What’s he talking about? Today, we take a look and invest right alongside his idea. And it should start to pay off with the arrival of the first swallows of spring in 2010. It’s also timely now — in this weak-kneed economy — because it has traditionally held up well even in when the economy is on the ropes. Even the Great Depression couldn’t put this thing down.

We start with simple truths. The world’s population has more than doubled since 1950 — from about 2.5 billion to 6.7 billion. By 2050, there will be more than 9 billion people on the planet. Almost all of this growth will come from undeveloped markets such as China and India. And they will all be doing one thing, for sure — eating.

Now, hang on. I know that is a banal insight by itself, but this story has layers like a tiramisu. The second layer is the mix of food eaten, which is important. These undeveloped economies are getting richer. Predictably, as people everywhere have done and continue to do when they have a little more money in their pockets, they change their diets. They spend more on food. The average Chinese spends 40 cents of every additional dollar earned on food. In India, it’s about 70 cents of every additional dollar. What do they buy?

They buy more meat, more fruits and more vegetables. Their calorie intake rises. That’s why the U.N. says we’ll need to boost food production by 70% by 2050 — a big task, given increasing restraints on water and quality arable land.

How do we meet that demand? Here the plotlines start to thicken and things get interesting…

Let’s look at soybeans specifically. China is the largest importer of soybeans and has been since 2000. China was once the largest exporter of soybeans, but flipped to a net importer in 1995. It may well be impossible for China to meet its demands for soybeans by producing more of its own. Passport Capital, an astute hedge fund, estimates that in order to grow enough soybeans to become self-sufficient, China would need to cultivate an area about the size of Nebraska.

That looks impossible against China’s arable land base, which has been in decline since 1988 — this despite the fact that China’s subsidizes agriculture. Another reason is the low level of water resources in China. Soybeans require a lot of water — 1,500 tonnes of water for one tonne of soybeans.

Who has lots of water? Brazil. So it is no surprise to discover that the increase in demand for soybeans from China has largely been met by increasing soybean acreage planted in Brazil. (Brazil is the second largest exporter of soybeans in the world, behind the U.S. and ahead of Argentina and Paraguay.)

The easiest way for China to get around its water shortage is to import soybeans. By importing soybeans, Passport calculates that China is effectively importing 14% of its water needs.

It looks likes this trend will continue for quite some time. When you look across the world, arable land per person is in decline. (Arable land simply means land that can be used for farming; it doesn’t mean that it is currently used for farming.) But one nation has more potential for converting arable land into producing farmland than anybody else by a country mile. It’s Brazil again.

Brazil has a large tropical savanna known as the cerrado. You can think of it as the world’s arable land bank. It’s an area of about 250 million acres — about as big an area as all of the arable land in the U.S. It gets plenty of rainfall and sunshine. The soil is very old and runs deep. But there is a problem: The soil is nutrient poor. You need to add a lot of potash and phosphate — two key nutrients — to grow soybeans there.

According to estimates by SLC Agricola and Morgan Stanley, the average new acre of farmland in the cerrado requires 14 times the amount of phosphate and three times the amount of potash of a typical American acre. This means that it is expensive to grow grains here. You need a high soybean price to make it worth the effort — and there is more to it than just adding the nutrients. There is road and rail access, for instance. Someone would have to build all that out, too.

Connecting the Dots — Grains Are Cheap

So now we are in a position to connect some dots. China’s increasing population and affluence will drive its soybean imports. These imports will come mainly from Brazil. And Brazil, as it converts more arable land to producing farmland, will need a lot of potash and phosphate.

What is true of soybeans is also true of wheat and corn and rice and other agricultural commodities. We’ll need more of all of them. And all of them face the same challenges for water and land. All of them require lots of fertilizer.

I’ve not mentioned the biofuel component. But this is another big pull on demand for grains. The U.S. alone aims to produce 15 billion gallons of ethanol by 2015. All over the world, food crops now compete with energy needs.

This is not a gloom-and-doom scenario. It simply means that there is a lot of support for higher prices for agricultural commodities. Inventory levels still remain low worldwide. Grain prices are all well off their highs. After adjusting for inflation, many of them are as cheap as they’ve been in decades.

This is why Jim Rogers said he likes the agricultural commodities. That’s what he was talking about in the quote up top. I couldn’t agree more.

I also mentioned how this idea was hard to kill. In the Great Depression, purchases for jewelry and clothing and the like fell by 50%. But purchases for food — even for meat — held steady. We’ve seen similar patterns in recent busts. In the Asian Crisis of 1998–2001, the demand for food held steady even while other markets collapsed.

