Many analysts and industry executives now believe that there are ample fundamental and technical reasons to support that we are on the verge of a major move up in the mining sector, especially in the gold and silver markets.
Interest Rates, Bear Markets and Opportunity
In a recent interview I conducted with Rick Rule (1/31/2013), founder and chairman of Sprott Global Resource Investments Ltd., Mr. Rule laid out his views on the current financial situation and how it influences the gold and silver markets. Involved in the security markets since 1974, Rule is a specialist in the mining and precious metals markets.
Mr. Rule believes that current interest rates are too low. "I don't believe the yields offered in debt markets, including government debt, are anywhere near sufficient to accommodate for the risk, particularly when you are looking at absolutely negative real yields." He believes that rates have to move higher, although it might take two or three years for rates to climb.
What do higher interest rates mean for precious metals?
"I think higher interest rates are a mixed blessing to the precious metals markets," Rule said. Rising rates will increase the cost of holding precious metals, but if interest rates rise because they are being pulled by the market, as they were in the 1970s, and are not pulling the market, then "that would be extremely good for precious metals."
Mr. Rule sees this as a "Time of transition from older, more sclerotic markets, which I would call less free, places like Western Europe, the United States, and Japan, and … frontier and emerging markets that are becoming slightly more free."
Mr. Rule finds it ironic that countries that had credit concerns in the 1990s now have the better balance sheets. Such a state is not because such nations were necessarily better run, but simply because they couldn't access world credit markets. He mentioned Russia, Chile and Indonesia as examples. As a consequence, they are less indebted than the United States and Western Europe.
Since these smaller markets are less debt-laden, they will probably recover first. However, recovery in these smaller markets is not as important to the global market as recovery in Western Europe or larger markets, "but it's very, very, very good for the natural resources space," Rule said. "Because as poor people get richer, the type of stuff they spend their money on is made of stuff. As Americans get richer, they buy services ... I think the outlook is going to be mixed, but I think it's going to be very good for commodities."
Mr. Rule said, "I love bear markets. In my experience, I've learned that what a bear market really is, is a sale." He pointed out that in consumer markets, when people go to buy a car, a can of soda or a sofa, they love things that are on sale, but such is not the case in financial investments. "By definition you can't buy goods on sale in a bull market; you have to buy them during a bear market."
"We believe this soft market [in mining stocks] will continue for a reasonably long period of time, certainly at least a year or two years," Rule said. He argued that some of the better junior mining company stocks have already bottomed out. However, it won't seem like the bottom, because so many of the juniors still have so far to fall. He stressed that stock selection is more crucial now in order to achieve profits, than by trying to increase equity by counting on a general market rebound.
Picking mining stocks that will make a nice return may be harder than it appears. Mr. Rule said that he estimates that 60% to 70% of the companies that occupy the junior mining space are worthless. He stressed that the excesses from the 2002-2010 bull market, with the exception of 2008, need to be worked out of the market, before a bottom is reached. The problem, he said, is that "Good companies and bad companies rose in the bull market. Both have fallen in the bear market. Success depends on being able to differentiate between the good and the bad."
But in a bear market, can even a good company prosper in mining? Last year, a down year, Mr. Rule said, when mining companies executed and showed deposits or exciting information, the market responded well. He mentioned Africa Gold Group, which went from 80 cents to 10 dollars and Goldquest, which went from 6 cents to 2 dollars as examples. "This is not a market that won't reward success."
Mr. Rule stressed the difference between picking a good stock with potential versus counting on a broad, market rise. "I think investors who are looking for a rise in the overall market are going to be disappointed for the next year or two," Mr. Rule said. "Speculators who are willing to do the work, the qualitative work, to differentiate between the good and the bad … the good ones are on sale."
How to Pick a Small Mining Company
Mr. Rule counseled that he would look at the preliminary economic assessment in the of a developmental junior that could lead to the possibility of a takeover by a mid-size or major in the future. "Such companies are selling at the greatest discount to the net asset values that I've seen in my career," Mr. Rule said. He suggested looking for companies with higher grade, low capital intensity and higher rates of return, which should do well in the next 18 months. He stressed, "When you see some of them start to go, there's going to be a real feeding frenzy."
He also sees mergers and consolidation in the future. Middle and large tier companies have spent maybe two-thirds of their market cap just maintaining their production. He sees maybe 15 or 20 financially accretive transactions possible, instead of mergers and consolidation merely to increase production.
In terms of management teams, he stressed the need for a team's skill set to be very specific to their type of company: type of mine, geographic area, scale, etc. A management team with experience and success operating a gold mine in Northern Quebec is probably going to have trouble making a success of a tin mine in Chile.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: The information in the Market Commentaries was obtained from sources believed to be reliable, but we do not guarantee its accuracy. Neither the information nor any opinion expressed therein constitutes a solicitation of the purchase or sale of any futures or options contracts.