Question: Where is the price of petroleum going?
Eric Sprott: Long term, up… I can see it hitting $200 or $300 or $400 a barrel.
— Barron’s, Aug. 18, 2008

Eric Sprott runs the Sprott Offshore Fund, a fund that’s delivered sizzling returns of 32% per year since 2002. Certainly, timing is important, as 2002 was the last great bottom. Even so, it’s not so easy. Lots of people have done a lot worse than average 32% since 2002. Sprott, a 63-year-old billionaire, has been on the money when it comes to calling the resource markets. That’s his meal ticket, and his fund is loaded with resource names.

Of course, with oil down more than 40% off its July high and the whole resource market in the tank, it seems outrageous to think that oil could hit $400 per barrel, as Sprott says in his Barron’s interview. I choked on my bagel as I was reading it one Saturday morning.

The point, though, is not really what anyone thinks the price of oil may or may not hit. The point is that the fundamentals of the resource markets still look good on a long-term basis. Sprott points to the continuing depletion of big oil fields and the difficulty of increasing production. “We spend more and more every year and get no more net production,” he says. He continues:

“And the list of countries whose oil production has peaked keeps growing, including Russia, which for eight consecutive months has had year-over-year declines. Companies have the same problem. The latest results from Exxon showed that its production was down about 3%.”

Oil is still immensely profitable to produce. If producers could economically up production, they would. In fact, many resource companies are making good money. They’ve got good balance sheets. They own things that are hard to find and reproduce. I think we’ve got to stick with the names even though the price action in the last few months has been horrible.

It’s a tough market right now. There is no way around that. Even those of us who stayed away from the imploding financial firms and avoided housing bubble stocks still got hurt. Even as we stuck with companies loaded with tangible assets at cheap prices, we’ve watched many of them just get even cheaper.

But we can’t give up the quest. Mostly, because getting through the valley will mean making a lot of money on the next ascent. I keep thinking how we’ll look back on this time one day and marvel at the prices some stocks traded at. We’ll wonder why we didn’t pick up some of Stock X when it was trading for one-fifth of the price.

That’s the sheer greed part of it all. But the quest is built on firmer ground. We hold to the theory that value wins out. Wide gaps between stock market prices and business values eventually close. We take it as a given that we won’t be able to time the tops and bottoms. So we play a probability game. We bet on probable winners in the full knowledge that some won’t work out. But we choose to stick with them as long as our essential theses remain intact…

Until next time,
Chris Mayer
November 13, 2008

This Small Cap Oil Company Will be Catapulted by the Coming Resource Rally was originally featured in the Penny Sleuth.

Every crisis, though, brings opportunity. In this one, investors will go back to investing in simpler, more durable things (at least until forgetfulness kicks in). For instance, investing in a company that supplies grains to hungry people looks like a better bet than investing in one that sells mortgages to people who can’t afford them. The focus will shift to things we need, rather than things we want.

As I write these words, I’m in Paris, France, sitting at one of those cafes that spill out onto the sidewalks. The two towers of Notre Dame are visible across the Seine. It is a bright and cool fall afternoon. A blackboard propped up outside the cafe carries the daily fare written in chalk. A typically gruff waiter in rolled shirt sleeves takes my order after what seems like a really long time. I’ve slipped into the Parisian pace of life, in which meals take an especially leisurely turn.

The French have a chance to gloat a bit. Even though the crisis in America, the world’s biggest economy, helps no one, the French may have a better shot than most at coming through it with only flesh wounds. The housing market stinks in France, too. Housing sales in France are off 20% in the last 12 months. But the French market is not nearly as leveraged as the U.S. market was.

Financial innovation seems to occur slowly here. Mortgages in France are typically for terms of only 15 years. The French have also not embraced creativity in this field, as most mortgages bear fixed rates of interest. There is no subprime market. And French consumers did not borrow much against the rising prices of their homes. (The savings rate here is 13% of income, versus zero in America.)

The U.S. economy followed a very different path. Sometime over the past few decades, we abandoned the old-world notion of making things. We turned to making shuffling paper our stock in trade. Precisely when and why this happened will be something for historians to debate. But sometime in the 1990s, the percentage of corporate profits from finance passed that from manufacturing.

It was the first time that had happened, and the gap has only grown wider since. Before the great credit crisis hit, profits from financial firms made up nearly half of corporate profits. Only 10% came from the manufacturing sector. As recently as the mid-1960s, it was the other way around.

The French go on and on about their cheeses, wines and breads. For us, mortgages became our national product. Mortgages, before the crisis hit, made up 60% of total bank loans and the financial sector grew to become our biggest sector — bigger than health care, retail or manufacturing.

The implication of this post-finance U.S. economy is a theme we’ll explore more in this letter. As an early conclusion, though, I believe the spread between finance and manufacturing has reached millennial extremes, like a rubber band at its limits. Now begins the snap back.

