Exposing the Stealth Secrets of Investing
Commodities / Gold & Silver Stocks Oct 28, 2008 - 01:52 PM GMTBy: The_Gold_Report
Ongoing education, excellent connections and a wealth of experience combine to give John Pugsley insights that are both compelling and provocative. Using analogies as diverse as dribbling basketballs and stocking up on tuna when it's a bargain in the supermarket, he talks about the importance of patience, a focus on fundamentals and the criteria he's using to identify the next wave of winners.
The Gold Report: What's your take of the gold market in these incredibly unstable financial times?
John Pugsley: Unstable is certainly a kind description of the current financial scene. Everyone is scrambling for a life preserver and the only thing that looks secure is U.S. Treasury debt. This is truly curious, since governments are addressing the crisis with the only tool they have: an avalanche of fiat money.
In spite of the misguided rush to the "security" of government debt, gold is doubtless the safest hedge around. That said, the short-term volatility of gold's price is intense. As financial anxiety turns toward panic, most people succumb to their herd instincts, and the herd is running toward the cliff.
The prices of stocks and gold and silver and everything jerk up and down like a rapidly dribbled basketball. Anyone offering predictions of what directions prices will be going tomorrow morning, next week, or at any specific time are pretending to have a crystal ball.
I don't believe it's possible to predict short-term price movements on gold or any other asset. Short-term swings are unpredictable; however, one thing is predictable: over time, and regardless of temporary euphoria or panic, tangible, useful things will hold their exchange value relative to other tangible useful things. Likewise, intangible useless things like paper currencies will not.
Gold happens to be the most practical commodity one can hold as a hedge against the inevitable fall in the purchasing power of paper money, so it's a natural long-term defense. In the next five years individuals will need some way to defend against price inflation. Holding tangible goods is the rational alternative to money, and gold is the most practical choice.
TGR: How do the other precious metals—silver, palladium, platinum, rhodium, titanium, for example—stack up in comparison?
JP: Basically, what is true of gold is, to some extent, true of silver. Historically, it has been the second monetary metal. However, there are industrial uses as well as decorative and monetary uses for silver, all of which affect demand and therefore price.
As you get farther away from gold and silver, you're into the other metals you mentioned where almost all of the demand comes from industrial uses. I don't closely watch the prices of platinum, palladium, and the other rare metals. Rather, I concentrate on the sector that I'm most interested in, which includes gold and silver, plus the more common industrial metals. Also, I don't concentrate on the metals themselves, but on the companies that produce them. In particular, the junior explorers and producers are the ones that are most highly leveraged to the price of commodities, such as gold, so those interest me the most.
TGR: But most of those juniors have tanked over the past six months. Do you see them recovering?
JP: They've tanked over the past six months, but the slide has accelerated: they've really tanked over the past six weeks. There are 5,000 or so junior resource companies, but probably 5% or maybe even fewer of those companies have any credibility among people who really understand the mining business. A lot of them were born when promoters saw the bull market coming. They formed companies, gathered some properties, issued a bunch of paper, and hit buyers who were excited by the bull market. “Hey, we've got a prospect here that you've got to buy!”
In the past five years the market was hot and investors were scooping up anything with “resource” in the name, in the same way they were buying anything with .com in the name from 1995 to 2001. That ploy works fine for hot markets. You can be certain that there will be mass burials of 90% of the juniors in the coming months. A lot of them will become shells. As Rick Rule has pointed out, the market will bifurcate. The majority of juniors that were born out of the euphoria of easy credit, unscrupulous stock promoters and the naiveté of investors will go to share heaven, and the solid 5% will survive and prosper. The Stealth Investor has worked hard to filter out companies in the 5% of juniors that are more than just stock promotions.
Right now, investors are frightened and aren't discriminating. This sector has experienced a bloodbath over the past months. Most of the juniors that have fallen through the floor are where they should be—they're not worth anything. However, even the solid, well-funded and well-guided junior resource companies are getting sucked into the vortex. Investors are dumping the good along with the bad, at the very time they should be buying the good.