Put it all together and you have a great case for higher grain prices. You also have an environment that is very good for fertilizers — in particular, potash and phosphate. An investment in the fertilizer stocks is an investment right alongside the grains.

I’ve just alerted my Capital & Crisis readers to two fertilizer stocks that I believe are best positioned to profit from the coming agricultural commodity boom, but there are a number of fertilizer plays out there that are also ripe for the picking.

A couple worth taking a look at include Agrium (NYSE: AGU) and Western Potash (TSE: WPX). Naturally, I’m partial to the ones that I’ve recommended to my C&C readers – and they’ve got pages of research to back up why that is – but these two tiny stocks could make interesting moves nonetheless.

Sincerely,
Chris Mayer

November 10, 2009

Jim Rogers: Time to Buy Agricultural Commodities was originally featured in the Penny Sleuth.

As recently as September 2008, realtors could claim that no one had lost money in the Dubai property market. That’s no longer true. In fact, now the market has too much of just about every property type. One headline story noted how 32,000 homes are about to come on the market next year, which is a big number to choke down in any city. Dubai had a huge property boom and now must suffer the flip side.

The hotels, too, are pretty empty. I’m staying at the new Address Hotel downtown, which has been open for only 25 days, we are told. I’m the first person to stay in my room. It still has that new carpet smell.

I wandered down for breakfast and was alone in a cavernous dining room. The hotel is brand-spanking new and everything looks wonderful. It’s just mostly empty. I think there are more hotel workers than there are guests.

In Dubai, revenue per room is down 35% from a year ago. Yet there is still an expansion going on. Next year, estimates call for a 15% increase in the number of rooms. This would mean a 40% increase in two years.

Over breakfast, I perused my complimentary copy of The National. One of the things I like to do in a foreign city is to read the local newspapers. I’m kind of a newspaper junkie anyway — I get three dailies delivered to my doorstep at home. In any event, I always find interesting nuggets from a perspective you might not get if all you read is The Wall Street Journal or Financial Times.

Today’s business page carried an array of tales… There was the arrival in Doha of a new LNG tanker, fresh from Seoul’s shipbuilding docks. There was a story about how UAE consumer confidence is up. Also, notes on bond issues in the Gulf, the latest figures on money supply in Kuwait (it’s rising at a frighteningly quick pace of 18.7%), the price of villas in Dubai and more. All sorts of little odds and ends that help paint the picture.

There was also a lot of chatter about infrastructure, which I found particularly interesting. Abu Dhabi, the capital of the UAE, which I will visit on this trip, is looking to raise $100 billion for infrastructure projects. From The National: “The emirate needs to fund new transport, electricity and telecommunications schemes…”

Dubai itself also has ambitious infrastructure spending plans. Last night, as we made our way to our hotel, we could see the new Dubai Metro stops along the way, which, lit up as they were in soft blue and white twinkling lights, looked like something out of the future.

Incredibly, the Dubai government last year spent about 45% of its budget on infrastructure projects — mostly on the roads and ports. But there is a lot more on tap, as The National reports:

“Dubai could invest as much as $20 billion in desalination projects in the next decade alone as it increases its water output by 2.72 billion liters a day… [There are also] plans to add 14,405 megawatts by 2017… Construction costs for those new plants amount to $11.6 billion, while infrastructure costs, including substations and transmission lines, will be about $11.6 billion.”

Sincerely,
Chris Mayer

October 6, 2009

Dubai’s Infrastructure Opportunity was originally featured in the Penny Sleuth.

I was in Manhattan last week attending Grant’s Fall Investment Conference. The U.N. General Assembly is meeting there, and the streets were blocked off in places. The NYPD was out in full force. I heard one passerby complain about the inconvenience of it all to one police officer. He responded, “Don’t blame the NYPD, blame the General Assembly.”

With the General Assembly in Manhattan and the G-20 in Pittsburgh, government has taken over the headlines this week. It seems half the world is mostly preoccupied with telling the other half what to do. No doubt, bossiness is in a bull market.

At Grant’s conference, I heard presentations on gold, the dollar, oil, real estate and more by a slate of luminaries, including John Paulson. Paulson is one of the best hedge fund managers in the world. There were many others, including Grant himself, who has created something of a stir lately.

Jim Grant, the host and editor of Grant’s Interest Rate Observer, has turned bullish on the recovery. In a Wall Street Journal piece on Saturday, the great bear turned in his claws and picked up the horns of a bull.

In a phrase, Grant’s thesis runs this way: The sharper the decline, the stronger the rebound. For this, he finds ample evidence in the historical record. The economy bounced back strongly after each sharp contraction — such as those in 1893-94, 1907-08, 1920-21 and 1929-31.

