Right on the heels of the Republican and Democratic National Conventions, the recent Casey Research Summit in Carlsbad, California—cosponsored by SprottGlobal—focused on a timely theme: "Navigating the Politicized Economy." The somber revelations of the summit contrasted with the buzz of the party conventions. The Gold Report sat down with Louis James, Casey Research's chief metals and mining investment strategist, Rick Rule, founder and chairman of Sprott Global Resource Investments and chairman of Sprott US Holdings, and Marin Katusa, Casey Research's chief energy investment strategist, to discuss how investors can position themselves in a politically driven economy.
The Gold Report: Before we get into some of the nitty-gritty from the summit, could you give us a big picture of the troubled economic waters we'll have to navigate if we want to stay afloat?
Louis James: When we said "Navigating the Politicized Economy," we weren't just talking about regulatory burdens but also about the overall response of governments around the world to the crisis that we've been calling for many years. That's the context. It's about how the world is responding to crisis. The response is political and very feelings-driven. It's not a rational or scientific way of optimizing outcomes. It's political, which means pandering to voters, which means doing whatever the larger number of usually less-informed people want as opposed to whatever science or engineering may determine is an ideal way to approach the issue. That's scary. How you deal with that is more of a philosophical than an engineering question: how do you personally plan your life, given a world in which everything is more political every day. I think everybody should be asking that question.
TGR: The Bureau of Labor Statistics jobs reports certainly always have political implications, and the news for August wasn't good. The 96,000 jobs added were well down from 141,000 in July and not nearly enough to keep pace with population growth. The unemployment rate fell somewhat, but only because more than half a million people quit looking for work and are no longer counted in the tally. Is the dismal jobs report what prompted the gold price to jump up to $1,740/ounce (oz)? The daily headlines coming from Europe? Or do you suppose gold's found a new bottom?
LJ: It's not just the jobs report and other economic indicators that affect the market and the prices of gold and silver. In today's market, it's the way they relate to the probability of more quantitative easing (QE). It's the mounting pressure for the Fed to do something. People watching this are saying it's likely the Fed will inject more liquidity, which would be bullish for commodities and particularly bullish for precious metals. But if the Fed doesn't do what's expected, those gains could reverse quickly.
Ultimately, over the long term, we think inflation always wins. The government is between the rock and the hard place. Inflation is the easiest way out. People who think Republicans will embrace great fiscal discipline and put the economy back in a belt-tightening mode and build savings for the future and real capital accumulation for investing—they're dreaming. It's not going to happen.
Long term, we remain extremely bullish for all commodities, particularly the precious metals but near term, things can vacillate and fluctuate quite a bit. If for whatever political reasons the Feds don't announce what people are speculating about, it could be bad. On the other hand, with a formal announcement about hundreds of billions of dollars of QE, the next uptick would dwarf the recent rise and could easily take us to new highs.
It's important to think long term, But as speculators, we're aware that in the short term, we seem to be coming out of a correction. If I had to go out on a limb, I'd say we probably have seen the bottom and we probably will see the QE. I don't know that I'd push all my chips to the center of the table, but I certainly wouldn't want to be out of the market at this time. (NOTE: The Fed did act as expected—it's now a fait accompli. . .)
TGR: Do you agree, Rick?
Rick Rule: Basically, I do. As we learned in Lacy Hunt's and Eric Sprott's fine presentations at the summit, the total unfunded liabilities on the U.S. balance sheet are somewhere between $85 trillion (T) and $200T, and growing—by about $1T/year on an on-balance-sheet basis, and $8 billion (B)/year on an off-balance sheet basis.
Gold and silver traditionally do well during periods of instability, turmoil and fear. I suspect that the political debate in the U.S. for the last few weeks has provoked some measure of fear in others, as it has in me. The specter of Obama vs. Romney feels bleak, so I understand the response of gold in that respect.
Often overlooked is the fact that the opportunity cost associated with holding gold is very low now. In its war on savers and driving down interest rates, the government has cut the costs for people to hold gold, assuming they hold it on a leveraged basis. It also used to be a disincentive to holding gold because it didn't pay any interest. Well, nothing else pays interest now, either. So if you think about holding gold in the context of the opportunity cost, that cost has disappeared.