Until next time,
Chris Mayer

November 3, 2008

P.S.: In the current issue of Capital & Crisis, I lay out my ideas for investing in the post-financial world. One idea focuses around a family-owned conglomerate that combines operations in pork, grains, shipping and more.

The Crisis of American Capitalism was originally featured in the Penny Sleuth.

Ford explains that the ship is using a “Somebody Else’s Problem field generator.” Essentially, the device makes people think the spaceship isn’t their concern — effectively rendering it invisible. Ford and Arthur can see it because they know what they’re looking for…while the crowd remains completely oblivious.

That’s how I feel sometimes when sifting through the big financial news sources. The pages and airwaves have stories loaded with opportunities, but few people seem to be paying attention. Investors see headlines but assume they’re someone else’s problem…letting thousands — even millions — of dollars in potential profits slip by.

Of course, it’s a little more complicated than just reading the news. Finding the next trends means connecting the dots…following stories to their logical conclusions.

Consider the first trend I see ahead…

The Hunt for Effective Leadership

It seems each week there’s a story about a change in leadership at one big company or another. Sometimes it’s just time for a new person to take the helm, like Delta Air Lines’ Richard Anderson, who took over for the retiring Gerald Grinstein. Or sometimes it’s a question of performance, like when Paul Pressler stepped down as head of The Gap. But more and more often, there’s a scandal involved. Among the more colorful examples of late is the tale of Gregory Reyes, former CEO of Brocade Communications. In August 2007, he was convicted of securities fraud, among other charges.

I expect several more stories like this to come to light in the next few months. And with them, a new trend will emerge. Investors will demand companies hire reputable, upfront CEOs. They’ll also flock to companies that already have proven management teams in place.

Bruce Berkowitz, manager of the Fairholme Fund (one of my favorites) sums it up nicely:

“We tend to be more about the jockey than the horse… You don’t have to predict the future if you know the company has the assets and the management to do well in difficult times. I believe that’s when the seeds for exceptional performance are planted.”

The basic idea is that you can make great gains in the stock market by betting on a proven manager, or jockey. If you invested in Berkshire Hathaway knowing nothing except Warren Buffett’s track record — that would be an extreme case of betting the jockey.

Obviously, if you have a great jockey on an old nag ready for the glue factory, there is only so much anybody can do. So if you can find a nice pile of assets and couple that with a great jockey, then you can have something special.

Until next time,
Chris Mayer

October 23, 2008

P.S.: That’s why I really like this company I’m going to tell you about. It has an interesting mix of assets and a proven team running the show. And these guys all own a significant percentage of the stock. So again, they are right in the fire with you.

The Wrong Jockey Can Leave Your Stocks Sitting in the Gate was originally featured in the Penny Sleuth.

“Everyone” in Wall Street parlance usually means derisively “the crowd” or “the herd.” Market lore is replete with tales of the madness of crowds and the follies of following the herd. Most people like to think they are not part of the multitude, yet by definition, most people are.

Today, as we gaze back at a market peak that looks more magnificent with the passage of time, we have plenty of fresh evidence that contrary thinking is good for the portfolio and good for the soul. Contrary thinking in early 2000 would have saved you a lot of money. But that is the nature of markets. Booming markets foster illusions; bear markets pull back the curtain.

Contrary thinking helps pull back that curtain before the crowd does — before it’s too late. What everyone knows is not worth knowing, as the old saw goes. Yet the crowd is not always wrong. The great myth about contrarian thinking is that it consists of simply betting against the crowd. The art of successful contrary thinking is in its astute application.

Under the Big Top

The great boom of the late 20th century was built on a lie. In retrospect, it is easier to see. Broadly speaking, the lie was simply that we could get something for nothing or that a new era had repealed the old laws of economics. In this aspect, the lie was probably as old as the oldest of human civilizations, told repeatedly over thousands of years. But the late-20th-century American bubble was perhaps novel in its size, scope and sheer ambition.

Under this big tent thrived a circus of bad ideas — that stocks were less risky than bonds, that the art of central banking had become a science that could eliminate recessions forever and that stocks were always a good investment, no matter the price paid for them.

All of these fallacies and more have their counterparts in the bubbles and booms of earlier epochs. There are new twists and variations on the theme, of course. Each historical episode is by nature a unique human experience, forever buried in the flux of time. Nonetheless, in its essentials, the late-20th-century boom had all the familiar markings of its siblings and cousins.

What a Wicked Web

Understanding the phenomenon of booms and busts is the beginning of successful contrarian investing. To do this, we’ll need to look at broader trends in the financial markets. In particular, the relationship between capital, money supply and interest rates. Like a spider’s silvery web, a pull or a tug on one thread sends telling vibrations throughout.

The consequence of tinkering with any one is to upset all three. As a result, money supply and capital are often confused for each other, and low interest rates are viewed as a laudatory policy goal or achievement. The consequences, however unintended, are ignored. The important distinctions and roles each of these influences plays in a market economy are often neglected.

