During a time in which sentiment towards natural resources is bordering on doom, Rick Rule, chairman of Sprott U.S. Holdings was kind enough to share a few comments.
Speaking first toward the phenomenon of market capitulation, Rick noted that,"Capitulation is a very dramatic event. It's when most participants in the market give up completely and simultaneously. They are two or three week periods [of] extraordinary [share price] violence. They're emotionally driven rather than arithmetically driven events."
One of the more important utilities of a capitulation, according to Rick, is that, "In my experience they have marked definitively the end of long bear markets."
When asked for a prediction on the gold price, Rick concluded that, "[The fight] is between gold and the U.S. 10-year treasury—and I don't see how over five years we can possibly lose that fight."
Here are his full interview comments with Sprott Global Resource Investment's Tekoa Da Silva:
Tekoa Da Silva: Rick, we've had an ongoing conversation over the last year on "issuer capitulation." For the person reading, can you explain that concept, and what's the climate of that conversation in the resource market right now?
Rick Rule: Capitulation is a very dramatic event. It's when most participants in the market give up completely and simultaneously. I've been through three of them before. They are two or three week periods with very violent volatility, but mostly on the downside. It's a situation where the few remaining buyers which have carried up a market give up, and the sellers begin to bail out at all costs.
Things that contribute to capitulations (because they're irrational activities) could be things like the simple fact that the calendar month of October has witnessed so many down cycles before. The apparent end of quantitative easing might also scare people, and the idea that they need to get out before pending tax-loss sales.
What marks capitulations are their extraordinary violence, their relatively short duration, and the fact that they're emotionally driven rather than arithmetically driven events. What's useful about capitulations is that, in my experience, they have marked definitively the end of long bear markets.
Markets turn from bad to good as a consequence of markets outperforming expectations, and capitulation dooms expectation. At the end of a capitulation period, the only outlook for the market is bad, and as a consequence (and by definition) it's almost impossible for the market not to outperform. That's been the case of every prior capitulation I've experienced.
The other utility of a capitulation is that it becomes broad-based. It extends not only to speculators, but also to officers and directors of junior mining companies. If we are going into an issuer capitulation period now, if past is prologue what will happen is that the issuers will finally lose hope for raising money in a higher market. They'll go ahead and raise the money they need now, and they'll begin the process of exploring their properties. You cannot save your way to prosperity in this business, you can only make money by investing money in exploration and development.
For 18 months the issuers have played chicken with the market, waiting to raise more money until share prices theoretically go higher, and as a consequence generated no value that would cause the share prices to go higher. The hallmark of the 2000 capitulation as an example, was to bring the very best issuers (the Robert Friedlands, Ross Beatys, Bob Quartermains and Lukas Lundins) back to market to say, "Let's go, let's raise money, let's build."
TD: What is the most common objection you receive when approaching these issuers with respect to capital needs, and is there a cycle of objections you see them going through?
RR: As an institution, we at Sprott have probably approached three dozen junior explorers or developers in the last 12 months and said, "We think it's time for you to advance your project more aggressively. We have faith in you, we like your property." In response the issuers have said uniformly, "Thank you for your faith, but we can't raise money at this price. This price is too cheap. At this price we dilute our existing shareholders too much."
While we think that's admirable in one regard, the issuers need to remember that this is a capital intensive business, and if you have no capital you have no business because you have no income.
What happens as a consequence of not raising money, is that the only money they spend is on general and administrative expenses, which in effect means that they cannibalize their business and generate their own dilution.
TD: Rick, we had a meeting at our offices here recently, and you said something very interesting. It had to do with mainstream news stories in the financial media and their irrelevance toward our specific investments. You indicated that relevant items to our investments are things such as cash flow and discounted net present value of an asset. Can you speak to that concept?
RR: Tekoa, I think you would agree that most news on the major media isn't really issue-oriented. It's become entertainment. When the nightly news in San Diego focuses on a cat stuck up a tree (a human interest story), as opposed to stories that are real with regard to San Diego, it tells you something about the utility of watching the nightly news.
That extends, of course, to the financial news. People are interested in the big picture, but people make money on their investments at the firm level. People make money in investing by understanding events that are intrinsic to the company they intend to invest in. Additionally, your expectation of the future colors the way you value investments. As an example, if you were of an opinion that the gold price was going to rise, you might be more generous with regards to valuing a company's resources and reserves than would otherwise be the case.
What happens to people who focus too slavishly on the news, is that they disarm themselves. They take themselves away from examining fundamentals such as the cash needs and the cash generating capabilities of a company, and focus more on cats stuck in trees.
TD: Rick, what would you say is the biggest advantage available in today's metals and mining market, and what would you say is the biggest risk?