I also think the recent spike in the gold price reflects the fact that some of the market has figured out that the government is trying to solve a solvency issue with liquidity. When one is deep in the hole, it's wise to stop digging. Also affecting the gold market is the realization that as weak as the U.S. dollar is—the joke is it's the worst currency in the world except all of the others—it has no obvious competitor in terms of the world's reserve currency. Historically, of course, gold has been a store of value as well as a transfer mechanism. It's the only common payment mechanism in the world that isn't a promise to pay but rather constitutes payment itself.
Marin Katusa: I don't know if I agree 100% with what Louis stated about having seen the bottom. I personally don't think we've seen the lows yet. Many funds that carried the last leg of the bull market in juniors have blown up. Yes, the stocks gained recently, but volumes and dollar amounts are nowhere near where they were in mid-2010 to mid-2011. I believe we're in a "pick right, sit tight market," but not in the beginning of the next leg of a sector-wide bull market. Tax gain selling season is looming. I don't think we've seen the end of the deflation in resource equities.
LJ: I'm thinking about the gold juniors in particular. We have what appears to be this macroeconomic thing, the impending liquidity, which I think is very bullish. We've also had some spectacular discoveries and, at last, some merger and acquisition (M&A) activity that has generated real excitement, which has been absent from our sector for most of the year. That makes it feel bottom-ish to me. Obviously, nobody knows, but I'm willing to go out on a limb and say this looks to be a good time to buy.
I understand the technicalities of what Marin is saying, but markets are rarely really about logic. They're very emotional. Momentum shouldn't play a role, but it does. To be clear, I'm not saying the bottom is in for sure, but my gut sense is that July might have been it. There are bargains out there now and I would not want to miss them. So at the end of the day, I'm agreeing with Marin: pick right, sit tight. Absolutely. But there's money out there that wants to be deployed. Some strong reactions we're seeing to good news from some companies show that there's money on the sidelines that's ready to come back into this sector.
TGR: But are they pricing in the higher resource prices?
LJ: I'm not sure they are, because the companies also have higher operating expenses. In addition, the capital to build big, new projects is really difficult to come by these days. So there's good reason for anybody who's paying attention to look at and balance the good and the bad.
RR: We represent the money on the sidelines. Sprott is sitting on about $700 million (M) in cash in permanent vehicles, looking to enter the market. In terms of the question of higher commodity prices, we need to remember the functional disconnect between the commodity prices and most juniors. Most juniors don't have gold; they're looking for it. If the price of something you don't have goes up, it shouldn't make any difference in your share price, although as Louis says, from a psychological point of view, it may affect perceptions.
It's important to note, too, that the sector is undergoing a money shift. Institutional demand has driven the type of stock that was popular in the market. Fund managers were looking for leverage to gold, which led them to high up-front capital costs, low-margin gold deposits. The industry managed to lose a fortune on those deposits in the last 10 years. Having lost billions of dollars for their investors, many institutions now don't have much left to invest. The drivers that existed in the market for the last decade are gone.
The people who have the money now are the industry itself, either raising money by way of equity or, in some cases, as a consequence of retained earnings or at least cash flow. Going forward, I expect financially accretive transactions rather than leverage to gold to drive the markets.
In a great speech at the Melbourne Mining Club, Nick Holland, the CEO of Gold Fields Ltd. (GFI:NYSE), talked about the total cost of production in the industry. Including acquisition, the cost is much closer to $1,200/ounce (oz) than $600/oz. The industry usually talks about cash costs, which is totally illusory. It omits the general and administrative (G&A) expense that goes into the mine, the upfront capital costs, the acquisition costs and, importantly, the $5B that the industry wrote off in the 1980s and 1990s.
So, extrapolating from the true total cost of production, the number of junior properties worth acquiring—acquisitions that would be accretive financially—is very low. So while the M&A activity that Louis talked about will surprise us in terms of premiums paid, it won't be as broadly spread as people might think. Maybe 30 or 35 properties are actually worth acquiring, and they will go at pretty prices.
