Submitted by Casey Research [7]
Rick Rule's Primer On Contrarian Speculation
In an interview with Louis James, Rick Rule provides an excellent summary of what contrarian speculation investment is and makes a powerful case that the current metals climate means gold stocks are the play to make.
Louis James: Ladies and gentlemen, welcome. Thank you very much for tuning in. We are at the Casey Research Summit – the reality check on the recovery of the economy. One of our luminary speakers who is always at our events, Rick Rule, is with us here now. We'd like you to give us the quick tour of your talk today and we'll go from there.
Rick Rule: Sure. My role here wasn't to do economics; that's not what I am. I am a speculator, and so I talked about where we are in the context of where people are with their own portfolios – in particular portfolios that are junior-resource centric – which is what I think most of your audience was interested in.
Louis: Right.
Rick: And my point was that there were some good forces in the market: lots of cash on the sidelines; some good work being done; and basically a good market for resources as a consequence both of population growth and demographic growth at the bottom of the economic pyramid, and in terms of historical supply constraints. And there were some bad factors in the market: excessive debt in the system; way too much government interference; very large social takes on a global basis, beginning to impact extractive industries. And there were some truly ugly factors – the ugly factors in particular being poor corporate as opposed to share market performance, and the unfortunate truth that probably 80% of the junior resource stocks on a global basis are valueless. So the sector itself is in perma-decline. Although the performance – as you know from being affiliated with Casey – of the top 10% of the sector can be extraordinary. It often serves merely to focus attention on the worst companies in the sector. And then I went on to say: "This is the set of circumstances that exists, now what can we do with this?"
The fact that the market has fallen, by some estimates, by half suggests by other estimates that the market is approximately half as risky as it used to be. Price has taken care of some of the risk that existed in the market before.
The second factor that we need to take into account on a going-forward basis is the fact that the industry itself didn't finance as aggressively last year as they did the year before, but although they didn't raise new capital, they didn't stop spending. I call this financial roulette. The issuers are engaged in this rather circular exercise, which is very risky: They're spending money to attempt to get results, to generate excitement, to raise their share price, to raise money. So they're spending money to raise money, which is a very, very risky strategy.
Most of the issuers will need to come back to market this year, and they're coming into a market that's in total disarray. The buyers that existed for the last 10 years – the small hedge funds and the open-ended hedge funds – are facing massive redemptions as we speak, so rather than being a source of new capital, they're a source of the selling that you see weighing down the market. We are going to have to, as investors, invest with a view to a different buyer on a going-forward basis, and the companies who are issuing equity are going to have to find a different class of buyer for the new financing. So we're in a time of real change and real turmoil – and hence a time of real opportunity.
My suspicion is that with so many issuers having to access the market and so few market participants that have the capability of differentiating between good and bad issuers, that just as the bad issuers were swept up with the good issuers in 2010, the good issuers are being swept out with the bad issuers in 2012. It's my supposition that for investors who are willing to work hard, take advice, and segregate viciously in terms of allocation of capital, that this will be the best private-placement investment period that we have enjoyed since 2002.
Louis: Okay, so this is one of the key takeaways: This is the year for private placements. You put that quite eloquently. A more simple way of summarizing it is that there are going to be a lot of desperate guys out there and they're going to be offering a lot more attractive terms – to people who are willing to wait for that to come to them. That's a good thing.
For the nonqualified investor out there – for the more general person – can you talk a little bit about being a contrarian or being a victim? Because right now there are a lot of people out there that I am… I don't fear a lot, but I'm afraid that a lot of good people are about to become victims just at the moment that they should be taking advantage of opportunities.
Rick: I think that's accurate. I've been in the business now 35 years, and I have seen these periods several times. I guess this is going to be one of your first descents into one of these things; and it is tragic. Some very, very nice people use their heart rather than their head and sadly they buy in periods like 2010. They buy at the top and sell at the bottom. That's the nature of things. There's no requirement that that be the nature of things, and I suspect that your audience self-selects more towards better performers because they've chosen to invest the time and the money to get recommendations from Casey Research, and in fact, in many cases do further research themselves. So I suspect that the universe that you're familiar with will be less victimized by this than others, but they certainly won't be immune to it.