In the current recession, GDP (a rough measure of economic activity) contracted nearly 4% from peak to trough, which is a sharp recession as these things go. So, Grant reasons, the rebound will follow the historical pattern.

Grant loves to challenge the consensus. And the consensus this time around is that the recovery will be weak. I loved the quote he pulled from economist A.C. Pigou: “The error of optimism dies in the crisis, but in dying it gives birth to an error of pessimism. This new error is born not an infant, but a giant.”

Grant makes an eloquent and thoughtful case, as he always does. He goes on to conclude in his editorial: “The world is positioned for disappointment. But in economic and financial matters, the world rarely gets what it expects. Pigou had humanity’s number.”

I hope Grant is right. It is an appealing case, but I don’t buy it. Too many of the problems of the prior boom remain unresolved. There is still too much leverage and debt in the system. And on a more basic level, business is not good across a spectrum of sectors. The contraction is still ongoing. I’m inclined to remember the old bearish refrain that things are never so bad that they can’t get worse.

It’s All About Markets

It’s true we’ve had a sharp contraction, but there is no rule that says we can’t contract more. A nearly 4% decline in GDP could turn into an 8% contraction when all is said and done. The move from 4% to 8% would be painful, indeed. Even then, we would be a far cry from the dark woods of the Great Depression.

In some ways, the whole discussion is irrelevant anyway. As investors, we care about markets, and not GDP growth. There is a great fallacy out there that if the economy does well, stocks should do well (or if the economy does poorly, stocks should do poorly). Hence, too many so-called investors waste an inordinate amount of time talking about recovery, or lack thereof.

It’s possible that Grant is right: GDP does expand strongly. But investors could still lose. We have one glaring historical example: From 1964-1981, GDP grew 370%. And the sales of the Fortune 500 more than sextupled. Yet the Dow Jones industrial average went from 874 on Dec. 31, 1964 to 875 on Dec. 31, 1981.

As Warren Buffett once wrote: “Now, I’m known as a long-term investor and a patient guy, but that is not my idea of a big move.”

For investors, it is all about the price paid. The really relevant question is not one of whether or not the economic recovery is real. The question is: are stocks cheap enough? To answer that, you have to look at stocks and compare them with the alternatives.

My answer is some stocks are cheap and some are not. It is hard to generalize. In my view, investing is a craft of the specific. It is in the picking of the trees in which investing skills pay off the most, not in assessing the forest. There are, undoubtedly, specific stocks that will prove nice investments over the next few years. Finding them is what we are all about.

Sincerely,
Chris Mayer

September 30, 2009

Are the Bears Turning Bullish? was originally featured in the Penny Sleuth.

In the spring of 1969, the Dow Jones industrial average stood at 969. By 1982, the Dow hit 1,071. That’s thirteen years of going nowhere. (We’ve had 10 years or so of going nowhere, though the ride between the poles has been anything but boring).

The problem is inflation makes that performance look better than it really was, like when a crooked judge makes a fight look close with a split decision even when the one fighter can barely walk to his corner and everybody in the building knows it was a rout.

Adjusted for inflation, or the weak dollar, the Dow was really more like 400. That makes it one of the worst stretches for the market since the 1930s.

The consumer price index, that flawed measure of inflation, doubled from 1960 to 1982. This is why a generation of people grew to believe that the best way to buy a house was to borrow all you could afford. And for a time, that looked brilliant. As Robert Sobel relates in a history of the period, a modest suburban home going for $30,000 in 1969 sold for $300,000 13 years later. With a lot of debt, your returns were much greater.

Of course, that kind of thinking eventually got us into a heap of trouble, as we now know.

But that period of time also had an effect on Corporate America’s balance sheets. When a company buys an asset, say a factory, it records its cost on its books. It will then depreciate this asset over time. So the value of the factory on its books will decline over time.

In a period of high inflation, its book value will be understated. The cost of a similar factory will be a lot higher in dollar terms, though the company will still show the old figure.

In other words, during periods of inflation, book values understate the true value of corporate assets. This happened in the 1960-82 period. Combine that with the stagnant market and you get many stocks trading for super cheap by 1982, when the great bull market began.

In fact, in July 1984, S&P reported that 30% of the stocks on the NYSE traded below net tangible book value. The old value mavens like Ben Graham would have had a field day.

What happened next, though, is what interests us especially. The low stock prices kicked off a takeover boom. The 1980s takeover mania was the busiest since the “age of Morgan at the turn of the century,” Sobel reports in his The Age of Giant Corporations. The 1980s was the age of the LBO, Barbarians at the Gate, Michael Milken and the corporate raider.