That's going to be very interesting, and stock selection absolutely will be the key. I anticipate a near-term move in junior share prices as a consequence of the excitement we're seeing in the market, but I also expect the issuance of equity coming out of the junior sector to swamp any amount of demand possible. Given the current structure of the industry, the only limit to share issuances is the standing inventory of timber between Vancouver Island and Newfoundland. These juniors are truly stunning in their ability to make paper. Some 4,000 companies in Canada are lurching toward extinction because they couldn't raise any money for the last two years. They're like a bunch of small governments; they've spent and spent and spent money, but they didn't raise any.
But in terms of linking any major movement in the junior market to a higher gold price? No chance. Paper covers rock. Remember that game?
TGR: So no real upside?
RR: Yes, there is. I see three pieces. We're already starting to see M&A, with fancy prices paid. Secondly, Louis alluded to the discovery cycle we're in. The market rewards discoveries. In a terrible market, GoldQuest Mining Corp. (GQC:TSX.V) goes from $0.06 to $1.60/share, Reservoir Minerals Inc. (RMC:TSX.V) goes from $0.35 to $3.07/share, and Africa Oil Corp. (AOI:TSX.V) goes from $0.80 to $10/share. We're 10 years and billions of dollars into this exploration cycle. There are some good discoveries. They'll make more discoveries, and the markets will reward them.
We haven't talked about it much, but we're starting to see signs of a third thing: Sellers are exhausted. That the recent increases in share prices have been on stupidly low volumes suggests that the sellers are exhausted. In the names where there's really a reason for the market to go up, it will go up. The difficulty is that those reasons are scarce. Most of the speculators—and I use that term guardedly—have fallen. They have not and will not deliver a reason for higher share prices. They won't get rewarded, but the ones who do will truly surprise us.
TGR: You said earlier you expect a lot of equities to be issued. But with the explorer market still at a low with no signs of a rebound despite the enthusiasm about gold, what causes you to foresee all this new paper coming out?
LJ: When share prices are falling, the issuers say, "Last week it was higher, I'm not going to raise money now." To use one of Doug Casey's favorite terms, it's perverse psychology. People make their decisions based on what happened last week, not on what's going to happen. So, perversely, when the prices are falling, when they should be taking money while they can, the financings fall off. As Marin likes to say, "Friend or foe, take the dough."
MK: When the prices turn up again, if we're seeing a lot more positive psychology, everybody is going to try to finance, thinking, "Oh, it's better than it was. We have to get money now while we can."
RR: Managements get rational when their salaries are at risk. We're getting to the point now where finances are being stretched thinly enough that they see true fundamentals coming into play—private school tuition going unpaid, the leased car getting towed, the country club dues delinquent. They wouldn't have sold at $0.25/share when it meant they had to lay off the receptionist, but they'll finance at a nickel if their wife's Jaguar is going to get towed from the Safeway parking lot. That's just the way it works, and we're getting close to that. If they have the opportunity to do it, if there suddenly is some measure of hope in the market, if it's possible to finance their nickel, and if doing so saves their salaries for a year, they'll do it.
TGR: But if the institutions are out, as Marin has said?
MK: I never said that they were out. What I'm saying is we need a lot of new money to come into the junior sector to replace the invested dollars that have gone to money heaven, and new funds to replace the funds that have blown up. Some, like the fund I manage with Rick, have done very well, but at least with our cash, we're waiting.
RR: Most of the traditional institutional investors in the gold sector are out of money. They need fresh new flows of investor capital. A move in the gold price to $1,800/oz might help with that. But certainly more direct in terms of the nickel and the dime issuances, Fidelity or BlackRock or Front Street weren't going to do those anyway. It would be the rank-and-file punters and speculative brokers.
TGR: With another round of QE3 appearing imminent, with what's going on in Europe, with the recent jobs report, many people are speculating that the general market will climb at least until the elections. Would that bring money back in? Will punters come out with the rising tide?
