Palisade – Sprott Monthly Market Update with Rick Rule: Gold Stocks Have a Long, Long, Run Ahead!Monday February 29, 2016 15:14
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Palisade Radio Host, Collin Kettell: Welcome back to another episode of Palisade Radio. This is your host Collin Kettell. Back in the program with us today for another Sprott monthly market update is Rick Rule. Rick, lots to talk about today. Thanks for coming back on the program.
CEO, Sprott US Holdings, Inc., Rick Rule:Collin, it is always a pleasure. Thank you for having me on monthly. I enjoy it.
CK: When an index makes a 63% move in a short period of time after being in a bear market for four and a half years, it begs the question if a new trend has been set. From January 19th to February 12th the HUI went from 100 to 163, a truly drastic move possibly indicative of a bottom. What is the consensus at Sprott at this time with this recent move?
RR: I am not sure we have a consensus Sprott-wide so I will speak for myself rather than Sprott. You and I discussed in the same interview space a couple of months ago the fact that people look to a broad number of indicators with regards to the gold market which I think is a mistake. I think the most important factor is gold versus US treasuries where US dollars are presented as treasuries. I think it is easy to note that the US treasury has been in a 30-year bull market as yield instrument and also as a store of value in a flight to safety period.
My suspicion is that with the yields on US treasuries going from 15 at the beginning of that market down to 1.6 today that the market has gone about as far as one could expect it to go. I am not suggesting that the US treasury is not a relatively attractive instrument compared to other sovereign issuances like the Japanese issuance or the euro instrument. But I think in an absolute sense it is becoming less and less attractive and therefore is competing less and less well with gold. I am not one with the sort of apocalyptic commentators that suggest that there is going to be a massive move in treasury or a massive default by the United States.
I am not even suggesting that gold is going to win the war against the US dollar. What I am going to suggest is that gold is going to and is currently losing the war less badly. Given the enormous size of the US treasury market and the small size of the gold market a small transfer of funds from the treasury market to the gold market which we are seeing in the last three months has an outside impact on the gold market. I think the last time we talked, Collin, that I mentioned that there was a major investment bank study, I think it was Morgan Stanley about six months ago that suggested that gold and gold equities currently occupied between 1/4 and 1/3 of 1% of the savings and investment matrix in the United States while the comparable number in 1980 was 8% where the median and the mean over the last three decades was about 1.5%.
What I am arguing for is a total or partial reversion to the mean which if it occurred would take gold as a part of the savings and investment matrix in the United States from 1/4 or 1/3 of 1% up to as high as 1.5%. That relatively small gain in market share in the savings and investment matrix in the United States given that the United States controls between 24 and 25% of global savings and investment would have an absolutely dramatic impact on gold and gold stocks. Will it occur immediately? No. Might gold retest support before it continues? Yes. But I believe that we are beginning to witness a little tiny bit of disintermediation out of the treasuries in favor of gold and I think that is extremely bullish.
CK: Rick, let us talk about the move that happened last week where gold at one point during the day was up about $60. For gold bugs it is a little bit unusual in that an upward move like that has not been seen maybe since the end of the last part of the bull market cycle in 2011. It was kind of reminiscent of those exhaustive moves where you had gold shooting up $50, $60 an ounce back when gold was at $1,900 or around there. I talked to a couple of my buddies who are bullion dealers just earlier today and they said that it was not too much new investor interest coming in and buying the gold. But they did have many of their existing clients calling in and loading up on gold that day which I guess indicates the retail audience. Maybe it was not too much of a part of that move. Maybe I am speculating. But what did you make significance-wise of that $60 move?
RR: I think there are three parts of the story. One, there was relatively good physical demand. But more importantly is I think you saw short covering. I think a lot of momentum-style investors, institutional investors were short gold. We speculated last year that at some point in time the shorts, given the outside short position, were going to have a religious experience, and they had a bit of that. I think we had a classical short squeeze. But the other thing is remember that the certificated gold products, the ETFs, GLD in particular, have witnessed dishoarding. That is they have witnessed really substantial selling for 18 months. There has been an absolutely incredible influx of cash into GLD. The consequence of that is that GLD has to take on gold or has to take on gold depository receipts.
