Source: The Critical Investor for Streetwise Reports 02/20/2020
The Critical Investor sits down with industry veteran Rick Rule for a wide-ranging conversation that includes commodities such as copper and uranium, Sprott’s investments, and his own economic philosophy and investment strategy.
After the first part of my interview with Rick Rule generated quite a bit of attention, I’m pleased to continue with the interview in this second, and equally extensive, part, in a series of no less than four parts. As Rick is one of the best speakers in the mining sector, there is no shortage of lengthy, witty, funny and knowledgeable answers. He has set the bar pretty high, as I am planning on inviting more big names with illustrious careers in this industry for a likewise in-depth questioning. For now, enjoy the next topics discussed by Rick Rule.
The Critical Investor (TCI): The biggest trap for junior mining investors is averaging down in my view, as fundamentals seem to be unfazed in a lot of cases when mining stocks go down. But sometimes the world around the company/project changes. How important is the macro environment to a thesis to you and Sprott?
Rick Rule (RR): The macro environment is, of course, very important to Sprott, and Sprott certainly has a view of the world that includes a positive outlook towards the precious metals price, and probably later on a positive view toward the prices of all resources. Having said that, at Sprott we make a substantial investment in geologists, engineers and financial analysts. So our investment decisions with regards to the juniors are a blend of our world and macro outlook, but also a micro outlook that looks at each company specifically, how they spend the money that they raised as an example, how much general and administrative expense occurs relative to project expenses, and the technical aspects associated with the project like geology and metallurgy.
Your point with regards to averaging down is an interesting point. In our experience with junior companies, what you are doing is participating in the answer to an unanswered question. And normally in exploration the expectation is failure. So in most circumstances when you have an indication from the company that the exploration thesis that they follow isn’t working, one must sell a stock. When the factors that caused you to buy the stock change for the worst, you must sell. So I think at Sprott, we try to balance our macro view associated with commodities pricing, and the political and social reality of the domicile of the company with a very nuanced view. We hope of the company’s internal exploration and their ability to answer unanswered questions, and also of course, the G part of ESG that is whether or not the management team is really geared towards success or merely is involved in the company for salary purposes. When a stock falls, where our view is unchanged or improved, we are often very aggressive buyers.
TCI: If I am correct there are two different main subjects within Sprott, the commodity thesis for a stock, and the exploration story.
RR: And probably the third would be our feeling with regards to social and political risks in the country. At Sprott we are involved in financing exploration ventures in 60 countries worldwide, which requires not just a study and a view on the political realities of that country at a national level, but also our view of the company’s ability to manage local sociology and the nuances of that local sociology with regards to mining. They’re all important circumstances. Of course, not that any of the others aren’t important, but the main driver is the success or failure of the exploration thesis.
TCI: I was wondering, as a company just has to drill and kill a subject or a project, it can go to another project or it can option or acquire a new exploration project when the first one was killed off. It can start over again, in that case you would be backing for example a very good management team. What do you do in that case as most of the share price has been lost?
RR: You know, in almost every circumstance where the answer to the unanswered exploration thesis is negative, we sell the stock.
If the company is run by somebody like the Lundin family that has a 100% track record of resurrecting juniors within their stable, we may suffer through the indecision associated with that period while the company is being groomed for a new project. Our preference is to accept first loss and to maintain a dialogue with the management team and look to reenter when there’s a new investment thesis. One of the problems and the advantages, frankly, of being Sprott is that we get shown transactions all the time and one of our challenges internally is to limit the number of names that we own to the number of names that we believe that we can follow better than our competition. And what that means is that if we are involved in a company with a management team that is second tier, the idea of holding on to a company and waiting until that company has resurrected is impractical for us because it consumes shelf space, intellectual shelf space for Sprott.
TCI: In percentages, how many companies do you think are Tier I and you would hold on to them no matter what project doesn’t work out?
RR: We believe that there are less than 10 tier one management teams worldwide, and we have them in our stable.
TCI: Less than 10, that is what kind of percentage of total companies usually in the portfolios of Sprott for juniors?
RR: We believe that with our current complement of research staff that we can stay reasonably apprised of 150 companies. We like to be under budget in effect. In other words, we like to maintain spare capacity system-wide, and the system is pretty broad now, including Tocqueville. We like to believe that every company in our stable, at least in our junior stable, is a company that we know better than most of our competition.
And we’re probably more comfortable as a firm owning a hundred names for firm-wide than 150 names for firm-wide. Now, of course, we don’t constrict our individual portfolio managers to using only firm-generated knowledge; that would be improper to sort of impose from the top really strict criteria on brilliant individual managers who have earned investors’ faith. But we fairly rigorously question our portfolio managers about the names in their portfolio and why they have them. And certainly every name that is a large part of our portfolio is probably known to and accepted by more than one portfolio manager and probably has a fairly high degree of conviction among our geological engineering and financial staff.
TCI: I want to talk to you about the uranium thesis. You have made the connection between low uranium prices and the problems that will arise for U.S. utilities being in business in six or seven years.
As U.S. utilities import most uranium from all over the world, including from countries with mines that can produce far below current spot prices, or have uranium as a byproduct, how do you think the current situation is unsustainable and prices simply need to go up? Isn’t this in the hands of Kazatomprom, which can control supply by expanding its ISR mines at will if needed/desired by Russia, and thus have the power to flood the market with cheap uranium below $50/lb into eternity?
RR: So let’s start with a broader question, first of all, which is uranium. Uranium is probably the topic that gets the contrarian’s blood boiling more than any other commodity. Uranium is an extremely volatile commodity, but it’s also one that acts on people’s emotions rather than being subject to purely rational investment theses. When people talk about uranium, they don’t necessarily talk about the price performance or the utility of the material. But in addition to that, they talk about Hiroshima, Nagasaki, Three Mile Island, Fukushima and Chernobyl, which is really a contrarian’s dream. In effect people ignore uranium when it’s in a bear market, but in addition to that, they hate it. And contrarians are taught to look for commodities that are hated. So it certainly ticks off that button. But the second button is of course utility. On an operating basis, nuclear power is after the upfront capital expense easily the cheapest form and the most reliable form of base load power.