LJ: If more significant discovery news comes out and generates excitement at the same time. Metals and mining is a drop in the bucket in comparison to the oil business. It's a very small market, and the gold subsector of that is of course even smaller. As Rick likes to say, a little bit of hope goes a long way, and it does touch everybody. In the same way that a Bre-X scandal can KO the entire industry, a Pretium Resources Inc. (PVG:TSX; PVG:NYSE) actually can uplift the industry—again, because it's such a small industry. And yes, that can enable everybody to raise money. At times, all you need to raise money in our sector is a pulse, and sometimes not even that. At other times, nobody can raise money on any terms.
TGR: Getting back to the navigating-in-a-politicized world theme, is there an investment opportunity today? Is this the time?
MK: It's always the time if you find the right companies. This is why I urge people to be very careful, patient and do their homework. The sector-wide bull is not there. It's company specific.
LJ: One more point. The speculative component goes away if the global economy visibly tanks or the wheels come off. So the near term certainly presents plenty of opportunity for lower prices, and this should be seen as a buying opportunity for the very best picks.
TGR: Last time we talked, you said risk mitigation is the key to success, but in a risky market like this, how do you do that?
MK: Many factors come into play. Louis and I have had the advantage of working very closely with and being mentored by both Doug Casey and Rick Rule, so I think the key thing is to first look at areas that interest you. At that point, determine your risk appetite as an individual investor and start doing your homework. It always starts with the people. That's the most important "P" of Casey Research's eight Ps of Resource Stock Evaluation. You also have to look at what type of investments a company is doing, its stage of development, financial metrics and so forth. Risk mitigation is complicated, but those are some quick and easy places to start.
RR: Another thing that many people can do to mitigate risk is hire help. For instance, if you can have 40 people in the Casey organization working for you six or seven days a week, and you get that help for the price of a $1,000 subscription that you can leverage against a $1M portfolio, it's pretty stupid not to do it.
Marin's point about people is key. These businesses are made by people. The deposit is important, but it isn't initially about the deposit; it's initially about the people. Another important factor in terms of specific company risk mitigation is balance sheets. When access to capital is uncertain, having capital is critical. In a capital-intensive business, if you don't have any capital, you don't have any business.
Then you get around to traditional securities analysis. You don't even necessarily have to get them right—just closer to right than your competitors do. Risk mitigation requires only knowing more than the people you're bidding against in the market.
TGR: But in any market you want to look at those sorts of things. Do you change how you invest in a volatile, risky market?
RR: I do. Volatile markets are very good for me. I like to buy stuff when nobody else wants to buy it. In the 1990s, those swings sometimes took years, and now they sometimes take weeks. The idea that I get more frequent sales, in other words, there are more frequent panics, is not anathema to me. It's nice for me. If the market gives me the opportunity to buy something at a 50% discount to what I think it's worth, I'm going to do it. As you get older, if you're successful, you learn that sometimes stuff is cheap enough. You don't wait for the absolute bottom. The fact that you get these opportunities more frequently is good.
TGR: How about the sell side?
RR: I've also had to be a more frequent seller. It used to be that for successful positions my average holding was something like 70 months. In the last two or three years, I've had situations in which every level of greed was fulfilled in three or four months. I guess that's wonderful, but certainly the volatility you talk about has changed my parameters.
TGR: Do you invest differently when it's a volatile market?
LJ: I'd say that when the risk appetite in the market changes, it changes what kind of investments we recommend. Volatility is our friend for the reasons Rick outlined. If you want to shoot for the 50-baggers or 100-baggers, you're not going to get them on multibillion-dollar companies. That means taking chances on a large number of earlier-stage companies.
But higher volatility generally means more risk aversion. Under those circumstances, we look for less-risky plays, so a development story rather than a grassroots story because the trend is well established. The share price trend in development-stage companies is well estabished; share prices spike on the discovery, decline during the "boring" engineering phase and then come up as the company ramps up to production. It's what Marin calls the pregnancy period, the nine months up until first pour.
For whatever reason, it seems to work out that way so it's a very reliable trend. If you can find a company with no discovery risk, with all the technical risk addressed, with the right people and a real project that will become a mine, the chances are very high that its stock will go up when the mine goes into production. So we'll look for much lower-risk investments of that nature when people are more risk averse, which tends to be when the market is more volatile.
