Sprott U.S. Holdings Chairman Rick Rule weighs on whether or not capitulation will occur in the resource sector and outlines the three catalysts he thinks will spark a rebound in this space. He also offers up his opinion on the future of the TSX Venture exchange, including tips on speculation, and mentions a surprising non-resource sector that he likes.
Announcer: The Small Cap Power Expert Interview.
SmallCapPower: Welcome back Rick! In a recent interview you said that capitulation is just beginning in the resource sector. Given that these stocks have been suffering for a few years now, what makes you so sure this will occur?
Rick: Well, I’m not sure that capitulation will occur. One of the difficulties about making a forecast is sometimes they come true and sometimes they don’t. At the point in time I discussed that was mid-August. And capitulation has not, in fact, occurred. Now, there’s an argument that says that the valuations are so low that capitulation doesn’t have to occur and I’m not disinclined to the argument. My experience has been, however, that bear markets are, at least, in junior resource stocks, over; truly and completely over, once capitulation does occur. So oddly I would welcome capitulation, not because I want to see another down leg in the market, but rather because I want to see that capitulation event that ends a long and ugly bear market.
SmallCapPower: So which catalyst(s) do you believe will spark a resource sector rebound?
Rick: I think there’s really going to be three catalysts. One will be simply recovery from overly bad valuations. The truth is that we’ll have a stealth bull market before we have a real bull market, just like the stealth bull market we had in 2000. In 2000 and 2001, the top 5% of juniors doubled and doubled again, and it was the success in the stealth bull market that caused the real bull market that occurred later in 2002 to get underway.
The other thing that will happen, I think, is that the real strength in the U.S. dollar will begin to subside. I’m not trying to suggest that the U.S. dollar will collapse, but I think its strength will be less overwhelming. A rolling over of the U.S. dollar in the same fashion that occurred in 2002 would be fairly good for general commodity prices, but would be very good for gold and silver prices and to some extent the junior equities market is gold and silver price dependent.
SmallCapPower: Given that the TMX Venture Exchange is loaded with resource juniors that probably have no reason to exist, what do you think the future holds for this exchange?
Rick: Well, if the bear market continues for another 18 months, the problem will take care of itself. The problem you described, 60% of the companies on the exchange with negative working capital is a travesty. And all of us share some blame. When an investor says, “How low can a stock go from five cents,” the answer, of course, is it can go to nothing. So the first thing is the investors need to stop buying nothing, nowhere companies. It’s a relatively simply measure to look at income statements and balance sheets of companies and find companies that don’t have any chance of survival. If you find those, sell them.
The brokerage firms, of course, shouldn’t deal with companies like that, but the exchange themselves needs to be much more active, much less concerned with listing fees, much more active in terms of suspending and ultimately delisting companies with negative working capital.
SmallCapPower: What effect do you think China and the U.S. Federal Reserve will have on resource stocks during the next one to two years?
Rick: I think in the very near term that Ms. Yellen prescribed interest rate increase is baked in the cake. She’s done a fairly good job of jaw boning, and I suspect that the interest rate hike will occur and I don’t think it will have any particular impact. If that interest rate hike is successful, that is, if she can make it stick and if she can follow on with a second interest rate hike, that would make the U.S. dollar stronger and will weaken the gold price and would be bad for natural resource equities.
If, by contrast, she can’t get a second interest rate hike across or worse for her, better for us she can’t make it stick, that would cause the U.S. dollar to rollover, and would be extremely attractive to the gold price, and would ultimately help the junior resource markets.
SmallCapPower: What’s your short-term outlook for gold?
Rick: I think that there are more factors in the near term lined up against gold than lined up for gold, but I do believe that the strength in the U.S. dollar is overblown. I believe the competitive instrument to gold on a global basis is the U.S. 10 year Treasury, and I think that the U.S. 10 year Treasury represents ultimately what Jim Grant calls return-free risk. And so while I don’t have any short-term outlook on gold, I think in the longer term and by longer term I mean two to five years. I’m not merely bullish, I’m very bullish with regards to gold.
SmallCapPower: What are your top ‘must haves’ before buying a particular stock?
Rick: With regards to juniors, what I’ve learned is that people are the most important. There are people who are serial outperformers and hanging out, if you will, with the serial outperformers is the first guarantee to success. The second is materiality. Too many times in small companies people are attracted to small projects. Small projects have the same probability of failure as large projects, but they can never make you large money. So a project or an exploration target that if it were successful would generate a billion or billion and a half dollar net asset value is the sort of thing you have to take. You have to be playing the game for big rewards if you’re taking big risks.
And the third, of course, is common sense. The people need to remember that you make money in junior stocks by answering unanswered questions. Answering unanswered question takes both time and money. Investors make two mistakes. They have trauma holding stock over a long weekend, and you’re never going to get an answer to an unanswered question over a long weekend. And they buy companies that don’t have the financial resources or the staying power to answer those unanswered questions. So high-quality people playing a game that will matter if they’re successful and having the resources to answer an unanswered question are the sort of Holy Grail of junior resource stock speculation.
SmallCapPower: Are there any non-resource sectors you like at this time?
Rick: The U.S. small to medium-sized community bank sector looks very attractive to me. If you have a bank that’s well capitalized, that operates in a locale where it has a very strong regional franchise. And, in particular, small banks that stick to one or two areas of expertise. Banks that don’t try to compete with the financial supermarkets but rather compete in sectors where they can out-compete the big banks in regions where they have very strong franchises.
The community banking business in the United States goes from strength to strength, and the way that usually resolves itself is that they build themselves up to a large enough asset base where they get bought by a bigger competitor. So buying a very strong regional bank at book or 125% of book, letting it build book for five years so that book doubles or triples and then being bought at twice book has been a three or four decade pathway to success, and I think it’s a game that’s just getting underway again now.
SmallCapPower: Thanks for taking the time for today’s interview Rick.
Rick: Always a pleasure. Thanks for having me in front of your audience.
Announcer: Keep up-to-date with all of your favorite small caps. Subscribe to our free newsletter and get daily Investment Ideas, breakout stocks, momentum gainers, and more.