RR: Tekoa, we at Sprott have emphasized to our clients for 20 years the need to understand that natural resource based businesses are extraordinarily cyclical and volatile. The most important thing you could understand in today's context, is that you have to be a contrarian or you will be a victim. The emotions you're feeling with regards to your investments are shared by all of your competitors, and right now they are negative—which is to say that your competitors are not showing up to make investments in "out of favor" sectors.
The way you make money is by buying low and selling high. Selling high presupposes that you buy low. When is it most possible to buy low? When all of your competitors are scared to death, which is a different way of saying "right now."
Can it go lower? Of course it can go lower. But what's the probability that the downside materially outweighs the upside? Nil, in my opinion.
Conversely, what's the biggest risk? Easy. For every investor the biggest risk is not Obama, not the central banks, not the big thinkers of the world, and it's not even Congress. The biggest risk to each individual investor is conveniently located to the left of the right ear, and the right of the left ear. Almost everybody's worst wounds are self-inflicted. Allowing your emotion and your experience in the immediate past to overly influence your expectation of the future will cause you to dismiss arithmatic and replace it with prejudice, which is where most people conspire to lose the most money.
TD: Rick, you've taught me a lot about the cyclical nature of the resource business, so I'd like to ask—what gives you the confidence we will have another upcycle in natural resources, and how far back does your experience go in terms of cycle participation?
RR: Well, my own experience goes back to the early 1970s, so sadly, that experience is long indeed. Confidence in resource markets can be as broad as confidence in the ascent of man—the longest running bull market in history. Despite the ups and downs, society over time increases its standard of material well-being, and simultaneously, increases its size. We're at 7 billion and counting, there's more people being born every day, and they all want to eat, Tekoa. That's the broadest set of circumstances we're in.
It's odd to me that resource investors, perhaps because of the hard money origins of many of them, believe a catastrophic decline will be the best possible outcome for the resource business. That's wrong. The best possible outcome for the resource business would be a boom, which increases utilization of commodities, and secondly, increases savings in gold which is an important part of the savings matrix of many people on earth.
Hence, the more wealth that's generated, the more demand we'll see for gold as part of the savings matrix. I believe the set of circumstances that's in front of us is severe but survivable. I lived through the down cycle in the 1970s and it was certainly dramatic; interest rates in the double digits, civil insurrection, generational change in the United States, as well as the Vietnam War.
The situation we have in front of us is certainly no better than that, but probably no worse either. The outcome is that the laws of supply and demand, and the laws of the market will ultimately prevail over the headlines.
The truth is that the material goods humans require will always do well. People will always need to eat, and they'll always want access to electricity which requires coal, nuclear, and copper. As people (particularly people in frontier and emerging markets) acquire more wealth, they'll require more savings products.
Again, an important part of the savings matrix in places like China, South Asia, India, and Pakistan, is gold. So ironically, an increase in living standards would probably be better for gold investors than a decrease in living standards. While I expect the time ahead of us will be turbulent, I also suspect that resource investors will do very well—in particular Tekoa, because we're starting from such a low base.
Think about the TSXV for a moment, an index down by about 80% in nominal terms, and I say nominal terms because the TSX throws out the worst companies. They throw out the people who failed. In real terms, that's a market that's down by 85%, which is arithmetically (and simultaneously) 85% less risky and 85% more attractive.
TD: On the subject of gold, we had the chance to visit a conference recently, the New Orleans Investment Conference. In attendance was former Federal Reserve Chairman Alan Greenspan, who as our readers know, was an early proponent of gold. What was your takeaway in regard to his comments on gold?
RR: Dr. Greenspan was very worth listening to. In the context that his beliefs probably reflect the beliefs of the big thinkers and ruling class in this country, except that he's probably more philosophically inclined towards you and me, which from my viewpoint makes him particularly interesting. He said as an example, that the beliefs he held in the 1960s as part of Ayn Rand's inner circle hadn't changed, but what changed was his job description. He went from being a university professor and a forecaster, to running the Fed, and he had to temper his beliefs in the context of his actions because of the requirements of his job. I found that to be an interesting point.
A second point he made, was that the idea that the Fed "isn't politicized," is silly. So while the investing public believes you have this independent Fed, nothing, according to Greenspan, could be further from the truth.
Another point he made that really supports the gold thesis, is that the Fed doesn't exist to defend the currency. The Fed exists to defend the banking system, which is a very, very different set of circumstances. As we saw in 2008, defending the currency and defending the banking system are often antithetical to each other.