The oil industry also had its takeover boom. In fact, the outlines of the 1980s oil and gas industry look similar to today’s. In 1970s, there was a drilling boom as people thought that oil and gas prices would rise indefinitely. That collapsed and then you had oil and gas companies sitting on huge reserves they built up during the boom.

So in a time when it cost $15 a barrel to get oil out the ground, many oil companies traded for $5 a barrel in proven reserves. Getty Oil traded for $72 per share, with assets of $250 per share. Marathon’s stock went for $68, though each share had $210 in assets backing it up. And on and on it went.

Enter T. Boone Pickens. An Oklahoma-born geologist, Pickens was well aware of the value of these companies. He started going after them and making millions of dollars as bidding wars ensued. He lost several of these, but still cleared millions in profits.

There was a roll call of takeovers in the industry during this time — Shell bought Belridge Oil for $3.6 billion, DuPont bought Conoco for $7.4 billion and U.S. Steel took out Marathon for $6.5 billion. (Yes, U.S. Steel thought it would be smart to diversify). These were some of the bigger deals.

I won’t go too much into the history of this period, and perhaps I’ve already gone into too much detail. But I think something similar may be unfolding in today’s market.

We have the potential for high inflation thanks to the government’s monetary and fiscal stimulus. We also have a weak economy. In oil and gas, we have many companies trading cheaply in the wake of a drilling boom gone bust. What we need now is a T. Boone Pickens to shake things up.

Sincerely,
Chris Mayer

September 3, 2009

A New Age of Corporate Takeovers Could Soon Emerge was originally featured in the Penny Sleuth.

And it’s a region that holds the key to growth opportunities that could eclipse the growth in the BRIC countries.

In fact, this region collectively has a bigger economy than Brazil, Russia or India already. And in terms of growth, it is growing faster than any of these countries. In terms of population, it’s bigger than the U.S. and nearly as populous the EU. It holds 60% of the world’s proven oil reserves and nearly half of its natural gas.

That last clue probably gives it away. I’m talking about the Middle East and North Africa, or MENA.

Among its largest economies are Saudi Arabia and the United Arab Emirates.

In one of my presentations at Agora Financial’s 10th Annual Investment Symposium in Vancouver, I focused on the growth in these economies because it touches on nearly everything we’ve talked about here recently – water and food scarcity issues, infrastructure needs, energy and the growth in non-U.S. trade. To start, let’s look at a couple of basic facts that push this along.

The first is explosive population growth. MENA is one of the fastest-growing regions in the world. Over the last 50 years, MENA’s population is up more than fourfold. And the population is still young, with the majority of the population under 25 years old. Over the next 30 years, MENA’s population will grow more than 60%, to nearly 700 million people.

The second is that trade is expanding in this part of the world, as I highlighted in last month’s letter. To show this in a different way, let’s look at Syria.

Yes, Syria. Long a pariah state with which the U.S. maintained frosty relations, all that is beginning to change. In July, the U.S. made a couple of announcements that I thought signaled an important shift. First, the U.S. would send an ambassador to Damascus after a four-year absence. Second, the U.S. would ease export bans to Syria.

But more important than this political thaw is the economic story. Syria has been a mercantile crossroads between East and West since its days as a link on the old Silk Road.

Put Your Money Where China Puts Theirs

The ancient city of Aleppo, for instance, was a key stop along the old Silk Road. Even today, it still has the longest covered market in the Middle East – a souk seven miles long. There you can find goods that take you back in history – soap made from olive oil or silk scarves and keffiyehs of a variety of colors. Head down an alleyway and find gold jewelry and stands of fresh pistachios and sacks of spices and more. Then there are the backstreets of hawkers with lamb – always plenty of lamb – and you smell the scent of lime, garlic and mint.

But much has changed, as Ben Simpfendorfer relates in The New Silk Road. Today, for the first time in 22 years, banks in Syria can set their own interest rates on loans and deposits. Today, you can change money on the street without the threat of a ball and chain winding up around your ankles. A stock market even opened for business in March.

The largest investor in the country is Haier, a Chinese company. It makes 50,000 washing machines and 50,000 microwave ovens in Syria every year. Another Chinese company, Sichuan Machinery Import & Export, recently completed a $180 million hydroelectric plant here. There are big real estate projects, including a new $300 million resort on the Syrian Mediterranean coast. There are some 40,000 new hotel beds coming online in the next three years – up from 48,000 currently. Tourism is already 13% of the economy.

Syria is basically following the “China model” of maintaining a closed political order but carving out free zones and allowing trade.

