Rick Rule: Play Metals Stock Volatility to Win
Source: Special to The Gold Report (9/2/11)
In March of 2011, Global Resource Investments Founder and Chairman Rick Rule predicted a time of unprecedented volatility. As investors struggle to recover from what, indeed, turned out to be one of the most up-and-down months in history, this special Gold Report from his latest web broadcast outlines his secrets for using volatility as a tool to take advantage of new opportunities.
First, he outlines the reasons for the volatility. Rule doesn't see a recovery in the United States. "I see government-induced liquidity in the market and I see some recovery in equities prices as a consequence of very, very, very low—make that negative—real interest rates as well as hope on Wall Street and in Washington," he says. The problem with this paper recovery is that liquidity wasn't what caused the recession. The issue is that individual and government balance sheets are unbalanced. Many of the assets are ephemeral. Unfortunately, liabilities are almost always real. "As a society, we owe an amount that is unserviceable relative to what we produce," he says.
By encouraging people to spend more money they don't have, the government is making the problem worse. Instead, he thinks people should rebalance their balance sheets and invest more in this country. "The idea that we can fix the fact that we owe too much money by encouraging borrowing and spending is an example of the idiocy that comes out of Pennsylvania Avenue and will continue to weigh down the recovery." He says, "Until we deal with the problems that confront us in society, we are not going to have a U.S. economic recovery."
Rule points to a war against savers. "The Fed has declared war on productive elements of society in order to distribute the benefits to the less productive elements of society. This is not the key to prosperity." Drilling down interest rates punishes savers and rewards spenders. "This is perverse, truly perverse," he says. He equates "quantitative easing" to a fancy way of saying "counterfeiting." Increasing the nation's money supply without increasing society's ability to create utility through the provision of goods and services is simply fraud. You can't maintain the value of a currency unit if you create it out of thin air far in advance of the society's ability to generate value. That is true in the U.S. and abroad. "I have always said that the U.S. dollar is the worst in the world except perhaps for all the others," he jokes. Rule is not alone in his low opinion of paper currency. Casey Research Chairman Doug Casey famously noted that the U.S. dollar is an I.O.U. nothing. The euro is a "who owes you" nothing. "It's an artificial construct," Rule says. "Europe truly is the triumph of politics over economics."
One example of the irrational European economic policy now in fashion is the decision to "bail" Greece out of the trouble it was having servicing debt that was 150% of GDP by requiring the struggling country to service debt that is 165% of GDP. "I defy the European Union to explain to me how by adding a big column of negative numbers they end up with a positive number; very, very, very problematic," Rule says. And, problems get deeper. "Because of the extremely close ties between the big banks on both sides of the Atlantic with large amounts of primary capital represented by sovereign debt, many of the large private sector banks have multiples of shareholder equity invested in securities by issuers like Italy, Spain, Portugal, Ireland and Greece that are insolvent. This means by real accounting standards most of the big banks in Europe are broke."
This economic reality doesn't mean that banks are going to fail any time soon, Rule explains. It simply means that the shareholder's equity in the bank—the value of assets minus the value of the liabilities—is probably negative if the securities that these banks have in sovereign—as opposed to solvent—issuers were removed. "The test going forward will be the test between those two words," Rule says. "Sovereign does not make solvent." He takes issue with the words of the famous CEO of Citicorp, Walter Wriston, who said countries don't go broke. "That was wrong. Countries do go broke. Countries will go broke. The question in Europe now is whether the savers—Finland, Austria and Germany—will decide that they and their children are going to carry the lifestyle of the rest of the Europe."
The discussion going on in Europe right now is the same as the one going on in the United States, he says. "Who should benefit from production—the producer or the non-producer?" He points to a war worldwide between these two factions. "Sadly, non-producers outnumber producers and, in a democracy, the war is often won by the non-producer." He likens democracy to a vote by five coyotes and a lamb over what to have for lunch. "That's really the nature of the debate that's taking place in the United States and Europe today."
"The good news about China," Rule says, "is that over the last 30 years the place has become more, as opposed to completely, free. More than 30 years ago, Deng Xiaoping, then leader of the Chinese Communist Party, said 'to become rich is glorious' and China has become very glorious as a consequence of that." Ironically, in this allegedly Communist country, there is no social safety net, meaning that people are on their own in China, Rule says. "As a consequence, savings are extraordinarily high, as much as 40% of a household income. So, China is generating enormous, enormous, enormous savings in direct contradiction to us, of course."
Rule also points to more capital investment-friendly tax laws in the East. "In the United States if a big producer builds a big piece of manufacturing equipment, it may be required to amortize that equipment for tax purposes over 30 years. In China, that same producer is allowed to expense the equipment, meaning that there is a huge incentive to add the capital necessary to raise the utility of the workers operating that machinery. China is much, much, much friendlier to capital formation. The United States is much, much, much friendlier to consumption." For these reasons and many more, Rule says "China, India and the frontier markets appear legitimately to be on the road to progress—a very different road than their European and North American cousins appear to have chosen."