Greenspan further said two things that I think are useful to our audience. When asked about the specific direction of both gold and interest rates, he responded first by saying that he made his living as a forecaster for 35 years, and as a consequence of that, he was very experienced at obfuscation (which I found amusing). The second thing he said when pinned down with regard to the direction of interest rates was—"measurably higher." In response to the direction of the gold price—"measurably higher." He said that in the context of his belief—that in a representative democracy wrapped around a welfare state—the demand for goods and services from the state will always exceed the demand for a sound currency.
He further stated the profligacy we experience in the U.S. will not merely continue, but accelerate. He didn't say it in those exact words, but when he said that a sound currency is incompatible with a representative democracy servicing a welfare state, you begin to understand something about the volatility of change to occur.
TD: Rick, one of the other things I noticed at that conference was the median age of the attendees, which looked to be about 65. What's the significance of that in your mind? Is it that that age group holds most of the country's wealth?
RR: I think I have three significant comments to that. First of all, youth is a very good thing, don't waste it. Secondly, it's pretty obvious why the audience was so old. The audience that's attracted to hard money or resource themes, is the audience that came into their investing prime during the decade of the 1970s, when gold ran from $35oz. to $850oz. The audience began to get a little younger in the beginning of the last decade, when the narrative associated with resources became supported by the rise in emerging and frontier markets.
I fully believe two things will happen over the course of the next decade. One, the discussion you and I are having with regard to resources which is not uniformly popular now, will become uniformly popular, as a consequence of the performance of those markets.
Two, as the performance of those markets accelerates, attention being paid by younger observers to that narrative will increase, because people's expectation of the future is set by their experience in the immediate past. Investors who are less forward thinking than you, Tekoa, but who are of your same age, haven't explored the topic of natural resources and precious metals, because they're more caught up in lifestyle topics, they're more caught up in technology investments, and they're caught up in narratives that have been more relevant to them.
If the price of copper doubles, or if the price of oil or gold doubles—the importance of this narrative becomes dramatically reinforced by first-hand experience, and the number of people listening to discussions like this will increase and their median age will decrease radically.
TD: Rick, at the few conferences I've been to over the last year, I've been hit with a question which is relevant to the current or future clients of Sprott: What should give them confidence that the next generation at Sprott will be able to carry forward the mandate to manage their assets? Furthermore, when you walk down the halls at Sprott Global and Sprott Inc. in Toronto, what are the encouraging signs you're seeing from this next generation?
RR: That's a wonderful question. The first thing is the culture at Sprott; we are a financial services firm that isn't overleveraged. We aren't run like an equity firm that has an 8% equity slice. We have a 100% equity slice, and people who are attracted to Sprott are attracted via the culture, and we don't think that will change.
The second thing is that young people who are attracted to Sprott and the Sprott culture are instinctively contrarian, or else they'd be going to work at one of the technology underwriters, they wouldn't be coming to work here. It's who we are and what we do that attracts these people, which is your first line of assurance that these are hard-working, contrarian people who are willing to invest in their future as opposed to generating capital to consume right this very instant.
The third thing is much more general, and it's interesting I guess when you hit my age, that the sort of collective wisdom is that the generation or two coming up underneath you is somehow less worthy. I suspect that was the feeling of my generation's parents and grandparents. But when I visit with people my own age, and they suggest that younger people are less motivated, or less well-educated, I look at them and laugh, and say, "Well you know, you ought to come to work with me—either in Toronto or San Diego."
When I look at the education, motivation, and maturity of the 30 yr. olds that work at Sprott and compare it to where I was at 30, I'm mightily impressed. The idea that the upcoming generation at Sprott is somehow substandard is laughable. It doesn't even merit consideration.
TD: As a final question Rick—what's your prediction on gold prices over the next 3-5 years?
RR: Higher. I have to echo Greenspan in that regard, but I'm not really in the predictions business, I'm in the net present value business. I sleep better owning gold than not, but to answer your question, from my point of view we're simply locked in a war with the U.S. 10 year note. If the dollar strengthens, it weakens gold. If the dollar weakens it strengthens gold. And I suspect that arithmetically, we're locked in a war that we can't help but win.
The best case value proposition offered up by the U.S. 10-year treasury is (if you believe their numbers) that you give them $100,000, and in 10 years they give you back $100,000. In other words—you make no money.
The mid case scenario is you give them $100,000, and given the decline in purchasing power of the basket of goods and services that you and I consume (not the CPI), they give you back $50,000. Now think about that. The promise is they deprive you of half of your purchasing power over 10 years.
So if the fight then is between gold and the U.S. 10 yr. treasury, I don't see how over 5 years we can possibly lose that fight.
TD: Thanks for sharing your comments.
RR: Thank you Tekoa.
Tekoa Da Silva