BMO Nesbitt Burns Basic Points Feb 2010
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Basic Points
Hard Rocks and Hard Shocks
February 19, 2009
Published by Coxe Advisors LLP
Distributed by BMO Capital Markets
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Company Name Stock Ticker Disclosures Company Name Stock Ticker Disclosures
Barrick Gold ABX 1, 3, 4 Goldcorp GG 1, 3, 4
BHP Billiton BHP Goldman Sachs GS
BP BP International Business Machines IBM
Caterpillar CAT JPMorgan Chase JPM 1
Citigroup C 3, 4 Kinross Gold KGC 1, 3, 4
Companhia Vale do Rio Doce RIO Nasdaq NDAQ 2
ConocoPhillips COP Newmont Mining NEM 3, 4
Exxon XOM Potash POT 1, 3, 4
Fannie Mae FNM 1 Rio Tinto RTP 3, 4
Freddie Mac FRE 1 SPDR KBW Regional Banking KRE
Freeport McMoRan FCX Xstrata XTA
(1) BMO Capital Markets or its ailiates owns 1% or more o any class o common equity securities o the company
(2) BMO Capital Markets makes a market in the security
(3) BMO Capital Markets or its ailiates managed or co-managed a public oering o securities o the company in the past twelve months
(4) BMO Capital Markets or its ailiates received compensation or investment banking services rom the company in the past twelve months
(5) BMO Capital Markets or its ailiates expects to receive or intends to seek compensation or investment banking services rom the companyin the next three months
(6) BMO Capital Markets has an actual, material confict o interest with the company
BMO Capital Markets Disclosures
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This third party publication is not prepared by BMO Capital Markets Corp., BMO Nesbitt Burns Inc., BMO Nesbitt Burns Ltee/Ltd and BMO Capital Markets Limited. The inormation, opinions, estimates, projections and other materials contained hereinare provided as o the date hereo and are subject to change without notice. Neither Bank o Montreal (BMO) nor its aliateshave independently veried or make any representation or warranty, express or implied, in respect thereo, take no responsibilityor any errors and omissions which may be contained herein or accept any liability whatsoever or any loss arising rom any use
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Don Coxe
THE COXE STRATEGY JOURNAL
Hard Rocks and Hard Shocks
February 19, 2009
published by
Coxe Advisors LLP
Chicago, IL
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THE COXE STRATEGY JOURNAL
Hard Rocks and Hard Shocks
February 19, 2009
Author: Don Coxe 312-461-5365DC@CoxeAdvisors.com
Editor: Angela Trudeau 604-929-8791AT@CoxeAdvisors.com
Coxe Advisors LLP. www.CoxeAdvisors.com
190 South LaSalle Street, 4th FloorChicago, Illinois USA 60603
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OVERVIEW
Hard Rocks and Hard Shocks
This is the month or the BMO Nesbitt Burns Resources Conerence, a majorevent or global mining companies, and or institutional investors in mining
stocks. It is our tradition to prepare an issue o our journal that will be o
particular interest to the attendees at that great gathering.
This meeting will also be the eighth anniversary o our keynote speech to the
2002 meeting (sparsely attended compared to this year, which should be a
record). Back then, we audaciously proclaimed The Birth o the Greatest-
Ever Commodity Boom.
As we began thinking about our keynote address or this years meeting,
we have been reviewing what we said at earlier meetings, and are struck by
how much the outlook has changed or the hard and sot rock industries,
because o the two great dramas o recent years: rst, the emergence o China
and India as the driving orces o the global economy, and secondly, the
international nancial crisis and recession.
We remain bullish on the longer-term outlook or commodities and the
shares o the commodity-oriented companies. But the ragile nancial state
o many major governments and banks means that we must consider the
implications or investment assets at a time when investorsand such basket
cases as Fannie Mae and Freddie Macare beginning to look orward with
trepidation to the time when the fows o what we call nancial heroin willslow down beore drying up.
We are leaving our cautious Recommended Asset Mix unchanged. The
powerul equity bull markets have, since last March, driven many valuations to
levels that make scant allowance or urther systemic shocks. Most commodity
stock prices are held back by the mixed messages o recovery in Europe and
the US, while China has switched rom expansionary to restrained liquidity
policies. Within the US, there are some hopeul recovery signsnotably the
recent strong perormance o the US regional banks in the KRE Index (despite
reports o rising problems with commercial real estate loans)but volatility,
as measured by the VIX, is rising anew.
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THE COXE STRATEGY JOURNAL2 February
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I The Base Metal Miners
When we spoke in 2002, the Canadiansand most o the Americansin
the audience were ocused primarily on the outlook or copper and nickel,
because Inco and Falconbridge were the core base metal investments in
Canadianand Canadian-orientedportolios.
Naturally, our enthusiasm was greeted with skepticism and, (we have since
learned) some outright scornparticularly rom the mining analysts and
rom mining executives.
We explained the importance o Triple Wateralls or macro-nancial analysis
by listing the three within our experience: in each case, a decade o bullishness
ended in mania, ollowed by two decades o collapse:
Commodities: The asset class o the Seventies, ending in January 1980,
ollowed by two decades o decline, disappointment, and despair.
Japan: The real estate and stock market stars o the Eighties, ending on the
last trading day o 1989; we predicted that Japans plunge still had many
years to run.
Technology: The asset class o the Nineties, ending March 2000. We
predicted that most technology stocks would be underachievers until late
in the ollowing decade. (Note: Google wasnt public at Nasdaqs peak.)
Hard Rocks and Hard Shocks
Copper
January 1, 1986 to February 18, 2010
50
100
150
200
250
300
350
400
450
Jan-86 Jan-89 Jan-92 Jan-95 Jan-98 Jan-01 Jan-04 Jan-07 Jan-10
320.25
Commodities: The asset
class o the Seventies,
ending in January 1980,
ollowed by two
decades o decline,
disappointment,
and despair.
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THE COXE STRATEGY JOURNAL
My entry into portolio management in 1972 came just in time or the
horrendous stock market crash o 1973-75. Commodities then became an
infation hedge class, driven initially by gold, silver and oil, but later by base
metals when the big oil companies began redeploying into mines some o the
billions o dollars o their proceeds rom the nationalization o their major
Mideast oil elds. One o the historic Dow Thirty o that eraAnacondawas
bought by a member o the club still known as Big Oil. Its purchaser explained
that its skills in extracting wealth rom the ground were equally applicable
to metals. That was a sign o mania driven by desperation. (The investment
was later written o.)
The peak came in 1980. Commodities entered their Triple Waterall collapse,
and 20 years o despond and despair ensued, as the capex born o the mania
was slowly and painully absorbed or sold or scrap.
By 2002, with the mining industry shrunken and disbelieving, the stage
was now set or a boomwhich would be driven by demand rom Asian
industrialization.
China and, to a lesser extent, India, had embarked on what would becomethe
largest-scale eforescence o human economic liberty in the history o mankind.
Buy what China needs to grow, we had been telling investors since 1999.
By 2002, most investors seem to have orgotten their enthusiasm or the
new millennium, which had arrived with two shocks: the Technology Crash, which spread into an overall equity bear market, ollowed by 9/11, which
meant we were collectively at risk rom attackers based in some o the most
primitive regions o the world.
Yet, we were telling them their biggest investment opportunity was coming
rom nations that had not long ago been considered so economically
backward as to be mere ootnotes to any global investment strategy.
...the largest-scale
eforescence o human
economic liberty in the
history o mankind.
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A chance meeting in Australia months previously had conrmed our
suspicion that good times would soon be returning or the ravaged base
metals companies:
Ater touring the amous desert massi sacred to the Aborigines as Uluru,
our group was supplied a desert dinner. I asked the gentleman next to
me what he did, and he replied that until a ew weeks ago he had been a
mining executive. Since I had long been a ollower o that industry I asked
which one. I ran Rio Tintos operations in Australia.
I explained that I was an investment strategist and had been negative on
mining companies or years. Was the outlook changing?
