L: Doug, we were talking about gold last week, so we should follow up with a look at gold stocks. If one of the reasons to own gold is that it’s real — it’s not paper, it’s not simultaneously someone else’s liability — why own gold stocks?
Doug: Leverage. Gold stocks are problematical as investments. That’s true of all resource stocks, especially stocks in exploration companies, as opposed to producers. If you want to make a proper investment, the way to do that is to follow the dictates of Graham and Dodd, or use the method Warren Buffett has proven to be so successful over many years. Unfortunately, resource stocks in general and metals exploration stocks in particular just don’t lend themselves to such methodologies. They are another class of security entirely.
L: "Security" may not be the right word. As I was reading the latest edition of Graham & Dodd’s classic book on securities analysis, I realized that their minimum criteria for investment wouldn’t even apply to the gold majors. The business is just too volatile. You can’t apply standard metrics.
Doug: It’s just impossible. For one thing, they cannot grow consistently, because their assets are always depleting. Nor can they predict what their rate of exploration success is going to be.
L: Right. As an asset, a mine is something that gets used up, as you dig it up and sell it off.
Doug: Exactly. And the underlying commodity prices can fluctuate wildly for all sorts of reasons. Mining stocks, and resource stocks in general, have to be viewed as speculations, as opposed to investments.
But that can be a good thing. For example, many of the best speculations have a political element to them. Governments are constantly creating distortions in the market, causing misallocations of capital. Whenever possible, the speculator tries to find out what these distortions are, because their consequences are predictable. They result in trends you can bet on. It’s like the government is guaranteeing your success, because you can almost always count on the government to do the wrong thing.
The classic example, not just coincidentally, concerns gold. The U.S. government suppressed its price for decades while creating huge numbers of dollars before it exploded upward in 1971. Speculators that understood some basic economics positioned themselves accordingly.
As applied to metals stocks, governments are constantly distorting the monetary situation, and gold in particular, being the market’s alternative to government money, is always affected by that. So gold stocks are really a way to short government — or go long on government stupidity, as it were.
The bad news is that governments act chaotically, spastically. The beast jerks to the tugs on its strings held by its various puppeteers. So it’s hard to predict price movements in the short term. You can only bet on the end results of chronic government monetary stupidity.
The good news is that, for that very same reason, these stocks are extremely volatile. That makes it possible, from time to time, to get not just doubles or triples but ten-baggers, twenty-baggers, and even a hundred-to-one shots in these mining stocks.
That kind of upside makes up for the fact that these stocks are lousy investments and that you will lose money on some of them.
L: One of our mantras: volatility can be your best friend.
Doug: Yes, volatility can be your best friend, as long as your timing is reasonable. I don’t mean timing tops and bottoms — no one can do that. I mean spotting the trend and betting on it when others are not, so you can buy low to later sell high. If you chase momentum and excitement, if you run with the crowd, buying when others are buying, you’re guaranteed to lose. You have to be a contrarian. In this business, you’re either a contrarian or road kill. When everyone is talking about these stocks on TV, you know the masses are interested, and that means they’ve gone to a level at which you should be a seller and not a buyer.
That makes it more a game of playing the psychology of the market, rather than doing securities analysis.
I’m not sure how many thousands of gold mining stocks there are in the world today — I’ll guess about 3,000 — but most of them are junk. If they have any gold, it’s mainly in the words written on the stock certificates. So, in addition to knowing when to buy and when to sell, your choice of individual stocks has to be intelligent too. Remember, most mining companies are burning matches.
L: All they do is spend money.
Doug: Exactly. That’s because most mining companies are really exploration companies. They are looking for viable deposits, which is quite literally like looking for a needle in a haystack. Finding gold is one thing. Finding an economical deposit of gold is something else entirely. And even if you do find an economical deposit of gold, it’s exceptionally difficult to make money mining it. Most of your capital costs are up front. The regulatory environment today is onerous in the extreme. Labor costs are far above what they used to be. It’s a really tough business.