If you understand the dichotomy in the juniors market and are careful enough to sort out the few solid companies from the thundering herd of wannabes, this is perhaps the greatest period of opportunity in our lifetimes. The farther our chosen companies fall, the greater bargains they become.
TGR: What are your criteria for selecting among the juniors? Do you follow the price trend of the stock?
JP: Absolutely not. Trend following and technical analysis are money machines for brokers, but not for investors.
The most successful investors of the past century, names such as Ben Graham, John Templeton, Peter Lynch and Warren Buffet—with no exceptions that I'm aware of—ridicule the ideas of trend following and technical analysis. They are all fundamentalists. I'm a proponent of fundamentals.
What we're looking for in a company is solid, experienced management, adequate cash and resources to reach the company's goal, and prospective properties. As for price, we get most interested when we see that the price fallen, but the fundamentals remain strong. It's not rocket science, it's just common sense, and every investor has heard the clichés a thousand times—you accumulate shares when the price is down; you buy when blood is running in the streets.
But you asked about the criteria we use to select companies. My belief is that the independent investor can enjoy an arena that's closed to the big players. So we start by looking at companies that are too small to interest institutions and brokerage firms, and thousands of others are legally verboten to licensed brokers because they are not fully registered with state and federal regulators. In general, we apply these criteria: First and foremost, we look for companies trading at a substantial discount to intrinsic value. As Warren Buffett said: "Intrinsic value is the only logical approach to evaluating the relative attractiveness of investments and businesses." Second, we search for smaller companies, micro-cap or even nano-cap. Generally, they'll be under $50 million in market capitalization. Many are out there with market caps under $10 million. Third, we watch for companies that are thinly traded and not institutionally owned. This means less competition for information, and hence inefficient markets. Finally, we concentrate on companies ignored by Wall Street, and are most excited by companies that licensed brokers and advisors are prohibited from recommending because of regulatory censorship. Regarding the most important qualification, intrinsic value, we only want companies that are selling at deep discounts to book value.
In a nutshell, the companies we're looking for must be small, and hopefully invisible to the big brokers and funds. They must have ample cash to fund their operations. They must have proven, frugal management. And they must concentrate on natural resources.
TGR: Could you give us an example?
JP: Sure. One that comes to mind is Altius Minerals Corporation (ALS:TSX.V) . It's a wonderful company we added back in April 2006 when it was selling at C$6. When it hit C$20, we sold one-third of our position and recovered our capital. Right now it's at C$4.50, which gives it a market cap of around C$140 million at the moment (a bit higher than our typical choice). It has current assets, that is, cash and cash equivalents of $175 million, and in addition has an additional $175 million in other assets. If you could buy the entire company, you'd get an immediate 25% return on you cash, plus get all of the other assets for free. You could more than double your money by simply liquidating it. That's what I mean by intrinsic value.
TGR: The market has been so wild. How are investors supposed to cope with that?
JP: You cope by recognizing what you don't and can't know. It's not possible to know what breaking news is going to stimulate investors to buy or sell on any particular day in the future. You'd have to know that to be able to trade in the short term.
Use the approach that Graham or Buffet or Templeton would. When everyone is frightened, when blood's running in the streets, when everyone else is selling, you help them out of their misery—you take the shares off their hands. Keep your powder dry; hold enough cash so you can continually add shares as prices fall.
The other advice I would have is, to paraphrase Omar Khayyam, pay cash and let the credit go. The most destructive illusion that investors have—and this is true in all sectors—is that they think that they can borrow money and invest it and magnify their profits. Leveraging through debt is great when markets rise, but when the credit cycle turns, leveraging is the road to failure. Look around right now. The financial battlefield is littered with the bodies of those who thought they were smart enough to get rich by leveraging. The companies we choose are not in debt, and not dependent upon borrowing to keep operations going. The majority of the prospect generators in the Stealth Investor portfolio have plenty of cash to meet their needs for months or years. They use their cash to do the preliminary exploration, take their discoveries to companies that have the deep pockets to handle developing and proving the resource. Those bigger companies take the project to the next stage. Eventually, when the resources are proven, the really big companies step in.