Of course, this isn’t some Big Rock Candy Mountain fantasy where the sun shines every day on the birds and the bees and the cigarette trees. There are all kinds of problems in Syria, and elsewhere, but I find the changes taking place so far absolutely remarkable.

In a sense, we’ve seen this movie before. Roger Owen wrote the classic study on the Middle East and its place in the economy. In his book, he covers the period 1800-1914. This was a time of growth and transformation. At least a few points are similar to today. Then, as now, the region experienced a huge population growth. The Middle East’s population alone grew 300%. Then, as now, trade grew even faster under a more liberalized economic regime.

Then, the Middle East benefited from growing demand for agricultural goods from European markets. Today, the region benefits from expanded trade with China and the rest of Asia for the region’s oil.

But that’s not to say that oil has solved the problems of the MENA countries…

Right now, these countries are looking to invest in farmland overseas. The Saudis have grabbed farmland in Indonesia. The UAE has locked down farmland in the Sudan and Pakistan. As Eckart Woertz of the Gulf Research Center in Dubai says: “In a global food crisis, you may find it difficult to secure food supplies at any price no matter how many oil revenues you have.”

When I got back home from Vancouver, there was an issue of The Economist waiting for me. It had a cover story on the Arab world titled “Waking From Its Sleep” and a 14-page special report within. What’s happening in this part of the world is starting to get more attention.

The key takeaway from all of this is to recognize this other, non-BRIC, growth engine and the needs and opportunities it creates. Once again, we’ll see enormous investment in food and water resources to feed and slake the thirst of all these people. And we’ll need all of the infrastructure and burn all of the hydrocarbons that come with that growth.

Sincerely,
Chris Mayer

August 26, 2009

Forget BRIC… These Emerging Economies Hold the New Keys to Growth was originally featured in the Penny Sleuth.

Part of the reason for the rise is weakness in the dollar. People often say that oil is denominated in dollars. But maybe it is the other way around; dollars are denominated in oil. A dollar is worth how much oil it can buy. Part of oil’s rise is simply marking down the value of the dollar. Weak dollar means higher oil prices.

People will blame the higher oil price on speculators, but something interesting is happening in the markets for minor metals like molybdenum. Prices are rising, too. The silvery metal, used to strengthen steel, is now $15 a pound — nearly double the $8 and change it fetched in April. This is significant, because there is no futures exchange for moly. It trades on a physical spot market. Speculators play a very small role here. The buyers of the metal use the metal.

So there is a demand story shaping up here, too, mostly focusing on a fragile recovery of some sort and mostly centered on China and the emerging markets. The market is looking ahead.

For instance, over the weekend, South Korea reported numbers that show signs of a recovery in that country. Industrial output fell less than expected, and trade volume surged to $60 billion. That was its best showing since last October. Also, South Korean companies have been reporting better-than-expected results.

The biggest buyer of South Korean goods is China. Still, it’s a confusing time because of all the stimulus money that governments around the world have been spending. So it’s hard to say what’s real and what’s just an illusion created by a temporary spending binge.

Another piece of the puzzle from last week: Spot iron prices in China (meaning iron ore for immediate delivery) topped $100 per ton. That’s the highest level since October 2008. The other breakthrough in iron ore last week came when BHP Billiton, the world’s largest miner, announced that a third of its customers were moving to prices linked to the spot market.

This is big news for the industry. The old way was to have annual contracts with a negotiated price. This was bad for iron ore companies because the contracted price lagged the increase in iron ore prices. And when iron ore prices fell, steelmakers just reneged on their contracts. As the iron companies found out, having contracts was a great way for iron ore producers to cap their upside and leave them with all the downside. Not so good.

The industry now looks like it is moving toward more spot pricing, which is a good thing for the producers. Iron ore prices have rallied too, along with crude oil and moly.

Every rally, like every bottle of beer, has a finite life span. There will be lots of bumps along the way, but the prices of many commodities — such as oil, iron ore and moly — will tack higher, in my view. Intelligent small-cap investors would be wise to pick up shares of their favorite companies in these sectors.

Sincerely,
Chris Mayer

August 4, 2009

Oil and Molybdenum Are Poised for Future Gains was originally featured in the Penny Sleuth.

This is an eye-opener. Whenever I talk about the Great Depression and compare it with what is going on today, I get a lot of skepticism. I hear a lot of people say, definitively, “This isn’t as bad as the Great Depression.”

What you have to remember, though, is the Great Depression unfolded like a train wreck in slow motion. It took awhile before it became the Great Depression. It wasn’t like someone flipped a switch and poof! — bread lines, Hoovervilles and hobos.