This foggy view of capital results in repeated episodes of crisis. Wide-scale malinvestment, or investing capital in ways later prove to be unprofitable, is the defining characteristic of booms, caused by a disruption in that nexus between capital, money and interest rates. Crisis is the result of that later inevitable reckoning when such booms are found to be unsustainable.

This boom-and-bust cycle is endlessly fascinating and instructive. At Capital & Crisis, we regularly look at the stock market, the bond market and the economy in general as we navigate our way through the perilous investment waterways of today’s markets. And we won’t hesitate to go against the crowd.

Until next time,
Chris Mayer

October 16, 2008

P.S.: One of our more recent picks in Capital & Crisis is now so cheap, it’s literally trading for less than its cash. Basically, you can buy the company; take its cash to cover your costs; and get everything else that comes with it for free.

The Significance of Swimming Against the Current was originally featured in the Penny Sleuth.

“Gastown, Vancouver’s oldest neighborhood…founded on the shoulders of desperate alcoholics by an entrepreneurial bar owner.”

— Anthony Bourdain, No Reservations

It might be too much to say Vancouver got its start with a bunch of alcoholics, but there’s no denying that Jack Deighton, or ‘Gassy Jack,’ as he was known, had a hand in making the city.

As legend has it, Gassy Jack, a garrulous Yorkshire-born steamship operator, arrived in 1867 with a yellow dog, a First Nations wife and a barrel of whiskey. He solicited help from workers by telling them if they helped him build a tavern, he’d give them free drinks. So they did, and within 24 hours, the Globe Saloon was open for business, slaking the thirst of a rough frontier crowd of miners, trappers and loggers.

When a little village grew up around the saloon, Gastown was born.

This is where modern Vancouver began. Today, Gastown is the old section of the city. You can stroll down its cobblestone streets adorned with antique street lamps and stop off at one of the many bars and restaurants. You can see the old steam clock on Water Street, a local landmark. (But it’s kind of a sham, because the steam clock is actually powered by electricity. It was also built in 1977, despite its antique look.) There are also some shops hocking the usual kitschy fare like faux totem poles and snow globes.

Salute the bronze statue of Gassy Jack, standing atop a whiskey barrel, in Maple Square. Then head over to my favorite microbrewery in the city, Steamworks, and order a Lions Gate Lager and a brick-oven pizza.

As you wipe the beer foam from your lips, you can think about the story of early wealth creation in Vancouver. Spanish explorers in search of the Northwest Passage arrived in the 18th century. You can still see their influence in street names such as Cordova, Cardero and Valdez. The British explorer Capt. James Cook also hit the west coast of Vancouver Island, looking for the Northwest Passage. Vancouver, though, gets its name from George Vancouver, who sailed the inlet in 1792.

Eventually, a number of early explorers, including Simon Fraser and Alexander MacKenzie, helped map the region’s interior. In 1824, the Hudson Bay Co. began running fur trading posts out here. In 1858, prospectors found gold on the banks of the Fraser and Thompson rivers. The first sawmills along the Fraser River opened up in 1860. And there you have the triumvirate that drew adventurers and entrepreneurs from all over — furs, gold and timber. Into that swirl stepped Gassy Jack.

I like the city of Vancouver and enjoy going there every year for my publisher’s big annual conference. This year’s theme tackled investing in the age of scarcity. Perfectly appropriate for the market we find ourselves in.

Gassy Jack and all those early explorers, adventurers, prospectors, loggers and miners did their part to spice up the 19th century. As with most of the history of the Americas, fortunes bloomed as men beat paths to nature’s riches. It was the basic stuff — metals, timber and other commodities — that made men rich. The voracious appetites fueled by the Industrial Revolution and rising urbanization created enormous demand for the natural storehouse of riches in the largely untapped Americas. If you were bold and talented (and lucky), you could strike out on some open valley or inviting hillside or promising riverbank — and dig or plant or pan your way to fame and fortune.

Despite all the advances and promises of the 21st century, we still need those basics. We’ve always needed them, but there is new urgency to the quest. The motor for that demand is a sort of second Industrial Revolution, in China and India, in particular. But it’s a revolution that broadens out to many emerging markets. The analogy is not lost on certain investors.

Jeremy Grantham heads up GMO, a respected money manager. Grantham has been largely spot on in the big-picture sense of staying bearish on stocks for the last eight years or so. He is bullish long term on commodities. In his latest quarterly letter, Grantham makes some good points about the future of commodities and emerging markets.

His conclusion first: “In the short term, slowing world economic growth combines with credit, currency and inflation problems to dominate the outlook and offer poor prospects for emerging markets and commodities. Longer term, the reverse is true, and they look like the assets to own.”

It is mostly the long term (looking out a couple of years) that interests me, although I obviously don’t aim to step into any immediate problems if I can help it.