TGR: Cash is the big problem now. The prospect generators must be struggling to find those deeper pockets.
JP: In the natural resources sector, there's more cash out there than you'd imagine. The big mining and oil companies—the BHPs, Barricks, Rio Tintos, Exxons, etc.—have been raking in cash for a long time, and they're flush. Even as their stock prices collapse in the current panic, they're out making acquisitions. I was looking at BHP not long ago. The stock is down 50% in a few months' time, but its net profit the last quarter was on the order of 29%. As a result, it's cash rich and aggressively looking for new acquisitions to replenish its declining reserves.
Despite enormous hits to their share price, these big mining companies have plenty of cash to buy the little guys. All the little guys have to do is come up with the proven or probable resources, which they are doing all the time. Many of the small prospect generators have 10 to 20 prospects being explored and analyzed by their teams of geologists and geo-scientists. They're taking samples, doing trenching, some drilling, and lots of analysis. Their cash outlay is very small. When their work suggests a high probability of a resource, they farm it out for cash or shares. This is a continuing process, so although these small prospect generators are using up cash, they're also replenishing cash through farm-outs on a regular basis.
TGR: Some investors also may have knowledge like yours, but most of us might look at a balance sheet and maybe see a company with a good amount of cash and a favorable ratio of assets to market—but we aren't geologists. We can't weigh whether properties they're prospecting will return anything. How do we know whether we can expect joint ventures and that a company will create cash flow going forward?
JP: Most investors use brokers that don't understand geology any better than they do. Most stockbrokers have minimal knowledge of the companies they tout. One of the very few brokerage firms that knows this business is Global Resource Investments in Carlsbad, California.
Either work with an advisory service or broker that knows the industries, get on a plane or on the phone or email and talk to the people who working the project. Talk to disinterested parties who are watching these properties. Investors who want to get into the small resource companies as a genre have to find somebody, be they specialists or advisors, that they trust who are able to gather this information.
I admit that I'm not a geologist either, although I majored in it for the first two-and-a-half years in college. I've been in the investment business, focused on natural resources, since 1969, watching what's going on, and writing about it. My studies in economics led me to recognize the importance of tangible wealth versus paper wealth, and that has solidified my trust in natural resources. Over the past four decades I've become acquainted with of hundreds of people in the industry. I have friends who finance these types of operations at the private-placement level, and friends who are geologists. I rely on others.
To be successful in this business, the investor should look for those in the industry who have a history of success over the years, and have a reputation for integrity. You find them by spending time and energy—attending conferences, talking to company managers, reading reports, and using common sense.
TGR: You mentioned Global Resource Investments. What are its credentials?
JP: It's a remarkable company. Rick Rule founded the company and still owns it. Many of the brokers and others on the staff are geologists or mining engineers. They're a great source for inside information and industry contacts. They have integrity, a tremendous track record, and they are fundamentalists. They don't look for market swings and churn the market in order to earn commissions. It's a great company, if you'll pardon the unsolicited commercial.
TGR: Does your Stealth Investor focus pretty exclusively on mining?
JP: Not specifically. We focus on natural resources. This covers mining, energy, and any other resource that comes out of the earth. Mining would include precious metals, base metals, diamonds, phosphates for fertilizers, etc. On the other side, energy includes oil, gas, geothermal, and even low-head hydro.
As I said, I'm a believer that natural resources hold the ultimate values that society depends on. You and I and everyone else consume these things daily, and will be using them as long as we live. Although the demand for oil, gas, water, gold, copper, phosphate, etc., may fluctuate with the business cycles, the demand will never cease.
