Rick Rule on mining

I used to think that it was odd that I thought that most mining companies were overvalued.  There are very few prominent investors who voice that viewpoint.  Some like Seth Klarman, David Einhorn, George Soros, and John Paulson have been getting into gold stocks.  I personally think that most of the sector is awful (*though I own gold stocks).  One of the few exceptions is Jim Rogers, who points to this study which found that commodities futures outperform commodity stocks by a large margin (futures did three times as well).  I’ve read Pierre Lassonde and Seymour Schulich’s books (they made their fortunes in mining royalties) and they aren’t that critical of the junior sector.

So then I discovered Rick Rule.  In my opinion, he is not a well-known investor like Jim Rogers or George Soros.  But what he is saying makes a lot of sense.

On junior miners:

It is critical for gold stock speculators to remember that the junior market, in aggregate, is always overvalued. If we were to merge every gold junior in the world into one entity (let’s call it Junior Goldco), that company would lose (profits and corporate acquisitions less industry expenditures) somewhere between two billion and eight billion dollars per year.
Why I’m Excited About This Market

On senior miners:

Between 2000 and 2010, the price of gold advanced from $250/oz to $1,200+/oz. One would have expected a meteoric rise in the free cash generation of the gold companies, but the industry’s cash-generating and earnings response was pathetic. Worse, while cash didn’t explode, equity issuances did, so they diluted the cash they already had. That led to disgust with the gold companies, which carried over into their stock valuations.
Casey Research Summit Special Report: Reality Check or Checkmate?

My comments: Gold miners should have done a lot better given that the gold price skyrocketed.  In theory, gold miners are leveraged to the price of gold since minor increases in gold price should cause a much larger jump in profits.  At a 33% profit margin, a 1% increase in gold price should cause a 3% increase in profits.  Of course gold miners are also leveraged to their operating costs.  But the big picture is that while operating costs have seen significant inflation the price of gold has gone up even more.

As far as Rick Rule’s comment on “cash generation” and “free cash” generation goes, he is saying that you should take a better look at the accounting profits of these companies.  One way to inflate reported earnings is to aggressively capitalize expenses, e.g. capitalize exploration expenses even if the exploration failed.  Another way is to lower D&A by claiming higher asset lives to spread out the expense over a longer period of time and into the future, lowering the annual reported expense.  If you look at free cash flow (e.g. profits – D&A + capital expenditures) and similar measures, you will see through these earnings-manipulating techniques.  Free cash flow arguably gives a better picture of a company’s profitability since the usual accounting games don’t affect free cash flow.

Currently, Rick Rule is excited about markets since many mining stocks aren’t so overvalued anymore.  The TSX Venture exchange for example has fallen around 40% in the past year… the last time markets did something like that was in 2008.  (Personally I still think that there are a lot of overpriced companies out there and I don’t know of any seniors buying back shares.)

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