Inside Sprott Inc.

Globe Investor Magazine, Feb. 21, 2008

The $2-billion Sprott Canadian Equity Fund is the oldest and largest product offered by Sprott Asset Management, and it’s run solely by Sprott. The fund has roughly 300 different positions, most of which can be categorized as penny stocks (or “low-priced,” as Sprott puts it). This style of investing has fed a widespread belief that the fund is too risky for mainstream purposes like, say, registered retirement savings plans. “The returns for this fund are like we’ve never seen before,” said David Paterson, an independent analyst who helps more than 600 investment advisers across the country select funds for their clients. “But, from a volatility standpoint, it kind of scares me. This is a fund that I could never, in good conscience, recommend as a core holding.”

The argument from analysts such as Paterson goes like this: Any fund that is capable of producing larger-than-life gains is vulnerable to staggering losses as well. In fact, Sprott Canadian Equity has been downright nasty at times. In the 12 months ending October 1998, for example, the fund lost 38.97%. Last August, near the peak of a liquidity crunch that rocked global markets, the fund plunged 12%, yet still ended the year up 14%. Sprott Canadian has shown a resilience that makes it almost machine-like in its excellence. At its 10th birthday, the fund’s return for the preceding 12 months was 33.7%, while its three- and five-year compound average annual returns were 26.9% and 26.7%, respectively (the 10-year return, remember, was 27.3%).

“We go where we think we can make the safest and best return for our customers,” Sprott says in explaining how his company’s funds balance risk and return. “Lots of people look at what we own and they say it’s risky. I seriously challenge that.” As an example, he uses his 2003 call on uranium, then trading around $14 per pound. “We realized there was going to be a shortage of uranium, which has obviously evolved. Two years later, the stocks are up 500 or 800%, and the price goes to $125. The question is, Was it a risky bet? We’d done the work; we had a pretty good idea of what should happen.” Ultimately, Sprott argues that his fund is simply misunderstood. “The reason we’ve outperformed is that our style is different,” he says. “We don’t buy the mean stock. That’s the last thing we want to do. We want to buy things where the opportunities are outsized, where it looks like we’re taking a big risk, but the reality is that we’re not. It’s just perceived risk.”

We like buying the little guy that no one else is buying Even Sprott’s fans are wary of the fund’s potential downside, however. Peter Loach, vice-president and managing director of mutual fund research at BMO Nesbitt Burns, says Sprott Canadian Equity is too racy to be on the firm’s core recommended list, but it is suggested for sophisticated clients who understand the volatility and can hold on for, say, five years. “Eric Sprott is in a class of his own,” Loach said. “But if you invest in this type of fund, the mandate has to be no whining in the short term. With a fund like this, there can be swings to the downside as well as the upside.”

In a typical day for Sprott, the morning confab is followed by as many as four or five meetings with executives from companies, most of them in the junior mining and oil and gas sectors that figure so prominently in Sprott Asset Management portfolios. “Toronto is the mining finance capital of the world, and our foyer is among the busiest in Toronto,” Sprott says. “We might very well spend more money on junior mining and oil and gas companies than anybody, because that’s what our focus is.”

Although they may not do the roadshows, when it comes to selling their funds the people at Sprott Asset Management know how to put the good word out about a stock. Sprott demurs on this topic, but Tomljenovic lays it out plainly. “We tell our stories,” he says. “The portfolio managers get on TV, and they’re not shy about taking positions in the marketplace and telling people about it, even if it’s controversial.”

Often, company executives will visit Sprott’s offices to encourage the firm’s participation in new share issues that are intended to raise funds. A positive response is not unusual. In early November, for example, the firm put in an order for a very large slice of a share issue by PhosCan Chemical Corp., which is working to bring a phosphate mine in Northern Ontario into production. PhosCan’s a good example of how Sprott’s personal connections, research and investment philosophies come together to make money for investors. PhosCan, a tiny company that is listed on the TSX Venture Exchange, was trading late last year at just under $1 per share. Part of the reason Sprott initially bought into the company was to help out the firm’s president, Stephen Case, whom he knew from previous dealings. But PhosCan also fit into one of those investing themes that Sprott uses to guide his investing. In a word—fertilizer. “We’re great believers that the world is going to run out of fertilizers, and that we have limited resources in that area,” he says. It’s a bit of a Malthusian theme—too many mouths to feed.”

Thomas Malthus was a 19th-century English political economist who believed that global population growth would out-strip increases in the food supply. Using Malthus’s theory to support an investment in the 21st-century fertilizer sector seems sound, but it doesn’t explain why Sprott Asset Management chose PhosCan, an obscure stock, as the basis for its small position in fertilizer stocks, rather than a more established company. “Yes, you can buy Potash Corp. of Saskatchewan,” Sprott remarks. “But we don’t like buying the big guy. We like buying the little guy that no one else is buying.”

The identification of promising themes plays a big role in Sprott’s stock-picking, but so does a kind of analysis he calls “prospectivity.” He neatly summarizes this selection process in a single sentence: “What could happen?” For example, seven years ago, Sprott recalled looking for gold stocks when the metal was around $325 (U.S.) per ounce—that’s less than half the price it would reach at the end of 2007. One name he came up with was Seabridge Gold, whose ore deposits would only become economical when gold prices reached at least $400 (U.S.). “I said, that’s perfect, that’s exactly what I want. The stock’s gone from, like, $1.60 to $30 in seven years.”

Self-evident in the periodic downdrafts experienced by owners of Sprott Canadian Equity is the fact that not all of Sprott’s bets work out so well as Timminco, PhosCan and Seabridge. One of his recent duds was Falcon Oil, a company that is trying to exploit a process for removing natural gas from underground rock formations. Sprott Asset Management bought into that one around $1 per share, and, while the stock subsequently rose as high as $7, it ended 2007 at around 50 cents.

With the air of an athlete who knows perfection is impossible, Sprott simply writes the stock off as not having done what the firm expected of it.

Tomljenovic admits to misfires in areas such as environmental technology and clean coal, but suggests that such mistakes are part of the process of finding tomorrow’s big winners. “The classic mistake that retail investors make is to sell their winners and hold their losers,” he said. “Here, you cut your losers and buy your winners.”

As impressive as the numbers are for Sprott Canadian Equity, a savvy investor has to wonder if this tall poppy will, at some point, be scythed down to size. One who suggests this is possible is Moshe Milevsky, associate professor of finance at the Schulich School of Business at York University and an independent-minded observer of the investing scene. “Statistically, this fund is pretty impressive,” says Milevsky. “But to say that this is going to persist and that somehow this is the winning portfolio, I’d be very reluctant to do that.” Sprott seems a bit annoyed at the suggestion that his fund will eventually falter or, as they say in fund analysis, regress to the mean. “All I know, is we’ve been incredibly successful, historically,” he says. “We think we know how to pick stocks. We’re cautious. The funny thing is, we’re more bearish than anybody.”