This Rationale was written in 2001. Paul is working on an updated version in light of the recent developments in the global economy.

I have to admit that I am a speculator. Not to do so would be deceptive to myself and others. Nonetheless, even as a speculator there are certain principles and theories about investing that shape one's decision making process. I call that an investment philosophy. My own has been shaped by the ideas and principles of Benjamin Graham and his colleague, David Dodd, as well as mentor Rick Rule. This may sound like a paradox since Benjamin Graham was definitely not a speculator, but I will explain.

In principle, I would prefer to be a value investor, seeking out investments that can be bought for less than their intrinsic value and hoping to capture a profit as the market recognizes an undervalued opportunity. On a rare occasion I still do come across such investments and they usually work out very well. But the excessive speculation that has enveloped the US equities markets during the past two decades has made "investing" almost impossible. Buying good companies at over-inflated prices cannot be regarded as investing no matter how good the companies, or their prospects, are. The fact is that what the American Investor has been doing for the past five years, or more, has been nothing other than speculating.

This speculating can be thought of as the "greater fool theory". I will buy an overpriced stock today and hope that some greater fool will buy it from me tomorrow at a higher price. In this game it is almost irrelevant what the company does, how expensive the stock is, what the future prospects of the company entail, or even whether the company will exist two years from now. The only criterion under consideration is whether the stock is likely to go up in the next few minutes, or for a "long term investor", sometime during the next week.

Investing, in the true sense of the word, is almost impossible in a market such as this. But that doesn't mean you have to follow the lemmings down a cliff. I decided to look for an investment sector that could be expected to be counter-cyclical to the US stock market, so that when the hens come home to roost I can count my blessings.

The focus of my attention is gold. I do admit that I am pro-gold, anti-fiat money, but the reason why I focus so much of my attention to the gold sector at the moment has more to do with the US stock market and the strength of the US dollar than with my personal ideas about money in general.

Since the early 1990's, starting with the currency crises that swept through South America, a tremendous amount of capital has found its way into US stock, bond and real estate markets. The foreign capital that flowed into the United States from abroad reduced US interest rates, supplied liquidity and capital for commerce, suppressed inflation and ultimately caused a stock market bubble of historical proportions.

The wealth effect that rippled through the US was stunning. Rational people lost all sense of reality. But the greed did not stop within the US borders. Foreigners, who were for the most part responsible for creating the environment which gave rise to these events, continued to send their hard earned savings to the U.S. of A. The undeniable result was a spectacular rise in the US dollar.

Now enters gold. At some point I have to put my money where my mouth is. In looking for an opportunity to profit from this mania, I stumbled on the obvious, but much neglected gold sector. If the dollar's rise was instrumental in creating this bull market mania, the dollar should also be pivotal during the ensuing bear market, which I believe has already begun and is going to shock US investors, and the world, with its severity. It is unreasonable to expect that the dollar can maintain its lofty trading range given the debt load of the United States, especially debt to foreigners, and the mammoth annual trade deficit. Shorting stocks is a very risky endeavor. Shorting currencies is no safer. Buying foreign currencies is an option but most of them have their own problems. Gold however is no-ones liability.

The gold price is measured internationally in terms of US dollars. As the dollar increases in value relative to foreign currencies it also increases relative to gold and the gold price falls. When the dollar declines in value, the gold price, as measured in US dollars, increases. Therefore to profit from a demise in the US economy, its markets and the dollar, one can simply buy gold and gold related investments (there are many articles about the the gold price and the Dollar in the Library on this site).

Much has been said about the demonetization of gold, the fact that gold has lost its value as a store of wealth, etc. I don't believe any of it. True, central bankers love to discredit gold and would like nothing more than a world without restrictions on their ability to print money. But gold is much more entrenched in our society than what the popular press would like to admit.

Enough digressing. Since investing in the current market is problematic due to vast amount of capital chasing a limited number of investments, we may as well call a spade a spade and admit that the majority of money "invested" in this market amounts to little else than gambling. And if I am going to gamble, I want to make sure the risks are aptly justified by the potential rewards. Other than buying gold bullion, investing in the gold sector is a risky business.

Mining companies are notorious for causing investors woe and mineral exploration is arguably one the riskiest businesses in the world. But mining companies offer exceptional leverage to gold prices and the exploration sector may be the best place for risk capital due to the structural changes that have taken place in the mining industry during the past five years.

When the price of gold started its decline in 1996, mining companies immediately started cutting costs. Among the budget items that were slashed, few were hit as hard as exploration expenditures. For most mining executives, exploration costs are difficult to reconcile with direct benefits, since world class discoveries are rare and exploration successes are few. Furthermore, most mining companies are run by engineers or people with a finance background, who have little passion for exploration and balk at the expenses that fail to yield measurable, or consistent, returns. But mining is a depleting business; the more you mine the less you have to mine. Exploration is the life-blood of the mining process.