Remember that for the last six or seven years the paper market has driven the physicals market and the paper market itself has been driven by the ETFs. ETF demand is positive now rather than negative, so the ETFs are stocking rather than dis-stocking or destocking gold. I am inclined to believe that the paper markets will now take gold up the same way the paper markets took gold up in 2009 and 2010 rather than taking gold markets down.
CK: Okay, it appears from our discussion here so far that gold may retest its low. You seem pretty optimistic particularly if the US dollar continues its rollover and does not spike back up on to the gold stocks. I hinted at this on my first question, but we have had that drastic move where we have seen several of the majors and the mid-tiers move as much as 50, 60, 70%. If now is not the bottom it would certainly not be a very good time to buy for people are not positioned yet, but at the same time if the bottom is in you do not want to miss the rally. Where do you see the gold stocks at at this point?
RR: No hurry on the big ones and the intermediates. I think the offer that you saw the other day of Franco Nevada is indicative of what you are going to see. The gold mining industry had a very close brush with capital inadequacy and the increase in demand for gold equities is going to be met by an absolute rush of bought deals among the seniors and intermediates. That is not to say that there will not be sufficient demand, but there is going to be a lot more supply than you think. The Canadian dealer network is extremely efficient in providing paper to a market that needs it. Longer term, my suspicion is that the gold— and by longer term I only really mean a year or year and a half, at all levels I think is going to be relatively attractive.
I think that some of the lessons that should have been learned in the down cycle, some of the stupid capital deployment decisions that were made, some of the decisions with regards to mergers and acquisitions, I think some of those lessons will be learned at least temporarily. I expect the industry to avoid making disastrous mistakes for at least two or three years. The consequence of an increasing gold price and increasing free cash flow per share that is not wasted for two or three years should be an increased cash flow on a per share basis, not an aggregate basis. I suspect that an increasing gold price and increasing corporate performance will have a very good impact on gold equities.
You will recall, Collin, that in the early part of the last decade we had a rapidly increasing gold price. But ironically the producers raised so much equity and misallocated so much equity that despite the fact that we had a gold price that ran from $260 an ounce ultimately to $1,900 per ounce, ironically, free cash flows per share declined. I think that the lessons of that misallocation of capital as I say are fresh enough that at least for the next two or three years the industry’s memory will inure it for many really stupid mistakes and the shareholders should benefit.
RR: Okay, thanks for that Rick. As we may have hit a bottom in the mining sector or certainly near I think it would be prudent to direct some of today’s discussion towards how to best select stocks and obviously this is something that is very individualized. Every individual is looking for something different in the space, so we will have to keep it at generalities. First question I want to ask you is regarding the majors and we cannot box all majors into one, but a lot of them made these notoriously bad acquisitions do not have the cleanest balance sheets right now. Is the major space something that you would allocate capital to?
RR: The answer to that is yes. I think that the major space will stall a little bit because of issuances. But I definitely would look at the seniors. Remember that when gold moves the first thing that moves is gold itself. Listeners to you that are underinvested in gold either as a speculative instrument or as a core asset in their portfolio need to address that and to begin to buy the gold.
The second place that you go is, of course, the senior producers, the high quality senior producers, the senior producers that have balance sheet flexibility that generate free cash and that have growing revenues. It is important that you do not buy the waterfront; particular that you buy the best issuers. I would draw your attention these are not recommendations. I would draw your attention to names like Franco Nevada, Goldcorp, Randgold; companies that have a history of operational efficiency, capital discipline, good balance sheets, and relatively low costs. One then can apply the same discipline in the intermediate size producers which generally come up after the big producers.