Logically, the math says, stick with the plan; if you broaden your buying out, you can capture spectacular wins. It doesn't take many 100-baggers to pay for all the ones that didn't work out. This is basically what Doug Casey does, but few people have that discipline to do that, so we tend to alter our recommendations when people are more risk-averse.
MK: A volatile market doesn't change the way we evaluate companies. It changes the way we execute on the information.
TGR: Eric Sprott claims silver's the investment of the decade. To what extent have you rebalanced your recommendations toward silver?
LJ: It's accidental, but if you look at our portfolio, you might think we agree 100% with Eric; we sure have a lot of silver plays, and almost all our producers are silver producers. There was a time, post-2008 crash, where I absolutely agreed with Eric's outlook on silver. Because silver has its industrial component—as we all know it's a precious metal but it's also an industrial commodity that gets used up, unlike gold—silver sold off much harder in 2008 than gold. The industrial component brought the metal down, which I saw as a great buying opportunity. But I consider that to have been event-specific. Must the gold/silver ratio go back to the historic 17:1, or whatever? No. I don't see any magic in these ratios. They don't have predictive power. Silver is not only an industrial metal as well as a precious metal, it's also a byproduct. Large copper mines produce significantly more silver than silver mines, and most silver mines are actually lead-zinc mines with big silver credits.
Thus, we'll have silver production whether or not there's silver demand. It's very different from the gold sector, with a very different risk-reward proposition.
TGR: What about cash? As investors, what percent do you recommend keeping in cash right now?
LJ: Our general guidance is still one-third gold, one-third stocks that will do well in a crisis, and one-third cash. We're keeping a lot of cash because we can't discount the possibility of another 2008-style crash. Doug thinks it will happen. It may not be as acute as 2008, but I think it will probably be longer and deeper. If we get stupid prices on great companies, we want to have cash for that. And until inflation really kicks in, cash is not a bad thing to have.
RR: Functionally for me in the money I manage, 10% cash is float. About my lowest allocation to cash is 10%. And I'm about 35%. I would like to be more heavily invested now. I see more opportunity in the market, where I can be a private placement investor because I believe if one is a speculator, one has to get warrants. That's the way one operates in the market. I have been singularly unsuccessful at negotiating placements on acceptable prices and terms. As a consequence, my cash position has grown organically as opposed to strategically. I would like to be much more fully invested now than I am. I think market prices are reasonable.
TGR: What do you think, Marin?
MK: We've closed out a lot of the big gains and now have fewer than 10 positions in the newsletter. I'm looking to deploy the money and like Rick, I've been unsuccessful on the terms. That's also why I think we're also going to go lower. Between March 2009 and March 2010, I did more than 75 private placements. They were on good terms with full three year warrants, but nowadays, because I can't get those attractive terms with companies that meet my criteria, I'm just sitting on the sidelines.
RR: These cash holdings aren't strategic for either one of us. We're not following any methodology that says you should be one-third in cash. It's opportunistic. We don't have the opportunity in this market to deploy the cash despite the fact that the market has taken these companies' share prices down. So far, the management teams haven't been willing to accept placements on terms that we, as check-writers, find realistic.
MK: A strategic advantage of funds doing private placements is because most funds would move markets if they wanted to fill their desired position in a junior in the open market. So there is a lot of strategy plus the kicker of the full warrant.
TGR: You've often said, Marin, you have a program that does cash on hand versus market cap.
MK: We call it the Casey Cash Box.
TGR: Only a handful of companies had the cash on hand a couple years ago. Is the fact that there are substantially more of them now part of why you're unable to renegotiate?
MK: No. It's a different sector in that half of the junior mining companies have less than $1M in the bank. It's a very different market today, but at the low of 2009, in March, we had about one-third of all the companies on both the Toronto and Venture trading less than cash, which was close to 700 companies. Today we have just under 45.
TGR: Does it depend on when the CEO's wife's Jag is being repossessed?
RR: That's very important.
TGR: Thank you for your insights.
Hear the recommendations of all 28 experts at the Casey Research "Navigating the Politicized Economy" Summit with the audio collection.