It’s also a form of base load power that’s extremely efficient from a carbon generation perspective. And despite the fact that many countries in the world believe that they’re rich enough to do without nuclear power or even that they have a moral duty to do without nuclear power. Nuclear power is an important part of the base load electrical generating capacity in many countries around the world. So the situation that we’re confronted with, looking at the uranium market, is very simple. With the price of the commodity on world markets substantially below the cost of production, and let me digress: The International Energy Agency suggests that on a global basis the total cost of producing a pound of uranium, importantly including cost of capital in prior year write downs, is between US$50 and 60 per pound, and yet the spot market for uranium as we speak is about $27 per pound, which means that the industry is losing in excess of $20 per pound and doing it 100 million times a year.
The upshot of that is that if you don’t believe that the price of uranium is going to go up within five or six years, you believe that the lights are going to go off. In countries like the United States that depend on nuclear power for base load generating capacity, that one seems fairly simple to me. The question of when becomes much more difficult because the uranium market stayed out of balance with regards to price and cost for 10 years once before. So the thesis as to the uranium price going up is a when question, not an if question, but the when question is very much in balance. I began to believe as much as two and a half years ago that the increase in uranium prices will only begin when through the Japanese reactor restarts, that is the restart of the Japanese nuclear capacity that was shut down as a consequence of Fukushima, utilities began to convert excess Japanese inventory into held for production inventory.
That has not happened. The pace of Japanese restarts has been very tepid, which means that the uranium price performance has been tepid. Now on a global basis, consumption for uranium now exceeds the pre-Fukushima level, largely as a consequence of newly built reactors in China and a couple in the Persian Gulf. And I think if you look three years out, the price of uranium is much higher, but I really can’t speak to the next 12 months given the extraordinary levels of Japanese inventory and the very slow levels of Japanese restarts. Now, with regards to the American question that’s somewhat more nuanced, the U.S. uranium industry petitioned President Trump and the U.S. government for what can only be described as a form of protection.
The suggestion is that uranium is a national security measure, and the consequence of that is that the U.S. government should assist the U.S. industry by making it, not compete with other, more efficient sources of uranium around the world and should create an artificial market for uranium in the United States. Well, that measure would of course would benefit me personally. I think it’s very bad politics. I don’t believe in any form of protectionism and it’s very difficult for me to believe that should we need it we wouldn’t be able to buy supply from Canada, Australia or for that matter of, frankly, Kazakhstan. The administration did not vote to reserve 20% of the U.S. market or 25% of the U.S. market for uranium producers. But in what I can only guess was a politically inspired move, it did suggest that the United States government buys uranium from U.S. producers to create a strategic stockpile.
And in that sense to subsidize domestic producers, that may or may not take place in truth. I don’t think it matters particularly except for in terms of the share prices of those few junior uranium producers. But I really believe that the market will take care of itself. Certainly you are seeing shutdowns in production or rather curtailments in production by both Cameco and Kazatomprom, and they’re really two different kinds of shutdowns. In Cameco very deep, extraordinarily high-grade production got shut down because the mines were extraordinarily loss making; in the case of Kazatomprom, the problem was the mines that were shut down were in situ recovery mines. I think there were two political factors in play. The first was that the Kazakh government came to believe that these shutdowns might do something to increase the uranium price on a global basis.
And frankly, some of the younger managers at Kazatomprom looked at the market from the same prism that Sprott does, that is saying, why would you produce pounds and sell them for US$26 or 27 when three years from now you can probably sell those same pounds for US$50 or 55. My suspicion is that because the Kazakhs can increase their production that will reverse the shutdowns much more efficiently than the Canadians, that you will see the Kazakhs gently and gradually increase their production as the uranium price increases. The Canadians have an entirely different set of circumstances. Returning their projects to production requires a fairly large capital and operating commitment. And I wouldn’t expect the high-grade deposits that Cameco operates to be returned to production until there was the ability to sell in fixed contracts a fairly substantial amount of material going forward so that some margin was guaranteed.
TCI: Let’s take a bit more specific look at the second part of the question, more or less focusing on an upper limit of $50 a pound being the threshold for the most economic projects outside of Kazakhstan in order to be brought online. What do you think about this scenario?
RR: I think that you will see the Kazakhs be extremely aggressive in the market between $50-60 a pound. The Kazakhs understand that they are the lowest cost producer in the world and we believe, although I can’t prove this to you, that the Kazakhs have fairly substantial uranium resources that could be converted to reserves. So a circumstance on a global basis where the uranium market again spiked to $130 to $150 per pound seems extremely unlikely to me. I think the circumstance where the uranium price got substantially above $75 a pound would see a fairly aggressive increase in productive capacity.
TCI: For sure, but my point is that Kazakhstan combined with Russian influence probably can control all the production outside of Kazakhstan by keeping the prices below $50 a pound.
RR: I don’t think necessarily that they have the ability to do that in the short term. When people look at the total cost of production, people don’t take into account the time that’s needed to bring a mine in production. And the capital that it takes to bring a mine into production.
TCI: I heard from some people very familiar with the Kazakhs and their production capacities that they can bring online a new expansion for just $100 million of capex, and then they can expand fairly quickly within a year.
RR: I think that’s true. They could increase incremental production by drilling new wells fields for in situ resources. But the truth is that the uranium market is out of balance now and in order to be able to flood the market as you suggest or control the market, that would take them sort of five or six years. I believe that the market will be in balance at US$50 to 60 per pound. I don’t see the market needing to go particularly higher than that for any time in the next decade. But that doesn’t say that it won’t spike above that in the near term. When I say near term, I mean three years or four years out as the supply-demand imbalance gets turned around. That is as we go into a new fuel cycle and as we secure contractual commitments for the financing of reactors. The truth is that the cost of the uranium that goes into a reactor is a fairly small component of the total cost of producing power. And in that sense, demand is very inelastic or put differently supply is very elastic and those fuel cycle and contract needs to take place in a much shorter period of time than the uranium producers can necessarily react to it. So the statement that you’ve made is true. If you look at it over the 10-year time frame, probably less true if you look at it over the five-year time frame.