Of course, the most spectacular moves, Collin, are always going to be in the speculative stocks. I suspect that we will not see a move, a real move, in the speculative stocks for as much as nine months. Of course, extra caution is required buying the speculative names. But for those listeners who have been in the game as long as some of your listeners have, who have paid the tuition, who pay attention to the numbers with regards to the juniors rather than the narratives, I think this will be a spectacular market. It is really important, Collin, to understand the depth and severity of the bear market and what that means for the bull market.
In the juniors, measured by the TSXV, this is a market that fell by half and then it fell by half again and then it fell by half again. This is a market that is down by 90% in real terms which means it is precisely arithmetically 90% more attractive than it was in 2011. This is a market that can double and make up as a consequence of doubling 15% of the decline that it suffered. This is a market that has a long, long way run if you select your stock correctly.
CK: Okay, and I want to ask you about streaming and royalty company. Some of them could be categorized as majors by their market cap. We did a chart a few weeks ago on Palisade Research that showed that these streaming companies have performed better than the majors over the past four and a half years of this bear market, which leads to my question will they underperform the majors coming out of this bear market?
RR: That is really good instinct that I do not happen to believe is correct for one reason. Remember that the royalty and streaming companies have no sustaining capital requirements, so their margins are incredible. They are in one sense better, pure vehicles with less operational and implementation risk. But what is much more important, Collin, for your listeners to understand is once in a generation opportunity, an arbitrage opportunity. The base metals mining industry is producing virtually every commodity that they produced at a loss right now. The need for capital in the base metals mining industry is extreme and their cost of capital is extraordinary.
Precious metals by-product streams in a base metals cash flow wrapper, a wrapper like Freeport or Vale or Vedanta or Czech command a six or seven times cash flow multiple. That is that revenue generates, Collin, is seven multiple. That same cash flow stream stripped out, made into a precious metals stream, in a company like Royal Gold or Franco Nevada or Silver Wheaton commands a fifteen to seventeen times multiple. The base metals mining industry needs to find $10 or $12 billion in equity for sustaining capital investments and debt pay downs, and the lowest cost of capital available to it is by selling these precious metals streams. At the same time that the sale of this stream is accretive to the base metals company, it is also accretive to the precious metals streaming company by giving them access to sustainable visible cash flows for very long periods of time on very high quality mines.
The recent success you saw in the bought deal by Franco Nevada and the upcoming, I believe, debt issuance by Franco Nevada herald in a period of time where as much as $10 or $12 billion worth of by-product precious metals streams passes from base metals mining companies to precious metals streaming companies which will set up the visibility of per share cash flows and per share dividends in the streaming companies almost irrespective of the precious metals price. If you get this increased quality and increased visibility of a revenue stream and you combine that with the upside in precious metals prices, both in terms of the free cash flow that these companies enjoy from the mineralization that is already economic and combine it with the optionality of mineralized material in these mines that is not economic at $1,100 but would be economic at $1,500, this has the potential to really transform the streaming business which is already very attractive in an absolute sense and particularly attractive in a relative sense against other mining companies.
CK: Another set of companies that you have been vocal on over the past couple of years is optionality. I do not want to focus too much on this but maybe provide a teaser as Sprott will be putting out a piece around the same time this interview is released focused solely on optionality. But, Rick, if you can maybe define briefly, as you have in the past, what makes an optionality company. Exeter, Tower Hill Mines, Chesapeake Gold, just a few at the top of my head, maybe as examples of what fits it and talk about investing in optionality companies.
RR: Sure, Collin. I love optionality. It has treated me so well. Just to acquaint your listeners with why the subject means so much to me, I think back to the last cycle, 1998 to 2002, and, frankly, to the cycle before that, 1991 to 1992, I can think of optionality companies like Silver Standard, $0.74 to $45; Pan American Silver, $0.50 to $45; Lumina Copper, $0.65, if my memory is correct, to $160. This is not a typo, Collin. Paladin uranium, $0.10, in fact, as low as a penny and a half to $10. How did these moves take place? It is pretty simple. At the bottom of the cycle there are very large deposits that were drilled off with the application of tens of millions of dollars that have no net present value at the then prevailing commodity prices. These deposits are occasionally sold for some amount of money that at least resembles the net present value which is zero.
