Following another few weeks of cascading metals and mining equity prices, Michael Kosowan, Investment Executive and Investment Advisor with Sprott Global Resource Investments and Sprott Private Wealth, was kind enough to share a few comments.
Speaking towards to the psychological challenge resource investors face in this market, Michael noted, “It’s uncomfortable swimming against the tides of uncertainty throughout these markets and the volatility that we experience…the sentiment is just abysmal…[But] therein lies the opportunity.”
Reflecting on the 2000 bottom in natural resources, Michael commented that he witnessed many juniors selling “For less than the cash they were holding. Meanwhile, you were getting the mineral upside, or the mineral potential they contained—for free.” The subsequent recovery produced momentum of “10x and 12x moves on a few of [the] larger caps names,” he further added.
Photo: High-Grade Drill Core Sample, Brucejack Project, Pretium Resources Inc.1
Here are his full interview comments with Sprott Global Resource Investment’s Tekoa Da Silva:
Tekoa Da Silva: Michael, we’ve seen an absolute demolishing of price over the last two weeks in the precious metals and resource space, and what I’d like to ask you about today is the extreme market sentiment we’re seeing in the marketplace. Before getting to that can you tell us a little bit about your background?
Michael Kosowan: I joined Sprott Global Resource Investments about 15 years ago. I have a background as a mining engineer, so I worked for senior mining companies and also exploration companies, and part of what I did in that context was evaluating junior resource projects, to see whether or not they made a good fit for an acquisition by a senior, or for another junior who wanted to expand a resource.
I started working under Rick Rule’s tutelage and learned the ropes as a broker. And since we’ve been acquired by Sprott, I’ve in effect been transferred up here to Toronto, and so I’m at the vanguard in terms of advancing the advisory practice that we have up here in Canada.
TD: Michael, in looking at market sentiment here—you said something interesting to me the other day, in terms of investor psychology, which was that there’s a segment of investors looking at the resource sector here, who are waiting for confirmation of a recovery (and that would be through the form of higher prices), before wanting to participate.
What are your thoughts there, and how does that confirmation viewpoint contrast to the other segments of your global client base?
MK: I think that the gold market likes to aggressively test its participant’s conviction, and weeks like we’ve just seen are another set of tests that the gold investor has to endure. It seems that they’re really questioning the thesis altogether of why they’re in this space.
But to me, a large part of the sentiment has to do with: “What is the gold price?” As the gold price breaks through psychologically important levels like $1,200 oz. as it has done over the last week, it brings the question to mind: “Am I doing the right thing?”
What I’ve looked at recently is the NYSE Arca Gold Bugs Index (HUI) to gold ratio, because I think it’s a very good sentiment indicator. So the HUI is a basket of gold stocks containing some of the brand names of gold bug households—names like Goldcorp, Agnico-Eagle, Barrick, Newmont—the larger cap stocks.2 The ratio represents what sentiment is towards buying those issues, and as I mentioned earlier, I started with Rick in 1999-2000. At that time the HUI/Gold ratio was at .15.
(Chart: NYSE Arca Gold Bugs Index “HUI” to gold ratio)
The ratio got up to more normalized levels between 2003 to 2007, at about .55. With the correction in 2008 and the real negative sentiment towards risky assets and gold stocks in general, we’re right back down to .15. As Yogi Berra said, “It’s like Déjà vu all over again,” in terms of sentiment towards gold issues.
Again, this is not the smallest of the small stocks, these are the large cap names that have cash flow and produce gold. So the sentiment is just abysmal, and in the context of wanting to purchase those stocks, therein lies the opportunity.
TD: Michael, what do you remember happening both nominally as well as anecdotally following the 2000 bottoming period in which you saw the HUI/Gold ratio at .15?
MK: Well, I remember the markets moved from being bad to less bad. The expectations in the context of that market were really, really low. All the bad news was basically factored into the pricing. We got to a point where even if the gold price dropped—it hit a low of about $330 an oz. in April of 2001 – the gold stocks basically maintained themselves, or were numb to that event entirely. It had to do with the fact that in the valuation of gold miners, a lower gold price was already expected. So it couldn’t get much worse in that sense.