He explained that, or twenty years, the industry was driven by men who
sought to prove their virility by opening bigger new mines than their
competitors. That strategy may have been good or their testosterone,
(he allowed), but it was terrible or shareholders. Stock prices were so
beaten-up that managements nally learned their lesson: rom here on,
they wouldnt be betting big on big new mines. (Refecting on that, I later
coined a maxim: Invest in an industry where Those who know it best, love it
least, because theyve been disappointed most.)
We asked, What could create the shortages that would get them to reopen
closed mines and open new ones?
China, he said. Theyre going to need a lot o metal to meet their growth
promises to their people, and they will soon have trouble getting it. Metal
prices will have to go up eventually.
That, I gured at the time, was the single most prophetic speech I was
likely to hear or years.
I knew rom having studied economic history that large-scale industrialization
created huge demand or metals, whereas mature economies modest annual
growth in consumption could be metin considerable measurerom
scrap.
By 2002, I was convinced the Prime Mover for the global economy in coming
decades would be Asianot Europe and North America.
Invest in an industry
where Those who know
it best, love it least,
because theyve been
disappointed most.
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THE COXE STRATEGY JOURNAL
The Boom Begins, and Has Its First Pause
BHP Billiton (BHP)January 1, 2002 February 17, 2010
0
10
20
30
40
50
60
70
80
90
100
Jan-02 May-03 Sep-04 Jan-06 May-07 Sep-08 Jan-10
74.25
BHP Billiton relative to S&P 500January 1, 2002 February 17, 2010
0
100
200
300
400
500
600
700
800
900
Ja n- 02 J an- 03 Ja n-0 4 J an-0 5 Ja n- 06 J an-0 7 Ja n-0 8 Ja n-0 9 J an- 10
739.68
Rio Tinto (RTP)
January 1, 2002 February 17, 2010
50
150
250
350
450
550
Ja n-0 2 J an- 03 J an-0 4 J an-0 5 J an-0 6 Ja n-0 7 J an- 08 J an- 09 J an- 10
215.25
Rio Tinto relative to S&P 500
January 1, 2002 February 17, 2010
100
150
200
250
300
350
400
450
500
550
600
Jan -0 2 J an -0 3 J an -0 4 J an-0 5 J an-0 6 J an-0 7 Ja n- 08 J an-0 9 Ja n-1 0
284.23
Vale (RIO)
March 23, 2002 to February 17, 2010
0
5
10
15
20
25
30
35
40
45
50
Mar-02 Jan-03 Nov-03 Sep-04 Jul-05 May-06 Mar-07 Jan-08 Nov-08 Sep-09
27.78
Vale relative to S&P 500
March 23, 2002 to February 17, 2010
0
200
400
600
800
1,000
1,200
1,400
1,600
1,800
Mar-02 Jan-03 Nov-03 Sep-04 Jul-05 May-06 Mar-07 Jan-08 Nov-08 Sep-09
1,336.96
Xstrata (XTA) (London)
March 23, 2002 to February 17, 2010
0
500
1,000
1,500
2,000
2,500
3,000
Mar-02 Jan-03 Nov-03 Sep-04 Jul-05 May-06 Mar-07 Jan-08 Nov-08 Sep-09
1,062.50
Xstrata (XTA) (London) relative to S&P 500
(currency adjusted)
March 23, 2002 to February 17, 2010
0
100
200
300
400
500
600
700
800
900
Mar-02 Jan-03 Nov-03 Sep-04 Jul-05 May-06 Mar-07 Jan-08 Nov-08 Sep-09
362.91
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These are the diversied base metal giants that operate around the world,
and their collective perormance is driven by demand and pricing or copper,
aluminum, iron ore, coal, nickel and zinc. (BHP has substantial oil and gas
production, and others have precious metal exposures in varying degrees,
but they trade on investors outlook or the key base metals and coal.)
CopperKing Copper serves a wide range o industrial markets, as
does aluminum. The others are tied directly into global iron and steel
production.
Copper
January 1, 2002 to February 18, 2010
0
50
100
150
200
250
300
350
400
450
Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10
320.30
Aluminum
January 1, 2002 to February 18, 2010
0.40
0.60
0.80
1.00
1.20
1.40
1.60
Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09
0.83
These are the diversifed
base metal giants...
they trade on investors
outlook or the key base
metals and coal.
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THE COXE STRATEGY JOURNAL
In 2002, and each speech thereater, we outlined the key nancial and
political principles or successul commodity stock investing:
First: invest in an industry that has completed its Triple Waterall Crash,
whose companies are led by battle-scarred executives and whose shares
are ollowed mostly by analysts who, like those executives, know it best,
and love it least, because theyve been disappointed most.
Secondly, invest in companies whose strength is unhedged reserves in the
ground in politically-secure areas o the world.As time went on and the stocks began to move, we added another maxim:
The Obesity Index.Avoid investing in stocks where the weight o analysts
on the Street is heavy in relation to that groups weight in the stock market,
In 1980, there were more oil analysts than tech analysts on Wall Street:
you should have sold oil and bought technology. Now the reverse was
true, even ater the rst stage o technologys Triple Waterall collapse. We
had, in eect the Anorexic Indexa ew analysts too scarred by years o
grim news to issue enthusiastic Buy stories.
ZincJanuary 1, 2002 to February 18, 2010
Nickel
January 1, 2002 to February 18, 2010
0
10,000
20,000
30,000
40,000
50,000
60,000
Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10
20 066
500
1,000
1,500
2,000
2,500
3,000
3,500
4,000
4,500
5,000
Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10
2,276.75
We had, in eect the
Anorexic Index
a ew analysts too
scarred by years o
grim news to issue
enthusiastic Buy
stories.
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By the late 1990s, most o the big base metal miners had virtually shut down
their exploration departments, ring their geologists, and hunkering down.
Why explore or new mines when youre losing money on the ones youre
operatingwhich are probably higher grade than what you might nd in
some bush, jungle or mountain topand ace strenuous opposition rom
local residents and global greens?
University geology departments had been shrinking or closing or more than
a decade, and many geologists had taken up careers outside their industry.
(A riend who was Chairman o Geology at a major university once told me
that one big reason they were able to keep the department going during the
bad times or exploration was demand rom students who had no intention
o working or mining companies. They wanted to learn about the industry
so they could get jobs with Greenpeace, environmental NGOs, and law
rms that sue to prevent mines rom operating. Some o these enthusiastic
demonologists doubtless got gloriously satisying work onAvatar.)
Such exploration as was being undertaken was mostly by the smaller
companies, who took advantage o the lack o competition rom the biggies
to stake claims around the world. That meant that the contract drillers which
had somehow survived the Triple Waterall Crash were getting more demand
or their services than they could ll.
Once the China story took hold with risk-oriented investors, smaller mining
and exploration companies were able to raise unds through equity oerings,
and they lled the gap let by the bruised biggies. Result: one o the great
winners rom the mining boom has been contract drillers:
Major Drilling Group
January 1, 2002 to February 17, 2010
0
10
20
30
40
50
60
70
Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10
23.47
Why explore or new
mines ....which are
probably higher grade
than what you might
fnd in some bush, jungle
or mountain top...
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THE COXE STRATEGY JOURNAL
In keeping with Those who know it best love it least, big mining and oil
companies, having slashed exploration and capex to the bone, did not
boost their exploration budgets in line with rising revenues as metal
demand climbed. A study in 2005 reported that global mining exploration
expenditures were roughly equal to what the industry had spent a decade
earlier.
The managements o those companies and the ew surviving analysts who
covered them looked at each uptick in prices o their production as selling
opportunities.
It took a while or copper prices to respond to the rapidly-rising demands
rom China (and, to a lesser extent, South Korea). One big reason was the
determination o the management o Phelps Dodge, one o the worlds ourbiggest producers, to lock in higher copper prices by selling huge amounts
o production orward in what was (alsely) called hedging. At the 2005
Conerence, I was asked during Q&A, How high can metal prices go? I
had heard Phelps managements presentation that morning, in which they
insisted that analysts should use 85 cents per pound or their long-term
earnings estimates. I replied, Why not use $2.00 or copper and $9.50 or
nickel? The Phelps team got up, and noisily marched out. In contrast, Incos
CEO was quite complimentary about the speech, and grinned, I loved your
$9.50 nickel.