TCI: And you don’t think Sprott has a good handle on utilities needs, so it can anticipate better from the demand side?
RR: Nobody has a good handle on that part of the market. I spent probably 15 months trying to get a really good handle on supply and demand for uranium from utilities from a state, or parastatal actors, from companies, and what I learned is that in addition to the fact that the market is very opaque even among knowledgeable players, there’s a lot more misinformation than there is information. And the truth is that the deeper that you question many actors, the more that you come away with is the fact that even the actors who are insiders are mystified as to the state of the uranium market.
TCI: This is remarkable. What would for example happen if you would go to every important utility in the U.S. and just ask them about their demands?
RR: You would get a sense of demand, but what you can’t get is a sense of how they intend to meet that demand. They just don’t say it because they don’t know. They don’t know what is the reasonable price to pay. They don’t know what the availability of uranium is going to be.
TCI: But they have their stockpiles dwindling, and some sort of schedule to meet their demands, and arrange long-term contracts. Regardless of price almost.
RR: Now we’re coming into a new fuel cycle. And really the question becomes for the uranium producers do they enter into long-term contracts sooner rather than later at lower prices, or do they wait for the market to come into some better balance? And the utilities right now are a little leery into entering into long-term contracts too soon because the long-term contracts generally employ uranium prices in excess of US$40 per pound, when those same pounds can be acquired in the near term in the spot market at less than $30 a pound.
So the utilities are paying a sort of a 25 or 30% premium to get long-term security of supply. It’s worth noting that the new-build market is very different. In most of the world, if you build a new reactor, which consumes, say, a million pounds of uranium a year, the upfront capital cost associated with that plant is sort of $6 to $8 billion. And normally as a condition of obtaining financing for that plant, you need to have obtained security of supply. The financial institutions are looking for security of supply sufficient to amortize on a net present value basis most of the production credit facility, which is to say eight or nine years, probably 60 or 70% of the fuel needs, for eight or nine years. So the real strength that you’re seeing in the contracting market now is coming out of the newbuilds in Asia.
TCI: But you don’t think there is some kind of a paradigm shift going on between utilities just buying on the spot market because they can have these persistent low prices? There will be solid contract pricing coming up?
RR: I think that there will be some contract pricing coming up, simply because the prices of uranium relative to the total cost of operating a plant are so small and these prices are so cheap. When we enter the refueling cycle, I think that likely some of these plants will opt for security of supply. And in effect pay up even though paying up means that that uranium is fairly cheap relative to the cost to supply it. The problem will come of course for the marginal players on both sides.
By the way, I’m sympathetic with your sense that the Kazakhs will be able to in some measure in the long term control the price of uranium. And I suspect that there are discussions within Kazatomprom as to how to maximize the yield of the nation from the uranium market. There are some managers within Kazatomprom, I believe, that think that they ought to be paying attention to the margin per pound that they enjoy. There are other managers who believe that they should be acting to exert some form of hegemonistic control over the uranium market. I don’t think that that issue has been decided even within Kazatomprom.
TCI: Next up is copper. Forecasts by the largest copper producers show a looming deficit, but a company like First Quantum intriguingly shows supply meeting demand until 2023 when reductions are included. How likely is it in your view that this is a viable scenario?
RR: Copper is really an interesting market as we speak. The incentive price for putting new copper mines in production is probably somewhere between US$3.25 and US$3.50 per pound, and the market is selling below that. Now, the truth is that the more efficient producers enjoy pretty substantial cash margins even at the current price. The problem is that there’s a deficit. We’re consuming more copper than we are producing and we’re producing that copper in many cases from mines that are extraordinarily long of tooth. The largest historical copper mine in the world is of course Bingham Canyon, which is responsible for most of U.S. production, but, or at least as the biggest producer in the United States and the mine is 110 years old.
Similarly, the largest producing mine in Chile is Escondida, which is 30 years old. Another very large one is Morenci, which is 150 years old, Grasberg in Indonesia is 35 years old, which is a different way of saying that most of the copper that now powers the world is coming out of mines that are extraordinarily long of tooth and past their prime, that in a normal market would be sufficient to boost the copper price. But this isn’t the normal market. This is a market that was originally probably boosted by urbanization in China, but it’s also a market that is concerned about the fact that we are now 9 or 10 years into a global economic recovery. And the recovery that many people, including Sprott, believes is more a consequence of artificially low interest rates than it is of healthy economies on a global basis.
In the long term an increase in the copper price is assured. It’s assured because there’s over a billion people in the world who aren’t connected to electricity. It’s assured because the bottom sort of 2 billion people in the world by income are gradually becoming richer and appreciate the utility that the electrical grid offers them. But in the near term, we need to be concerned about the possible impacts of the global economic slowdown that is a sort of a reversion to the mean in global economies, which would reduce demand in the near term.
I personally remain attracted to very high quality copper deposits because traditionally copper mining companies have been among the most profitable mining companies on the planet. And on balance, I would suggest that the bigger copper miners are better run than the bigger gold miners. So I personally love the copper business. I’m guarded in terms of my outlook for copper in the near term because I share with Sprott a concern about a global economic slowdown after a 10-year recovery where at least I believe that much of the recovery is a consequence of artificially low interest rates.
What I think you’re going to see isn’t so much deliberate reductions as the fact that most of the important producing capacity in copper worldwide is past its prime. So I think the reductions that you’re going to see are going to be a combination of naturally reducing grades in the large deposits and the fact that it’s very, very difficult to bring a new deposit online at today’s copper prices. The exception of course being Kamoa Kakula, the Ivanhoe Zijin project in Congo, which has at least in the first six or seven years an average grade of 6.5%, which is about 10 times the average mine grade worldwide. When we see the very large, particularly new world copper porphyry projects, they’re available to bring in production. What you see is that the upfront cash costs, the capital costs to build them are so extraordinary that they require copper prices in the US$3.25 – $3.50 cents per pound to make them financeable and economic.
