Jay:  Alright, Rick Rule, thank you so much for joining us. For the audience tuning in from around the world, we have Rick Rule, who is the president and CEO of Sprott U.S. Holdings and one of the foremost experts in natural resources investing. We’re very lucky and fortunate to have you on. Rick, maybe you can give us a little bit of background for those of the audience members that don’t know much about you or Sprott and what you guys do there.

Rick:  I’ll answer the questions in reverse order. Sprott is a global investment manager focused on natural resources and precious metals. We manage about ten billion dollars worldwide on behalf of 200 thousand investors and, as I say, our focus is on natural resources and precious metals.

I have been in the natural resources and investment business — I’m embarrassed to say but you can tell by looking — for about 40 years. I’ve never strayed from my own extractive, yet it’s treated me very well, and I’m pleased to talk about a subject that I’ve spent 40 years getting to know.

Jay:  Absolutely. I’m just curious for myself, as an investor my whole career, investing kind of takes you down different paths, and there’s many ways to make money in the abundance of the markets. I’m just curious as to how you found and focused on natural resources investing particularly.

Rick:  Well, I guess two ways. One was fairly selfish. I like to be outdoors, and the circumstance of investing in agriculture and timber was attractive to me. And the whole sense that a young man had of a treasure hunt, the pot of gold at the end of the rainbow, was attractive to me.

I also came of age in investing in the 1970s where the sort of Malthusian — incorrect, by the way — projections associated with the Club of Rome dominated the investment landscape.

But perhaps more pragmatically, I grew up in San Jose, California, the self-proclaimed capital of Silicon Valley. And the alternative to me was technology investing. And one of the things I learned in the 1970s about technology investing was, first of all, that one shouldn’t invest in businesses that one couldn’t spell or understand. And the other thing was that I came to understand that the half-life of an innovation in technology was about 18 months, which meant that by the time I came to understand the investment, it was obsolete.

So my alternative was competing with extraordinarily smart people in a business that had a shelf-life of 18 months or participating in a business that had very broad product cycles like coal and oil, the added advantage being that I could spell my subjects where, in so many technology issues, I couldn’t even spell the subject.

Jay:  Interesting. There’s definitely an argument and a case to be made for when investors invest. I don’t know what the percentage is, but it must be over 90% of option out there are basically paper and non-physical products that most people invest in. So to be able to actually invest in real physical things like coal and precious metals is comforting as well as prudent, perhaps, for an investor.

Let’s begin our chat today with just I wanted to get your market overview, and that could lead us down into, obviously, you have to pretty strong opinion, I guess, at this point, about precious metals, particularly gold and such. How do you feel about the markets?

We’re sitting very expensive in equity market valuations by all measures. Obviously we’re coming at the end of this long period of depressed interest rates. There’s a lot of debt servicing that needs to be paid, so the U.S. is kind of stuck in a corner right now. To add on top of that, we have a lot of interesting macro and geopolitical events that keep popping up in addition to our current administration as well as globally we have some data points that are interesting as well. I’d love to hear just general market thoughts first, Rick.

Rick:  Sure, I do agree with you that equity valuations and, for that matter, debt valuations are at historic highs, certainly what I would consider to be the artificial downward manipulation of interest rates. And the recovery and global confidence has a lot to do with that.

You use a different discount rate for bond yields and for equity dividend distributions in a period of low interest rates than you would in a period of higher interest rates. While at the same time, on the equity side, the artificial suppression of interest rates has reduced the issuer’s cost of capital.

My suspicion is that if you saw the cessation of interest rate manipulation or if you saw the cessation of confidence in global markets — liquidity concerns is not example, like we had in 2008 — that you would have broadly harder markets in debt or equity. This isn’t a prediction. This is merely an observation.

