Contrarian or Victim? The Choice is Yours
Source: Rick Rule, Global Resource Investments (8/28/07)
A Tutorial for Troubled Times: I personally see us in the mid stage of a broad bull market in resources. At this instant, we are in a “wall of worry” correction. The world has woken up to the potential of resource markets, expectations have been frothy, but the inevitable supply increases that crush a market have not occurred, and will not occur for some time, because of the huge capital investments and long lead times inherent to these industries.
Most speculators want to be contrarians when it's popular and comfortable, which is a challenging task.
This June, the prevailing sentiment among natural resource investors was that the sky was rosy for the sector. Worldwide underinvestment in productive resource capacity for two decades meant that resource supplies were constrained for an extended period of time. Emerging markets, particularly China and India, were driving resource demand as billions of people aspired to the western lifestyle. Political and social unrest in the former Soviet Union, the Middle East, Sub-Saharan Africa and Latin America further destabilized supplies, increasing the value of existing production. Polititically inspired supply constraints like "nimbyism", nationalism and resource taxation constrained new supply initiatives, making existing capacity more valuable. Absurd monetary and credit practices increased the appeal of real, tangible assets, given the insanity of financial markets. The only answer to that combination of circumstances was an aggressively positive attitude towards natural resource investments, ESPECIALLY because the stocks were performing well.
What has changed? Have we, in sixty days, restored the productive capacity of industries that suffered from 25 years of malinvestment and underinvestment? Has a new set of circumstances allowed us to increase supplies without the long lead times inherent in capital intensive industries? Have billions of people in emerging markets changed their aspirations, and retreated towards contentment with a lifestyle that saw them living in mud huts with starving children? Has the political and social unrest in Iran, Venezuela, Nigeria, and places like that subsided to the extent that raw materials consumers are comfortable with their reliability as suppliers? Have the electorates and the politicians become more rational in resource regulation? Have absurd monetary and credit practices become less of a concern to anyone? These are only partly rhetorical questions. Review them and answer yes, or no.
So what has changed? Perception and the price of opportunity!
BUY ASSETS ON SALE, AND A FAIRY TALE
Financial products and the perception of certain consumers of those products are odd. I like to illustrate this with a piece of reality based fiction, a fairy tale. Our offices are in a typical Southern California strip mall, with our brokerage offices on the south side of the mall and a grocery on the north side. One day, a traditional couple (the man handles the financial affairs, while the lady handles domestic matters) enters the center. The husband comes down to our brokerage offices, while the woman proceeds to the grocery store. Once in the store, the lady finds a display of canned tuna. Her family likes tuna, she is familiar with the brand, and it is reasonably priced. She purchases some at $2 per can, as well as other groceries. The husband is curious about a stock. It is a gold stock that he is a bit familiar with from newsletters and internet discussions, and it appears reasonably priced, so he pays $2 per share for some. Husband and wife return home, reasonably satisfied with their purchases. Two weeks later they return, and resume their respective tasks. The wife, on entering the grocery store discovers to her horror that the same can of tuna she bought for $2 is now selling for $4! She is incensed at the price gouging engaged in by this unscrupulous merchant, and after vociferously threatening the store manager with a letter to the Better Business Bureau, she buys some canned chicken, and leaves the store in a "huff". The husband, upon entering the brokerage office discovers to his delight that his $2 stock is now selling for $4!!! Elated, the husband doubles his position. As the couple discusses their respective experiences, the husband reassures the wife that with his investment acumen they can afford her tuna habit.
Two weeks later they return, and again go about their respective tasks. As the lady enters the store, she is delighted to see that consumer resistance to the aggressively overpriced tuna has caused such an increase in inventory that the same tuna is on sale for $1. She is ecstatic, and buys so much tuna that her car rides very low in the rear. The husband, to his dismay, finds his favorite stock has declined to $1, and he liquidates his entire position, in disgust!
So ask yourself – which member of the household is the more astute investor? Such is a market cycle. The respective reactions of the husband and wife teach us a lot about speculative behavior. One should buy financial assets on sale.
In truth, the key to investment performance for all speculators is conveniently located east of one ear, and west of the other.
Many of you have experienced one or more resource cycles with us. For others, this is your first voyage. Down cycles in the resource business are messy affairs. The capital intensive nature of productive capacity in resources is such that producers will produce down to, and then below marginal production cost, first to generate cash to service debt, then in a desperate bid to be the last man standing to enjoy the inevitable rebound. Producers with negative operating margins strive to make it up on volume! With the industry in liquidation, there is little interest or investment in new capacity or exploration. After all, if you’re existing operation is in liquidation, your inclination to expand is constrained. Capital markets respond with apathy, and then capitulative selling.