Then you saw the projects start to improve. You started to see the seniors develop a religion of austerity (as they are trying to do right now), and their numbers started to get better. The write-downs and drawbacks they had experienced previously were points to spring-board and build constructively from. Analysts then couldn’t ignore the positive revaluations as these companies dug themselves out of a hole, and likewise, people started to buy them again. So you saw share prices increase quite significantly. What happened in a nominal sense, is that there were some very good returns on those types of stocks.
In the junior space, there were companies that were trading at negative enterprise value, so you could buy them very, very cheaply. You could buy them for less than the cash they were holding. Meanwhile, you were getting the mineral upside, or the mineral potential they contained, for “free”, and that’s a really nice place to be.
I think one should look at these stocks when they’re at these fire-sale prices, or able to buy high-potential juniors at half price or cash valuations.
TD: Michael, when the sector moves down dramatically like it has, does the existential risk of a company intensify, and how can one mitigate that risk?
MK: I think existential risk does intensify because these companies are capital intensive businesses, so no capital—no business. There’s a real threat that they blink out of existence all together if they can’t raise the dough. It’s sort of a culling of the herd process with these groups if they are unable to access capital, and some look for other lines of business where the company is in effect reduced to being a publicly listed shell that’s looking for a new venture. Back in the 90s a lot of the junior resource companies for instance transferred into tech companies and the latest trend could be that they turn into marijuana.
So there’s the need for cash, but the importance of management is paramount. In these kinds of markets management has to prove their mettle, because even companies with strong cash positions but weak management may also fall victim to being taken over by someone else at a fraction of their cash value.
I think these points and these market extremes are when you really need to follow the professionals running these companies and the management teams behind them. If they are backing projects or what seems like fairly aggressive acquisitions in a weak space, there’s probably reasoning behind it, certainly for management groups that have experience in this sector. So following them and being really judicious on getting the highest quality management teams you can find is important. These market bottoms give you the ability to buy high quality companies with strong management groups at discounted prices, as they’re discounted pretty much like everything else.
So I think migrating to that concept is important, along with getting the best advice you can as far as who those groups are.
TD: Michael, do you ever sit back and think on any client conversations you had at the time in 2000 in which maybe you had a high-net worth individual that said, “You know what, I’d like you to get in the market and buy me as much of this shopping list as you can,” or maybe the smaller investor that said, “Hey—I’m scared as heck, but I like this idea. Can you execute it for me?”
Do you have memories such as those, and if so, how did they play out over the following 5-6 years?
MK: I do. There were times when people drew the line (and they certainly didn’t feel very comfortable), but they said, “I know this is right [to buy], but I don’t feel good doing it.”
It’s uncomfortable swimming against the tides of uncertainty throughout these markets and the volatility that we experience. But I think there were people in two camps—there were those who wanted to own the metals directly, or through a market product like the Sprott Physical Gold Trusts (which didn’t exist then), and then there were people recognizing that they were buying cash at a discount in the context of some of these junior equity companies that also had potential upside.
But I should again note that many juniors fell victim to the “culling of the herd” process which occurred at that time as well, i.e., shareholders ended up losing all or most of their investment. What I mean here is that companies were unable to raise capital to pursue their business model, which is exploring for minerals assets they wanted to have. So those companies that fell by the wayside couldn’t access capital markets, and basically had to find a new line of business for the shell of the company that was remaining or adopt an entirely different business model altogether.
TD: Michael, you also noted to me the other day the challenge of the investment professional, in not only finding hated markets and quality investments therein, but in conveying those investment ideas to the investor.
When you observe your client base, how would you describe the level of acceptance towards investing in resources right now, and do you see a correlation between a person’s net worth and their willingness to consider truly hated investment ideas?
MK: I think for a higher net worth individual, they have more play money. They have a larger nominal amount they can put into a market like this, and it’s not going to change what they eat for breakfast if the speculation or venture fails. So in that regard I think they’re able to put some money to work in things that are considered fairly far-flung, or drill-hole type plays where the risk is quite high, but the reward is as well. I think we as a group at Sprott do a pretty good job at trying to balance out the risk through a series of names so you don’t just own one stock—you’re in effect buying a basket of these higher-risk plays if that’s what the investor is seeking.