Another point to remember is that the Great Depression was a global economic event. It wasn’t just confined to the U.S. You have a take a wide-angle view of the global economy to get a better sense of the breadth of the slump. And so it is today.

Take a look at the next few charts, from economists Barry Eichengreen and Kevin O’Rourke. The first plots world industrial output from June 1929 against industrial output from April 2008:

We’re tracking that path pretty closely.

Then there are world stock markets:

We’re actually worse off right now.

Finally, take a look at the volume of world trade:

Again, here we’re actually ahead of the pace set in the Great Depression.

There are several other charts, but I think you get the point. Eichengreen and O’Rourke conclude:

“To summarize: The world is currently undergoing an economic shock every bit as big as the Great Depression shock of 1929-30. Looking just at the U.S. leads one to overlook how alarming the current situation is even in comparison with 1929-30.”

Even so, there are many differences between now and then. One big difference that doesn’t get much play is the fact that today we have large emerging economies such as China, India, Russia and Brazil.

Investment strategist Murray Stahl, in a recent letter, pointed out “the most important difference between that era and this era, which is the robust economic development of China, India, Russia and Brazil. During the Great Depression, those nations were in the opposite condition.”

China was in the midst of a civil war and then had to fend off a Japanese invasion. India wasn’t even on the economic map as anything of any consequence. Russia was backward and militantly communist. And Brazil had all kinds of political problems, including trying to put down a communist movement.

Today, those four countries are in much better shape. They are much larger and are still growing.

There are many more differences, and I don’t expect what we’re going through to play out like the Great Depression, except maybe in some of the broadest outlines. This is, or will be, known as the greatest crisis the world has faced since the Great Depression.

How it is similar is also in some of the valuations in individual stocks and securities. As Stahl writes, we share with the Great Depression the “bizarre valuations on highly liquid securities in the world capital markets [such] that I have never before seen in my 30-plus years of investment practice.” In that, there is opportunity.

As I’ve written before, I think there is room for investing even in a weak economy. There are lessons we can learn from the Great Depression. Some stocks will do better than others. I expect the needed commodities that fuel those big emerging economies will be good places to be.

And these hard assets also provide some protection in a world where paper currencies are not likely to hold their value as cash-strapped governments around the world crank up the printing presses.

Sincerely,
Chris Mayer

June 30, 2009

Depression Then and Now: Three Eye-Opening Charts was originally featured in the Penny Sleuth.

One discussion talks about where you are likely to find inefficiencies, or market pricing “errors.” This is useful to think about as an investor, because you want to find those soft spots where markets misprice widely. Some markets are efficient and hard to beat. Some markets are less efficient.

Markets tend toward inefficiency when:

• The situation is complex
• When the time frame for a payoff is longer, rather than shorter
• When participants are unsophisticated or use borrowed money
• When external forces are weak (for instance, when liquidity is low).

We tend to avoid complex situations, but even in simple situations, markets can be very wrong. “Markets for securities can be grossly inefficient,” Whitman writes, “even though the analysis is simple and few variables are involved.”

As for time frame and participants, Whitman maintains that a well-trained and informed analyst — not influenced by short-term price swings — is likely to find these inefficiencies. Someone who is unsophisticated, uses borrowed money and allows short-term price movements to influence his thinking will find the going a lot tougher.

The reason borrowed money is important is because if you borrow money to buy stocks, you put yourself at the mercy of the market to some degree. A stock that is temporarily cut in half on borrowed money becomes a problem for you and may force you out at a bad time.

The other discussion that is worth passing on to you involves risk. First, Whitman lets you in on a little secret that I don’t think most investors believe is true. “The secret to building a great fortune is to avoid, as completely as possible, the taking of any investment risk.” If you study great entrepreneurs, you find that they often took little risks. In his book The Dhandho Investor, Mohnish Pabrai goes through several interesting examples. Richard Branson, for instance, started Virgin Atlantic with little money down.

Most successful investors, too, seek to lower risks as much as possible, while retaining upside potential. So how do investors reduce risk? Whitman has five suggestions.

Buy cheap. As an outside investor, you protect yourself by buying cheap. Whitman points out that Buffett likes to say how he wants to buy great companies at reasonable prices. But Buffett is a control investor — that is, he often has influence over the companies he invests in. As an outside passive minority investor, or OPMI, you do not have such influence. Therefore, the standard of great companies at reasonable prices “is not good enough.”

Whitman writes: “OPMIs pretty much have to leave companies as is, and therefore place particular effort into buying into well-managed businesses with stable, but clearly superior, managements.”

Buying cheap is the best protection you have as an investor in common stocks.