So the reduction that you’re going to see is a natural consequence of diminished grade and perhaps reduced sustaining capital expenditures in the face of fairly weak copper prices relative to the company’s ability to build new projects, which while discovered are so capital intensive that the boards and the banks won’t finance them until the copper price is demonstrably above $3.25 per pound.
The reduction isn’t so much a corporate strategy that is like the uranium space where you’re seeing people shutting mines down. What you’re looking at in the copper business is that if you look at the biggest mines worldwide, which have traditionally supplied copper demand, as they go lower in the system, they transition out of the higher-grade material that they’ve been producing for the last 15 or 20 years into lower-grade material. As an example Grasberg used to have a 1.5% cutoff. That cutoff is now 0.5%, and there are lots of other examples. In fact, the average produced grade of copper worldwide now is about 0.5%, meaning that it’s halved over 20 years. So the reduction in supply that First Quantum talks about is very consistent with what I’ve been talking about. The fact that the largest copper producers in the world by mines are either at or well past their prime.
The challenge that we have is that the new capacity in particular is challenged by the financeability of that capacity. There are probably 50 deposits worldwide that are drilled to the extent that if the copper price was sufficient, they could be financed and put in production. The difficulty is to build a new porphyry deposit these days, let’s just say the average capital cost to put them in production. These deposits can easily require $5 billion to be put into production. That sum, particularly the debt components, are effectively unavailable at today’s copper prices, in these capital markets. It’s the old fashioned question between resource and reserve. The definition between resource and reserve is often a function of the price. At $3.50 cents per pound, there’s lots of copper in the world. At $2.75 the outlook is much more challenged.
By the way, First Quantum’s experience in various jurisdictions, which were first good and then became bad, particularly both in Zambia and Congo, add a whole different dimension to the discussion of copper. When I talk about the ability to finance projects into production at $3.50 per pound, I’m talking about that absent rapacious governments or civil wars. A lot of the latent productive capacity in copper exists in frontier markets where decisions haven’t been made as to what the appropriate social take is or who gets it.
The Zambian copper belt is an example that straddles both Zambia and Congo, exposes the copper market and the companies operating there to a range of social and political challenges that haven’t been present in places like Australia, Chile, the United States and Canada. Similarly, the increase in production capacity at Oyu Tolgoi in Mongolia has been a challenge because of the uncertain outlook with regards to social take in Mongolia, and the ability of Rio Tinto and the Mongolian government to finance the expansion given the uncertain political outlook, which is, probably a whole separate discussion that should take place in any copper discussion. But one that I’m probably ill-equipped to participate in.
TCI: Notwithstanding this, this looks like a solid overview of copper mining fundamentals. Let’s switch to something more general again. You said you value Austrian economics and libertarianism. What exactly is the influence of both on your investment strategies, and may be a bit watered down for size on the investment strategies of Sprott?
RR: To me the most important investment criteria exist at the firm level. I’m more a micro guy in an economic sense than a macro guy. That being said I believe that the global political system on a macro level has some very obvious challenges. And I look at those challenges certainly from a perspective that in economic terms would be described as Austrian, and from a philosophical point of view would be described as libertarian. I think history, separate from ideology, has shown that when individuals are more free, countries and societies become more rich. If you look at the best example in the last 30 years, yes, I’ll sensibly leave out a Communist country.
But in China, when Deng Xiaoping said, “It doesn’t matter whether a cat is white or red, the question becomes can it catch mice”? And when he similarly said “to be rich is glorious,” in other words, when individual initiative was unleashed in China, the result was truly astonishing. Similarly, those few examples in the world where individual economics, and the rule of law of course, has been a guiding principle, I’ve seen resounding successes. I look towards places like Hong Kong and Singapore. Sadly from my point of view, the world is becoming much more controlled, frankly, much more socialist. And so my own view of the opportunity and growth is challenged because I see increasing communal and state depredation of individual initiatives.
I would simply say that history, at least in my lifetime, has affirmed that people who have more individual liberty and lower tax environments have been more conducive to economic growth and entrepreneurialism. From my own point of view I see more societies around the world opting for more state and more distribution, and hence I see lower prosperity going forward. So in that sense, my libertarian self makes me a much more cautious investor. I need to say that in the long-term I remain very optimistic. It is interesting that even in the state where I live, California, a place where government has become more and more intrusive, individual initiative is still such that five or six young people can take over a garage in Sunnyvale, California, and out pops Google, which is to say in the long term, individual initiative is so strong that it can outmaneuver communal stupidity.
But I must say that as individuals sometimes when we generate so much wealth and so much utility that we can overcome the depredation of the state, both in terms of idiotic regulation and excessive taxation. In the near term the state makes everyone poorer in my view and makes me more cautious. In the longer term, people are enormously inventive and can find ways to increase the utility of their endeavors, even despite the states and democracies on a global basis are a bit challenged. By the way, I’m not anti-democratic. I’m saying that the truth is that the world has many more spenders than it has savers. And in a place where the economy is controlled by the voters, the spenders always vote to distribute the assets of the savers. In other words, there is always a war on the savers and creators by the spenders. If the savers were allowed greater abilities to invest through less regulation and less taxation, the world as a whole would be much, much richer. But there’s a pendulum that swings back and forth between encouraging savings and investment, and encouraging redistribution and consumption. And it would seem that we are as a society, as a global society, swinging towards more regulation, more taxation, and more consumption away from an encouragement in savings, innovation and investment.
TCI: Interesting. So you see a direct connection between that, or is that libertarianism speaking?
RR: I do. I think history shows you that connection frankly. I would credit some of it to libertarianism. I would prefer to say that I’m a libertarian because I’ve been an amateur historian. I’ve looked for systems that have generated wealth and the private generation of utility, the savings of the economic margin generated by innovation in the hands of individuals who reinvest, rather than in the hands of politicians who distributed to buy votes, is always in my view, more efficient. Societies that have liberalized, that is societies that have allowed more individual participation are always societies that have prospered and societies sort of swung towards the state have always made themselves poorer.
TCI: The other thing is that these kinds of societies require more individualism and therefore create larger differences, utilities as you say, but you also get for example more harsh cases at the low end of such a society. Is that viable as a society in order to survive in the long run?