In liquidation, the stage is set for recovery. The low product prices increase the utility of commodities to consumers, increasing demand even as supplies are being diminished by the liquidation of productive capacity and the elimination of the exploration and development pipeline. As the liquidation matures, we enter into a "stealth bull market". It isn't so much a factor of new investment buying, as an elimination of capitulative selling. At any rate, stocks begin to rebound off an oversold base, not that many people are around to notice.
The reduction in productive capacity (supply) and the increase in demand eventually results in small commodity price increases. This pricing relief and the improvement in equity pricing get noticed by the few industry survivors and a cautious but firm bull market begins. As demand outstrips supply, the industry is unable, and unwilling to respond. They don't yet have either the financial or psychological resources to make investments that until very recently yielded only pain. This involuntary supply side prudence cause commodity prices to rise further and yields greatly improved operating results to producers. These results serve as an explanation for the new found performance of the equity markets and a genuine bull market ensues. These bull markets are punctuated by "wall of worry" corrections, as rational fears of the industry’s cyclical nature collide with the then current bullish conditions. As product pricing stays firm, the industry seeks to expand, but is constrained by the long lead times necessary to find and or build mines, mills, smelters, pipelines and the like; so despite impending supply increases, current product prices rise further. Equity markets become ecstatic, and "new era" pronouncements abound as the investment community perceives the virtuous circle of high per unit profitability, and increasing unit production. Equity prices soar, production increases occur, we are all rich, smart, young, good looking, virtuous…and deluded.
The increase in product pricing reduces the utility to consumers, constraining demand. Increased investment increases supply, supply outstrips demand, and prices begin to fall. Producers price to, and then below, marginal cost… and the cycle begins anew.
Warren Buffett said it best, "be brave when others are afraid, and afraid when others are brave”.
These industries are cyclical, remember? And that’s the good news! Buying these industries when they are in liquidation, and selling them when they thrive is most of what we need to know.
These securities are also volatile… and that’s good news. Without volatility there is no $1 tuna. Shop at sales!
JUNIOR MARKETS ARE BECOMING EVEN MORE VOLATILE
The junior markets are becoming even more volatile than they have traditionally been, driven by several interconnected phenomenon. First, the markets are now international, with Asian, Middle Eastern and European money flowing into and out of very thin markets, often buying and selling for reasons unrelated to the real prospects of the individual underlying equities. Large institutions, particularly open ended mutual funds are big players in tiny markets. In times when the public perceptions of these markets is good, money flows into resource and small cap funds and is deployed by newly minted investment geniuses into increasingly irrationally priced equities; as perceptions change and the money disintermediates, managers must liquidate increasingly cheap positions. These managers don't have the luxury of selling what they want. They sell what they can. Smaller institutions like hedge funds and liquidity funds have been huge players in these markets, and as their performance falters they too migrate from being aggressive buyers to aggressive sellers. Finally, individual participation in equity markets is at an all time high, with millions of bull-market-spawned, internet-wired speculators trading speculative equities with less than perfect knowledge about the businesses that underlie those trading vehicles. The information most of the participants rely on for their investment decisions is delivered by the markets themselves, the blind leading the blind.
The mob bids up the market, the mob sells the market down. What is the rational speculator to do? Shop for tuna on sale!
Volatility is not just a condition, it's a tool. If it is a tool that you are unwilling or unable to utilize, you should consider a different investment medium.
PSYCHO ANALYSIS AND SECURITY ANALYSIS
Markets are emotional too, and that is also good news! We are programmed to seek pleasure, and avoid pain. We hate to be wrong alone, seeking solace in the crowd. Our expectations for the future are set by our experiences in the immediate past. When we experience success in a market, we experience pleasure, and as pleasure seekers we are eager to repeat the sensation. We feel smart, confident, even smug. We understand this stuff, we've learned our lessons, experienced the risks, overcome the adversity… bring on the rewards. Bluntly, we confuse a bull market with brains. When markets get cheap on our watch, our most recent memory is pain, which we seek to avoid. We either blame the market, the government, the Moslems, the tri-lateral commission, or rarely, ourselves. But, eager to avoid blame, no price is too cheap; until at last it is no longer cheap, and we muster up the courage to re-enter.
In the short term, markets are a voting machine, a measure of the mob's emotion and prejudice. Letting a mob, whose median intelligence and access to information is less than your own, dictate your actions is tantamount to assigning yourself a large handicap. In the long term, markets are weighing machines, swinging on a pendulum between undervalued and overvalued. Being a pawnbroker to the mob, buying goods on sale when the mob is depressed, and selling back marked up goods when the market is elated, is what markets are for. Do what is rationally easy, not what is emotionally easy… if you can't find much to buy rationally, start selling. If a market goes "no bid", put one up.