Longer-term backing for commodities demand comes from two sources, Grantham says:

“The first is that if enough people enter economic take-off at approximately the same time, as 2.3 billion Chinese and Indians have now done, then the pressure on resources might happen to increase marginal costs slightly faster than technology could offset them.”

This has already happened. It’s why the price of oil, for example, is so much higher than historical averages. All that demand hits very quickly, but it takes time to bring new supply to market. In the interim, higher prices result.

This seems well-known already. Most investors realize that behind the commodities boom stands surging demand from countries such as China — former ‘runts’ now muscling in on the global dinner table.

The second reason is more interesting. Grantham believes that the global growth spurt has come at the expense of eating away at some hard-to-replace resources:

“Underground water resources that currently sustain some of our most productive land but, like a metronome, tick off a reduction of several feet each year; rain-fed waters that, although renewable, are finite and already so overused that previously valuable lakes retreat to sometimes disastrous local effects and river volumes, once seemingly limitless, are now fought over; subsoil, which took thousands of years to form, is depleted through casual use (in the Midwest, for every bushel of wheat produced, it is said that a bushel of subsoil is lost. Our farmers are in the mining business! Yes, the soil is incredibly deep, but it is still finite); high-grade mineral ores are fully developed, the very best are long gone and all are irreplaceable; previously fertile land has often been overgrazed and turned into desert.”

At Mayer’s Special Situations, we’ve been on the water beat since this publication began in summer 2006. We’ve also watched the agricultural boom unfold, and we’ve picked up nice profits along the way. We are, in fact, still invested in these ideas.

Along with these ideas, oil, natural gas and base metals all have become more difficult and expensive to produce. Recently, we’ve had to sit through a pretty tough correction on the commodity names. Stocks in these sectors have sold off in a big way this summer, as I’ve noted. Based purely on fundamentals, though, these stocks haven’t looked this cheap in years.

But short term, such drawdowns are common on the way to eventual higher prices. Grantham, too, says as much:

“The prices of commodities are likely to crack short term, but this will be just a tease. In the next decades, the prices of all future raw materials will be priced as just what they are: irreplaceable. Oil, for example, will never again be priced on the marginal cost of pumping a marginal barrel from some giant Saudi oil field, as has been the practice for most of the last 100 years of oil production. Real cost is always replacement cost, and oil, a precious feedstock for chemicals and fertilizers, simply cannot be replaced.”

I don’t take as hard a plumb line as old Grantham does. I believe there is, even now, lots of room for innovation and replacement. Oil, for example, is replaceable in a broad sense. We can get energy from a broad array of sources. But it’s not an easy or painless transition.

Slowing economic growth is the bigger issue. That’s problematic for most commodities, short term. The market, though, is probably punishing the commodity companies too severely. That creates some interesting opportunities.

You can more easily pick up stocks trading for discounts to readily ascertainable net asset values now than anytime in the last five years, in my view. It doesn’t mean making money in commodities is a lock or that it will be easy. Lots can go wrong with individual companies, and the drawdowns will probably be more than most investors can stomach. But longer term, looking out a few years, I think an investor will be happy with the portfolio assembled in the doubtful summer days of 2008.

Regards,
Chris Mayer
September 30, 2008

Natural Scarcity Overlooked by Wall Street was originally featured in the Penny Sleuth.

“Taking the long view, we are running out of dirt.”

— David R. Montgomery, geologist

Over the summer, Iran bought a large amount — more than ONE million tons — of wheat from the U.S.

That’s something we’ve not seen in 27 summers. In Iran’s case, a tough drought cut the wheat harvest by a third, forcing the country to look abroad. But still, the fact that Iran had to come to the U.S. is telling. It’s like Lee asking Grant for rations in the summer of 1863. As one analyst put it: “Do you think Iran would come to the U.S. if they had any place else they could buy it… They’re searching the world for wheat. They’re buying the U.S. because it’s the only thing they can buy.”

Markets, like great unscripted dramas, develop their own plotlines as time rolls on. Now unfolding is a new plotline in the agriculture boom. It begins with the fact that there are fewer and fewer options these days for importers looking for large quantities of high-quality grains. But it speaks more to a deeper issue: an emerging shortage in fertile soil. Yes, we’re running out of good dirt.

In fact, fertile soil — good dirt — may become more important to land values than oil or minerals in the ground. Some say it is already a strategic asset on par with oil. As Lennart Bage, president of a U.N. fund for agricultural development says, “Now fertile land with access to water has become a strategic asset.”

Doubtful? Consider rising export restrictions around the globe, which act as a sort of fence keeping the goods within borders. India curbs exports on rice. The Ukraine halts wheat shipments altogether. The number of grain-exporting regions has dwindled, like the vanishing buffalo herds. Before World War II, only Europe imported grain. South America, as recently as the 1930s, produced twice as much grain as North America. The old Soviet Union, for all its faults, exported grain. Africa was self-sufficient. Today, only three major grain exporters remain: North America, Australia and New Zealand.

