Discovery Investing. Focusing on the Big Opportunities
Source: The Gold Report (3/28/08)
Dr. Michael Berry, a pioneer in the field of discovery investing who researches companies in natural resources, high technology, and biotech, talks about creating wealth in an extremely volatile economy and the role of precious metals in the asset allocation of the individual investor.
TGR: We want to ask you about the commodities market, but let's start with the bigger picture. What's in store for the markets in general?
MB: I've been in this market 30 years and I've never seen this much volatility–not even in 1987. Until late June or July, nobody knew what the sub-prime market was, except the people who were making markets in it. Then suddenly, the sub-prime situation began wreaking havoc with the economy. Since late summer we've had six interest rate cuts by the Federal Reserve to try to rectify the situation.
TGR: Do you think the Fed's strategy is working?
MB: So far the rate cuts haven't been effective, with the exception of the first two rate cuts, which supported the stock market. I think the Fed hoped that by the middle of October the economy would turn around. But the third rate cut was followed by a major decline in the equity market. The fourth cut also stimulated a decline, and although the market is up again, it remains very, very volatile.
The Fed itself is in panic mode and for good reason. It backed the purchase of Bear Stearns by JP Morgan, which was a hurried affair. Congress will do whatever it must do to stimulate and support the credit system. There is more visibility now that “the Bear” has fallen but if there are many more “hits to the bridge” like that of Bear Stearns cash problems, the US and global financial systems will continue to shudder. It will be crucial to see how Senators, Clinton, Obama and McCain relate to and understand these problems.
TGR: Where do we go from here?
MB: The Fed has to decide between more rate cuts, which would further weaken the dollar, and raising rates in order to defend the dollar. With so much debt floating around out there, raising rates would spell trouble, especially with millions of interest rate re-sets coming due. However, there are geopolitical consequences of a weaker dollar. I don't think the Fed will go much below 2% on the overnight rate. Because if it does, we'll see the Europeans, the Japanese, the Canadians, lower their rates. And then it will be a race to the bottom on this currency thing.
TGR: There's really no easy answer, is there?
MB: Not really. I sure wouldn't want to be in Dr. Bernanke's shoes right now. For months, the Fed argued over what to do about inflation. Yet in a recent communiqué, which announced the lowering by 50 basis points, there was no mention of it. I've been saying in my Morning Notes for well over a year now that the Fed would target inflation. There was subtle talk about allowing some inflation but hopefully controlling it. However, we now have significant inflation.
TGR: Will other countries eventually stop accepting the dollar, if it continues to weaken?
MB: Absolutely. At some point, the Saudis, the Russians, the Iranians, the Venezuelans—the OPEC Cartel—are going to react by refusing to accept the U.S. dollar in payment for oil. Recently, one of the highly placed Saudi bankers said it wouldn't decouple its currency from the dollar unless the dollar declined by another 30%. Well, that's kind of a non-denial denial; he's saying they will decouple if the dollar declines significantly.
TGR: What do you think should be done?
MB: I believe it's all about saving the banks. Right now interest rates are falling, which is considered deflationary, yet the yield curve is positively sloped. That's very good for the banks. Up until about six months ago–and for a period of two years—we had a flat-to-inverted yield curve. So, there are some positive things at work there. However, the key element to watch is the credit situation. When are we going to have some visibility on the credit cycle? And are we going to see more credit liquidations, which will be significant?
There's no doubt the economy is slowing. In the global context, it will be interesting to see if the Asian economies are decoupled enough from the U.S. economy to carry us. I think they will probably provide some cover. China, India, Brazil, Russia are still growing at significant rates. They're still building out infrastructure. The commodity cycle is still very strong. We still have $100+/barrel oil. You would expect oil and copper to be the telltale leading indicators of a much-expected recession, but copper is still trading well above $3.00, and oil, as I mentioned, is still over $100. That's very unusual. I don't think we've seen anything like it before.
TGR: So what does the smart investor do in this market?
MB: About two years ago, I started advising my clients to raise cash—not 100%, but really go back to their portfolios and look very carefully at what they owned and take some profits off the table. Raise some cash, own gold, either in the form of physical gold or shares. I think I used the term, "Keep your powder dry."
TGR: You were making those recommendations two years ago?
MB: That's right. We started to see this volatility almost two years ago. I remember one day being in El Paso, Texas, looking at an alternative energy company, and the stock market was down 200-300 points that day. And I realized we were going to experience lots of volatility and probably lower markets because of what was happening in real estate. Real estate began to turn down in 2005. It was obvious then that much of the debt backing the real estate was likely to default . I took a lot of heat for those recommendations two years ago because I was ahead of the curve. But now we've reached a phase where within the next 12-18 months there are going to be some real bargains out there
TGR: And now?