Emotions run through all of us, myself included. It is very important to bear in mind specifically what you said. I have said for many years that you're either a contrarian or a victim. It's a nice catch phrase, and it's also true. This is a cyclical, capital-intensive business. There are long periods that are required to address supply-demand imbalances both ways; and so market declines last a long time. Market advances can also last a long time and be very, very dramatic.
What's important is that good markets are for selling and bad markets are for buying; it's counterintuitive. Your perception of how events will play out in the future is determined mostly by your experience in the immediate past; and if the last three investment decisions that you've made have rewarded you – if you feel good about your precepts – you begin to do something natural, which is confuse a bull market with brains, and you begin to become very aggressive. If your last three decisions – irrespective of whether they were well thought out – haven't played out so well, you become cautious. What you need to do is teach your brain to overwhelm or overrule your heart and understand that cheaper is better and more expensive is less good. It's difficult, but it must be done. Many things that are rewarding are difficult.
Louis: Very good. Okay, so resources are broad; are there any focuses within that? Are you more interested in metals, precious metals, oil and gas – what's your favorite flavor right now?
Rick: A lot of it is personal; and with me it's precious metals. The reason for that is that I'm a reasonably well-known gold broker, and in 2010, as a consequence of the pricing, I was way underweight gold stocks. I was afraid because if gold had broken out, my clients would, for some reason, probably have strung me up. I would like to address those imbalances. It's very seldom that you see an opportunity to buy the junior gold sector – or the senior gold sector – at reasonable prices. This is the first time that I have seen the sector at reasonable prices relative to the price of gold since 2004.
These are rare events, and in my experience in my career, when you have the opportunity to build positions in high-quality precious metals companies at reasonable prices – not cheap prices, but at reasonable prices – you're well advised to take that opportunity. So my principal focus is in the gold, silver, and platinum sector, in the precious metal sectors as we speak. That isn't to say that I don't like some other sectors, including broadly the energy sector, but I have more opportunities spread over a decade to be in the energy business. It's a much bigger business – it's the business I'm from – and in my experience opportunities to participate efficiently in the precious metals sectors are rare and this is one.
Louis: Okay, that's a great point for everybody to remember. Is there a timeframe? I know Doug hates crystal-ball questions and you probably do just as much – but you did say from the podium that you expect we're probably going to see more bearish emotion over the months ahead as the summer is probably going to be a "sell in May and go away" type summer. I have to say my gut feeling, for whatever it's worth is in harmony with that, but it could go any number of other ways. There could be black-swan events that send gold screeching up. Bets are off at that point.
But even if that doesn't happen, I've also encountered more mainstream people now talking about gold in an informed way that's really surprised me. I had dinner with a friend a couple of nights ago, a more mainstream investor who bought Newmont because of the dividend and because he was aware that commodity prices have held on, but the gold stocks – or gold in particular has held on, but the gold stocks are all selling off, and to him that was an opportunity. "Wow, the commodity is still there, but the stocks are cheaper, that looks good." So maybe that's just one data point, but it is a contrary data point. If there is an awareness percolating out there in broader markets that this is an opportunity as you've just said, could that contravene the "sell in May and go away" wisdom; and could we actually see greed take over from fear in the marketplace?
Rick: Yes and yes. I mean, the most important thing about the phenomenon that you describe this person observing is that it's true. Many people observe phenomena that aren't true, in which case their reaction to it is usually fairly short-lived, but the phenomenon that you described is accurate. And the phenomenon that you yourself observed, which is a greater understanding of the gold story among the broader investing public, is also true. Both of those are very bullish.
Another thing that’s bullish is that within the community the sentiment is so negative that it may be that everybody is talking their books and all the selling that they see coming has already occurred. I don't believe that to be the truth because I see fund flows out of small funds and fund flows out of mutual funds, so I see logical selling pressure, not buying pressure, but everybody sees the same thing and we may all be wrong.
In terms of what could turn it around, I see three things. You named one of them: an anomalous black-swan economic event that causes the "catastrophe insurance" trade in gold to come back to the fore. There's no more powerful economic motivation in the world than fear; the other one of course being greed. The useful thing about gold in terms of a bull market is that gold plays to both of the primary investment motivations, so the fear buyer stimulates the greed buyer and the greed buyer reinforces the precept of the fear buyer. And when you get a real gold bull market, it ratchets back and forth between those buyers on the way higher. So that's one thing, an anomalous black-swan event.