No surprise, then, to find faith in the global food supply at generational lows. So begins the scramble to secure farmland. Saudi Arabia, for example, is particularly at the mercy of the winds of global agriculture. It has little ability to produce its own food. The kingdom, reports the Financial Times, “is scouring the globe for fertile lands in a search that has taken Saudi officials to Sudan, Ukraine, Pakistan and Thailand.” Saudi Arabia’s quest is not one it pursues alone. There are many hunters.

The UAE has also been looking to lock down acreage in Sudan and Kazakhstan. Libya is looking to lease farms in the Ukraine. South Korea has been poking around in Mongolia. Even China is exploring investing in farmland in Southeast Asia. While China has plenty of cultivable land, it does not have a lot of water.

“This is a new trend within the global food crisis,” says Joachim von Braun, the director of the International Food Policy Research Institute. “The dominant force today is security of food supplies.” Food prices reflect this crimp in supply.

The mainstream press focuses on issues such as population, dietary shifts and the impact of biofuels. One thing that doesn’t get talked about much may be the most important thing of all: A growing shortage of quality topsoil. Call it the topsoil crisis.

Quality soil is loose, clumpy, filled with air pockets and teeming with life. It’s a complex microecosystem all its own. On average, the planet has little more than THREE feet of topsoil spread over its surface. The Seattle Post-Intelligencer calls it “the shallow skin of nutrient-rich matter that sustains most of our food.”

The problem is that we’re losing it faster than we can replace it. And replacing it isn’t easy. It grows back an inch or two over hundreds of years.

This is not lost on certain far-seeing investors. Jeremy Grantham, the curmudgeonly head of the money manager GMO, wrote about soil depletion in his last quarterly letter. “Our farmers are in the mining business! Yes, the soil is incredibly deep, but it is still finite.” For every bushel of wheat produced, we lose two bushels of topsoil.

Until the final decades of the 20th century, the amount of new farm acreage added to the mix by clearing land offset the losses on a global basis. In the 1980s, the amount of land under cultivation began to fall for the first time since humble early humanity began to farm the rich land around the Tigris and Euphrates. It continues to fall today.

We lose topsoil to development, erosion and desertification. “Globally, it’s clear we are eroding soils at a rate much faster than they can form,” notes John Reganold, a soils scientist at Washington State University. Estimates vary. In the U.S., the National Academy of Sciences says we’re losing it 10 times faster than it’s being replaced. The U.N. says that on a global basis, the rate of loss is 10-100 times faster than that of replacement.

In any case, it seems safe to say that good dirt is in short supply. The obvious investment conclusion: Buy farmland. That’s hard to do as an individual investor, although there are at least a few options. One is Cresud (CRESY: NASDAQ), which owns ONE million acres of farmland in Argentina. Though harder to buy, Black Earth Farming (BLERF: PINK SHEETS) owns farmland in Russia — which presents its own risks.

More investment ideas will surely surface as time goes by. The topsoil crisis has a long way to go. It’s not going to resolve itself anytime soon. In the meantime, though, investors may want to rethink the phrase “cheap as dirt.”

Regards,
Chris Mayer
September 26, 2008

P.S.: Readers of my Mayer’s Special Situations have been investing in agriculture plays for a long time. This industry, while not reported on nearly enough, is booming. My readers have had the chance to make as much as 100% with Lindsay Corp (LNN: NYSE) and 177% with Titan Int’l. (TWI: NYSE).

Investing in Agriculture was originally featured in the Penny Sleuth.

Investors are always on the lookout for the next big thing. You know the sort, a big-picture idea so powerful and long-lasting that you can confidently ride your investments through the ups and downs that market life presents. Holmes calls these “global megatrends” — “sustainable and substantial growth in capital expenditures in any country or sector.”

Holmes offered a couple of past examples. There was the massive growth of infrastructure in the ‘50s and ‘60s, which included the postwar rebuilding of Europe and the massive highway system build-out in the U.S. There was the 1990s megatrend, which led to massive growth in information technology and data communications. And there is the present megatrend: “Unprecedented change in global growth driven by globalization, urbanization and wealth creation, [which] leads to a global infrastructure boom on a massive, intractable scale.”

That’s quite a mouthful, but I believe Holmes is right. Holmes also cites numerous studies — one by Booz Allen Hamilton, as well as ones by World Energy Outlook, the U.S. Department of Transportation, the OECD and a host of other official-sounding places. But the total bill, give or take a few trillion, is about $41 trillion out to 2030 – for water, power, roads and bridges, as well as marine and seaports.

This is your next megatrend. Don’t miss it. We have some ideas at work here, but before we get too ahead of ourselves, let’s look again at some of the key points of the thesis.

First, some mega population shifts. By the end of 2008, half of the world’s people will live in urban areas. Leading the way are some 500 million Chinese and another 540 million Indians. The world’s cities are getting a lot bigger. Beijing alone grew from 12 million to 16 million in the past decade. Plus, there are a lot more souls on the orb than ever — 6 billion of us. Next year, the world’s total urban population alone will exceed the total world population in 1965.

