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On the Money: Sprott Resource

As the world’s population grows, so too does its demand for resources. Here’s how investors could profit

Jody Chudley is the author of The Punchcard Portfolio, a value-oriented newsletter with a focus on Canadian oil and gas stocks

Oct 29, 2013

by Jody Chudley

Sometimes a picture tells a thousand words. And sometimes a picture simply blows your mind. I think the one that shows the growth of the population of the planet– one that’s essentially gone parabolic – belongs among the latter. We will add more people in the 13 years between 2011 and 2024 than the entire population of the planet was 200 years earlier. This skyrocketing population creates a similarly massive increase in demand for the Earth’s natural resources. Resources which are, of course, limited in supply. As a human being, that is concerning. As an investor, that is an opportunity.

One of the sharpest investors of the last 30 years is Jeremy Grantham. Grantham warned investors to avoid assets exposed to the Japanese bubbles (equity and real estate) of the late 1980s, the growth stock bubble of the late 1990s and the debt bubble in 2008. If Grantham is warning about something, it is usually smart to listen. And what is Grantham saying about the future of resource prices? “Prices of global raw materials are now rising fast. This does not constitute a bubble, however, but a genuine paradigm shift, perhaps the most important economic change since the industrial revolution. Simply, we are running out.”

For investors, Grantham has some very simple advice: buy stuff in the ground. And if you think Grantham knows what he is talking about – and I do – you might want to take a look at Sprott Resource, which offers an attractive way to get exposure to several commodities. Sprott Resource was founded in 2007 by legendary investor and namesake Eric Sprott in order to take advantage of a future in which the company’s management believes trust in paper currencies will erode. The thesis is to invest in natural resources, including precious metals, energy and agriculture, which represent tangible value from which investors will benefit as basic resources become more precious.

Unlike closed- or open-end mutual funds, Sprott Resource is a corporation that can invest capital on a more permanent basis. Because it isn’t subject to redemptions and cash calls, it can deploy its capital with a longer- term view, and use it to do everything from buy companies that it thinks are trading cheaply to taking an active approach in ones it really likes. The company also looks for distressed deals. In other words, Sprott Resource is like a publicly traded private equity firm that invests capital and patiently holds it for long-term rewards.

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A key advantage that Sprott Resource has is that it gets deal flow from Sprott Asset Management, which is the Canadian leader in providing capital to the resource sector. Sprott gets a look at most deals in Canada, and is usually first in line for the best ones out there. It’s already hit a few massive home runs for its investors, such as the $55-million investment it made in PBS Coal. During a time when there was a trough in coal prices, Sprott recapitalized the company when existing shareholders wanted an exit and capital was needed to expand the mine. Subsequently, when coal prices recovered (only 11 months later), Sprott sold PBS Coal to a strategic buyer from Russia for $240 million.

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The second successful investment was in Waseca Energy. Sprott bought land in the established Lloydminster heavy oil region during the financial crisis of 2008 in a partnership with Waseca’s management. Heavy oil prices were depressed at the time of the investment, and virtually all resource companies were significantly capital-constrained. Sprott was opportunistic and again struck for big gains, turning a $44-million investment into $111 million in four years.

As of July 31, 2013, the Sprott Resource portfolio was allocated mostly to energy (50 per cent), agriculture (28 per cent) and precious metals (22 per cent). Its largest investments are in Long Run Exploration, which comprises a whopping 40 per cent of its overall portfolio, gold (it holds 73,971 ounces of physical bullion) and a private company called One Earth Firms, which was started by Sprott itself to take advantage of underused land in Canada. The plan for One Earth is to be one of the largest vertically integrated farms in the world, and the potential for profit realization here is through an IPO or sale to a sovereign wealth fund, private equity firm or an agriculture company.

The last couple of years have been a horror show for investors in small and intermediate Canadian resource companies, and Sprott Resource has not been immune to this. Currently, Sprott Resource trades for roughly a 13 per cent discount to its net asset value (the value of its investment portfolio less any liabilities). That discount provides investors with upside to the current trading value of Sprott’s investments. That is attractive.

What makes the proposition more attractive is that Sprott’s investment portfolio itself is significantly undervalued as well. That could give investors the double benefit of the discount to net asset value narrowing and the market value of the entire portfolio increasing. If you are like Jeremy Grantham and believe that resource prices are headed higher over the long term, the best thing to do with Sprott is buy it and then check back in 10 years. If resource prices do as expected, investors in Sprott Resource should do very well.

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