Phelps had locked in 85-95 cent copper on huge long-term contracts. They
doubled up with more sales in the $1.25 range. Insiders exercised stock
options and sold heavily with copper prices trading not ar rom $1. Result?
In 2006, with copper prices soaring to $3.00, the honchos o the Arizona
desert ound themselves under water and were bought outat a bargain
price or their superb assetsby Freeport McMoRan.
The management o BHP, led by the shrewd Chip Goodyear, had a dierent
view. The giant continued to expand production, eschewed hedging, and
shocked the industry by buying Olympic Dam, which had the largest known
undeveloped reserves o copper. At the Society o Economic Geologists
Convention in 2006, Rio Tinto people were smiling about the very large
sum BHP had paid or Olympic. In his speech the next morning Mr.
Goodyear noted, Yes, we paid a very large sum or those copper reserves.
But we also got the worlds largest known uranium reserves or ree. That is
the optionality that builds great mining companies. He urther explained
optionality with reerence to Freeports giant Grasberg minethe worlds
biggest gold deposit and one o the three biggest known copper deposits.
In 2006, with copper
prices soaring to $3.00,
the honchos o the
Arizona desert ound
themselves under water...
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When the mine was being readied or production in 1988, its reserve lie was
estimated at 20 years, but the geology in the region was extremely avorable.
He said that its current estimated reserve lie was many decades.
That approach to optionality should, we elt, be used by investors in mining
stocks. Look or companies owning properties with great, unhedged, proven
reserves, and with indicated geologic potential or massive additions to those
reserves, includingin some casesthe likelihood o proving economic
quantities o other minerals.
The Crash: Was That The End of the Greatest-Ever Commodity Boom?
As the stock charts show, the big miners took bigger hits during the Crash
than most other big non-nancial companies.Naysayers who had dismissed the commodity boom as another 1990s bubble
were gleeul. So much or the China story! How will China continue to buy
copper and coal when its exports collapse and it alls into recession? Those
big mine expansions in Australia and Asia will probably go bust.
However, as those charts also show, the mining stocks came roaring back.
Their cash fows are once again robust, and the only one o the majors
with a modestly worrisome balance sheet is Rio Tinto, which leapt late
into the acquisition game, buying Alcan right at the top. But RTPs earnings
are powerul, and it is having no diculty in raising money. Meanwhile,
Freeport, which borrowed to expand Grasberg and buy Phelps Dodge, could
be debt-ree by next year, i copper and gold prices stay near current levels.
BHP announced its earnings or the rst hal o scal 2010 last week$6.1
billion, up rom recession trough $2.6 billion. O perhaps more importance
were its announced capex plansup 17% in this year, not including $5.8
billion or its joint iron ore venture with Rio Tinto that still awaits nal
government approval. The company had earlier advised the it was now
seeing strong price recovery driven by demand in China and restocking in
the developed world. This optimism was conrmed in a Wall Street Journal
report last week which asserted, The prices o ingredients to make steeliron ore and coalare rising sharply.
That approach to
optionality should...
be used by investors in
mining stocks.
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Contrast that powerul recovery in prices o minerals and stocks rom
recession depths with the anemic GDP outlook or the US and Europe.
On the evidence, The Greatest-Ever Commodity Boom remains intact.
What the Crash and subsequent events have demonstrated is that these
companies have ar less endogenous risk than most macro-analysts realize.
Many deep cyclical US stocks that rely on US economic activity have barely
recovered rom the Crash, and their utures depend on the success o the
Obama-Bernanke-Geithner programs. The miners are true global companies,
and the strong recoveries across Asia more than oset sparse demand rom
American and European customers.
Chinas Second Long March Goes Global
As metal pricesparticularly iron orecontinued to climb to record levels,
The China Story took a new turn. Stung by the iron ore cartelBHP, Rio
Tinto and ValeChina began sending its minions across the world looking
or metal reserves. When BHP tried to buy Rio Tinto, (which had recently
bought Alcan), the Chinese were alarmed that the merged company would
have the properties, production, and cash fow to have a lock on Australias
production o iron ore. Chinalco leapt in, buying sucient RTP shares within
24 hours to put a hold on the merger, which was already in trouble because
o anti-trust claims by Australia and the European Economic Community.
This year, China made its next move to lock in control o major Australianproperties that produce what Chinas steel mills need: the Export-Import
Bank o China is putting up $5.6 billion o the estimated $8 billion cost o
developing Clive Palmers huge Resourcehouse coal project in Queensland,
which will be built by Metallurgical Corp. o China.
China is investing almost everywhereincluding in Quebec, where Wuhan
Iron and Steel has taken a $240 million stake in Consolidated Thompson
Iron Mines. Stung by governmental intrusions into attempts to buy major
commodity companies such as Rio Tinto and Unocal, what is happening
is that Chinese state-owned or controlled companies are buying minority
and controlling stakes in companies with mineral properties across the
worldand opening mines in hellhole countries backed by their own
security personnel.
The Greatest-Ever
Commodity Boom
remains intact.
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Although the Crash was devastating to the miners stockholders, it may
have accelerated the emerging competition or ownership o resources rom
government-owned mining companies and Sovereign Wealth Funds. These
cash-fow-rich organizations tried buying up mining and oil companies,
but ound that Western governments were unhappy about losing national
treasures. The situation was asymmetric: it was dicultor impossibleor
resource companies to buy control o Chinese, Brazilian or Indian companies,
but the government-controlled companies were able to hymn the virtues o
ree markets as they made major acquisitions abroad. Vale bought Inco, and,
(as we bitterly complained at the time), the Canadian government sat by
as the EEC bureaucrats took geologic time to consider the implications or
European steel mills o Incos planned merger with Falconbridge. That merger
would have prevented a takeover o Inco, and would have blended the giantSudbury operations o the companies. As a result o Brussels stalling, Xstrata
was able to pick up Falconbridge, while Inco was let virtually deenseless
against Vales big bid, at a time hedge unds were huge holders o Inco
shares.
We believe that the government-controlled companies and Sovereign Wealth
Funds will eventually dominate the worlds base metal industry unless
investors collectively revise their appraisals o minings risks and rewards,
and governments in the countries where the miners are incorporated change
their purist views about takeover rights by government-controlled companies.
Five years ago, or example, Falconbridge and Inco were jewels in Canadian
portolios and RSPs. Ater the dust had settled, a Brazilian-government-
controlled company owned Inco, and a company o shadowy origins that
was partially spun-o rom the Marc Rich group owned Falconbridge. Those
outcomes are dubious tributes to the glories o capitalism and ree markets.
Those outcomes are
dubious tributes to the
glories o capitalism
and ree markets.
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THE COXE STRATEGY JOURNAL
The Next Eight Years
What now?
The mining industry has long been loathed by environmentalists. It is relatively
riendless among G-7 governments as a polluter and a big contributor to
global warming.
Nobody wants a big smelter upwind.
Nobody wants any runo o toxic chemicals into local rivers and bays. The
industry, ortunately, has devoted billions to research and construction to
make it a clean air, clean water producer o what the world needs nowand
in the uture.Global warming is a dierent kind o challenge (as will be discussed in
the Investment Environment). Cleaning up air and water pollution rom
sulphuric and other acids and metal dust is something that is being done
at costs the industry can bear. But its smelters are CO2
producers, which the
warmists have been opposing with all their connections and might.
One reason why so many investors consider the mining stocks to be high-risk is
that resource companies still suer rom what could be called G-Sevencentric-
Evaluations. For the early years o the boom, skeptics regularly dismissed
these stocks as terrible investments: Theyve been that way or twenty years,
and, apart rom the infation boom, theyve been deep cyclicals that cant
deliver good long-term returns. They dont t the stable grower model made
amous by Warren Buett, and they have, in most cases, no control over the
prices o their output. They nally get around to opening big new mines late
in one cycle, and then a recession arrives, prices collapse, and they have to
keep pumping stu out or whatever they can get. They are their own worst
enemies.