This helps drive economic growth. Asia as a whole, for example, is building five times more homes than the U.S. Incredibly, China alone is constructing 80 percent of them. This, in turn, drives consumption of many commodities, including things you may not think of immediately — like cement. Asia — excluding Japan — uses about 14 times as much cement as the U.S. Asia ex-Japan has also overtaken the U.S. in steel production by a country mile. Asian steel production is more than six times the U.S.’ Electricity consumption is 32 percent more than the U.S.’

I could go on like this for pages…the stats are simply amazing. But I think you get the idea. The industrialization of Asia’s enormous populations has unleashed a torrent of demand for the basics.

There was a lot of discussion at the conference in Vancouver about just how much of Asia’s economic growth begins with U.S. consumers. The answer isn’t clear, as you might expect. But it is clear that trade routes in Asia are flourishing. I’ve talked about the New Silk Road before. It’s one of my favorite themes — the opening of old trade routes that stretch across the Middle East through India and into China. Holmes had a chart that showed that the Asian stretch of that old road is still healthy — despite an economic slowdown in the U.S.

Asian trade is ticking up, even as U.S. exports take a dip. It’s not the only data point, either. Asian retail sales are also trending higher as U.S. retail sales head lower. I think it’s a bit arrogant on the part of some analysts to say that China exists to satisfy our needs for rubber toys and cheap underwear. In their view, a U.S. slowdown dooms most of Asia’s export-driven economies. Plenty of evidence shows that’s not the case, at least not yet.

In fact, Asian demand is on the rise for a whole host of goods. In 2008, vehicle sales in Asia ex-Japan are set to exceed those in the U.S. First time that’s ever happened. Sometime in 2008, also for the first time ever, there will be more Internet subscribers in China than in the U.S. I suspect that’s one top spot that the U.S. will never claim again. There are also four times the number of mobile subscribers in Asia than in the U.S.

All of these points come from Holmes presentation, which I think painted an amazing panorama of the truly historic shifts in the global economy.

As fast as the Asian economies are growing, their demand for power is growing faster. You can also expect to see increasing use of aluminum, copper, iron ore, coal and nickel — all basic infrastructure materials.

Holmes offered that to satisfy the global demand for copper, the world would need to mine as much in the next 25 years as it has up to this point in history. These predictions may prove wildly inaccurate. But even if they are only directionally correct, it points to a long bull market in the basics.

As we come to learn early in our investing careers, the market seldom moves in a straight line. Years can separate cause and effect. One of the great megatrends in the market today is this idea of infrastructure and all that it entails. So don’t let the recent volatility in the stock market blind you to long-term investment opportunities.

These are the moments to enter the fray, not to run from it…

Regards,
Chris Mayer
September 19, 2008

Investing in Asian Infrastructure was originally featured in the Penny Sleuth.

Does this really promise big change in the course of U.S. financial markets? After all, both companies trade on the New York Stock Exchange. The basic idea is that these companies supposedly belong to shareholders. These shareholders are owners just like the guy who owns the gas station on the corner or the husband and wife team that runs the French bistro on Main Street.

But Fannie and Freddie were never really private companies like these others. Entrepreneurs usually start businesses. Congress created the mortgage giants by charter (hence, they are called government-sponsored enterprises, or GSEs). And the two giants enjoyed many advantages from that parentage. Fannie and Freddie have long operated in a sort of limbo as a result, neither fish nor fowl. Both carry the implicit guarantee that if something went truly wrong, the government would come along and make it right.

And so it has. Bondholders are happy today. Stockholders are not. Fannie Mae fell 90% on Monday, and Freddie Mac fell 83%. I have no flag in either camp, but I certainly have no sympathy for the stockholders. Anyone who gave them a fair look could see that both GSEs were ticking time bombs.

In fact, I wrote an essay for the Mises Institute titled “Mortgage Market Socialism” way back in 2002. I pointed out the dangers of the growth of these GSEs far outpacing that of the mortgage market. If I may quote: “The longer the GSEs are able to expand as they have, the more certain it becomes that someday taxpayers will have to bear the cost of such excess.”

This is one of those times when I am not happy to have gotten it right. Taxpayers — of which I am one — will now pay for these mistakes. Yet despite all of the hubbub in the papers, this is nothing new.

This action by the U.S. government does not really signify any sea change in financial markets. It’s just another step in a long journey on the same path. If you read financial history, you come to appreciate this overwhelmingly powerful trend. As Freeman Tilden wrote in his 1935 book A World in Debt:

“The whole progress of the legislative attitude toward the debtor, from the Roman Republic to the present day, has been steadily, though with occasional backward lapses, toward making debt easier to incur, lightening the burden of carrying and softening the consequences of default.”

