Stockhouse Movers & Shakers: Rick Rule says junior resource sector is overpriced

A high profile speaker on the mining conference circuit, Rule has been involved in micro-cap investing and analysis for over 35 years.

Much has changed since Rick Rule sold his interest in a Vancouver night club in 1979, freeing him up to launch a career in the stock investment business. But one thing still holds true, he says.

The vast majority of investors in micro-cap resource stocks are sinking their money into companies that are woefully underfunded and run by managers with no track record of success in what they are aiming to achieve. Indeed, he says as many as 80 per cent of these companies may be worthless.

“That’s probably a conservative estimate,’’ said Rule, who is now based in San Diego, where he is Chairman of Global Resources Investments Ltd., a global leader in microcap investing, with US$8 billion worth of assets under management.

A high profile speaker on the mining conference circuit, he has been involved in micro-cap investing and analysis since the days, 35 years ago, when he owned the Sneaky Pete’s nightclub in Vancouver and began to rub shoulders with Peter Brown, Murray Pezim and other lions of the Canadian penny stock scene.

But in spite of the sector’s high risk nature, Rule believes micro-cap stocks are still a good place to invest for people who are prepared to do their homework and have the courage to trust their convictions, even when the chips are down.

“It means that a business that appears to be extraordinarily risky, is much less risky for the person who does the work,” he said.

Drilling down into the financial reports and disclosure documents of small resource firms is what Rule believes he does best. It is something he will spend more time on now that Global Resources is being swallowed by Toronto-based fund company Sprott Inc. (TSX: T.SII, Stock Forum).

“I think that the junior resource sector as a whole is stupidly overpriced,’’ Rule said.

But he says many speculators fail to recognize this because they are momentum-driven reward chasers, who don’t pay attention to balance sheets and the track record of the people who run the companies that they are investing in.

“That always ends unhappily,” he said.

Based on his own experience, Rule says there are a number of things that people should consider when they are thinking of investing in a micro-cap stock.

“You probably start with management,” he said. “You make sure that the expertise exhibited by management is expertise that is specifically suited to the task at hand.’’

He said a management team that successfully operated a gold mine in French-speaking Quebec isn’t necessarily going to be so successful if they are exploring for gold and copper in Spanish-speaking Peru.

Rule advises investors to be wary of junior companies that are looking for small mines.

A waste of time

“The idea that you can put a small mine into production and use the cash flow to explore and build a bigger mine is seductive to entrepreneurial mind sets. But it almost never works.’’

This is because small companies usually can’t afford a big enough management team to be able to successfully explore and operate simultaneously.

He says it means that if something goes wrong and management becomes focused on trying to fix what is broken, they likely don’t have time to add value via exploration.

“I think that gold targets that are smaller than one million ounces are a waste of time,’’ Rule said.

Meanwhile, he says investors who ignore financial risk are doing so at their peril.

For example, if a company is proposing $5 million work program, has $2 million in annual general and administrative expenses, and $1.5 million in the treasury, that’s just another way of saying that the company is going to be broke in March, he says.

The state of company balance sheets may be particularly important because stock markets are unlikely to be as benign in the next year and a half as they have been in recent months, he says.

“If you are facing a period, where I believe volatility will be the norm, where there is an extreme danger of the liquidity-driven decline that is reminiscent of 2007 and 2008, I think that you need to buy companies with 12 to 18 months worth of working capital already in the treasury,’’ he said.

Still, the good news is that major mining companies such as Newmont Mining Corp. (NYSE: NEM, Stock Forum), Anglo American PLC (OTO: AAUKY, Stock Forum)and Barrick Gold Corp. (TSX: T.ABX, Stock Forum) and (NYSE: ABX, Stock Forum) will find it increasingly difficult to replace the reserves they are mining without resorting to takeovers. “Without mergers and acquisitions, they are merely cannibalizing their own resource base,’’ he said.

It means that companies with promising discoveries will sell for “truly eye popping multiples.’’

The pending Andean Resources Corp. (TSX: T.AND, Stock Forum) takeover by Goldcorp Inc. (TSX: T.G, Stock Forum) is an example of that, Rule said. The takeover of Red Back Mining Inc. (TSX: T.RBI, Stock Forum) by Kinross Gold Corp. (TSX: T.K, Stock Forum) is merely a warning sign of what is to come in West Africa. “You are going to see a lot of consolidation in West Africa,’’ said Rule.

It is a trend that has already been recognized by savvy investors like Frank Giustra, who has been gearing up to take advantage of the situation via Endeavour Mining Corp. (TSX: T.EDV, Stock Forum), the mining company that he indirectly controls.

“I think that the spinoff by Barrick of African Barrick was done to give Barrick staff a currency that they could use to participate in West African consolidation,’’ Rule said.

Meanwhile, Rule is telling investors to be mindful of the fact that exploration equities are generally cheaper in Australia than they are in Canada, which means there will be takeovers of Australian domiciled explorers by U.S. or Canadian explorers.

The North American companies have higher market caps relative to their assets, than the Australians do, he said.

Rick Rule Biography

Rick Rule is Chairman of Global Resources Investments Ltd. He began his career in the securities business in 1974 and has been principally involved in natural resource security investments ever since. He is both a popular speaker and a leading investor specializing in mining, energy, water, forest products and agriculture. Rule’s investments firms will become wholly-owned subsidiaries of Sprott Inc. in early 2011.