When I look at broad indexes, especially American indexes because I’m America and look more at American indexes, the S&P 500 as an example, is richly priced. It’s also a group of amazing companies, a group of companies that are operating at historically wide profit margins despite a very strong U.S. dollar. It really is an amazing accomplishment. And a weaker U.S. dollar, paradoxically, would probably improve the earnings of many constituents of the S&P 500.

That notwithstanding, my suspicion is that the index is probably high partly because of artificially low interest rates which value their dividend distributions higher, and lower their cost of capital.

With regards to global economic situations, we’re in an interesting place. We’re allegedly in a synchronized global recovery, but I can’t talk to anybody anywhere who seems to believe that their economy is in good shape. Maybe it’s the circle that I run in, but I’m not seeing anybody describing overwhelming demands for their products. I’m not seeing anybody that’s able to move up prices as a consequence of imbalance of supply and demand.

So my own suspicion — and I’m not an economist; I’m a credit analyst. I want to tell you that. But my own suspicion is that the recovery that we’re seeing is at least partly a function, again, of artificially low, manipulated interest rates. And the cessation of interest rate manipulation, I suspect, would have a deleterious impact on economies and broader markets.

Perhaps I am being self-serving with the next statement. But natural resource markets in the past five or six years have experienced anything but ebullient times. Our markets, if you measure the commodities, were off by 50 or 60%. If you measure the equities, in particular, the junior equities measured by the Toronto Stock Exchange Venture Index, they were off 88% in nominal terms and 90% in real terms.

And if you learn anything about resource businesses, this you learn is that they are the most cyclical industries on the planet — capital intensive and cyclical.

Bull markets, like the one we enjoyed at the beginning of the last decade, are the authors of bear markets, and bear markets are the authors of bull markets. Once you understand that statement, you understand that the consequence of a 90% decline in equities prices is usually a pretty good bull market.

So I feel relatively attracted to my sector. I say “relatively” rather than “absolutely” because usually extractive industry bull markets outside of precious metals are driven by global economic recovery. And the global economic recovery that I see is muted at best, or at least hidden from me.

Jay:  Well, I think you bring up a very valid argument. As we look to come off this period of accommodative monetary policy, the U.S., it seems like it’s doing better and recovering. I don’t know how long that’s going to take, but obviously this cheap cost of capital and funding has definitely pushed markets up. And at some point when rates normalize, there’s going to be a pain trade so to speak. I can only advise or see that prudently an investor right now would be wanting to take some chips off the table if they’re in a lot of U.S. equities and perhaps looking at some other areas of opportunity, such as what you mentioned, natural resources or gold, which are very cyclical by natural, again, as you just stated. But it seems like that’s a good switch trade for many people.

Speaking specifically about gold and precious metals, there’s a number of ways to play that. You can play it physically, or you can play some of the mining stocks which have traditionally been quite popular to play. What is your view on how an investor might position themselves to have exposure in, say, gold or precious metals?

Rick:  First of all, I would say that that has to do with the investor. I myself do both. I’m in the odd position of, because I work at Sprott and my income is geared positively to the gold price, I don’t actually really need to own physical gold at all. But as a consequence of my view of the world, I own a lot of gold. It’s odd being in a position where you own a lot of something, and you hope the price of it does not go up.

You see, I regard my gold as insurance. And you need to be nervous about hoping that you get paid on an insurance policy. Think about life insurance. You pay a premium, and you hope you don’t collect the balance because that means somebody died. Auto insurance means you had the wreck. House insurance means that your house burned down. And gold has functioned for 2,000 years in many different societies as catastrophe insurance, as an insurance against the depredation of the commons.

So the whole set of circumstances that makes the gold price go up is something that I hope doesn’t occur, despite the fact that I own a lot of it.

Gold stocks are very different. Traditionally gold stocks have been viewed as leveraged warrants on the gold price, which I think is harmful. We have asked gold companies to exhibit leverage to the gold price. Ironically, that will leverage a cruise to the most inefficient, high-cost producers. So while we’ve asked companies to be leveraged, we’ve asked them to be inefficient, and they have complied.

