The Sprott approach to mining investment

Tuesday, May 30, 2017

In mining investment you are either a contrarian or will be a victim, according to Rick Rule, CEO of Sprott US Holdings.

This cardinal rule underpins Sprott's strategy of seeking opportunities in industries which are effectively in liquidation, with production costs exceeding prices.

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These include copper, a favored metal for the CEO, with Chile remaining his favorite jurisdiction globally, partly due to spectacular mineral endowment.

The company seeks investments in companies run by serially successful entrepreneurs, with political risk seen as less of a put-off than technical risk.

Rick Rule is a member of the advisory board for the 2017 Investing in LatAm Mining Cumbre event taking place in Santiago, Chile on July 11-12.

BNamericas: What is your approach to investment in mining?

Rule: The cardinal rule is, you're either a contrarian or you'll be a victim.

Mining investments are cyclical, capital intensive and volatile. That's either of use to you or you'll be used by it.

Industries that have the total cost of production in excess of the sales price of the product, that is industries in liquidation, are of interest to us because either the price of the commodity rises or that substance becomes unavailable to society.

We're attempting to have the courage to buy the best assets and companies that we can in sectors that are in liquidation when we buy them.

The second precept is that human performance is very preferentially distributed. We're followers of Pareto's Law, which is popularized as the 80:20 rule, suggesting 20% of the population generates 80% of the positive utility in any task.

What that suggests is that you do your very best to eliminate at least 80-90% of the issuers, and focus on those that are led and financed by serially successful entrepreneurs.

The third thing is you have to align yourself with tier 1 deposits. Too much time and effort is spent worldwide on small mines, the thesis being that you can use the cash generated from a small mine to grow a company without dilution - a wonderful story and almost always fiction.

Our experience has been that small companies can't afford the G&A to simultaneously have explorers, developers and producers under one roof.

Exploration companies that are unfortunate enough to discovery small mines almost invariably do generate cash flow - mostly negative!

And the explorers waste their time trying to fix a small mine, something they're bad at, rather than exploring for a big mine, which they might be good at.

Fourth, in earlier stage exploration, which we're extremely fond of, we either want to back the prospector-generator JV business model, under which teams use their technical and commercial acumen to develop exploration theses, and peg or option large pieces of land and then bring in other partners to do the heavy exploration lifting, retaining a carried interest.

Or we want to see the third dimension, which is a very nice discovery hole.

And fifth, we're much more willing to take political than technical risk. I prefer the risk to reward available to me in Congo as opposed to California. Congo offers better deposits and a social circumstance in which they can't do without mining, two attributes missing in more familiar terrain.

BNamericas: How do you view LatAm jurisdictions?

Rule: My favorite jurisdiction globally is Chile. It's becoming less attractive, but from a base that's so much higher than the rest of the world.

I like the targets available to me in LatAm. So despite the fact that I think Argentine political risk is understated under President Mauricio Macri, I'm attracted to the exploration potential.

I'm attracted to Brazil and Peru for the same reason. And the countries that aren't looked on with favor, particularly Nicaragua, are less risky than they're perceived to be.

In my own 15-year experience in Nicaragua the only thing the government asked us to do is what we said we would do, which is obviously a reasonable request.

I'm very attracted, although I have no way in, to technical teams that have historic experience in Venezuela. I love getting involved in races where I'm the only runner.

BNamericas: Why Chile?

Rule: The proven mineral endowment in Chile is spectacular. The mining law and regulatory climate is sophisticated and easily understood. The environmental code in particular is very straightforward, and enforced, meaning if you do no harm you have no problem. If you do harm, you have extraordinary problems.

The rule of law is also very much in place, and it's understandable with regards to minerals.

Roads, water, power are excellent. Although the country has suffered from power shortages that's really a function of spectacular growth, and the country has made enormous private investment in power supply and distribution.

My belief is the power shortages that have plagued the copper producers in the north for the last 12 years are effectively over.

Chilean water law is a model for dry areas around the world.