Dare we say it? Its dierent this time.
Despite the worst Crash and recession since the Depression, prices o key
industrial commodities, such as copper and crude oil, are trading at highlyprotable levels or ecient producers. The S&P is up by one-third in eight
years but copper is up 192% and crude is up 130%.
...resource companies
still suer rom
what could be called
G-Sevencentric-
Evaluations.
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One reason is that known economic reserves in politically-secure areas
have not increased, despite heavy capex in recent years. Costs o nding,
developing and producing are up sharply, which means the small and mid-cap
entrepreneurial companies that in earlier booms supplied substantial new
production (either by themselves or through being taken out by majors)
have not been able to ll those roles to the same extent this time.
Why?
Mostly because o politics.
Robert Friedland, a respected giant among mining promoters, is a modern
Gulliver, beset by Lilliputians. His superb Ivanhoe copper mine in Mongolia,
which could increase that poor nations GDP by one-third, is nally going
orward ater years o politically-driven delays. Just when it looked as i
he was on the verge o getting ull nancing, the Mongolian government
announced punitive new resource taxes. It has taken three years or him,
and his new partner, Rio Tinto, to get the government to repeal those mine-
killing levies, but investors are naturally wary that once many billions have
been invested and the ore fows, the cash-strapped government will enact big
tax increases. His vision, guts and smarts have outlined potentially gigantic
reserves in the Congo. They once looked secure because he had negotiated
rights with a government backed by the UN. Alas, as o now, his guts havent
brought glory. The Congo has reverted to its pre-Belgian pattern o bloody
tribal warare.
Where is it sae to bring on new mines?
I there arent major environmental challenges, and i local native tribes
dont claim veto powers while they sort out among themselves who has the
historic rights, then most provinces in Canadaand particularly Quebec
remain sae or miners. (Mining exploration in remote regions, as we have
been told by one o the leading contract drillers, is in Quebecoisgenes dating
back to Les Coureurs de Bois who lived, hunted and trapped in the wilds. Their
descendants are, he said, among the worlds best and most reliable workers
in the bush or jungle.)
Perhaps the best place or mining in North America is Nevada, because
the local governments are riendly and Congress has been unabledespite
decades o eortto come up with a royalty scheme or ederal lands. Result:
companies only pay regular corporate taxes. The miners have strong support
in Washington with Harry Reid as Senate Majority Leader, and he gets help
rom Senators in other states with substantial ederal lands.
Robert Friedland,
a respected giant among
mining promoters,
is a modern Gulliver,
beset by Lilliputians.
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Conclusion
The base metals and coal are the purest Chindia plays among the ourcommodity asset classes (base metals and coal, precious metals, energy, and
agriculture). Among those metals that trade on the exchanges, the China
infuence is powerul; or those steelmaking ingredients that trade by overseas
contractiron ore and metallurgical coalChina is the price-setter.
We underweight these stocks within our recommended commodity stock
portolio because they have the highest economic risk o the our classes,
and have the most to lose i the global economic recovery alters when the
nancial heroin supply dwindles. Chinas inventory policies are opaque,
and base metal contangos in the metal uturesmost notably in aluminum
stimulate speculative activity that makes valuations vulnerable to major sell-os.
However, the base metals may well have the best upside potential o any
group whenor ioverall global economic growth resumes and investors
no longer have reason to worry about metal price bubbles.
We expect to boost our recommended exposure to the base metals sharply
this year, as our concerns about a double-dip US economy ade.
China is the price-setter.
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II The Latest Chapters in the Financial Crisis
The best moment or us, in our continuous coverage o the debate about the
nancial crisis was Obamas response to the Massachusetts Tea Party shock,
in which an obscure, centrist-conservative state senator named Scott Brown
won the Senate seat that had been under Kennedy amily control since 1952.
Within hours, Obama announced that he was endorsing Paul Volckers banking
reorm proposals (which we endorsed enthusiastically in our last issue). Then
we heard that Barney Frank and Chris Dodd would be proposing the reorms
in their respective committees. The surprise at being on the same page at the
same time with Obama, Frank and Dodd recalled or us the time we absent-
mindedly wandered into the wrong restroom at OHare.
The worst moment or us was to come two days later. Mr. Volcker appearedbeore the Senate Banking Committee, whose members are the objects o
Wall Streets tenderest attentions and most generous gits. The Democrats
were, in the words o Wodehouse not exactly disgruntled, but they werent
gruntled either.
The Republicans were more openly hostile. Republican Senator Richard
Shelby o Alabama became the Brutus in this latest Capitol drama. As The
Wall Street Journal described it, He questioned Mr. Volcker in a ashion that
suggested the utmost respect or a great hero o economic crises past and the
patronizing condescension one would give an 82-year-old suspected o being
out-o-touch with the modern nancial world and, perhaps, a bit senile..Mr. Shelby has taken $2 million rom nancial interests, more than double
the contributions rom the next leading industry.But thats how it is in
Washington these days. Unlike the Congress o the 1930s this body is more
beholden to politics than to reorming a broken system that has put the
American economy in a hole so deep the competitiveness o every American
industry is now in question.
Ater Shelby announced his opposition, other Republicans rushed, Gadarene-
Swinishly, to join him, and the Democrats quietly withdrew rom the scene,
unwilling to mount a ght that their biggest donors opposed.
Shelby may well be remembered as the Capitol killer who destroyed the
rescue program oered by the man who could reasonably be regarded as a
short-list candidate or the noblest American o them all. Prior to shating
Volcker, he was best-known or holding up 70 ederal appointments o all
kinds because he demands approval o a big tanker deal or his state.
Ater Shelby announced
his opposition, other
Republicans rushed,
Gadarene-Swinishly,
to join him...
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Another o the central gures in the book, JP Morgans Jamie Dimon, who is
one o the most vocierous and powerul o the Wall Street barons, was upset
with Volckers proposals. He deended the Street, saying that a crisis comes
every ve to seven years.
Really?
Will that go into history as the Morgan equivalent o Chuck Princes
memorable, As long as the music is playing, youve got to get up and
dance?
The Crash wasnt some Seven-Year Hitch. And even ater nearly two years
o multi-trillion spending, 8.5 million Americans are unemployed, and the
stock market is where it was twelve years ago.
Nor was all this misery necessary. Had the B5 and their bankerly brethren
not pigged out on their ancy, impenetrable CDOs and CDSes, that Buett
and Volcker had routinely derided as socially useless and outright dangerous,
there would have been no Crash, and no recession.
In general, Wall Streets words o repentance and its acceptance o meaningul
reorm are as impressive and reliable as the investment quality o the average
sub-prime CDO that theyd love you to buy.
That doesnt bode well or the nancial recovery on which the nation
depends.
On the other hand, the KRE is looking better in recent weeks. I its relative
strength continues through a stock market correction, we would be looking
or the time to give the All Clear signal to investors.
Wall Streets words
o repentance and
its acceptance o
meaningul reorm
are as impressive
and reliable as the
investment quality
o the average
sub-prime CDO...
KBW US Regional Banking ETF (KRE) relative to S&P 500
January 1, 2009 to February 18, 2010
50
60
70
80
90
100
110
Jan-09 Mar-09 May-09 Jul-09 Sep-09 Nov-09 Jan-10
69.25
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III Turning of the Tide?
When the nancial markets and economies imploded, Letist publicists and
politicians could barely conceal their satisaction: at last the era o greed that
began with Reagan and Thatcher and spread across the world so obscenely
ater the collapse o Bolshevism was over. Voters everywhere would now,
nally, demand socialist-oriented policies. Letist parties would transorm
the political landscapes o the world. Greed is dead! Government is no longer
the problem, it is the solution!
