Eric sprott is looking glum. The $940.5-million Sprott Canadian Equity Fund he has managed since its inception in September 1997 has been struggling this year and lagging the benchmark S&P/TSX index. Year-to-date, it is up 2.8%, a paltry figure set against the index’s 15.7% return.

That is quite a comedown, given that Sprott has established himself as one of the hottest hands in the fund industry. By taking positions in gold bullion, little-known gold and energy plays and “special situations,” mainly in the small-cap arena, Sprott soundly beat his peers in the Canadian equity category between 1999 and 2004.

The record speaks volumes. For the five years ended July 31, the fund had an average annual compound rate of return of 30%, compared with 5.9% for the median fund and 1.7% for the index. Over three years, the fund averaged 24.8%, vs 13.2% for the median fund and 18.6% for the index. In the 12-month period, it returned 28.9%, compared with 18.6% for the median fund and 25.5% for the index.

This year, well, it’s another story. “I’m not happy with the recent performance,” says Sprott, 60, sitting in an Inuit-art filled boardroom at Sprott Asset Management Inc. , the Toronto-based firm of which he is president. “But, a year from now, gold could go crazy and our small caps could take off and so could the fund’s performance.”

Fund analysts such as Gordon Pape have high praise for Sprott and the fund, even if it is highly volatile. “The numbers are terrific and he has done an outstanding job,” says Pape, a Toronto commentator who gives the fund a top rating. “Until recently, his instincts have been bang-on. But it depends on whether his bear market view will continue. If you want some insurance in case the market does go down, you may want to take a position when and if the fund opens.”

Another fan is James Gauthier, fund analyst at Toronto-based Dundee Securities Inc. “He has a tremendous track record, although the fund is very volatile, and has a high-octane portfolio,” he says, adding that Sprott now has an additional challenge in that the fund is almost 15 times bigger than it was four years ago. Should the fund re-open, Gauthier says, it’s appropriate for someone who shares Sprott’s contrarian views — and the ability to withstand the fund’s volatility.

Sprott attributes the recent underperformance to several factors. First, his long-term bearish stance doesn’t do well when markets thrive. “If you look at the bear years — 2000 and 2001— we were up 44% and 43.7%, respectively. We’re a little contrarian.”
Moreover, in the first half of this year, the fund had between 20% and 30% cash because of Sprott’s concerns about the market. That only acted as a drag on performance.

Second, he has held about 30% in gold bullion and precious metals stocks, which have not done well lately. Third, he has invested about 40% in energy stocks, which should have done well except for the fact the fund emphasized coal and uranium stocks, which corrected this year after a massive run-up in 2004. Names include Pine Valley Mining Corp., Macarthur Coal Ltd. and Western Canadian Coal Ltd. “Sometimes there is a payback after a big run. We tend to be owners, not traders. These names held us back.”

Yet, clearly, he’s still in the game. Sprott, who blends top-down analysis with bottom-up stock-picking, is not about to change his style or methodology. He may be idiosyncratic in his selections, but he is not about to abandon the willingness to get in early while the crowd is focused on the tried-and-true.

“We were very early with uranium and junior coal stocks last year,” he recalls. “We were also early in the gold bull run of 2001. I’m not an old gold ‘bull’ but I thought it was time to get in.” Even though gold stocks have been laggards lately, Sprott is convinced they will shine again.

Currently, about 18% of the fund is invested in bullion, 16% gold stocks, 21% oil and gas, 15% coal, 5% uranium, 4% base metals, 10% special situations and 11% cash. The fund boasts 150 names, although the top 10 account for about 50% of the portfolio. “We really focus on a few key names to carry the day. We hope that what we thought might happen with a small investment does happen. That’s the big hope.”

@page_break@He cites a top holding that is categorized as a special situation. In late 2004, he paid about US$12 for Syneron Medical Ltd., an Israeli company that has a Nasdaq listing. The firm makes and distributes aesthetic devices powered by proprietary technology that uses so-called bi-polar radio frequency and light. “It has a product that gets rid of cellulite. But it is also becoming a favourite with investors,” he says, noting he has been building his position even as the price has been climbing because of media attention over the firm’s rapid sales growth. The stock is trading at US$40.