But, all is not bright in China. "Some 10,000 people rule 1.3 billion people and official sector misallocation is always a threat. The government decides what sectors should succeed, what sectors should fail. Expect the road to progress in China to be bumpy," Rule warns.
The combination of domestic and international challenges on the horizon set the stage for more volatility, Rule concludes. "So many black swan events are looming that they resemble a flock of black swans. The idea that one of those black swans could precipitate an event like the '07–'08 liquidity crisis appears to me to be a very, very, very good possibility." He goes so far as to suggest that in the next 18 months to 2 years, we could see a shut down for some period of time in interbank lending and frozen debt market liquidity. "In that set of circumstances you would want to have some cash," he warns.
Golden (and Platinum) Opportunities
All of this darkness could shine a light on the metals—gold, silver, platinum and palladium, Rule says. "The most important part of the pricing of these metals is the continued debasement of fiat currencies. Metals prices worldwide are denominated in U.S. dollars. If the value of the denominator itself continues to decline, which I think it will, the nominal price for precious metals should continue to increase." The increase may not be steady. "I suspect that these prices both up and down will be volatile for a few reasons," Rule says. "Gold markets in particular, maybe silver markets as well, are determined by both of the primary economic motivators in the world—greed and fear. A raging bull market, which I think we might get into, compels people to buy gold bullion because they are afraid of the depreciation in dollars. This, in turn, stimulates the greed buyer who buys simply because the price went up and he or she understands the thesis. The price escalation in bullion that was driven by the greed buyer reinforces the fears of the fear buyer. And, the prices reverberate higher and higher as fear buyers and greed buyers compete with each other. That's the market that we saw in 1979–1981—the single strangest bull market that I have experienced in my career. I suspect that we are likely in the early stages of a market that resembles that."
The second set of circumstances Rule identifies as pushing gold prices up over the next year is supply-based. "In classical economics you are taught that higher product prices lead to increased supply. Because mining is a capital-intensive business, the response of the producers to increased commodity prices is not direct or immediate, particularly if interbank lending dries up debt financing needed for the large capital-intensive projects. There will be supply constraints that are, in some fashion, artificial."
For supply-side reasons, Rule is increasingly attracted to the platinum business. More than 80% of platinum and palladium—PGM metals—come from three countries: South Africa, Zimbabwe and Russia. He cites local political turmoil as a limiting factor in the continued production in these areas. "Increasingly, South African governments are calling for more social rent—higher taxes, government participation in wage negotiations and, in some cases, outright nationalization. This will absolutely constrain the industry from making the investments in increasing production and sustaining their existing production over the five to seven years. Given that South Africa is the most important platinum producer in the world and it's highly likely that the South African platinum producers will continue to constrain working capital investments, I would suspect that on a five-year going forward basis platinum production will falter."
Moving north to Zimbabwe, Rule is no more optimistic. "President Robert Mugabe and his associates stole everything in the country that had any value. Now they have decided that about 150 people should control 51% ownership of the platinum mines in Zimbabwe. If you look at the track record of the black political elite in Zimbabwe managing the assets they have stolen over the last 20 years, you will see that the potential impact on platinum supplies as a consequence of their stealing productive capacity will be catastrophic."
Rule sees Russia as a bright spot. "Russia gets slowly better over time. Yes, there are problems. The place is corrupt. They tend to attempt to mediate commercial disputes by shooting each other. There are problems with alcoholism. But, gradually things are improving in Russia. The difficulty isn't Russian politics, but the fact that the big platinum and palladium producer there is running into lower and lower grades and having to go farther and farther down in the mines. Its production problems are organic as opposed to political."
The bottom line for Rule is that there are going to be supply-side challenges in the platinum business at the same time that demand for platinum both as a precious metal for investment purposes and as an industrial metal for auto catalysts continues to increase. Rule acknowledges that a slowdown in the economy in Western Europe and North America will constrain vehicle demand there, but cites exploding vehicle demand in emerging markets, particularly China and India. Western air quality standards being imposed in both of these countries means that auto catalysts using platinum and palladium have kept pace with vehicle sales in those markets. "Strong demand and declining supplies point to very, very, very interesting opportunities in platinum markets," he concludes.
Good news for commodity prices has not always translated to rising junior mining stock prices. Rule sees four reasons for this disconnect. The first is historical. He credits the dramatic rise in precious metal stocks five years ago to an anticipation of the increase in bullion prices. "Some of the reaction that you might have expected in the equities prices might have occurred before the event took place," he explains.
The second reason is what he calls "dismal corporate performance" over the last 10 years. "One would expect with the gold price increasing from $260 an ounce (oz.) to $1,800/oz. and silver increasing from $4/oz. to $40/oz. would result in absolutely skyrocketing free cash flows generated from the companies, but that didn't happen. The operating response relative to the increase in product prices was, to be charitable, anemic." The financial services industry, which had spectacular cash-generating expectations based on the returns of the 1970s, has been particularly disappointed. "There has been widespread disgust among gold share investors to the cash-generating performance of the companies relative to the escalation in their product prices," Rule says.