The fancy modern words for this process are the “democratization of credit” and the “socialization of risk.” Another excellent historical study of this process is James Grant’s Money of the Mind: Borrowing and Lending in America from the Civil War to Michael Milken. It is beautifully written, for one thing. And it will show you this process has been going on for a long, long time.

I know the above is a bit off my usual beat. We are about making money in the more obscure nooks and crannies of penny stocks. But this event deserves some sort of comment — mainly because I believe all of the newspapers have missed something. They have all missed this bigger point: This huge trend snakes its way through financial history.

What does it all mean and how does it all end? I suspect we are on a path similar to that of Argentina. One day, we’ll have some major Argentine-style financial crisis. We’ll have Argentine inflation and a similar loss of faith in the banking system and the currency. The government will chew away and destroy a lot of wealth in the process.

Hopefully, I won’t quote myself on that someday soon. In the meantime, though, I think one of the best things an investor can do is focus on buying useful and tangible assets that ought to hold their value against a depreciating paper currency. These assets include oil and gas, metals and minerals and land and water rights. The shares of the companies that own or find these assets ought to do well. Commodities will have their day in the sun once again.

So hang tight, and we’ll let you know when the next investment opportunity comes around.

Sincerely,
Chris Mayer
September 10, 2008

Predicting Fannie and Freddie Would Fall was originally featured in the Penny Sleuth.

I hadn’t seen Forstmann’s name in years. He once lorded over one of the world’s most famous private equity firms, Forstmann Little. For a time, it was, as the Journal notes, “the most successful private equity firm in the world, renowned for both its outsized returns and its caution.” When things got a little too crazy, Forstmann chose not to play. For two years, he sat on $2 billion of uninvested funds. That’s discipline you don’t find often, in any era.

Ted Forstmann’s caution saved his firm a lot of pain when the private equity market collapsed later. As the interview made plain, old Forstmann has that bad feeling again. “Buffett once told me,” he said, “there are three ‘I’s in every cycle. The ‘innovator,’ that’s the first ‘I.’ After the innovator comes the ‘imitator.’ And after the imitator in the cycle comes the ‘idiot.’” We’re in the idiot phase now, he says.

The idiot phase is when financial disasters strike. It’s when the market reveals all the mistakes of the prior boom. It’s when all these supposedly smart people running billion-dollar financial firms get their heads handed to them. “The creation of much too much money caused all of this excess,” he says.

He would’ve found agreeable company in Vienna. The inaugural meeting of the Society for Austrian Economic Thought took place in the elegant salons of the Hotel Imperial. Here, a motley crew of entrepreneurs, philosophers and economists from all over the world met to discuss the world’s troubles.

Austrian Economics, in case you don’t know, refers to a school of thought originating largely in Vienna in the late 19th and early 20th centuries. Its great thinkers include Ludwig von Mises, for instance, who was actually born in what today is Ukraine. (As an aside, this sort of thing happened a lot, as the old Austro-Hungarian Empire’s borders shifted in later years. Carl Menger, another founding Austrian thinker, was actually born in what is today Poland.)

One definite theme of the meeting was the sick monetary systems of the world’s economies. Dr. Andre Homberg, a friend, reader and the organizer of the event, laid it out as the five “D”s:

• Delusions — the notion that “the welfare state can provide everyone with a free lunch and a reliable pension and health care”
• Deficits and Debts — the accumulation of enormous fiscal imbalances, particularly in the public sector
• Dollars — the debasement of the dollar and reckless credit expansion
• Derivatives — Dr. Homberg pointed out that the notional value of derivatives topped $1,000 trillion, as per a recent IBS report. “This excessive leverage could implode anytime and make the U.S. subprime debacle look like a day at the beach,” he said.

The end result of all this? Dr. Homberg happily explained: “The prices of everything that you must have will escalate at a speed that you will not believe. The prices of energy and fuel will continue to spiral higher. Food and water prices will accelerate upward and will result in a lower standard of living for yourself, your family and your loved ones.”

It was a cheery afternoon, let me tell you. There’s nothing quite like sitting under crystal chandeliers in a decadent 100-plus-year-old salon, spooning your weichsel-chily kaltschale mit gebratener Steingarnele — a sort of cold soup with sour cherries, chili and roasted prawn — while also matter-of-factly chatting about the end of the world as we know it.

There are plenty of reasons to feel gloomy. But even Dr. Homberg allowed that there would be great opportunities to make a lot of money. “At least for the ones that understand the forces involved,” he added, “and have the courage to grab the opportunities that this process will create.” Homberg is financially independent, in large part owing to his deft investing since 2000. I’m proud to count him as a loyal reader.

Going forward, I think it will be important to stick with real assets during these inflationary times. I’ve got two very interesting ideas I’m researching now. Both of them are quirky oddball opportunities rich in tangible inflation-beating assets.

Also, in thinking back to the “I” cycle, the idiots eventually make way for the innovators, the winners in the next up cycle. Among the innovators in this cycle will be those who solve or ease the high cost of oil.