Buy only when you have an excellent financial condition. Whitman writes you should not “knowingly acquire the common stock of any company unless that company enjoys a super strong financial condition.” A great financial condition simply gives you some margin for error. It’s hard to go bankrupt if you have an excellent financial condition. In addition, it should be an understandable business with good disclosures. This helps keep you from being snookered.

Ignore market risk. Whitman believes changes in market prices are not measures of long-term investment risk or potential. This is hardest for most people to get over. But most great investors give little weight to daily, or even annual, price changes. Just look at the price charts of any stock. You see huge price swings even in a year’s time.

Buy growth, but don’t pay for it. Investors are better off betting on companies that can grow over time. Growth, though, is often misused by financial people. “Most market participants do not mean growth,” Whitman says, “but rather mean generally recognized growth.” That kind of growth you have to pay up for. Whitman prefers growth companies that are not generally recognized as such and, therefore, can be great bargains.

It is usually a good idea to be a buy-and-hold investor. If you do all the upfront work well, then you can often continue to hold onto a stock for as long as your initial thesis is intact. The simple idea here is when you have really found a gem, you should be a reluctant seller. Let the idea work for you. That might not seem like good advice after 2008, but good businesses do increase their net asset values over time. Time is an important ingredient to compounding an investment’s value over time.

Good times to sell are when you have made a mistake. Whitman writes that a mistake would include some fundamental impairment — like a loss of credit standing that means the business can no longer do in the future what it did in the past. Sell, also, when a stock becomes grossly overvalued. And finally, sell for portfolio considerations — such as tax reasons.

To sum up, Whitman’s book touches on two important ideas for investors to boost their returns. First, focus on those markets and situations in which you are likely to find inefficiencies. Second, aim to lower your investment risks. We look to do both as often as possible here.

Sincerely,
Chris Mayer

May 28, 2009

Two Ideas for Investing Success was originally featured in the Penny Sleuth.

So here we are in a shaky economy tottering on a ledge and along comes the EPA ready to shove it right off. As The Wall Street Journal reported: “The landmark decision lays the groundwork for federal efforts to cap carbon emissions – at a potential cost of billions of dollars to businesses and government.”

In other words, the war on the so-called greenhouse gases is officially under way – and it is going to be expensive. Each passing month brings us closer to capping, taxing or cutting the gases thought to cause global warming.

I don’t think investors appreciate how far-reaching such efforts could be. And there will be definite winners and losers as a result. Some of these are far from obvious and some are in plain sight.

The first obvious big loser is American coal, from which we get half about of our electricity needs. Already, you see companies reacting to this news. Consol Energy, a big coal company, said it halted two big mines in Appalachia because of uncertainty over the costs of pending new regulations. If you own a U.S. coal miner, I’d fold the hand, so to speak.

Coal-fired power plants look like big losers, too. And the utility AES, the biggest user of coal in North America, is looking to shutter some of its coal plants. It is also looking at how high rates would have to go to comply with possible rule changes. In some places, rates could rise as high as 50%. It is no sure thing that AES could get such rate increases.

Natural gas-fired plants, though, may be one winner relative to coal, because natural gas burns cleaner than coal. Already, in just the last few months, as the market ponders talk of new emissions caps, you could see gaps opening up between coal utilities and natural gas utilities.

Though the new rules could be a year or more away, those gaps may well widen over time as investors anticipate the likely bad ending for coal. So I would not own a U.S. coal utility right now, either. It is no fun wearing a target on your back – especially since the guy throwing the darts makes all the rules.

Instead, I’d rather be the guy who gets to make and sell the new equipment that helps utilities “clean up.” The demand for cleaner-burning fuels will boost the need for its high-quality pumps, valves and seals. These products work to improve efficiency and emissions. Two similar companies I’m keeping an eye on include Fluor Corp. and Foster Wheeler.

But there is much more…

Besides carbon dioxide, the EPA also named five other industrial gases to its hit list, including methane. This could have an impact on landfills, which emit methane and carbon dioxide. One of the companies I am following is Covanta, which turns waste into energy, essentially replacing landfills. For every one ton of trash burned in a waste-to-energy facility, one ton less of carbon dioxide is released into the air. It also captures the methane gas.

So again, big penalty for those who run landfills – but potentially a boon to those with solutions, like Covanta.

There are many other ways the EPA’s ruling could affect the lay of the land. The EPA could raise fuel-efficiency requirements on cars. It could require more hybrids and electric cars. This would be good for makers of car batteries. It would also be good for the things that go into making more efficient car batteries – such as lithium or cobalt, which are ideas I prefer over the battery makers themselves.