WHERE ARE WE NOW?
I personally see us in the mid stage of a broad bull market in resources. At this instant, we are in a “wall of worry” correction. The world has woken up to the potential of resource markets, expectations have been frothy, but the inevitable supply increases that crush a market have not occurred, and will not occur for some time, because of the huge capital investments and long lead times inherent to these industries. I think most of the free money (the stealth bull market) has been made. My strategy will be to cycle out of popular sectors,(Uranium), into unpopular sectors, (Canadian natural gas), buy panics (hello, anyone listening?) and sell rallies. Supply increases have not yet occurred, although the capital spending cycle has rendered them inevitable. Demand, even in the face of strong price increases, is very strong. Emerging market demand is part of that story, insidious inflation is another factor. If we adjust the prices that we experienced forty years ago, or twenty years ago, to constant dollars, we see that commodity prices are high only in nominal, not in real terms. The political and social challenges to supply from the Middle East, the American Imperial Empire, Russia, Oxfam (the Luddite lords of famine) and the rest of the elite rabble are very real.
Finally, the credit conundrum is, well, a conundrum. On the one hand, there is no doubt that part of the resource demand is artificial, a response to a liquidity driven boom. More rational credit supplies can and will impact the broad economy, with profound implications for commodity demand. Limiting mortgages to people who can afford to pay back the loan will constrain demand for building materials. On the other hand, less debt financing and more expensive equity will limit supply increases. These are capital intensive businesses- no capital, no business. And, the idiotic increases in the money supply we are seeing now will make money worth less, and "stuff" worth more.
So where does this leave us? Where we started - being contrarians, or victims.
WHERE DO WE GO FROM HERE?
The broad resource markets are in the midst of a classic “wall of worry” correction. Junior markets are collapsing for a variety of very valid reasons.
1) First and foremost, the junior markets as a whole were, and still are, insanely overpriced. Only about 10% of 5000 odd junior companies have any real value, and most of the market players don’t have the ability or the will to discriminate between the good, the bad, and the ugly. The Uranium mania is a classic example of this. In 2000, the price of Uranium as a commodity was very cheap, it had to go up, but because the markets had been dormant for so many years, nobody cared. When the price did go up, people began to care, and after the price had increased enough that it didn’t have to rise further, people became obsessed. By this year, 550 “uranium” companies littered the investment landscape. The vast majority (maybe 500!) shared two serious faults: First, THEY HAD NO URANIUM. If the price of something you don’t have any of rises, it makes no real difference to you. Secondly, after a 25 year “bear market” in uranium, there are perhaps 30 qualified exploration teams left to run 550 companies, (meaning that the probability that an individual company had a qualified team was a function of dividing 30 by 550).
There are too many juniors in the market, and the VAST majority are totally valueless. Many of my investment conference colleagues bemoan the degradation of the US dollar by the profligate printing of same by the treasury. The US treasury is an abject failure at printing worthless paper when compared to the Canadian dealer community. The private sector is always more efficient! It is difficult to research and find the one in ten juniors that stand a chance, and more difficult yet to discriminate rationally among the good ones. It is easier for the dealers to create brand new worthless paper, than to sort out the existing paper, and if the market doesn’t discriminate, it is much more profitable.
2) Many important market players were and are incompetent. A twenty year “bear market” in resources has thinned the ranks of competent participants in resource financial services. The professional function of discrimination in resource capital markets has with some exceptions (Global, I hope) has gone largely unfulfilled. The brokers and investment bankers are increasingly “fee whores” rather than gate keepers, and the level of professionalism among many of the large and small institutional investors would be laughable had it not become tragic.
3) The market is liquidity driven. Global flows of liquidity; from the Japanese Central Bank bailout of their finance industry to the US Fed’s destruction of the dollar has left the world awash in cash. The same instinct that spawns a trillion dollar industry devoted to lending mortgage money to people who can’t pay it back in order that they can buy overpriced real estate, is the instinct that finances uranium companies with no uranium, run by people who can’t spell uranium. A bunch of that “dumb money” is going to go to “money heaven”, that is, it will disappear into the same thin air out of which it was created. A good thing of course, unless that “dumb money” was yours. The evaporation of vast quantities of “dumb money” has led to a liquidity crisis, which has damaged liquidity driven markets, and junior resource markets are like most risk markets, generally very illiquid.