One of the things that I like about the gold space right now is that, for at least the last two years, managements have been nervous about repeating the sins of the past. And my observation is that the industry is, for the first time in 40 years, focused on return on capital employed and being more efficient.

I also note with some pleasure that, although the gold price has done well in the last 12 months, the gold stocks have done poorly, which is to say there is an increasing divergence between the price of the product that they produce and the free cash flows that they generate relative to their enterprise value and their market capitalization. This has happened four times in my career. I’m not going to say that past is prologue, but in all of the previous four times that this has occurred, the gold stocks have played a really good game of catch-up.

I’m excited about that prospect, but I’m excited about it particularly in view of the newfound focus on efficiency in the gold stock industry. I’m hoping that, in addition to having a catch-up that they deserve it too.

Jay:  Gotcha. That’s exciting to see it play out. If past is prologue, as you say, if the last four times is the same thing that’s happened, then it’s certainly a space for us to watch.

You have spoken recently about a very unique pricing anomaly, or mispricing or dislocation, that is occurring right now within one of the ETFs of the Junior Gold Miners, which is the GDXJ. Could you share with the audience your view there and what the potential opportunity that lies there is?

 

Rick:  This is an ongoing anomaly. You’ll notice that the GDXJ has to rebalance quarterly, which means that it’s an exploitable inefficiency that should continue for some period of time, a gift that keeps on giving. It’s important to state, first of all, that the GDXJ is probably the most successful sector ETF ever introduced, measured by the assets under management in the EFT relative to the assets available in the sector.

We have a situation where an EFT that was designed the mimic the sector has come to dominate the sector. In other words, the tail is wagging the dog. Fund flows into the GDXJ have been so large relative to the size of the sector that companies that are included in the GDXJ become overvalued and overbought relative to the rest of the sector.

In fact, that success is so great that the GDXJ is really not a junior index at all anymore. It’s a junior index in drag.

The median market capitalization, I believe, is approaching $5 billion — hardly your or my interpretation of a “junior.” And sometimes as much as 20% of an assessed value of the GDXJ is made up of its purchases of its sister index, the GDX.

The consequence of that is really twofold. First of all, given the fact that many of the fund flows that used to go into the individual companies go into the GDXJ and that those fund flows are concentrated into 30 or 40 issuers out of a 3,000-issuer universe, an enormous pricing paradox takes place. The favored few do well at the expense of the many. And the opportunity that I see is to look at the constituents in the GDXJ and, rather than succumb to the temptation of buying those momentum stocks, figure out who of the unfavored they will have to buy.

The truth is that market anomalies where one company has a lower cost of capital than other company that’s a direct competitor do not exist over time, because the company with the lower cost of capital takes over the company with a higher cost of capital, a wonderful Darwinian efficiency in the market.

So the anomaly that I see for the next 18 months will be to look at the major constituents of the GDXJ and figure out which of the unloved, unwashed companies in the rest of the industry are strategic targets for the favored few, buy them, and wait for the takeover.

Jay:  Well, I think that it certainly requires work to do, but if your thesis is correct and you could be looking at some pretty significant gains off the back of that M&A activity… And what do you expect would happen in, say you give it an 18 month timeline. Do you expect all of that to normalize and all the M&A to have completed at that point?

Rick:  I don’t. I see it as an ongoing opportunity. Unless the market capitalization of the entire sector, relative to the GDXJ increases so that the GDXJ’s impact on the market is less profound than it is now, I see that opportunity taking place for a very long time.

My suspicion is that if you employ the strategy now, it could take as much as 18 months to profit from it profitably. But as long as the circumstance exists where the favored few are overvalued relative to the sector, this opportunity will go on.

The need for the explanation has to do with the fact that many people who speculate in stocks don’t have enough faith in the information that they employ to hold the stocks for the 12 to 18 months that are necessary for them to enjoy the benefit of the strategy that they employed.