“The fundamentals are going to prove quite compelling. The stock has a lot left in it,” he says, adding he is reluctant to set a target price.

Sprott is also enthusiastic about Delta Petroleum Corp., a Denver, Colorado.-based small-cap exploration firm active in the Rocky Mountains. “We have very large expectations for it — many hundreds of per cent of upside,” he says. The firm, along with EnCana Corp., is involved in the Columbia River Basin natural gas play that covers 425,000 acres in Washington State.

“It [has] been described as minimal exploration risk because you are drilling into a source rock we all know is there. As long as the rock is there, you can extract gas from it. We pretty well know we’re not likely to have failures, but we’re keeping our fingers crossed,” says Sprott, who believes the project could have up to 100 trillion cubic feet of gas, or the equivalent of what the U.S. consumes in about four years. Sprott paid about US$13.50 in April 2004, and the stock is now trading at US$17.50.

“This is what we call ‘prospectivity’,” he says, conceding that stock-picking involves as much art as it does science. “We can’t wait to know for sure. We have to look at the prospects and then buy early.”

An accountant by training, and a bachelor of commerce graduate from Carleton University, Sprott has seen numerous cycles since he entered the investment industry in 1968. That year, he decided auditing was not for him and joined Merrill Lynch Canada Inc., where he worked for two years as an analyst covering a wide variety of sectors, from textiles to farm equipment. In 1970, he joined Loewen Ondaatje & Co. as an institutional sales representative.

But Sprott has always been a bit of a risk-taker — indeed, he likes to play blackjack at the casinos where lately he’s not been doing too well — and, in 1981, he went out on his own after a philosophical difference with Loewen management.

Sprott established Sprott Securities Ltd., a boutique brokerage that specialized in small and mid-sized companies. He also began running money for institutional and high net-worth clients and likes mentioning the fact that a $100,000 investment made in 1981 would be worth $20 million today. In August 2000, he spun off the firm’s management arm into an independent firm, Sprott Asset Management (he severed his ties to Sprott Securities in 2002). Among the dozen products SAM offers, Sprott Canadian Equity accounts for more than one-third of the company’s $2.6 billion in assets. That fund has been closed to new investors since March.

What has changed little is Sprott’s persistent bearishness and belief that the current market rebound is unsustainable. He also worries that the Fed’s decision to raise rates will burst the real estate bubble that the Fed unwittingly created in the U.S. — and ultimately Canada, as well.

Looking ahead, Sprott will not pinpoint when the market will fall, but argues its decline is inevitable.

His pessimism has caused him to shift heavily into oil and gas stocks in the past 12 to 18 months. This is driven by a conviction that global economies are threatened by a factor known as “peak oil.” Coined in 1956 by scientist M. King Hubbert, it refers to the peak in oil production that is occurring now and will inevitably be followed by a rapid decline.
“Nobody gets it. Everybody thinks it’s about oil prices going up. It’s not. It’s oil production going down. If you’re producing 85 million barrels of oil globally today, in 10 years you would only produce 72. Try that on the world — it’s a disaster,” says Sprott, adding that Hubbert accurately predicted U.S. domestic oil production would peak in 1970.

Because oil companies are going into less economically viable reservoirs, “the decline rate keeps getting higher,” he says, referring to the rate at which production inevitably declines. Sprott believes the decline rate — estimated at 8% globally — may be higher than people realize. “We’re going to run out of oil.”

Rising energy costs will hurt consumers. “Something has to give.”

In a similar vein, he favours gold bullion and stocks. Pointing to the U.S.’s US$715-billion trade deficit, he says, “It is negative to the U.S. dollar. And the deficit does not go away when oil [hits new highs] — it gets worse.” Downward pressure on the U.S. dollar usually translates into higher gold prices, but this year the currency has risen against the yen and euro. But Sprott thinks the rally is over, and gold will rise again.

“The problems don’t go away,” he says, predicting all commodity prices will rise. IE