Except that it hasnt been turning out that way. Consider Europe: Apart rom
Greece and Spain, two o the Mediterraneans members in the Eurozones
amily o PIIGS (Portugal, Ireland, Italy, Greece and Spain), elections have
been going or center-right or conservative parties. Admittedly, in Latin America, the tide toward the dictatorial Let in Venezuela, Ecuador, and
Argentina, which began even as most o that region was turning to the Right,
is continuing. But even in those dens o political stench, the caudillos are now
having trouble holding down political discontent.
The most important conrmation o this trend toward normalcy came in
last years election in India, in which the center-right Congress party o
Manmohan Singh was returned with a larger majority.
We have commented on these reassuring trends previously. Now we must take
note o something that could be even more momentous: the tide in bondrisk appraisals away rom sovereign credits toward high-quality corporate
bonds. As voters seem to be moving away rom reliance on Big Government
and looking to the business community to revive their economies, bond
investors have begun to migrate rom the debt o hideously over-indebted
governments to the debt o well-managed companies that will be part o the
economic progress o uture years.
If, as we expect, this trend continues, it would be one of historys greatest sea
changes in bond investing.
Harvards Kenneth Rogo may have helped set o this swing among bond
investors with the publication o a remarkable history o debt deaults over
six centuries. He shows that the list o countries which have never deaulted
on their own debt is a handul. (Canada, by the way, is a member o that
virtuous group.) The record o European, Asian and Latin American countries
is enough to make a moralist weep and a sovereign bond investor consider
hemlock as an alternative acquisition. Rogo asks why sovereign credits are,
The record o European,
Asian and Latin
American countries
is enough to make a
moralist weep and
a sovereign bond
investor consider
hemlock as an
alternative acquisition.
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according to banking system rules, always ranked higher than any corporate
credits. He shows that many o the biggest corporations have never deaulted.
He is, in eect, challenging the Basel rules which provide that a bank holding
Greek bonds does not need to allocate capital or that investment, whereas
i it holds Exxon Mobil bonds, it does. As Mr. Bumble would say: The law
is a ass.
The new doubts about sovereign credits are based on the rapidly-unolding
evidence that governments unionized employees salaries, pensions and
health care have created a huge new class o winnersand ew governments
can aord what previous governments promised to the privileged. Watching
the striking unionized government employees screaming threats in Athens,
we realized that those peoplewho retire as early as 58 or no later than 63
with great pensionsmay have more to argue about with most o their ellow
citizens than the Greeks had with the Trojans. (Our avorite rioter quote,
We gave the world democracy: now its time to pay us back.) Athenian
democracy disappeared 23 centuries ago, and only returned when Truman
intervened ater World War II to prevent the USSR rom taking over. Greeces
democratic perormance since then suggests that the genes o Pericles and
Solon are extinct.
In other words, manyi not mostgovernments are struggling under the
piled weight o all the sweetheart pension and union promises o the past,
while the economies on whose taxes they rely are orced to compete in thepresentand ace a uture o increasingly ormidable competition rom
economies that were deemed irrelevant when those costly promises were
made. To add injury to destiny, they have to bail out bad banks and insurers.
Why buy the paper o sovereign issuers that keep going deeper into debt and
have no realistic programs or doing better? (Although the dollar currently
benets rom the Greek-driven rush out o the euro, the IMFs calculation
o current decit to GDP ratios puts the US in Greeces league. Only the
USs reserve status allows Washington to keep boosting wages and benets
to government employees while the private sector languishes. According to
one study, the number o Federal employees earning more than $150,000per year has doubled in the past 18 months.)
I people are collectively beginning to mistrust Big Government and Zero
Interest Rates, then it should be no surprise that investment-grade nonnancial
corporate credits gain on governments almost every week.
Greeces democratic
perormance since
then suggests that the
genes o Pericles and
Solon are extinct.
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Until recent months, the United States seemed to be an exception to this
rule that governments were moving rom the Let toward the center-right.
Mr. Obama ran as a centrist against the record o a aux conservative who
had added a huge new entitlement (Prescription Drugs) and a major ederal
intrusion into school systems (No Child Let Behind), and drove the US into
a war based on botched intelligence about WMDs. Result: a big rise in scal
decits and the national debt. Bush also ailed dismally by kowtowing to
the Fannie Mae and Freddie Mac backers in Congress who kept legislating
reductions in down payments and credit ratings or mortgagors. Despite
strong support rom Congressional Republicans and Allan Greenspan, he
caved in to the Congressional Democrats who kept insisting that Fan and
Fred posed no risk whatever to the nancial system.
Inheriting this mess and a ull-blown nancial crisis, Obama proceeded
to surprise many o his supporters by introducing massive, costly new
ederal programs in health care and global warming. The result: decitsin
both the short and long-termar above earlier estimates and the kind o
rising political discontent that opens the doors to populists. As early as the
Midterm elections, i current polls hold, the US will have rejected dreamy
progressivism, and will, at least supercially, more closely resemble the
political trends abroad. (Whether the new winners in November will prove
to be sensible centrists and moderate conservatives remains to be seen, and
the auguries at this point are hardly encouraging.)
Obama has had one big stroke o luck recently. The Euro-turmoil about
Greece and the other PIIGS has orced China and other central banks to
reconsider their reduction in Treasury buying in avor o buying Eurozone
bonds. Major investors had been warning o a coming crisiswith sharply
rising interestas projections or US decits kept climbing. The White House
Budget oce minions kept grinding out reassuring gures about global
demand or Treasurys. Those geeks should thank the Greeks.
Conclusion
I the big bosses o the Big Government trend are losing public condence,then, at some point, private investors and pension unds will decide to build
some longer-term protection into their unds against worsening economies
and the rapidly-deteriorating quality o ederal and state bonds.
Theres a our-letter word or the clear alternative to all these machinations
and program and decits and bad bank paper: gold.
The White House Budget
ofce minions kept
grinding out reassuring
fgures about global
demand or Treasurys.
Those geeks should
thank the Greeks.
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IV The Precious Metals
Gold
January 1, 2002 to February 17, 2010
Silver
January 1, 2002 to February 17, 2010
Platinum
January 1, 2002 to February 17, 2010
200
400
600
800
1,000
1,200
1,400
Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10
1,120.10
0
500
1,000
1,500
2,000
2,500
Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10
1,609.80
0
500
1,000
1,500
2,000
2,500
Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10
1,537.10
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Goldcorp (NYSE: GG)
January 1, 2002 to February 17, 2010
0
10
20
30
40
50
60
Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10
38.65
Newmont (NYSE: NEM)
January 1, 2002 to February 17, 2010
0
10
20
30
40
50
60
70
Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10
47.24
Kinross (NYSE:K)
January 1, 2002 to February 17, 2010
0
5
10
15
20
25
30
Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10
18.50
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Among the biggest metal stories since the last Resources Conerence have
been the dramatic run-up in gold prices, and the announcement o Barricks
unwinding o its hedges.
Barricks hedging program was the right big thing during the years o golds
Triple Waterall collapseand the wrong big thing once gold had entered a
new long-term bull market. The Barrickvolte-ace helped drive gold prices to
new heights.
For decades, many gold companies executives and promoters spoke longingly
o the coming Golden Age when gold would trade at $1,000 an ounce. Gold
nally broke through that magic barrier last September, and has remained in
The Promised Land since then, but gold mining stocks (as measured by the
XAU) peaked out weeks ago.
As we wrote in December (Financial Heroin), when gold broke into Four
Digitland, it suddenly began to look less like a store o value and more like
a speculators plaything. Why was gold running wild? We cheekily suggested,
as historians, that this moment in metal history could be driven by dates o
the past. According to this dubious hypothesis, golds rst target should be
1066 (The Battle o Hastings), the next 1215 (Magna Carta), with a near-
term peak o 1258 (The Provisions o Oxord) and a one-year target o 1345
(Onset o The Black Death, which began to ade away by 1350). Bullion
bounced all the way to Magna Carta beore the mini-bubble burst and gold
plunged briefy back, bottoming outat 1066.
What converted so many skeptics into chrysophiles was (1) Barricks
capitulation to market orces, and (2) word that the Government o India
was buying 2,000 tonnes o gold rom the IMF or its oreign exchange
reserves. Analysts also noted that the list o European central banks who
were not taking advantage o their gold selling rights under the Washington
Agreement seemed to be gaining new members.