The third factor is sector market-cap explosion. "Issuers—the mining companies and their cohorts in the financial services community—were engaged in inflation in the same way that governments around the world have issued lots of paper. Mining companies have issued billions of shares so that although the share price escalation has not been dramatic, the combined market capitalization of the precious metal sector producer, developer and explorer has grown at an extraordinary pace. There are many more issuers now than there were 10 years ago and every one of those issuers has many, many, more shares outstanding. You have to be very careful when you buy these things."
The fourth point Rule makes is another cautionary one. "In the junior exploration sector, as many as 90% of market participants have absolutely no value. They are worth nothing. So, the sector as a whole can't experience dramatic price appreciation when 90% of the paper in the sector is counterfeit or valueless. In fact, the gold shares are suffering from the same type of value depreciation as the U.S. dollar. You need to pay particular attention to defending yourself and your portfolios from these valueless, zombie security issuers."
Rule stresses the importance of carefully evaluating a portfolio now, before the precious metals equity markets start experiencing price appreciation in the next three to six months. Why now? "Any price appreciation anticipation is over," he says. "There is no premium built into the metals prices relative to the commodity anymore. In fact, this disparity has been noted. We think for the first time in some time the precious metals equities are reasonably priced relative to the metal itself," Rule says.
Rule is also more positive on the issue of executive competence. "Corporate performance, which has lagged terribly over the last five years has begun to increase," he says. For the last two or three years, the industry as a whole has generated about $2 billion (B)–$2.5B a year in surplus cash. This year, he expects the industry to generate between $4.5B–$5B, a clean double in 12 months. "The performance that hasn't occurred hitherto is beginning to occur now," he says. This cash on company balance sheets will enable them to do many things—greenfield and brownfield developments in their own portfolios along with mergers and acquisitions.
These are all positives for company prospects, Rule says. "We are now truly in a discovery cycle. For the last nine years the exploration industry has been well funded and well staffed. That spending cycle is beginning to yield discoveries. There is nothing, nothing that adds both liquidity and courage to junior equities markets like discovery." Rule points to the last discovery cycle in '95 and '96 when some stocks went from $0.30 to $30.00 in 19 months. "My suspicion is that the underperformance of select precious metals equities for the next three to six months is over. Will it be volatile? It will absolutely be volatile. But, the fact is anticipation is no longer in the market; there isn't a bullish outlook, which perversely is good. There is liquidity in the system. There is the will and the urge to merge so consolidation will take place. And, all of this will be punctuated by discovery."
Rule also advises balance when it comes to choosing between seniors and juniors. "For those of you who are investors, for those of you who look at a return on capital employed rather than praying for a return of capital employed, you would go to the senior producers and the senior producers would do well. We particularly favor acquisition strategies that involve buying select seniors and your global broker can help you in that selection. And, then selling puts and calls against core positions. That is, allowing the market to pay you to buy low and sell high or acquiring the position simply by selling a put. We think the seniors are uniquely priced. We don't think, by the way, that you pile in and build 100% position right now. We think you take a third position or a half position relative to where you want to end up because we are going to experience incredible volatility. But, we think this is the time to begin to establish positions."
Rule cautions that investors need to be willing to take more risk with juniors. "The volatility will be more pronounced the farther out the quality scale you become. But the potential for reward is outsized too." He anticipates a lot of mergers with juniors acquiring each other and juniors being acquired by the intermediates and intermediates and juniors being acquired by the seniors. "Given the relative underperformance of the juniors this year to last year, in November and December of this year—during tax-loss selling seasons—could be a once-in-a-decade acquisition opportunity."
Rule ends by reiterating his words of warning about the volatility in the air. "This will not be stair steps to heaven. This market will not go straight up. The buzz word and I'm going to say it again and again and again in this broadcast is going to be volatility." Again, he looks to the past to illustrate what could happen in the coming year. "Some of you will remember the 1970s bull market in precious metals when the price advanced from $35/oz. to $850/oz., a truly breathtaking ascent. You need to bear in mind that in 1975, in the middle of that ascent, the gold price fell from $210/oz. to $104/oz., a 50% decline. And the share price decline in the mining shares was even more dramatic. Did it matter over the course of a decade? No. Did it matter to people who suffered through the decline personally? Absolutely. So, while we think the sector is a good place to be don't think of it as a place without risk."
Founder and CEO of Global Resource Investments (GRI), Rick Rule began his career in the securities business in 1974 and has been principally involved in natural resource security investments ever since. He is a leading American retail broker specializing in mining, energy, water utilities, forest products and agriculture. Rule's company has built a sterling reputation for its specialist expertise in taking advantage of global opportunities in the resources industries. Last month, Rule closed a landmark deal with Eric Sprott, another famous powerhouse in the arena. With GRI now a wholly owned subsidiary, Sprott, Inc. manages a portfolio of small-cap resource investments worth more than $8 billion and boasts a workforce of more than 130 professionals in Canada and the U.S. This article is based on Rule's August 31Global Resource Investments webcast. Listen to the entire webcast.
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