RR: I think it is viable. I think envy is an ongoing problem, but the truth is that societies need to generate some wealth to redistribute and that wealth has never generated by the collective. It’s always generated by the individual. I think societies swing back and forth between what most of them want and what they can afford. Again, I point towards the most controlled economy in the world, which was China when China made the decision that their version of communalism wasn’t working, and liberalized when they allowed, as an example, the farmer to keep more of the economic benefit from farming and they dismantled the communal forms. Was there greater disparity in income and living standards in China’s certainly, but did the poorest of the poor advance and did the economy itself advanced markedly? Yes, much more dramatically. So I believe that there will be an ongoing discrepancy between the advancement of mankind as a whole and the wishes of the people who are spenders rather than savers.
TCI: Sprott is a large entity, with about US$10 billion assets under management (AUM). What part of AUM is allocated to mining stocks? How much into debt? Where do your criteria differ when lending compared to other mayor players in this field?
RR: In terms of Sprott, as you suggest, we are a fairly large entity in truth with the recent acquisition of the Tocqueville group of precious metals oriented mutual funds, our assets under management and assets under administration are in the US$12 billion range. And in fact, almost all of that AUM is oriented towards physical precious metals, or mining equities or debt. We have about $250 million in assets under administration that are in general equities, value and deep value strategies, but well in excess of 95% of our assets under management and assets under administration are involved in mining or precious metals, physical precious metals strategies.
TCI: Can you break that down or is that more or less confidential?
RR: It isn’t confidential at all. I don’t follow it in that fashion, but I’ll do my best. And in terms of what we’re talking about now, I would have to report it in Canadian dollars, which is how our board thinks. Somewhere slightly in excess of CA$6 billion would be in our physical precious metals trusts: the Sprott Physical Gold and Silver Trust, the Sprott Physical Gold Trust, the Sprott Physical Silver Trust and the Sprott Physical Platinum and Palladium Trust.
TCI: And that’s backed by actual physical precious metals?
RR: Absolutely, these are not ETFs. These are not investment entities that shrink and swell every day depending on changes in AUM. So there are no depository receipts. These are physical, precious metals trusts with the assets held at the Royal Canadian Mint. We have somewhere in the range of $300 million in precious metals, equities, ETFs, the Sprott gold miners index, and the Sprott junior gold miners index. Importantly, these are factor based rather than market cap or liquidity based ETFs. We have in the range of $2 billion in managed equities between our segregated managed accounts institutional accounts and the Tocqueville assets, which don’t officially become ours until the middle of January 2020.
Then we have about a $1.5 billion in institutional and retail strategies associated with lending activities to publicly listed mining companies. We are, we believe, the largest provider of construction and project credit for non-investment grade mining companies worldwide. And this is supported by both high net retail and also institutional, primarily U.S. institutional clients of Sprott. In addition between the United States and Canada, we have somewhere in excess of $1.2 billion in assets under administration rather than management. These are in our wealth management groups where we advise high net worth retail and institutional clients, but don’t formally manage that money. In addition, as you know, Sprott has a rather large balance sheet for an investment manager which is invested largely in our own strategies. It’s worth noting that that balance sheet in addition to being fairly large is good. In the sense that there is no net debt currently on the balance sheet after cash. And there is a $95 million credit line, which with the Royal bank of Canada, which was effectively undrawn.
TCI: This credit line seems small for such a firm with that much AUM?
RR: We are a relatively small firm but with fairly limited capital needs and pretty large capital sources. Most of our balance sheet is liquid. Most of it is invested in our own investment products. We have the ability as a consequence of that fairly stout balance sheet and decent levels of free cash as well as our credit line to reinvest in our basic business. At the same time that we are able to acquire new businesses like the Tocqueville acquisition that we just did as well as periodically buy back our shares on the market, which we were fairly aggressively doing in the last three months.
For the last part of your question, I would say that our lending criteria, this is going to sound simple but it isn’t, our focus is not so much on the relative yield as it is on getting repaid. We have, if you look back in our lending business to before the time when we owned it, the predecessor business, we have been in the lending business for about 30 years and have originated probably $7 billion in loans over that period of time. And we’ve experienced less than $10 million in historical credit losses in mining during that time. So our underwriting criteria are fairly stringent. We began life as bridge lenders, that is providing interim finance for small property acquisitions.
But in the aftermath of the 2008 banking crisis and the subsequent Basel III banking accords, the large project banks like Deutsche Bank and Barclays, Royal Bank of Canada, Chase Manhattan Bank, were constrained by regulators from participating in project and construction finance, new mine construction finance for smaller non-investment grade mining companies, and Sprott and several other companies came into that space. It really was a regulatory void. This is a fairly large business and with the new trend in mergers and acquisition, we’re seeing opportunities not just in new mine construction but also in merger and acquisition finance. So in addition to being a fairly large opportunity for a firm our size it’s a business where we see the opportunity set growing fairly rapidly too. Our primary criterion is understanding the value of the project at its state of completion and who the asset would be of value to if the existing borrower wasn’t able to complete. If you are lending, say, $150 million to a company that doesn’t have the ability to pay you back without successful completion of the project, you want to be very certain, first of all, that the money you lend them is sufficient to complete it. But you also need to know who the asset becomes strategic to if your existing borrower runs into technical or financial difficulties. We have been very successful over time as a consequence of our fairly stringent underwriting capabilities of when we have had borrowers that ran into problems working with them because we were confident in our knowledge of the value of the projects and understood that the difficulties that we were experiencing were temporary rather than permanent difficulties. We have been able to work with our borrowers because we have been fairly prudent lenders.
TCI: Where would you say that you would differ from, for example, Orion Resource Partners?
RR: I think Orion, they’re very good competitors by the way; I have nothing but praise for the Orion people. I of course think we’re better, but that doesn’t detract from the fact that they are good competitors. I would say that we differ from Orion in the sense that they are beginning to morph into a private equity firm. That is, they’re looking to participate in all parts of the balance sheet and on occasion even to take the companies, that they have lent to, private.