The new elixir or gold investors and gold bugs alike: what happens i (1) all
the central banks in the Washington Agreement stop selling and start buying
and (2) China and other heavyweights decide to put a meaningul percentageo gold into their orex reserves? As gold broke through $1,000, that kind o
buzz began to spread, and, ater thirty years in which gold bugs talked o
Gold at a thousand, suddenly the new target was $2,000. The wise Pope
(Alexander, that is), would understand:
Hope springs eternal in the human breast.
Man never was, but always to be blest.
Gold fnally broke
through that magic
barrier last September,
and has remained in
The Promised Land
since then...
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We have advised those who, terried by soaring global scal decits and
global liquidity, talk o a rush to cash by selling most or all their equities that
gold could be the optimal investment under both extreme outcomes.
Since we regard cash as an unattractive asset or investors who ear Depression
most (they should own long-duration high-quality bonds instead), we argue
that a holding o gold and gold stocks oers excellent protection under both
extremes, and attractive potential under a regime o moderate infation and
modest recovery.
Gold was the best investment during the Rooseveltian 1930s and the
Carteresque 1970s. Mr. Obama seems at times to be a blend o those two
Democratic Presidents. The rst was a condent, charismatic interventionist,
whose economy was actually rescued by World War II; the second was a well-meaning, yet inept, President who seriously weakened America at home and
abroad. Nothing became him in his Presidency as the leaving o itrst, by
giving the world the git o Paul Volcker, and then by losing to the reormist
Ronald Reagan. While on vacation, we spent some time watching Obama on
TV. We ound him even more impressive than we had thought previously.
What hes peddling may well be the wrong answers to our problems, but his
charm and energy are inectious.
Such bad news as there has been about gold recently has been conned
to disappointing news rom some o the major gold mining stocks that
unleashed big sellos.
We have held some o these recently-wounded companies in our Fund (The
Coxe Commodity Strategy Fund) because o our belie that long-duration
unhedged reserves in politically-secure ground meant they were better than
bullion in a bull market or gold.
Why? Because all mining (and oil) companies report reserves on the basic
o economically-recoverable minerals. I gold were back at $250, total
mineable gold reserves might be barely adequate to meet the collective bling
demands o all Grammy winners. Conversely, were it $2,000, new-mined
gold production would surge past current levelsbut it wouldnt double:There aint enough gold in them thar hills.
Miners report three kinds o mineral reserves: proven and probable reserves,
and resources. The latter category is generally lower-grade, has not been
drilled out in detail, and may have been estimated primarily by geophysical
and geochemical techniques.
I gold were back at
$250, total mineable
gold reserves might
be barely adequate
to meet the collective
bling demands o all
Grammy winners.
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One reason a big boost in bullion prices has not meant a big jump in gold
productionbut was actually accompanied by declining outputis that
the kinds o mining companies in which you should invest are those who
recognize that each ton o ore taken out o the ground brings the mine closer
to closure. A mines closing is painul or stockholders and management, but
is usually a disaster or a community. Thereore, responsible mining means
mining some lower-grade ore during periods o high metal prices to expand
mine lives. This not only serves the community, it protects the value o the
companys biggest assetthe mine. This was illustrated a while back when
Freeport McMoRan announced a slight reduction in its copper and gold
output, which meant earnings came in modestly below the estimates o some
Street analysts. Some o these responded with criticisms o managements
ailure to execute, and argued that shareholders should reconsider theirapproach to the stock.
These criticisms bespoke not sophistication, but ignorance.
When copper and gold prices soared, that gave Freeport the chance to mine
some lower-grade sections o its Grasberg mine, thereby extending its lie
and smoothing its earnings growth.
The idea o steady, uninterrupted, and predicted growth in per-share
earnings is a construct o modern portolio theories about what makes good
investments. It doesnt work with commodity companies, because the prices
o their products are subject to wide swings over time. As applied to mines,
that valuation technique makes as much sense as giving the Academy Award
to the actress whose acial expressions are the most predictable.
Thats one reason why we do not recommend giving the highest recognition
to mining analysts who make the most accurate short-term earnings orecasts.
We rely most on those analysts who have real understanding o the nature
and challenges o each o the mines a company is operating or is planning to
open (or re-open), and the managements longer-term strategies.
Nevertheless, rising metal prices will almost always mean increased ore
reservesand in some cases, the results can be dramatic. There are hugeore-bodies in politically-secure areas o the world that are virtually worthless
at $1.25 copper and $600 gold but can be bonanzas at $3.00 copper and
$1100 gold.
...that valuation
technique makes as
much sense as giving
the Academy Award
to the actress whose
acial expressions are
the most predictable.
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We have argued that investors should overweight the gold mines and
underweight the bullion i they are bullish on the metal, and reverse the
strategy i they turn bearish on the metal. Quite simply, higher gold prices
not only mean more prots rom existing reserves, but likely mean major
additions to published reserves. You winor losetwo ways on a signicant
move in metal prices.
There is one other alternative orm o precious metal investing that we have
employed in the Coxe Commodity Strategy Fund: the royalty and streaming
companies. The pioneer in this eld was the original Franco-Nevada, which
was merged away, but has since been reincarnated. It has acquired some
imitators and competitors, but the eld doesnt yet look so overcrowded
that investors returns will shrink. These companies dont operate mines:
they buy percentage shares o the output, either on an overall basis, or one
component part o the productionusually a precious metal. A relatively
recent entrant to this entrepreneurial sectorSilver Wheatonillustrates the
most impressive eature o the concept: According to The Northern Miner, the
company has the highest market capitalization per employee on the New
York Stock Exchange23 employees or a $6 billion company.
...investors should
overweight the
gold mines and
underweight the
bullion i they are
bullish on the metal,
and reverse the
strategy i they turn
bearish on the metal.
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Conclusion
The latest published estimates or global scal decits this year and last are$14 trillion. Dennis Gartman quotes a riend who explains a trillion by saying
that a pile o US $100 bills totaling a trillion dollar would be 800 miles high.
Conversely, all the gold on earth could be held within a ew bank vaults.
It is less than a century since all major currencies became non-exchangeable
into gold (or, the case o US, silver). That is, in human experience terms,
a brie interval. During that time there have been two World Wars, many
lesser wars, one Great Depression, many recessions, and many localized
depressions. The purchasing power o the greenbackthe global store o
valuedeclines year in, year out.
Since the invention o paper money and the development o oreign exchange
markets, there has never been a time when the central bank o almost every
industrial nation in the world that matters is pumping out money at near-
zero nominal ratesand government decits continue to explode, while
demographies in the G-7 countries continue to erode. Long beore the ty-
year bonds o some European countries mature, the workorces o their
issuing countries relative to retirees will have plummeted to levels that are
insupportable under almostanyeconomic theory.
When the sum o existing debts, present decits, and uture projected decits
is so ar beyond human experience, investors should go back to the OldReliable: There may never have been a time where Gold had a better claim to
inclusion in all portolios dedicated to wealth conservation.
What has long been the popular metaphor or a sure-re money-making idea
o almost any kind?
Its a gold mine.
Exactly.
What has long been
the popular metaphor
or a sure-fre
money-making idea
o almost any kind?
Its a gold mine.
Exactly.
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V Is a Fertilizer Producer a Mining Stock or an Agricultural Stock?Or Does It Matter?
For months there had been growing speculation that the big mining
companies were going to add ertilizer to their product mix.
Then, within weeks, Vale bought Bunges Brazilian ertilizer operations, and
BHP bought a small Saskatchewan ertilizer wannabe, Athabasca Potash.
BHP has long held rights to potash permit land around the main producing
properties o the giant Potash Corporation, and is developing a potash mine
(Jansen) that adjoins Athabascas leases.
(Not that the miners are the only buyers: the worlds biggest ertilizer
company, controlled by the Norwegian government, bought a US nitrogen
producer this week. Its not only a big deal, its positively poetic: Yara bought
Terra.)