MB: I'm focused almost exclusively on discovery investing. By that I mean looking for real world-class discoveries. It may be a discovery in the resource sector—for instance, a uranium discovery, an oil discovery, an oil sands discovery, a gold mine, a copper mine. Or it may be a discovery in the energy sector, or in the technical sector. But it has to have the potential to be a world-class discovery. I work only with world-class experts, those individuals in the process of making these discoveries. I look for the catalysts; I look for the great management, but most importantly, I look for the potential for a great discovery.
TGR: You actually coined the term "discovery investing" and you're writing a book on it, aren't you? What’s the history behind that?
MB: I taught investments and corporate finance at the University of Virginia for a long time. While I was there, I worked with some people on Wall Street. We looked at behavioral investing, and I realized what I was teaching, at least in the 1980s, was a good deal of theory that relied on four assumptions: 1) everyone was rational; 2) markets were efficient; 3) everyone knew everything about a stock; 4) so the prices always came to a correct equilibrium. But that's not what I was seeing in the marketplace at the time. So, I eventually gave up a tenured professorship, went to Wall Street, worked with David Dreman, and learned how to invest. And I learned that prices can be out of equilibrium, they can go too high and too low and remain there for a long time. These are the so-called “bubbles.” I managed a small cap Value fund at one firm, and mid-cap value stocks at another. But University professors don’t teach how to buy micro-cap stocks. They’re considered gauche. Too much risk. Sometimes they're called Vancouver stocks, or penny dreadfuls. But that’s where all the discoveries are made.
TGR: What other insights did you gain once you left the university?
MB: I realized that Wall Street likes to put investors into boxes. You’re either growth or value, small or large. So the institutions look at you and say, "I want a large-cap growth investor. Let's look at them all." I realized those strategies go out of favor from time to time. In 1996, value was in favor; by 1998, it was out of favor. We had oil trading for $10 a barrel, and you couldn't give away an oil stock. Now we have the polar opposite situation. So I decided I never wanted to be in an investing strategy that would go out of favor for a long time. And I realized that the one constant in investing is that at the beginning of every investment strategy is a discovery process.
TGR: That’s when you coined the term “discovery investing”?
MB: Right. I began to do a lot of research and investing on my own and really developed this concept from scratch. My research showed that it’s really a matter of identifying world class potential. Now, do you always find it? No. Do all discoveries pan out? No, they do not. But, it takes only one discovery to create tremendous wealth. So, I diversify across different commodities, and I diversify out of commodities and into high tech and biotech, in search of opportunities I consider to be world class in their discovery potential.
TGR: You also developed a 10-point grid for commodities, didn’t you?
MB: Yes. Some of my associates had a 10-point grid that they used to evaluate the discovery potential of every value stock. They asked me to develop one for commodities, because they didn’t know enough about that sector. So I did, and I refined it. Now every time I see a company that could have major discovery potential, I will grade it on those 10 points. It's worked exceedingly well. I also developed an overlay for the grid that uses sentiment to re rank the discovery stocks.
TGR: Any other tips for this type of investing?
MB: You must use traditional allocation and diversification tools. I advise people to take one percent, two percent, five percent of their portfolio, whatever they’re comfortable with, allocate it to discovery. Then, within that context, to diversify. I advise them not to worry about cap size, how big or how small a stock is, or whether it’s a growth stock or value stock.
TGR: Do investors have trouble with that advice, because it goes against the norm?
MB: It’s really not a hard sell. I will show a graph of a company – let’s use Canplats Resources Corp. (V.CPQ, PK.CPQRF, F.CPQ, DE.CPQ, BE.CPQ), as an example. On December 13, Canplats drilled a hole of 184 meters of 1.6 grams of gold and about 35 grams of silver. Now, that's a heck of a drill hole. So I show the stock, then I show the event – in this case, the successful drill – and I point out that this is the discovery. This is wealth creation through discovery. Now there are some issues that can happen with discovery. One of them is something we call the "mystery history shift." In other words, when you get the first discovery, the stock will be bid up, there will be an over-reaction to the good news. Then it will fall back down. So, you have a couple of natural buying and selling opportunities. But I’m a buy-and-hold investor. If I believe in a great world-class opportunity, I'm going to hold that until I see the discovery come to fruition.
TGR: Any other examples from the mining industry that come to mind?
MB: Well, let’s look at Noront Resources Ltd. (TSX Venture: NOT). In January it hit a wonderful 5 or 6 meter intercept, very big, in Northern Ontario. Now, in this market today, every stock is being punished, so it didn't work out quite as well for them. But here's a $4 stock that was a 50-cent stock two years ago. Discovery investing is wonderful for children and teenagers. The prices are low enough that they can experiment, and if they have one success, they can see how wealth is created through the risk and reward trade-off in the discovery sector. We never teach it in universities; nobody ever teaches how to buy little stocks that are real little and have lots of risk. What I’ve done is to develop the empirical and theoretical behavioral basis for this sector. In fact, we're taught to shun them. That's a pity because, you know, those kinds of stocks often turn out to be the Microsofts of the world. You never know.