Orion I believe also has, from an underwriting point of view, a more aggressive outlook on the gold and silver price. Well, we privately believe that gold and silver prices are going higher, we don’t believe that our opinion as to pricing constitutes anything to do with a loan criterion. We want the loans to work at current strip. So I would say that we are purer lenders than the Orion people who have looked to participate much more aggressively throughout the balance sheet. This isn’t to say that in the right circumstance that Sprott wouldn’t provide equity. We are also in the equity business. It doesn’t mean that we wouldn’t buy a stream or engage in other types of financial transaction, but historically we have been bridge lenders or we have been project lenders.
I would say the advantage that we might have over Orion is because we are very active in early stage mining equities, by the time that most of our competitors find a lending opportunity that is by the time that the issuer has a feasibility study done, we have often known the issuer where for 8 or 10 years, we have often financed some or all of the exploration that has led to the production of a feasibility study. And we are active in the equity business rather than in the lending business in earlier stage companies. To the extent that we have specialized in providing what we consider to be catalytic equity, finance, financing of project acquisitions, financing of what we see as catalytic exploration, financing, pre-feasibility studies, financing preliminary economic assessments, financing feasibility studies. So very often, as I say, by the time that our competitors in lending are aware of the opportunity, that is from the time that the companies issue a bankable feasibility study, we have often known the issuers for 8 or 10 years. And I would suggest that that sort of a long-term relationship is one of Sprott’s competitive advantages.
TCI: So it gives you an edge, but it also more riskier to enter at an earlier stage, so it comes at a price.
RR: Certainly the earlier equity businesses is much riskier. You will have more knowledge and more experience. Each business generates knowledge that’s useful to the other businesses. But the businesses themselves aren’t co-mingled.
TCI: So you basically say parties like Orion wait until the project is a little bit more derisked and then come in.
RR: Correct. And you know, our lending business, we like it de-risked too. It’s just that in our equity business where we take more risk in hopes of higher rewards, we have already developed relationships with companies before they become borrowers.
TCI: Maybe you can give specific criteria, for example, on the size of a project, how many million ounces or something, and how do you differ from Orion or a Red Kite?
RR: I would say that all of us are reasonably competitive in loans really as small as $50 million up to, because we would have to syndicate it to each other, probably $1 billion. I would suggest that our own sweet spot that is what we would prefer would be somewhere between $100 and $200 million. We prefer to loan 30 to 40% of the net present value of the project as established by the valuations in the feasibility study. Our loan to completed value is a fairly low. Our loan as a percentage of the total project budget or construction budget could be as high as 65%, with the rest of the capital being contributed by equity or other financial products like streams. At Sprott, probably like our competitors, we prefer to be a senior in the stack. That is, we want to be senior secured creditors very much like you would see in modern construction finance for an office tower or an apartment building. Your readers who want to understand that our business, if they’re familiar with banking, might view us in effect as a construction lender, which is what we are. And so we like to senior secured position. This is one of my favorite questions btw, I love that business.
TCI: Well by all means you could go on if you have more to add on the subject?
RR: One reason to like resource lending better than resource equities investment, as been the absolute, and relative outperformance of lending over the past decade. The TSXV Resource subindex lost in excess of 85% of it’s value over the past decade, while the Sprott lending business, on balance sheet, generated 15% compound annual returns. No guarantees that the next ten years will be as good as the last, but those numbers are very compelling
TCI: So is Sprott focusing on that arm when equities are going into a bear market?
RR: Well, we believe that the activities are different and complementary. We believe that we can do both things simultaneously, and that our exposure to one makes us stronger in the other.
TCI: So you treat them as two different businesses, or you shift for weighting between debt and equities or other assets when the circumstances change?
RR: We run the equities business as a standalone business and the debt business as a standalone business, so we don’t confuse the two on our balance sheet or with our clients. We have clients that invest with us in both strategies, but you need to think of the strategies as separate and segregated silos, even to the extent that often the lending part of our business will for regulatory reasons be constrained from giving information to the equity part of our business.
TCI: That sounds like there is some kind of a Chinese wall on occasion?
RR: You know as an example, our intention to make a loan before it’s been announced publicly might be material nonpublic information. So you can’t allow your equity portfolio managers to have access to information about the intentions of your lending team. Now the background information, the knowledge that we gain as a firm, the knowledge that our geologists have, looking at exploration projects and watching them become feasibility stage projects, all of the knowledge that the firm acquires in the equity side and the debt side becomes very symbiotic and in fact benefits all Sprott clients irrespective of product line.
TCI: You like gold as a storage of value, payment in full. What part of your own AUM is physical gold?
RR: If you mean on the balance sheet of Sprott, I’m going to guess that we only have about $10 million invested in our own physical products. Those physical products as a part of our product spread are probably 40% of our total managed assets under management. So from Sprott’s point of view, we probably, and I’m guessing now, we probably hold $10 million worth of our liquid tradable assets in our physical precious metals trusts. Those physical precious metals trusts probably account for 35 to 40% of assets under management exclusive of assets under administration.
In regard to my personal holdings, I would prefer not to disclose other than to say a rational investor in my position, which is to say relatively wealthy, but with a large portion of his net worth invested in a gold asset manager like Sprott, would probably rationally have less money invested in physical precious metals than I do. Less money because if the gold and silver prices do what I believe they’re going to do, the business of Sprott and also the share price of Sprott could be reasonably expected to do very well. In other words, as a consequence of my basic business, I’m indirectly very invested in gold and silver. That not withstanding, because I’m fairly old at 66 years of age and I am of comfortable means, I still have a fairly substantial gold and silver position because I regard physical precious metals or the proxies like the Sprott Trust to be insurance, a different but very good form of liquidity.
So while rationally probably I shouldn’t be invested in gold or I should have a small proportion of my net worth in gold as a consequence of the indirect investments represented elsewhere in my portfolio, I do have what most people would recognize as a large weighting in physical precious metals. My personal holdings are not over 10% in this regard, understand that a lot of my own personal portfolio is made up of our other investing products including our lending partnerships, our equities partnerships and equities held independently from my own account. So if you looked at my total mining and precious metals portfolio it would exceed 40% of my net worth, which is more than I would advise most investors to concentrate on mining and precious metals. I have advantages over many investors in the sense that this is what I do. I watch it very carefully and I’m expert in it, but certainly if you looked at my total portfolio, precious metals and mining would probably exceed 40% of my total portfolio.