The war on greenhouse gases could also dramatically affect our homes and offices. Worldwide, the energy we use to build, heat, cool and light buildings makes up about 40% of energy demand. This is even more energy than the world’s transportation networks guzzle.

Better insulation, new windows and even more efficient water heaters can make a big difference on the carbon footprint of a building. Just heating water alone can make up 15% of the energy used in a home.

Another company I am following is A.O. Smith. This company has a dominant position in water heaters, as well as a rapidly growing business in China – where the need is more acute. It also makes heating and air conditioning systems. A good chunk of A.O. Smith’s sales come from replacement markets – just fixing what is in place. Stricter building codes and a need to cut energy use could be good for businesses like Smith’s.

However, this is not all driven by government’s iron hand. In fact, in some cases, it is just good business sense. The Empire State Building, for instance, is undergoing a major makeover. But it is one you can’t see from the outside. Instead, it’s all about the insulation, smart meters, new boilers and more. According to the Financial Times: “The retrofit of the Empire State Building will cost about $20 million, but its annual energy savings will be $4.4 million when it is complete.” That’s not a bad payback.

In any event, the efforts to save energy and reduce greenhouse gases – whatever their source – is an important story and sets up a lot of things for us to look deeper into in future letters. We are still early in this game.

Sincerely,
Chris Mayer

May 13, 2009

How to Profit from the War on Greenhouse Gasses was originally featured in the Penny Sleuth.

In short, people seem to have had enough of stocks. They’re moving into bonds. Oddly, and as strange as it sounds, this inflection point just might be the turning point for stocks. Put another way, investors as a group just got the last 10 years wrong. Thinking in contrary fashion, they may get the next 10 years wrong as well.

Stocks, as a group, have not done well now for 10 years. As of yesterday, if you had put $10,000 in the S&P 500 10 years ago, you would now have about $6,200 — a loss of 38%. And it’s worse than that considering the effects of inflation.

If you look at bonds, they’ve done much better. The Merrill Lynch U.S. Corporate Master index, a measure of high-grade debt, for instance, has gained 58% in the last 10 years.

You can hear the gears turning. Stocks have not done well, investors reason, and bonds have done much better. Therefore, buy bonds.

That’s what they are doing in large numbers. Here are some telling quotes from a recent Wall Street Journal article. From a manager of $185 million in individual accounts:

“I think a lot of investors have just had it with the equity markets… The baby boomers are saying, ‘I’m too old to make up these losses… I’m not going to risk it.”

Another, who has $414 million in assets under management:

“The credit markets are the market, and the stock market is a sideshow, period.”

One more, from a money manager of $900 million in assets:

“The debt markets seem pretty well understood, while the outlook for equities is still murky.”

Even the Journal itself waxes on about the simplicities of bonds. You only have to figure out if the company can meet the minimum payments of the bonds. You don’t have to worry about figuring out growth rates or what earnings per share may be. “With no end to the recession in sight,” the Journal sighs, “logic for buying equities is wavering.”

(If you’re like me, you’re probably suspicious of someone who repeatedly says “equities” when the plain-old word “stocks” suffices.)

So the stock market has been cut in half… and NOW these advisers are all cheerleaders for the bond market. Already this year, bond funds have added some $15 billion to their assets. Last year, investors took out nearly $200 billion from their stock mutual funds.

Going with what’s worked well in the past sounds reasonable, but investing is an odd thing. It’s not like many other areas of life.

If you get a bad haircut after going to the same barber for a few times, you stop going to that barber and find another. You don’t stick with bad barbers and you don’t go looking for bad barbers.

And if you get a good meal at a restaurant, you keep going back. You don’t worry about the restaurant getting too popular. You don’t look for a dive where hardly anyone goes, thinking you’ll get a better meal.

Investing is almost the exact opposite — which is one of the things that make it so hard. The best way to make a lot of money in stocks is to buy something good that few people seem to want. Then you sit on it, and when people get excited about buying it again, you gladly sell at a premium price and make some multiple on your initial investment.

All the greats made most of their hay in just this fashion — John Templeton buying up small-cap stocks in the Great Depression… Warren Buffett picking up The Washington Post and adding shares of GEICO in the depths after the 1973 market tank… and on and on…

The best deals become available during times like now. That much is a fact. I’m not saying it’s easy. I’m not saying all stocks will rise. Some of them are going to go to zero. Some of them are never going to come back. But some of them are great businesses and have great assets that will certainly come back at some point.

I know it can be tough when stocks you own are down so much. But looking ahead, I can’t help but be more optimistic…

Regards,
Chris Mayer

February 27, 2009

Why You Shouldn’t Move to Bonds was originally featured in the Penny Sleuth.