4) The market and its participants suffered from irrational expectations. After several years of a raging bull market, participants have come to believe that inordinate success is a condition they have a right to expect. A very famous Canadian investment banker was quoted as saying he “wouldn’t get out of bed for deals less than C$100,000,000”. He should develop insomnia. Investment conference participants explain that they use the maximum margin available, and enquire of the speakers “what do you have that will triple in ninety days?” The correct answer is that the questioners debit balance and tax losses are the most likely near term triples we are aware of. This market has good money left in it, don’t spoil it for yourself with idiotic expectations
5) Many of the “players” are momentum driven. These traders are market players, traders who are often unknowing and unconcerned with industry or company specific fundamentals. Competent traders are good for markets, they add liquidity and if they are canny and disciplined, can make a fortune. But that’s a big “if”. Most of the momentum players are as apt as the fictional husband in our tuna story, and as likely to experience success. They rush into “up” markets, overpaying for instruments they don’t understand, and crowd out of down markets, liquidating the good with the bad.
Every great party results in a great hangover, and this week we all have headaches. The “sorting out” will be painful but profitable. The lessons learned, if learned, will be invaluable. The factors that caused the euphoria in resource markets earlier in the year are still present, they are just available at a discount. We need to learn to profit from cyclicality, not become its victim. We need to cherish volatility, not fear it. We need to remember that there is no commandment from God that says we must emulate the stupidity of the mob. We must use liquidity, and avoid being used by the “fee whores” In essence; we must employ common sense, and buy financial assets on sale.
WHAT DO WE DO NOW?
We have had a “wake up” call. Review the reasons you became a resource investor and/or speculator. Are those reasons still valid in your view? Do you have the emotional strength to be a contrarian, using cyclicality, welcoming volatility, buying panics, and selling rallies? If not, do yourself and your broker a favor, and close your account. If this sector appeals, then use this panic as a slap in the face. Lets review your portfolio, lets sell the securities that are not absolutely “best of breed” in terms of management, balance sheet and asset base. Let's sell even those that are best of breed, if they are well overpriced. Let’s consider making tax loss sales in September and October as the market recovers, so that we can offset gains taken earlier in the year. Let’s be very, very harsh.
Look at your total personal balance sheet. Are you where you need to be, or would like to be?
Are you over exposed to resources? Are you overly speculative? Do you have sufficient liquidity? I believe the global central banker’s response to this liquidity crisis will be bad for ALL fiat currencies. As the dollar devalues, I believe others must and will follow. More currency from thin air devalues the existing supply. I think the strong export currencies will fall, these are self correcting mechanisms. I think the Euro zone is sclerotic and it must fall as well. In the short term interest rates are stable to lower in my view, so short dated bonds from high quality issuers are ok. Long debt is insane!
Own some gold. Pray it doesn’t perform! Gold is a medium of exchange, the best in recorded history, and a store of value. Gold is also catastrophe insurance. Own it first as insurance.
Speculate on then high quality gold stocks, buying panics, and if you like, selling rallies. We will help you discriminate.
Own only “best of breed” base metals stocks. While base metals prices are not high by historical standards, the industry is enjoying excellent operating margins, supplies will increase, and consumer utility is diminished by this pricing environment. Projects in the lowest cost quartile worldwide will perform for you. Chasing the marginal producers to maximize returns in commodity up cycles is a strategy to employ at the bottom of the next “bear market”, not now. Own energy. Conventional oil and gas is reasonably priced, given the supply\demand balance. Again, focus on “best of breed” not “story stocks”; buy on a net enterprise value to net asset value basis, and buy corporate efficiency, based on operating margins and reserve acquisition efficiency. Speculate on the junior Canadian gas producers… this is cheap tuna, and know that the play will take two to three years to work out.
Know when you buy a stock, why you bought it, why you will sell it, and when and under what conditions that might occur. If you have analyzed the situation correctly, and the stock has reacted accordingly, sell. If the reason you own a stock becomes invalid, sell. If a company adds value that is not reflected in the market, buy.
Remember, whether we like these conditions or not is not relevant. We can use these markets or be used by them, and the choice is ours!
If you have any questions, please contact your Global broker. If you don’t have a Global broker, visit out website at www.globalresourceinvestments.com or contact us at 800-477-7853 or 760-943-3939.
It is also important that I disclose that low-priced securities can be very risky. Trading in low-priced securities may result in the loss of part or all of your investment. Because of significant volatility, large dealer spreads and very limited market liquidity, typically you will not be able to sell a low-priced security immediately back to the dealer at the same price it sold the stock to you. In some cases, the stock may fall quickly in value. International investing should be considered one component of a complete and diversified investment program. Investing in foreign markets entails greater risks than those normally associated with domestic markets, such as political, currency, economic and market risks. You should carefully consider whether trading in low-priced and international securities is suitable for you in light of your circumstances and financial resources.
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