The second thing is that the very low prices relative to historic norms that we are seeing in the precious metals business and the incredible investment in precious metals productive capacity we've seen in the last 10 years mean that we are in the early stages now of a merger-and-acquisition cycle. Markets work, and these low prices will beget takeovers, and the takeovers will add both liquidity and hope to the sector.
And the third is – and we're ignoring this completely in this market – is that we're very early on in a discovery cycle. And as much liquidity and hope as takeovers add, a big discovery is like a takeover on steroids.
Louis: The market always loves a discovery.
Rick: An event like Arequipa that goes from $0.30 to $30 in 19 months is the type of thing that really gets people's pulse racing; and I think it's unlikely that we won't have a major discovery in the next 12 months. There's too much money being spent in good places by too many good people. That's going to be, from my point of view, the real black swan.
Louis: That's a pretty optimistic, positive statement there.
Rick: I know.
Louis: Almost a Casey-style declarative statement.
Rick: I know a lot of good geologists. I don't have a lot of talent in the world, but I'm pretty good at hiring geologists; and I know a lot of really good geologists who are doing really good work. Exploration takes a long, long time. People want exploration results in 90 days, but what people want doesn't matter. We have been funding the exploration business now aggressively for 10 years, and we're funding increasingly good people who increasingly have the experience to conduct exploration in the junior venue rather than as part of Barrick or Newmont or some larger company, and I think we will be surprised by discovery in the junior sector.
Louis: Okay, discovery versus development: if we're looking at new buyers, that tends to put the spotlight on development stories, de-risking existing discoveries, getting ready for that takeover and/or production. But I also know that you like the prospect-generator model. Have you shifted from investing more in prospect generators to developers now, or–
Rick: In normal markets, I have focused on earlier-stage exploration because it's less popular. I always choose sectors that I have to myself. I can't always win a debate with 50 participants, but I can always win a debate where there's only one participant. So, over 30 years I have done extremely well investing in exploration – in early-stage exploration – because I was the only one in it. And I have patience; I am willing to finance and continue to finance a company for five or six or seven years. I invest in process. Investing in process is how you get a big position, in something like ATAC at $0.10 and see it go to $7. There's no other way to do it. You get in on the ground floor by creating the ground floor, so I love that space.
Right now you are seeing the broadest discrepancy between the valuations established in scoping and pre-feasibility studies to enterprise value that I've seen in 35 years in the business. As a consequence of the opportunity available to me in the development space, given the fact that the market's on sale, I have diverted some of my traditional focus on earlier-stage exploration to come into a sector that normally is denied to me by wealthier, I would say, less-rational participants. They just seem to have gone on strike, and so I've decided to show up and go to work.
I see as a consequence of the values that have been established, a very, very active merger-and-acquisition market in the next 18 months. This is one of the reasons why despite the fact that I think the market is going to continue to decline, I've become a fairly aggressive investor. While I think the overall market is going lower, I think there's going to be a dozen or 20 takeovers with 35 to 50 to 60 percent premiums, and I think our organization with its incredible investment in technical people will have the ability to differentiate.
We're not going to get everything that is taken over. Some of the things that we think are going to be taken over won't be, but I think that it will be an activity which will yield us substantial rates of return on substantial amounts of capital. In other words, we'll be able to deploy significant amounts of capital for high internal rates of return, and opportunities to do that in a market don't come very often.
Louis: That's really interesting. Let me address directly the readers – I'm sorry, viewers. There's a lot in there, that was an earful. Something that Rick said is really worth focusing on: discipline. Listen to what he said. This is a sector where buyouts, the takeovers of development companies make sense. They make money for people. But when a lot of people liked it – what does that mean? It means that prices were up. Rick didn't buy. Investing in developers makes sense, it's a good business plan, but he didn't buy because other people were pushing the prices up. Now, when it's not loved, nobody wants to hear about it, Rick is moving in. This is contrarian discipline, and this is how you become successful rather than roadkill in this sector.
So hats off to you for that, and thank you very much for your time.
Rick: My pleasure, Louis, I enjoyed the process.