Mining stocks may have moved from a bear market to a place where they are becoming contrarian plays, says Mike Niehuser, founder of Beacon Rock Research, opening opportunities for value investing. With the concept of "Too Big To Fail" unknown in the mining world, the field of companies is shrinking, making room for potential winners. In this interview with The Gold Report, Niehuser warns that companies need more than good projects and cash to outperform their peers.
The Gold Report: We are coming to the end of 2013, and you've been busy visiting projects and attending conferences. What are some themes you see in metals and resource stocks?
Mike Niehuser: It is clear that following the PDAC Convention last spring, conferences seem to be down in numbers of attendees and participating companies, probably a result of challenges raising money or running out of money. But it feels as if we have moved from a feeling of fear of what's to come to an acceptance of how to move forward. What is interesting to me about the recent Metals & Minerals Investment Conference in San Francisco is that the commentators all seem to be reaching the same conclusion but with different words. It's similar to several people witnessing a traffic accident; the result is plain to see, but the way it happened can be perceived quite differently.
TGR: Are you referring to mining stocks?
MN: There seems to be a definite consensus that we are at a bottom for mining stocks, but the question nobody dares to touch is how long it will last. One company had a nice little chart in its corporate presentation going back to 1983 for small-cap mining stocks. It showed bottoms lasting a couple of years prior to 2000, with greater volatility, in 2008, for example. I'm thinking we may be in for a couple of years that could be positive. This would imply that we have moved from a bear market to the place where mining stocks are becoming contrarian plays. I suspect this is how we begin to move off the bottom. I don't see an immediate massive sector rotation back into mining stocks, but this is fine for me because it favors company selection and value investing.
TGR: That seems optimistic. How do you know that?
MN: There are a few success stories out there that have appreciated. Companies still get rewarded for results, they just need to be material and faster than their cash burn rate. Also, appreciation generally follows companies with good capital structure and insider buying. All this is just basic value investing for those with the potential to deliver more than their peers. With a smaller field of companies, the market has already culled the herd, and 2014 could be a much better year. The sector and companies will be under pressure. This will provide further opportunities at year-end, especially with further declines in metal prices.
TGR: What do you see for metal prices?
MN: Certainly the Federal Reserve tapering, or reducing its bond buying, is getting all the attention, but I think this is misleading because the Fed is genetically predisposed to easy money in one form or another. I am shocked to see the velocity of money dropping like a rock. If you go to the Federal Reserve Bank of St. Louis' website and look up the chart for the Velocity of M2 Money Stock, velocity is at the lowest level in more than 50 years. How we are not in a full blown depression can only be a result of ongoing bond purchases by the Federal Reserve, funding government largess.
Quantitative easing [QE] suppresses interest rates, which benefits those with access to capital markets like large corporations, and good luck to the rest of us. The drop in velocity is a rational response to the administration's "fundamental transformation" that has increased uncertainty and led to holding higher cash balances. This causes deflation in the short run. When holders of cash are shaken seeing the value of their position eroded by QE, the horse will be out of the gate.
It is interesting that the leading economic indicators are positive, but this indicator is heavily weighted to low interest rates. So, in effect, the Federal Reserve is grading its own papers. With the appointment of the new Fed chair I don't anticipate any changes in QE. If you pulled QE out in 2013, we probably would have negative growth over the last four quarters.
I don't like QE because it is a Keynesian mechanism based on the premise that individuals are subject to animal spirits, or, in effect, are stupid. This is offensive to me. I would prefer what Friedman suggested for a passive monetary policy that didn't try to trick consumers and investors, but trusted their individual judgment for consumption and investment.
QE is like meth-it makes you feel warm and pretty out on the street. It allows you to steal from others without concern. QE redistributes wealth. It is the drug that enslaves the user and robs seniors of their independence and from receiving a fair return on their savings. It promises the young an education at an inflated price, it places an extra burden on the productive and it destroys the middle class. If you want to see who is getting rich, go to Washington to see how the dealers are doing.
