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Playing the Niche to Outperform the Major Stock Indices

Commodities / Gold & Silver Stocks Apr 27, 2010 - 01:53 AM GMT

By: The_Gold_Report


Best Financial Markets Analysis ArticleJohn Pugsley's Stealth Investor portfolio has been outperforming the major indices since its inception four years ago. In this exclusive interview with The Gold Report, John explains how focusing on companies with smaller market caps allows his portfolio to upstage the market, and why the precious metals and energy sectors offer investors unique opportunities.

The Gold Report: John, your Stealth Investor portfolio outperformed the DOW, S&P and NASDAQ. To what do you attribute your success?

John Pugsley: There are several reasons we've consistently outperformed the market.

First, we're concentrating on micro-cap and nano-cap natural resource exploration and development companies with market caps usually under $50 million and sometimes under $10 million. Within this relatively large group we've been successful in identifying a small number of outstanding firms that are deeply undervalued simply because they are off the radar of brokers, institutions and investment newsletters. Without brokers and investment letters getting the word out to individual investors, these stocks' share prices languish.

TGR: So why aren't they promoted by brokers?

JP: Two or three reasons. First, the smaller companies can't afford the registration costs to register their shares in the United States with the SEC and all of the state securities agencies. In fact, many of the companies discovered by Stealth Investor are required by law to put a notice in their press releases stating that the information should not be disseminated or the securities offered or sold in the U.S. Since it's illegal for U.S. brokers to introduce or promote companies that aren't fully registered, these companies don't get exposed to the big market of U.S. investors. Of course, if an investor knows of a company, and asks a broker to buy it, the broker can place the order. The broker just can't recommend non-U.S.-registered companies to clients. This severely limits a small company's ability to raise capital.

Secondly, even when it's legal for brokers to recommend a company, tiny companies are usually of little interest to brokerage firms and underwriters. There just isn't enough "juice" to get a broker's attention.

Third, companies with small market caps are usually of no interest to funds. There just isn't enough float to allow a fund to take a substantial position. The big money managers are looking for opportunities to place large chunks of capital, and since it takes about the same amount of due diligence to study a small company as a big one, the funds tend to ignore the small firms.

TGR: There are a lot of stock advisory letters. Why aren't the companies you recommend being recommended by other advisory services?

JP: Most financial newsletters have larger subscriber bases. When a letter has 2,500 or 5,000 subscribers or more, every recommendation results in a rush of buy orders. The share float of a company with a market cap of $10 million may have a float of only one or two million shares. If the price is a dollar or two, it takes very little in the way of buy orders to drive the price out of sight. When a rush of orders hits, the price immediately soars, and subscribers get disgruntled because they're unable to get shares. The point is, letters with a larger number of readers just don't bother to recommend nano-cap companies.

I knew from past experience that I couldn't really exploit this niche of undervalued stocks unless my subscriber base was so small that the price of a stock wouldn't be affected by the buying pressure from my subscribers. Consequently, I have limited the number of subscribers. I probably have the smallest number of subscribers for any letter in the industry. Small, but very successful.

TGR: How do you identify the companies that finally make it into Stealth Investor?

JP: Good question. I still have to ferret out the truly undervalued small companies out of the thousands of little natural resource companies struggling to make it. I have an advantage over some of my younger brethren. I've been writing about natural resources for nearly 40 years, and as a consequence have become friends with a wide range of people in the industry—geologists, engineers, successful entrepreneurs, CEOs, brokers, etc. By tapping this resource I get tips on deeply undervalued companies, as well as solid opinions on those that seem to fit our model.

The idea has worked extremely well. From our start four years ago, our portfolio is up 147%, while during the same period the S&P500 is down 5.7%. So while the subprime credit collapse drove everything down, we've managed to pull through, survive and make great profits. It's all because we're in a unique niche.

I might add that there is another element in our success: we concentrate in natural resources. When government printing presses are gushing IOUs, solid value lies in tangible goods, not in paper promises. While one can buy physical commodities like copper and gold and store them away, owning those same tangibles still in the ground is an even better hedge against inflation. Before they're going to be tapped and brought to the surface, the price of those commodities must be high enough to yield a profit to the companies producing them. It's automatic. By discovering and acquiring resources in the ground, we're storing value.

TGR: In your Stealth Investor newsletter at the end of March, you talked about a paradigm shift coming in the way people look at the economy, but you also said that we shouldn't hold our breaths. When do you see that paradigm shift happening?