L: If someone describes a new business venture to you, saying: "Oh, it’ll be a gold mine!" Do you run away?
Doug: Almost. And it’s odd because historically, gold mining used to be an excellent business to be in. For example, take the Homestake Mine in Deadwood, South Dakota, which was discovered in 1876 — at just about the time of Custer’s last stand, actually. When they first raised capital for that, their dividend structure was something like 100% of the initial share price, paid per month. That was driven by the extraordinary discovery. Even though the technology was very primitive and inefficient in those days, labor costs were low, you didn’t have to worry about environmental problems, there were no taxes on whatever you earned, you didn’t have to pay mountains of money to lawyers — today, you probably pay your lawyers more than you pay your geologists and engineers.
So, the business has changed immensely over time. It’s perverse because with the improvements in technology, gold mining should have become more economical, not less. The farther back you go in history, the higher the grade you’d have to mine in order to make it worthwhile. If we go back to ancient history, a mineable deposit probably had to be at least an ounce of gold per ton to be viable. Today, you can mine deposits that run as low as a hundredth of an ounce (0.3 g/t). It’s possible to go even lower, but you need very cooperative ore. And that trend towards lower grades becoming economical is going to continue.
For thousands of years, people have been looking for gold in the most obscure and bizarre places all over the world. That’s because of the 92 naturally occurring elements in the periodic table, gold was probably the first metal that man discovered and made use of. The reason for that is simple; gold is the most inert of the metals.
L: Because it doesn’t react easily and form compounds, you can find the pure metal in nature.
Doug: Right. You can find it in its pure form, and it doesn’t degrade and it doesn’t rust. In fact, of all the elements gold is not only the most inert, it’s also the most ductile and the most malleable. And, after silver, it’s the best conductor of both heat and electricity, and the most reflective. In today’s world, that makes it a high-tech metal. New uses are found for it weekly. It has many uses besides its primary one as money and its secondary use as jewelry. But it was probably also man’s first metal.
But for that same reason, all the high-grade, easy-to-find gold deposits have already been found. There’s got to be a few left to be discovered, but by and large, we’re going to larger-volume, lower-grade, "no-see-um" type deposits at this point. Gold mining is no longer a business in which, like in the movie The Treasure of the Sierra Madre, you can get a couple of guys, some picks and mules, and go out and find the mother load. Unfortunately. Now, it’s usually a large-scale, industrial earth-moving operation next to a chemical plant.
L: They operate on very slender margins — and they can be rendered unprofitable by a slight shift in government regulations or taxes. So, we want to own these companies… why?
Doug: You want them strictly as speculative vehicles that offer the potential for ten, a hundred — or even a thousand times returns on your money. Getting a thousand times on your money is extraordinary, of course — you have to buy at the bottom and sell at the top — but people have done it. It’s happened not just once or twice but quite a number of times that individual stocks have moved by that much.
That’s the good news. The bad news is that these things fluctuate down even more dramatically than they fluctuate up. Don’t forget that they are burning matches that can actually go to zero. And when they go down, they usually drop at least twice as fast as they went up.
L: That’s true, but as bad as a total loss is, you can only lose 100% — but there’s no such limit to the upside. A 100% gain is only a double, and we do much better than that for subscribers numerous times per year.
Doug: Exactly. And as shareholders in everything from Fannie Mae to AIG, to Lehman Brothers, and many more have found out, even the biggest, most solid companies can go to zero.
L: So, what you’re telling me is that the answer to "Why gold?" is really quite different to the answer to "Why gold stocks?" These are in completely different classes, bought for completely different reasons.
Doug: Yes. You buy gold, the metal, because you’re prudent. It’s for safety, liquidity, insurance. The gold stocks, even though they explore for or mine gold, are at the polar opposite of the investment spectrum; you buy those for extreme volatility and the chance it creates for spectacular gains. It’s rather paradoxical, actually.
L: You buy gold for safety and gold stocks specifically to profit from their "un-safety"…
Doug: Exactly. [Laughing.] They really are total opposites, even though it’s the same commodity in question. It’s odd, but then, life is often stranger than fiction.