Several brokers have been fatly predicting that BHP will buy Potash, a
company whose stock has recently languished in response to disappointing
earnings:
Potash (NYSE:POT)
January 1, 2002 to February 17, 2010
The CEO o Potash, the messianic Bill Doyle, who is almost never rufed,
recently complained that BHP is trying to buy ertilizer companies on thecheap.
Why did BHP move into agriculture? Answer: its so big it has to think big.
Since BHP was rustrated in its attempt to buy Rio Tinto, it has what most
companies would consider a lovely challenge: how to reinvest its powerul
cash fow.
0
50
100
150
200
250
Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10
115.20
...its positively poetic:
Yara bought Terra.
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Canadas ederal Cabinet was only slightly more involved in the Falco-Inco
takeover battles than were the Commissioner o the National Hockey League
and the artistic director o the National Arts Centre. So Ottawa should not
be considered the premier player i Potash is the prey. The Saskatchewan
government, one o Canadas most quietly competent, should, in our view,
set up an inormal committee within the Department o Agriculture or the
Department o Finance to prepare a position paper on the provinces response
to any uture takeover bid.
We greatly admire the management and ethics o BHP, but we eel that the
people o Saskatchewan should be heard i Potash Corpa true national
treasure (even though its top management resides near Chicago)control is
at stake. A thousand years is a long time or remorse.
Canadas ederal Cabinet
was only slightly more
involved in the Falco-Inco
takeover battles than
were the Commissioner
o the National Hockey
League and the artistic
director o the National
Arts Centre.
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INVESTMENT ENVIRONMENT
For investors worried about anemic growth in the G-7, industrial commoditiesand commodity stocks may look highly risky, ater their dramatic snapbacks
rom the Depression ears o a year ago.
We talk rom time-to-time with pension unds about the attractions o
commodities, and requently nd great willingness to consider new or
increased allocations to this sector despite all the worries about decits and
unemployment in the developed world.
In the US, many pension und managers and consultants cite a paper
recommending commodity investing published our years ago by two Yale
proessorsGary Gorton and Geert Rouwenhorst. The Financial Times last
week interviewed them about how their orecasts had worked out, given
that prices in the years ollowing the reports publication moved in tandem
with other asset classesAs stock markets plummeted worldwide in 2008,
commodities ared just as badly. The academics seemed unrufed, still
maintaining that Over a long period, commodity utures returns match
equities but with a negative correlation.
Their work tends to conrm our riend David Rosenbergs cogent analysis that
commodities and equities move in dierent long wavesand that equities
are still in a long-term bear market, whereas commodities are still in a long-
term bull market.
What does that imply or commodity stocks? Can they be in a long-term bull
market while the major equity indices are still in bear markets?
We believe that well-managed commodity companies oer investors the
opportunity to position themselves in the industries that are perorming
more strongly than the global economy, while under-exposing themselves
to shares in companies whose market caps refect the way the advanced
economies used to be when the industrial world was still industrializing
rapidlyas was its supply o citizens under age 25.
That was beore the combined impact o negative demographies, disastrouslyengineered nancial behemoths, and overburdened governments brought
the developed worlds global economic leadership to an end.
Car drivers drive by watching the road ahead, with requent checks to the rear-
view mirror. Northrop Frye, one o Canadas most renowned intellectuals,
argued that the best way to travel across Canada by train was to ride seated
backwardwatching where you have been.
...equities are still
in a long-term bear
market, whereas
commodities are
still in a long-term
bull market.
Hard Rocks and Hard Shocks
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The major equity indices oer that vistayou know the companies, you
know their competitive positions, and you know which products and services
have been their growth engines. This is ordinarily comorting, compared to
the neck strain rom trying to peer into the landscape ahead.
Commodity stocks are the asset class that should be priced mostly by appraisals
o the uture o the global economy. They are the pre-eminentglobal asset class
because the materials the companies produce are priced internationally, and
are tied to rising demand in the astest-rising economies. These economies
are the Global Olympiansyoung, competitive and optimistic. The advanced
industrial economies are rapidly becoming the equivalents o the high-end
gol and country clubs where the successul people whove already made
their wealth come to retire, play and drink with their own kindand where
they dont have to compete with aggressive young upstarts.
Governments debts are the accumulated buildup o cumulative spending
growth above GDP growththe underpayments made by earlier generations
or the rewards their politicians showered on them. They are an ever-present
reminder o past budget antasies.
Investors have begun the momentous process o re-evaluating the endogenous
risk in the pre-eminent backward-looking asset classOECD government
bondscompared with high-grade corporate debt, which is priced the
way drivers drive carslooking orward most o the time, with occasional
shoulder checks.
But, you ask, dont government bond prices refect perceptions o uture
decits? Yes, governments, economists and investment rms routinely
publish projections o uture public debt situations.
However, apart rom basket cases like Greece, those longer-term guesstimates
seem to have little or no eect on bond prices today. Else why would 30-year
Treasurys oer a nominal yield o just 4.6%, when the range o uture US
national debt estimates is rom the deeply worrisome to the utterly terriying?
Obamas own orecasts are or endless decits, even though they predict
strong economic growth orever, no real increase in infation, and only a onepercent rise in long Treasury yields. The nations debt/GDP ratio is widely
predicted to be heading within a very ew yearsinto the Mediterranean
Eurozonethe Twilight Zone or risk-conscious investors.
These economies are
the Global Olympians
young, competitive
and optimistic.
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In contrast, blue-chip corporate debt sells based on the current balance sheet
and on assumptions about managements commitments to restrain uture
bond issues in line withor less thanactual earnings growth. Were IBM to
announce it expected to lose money or the next decade, but by then it would
dominate the computer service business, the yield on its outstanding bonds
would skyrocket, and it would be eectively priced out o the bond market.
So, what about the evaluations o commodity stocks?
The good mining companies should be priced three ways: the past, the
present, and the uture:
The past is there in the orm o the existing mines and reserves;
The present is there in the orm o earnings and new discoveries.
The uture is there in the orm o expectations about the growth o Chindia
and other emerged and emerging economies, and the companies abilities
to position themselves or even greater uture protability as hundreds o
millions o new consumers vie or the products that will come rom the
manuacture and use o commodities.
We place the greatest emphasis on the uture, whereas the Street tends to
downgrade it, posting long-term base metal price orecasts that plunge to
levels last seen in 2005 or thereabouts. We disagree strongly with those uture
earnings projections and question why any smart investor would want to payup or mining stocks that supposedly ace grim years later in this decade
and beyond. Peddling stock with a orecast o uture sustained gloom rarely
worksexcept or selling box seats or Wrigley Field.
The endogenous risk or the well-managed mining companies compared to
the broad stock market is much less than most backward-looking conventional
strategists assert, and the uture protability is greater than most analysts
dare to predict.
Peddling stock with
a orecast o uture
sustained gloom rarely
worksexcept or
selling box seats or
Wrigley Field.
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The Global Warmists Crisis
Global warming began to emerge as the new challenge to the economies
o the industrial world ater the Fall o the Berlin Wall and the subsequent
implosion o Bolshevism. The devastated global Let ound a new cause
that, by attracting support rom across the political spectrum, could give
Big Governments even greater power than they exercised beore Reagan and
Thatcher made capitalism ashionable.
Crucial to warmisms rapid rise to power was its insistence that the science
o global warming was settled. Dissenters within the scientic community
ound themselves marginalized and ridiculed, and their access to publications
restricted.
The Nobel Peace Prize awarded to the UNs Intergovermental Panel on
Climate Control (IPCC) and Al Gore sanctied the cause. The Copenhagen
Conerence was to be the occasion at which the industrial world would not
only pledge itsel to imposing strict controls on its practices, but would
pledge up to $100 billion in payments to the Third World in reparation or
the damages to emerging economies rom Western industrialization, and to
assist its members in achieving climate-sensitive economic growth.
Then the settled consensus began to become unsettled:
Firstcame Climategatethe thousands o hacked emails that showed
the extent to which the scientic dogmatists went to cover up embarrassingdata and discredit their opponents.
