to make your own decisions based on your risk tolerance. Your mileage will vary. Read the financial statements, talk to management. At some point you have to act, but you can and should wait until you are fully confident in your investment decision, so your confidence won't be easily shaken by market volatility. It's not like baseball; you can wait for the perfect ball, so don't swing until you're sure you're buying low.
MK: Great tools are available. Watch the legends and insiders to see what they are buying and selling.
TGR: My last question is how does a new investor start in this industry?
RR: Go for a walk. Have a conversation with yourself. Do a personality audit. How hard are you willing to work and what is your risk tolerance? If you aren't willing to work and don't like volatility, try owning physical trusts, ETFs or seniors. If you have a longer-term perspective and stomach for volatility, you can take advantage of the opportunities in the junior space. But you need to have a plan.
MK: You can't succeed unless you are passionate in whatever you do. If you don't really like the sector, then you won't go as deep as you need to have success and you won't make the best decisions. Make sure you have a passion for mining. And have fun. Life is short.
You also have to be willing to make lonely trades. When everyone else says you are wrong, that is when investing becomes very interesting.
RR: Just because everyone else's money dies, that doesn't mean your money has to die. You are responsible for your future.