I’m currently reading an interesting book, Engines That Move Markets by Alasdair Nairn. It’s all about the history-making shifts of various innovations — canals, railroads, telephones, etc. In particular, the book focuses on their impacts on markets and investing. One early lesson is how people misread key events and missed great investments in the process.

One early quote stands out. The Quarterly Review in March 1825, noted: “What could be more palpably absurd than the prospect held of locomotives traveling twice as fast as stagecoaches?” Stagecoach and canal investors who doubted the power of the trains lost a lot of money. While the losers are easy to spot in retrospect, they’re not usually so obvious to investors at the time, as The Quarterly Review comment shows.

As far as identifying the winners of this process, that was also not obvious. The railroads proved poor investments for most. By the mid-1870s, 40% of American railroad bonds were in default. The real winners were the people who enjoyed the lower cost of freight — traders and merchants expanding into new markets. So, too, the winners in this crisis might not be so obvious.

Regards,
Chris Mayer
September 2, 2008

Looking for the Innovators was originally featured in the Penny Sleuth.

“From here in Africa, we sailed with ivory, mangrove, coconuts, tortoise and cowrie shells,” says an old sailor named Bwama Shafi in a dusty, old issue of National Geographic. “From Arabia, we brought dates, whale oil, carpets and incense. From India, pots, glassware and cloth. Trade was our life, you see.

“The wind in our sails made us rich,” the old seadog explained, “just as it did our ancestors. In the season, dozens of foreign dhows would arrive — booms 100 feet long or more, great sails white against the sky. And at night! Hundreds of dhows big and small anchored in the harbor, their cooking fires shining like stars in the night.”

Africa had good harbors and plentiful fish and lots to trade with India and Arabia. Ties between India and Africa, especially, strengthened under the common influence of Islam and the Portuguese. (Portugal colonized both Goa and Africa’s coast.) Africa is also home to a large population of ethnic Indians, which helps bridge trade further.

These historical ties and old trade routes are reviving once again. In the spring, Delhi hosted the first Indian-African summit. Trade between India and Africa tops $25 billion per year. Nigeria, for example, accounts for 10% of India’s crude oil imports. But China’s trade with Africa is a lot more — $55 billion annually. The reason for this boom in trade? A hunger for the natural resources of Africa.

Africa increasingly is right in the middle of the global quest for natural resources. It has the highest ratio of light and sweet crude in the world — the best-quality stuff you can find. And most of its oil — some 83% — comes from large fields that produce at least 100 million barrels per day. Meaningful amounts of premium oil in large fields explains why Africa attracts so much investment. Between 2002-2006, the big oil companies tripled their spending in Africa.

The recent discovery of oil sands in the Congo by Eni, a big Italian oil group, lends more credence to the idea of Africa as the future of global oil supply. Eni hasn’t said how much resource its vast acreage might hold. But the Financial Times reports early samples suggest that “the area as a whole could hold more oil than Eni’s entire reserves of seven billion barrels of oil equivalent.” That would put Eni’s resource on par with the huge Kashagan field in Kazakhstan. Eni potentially doubled its oil reserves with this one African find.

Right now, Africa produces only about 12% of the world’s oil output. By 2012, that could be 30%. No wonder, then, that it has become such a competitive battleground for the oil companies. In a recent auction, India’s state oil company bid $321 million for an Angolan oil block. A Chinese oil giant bid $725 million. Guess who won?

It’s not just about oil, either. Africa holds tremendous amounts of natural gas, minerals and natural resources of all kinds. Much of these resources reside in places that are business-friendly. But there is often a fragile social fabric, which seems ever on the brink of civil war or a coup, or worse.

In Niger, for example, you will find some of the world’s largest deposits of uranium. Niger plans to double its output over the next several years.

Companies from all over the world — Australia, Canada, China, India and France — scramble to lock down claims. But the uranium deposits lie in the ancestral home of the nomadic Tuareg. The Blue Men of the Desert (so-called due to the color of their favored indigo dyes) return to old ceremonial grounds to find red flags marking uranium deposits. The result is predictable — battles between the Niger army and Tuareg fighters, and bloodshed.

Yet the rewards dangling before the world’s eyes are so great. Many companies will walk the edge of that precipice for a shot at glory. Many of the companies I have recommended to the readers of my investment letter, Capital & Crisis, operate in Africa.

Ryszard Kapuscinski, the late journalist, once wrote that Africa was too large to describe. Africa was “a veritable ocean, a separate planet, a varied, immensely rich cosmos” (The Heat of the Serengeti Plain, 1962). “Only with the greatest simplification,” he wrote, “can we say ‘Africa.’ In reality, except as a geographic appellation, Africa does not exist.”

Scio-economically, Africa remains as “non-existent” today as it did when Kapuscinski penned these words in 1962. But when it comes to natural resources, Africa not only exists, it occupies the center of the map.

Sincerely,
Chris Mayer
August 28, 2008

Investing in Africa was originally featured in the Penny Sleuth.