I remember, as an example, Ross Beaty, buying copper deposits that majors had spent $90 million on and he buy them for $2 or $3 million because these deposits at the then prevailing price of copper were worth nothing. But if the price of the commodity contained in the deposit goes up and these very large deposits are suddenly economic the increase in value can be truly astronomical, along the lines of those which I have already shared to you. What is important, Collin, in an optionality company is that you preserve the optionality.
The most important thing a management company can do if they control a very large drilled off resource that is not economic at current prices, but could be economic at foreseeable prices, the most important thing they can do is nothing. Almost every dollar that you spent “beneficiating” that deposit requires the issuance of equity which lowers the existing shareholders proportional ownership of the optionality. It is very difficult to convince operating management teams to do nothing and even more difficult, even more difficult, to convince them to get paid appropriately for doing nothing which is not much.
My suspicion is this round what needs to happen among the optionality companies. The second tier optionality companies, and we can name some good names, is that they need to find a way to emerge. They need to find a way to lower the general and administrative charge measured per ounce in the ground, and also give themselves a number of projects so that when the metals price increases and their cost of capital decreases that they can focus their efforts on the best deposits.
People who criticize me for my optionality thesis point out to me that each of the companies I named, Silver Standard, Pan American, Lumina Copper, all beneficiated their projects ultimately. That is they all raise money and begin to do additional drilling or took steps to advance the projects to production. What the detractors failed to note is that they did not do that. They did not raise additional capital. They did not spend money until the move in commodity prices had begun and until their share prices had escalated by 400 or 500% thus greatly reducing their cost of capital.
The right thing to do right now for these companies is to acquire additional ounces and do nothing else. Beneficiate the projects later as the commodity price rises and the attractiveness of the deposits is obvious to the markets and the cost of capital goes down. I suspect – I do not know Collin because past is never completely prologue – but I suspect that the easiest and the most dramatic upside that we will experience in this market other than the occasional discovery will be from optionality, provided that the management team really understands how to deliver the benefits of optionality to the owners of the company, the shareholders.
CK: Rick, when I think of optionality plays right now and I can come up with Tower Hill or Exeter as two examples, they are both projects that are rather developed. Maybe more drilling could be done. That begs the question when you are looking at optionality plays, are you looking for something that is not fully developed in that by further beneficiating the project as the bull market returns they will really the value added or are you looking at projects that are already potentially fully developed at PEA level and are just far away in terms of price, the commodity from actually getting financed?
RR: Well, my preference, Collin, of course, would be a project that had a feasibility study done and was permitted. I seldom get that. What you want is a fantasy; what you can have is what is important. Certainly, the more advanced the project, the more work that is done, the less time and aggravation standing between you and production or you and the sale of the project when the market returns to viability is the best. But what one needs to look at, Collin, really is a matrix depending on the size of the deposit, the availability of the data, the upside that may exist in the deposit as a consequence of additional drilling or beneficiation, the upside which may remain in the project by delivering a feasibility study at such point in time where your cost of capital is low enough to afford it. Then, of course, the wrapper that it is in, the market capitalization of the company and the so-called redundant assets like cash, the thing that precludes you from needing to dilute in order to maintain the general and administrative expense associated with keeping the company. There is no one size fits all answer. There is a matrix of factors that go in to constructing an optionality portfolio.
CK: Okay and one last section of the market that I want to ask you about. Is the junior, micro cap junior stocks, which you have already noted probably will not move for at least another nine to twelve months, and what we have talked about in the past is the power of warrants associated with these small companies. I want to ask you if there is any reason for an investor entering right now aside from potentially wanting immediate liquidity to not participate in a private placement and get those warrants. Can you advise people in any situation why you would not want warrants right now?