Jay:  That’s right. Once again, one of the flaws that a lot of investors have, and that’s not in specific or particular to natural resources mining. In all asset classes, it’s just an investor flaw. Either they don’t do even work so their conviction level is not high enough or they’re not patient enough, and they succumb to market forces or emotions and exit a trade before they should.

Rick, you’ve done a lot of work in the private placement arena, particularly with some of these junior companies or even pre-revenue type situations. In theory, it sounds very sexy and appealing for an outside investor. Now, that’s also a very high-risk type asset class to get involved in.

What are some strategies that you employ when you look at doing some of these investments into pre-revenue type companies?

Rick:  Two preliminary comments. First of all, it is, as you suggest, extremely risky. So take what I’m going to say afterwards in the context of risky. Second of all, it’s not investing at all. It’s speculating. I need to stress first of all that all the money I now invest I made speculating, so I’m not against speculation. I am a speculator.

Moving on to answer the question directly… First of all, it requires a different standard of work and a different standard of due diligence. And speculators who are not willing to devoted the time should be discouraged from participating in the sector.

The techniques that you employ are frighteningly similar to the techniques that you should employ in any other speculation. The reason that you participate in a private placement is very simple. There are only two reasons.

The first is that the private placement ideally is constructed to be time sensitive. You are adding capital to a company that will result in an event that could be catalytic. You aren’t buying it merely because it’s undervalued, but rather particularly through pre-revenue companies, you’re answering an important unanswered question where, in the event of a yes answer — and a yes answer is by no means certain — you can get a substantial increase in the share price in the stock. So first of all, it’s time sensitive. It’s much more timely.

Secondly, you sort of focus on the investment. But most importantly of all, an intelligently constructed private placement has as an inducement for you to contribute the capital, a warrant, a warrant being the right but not the obligation to buy more stock at a fixed price after you’ve gotten the yes answer. In other words, you get to participate in success retroactively as a consequence of having funded that success.

And I need to tell your listeners, to the extent that you participate in private placements and you don’t get a warrant, there’s no point in doing it. People get attracted to the theme private placement because they have heard about the money that myself and other professional practitioners have made in the sector. And they participate in private placements without the correct inducements.

So the first thing to understand about private placements is that you make them to answer unanswered questions that will result, in the event of a yes answer, in a catalytic move in the stock. And as a consequence for contributing that risk capital, you get a warrant.

The rest of the process is similar. The first is that you need to understand that performance in the junior, in the exploration sector, is very closely paralleled to performance in pre-revenue technology companies, meaning that it’s completely disaggregated. Well in excess of 60% of the positive performance in the sector is generated by 5% of the issuers. Probably 80% of the issuers in the junior resource market are absolutely valueless. And so you have to concentrate your investments either in private placement or after-market purchases around management teams that have been serially successful.

The second thing is, given the fact that you’re taking enormous risks, you need to play the game in anticipation of big rewards. Most speculators are would-be or actual entrepreneurs. There’s a sort of seductive sense that you could fund a small cash-flow generating acquisition and then use the free cash flow to grow the company, the old bootstrap thing. It’s very seductive, and it happens to be wrong.

Everything that can go wrong with a small mine can go wrong with a big mine. But a small mine can never make you big money. And disassociating risk from reward is a huge mistake that people make. So it’s important to know the size of the prize and only play for big prized. And it’s important to play the game with people who have been successful before.

It’s also important, when you make an investment, to understand just exactly what the value is. What is the unanswered question? Is the person asking the question, the CEO of the company, qualified to ask the question? In other words, is his or her resume, the success that they’ve exhibited, specifically related to the task at hand? Should you give a da** what their question is? Is a yes answer worth sufficient money to take the risk? Is the path that they propose to take the test the thesis efficient, and will it answer the question? How much money will it take? Do they have that much money? And importantly, how much time will it take?