TCI: Yes it is a lot. And if you could disclose something about this other 60%, it would be real estate or bonds?
RR: I have traditionally been a pretty good buyer of real estate in sectors that were at the time depressed. So as an example, I was an investor and have a legacy position in very high quality multifamily residential apartment buildings in state capitals. I have a reasonably large personal portfolio in a high quality U.S.-based farmland. I am also an investor in the specialized financial services sector. Over the course of my life I’ve been part of starting several banks and a couple of insurance companies. The consequence of that is that I consider myself a relatively competent investor in financial services. And I do have investments outside the natural resource sector in insurance companies, generalized financial services companies, banks, and a private financial services business in investment management and investment banking in Africa and frontier market focus. I tend not to do things I don’t understand very well unless they’re very, very, very deeply out of favor. So one thing I’m doing personally right now is investing in dry bulk shipping, which is not an area that I understand particularly well, but it is an area that’s so bombed out with such extraordinary valuations and so out of favor that I am dipping my toe into the dry bulk shipping sector.
I would like to add something on my liquidity at the moment. In terms of my own assets under management as a function of my liquidity gold is probably 10% of my total liquidity. And when I’m talking about liquidity I’m talking about things like U.S. dollars, Canadian dollars, euros, in other words, cash equivalence. I consider precious metals to be good but volatile liquidity, and my own personal account is highly liquid right now. I have a lot of liquidity, a lot of cash, cash equivalence, short-term securities. And I would say that physical gold, silver and platinum and palladium as represented largely by the Sprott products is probably 10% of my total portfolio liquidity.
TCI: Is there a reason that you’re so liquid at the moment?
RR: I’m not an economist, but I have been investing for in excess of 40 years, and I have noticed that every, I don’t know, 8 to 12 or 13 years, there’s some form of economic and market reset.
2008 would be the most recent example. We have now been, depending on how you measure them, 9 or 10 years into an economic recovery worldwide, however tepid. My experience tells me that 9 or 10 years of recovery is a fairly long of tooth recovery. I also believe that the recovery that we are in has been driven as much by artificially low interest rates as it has been by any global macro factors. So I have a nervousness that we are going to come into sometime in the next one to five years an economic reset. The second thing is that traditionally in my portfolio I always had a reasonable position in 5 to 10 year corporate bonds and I didn’t consider them to be liquidity. I considered them to be an investment. The interest rates that are payable now on those corporate bonds are not in my own opinion sufficient compensation for the risk I have buying them, and other yield oriented instruments, which for me traditionally have been things like pipelines and processing facilities, things which yield steady yields have been bid up in price to the extent that the yields haven’t, from my point of view, been competitive.
So partially I’m opportunity constrained. Two categories of investments that I have traditionally participated in aggressively are, from my point of view, improperly priced. Besides this, I feel the strategic need for liquidity because I believe that there’s a high probability that sometime in the next one to five years we could have a fairly aggressive reset of bond and equity prices. If you go into a circumstance like 2008 with some experience and a lot of liquidity, what happens is that you have the tools and as a consequence, the courage to take advantage of the situation rather than being taken advantage of.
TCI: I read about your strategy of looking at less explored areas, as chances of finding something tend to be higher when there hasn’t been much exploration. Unfortunately these areas are, as you acknowledge, not always the best jurisdictions for mining, and in turn bear higher risk. Where do you draw the line in these jurisdictions?
RR: This is another favorite of mine. I in fact do have a strategy of looking in less explored areas and areas that are perceived to be of higher risk. And I wouldn’t dispute the fact that there is a lot of political risk in my strategy, nor would I pretend that over 40 years I haven’t occasionally been penalized by my willingness to take political risk. What I would tell you and your audience is that there is more political risk in countries that they often regard as stable than they might believe. Mining is an activity that doesn’t enjoy political favor and is also an activity that politicians love to plunder because the capital investments are high and the locations are fixed.
What I have discovered over 40 years, this is going to be a very politically incorrect statement, but I’ll say it, is that money stolen from me by white people in English according to the rule of law by the legislature is just as gone as money that was stolen from me in frontier markets by people who don’t speak English when they steal it from me. That’s the first thing. It isn’t to say that when I invest in some place like Congo or Sudan or Bolivia or Myanmar, all of which I’ve invested in, it doesn’t say that I am not exposing myself to political risk there. It’s just the people who invest in places like California and British Columbia and New Zealand also expose themselves to political risk, but these are political risks in their language by people of their complexion, and they feel more comfortable, I think incorrectly, with the level of political risk that they expose themselves to.
Also because part of my portfolio is involved in otherwise risky activities that is exploration. What I have learned over 40 years is that technical risk is a bigger risk for me than political risk. That is the risk of failure in early exploration where it is in fact the expectation means that exploring in fairly virgin terrain, places that haven’t been explored by modern technology ever, in search of large outcropping deposits is actually better in terms of risk/reward than in concentrating my investments in exploration in places that are more comfortable to explore, and as a consequence of seeing much more thorough investigation, I was taught early in my career that money is made in exploration by employing new technology in old places or old technology in new places. But the idea that you can make big money employing old technology in old places supposes that you’re smarter than everyone who has come before you, which I think is highly unlikely.
The consequence of that is that I am always busy exploring in places that I think have enormous potential, but where the competition is less active and that’s worked out for me extraordinarily well over time. I’ve made money in Russia, I’ve made money in Mongolia, I made money in Peru right after the Shining Path were shown the door. I’ve made money in Congo. That isn’t to say I haven’t lost money in these places, but I have been able to participate over 40 years in many more tier-one world-class discoveries as a consequence of my willingness to go to countries that other people couldn’t spell.
TCI: Could it be that this country risk in certain instances could only be neutralized by excellent entrepreneurs like Robert Friedland in DRC for example, and that you wouldn’t take on the same project with a less high profiled entrepreneur?