Even so, mineral exploration budgets have been reduced by 50% during the past four years and now major mining companies are scrambling for access to new deposits. Five years have gone by with very few major discoveries and a lot of ore has been irreversibly extracted. It typically takes several years to develop a new deposit, if one can be found, and a few more years after that to construct a mine. The mining industry is facing a huge dilemma. Too little money has been allocated to exploration and many mining companies have reduced their exploration departments to the point where they are hardly capable of large scale, international grass-roots exploration. Exactly what is needed.

Many major mining companies have already admitted that they cannot compete on the exploration front with junior companies. This is where the opportunity lies. Exploration is extremely capital intensive but it should be regarded as a knowledge based business. Junior exploration companies have to use their expertise to find prospective properties and then joint venture these to the major mining companies, which contribute the capital required. This is a simple model that works. It is analogous to someone coming up to you with the proposal that he will pay for a stack of lottery tickets if you will pick the numbers and you both share the winnings if there are any.

Even though there is total apathy in the stock market for junior exploration company shares, the companies themselves are very busy. Good exploration companies capable of generating quality projects are inundated with interest from major mining companies desperate for new deposits. There has been a true division of labor in the mining industry. The capital intensive development and extraction of ore is done by major mining companies and the knowledge intensive search for new deposits is being spearheaded by entrepreneurial geologists who run their own junior exploration companies.

Comprehension of the business cycle associated with mining and exploration, as well as an understanding of geology, can make a big difference when it comes to speculating on junior exploration stocks. Market timing is problematic under any circumstances but I am wagering my personal capital that the next five years are going to be extraordinarily profitable for the exploration industry. Without exploration there can be no mining and without mining there will be no replenishment of the minerals we use, which means no new houses, cars, telephones, computers, etc. I am prepared to take the risk that human progress is not going to stop dead in its tracks during the year 2001, and that means that the world is going to need new sources of minerals.

The day will come when the US equities markets will have returned to a semblance of sanity, and value investing will once again be a profitable application of time and effort. I look forward to that. Until then I am betting that the dollar will weaken, the gold price will rise and the world will not want to be without the benefits of minerals.
Now Benjamin Graham and David Dodd's ideas do have something to do with my approach to speculation. They popularized the notion of value investing, an approach that seeks to find investments that can be purchased for less than their intrinsic value. Investing requires us to look at high quality companies with stable earnings, cash flow and a solid business. Then the potential investments have to be evaluated relative to prevailing interest rates and alternative uses of capital.

While market timing is about as accurate a science as reading tea leaves, it is irrefutably crucial to the outcome of investment activities. Fortunately, value investing has a built in market timing mechanism that doesn't require market timing at all. Close to the top of a business cycle, or a bull market, stocks are generally expensive relative to their intrinsic value. This is a good time to liquidate equities and shift capital towards other sectors. Conversely, during troughs in the business cycle, or a bear market, equities generally sell for less than the intrinsic value of the companies and this is an excellent time to increase one's capital allocation in the depressed sector. Of course this is easier said than done, because human nature makes it extremely difficult to be contrarian.

Equity sectors do not all march to the same drum and shifting capital from one sector to another is paramount to investment success. Many studies have found that asset allocation is far more important to the outcome of an investment strategy than stock picking. Using the method of value investing it is possible to allocate assets in sectors that are closer to the bottom of their cycles, since that is where the value is, and hence reduce capital risk while maximizing potential returns. However, the current state of the economy, and particularly the stock market, is far from normal. We appear to be reliving a mania similar to the late 1920's, which of course led to the Great Depression as speculative excesses were worked off and capital mis-allocation was corrected. Doug Casey has said that the aftermath of the current mania might in due course be referred to as the Greater Depression. I think he could be right.

So what can we do with our capital? Make sure to obey investment rule #1: "Do not lose your capital". Another one of Doug's favorite saying is that in future people will become more and more concerned with the "return of their capital than the return on their capital". This paradigm shift has already started.

The safest place to store wealth right now is in cash. Real estate markets are just as insane as the equities markets and with the amount of consumer and private debt outstanding, the lending institutions may find themselves to be equity owners of real estate they did not intend to own. Bond yields are at historic lows and with the expansion of the money supply that Alan Greenspan has provided to make sure the speculative bubble didn't burst, we cannot rest assured that inflation will not rear its ugly head. But the dollar itself has problems and a decline in the dollar exchange rate can affect the buying power of cash, in addition to any internal inflation we may experience. That is why it is prudent to protect your cash with an investment in gold. Gold should move counter-cyclically to the dollar and protect the buying power of dollar assets.

In the mean time, speculative capital can be allocated to the exploration sector, where I believe it is possible to find both value and extraordinarily good risk/reward opportunities. Believe it or not, there are junior exploration, and junior mining companies, that trade at a discount to their intrinsic value and even though one cannot consider these "investments" in the true sense of the word, it is possible to apply the ideas of value investing to the activity of speculation.

The principles of value investing protect capital from insane and unintended speculation and delivers sound criteria for selecting potential investments. I'll stick to that.

(January 2001)