TGR: So should the Federal Reserve end QE right now?
MN: If the economy is as strong as the stock market is telling us, why not? The antidote for QE is reality, stable money. It doesn't have to be a gold standard, but just some stability to stop manipulating the money supply. It's become insider trading by the government. Look to the pilgrims, they lost everything and learned to adapt and they survived. So can we. Of course, I am an optimist.
TGR: So where do you see gold prices going in the near term?
MN: Who knows? We can expect gold to be lower in the near term. QE benefits Wall Street, big companies and government workers and beneficiaries. These consume rather than save. Velocity is dropping too fast for QE to keep gold prices up in the near term, especially with talk of tapering. It will be interesting to see who is buying this holiday season and how much, and what they have left at the end of the day. It will be interesting to watch consumer sentiment meet reality; it will be subtle.
TGR: What about investor sentiment for mining stocks?
MN: It appears that we are at a classic place where you know we are at the top when your barber is giving you hot stock tips, and we are near the bottom when they are plugging bitcoins over gold. Gold is real and has a history. What is important is that with year-end tax loss selling and with metal prices at or below advertised costs of production, there should be some real bargains. If we are near a bottom, this is when value investors become active, and this is the domain of the contrarian.
It is not enough to find companies with cash and good projects. You need a business that has a good aggressive management team working together with a realistic plan leading to success. This defines who survived the downturn and who will come out of it first. We have seen the losers, and now the winners are beginning to emerge. It will still take some time for them to get the recognition that they will need to earn. Good company selection is important to pick stocks with potential for appreciation, but a little sector rotation could make them look real smart. With an apparent reduction in active junior mining stocks, by definition, when sentiment reverses, it could be quite dramatic given a smaller roster of mining stocks.
TGR: With volatility in mining stocks don't you feel investors hurt by the downturn will stay away?
MN: Investors may feel they have been lied to by companies and maybe a little bit by themselves. Rising prices never keep up with increasing expectations. The problem of course with mining is that miners seem to operate with costs of production up to the metal price. When expectations cool, metal prices stall and mines fail to meet earnings growth expectations, and investors look for someone to blame.
Nobody questions corporate decisions when stock prices increase, but they do question ethics when they decline. But this is why I love the mining sector: there is no Too Big To Fail here. If you don't cut it, you fix it or you're gone. There's no subsidizing failure except by investors believing in good projects. This is why the sector could come roaring back. The only thing that can get in the way is government. This means the headwinds of higher taxes, regulatory corruption and career focused NGOs.
TGR: When do you think money might start moving back into the mining sector?
MN: It could start next spring, but I wouldn't set my clock by it. At some point investors are going to see returns diminish in the broader market and will look for alternatives. They naturally will look for oversold areas for greater returns. This is optimistic. So my concern is that with QE we may see a shrinking class of contrarian retail investors that are the foot soldiers of a bull market. These investors have the greatest acuity for seeing value and have the greatest willingness to do their homework and to accept risk with a longer time horizon.
TGR: What have you seen and what do you like?
MN: For the most part sticking close to North America, to metals and jurisdictions I understand. I'm looking for companies with good prospects to positively surprise investors by improving production, reworking development plans or exploration potential, and special situations.
TGR: What about rare earths? Are they on their back right now?
MN: While rare earth prices and company stocks are down, I believe this is a stage where, when enthusiasm wanes, heavy rare earth projects will be distinguished from the lights, and a few winners among the 300+ rare earth projects will emerge.
TGR: Thank you for taking the time to join us.
This interview was published by The Gold Report.
Mike Niehuser is the founder of Beacon Rock Research, LLC, which produces research for an institutional audience and focuses in part on precious, base and industrial metals, oil and gas and alternative energy. Previously a vice president and senior equity analyst with the Robins Group, he also worked as an equity analyst with The RedChip Review. He holds a bachelor's degree in finance from the University of Oregon.
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