Secondwas Copenhagen. TV viewers across the world saw rioters in the
streets and socialists like Hugo Chavez getting standing ovations when
they demanded the end o capitalism. No deal was reached.
Third was the revelation that the IPCCs headline claim that the great
Himalayan glaciers would disappear within 35 years was as scientically
based as reports o conversations with a Yeti (The Himalayan Bigoot).
The one scientic paper used or that scary claim had actually talked o
the possibility they would disappear by 2350, but the basis o the IPCCassertion was anecdotal reports rom a ew enthusiasts at the World Wildlie
Foundation (WWF), which had long ago morphed rom saving pandas to
ghting warming.
Fourth came the report rom Swiss glaciologists that the Davos Glacier, the
most infuential ice sheet on world opinion, had not shrunk because o
global warming but because o eight years o ar-above-average sunlight.
...the IPCCs headline
claim that the great
Himalayan glaciers
would disappear
within 35 years
was as scientifcally
based as reports o
conversations with a
Yeti...
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Fith came Amazongate. The IPCC had leapt into the cause to save the rain
orest by claiming that a huge percentage o orestland aced destruction
rom warming. Now it was revealed that the only basis or that scientic
alarmism was an article written by a pair o youthul global warmists with
scanty scientic credentialsone o whom worked or the WWF.
Sixth came the saving o Holland. The IPCC had reported that, because o
rising oceans, 55% o the Netherlands was below sea level. Dutch scientists
showed that the part o its landmass protected by dikes was a small raction
o the nationand it hadnt shrunk recently.
Seventh came the conessions o Phil Jones, the ormer head o the East
Anglia climate institute whose emails had been hacked. He had been put
on leave ater the scandal broke. He admitted that their studies showedno statistical evidence that the world had been warming since 1995, and
that the historical records showed the world was warmer 1,000 years ago
than now. He said that what was needed in coming years was a return to
peer-reviewed research.
More and more conessions and revelations come out each week.
This week, the big business alliance that had been backing Obamas Cap and
Trade bill began to unravel, as BP, Caterpillar and Conoco Phillips pulled out.
Its biggest remaining member is General Electric, which has built its business
model on building alternative energy devices. The legislation is stuck in theSenate, and it now looks as i that will be its tomb.
The record snowalls across the Southern and Eastern US cheered the
opponents o global warming, but the warmists point to the problems or
the Vancouver Olympics to argue that, as they said all along, warming meant
wild weather swings, so a snowbound Washington is actually proo o their
claims. On balance, those snowalls were urther bad news politically or
warmistsbecause o their impact on ordinary peoples perceptionsbut
they certainly werent decisive. What matters most is the week-to-week
accumulation o evidence that the science o warming has to go back to
the drawing boards. There is no chance now that voters in the developedworld will support governments that impose heavy burdens on their own
economies, while sending billions in reparations to the newly industrializing
nations that have become such ormidable competitorsand ormidable
polluters.
What matters most
is the week-to-week
accumulation o
evidence that the
science o warming
has to go back to the
drawing boards.
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The investment implications are immense:
Coaliscomingback,andWarrenBuffettsbetonBNSFwillpayoff. The Canadian oil sandswillprobablynever get supportfrom the
environmental elites, but the odds that the US will ban imports o
Canadian heavy oil now range between slim and none. Moreover, the
supposed global consensus demanding the shutdown o the oilsands
soon will be history. Suncor and the other producers can start breathing
more easilyand investors who dumped their shares to prove their green
virtues may begin to reassess their decisions.
TheUSEnvironmentalProtectionAdministrationscarte blanche to involve
itsel in business decisions across the economy will probably not outlive
the US Midterm elections. That is good news or the US economyand
particularly or transportation and industrial companies.
The businessmodelof Blood&Goremayhaveto undergo some
revisions.
No one has proved that man-made global warming does notexist.
But, week by week, more and more people across the world will come to
believe that no one has proved beyond reasonable doubt that it does.
The game has changed.
Is Bernanke Running Out of Heroin?
As we were going to press, Bernanke announced a boost in the Discount
Ratethe ee or short-term emergency loans to banks. He also announced
there would be no change to the ed unds rate. Commoditiesparticularly
goldwere hit hard. We see this as central bankers cosmetology---not
surgery. He doubtless would love to abort the commodity recovery, which
was conrmed by a big surge in the Crude Goods component o the PPI.
As an economic historian, he knows that indicator was the one that, in the1970s, rst fashed powerul evidence o the stagfation to come. The only
capital punishment open to him is closing down bad banks. He cant shoot
the infation messenger.
The business model
o Blood & Gore may
have to undergo
some revisions.
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RECOMMENDED ASSET ALLOCATION
Allocations Change
US Equities 17 unch
Foreign Equities
European Equities 5 unch
Japanese and Korean Equities 2 unch
Canadian and Australian Equities 11 unch
Emerging Markets 14 unch
Bonds
US Bonds 12 unchCanadian Bonds 8 unch
International Bonds 11 unch
Long-Term Infation Hedged Bonds 10 unch
Cash 10 unch
Years ChangeUS 5.25 unch
Canada 5.00 unch
International 4.50 unch
Recommended Asset Allocation(for U.S. Pension Funds)
Bond Durations
Change
Precious Metals 33% unch
Agriculture 30% 3Energy 22% unch
Base Metals & Steel 15% +3
Global Exposure to Commodity Stocks
We recommend these sector weightings to all clientsfor commodity exposurewhether in pure commodity
stock portfolios or as the commodity component ofequity and balanced funds.
Hard Rocks and Hard Shocks
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INVESTMENT RECOMMENDATIONS
1. This is assuredly an inopportune time to increase equity exposureandan opportune time or prot-taking.
Major stock indices are breaking down. For the S&P, it would take only
an 8% retrenchment rom its current level to break the 200-Day Moving
Average, and take the index to late summer levels.
2. Maintain a strong overweighting in commodity stocks within equity
portolios.
3. Maintain high exposure to gold bullion and the gold miners whose
production comes rom politically-secure areas.
The core belie system or gold is that governments cant be trusted. Investing in
miners dependent on the sustained honesty and wisdom o conspicuously dubious
governments may work out or a time, but the principle behind that strategy is
oxymoronic.
4. Investors should overweight base metal miners within the cyclical
component o their equity portolios.
The base metal miners earnings have come back aster than all but the
most optimistic would have predicted when the worlds crisis managers
were engaged in panic-driven ad hoc strategies to avert a Depression. Few
investors grasped the signicance o the act that the new players on the
global blockChina and Indiawerent even in recession. Result: metal
inventories never mounted to levels that would have imperiled major
miners.
5. Here is a strategy or corporate clients to consider: borrowdont
buydebt denominated in euros.
The Eurozone, justly renowned or its liberal dispensations o pork, barely
emerged rom the Crash beore being aced with a big PIIGS (Portugal,
Ireland, Italy, Greece and Spain) problem. Germany has a veto on any
orm o bailout or the big spenders, and German voters were never givena chance to vote on whether they really wanted to swap their beloved
Deutschemarks or euros. Canada recently demonstrated its smarts by
borrowing heavily in euros.
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Coxe Advisors LLP 2009. All rights reserved. Unauthorized reproduction, distribution, transmission or publicationwithout the prior express written consent o Coxe Advisors LLP (Coxe) is strictly prohibited. Coxe is an investment adviser
registered with the U.S. Securities and Exchange Commission. Nothing herein implies that the rm is recommended or
approved by the United States government or any regulatory agency.
Inormation, opinions, estimates, projections and other materials (reerred to collectively herein as, Inormation) contained
herein are provided as o the date hereo and are subject to change without notice. From time to time, Coxe publications
may contain Inormation with regard to securities, commodities, derivatives or other investment assets (each reerred to
herein as an Investment, or collectively, the Investments), or investment strategies. Due to staggered publication dates,
any Inormation contained herein may dier rom Inormation contained in prior or subsequent publications. Inormation
discussed herein may have been obtained rom various unaliated third party sources beli
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