Rick Rule: Capitalize on Gold Stock Volatility

The developed societies of the West are descending and destabilizing. People have come to believe that they are entitled to live beyond their means. I'm not an economist or a political scientist, but that perception leads to some very hard math. How can you add a column of negative numbers and come up with a positive? It's not a uniquely American problem either. People in the old Western societies, Canada and Australia suffer from the same delusion. We are old; we are fat; we are white and we are rich. Our collective problem was described by my grandfather in the following diddy: "When your outgo exceeds your income, your upkeep becomes your downfall."

I'm not just talking about a problem of tax receipts or government spending or entitlements. It isn't that we're collectively stupid. It's that we're individually stupid. There seems to be a belief in the United States that a 55-year-old auto worker can make $55 an hour because he or she can employ technology better than a 22-year-old Indian auto worker. I don't think so.

Another problem is that the root causes of the liquidity crisis of 2008 have still not been addressed. If you have a big problem that manifested itself in a fairly dramatic fashion and you haven't addressed the causes, do you think it's reasonable to be afraid of the fact that that probability may reassert itself? I do.

So, what's the good news? The emerging and frontier markets—societies where people are un-free are becoming a bit more free. As they become a bit freer, they become richer. Remember Chinese Communist Party Leader Deng Xiaoping, who famously said, "To become rich is glorious." That phrase turned China loose. Make no mistake, we aren't talking about an unending upward linear spiral. There is plenty of room for negative surprises. We have seen in places like Libya, Yemen and California that the road to freedom is uneven. But it is an undeniable force.

So we have descending destabilization of Western societies, which is not good for commodities. It's not good for anything. But we also have ascending emerging markets. That is good for resources. When people get more money at the bottom of the economic pyramid, they buy things made of stuff. A poor person might trade a thatch roof for a metal roof. He might trade walking for a bicycle and eventually for a motor scooter. Old, fat, rich people buy a nice dinner. Maybe we buy an iPod for a grandchild and load it with virtual songs. All good things, but they are not made of stuff. Selling stuff is what makes investors rich.

Think about it as two great weather systems coming together. Old, spoiled, rich and stupid meets this amazing demand for resources. What happens when two big weather systems collide? Stormy weather, turbulence, volatility. I think we're going to see volatility on steroids. Volatility can cause strange things. There's a big up-move on silver right now. We believe in it. Silver pops up 30%. Then there's that other kind of volatility like in 2008 when things fell off a cliff. They got really cheap. So, you have to manage your expectations going forward. There will be more upward spikes and more down-spikes.

Now, volatility doesn't need to be a risk. It's up to you. Remember this. Perceptions of the future are set by immediate past experiences. That means in the near term, as the financial author Jim Dines famously says, a trend in motion stays in motion until it stops. Today, people buy gold and silver stocks. They make money and then they buy more gold and silver stocks. We often confuse a bull market with brains. Markets gain momentum and gain momentum and gain momentum and gain momentum. We buy a stock for $1.00. The stock goes to $2.00. What do we do? We double up. Think about this. Is this rational behavior? No, but it feels good. We're smart. The stock went up. The sector's good because the stock went up. The higher the prices go, the better we like it despite the fact that the value is eroding right in front of us. The contrarian thesis, of course, is to be brave when others are afraid and afraid when others are brave. It's a wonderful slogan, but it's damn hard. When a company is selling for half its worth, people complain that it never goes up. In other words, the fact that it's cheap becomes a curse; a wonderful curse, from my point of view. Unless, as occasionally happens, I'm wrong. What's the biggest investment risk out there? Obama? Debt? Nuclear arms? No. The biggest investment risk you have is to the left of your right ear and to the right of your left ear. All of my worst financial experiences were self-inflicted.

The reality is that volatility is good because it represents a series of 40% off sales. It's up to you whether you take advantage of volatility or whether volatility takes advantage of you. Common sense is the real determinant, over time, of whether you will do well. If something doesn't make sense, very often it's because it doesn't make sense. Financier George Soros made almost all of his money finding widely-held premises that were wrong and betting against them. He famously decided in the year 2000 that the United States society was hubris infected. You remember the spectacular bull market of 2000. We had vanquished the Soviet Union, and everyone thought nothing could go wrong with America. Soros bet against it. That's the kind of common sense that will allow you to deal with volatility.

My approach is very simple. It comes down to this: "Hit them where they ain't." Know this: A trade that's popular, a perception that's popular, an idea that's popular is very likely overpriced. I've come to prefer underpriced. That's why I concentrate on stuff that's unpopular. Fortunately for me, unpopular stocks are in fairly good supply. It's an orientation that has served me well over the long term. Over the short term, however, this approach can be inconvenient from time to time. One thing that happens with lonely trades is that when you make a mistake, you usually make a fairly serious mistake. Your speculative portfolio isn't trying hard enough if you don't have a couple of positions lose 30% or 40%. I know this is hard to stomach, but it is true.

So, how do you create a portfolio that flourishes in the face of volatility when the resource market is no longer cheap? First, create liquidity; have some cash. It's OK if your cash is bullion, but have some cash. You have to have cash. When volatility occurs, cash will do two wonderful things for you. It will give you the courage to act in down markets. It doesn't matter if stocks are cheap if you can't do anything about it. So, have some liquidity.

Second, remember that in small companies, people make the difference. Speculate based on ability. Don't be a gold investor or a silver investor. If you are speculating on exploration, buy Andy Wallace, Lukas Lundin or Ross Beaty. Find people who have proven track records. When it comes to the junior mining sector, 90% of these companies are worth nothing. All of the wealth creation occurs in a very small subset. And, the best determinant of success is the ability of the people running the company. Doug Casey famously said, "A lot of the guys in this market, if it weren't for the junior stock business, would wear a mask and a gun when they went into a 7-Eleven." I can't stress this enough; this is a people game.

Third, consider the true value of a company. I've heard people say that XYZ company is cheap because it has a $20M market cap. But the company might only have $1.98 in the treasury and it is spending $200,000 a month. It may have a piece of orangutan pasture in Indonesia and a piece of jackrabbit pasture in Nevada. It is considered cheap because similar scams are priced at $40M. It's truly insane.

The fourth thing that needs to be in a volatility-optimized portfolio is discovery. A lot of people right now are trying to bring back tired old properties. Occasionally they work. But, discovery is where the money is made. If you're going to speculate, swing for the fence. Betting only on small operations does nothing to limit risk. I've learned in 30 years that anything that can go wrong with a big mine can go wrong with a small mine. Only big mines can make you big money, however. If you're taking a chance where the most likely expectation is failure, your successes have to amortize your failures. So look for big successes because you're going to have lots of failures. That's the way it works.

Good luck.

You can hear even more from Rick, including his top investments right now, in the comfort of your home. Listen to 35 renowned economists, investment pros and resource experts who, at a just-concluded Casey Summit, shared their outlooks for the future of the U.S. economy, the dollar, and the markets along with their best investment advice and personal stock picks. Find out more.

Rick Rule, founder of Global Resource Investments (GRI), began his career in the securities business in 1974, and has been principally involved in natural resource security investments ever since. He is a leading American retail broker specializing in mining, energy, water utilities, forest products and agriculture. Rule's company has built a national reputation for its specialist expertise in taking advantage of global opportunities in the oil and gas, mining, alternative energy, agriculture, forestry, and water industries.

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