Finally, human resources in Chile associated with mining, by which I mean the availability of mining professionals, miners and contractors, is superb. It's on par with Canada and Australia.

BNamericas: What's your view of Mexico?

Rule: I like Mexico probably second best in the hemisphere, in part because I'm close to it.

Some of the attributes present in Chile, in particular the non-corrupt political system, the rule of law, and straightforward regulatory climate, are missing in Mexico, but Mexican geology is probably second best in LatAm, after Chile.

Are there social challenges on top of the political challenges? Of course. Widespread criminal activity is a challenge.

BNamericas: Which metals do you favor?

Rule: I like copper. I like big markets where if you have success you'll make big money. We believe that the incentive price for putting new porphyries into production is in the range of US$3.25-3.50/lb.

If we don't see those prices in the next three years we'll begin to experience genuine shortages of copper.

Pricing imbalances are resolved in one of two ways, through demand creation or supply destruction.

I don't see the emergence of demand anywhere in the world. I don't see any economy firing on eight cylinders, including China.

On a global basis, every year we're using the equivalent of one Bingham Canyon, and we're not finding or developing one Bingham Canyon.

Existing productive capacity isn't being replaced or even maintained, so what we're seeing is supply destruction.

It is important to remember that when you destroy supply capabilities the industry can't respond to pricing signals by increasing supply, because it's capital intensive and takes a long time.

You get an extraordinarily messy pricing response to supply destruction, which we saw at the beginning of the last decade, when copper went from US$0.90-0.95/lb to US$4.50/lb.

And that circumstance is what gave rise to the extraordinary success I enjoyed with Ross Beatty at Lumina Copper.

A US$2/share initial investment returned well over US$170 over seven years.

The financial response you can get by buying a deposit that doesn't make any money in a depressed copper price environment, but can be brought into production or sold in a different pricing environment, is an extraordinary opportunity.

I look for minerals where the industry is in liquidation. The agricultural mineral business is in liquidation at current price points, phosphates and nitrates.

Copper and uranium as well. The problem for most investors is that they don't have the patience, because you don't know when this will resolve itself. You have to be willing to continue to feed the deposit.

BNamericas: How do you see investor sentiment toward mining?

Rule: Most investors can't spell mining. Around 1980, precious metals and precious metals equities had an 8% market share in investible capital in the US. Right now, the equivalent is 0.3%. The three decade median is 1.5%.

If sentiment returned to three-decade norms, you'd have a five-fold increase in demand in the biggest investment market in the world. That's part of the opportunity.

I don't think mining will eclipse retail or technology, and I don't think gold will eclipse the US dollar or 10-year treasury. What I do think is our market share will go up from non-existent to registering a pulse.

If that happens the potential upside in mining assets, over a 5-7 year timeframe, could be extraordinary.

BNamericas: Is mining capital constrained?

Rule: We believe the market is substantially overcapitalized.

Speaking personally rather than for Sprott, I believe 80% of the junior listings worldwide have a net present value of zero. The companies that are deserving of finance are a subgroup of perhaps 20% of listed entities worldwide.

There has been too little discrimination in terms of quality. A lot more rigorous fundamental analysis has to take place in capital provision. What we call the cockroaches need to be allowed to die.

Areas that are regarded as politically risky have, probably for good reason, had capital shortages, but the only capital shortage that we really see in the market now is more of a regulatory than a capital markets failing, and that's the provision of capital for mine construction and development among non-investment grade issuers.

That's a market we're in, and it's becoming increasingly well-served because there's a market response.

In the last 10 years, that's the only part of the sector that I could reasonably describe as capital constrained, if you agree that most of the juniors are valueless.

About Rick Rule

Rick Rule is CEO of Sprott US Holdings, leading a team of earth science and finance professionals in resource investment management.

About the company

Sprott US Holdings is a holding company made up of three separate companies, Sprott Global Resource Investments, Sprott Asset Management USA, and Resource Capital Investment Corporation.

Parent company Sprott Inc, based in Toronto, Canada, has about US$9.7bn in assets under management, with about US$7bn invested in the natural resources sector.