But in talking to clients (and if are they on board with this approach to natural resources at all), it’s important to stay in touch on an ongoing basis to make sure they’re aware of this type of volatility, how it’s possible, and how to best take advantage of it. To me, volatility is not synonymous with risk; it’s something that occurs in the marketplace that you need to harness, or learn how to harness, regardless of how difficult it is.
For us, an ongoing continuous relationship with a client gives you that leg-up to take action when those types of opportunities present themselves. At market bottoms like where we are now, it’s important obviously to really look objectively at the valuations that are presented and start purchasing them.
Conversely, I’ve found that the opposite is also a big problem and perhaps even worse—when we’re heading into a toppy or inflationary market, and everybody is waxing poetic about how great the market is. You have to have the wherewithal to convince your client to do the right thing, temper his enthusiasm for that investment, and actually start to sell it.
Meanwhile, everybody else on the street, the newsletter writers and the media, are just singing the praises of this investment as if it’s the greatest thing since sliced bread. And there’s usually merit behind it, but it’s also important for the client to recognize that financial risks need to be curbed at that time.
TD: Michael, what are your thoughts on the recovery coming out of this bottom as compared to the previous bottoms you’ve experienced in your career, in 2000 and 2008? Do you think stronger fundamentals are in place today?
MK: I’m not a market technician, but I’ve spoken to a lot of my analyst colleagues and friends that the longer we are drawn through this bear market, the more powerful the potential upsurge could be. While I don’t think we’re looking at a v-shaped recovery, I think you’re going to see good old fashioned “blocking and tackling,” which could occur as a stair-stepping up of the juniors.
It has less to do with the fascination and excitement you get from positive drill results, but rather from objective reasoning, mergers and acquisitions, and buying value in the context of this market.
From my perspective, what’s really happened to the industry is that they’ve [the majors] put themselves into a position where there isn’t a very good pipeline of high-grade, high-margin style deposits. So those types of discoveries are going to be heavily sought-after, not only by the individual companies, but by the entire industry.
As the majors get more capital, there’s going to be a dogfight for the high-grade projects that do exist.
TD: So is that a segment of the junior resource space that’s most interesting to you here Michael?
MK: I think for people who are more conservative, they are able to buy value at a discount. You’re able to buy ounces in the ground cheaply, and as I mentioned, at negative enterprise value. But the other thing that I think of, having been somebody who worked for a major mining company as long as I have, is the fact that the cost of drilling and hiring a contractor and geologist to drill out and develop a resource base is in a lot of cases more costly than it is to explore on the stock boards for a good asset or company that has a valid resource for takeover.
So that’s not even incorporating the high-risk involved in mineral exploration, or discovering the project in the first place. So from a real nuts and bolts valuation perspective, it makes a lot more sense to look at the stock boards at this point in time.
TD: Michael is there anything you think we may have missed?
MK: Well, at the risk of sounding like a cheerleader here—I really don’t think this is a time to be discouraged. It’s actually a time to keep your head up and be objective about what the volatility in the market is offering us, and the kind of opportunity this is.
You want to be strategic and well-informed on what you’re looking for as far as a company goes. Cash in the bank is important, management is important, high-margin deposits and resources in the ground—those types of issues are always important. So I think instead of being discouraged, this is a time to trim and prune, and look for the best quality, because as the market’s fallen down, it has done so indiscriminately. The good, the bad, and the ugly have all been dragged down.
So do yourself a really big favor and graduate up to the good.
As you do that, you accomplish two things I think. One, the higher-quality companies are the ones with cash, so they’re going to be able to maintain themselves better throughout this downturn (and who knows how long it will last). Secondly, when this market does recover, the high-quality names are more likely to rebound with force and vigor, because they have the assets that the industry covets.
TD: Michael Kosowan, Investment Executive with Sprott Global Resource Investments and Investment Advisor with Sprott Private Wealth, thanks for sharing your comments.
MK: Thank you Tekoa, it’s been my pleasure.
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