Companies always will need to find and produce those resources, and to do so they need to make a profit. That combination insures that natural resources must rise in price as the currency falls in value. That's why I feel so comfortable with our strategy, even in the face of this credit meltdown. The meltdown affects the paper-debt markets but the real values are in things that human beings consume. They'll always be needed.
TGR: Are you rebalancing your portfolio in light of what you see ahead in the next couple of years?
JP: Not in the sense of moving from one sector to another. I have zero confidence that society will abandon its love affair with paper money, so I'll stick with natural resources for the foreseeable future. I'll keep my antenna tuned towards signals from deeply undervalued companies. I don't care what they're looking for, whether it's hydroelectric or phosphate or copper or gold. The prospect generator will be filling a critical role, and we'll stick with them.
My niche is discovering companies that are small enough to be under the radar of the big funds and investment brokerage firms so that nobody knows about them. In fact, this is why we call our newsletter the Stealth Investor . We're looking for companies that basically are unknown to broad markets.
TGR: You're looking at the prospect generator component, which is find it, prove it, joint venture it, or sell it. If someone follows your portfolio strategies, are they looking to two or three years out before they get a return?
JP: Although we've had cases where we doubled or tripled our investment within a couple of months or a year, we always assume it will be eighteen months to three years before the companies we choose will meet their operating targets. No one should get into the Stealth Investor portfolio without the patience to buy and hold for at least two to three years. But to go back to your question, does it always take three years? No. Until this big credit crisis, our portfolio was showing 100%+ annual gains after the first year. Subscribers who came in and cashed out anywhere along the way did extremely well.
This intense credit collapse has resulted in 50% to 80% drops in many companies in the portfolio. They are mouth-watering bargains. An example is Canplats Resources Corporation (TSX:CPQ) . We first bought it in June of 2006 at C$0.22 and within a few months it hit C$0.45, so we sold half and recovered our investment. We're still holding the other half. We were up over 1600% at one point, but kept holding because what the company was doing was clearly paying off. The company is doing exceedingly well, but the price has plunged from a high of C$5.40 to around C$1.25. I expect to see it at $10 when the dust settles.
These global price declines are terribly hard on the companies and their managements, but from my clients' standpoint, it's rather delightful. Just because the company stock is selling for half what it was six months ago, that doesn't mean the value of the company has fallen. Not at all; it represents an opportunity. They're sound investments and from a value viewpoint, they're going to do very well. We're adding to our positions in many of the companies in our portfolio.
TGR: How about some examples from your portfolio of companies that particularly intrigue you?
JP: Let's see. One of them—a little larger than our normal company—is Sprott Resources Corporation (SCP) . We bought it in May 2006 at C$1.60. It went all the way up to C$4, at which point we sold half, took some profit, and have held the rest. It's a fabulous company with lots of cash. It's now at about C$1.80 and is a terrific bargain at that price.
TGR: Who else?
JP: Another company I like is Altius, which I mentioned earlier. They're a little bit larger. The fellow who started it, Brian Dalton, is a genius. He was one of the discoverers of the Voisey Bay nickel deposit that Inco is now promoting. He wound up with a royalty from that, which he put in to Altius, so they have nice cash flow from this royalty.
The company has 31 million shares outstanding. At the current price of about C$4.50, it has a market cap of C$140 million. It has C$175 million cash in the treasury, plus another C$75 million in solid assets. They are exploring in Labrador, and they have some phosphate properties. The value is tremendous, so we are a big supporter of Altius.
TGR: Do you follow Eurasian Minerals Inc (TSX.V:EMX) ?
JP: Yes. It's a well cashed-up property with good assets. The company has a current market cap of C$18 million, and has cash of C$13 million, plus another C$3 million in other assets, so it's currently selling at about book value. Their activities in Turkey and Kyrgys Republic are solid, but the current promise lies in Haiti. They control over 500 square kilometers of some extremely prospective gold and copper properties there. We originally got into Eurasian about the same time we got into a couple of the others (like Sprott) back in May of 2006. We first bought it at C$1.05 and then sold half of it when it got up to C$2. So, basically, the remaining stock in our portfolio is free now. I do like Eurasian.