L: And it’s being a contrarian — "timing" in the sense of making a rational decision about a trend in evident motion — that helps stack the odds in your favor. It allows you to guess when market volatility will, on average, head upwards, making it possible for you to buy low and sell high.
Doug: You know, I first started looking at gold stocks back in the early 1970s. In those days, South African stocks were the "blue chips" of the mining industry. As a country, South Africa mined about 60% of all the gold mined in the world, and costs were very low. Gold was controlled at $35 per ounce until Nixon closed the gold window in 1971, but some of the South Africans were able to mine it for $20 an ounce or less. They were paying huge dividends.
Gold had run up from $35 to $200 in early 1974, then corrected down to $100 by 1976. It had come off 50%, but at the same time that gold was bottoming around $100, they had some serious riots in Soweto. So the gold stocks got a double hit: falling gold prices and fear of revolution in South Africa. That made it possible, in those days, to buy into short-lived, high-cost mining companies very cheaply; the stocks of the marginal companies were yielding current dividends of 50% to 75%. They were penny stocks in those days. They no longer exist; they’ve all been merged into mining finance houses long since then. Three names that I remember from those days were Leslie, Bracken, Grootvlei… I owned a lot of shares in them. If you bought Leslie for 80 cents a share, you’d expect, based on previous dividends, to get about 60 cents a share in that year.
But then gold started flying upwards, the psychology regarding South Africa changed, and by 1980, the next real peak, you were getting several times what you paid for the stock, in dividends alone, per year.
L: Wow. I can think of some leveraged companies that might be able to deliver that sort of performance, if gold goes where we think it will. So, where do you think we are in the current trend or metals cycle? You’ve spoken of the Stealth, Wall of Worry, and Mania Phases of a bull market for metals — do you still think of our market in those terms?
Doug: That’s the big question, isn’t it? Well, the last major bottom in this sector was from 1998 to 2002. Many of these junior mining stocks — mostly traded in Canada, where about 75% of all the gold stocks in the world trade — were trading for less than cash in the bank. Literally. You’d get all their properties, their technology, the expertise of their management, totally for free. Or less.
L: I remember seeing past issues in which you said, "If I could call your broker and order these stocks for you, I would."
Doug: Yes. But nobody wanted to hear about it at that time. Gold was low, and there was a bubble in Internet stocks — why would anyone want to get involved in a dead-duck, 19th century, "choo-choo train" industry like gold mining? It had been completely discredited by the long bear market — but that made it the ideal time to buy them, of course. That was deep in the Stealth Phase.
Over the next six to eight years, these stocks took off, moving us into the Wall of Worry Phase. But the stocks didn’t fly the way they did in past bull markets. I think that’s mostly because they were so depleted of capital, they were selling lots of shares. So their market capitalizations — the aggregate value given them by the market — were increasing, but their share prices weren’t. Not as much. Remember, these companies very rarely have any earnings, but they always need capital, and the only way they can get it is by selling new shares, which dilutes the value of the individual shares, including those held by existing shareholders.
Then last fall hit, and nobody, but nobody, wanted anything speculative. These most volatile of stocks showed their nature and plunged through the floor in the general flight to safety. That made last fall the second best time to buy mining shares this cycle, and I know you recommended some pretty aggressive buying last fall, near the bottom.
Now, many of these shares — the better ones at least — have recovered substantially, and some have even surpassed pre-crash highs. Again, the Wall of Worry Phase is characterized by large fluctuations that separate the wolves from the sheep (and the sheep from their cash).
Where does that leave us? Well, as you know, I think gold is going to go much, much higher. And that is going to direct a lot of attention towards these gold stocks. When people get gold fever, they are not just driven by greed, they’re usually driven by fear as well, so you get both of the most powerful market motivators working for you at once. It’s a rare class of securities that can benefit from fear and greed at once.