JP: The ruling economic paradigm embraced by almost all of the economics profession and certainly by the politicians and bankers, is "Keynesianism." It holds that the cure for a recession or depression is to drown it in government spending and central bank monetary expansion.

This is a recipe for stagnation and inflation, but a shift away from a belief in deficits and fiat money creation won't happen until there's true catastrophic decline in the world economy. In fact, the Keynesian paradigm may not be abandoned even then. The collapse and depression of 1930s, which was caused by the credit explosion that ensued after the creation of the Federal Reserve in 1913, could have turned us back to a true gold standard. Instead, Keynes came in and gave the politicians new justification for more government spending and money printing. There was such a collapse between 1929 and 1932 that one would've assumed that they would have gone back to 19th century classical economics and a stable monetary system. It didn't happen.

Based on the current worldwide belief in Keynesian economics, and considering the measures that are now being pursued to deal with the credit collapse, this current depression will probably continue for another 10, or 15 years or longer. It isn't going to end in the next few months, or few years, as the economists are suggesting, because they are trying to cure the problem with a dose of the "hair-of-the-dog," the same drug that caused the problem in the first place.

TGR: John, as we've discussed, your investment strategy has been pretty successful for the past four years. How important is the particular sector, such as the precious metal sector or the alternative energy sector, when you're making your investment decisions?

JP: Not very important. I'm looking for raw resources in the ground. I'm not looking at any one sector like gold, industrial metals, oil and gas or water. I'm trying to find companies that are searching for or developing all types of natural resources. Whether it's gold, water, or phosphate doesn't really make much difference in my eyes. It's a question of how necessary is the commodity, how good is the management, what properties do they own, and how cheap the stock is.

TGR: What about the difference between companies in discovery mode versus companies in production mode? Does that have an impact?

JP: Yes, it does. Generally, companies that are producing minerals, oil, gas, etc., tend to be much bigger. It takes a lot more capital to develop and mine minerals or produce oil than it does to explore and find deposits. Our unique, under-the-radar niche consists of tiny companies in the exploration or prospect generation sector that will make discoveries and then joint venture them or sell them to larger companies. We are looking at the early-stage prospect generators as the best prospects for our particular strategy.

TGR: You said that the rewards in your portfolio are due to your focus on "off-the-radar" natural resource opportunities. Can you share some of those off-the-radar natural resource opportunities with our readers?

JP: One example is Altius Minerals Corp. (TSX.V:ALS) It is one of my favorites. We started buying Altius four years ago. We put in a buy recommendation when it was at C$6 and C$10. Then it jumped up to $20 and we sold a third and got our money back. The price subsequently fell and we bought second and third tranches at lower prices, and those are much higher. Altius is a good example of a prospect generator but also has other interests. It was small and it was an excellent opportunity for us.

We bought into Canplats four years ago when it was a fledgling, it made a significant discovery, and was bought out last year by Goldcorp Inc. (NYSE:GG;TSX:G). Along the way we took some profits, but in the end it was a 20-bagger for us.

Diamonds are another of our more profitable picks. We bought Motapa Diamonds early on. It became Lucara Diamond Corp. (TSX.V:LUC) and Lucara has done very well for us. We've bought into it two or three times as it moved up. We're still holding and shares in two tranches we now hold are up 235% and 352%, respectively.

We added Reservoir Capital Corp. (TSX.V:REO) in October 2006. Reservoir is a Canada-based company acquiring and developing hydroelectric projects in Serbia and southeast Europe. It also is involved in exploration and development of mineral properties. I recently spent some time with Miles Thompson, the CEO of Reservoir, and I'm hoping to get a chance to tour their Serbian projects. They've recently entered into agreements to sell power from their hydroelectric projects to the Serbian and Italian governments.

Sprott Resource Corp. (TSX:SCP) has been a wonderful company for us. We bought in back in spring 2006 at C$1.60 then sold half of it when it hit $4. We bought a second tranche in October 2008, and are holding both tranches at this point.

Our current holding in uranium is Kalahari Minerals plc (AIM:KAH;NSX:KAH). They hold about a 40% interest in Extract Resources Ltd. (TSX:EXT;ASX:EXT), an Australian company that has the big Husab uranium property in Namibia. Husab will probably turn out to be the biggest uranium deposit discovered to date. So we've done extremely well with Kalahari over time.