TGR: GoldQuest Mining Corporation (CDNX:GQC.V) , too?
JP: GoldQuest has been in our portfolio only since August, so it's a relatively new addition. We like the people and it's small enough to fit our portfolio profile. It has really taken a beating, falling from a high of C$1.30 down to about C$0.10. Last time I looked, GoldQuest had C$3 million in cash and another C$5 million in properties, against a market cap of C$5.5 million. So yes, a very, very solid undervalued little company.
TGR: How do investors look at two- to three- to four-year plays when they've just lost 25% to 30% of their asset base?
JP: Looking longer-term is the only rational way to invest, regardless of whether your portfolio has gone up or down in the short term. In the three years we've running the Stealth portfolio, someone who followed every recommendation would be about even, in spite of the enormous losses of the past months. In spite of our strategy being classed as speculative, the strategy has performed a heck of a lot better than the Dow and the S&P have done.
We're very bullish about the future. We are scraping wonderful values off the bottom of the barrel at very low cost. Inflation will be the big problem ahead, but inflation is the very thing that's going to guarantee that natural resources will be the big winner.
TGR: But won't it also inhibit the juniors? If we have inflation, they will face two negatives—higher cost of production and lower demand.
JP: Looking at the short term, yes, demand is down. But in the intermediate term or longer, no resources will be developed unless companies can make a profit developing them. When you start losing money you go out of business. If producers go out of business, supply drops, yet there's still a demand for copper. The price of copper has to go up. The prices of the commodities themselves must increase enough to pay for the cost of development and production.
It happened in the '70s. In 1979 I wrote a book called the Copper Play . It argued that the cost of producing was 70 cents a pound on average and the metal is selling below that. The price of the metal had to go up. The strategy recommended in the books was to buy futures contracts on copper—a year, two years, three years out. Sure enough, boom! Eventually the supply-demand equation caught up. The companies were losing so much that they cut output, supply fell and eventually the price of copper shot up to $1.40. Those futures contracts paid off handsomely. We repeated that cycle the next time. It fell back down again, so we just went in and bought the metal again on the futures exchange. That's the same thing that's going to happen now.
TGR: Which brings us back to having a longer-term perspective on holding the natural resources.
JP: Yes. Don't go in these things for the short term. That's just a wild gamble. But anybody who goes in and has patience will see the kind of performance on a portfolio like this that will be equal over the longer term to what somebody like Buffet or Templeton achieved because they did exactly the same thing. They went in when blood was running in the streets, they kept doing that year after year after year, finding the things that were oversold, buying them at the low, and being patient. Just being patient and waiting.
TGR: You've been preaching the patience gospel for a long time, as well as practicing it.
JP: I've recently written several articles about the credit collapse, the markets, and this question of patience. I'll put them on The Stealth Investor website as freebies for your readers. Maybe that will help them see past the hits their assets have been taking.
John Pugsley entered the investment business in the late 1960s, and started sharing some of what he'd learned through his first book , Common Sense Economics. The book sold more than 150,000 hardcover copies. The second book he penned— The Alpha Strategy: The Ultimate Plan of Financial Self-Defense for the Small Investor— spent nine weeks on the New York Times' bestseller list and is considered a standard reference on stocking up on food and household goods as a hedge against inflation. He started Common Sense Viewpoint, an investment-economic newsletter covering political, economic and investment topics, in 1975 and published it for 10 years. At it's peak it had over 30,000 subscribers. He then wrote and published John Pugsley's Journal, for another decade. A popular speaker and talk show guest as well as a prolific author and successful investor, he is currently pouring his experience and energy into The Stealth Investor, a weekly stock advisory that alerts subscribers to potential investments beneath the radar of the big funds and brokerage houses.
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