Remember that the Fed’s pumping up of the money supply ignited a huge bubble in tech stocks, and then an even more massive global bubble in real estate — which is over for a long time, incidentally — but they’re still creating tons of dollars. That will inevitably ignite other asset bubbles. Where? I can’t say for certain, but I say the odds are extremely high that as gold goes up, for all the reasons we spoke about last week and more, that a lot of this funny money is going to be directed into these gold stocks, which are not just a micro-cap area of the market but a nanocap area of the market.
I’ve said it before, and I’ll say it again: when the public gets the bit in its teeth and wants to buy gold stocks, it’s going to be like trying to siphon the contents of the Hoover Dam through a garden hose.
Gold stocks, as a class, are going to be explosive. Now, you’ve got to remember that most of them are junk. Most will never, ever find an economical deposit. But it’s hopes and dreams that drive them, not reality, and even without merit, they can still go ten, twenty, or thirty times your entry price. And the companies that actually have the goods can go much higher than that.
At the moment, gold stock prices are not as cheap, in either relative or absolute terms, as they were at the turn of the century, nor last fall. But given that the Mania Phase is still ahead, they are good speculations right now — especially the ones that have actually discovered gold deposits that look economical.
L: So, if you buy good companies now, with good projects, good management, working in stable jurisdictions, with a couple years of operating cash to see them through the Wall of Worry fluctuations — if you buy these and hold for the Mania Phase, you should come out very well. But you can’t blink and get stampeded out of your positions when the market fluctuates sharply.
Doug: That’s exactly right. At the particular stage where we are right now in this market for these extraordinarily volatile securities, if you buy a quality exploration company, or a quality development company (which is to say, a company that has found something and is advancing it towards production), those shares could still go down 10%, 20%, 30%, or even 50%, but ultimately there’s an excellent chance that that same stock will go up by 10, 50, or even 100 times. I hate to use such hard-to-believe numbers, but that is the way this market works. When the coming resource bubble is ignited, there are excellent odds you’ll be laughing all the way to the bank in a few years.
I should stress that I’m not saying that this is the perfect time to buy. We’re not at a market bottom as we were in 2001, nor an interim bottom like last November, and I can’t say I know the Mania Phase is just around the corner. But I think this is a very reasonable time to be buying these stocks. And it’s absolutely a good time to start educating yourself about them. There’s just such a good chance a massive bubble is going to be ignited in this area.
L: These are obviously the kinds of things we research, make recommendations on, and educate about in our metals newsletters, but one thing we should stress for non-subscribers reading this interview is that this strategy applies only to the speculative portion of your portfolio. No one should gamble with their rent money nor the money they’ve saved for college tuition, etc.
Doug: Right. The ideal speculator’s portfolio would be divided into ten areas, each totally different and not correlated with each other. Each of these areas should have, in your subjective opinion, the ability to move 1,000% in price.
Why is that? Because most of the time, we’re wrong when we pick areas to speculate in, certainly in areas where you can’t apply Graham-Dodd-type logic. But if you’re wrong on nine out of ten of them — and it would be hard to do that badly — then you at least break even on the one ten-bagger (1,000% winner). What’s more likely is that a couple will blow up and go to zero, a couple will go down 30%, 40%, 50%, but you’ll also have a couple doubles or triples, and maybe, on one or two of them, you’ll get a ten-to-one or better win.
So, it looks very risky (and falling in love with any single stock is very risky), but it’s actually an intelligent way to diversify your risk and stack the odds of profiting on volatility in your favor.
Note that I don’t mean that these "areas" should be ten different stocks in the junior mining sector — that wouldn’t be diversification. As I say, ideally, I’d have ten such areas with potential for 1,000% gains, but it’s usually impossible to find that many at once. If you can find only two or three, what do you do with the rest of your money? Well, at this point, I would put a lot of it into gold, in one form or another, while keeping your powder dry as you look for the next idea opportunity.
And ideally, I’d look at every market in every country in the world. People who look only in the U.S., or only in stocks, or only in real estate — they just don’t get to see enough balls to swing at.
L: Okay, got it. Thank you very much.
Doug: A pleasure, as always.