If you have a six-month investment horizon — and rationally it’s going to take you 18 months to get an answer — you aren’t going to be around to get an answer. So you shouldn’t make the investment.

Jay:  Wise words. Wise words, Rick. Thank you for the advice on somewhat of a speculative investment class.

I wanted to quickly, quickly talk about your thoughts on uranium, which is another one of these very highly talked about, discussed assets. And the prices have been depressed for a while. What are your views?

Rick:  Well, I should start by saying the last uranium bull market was probably the most profound speculative event of my career. I got there early — some would say too early — four years early. If you’re four years early to 10% annualized discount, you’re often wrong as opposed to early.

But the truth is that in that last experience, there were five uranium juniors in the universe — I owned them all — did worst of them went 22 to 1. If you get that type of rent over five or six years, you can afford almost any kind of discount you want. And I believe in this case that past is prologue.

The thesis goes like this. Despite the fact that uranium is very unpopular, it’s critical. And the International Energy Agency suggests it costs $60 a pound, fully loaded, to make uranium on a world-wide basis. So the industry makes the stuff for $60 and they sell it today for 22. They lose $38 a pound and, of course, being miners, try to make it up on volume. That can’t go on for too long.

So one of two things happens. Either the uranium price goes up or the lights go out. I’ll leave it to your listeners to figure out which.

Now timing is an interesting question. You’ll recall that the last bull market saw an overshoot in uranium prices. At that point in time, the market clearing price was probably $45, and the price of uranium went to $145 before setting out at about $80. But then supply and demand changed all of a sudden as a consequence of Fukushima. We took away 16% of worldwide demand, and we took it away from a society, Japan, that believed in energy security, the consequence of that belief had unusually large inventories.

So well in excess, well in excess of 25 or 30 million pounds of annual demand came out of the market, and potentially 150 million pounds of excess supply came on the market, the mother of all bear markets.

So in terms of timing, my supposition is this. The uranium price will move when Japanese reactor restarts begin in earnest. When that happens, the game is on. And suspect it’s going to be an amazing game.

At the bottom of the last market — as I say, there were five uranium juniors worldwide. At the top of the bull market when everybody was interested, there were 500 uranium juniors. That in itself was an amazing statistic. There were probably 20 — maybe 20 — management teams that were capable of looking for uranium, that couldn’t even spell uranium.

So to function at the top of a bull market that your company had a competent management team was a function of dividing the number of teams available — 20 — by the number of holes for them — which is 500, which is to say bad odds indeed. That number has probably shrunk now from 500 to 25, and there’s probably five or six worth speculating in. In other words, the speculative universe has returned to where it was at the bottom of the last bear market.

The important difference is there’s a whole generation of speculators who were around for the last bull market. And when this bull market gets going, it’s going to find an audience that is more rabid and more responsive than happened last time.

You will note that the first three months of this year, the uranium juniors all doubled and tripled on very little volume which suggests that even in the absence of buying, we’ve really worn out the sellers in the space. And the circumstance where the best of the companies moved from weak hands to strong and then the underlying commodity performs is a situation where, in this case, would be past is prologue. And believe me, I look forward to it.

Jay:  Absolutely. Like you said, I believe there’s a lot of pent up demand on the sidelines just waiting for that event to happen.

Rick, I want to just shift gears. You spoke a about Japan. I want to talk a little bit about the region here in Asia and China and your thoughts on how China is going to play out and how a national resources investor could benefit from some of the trends that we see going forward.

Rick:  I’m bullish on China. I’m not trying to say that China’s future will be an untarnished, upward chart. Certainly a circumstance where you have the strong remnants of a command-control economy is inefficient. A free market economy where there are good feedback mechanisms is messier, but it’s more efficient.

That being said, and at the risk of sounding racist, the Chinese diaspora has been enormously successful anywhere in the world because of traits that, while they’re not unique to Chinese people, are virtuous. The focus on hard work, the focus on savings, and the focus on education, to the extent that you make the Chinese people a little more free, which happens gradually — irrespective perhaps of the intention of the state — you make that same group of people enormously, enormously wealthier.