RR: Well, remember that not all opportunities are created equal. There are a lot of companies that are going to attempt to do financings because they need the money that will offer warrants when the underlying security is valueless. Having an option on a valueless opportunity, of course, has no value. Not all private placements are created equal. For clients that are either discerning themselves or have access to discerning brokers and have the ability to participate in private placements with warrants, it is like an aftermarket opportunity but an after-market opportunity on steroids.
Remember that you make money in the microcap sector as we discussed on your show before, Collin, by answering unanswered questions. Answering unanswered questions takes money which is why the private placement gets raised. If you contribute to capital for what is potentially a catalytic event for an issuer you ought to be rewarded in a disproportionate way. The warrant is that way. It is the right but not the obligation to participate in the value that you created after the value has been created. Now that does not suggest that investors need to confine all of their activities to private placements. We saw a couple of weeks ago how a little tiny bit of interest could catapult the market capitalizations of various small market cap stocks.
I was at Roundup, a technical conference in Vancouver, and there was a couple of issuers there Kootenay Silver and Northair Mines that announced an amalgamation. I think the combined market caps of the companies were about $8 million and a $30,000 buy order took the price of Kootenay Silver from $0.20 to $0.32. We are in a market where, yes, the buyers are exhausted but the sellers are exhausted, too. You will see evidence of $3 and $4 million market capitalizations in companies that used to be $70 million market capitalizations getting outsized moves simply because there is a bid of some sort.
That is not any reason, Collin, why your listeners should go out and buy the waterfront in terms of juniors. It just goes back to the point that we made earlier in your show that a market that fell by half and then fell by half and then fell by half can double and have a very long way to go. The best way to play it for sure via private placements and the best, most viable companies that you can, with long-dated warrants so that you get the retroactive right to take advantage of the value that you created. But there will be other opportunities, too, in this market simply because of its extraordinarily oversold nature.
CK: Thank you for that, Rick. I want to ask you one final question. I like to throw an interesting question into the end of each of our interviews. This week I want to ask you back in 2000, gold was trading below $300 an ounce and uranium was hovering around $7 a pound. At the time the minerals were still being produced. Some companies, while maybe limited, managed to make a profit. I can understand and wrap my head around the fact that inflation and inflation alone would drive the cost of production up to the point where uranium at $35 per pound and gold at $1,200 an ounce is causing so much damage to these producers. My question for you is has inflation really been the sole driver of this phenomenon over just 15 short years?
RR: As usual, Collin, a very perceptive question. You are to be praised for it and the answer to that is no. There are a myriad of impacts. The most important one is stupid investment decisions by management teams and absolutely promiscuous provision of capital to the industry by investors and investment banks. A second would be, Collin, the fact that during periods of low commodity prices, the industry to be charitable mines material were the mine grade exceeds average resource grade. That is a fancy way of saying that they high grade. In other words they buy their best material so that they generate some free cash and not inconsequentially management salaries.
What happens when you do that is that you have the appearance of being profitable during periods of low commodity prices, but you greatly restrict the yield from the rock when you have to go back to mining what is no longer average grade but rather is below average grade as a consequence of you already having harvested the high grade pockets. A lot of the response that we saw in terms of the increase in unit prices in the middle part of the last decade was the fact that we had mined the high grade eyes out of deposits during low commodity prices in an attempt to generate cash and pay salaries and the same thing is happening today, Collin.
CK: Okay, Rick, many thanks for coming back on the program and spending a solid half hour with us answering my questions. Looking forward to getting you back on the show next month.
RR: Always a pleasure, Collin. If I might leave one commercial, any of your listeners who want to be in contact with me and ask me questions directly I am available at rrule, that is R-R-U-L-E @sprottglobal.com. Thanks as always for the perceptive questions, Collin. It is a pleasure to have discussions with you.
By Palisade Radio