We also have Esperanza Silver Corp. (TSX.V:EPZ) in the portfolio. In addition to the people that are involved in it, their properties are wildly prospective. I first discovered Esperanza when the company was exploring in Peru. Bill Pincus, the CEO, had a couple of geologists down there looking as outcrops and stream sediments, and one of their horseback guides said, "Oh, you're looking for that kind of rock. I know where there's some up this canyon." They made an enormous silver-gold discovery, named it San Luis, and joint-ventured it with Silver Standard Resources Inc. (TSX:SSO;NASDAQ:SSRI). They just released promising new drilling results from a 50-hole drill campaign at their Cerro Jumil project in Mexico. I think it's going to be a really enormous resource by the time they're done. The company has ample capital and because of Cerro Jumil, this is going to be an ongoing success. I really like the people, what they've done. Esperanza remains in our portfolio.

TGR: You touched on the green energy area. As that alternative energy sector continues to get attention, what do you feel are going to be the key factors driving that sector forward?

JP: The driving force behind green energy is environmental activism. These "greenies" put pressure on the politicians, and the politicians subsidize the sector, both with cash subsidies, as well as regulations that force utilities to get certain percentages of their power from renewable energy sources. Thanks to government subsidy, green energy is going to be the wave of the immediate future. A lot of the green energy section is puffery. Wind and solar, for example, in most cases would be unprofitable to produced if it weren't for government subsidies.

The green-energy industries I find attractive as an investment are low-head hydro and, of course, the biggie, geothermal. These two sources are continuous, and in unending supply, at least in those areas of the world where the resources are available. With the addition of state and federal government subsidies geothermal is a no-brainer.

TGR: Are there any geothermal companies that you're excited about?

JP: Without mentioning any that are currently in Stealth Investor portfolio (since my subscribers pay a lot of money for my recommendations), one that I think is going to be very successful is Ross Beaty's Magma Energy Corp. (TSX:MHY). We briefly recommended Sierra Geothermal Power Corp. (TSX.V:SRA), but have decided that it no longer has the potential we hoped for.

TGR: What is it about Magma Energy that you like?

JP: Two things. The company is assembling a portfolio of properties that are highly prospective. The biggest thing is Ross Beaty himself: his genius at management, which has been proven over his copper projects and silver projects, the capital he has behind him, and his ability to raise ever-larger amounts of capital to build this company. Ross Beaty is the asset that makes Magma truly exciting.

TGR: Are there any pearls of wisdom you'd like to share with our readers?

JP: I think that the individual who hopes to survive financially in the near future, and in the next 10 or 20 years, should invest significant time and money in gaining a deep understanding of economics. We're very unlikely to experience the long bull markets of the past three decades where it was possible to ride the bull and get rich. The sub-prime real estate collapse and the concomitant plunge in stock prices is not just a normal up and down cycle.

The few who understood what Greenspan and the politicians were doing to blow up the real estate and stock market balloon through credit expansion, subsidy and regulation exited real estate and the broad markets three or four years ago. To those of us who understand the fallacies of Keynesian economics, it was apparent that these markets were dangerously overvalued. Going forward, it's not possible simply to take recommendations from brokers or investment gurus (even this one) and expect to survive. The answer is to back away from the experts, and become knowledgeable. Economics is just common sense. If somebody's offering you something for nothing, like interest rates at 1%, and free money to buy a house you can't afford, there's something wrong. Self-education is the secret that will help people survive in the days ahead.

TGR: Great advice, John. We appreciate your insights.

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 its 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 Stealth Investor, a weekly stock advisory that alerts subscribers to potential investments beneath the radar of the big funds and brokerage houses.

Want to read more exclusive Gold Report interviews like this? Sign up for our free e-newsletter, and you'll learn when new articles have been published. To see a list of recent interviews with industry analysts and commentators, visit our Expert Insights page.
1) Tim McLaughlin of The Gold Report conducted this interview. He personally and/or his family own shares of the following companies mentioned in this interview: None
2) The following companies mentioned in the interview are sponsors of The Energy Report or The Gold Report: Esperanza Silver Corp., Magma Energy Corp., Goldcorp Inc.
3) John Pugsley: I personally and/or my family own shares of one or more of the companies mentioned in this interview. Neither I nor anyone in my family has been or will be paid by any of the companies mentioned.

The GOLD Report is Copyright © 2010 by Streetwise Inc. All rights are reserved. Streetwise Inc. hereby grants an unrestricted license to use or disseminate this copyrighted material only in whole (and always including this disclaimer), but never in part. The GOLD Report does not render investment advice and does not endorse or recommend the business, products, services or securities of any company mentioned in this report. From time to time, Streetwise Inc. directors, officers, employees or members of their families, as well as persons interviewed for articles on the site, may have a long or short position in securities mentioned and may make purchases and/or sales of those securities in the open market or otherwise.

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