RR: The answer to that is yes. And by the way, I think that’s an extremely astute question. One of the things that I need to do in any of my speculations or investments is look at the pedigree of the management relative to the task at hand. That is their ability to deal with the whole range of challenges that you’ve been confronted with. I have invested for 40 years with the Lundin family, first with Adolf and now with his two sons, Lucas and Ian. And I’m delighted to say actually with a grandson, Adam Lundin. And one of the hallmarks of the Lundin family has been an extraordinary lack of ethnocentricity. A family that although they were of Swedish origin has been successful in Argentina, successful in Chile, successful in Sudan, successful in Congo, successful in South Africa, serially successful in countries and in cultures where many of their competitors couldn’t go. Successful too because they took the time to understand the places that they were active in and developed strategies for dealing with the locals, both in terms of the population and the politicians, in ways that exhibited a lot of cultural sensitivity.
There are teams that have the technical or financial acumen but don’t have the political or social skills to adapt themselves to local circumstances and backing those people is a bit of an art form. It’s also worthy to note that right now in some states that are viewed as being very politically risky, it’s a huge benefit to have Chinese partners because the Chinese state, whether you agree with them or not, has been extremely active in backing Chinese parastatal actors in the oil and gas and mining business, employing their own statecraft at the political level to pave the way for their entrepreneurs to be active in those those countries. So as an example, Robert Friedland, who you point to in Congo, has enlisted as partners Zijin mining, the largest non-ferrous mining metals mining company in China and also CITIC, China International Trade and Investment Corporation, as both shareholders of Ivanhoe, but also direct stakeholders in Ivanhoe’s investments in the Congo.
And some of the political interaction that takes place between Ivanhoe and the government of Congo and also the regional governments in Katanga is done with the aid, both of these Chinese parastatal firms and also the government of the People’s Republic of China. Whether you agree with this politically or not, it’s an extremely intelligent and extremely helpful circumstance. Similarly, Friedland’s partner in South Africa in the Platreef project is JOGMEC, a Japanese consortium made up of very large Japanese industrial concerns and the government of Japan. The ability that Robert Friedland has first of all to work well with locals as people; secondly, to work with host governments and also to work with joint venture partners that give him strategic advantages in these countries is one of the hallmarks of Robert Friedland. One of the reasons why Friedland was prior to this a success in Mongolia and is now a success both in South Africa and Congo.
TCI: It goes hand in hand, discovering those huge deposits but also having super efficient relationships between the ones in power basically.
RR: Yes. And you know, he is also doing it really for the benefits of the locals. This is one of the things that really impressed me with Robert’s activities in Congo, and also by the way with Mark Bristow and Barrick’s activities throughout Africa. Historically in my life, when I would go to Africa to work and invest what you would see is a superstructure, a management superstructure that was entirely made up of expats and Caucasians. And if you look at Robert Friedland’s Congolese or South African operations or where you look at Mark Bristow’s operations in West Africa, that isn’t what you see. You will see Ghanaian operations managed at the top by Ghanaians, you will see an extremely efficient transfer of both authority and talent from expats at the beginning towards locals.
TCI: So the local teams are trained at an early stage?
RR: Trained over years and trusted and given authority. The other thing that you will see as a consequence of that respect for locals and the respect shown to locals and the training given to the locals, is an extraordinary a sense of willingness, sense of loyalty on behalf of the locals towards the company. Ivanhoe’s Congolese or Katangan employees are Katangan, but they have a fierce, fierce loyalty to Ivanhoe. Robert Friedland has told me personally that the talent pool in a place like Congo is vast, but the opportunities afforded to them as a consequence of their history are narrow. And he says that the statistical probability of him being able to hire a brilliant Congolese is higher than the statistical probability of his ability to hire a brilliant Canadian, Australian or American.
And Mark Bristow says the same thing. He said that the opportunities available to the domestic talent pool are fairly low. And in fact that his ability to make superb hires of locals is better. That it isn’t just an ESG consideration, that it’s a risk adjusted net present value consideration to hire locals. And this type of thinking is what sets apart the Friedlands and the Bristows and the Lundin’s from their less successful competitors.
TCI: Of course these the names you mentioned are very successful and unicorns in their own way, but it also sounds pretty logical to do it that way?
RR: It’s simply logical after the fact. But when you’re the first to do it, when you’re a pioneer, it’s less logical. Probably initially, you know, you have to use an expat team. But this brings up a question you didn’t ask, but it’s worth stressing. Robert was working in Congo for 20 years before he succeeded and during the whole time he was working in Congo, he was building up his stable of locals. Many people don’t know this, but he was working in South Africa for 15 or 16 years before they made the Platreef discovery. And in fact his South African business was headed by Cyril Ramaphosa, the current president of South Africa.
TCI: I didn’t know this interesting fact, there is no free lunch or shortcuts obviously. I see our time for this session has been consumed, so I would like to thank you again for taking the time so generously, providing us with lots of interesting answers.
RR: The pleasure is all mine, I have never been part of such an extensive interview but enjoy all of it thoroughly.
This concludes the second part of four of a large interview with Rick Rule, CEO of Sprott US Holdings, part of Sprott Inc which is a U$12 billion global asset manager with over 200,000 clients.
I hope you will find this article interesting and useful, and will have further interest in my upcoming articles on mining. To never miss a thing, please subscribe to my free newsletter on my website, http://www.criticalinvestor.eu in order to get an email notice of my new articles soon after they are published.
The Critical Investor is a newsletter and comprehensive junior mining platform, providing analysis, blog and newsfeed and all sorts of information about junior mining. The editor is an avid and critical junior mining stock investor from The Netherlands, with an MSc background in construction/project management. Number cruncher at project economics, looking for high quality companies, mostly growth/turnaround/catalyst-driven to avoid too much dependence/influence of long-term commodity pricing/market sentiments, and often looking for long-term deep value. Getting burned in the past himself at junior mining investments by following overly positive sources that more often than not avoided to mention (hidden) risks or critical flaws, The Critical Investor learned his lesson well, and goes a few steps further ever since, providing a fresh, more in-depth, and critical vision on things, hence the name.
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