The best thing, in my opinion, that’s happened in the last 40 years in mankind was Deng Xiaoping saying, “To become rich is glorious,” saying, in effect, to Chinese people “The state can’t take care of every one of your needs. You have to begin to look after yourself.”

That circumstance, allowing people to look after themselves and freeing the state of the yoke of looking after a billion people and simultaneously freeing those billion people from the yoke of the state, has been responsible for much of the economic resurgence of the world — not merely of China.

And my suspicion is — and I am by no means a China expert. Look at me. I’m an old, fat white guy — but based on my powers of observation, based on serving Chinese clients and, in some instances, the Chinese state, I think that the trend towards individual liberty — gradual individual liberty in China — is an unbreakable trend. That consequence tells me that the community that’s still in China can begin to participate like the Hun community in Vancouver or San Francisco or Los Angeles or London.

The circumstances where we have well in excess of a billion people that continue the transformation from frontier market to developed economy, particularly given the cultural advantages that the Chinese seem to enjoy with regards to hard work, thrift, and education, means that from my point of view, the next 20 years will be prosperous for the Chinese people and for resource industries too.

It’s important to note, I think, that in all the frontier markets, material advance at the bottom of the demographic pyramid is unusually beneficial to extractive industries. When rich, old white folks like me get more money, there’s no stuff they want to buy because they already have too much stuff. We improve our life by getting rid of stuff. Or if we buy something, we buy some little gizmo from Apple that doesn’t contain any junk in it. It’s a service.

But when people at the bottom of the economic pyramid become materially more wealthy, they increase the calorie consumption of their family from 1500 calories per day to 2200 calories per day. They substitute a steel roof for a thatched roof. They upgrade from foot to bicycle and from bicycle to motor scooter. All of this upgrade is extremely materially intensive.

So the increase in living standards that you see in China is disproportionately beneficial to extractive industries relative to increases in GDP that you would see in a more developed country.

Jay:  It makes perfect sense. I’m excited to see how China plays out, and we’re sitting here in the front seat of it, so it’s going to be an exciting time.

Rick, thank you so much for your time and for your insights and for sharing your knowledge with the audience. I think the audience is going to get a lot of value out of this conversation that we’ve had.

Can you take a moment and tell us a little bit about what you’re working on, anything exciting either personally or at Sprott? I know that you guys do a number of events and just have a ton of resources available for free online at your website. What else can you tell us about what work you’re doing these days?

Rick:  I would urge all of your listeners to go to our website — www.SprottGlobal.com. There are 200 hours of educational material on natural resources at that website, including the Mining Investment College, which the Colorado School of Mines used to sell for $1000 and I give away free.

I would also encourage your listeners to subscribe to our blog, Sprott’s Thoughts. I guarantee they’ll get their money’s worth because it’s absolutely free.

Beyond that, we manage money on behalf of institutions and individuals on a global basis in natural resources for people, as an example, who don’t want to hold physical gold because of the risk and the cost associated with that — or physical silver or physical platinum and palladium. We sponsor exchange-traded trusts in each of those metals — the Sprott Physical Gold Trust, the Sprott Physical Silver Trust, the Sportt Physical Platinum and Palladium Trust — all of which trade on the New York Stock Exchange — and for your American viewers, offer substantial tax advantage relative to owning physical gold.

We, of course, operate in debt and equity markets on behalf of investors in all sizes and on a global basis.

Jay:  Fantastic. Well, thanks again for your time, Rick. We had a great conversation, and I think that, again, there’s a lot of value that you’ve given for the audience tuning in. We’ll be sure to head over did website and check out the great work that you’re doing.

Rick:  Thank you for the opportunity to visit with your audience and have this discussion.

Jay:  Great. Thank you so much. Take care.