Letís do some housing math.  Last fall there were about one million delinquent mortgages.  Let us presume the current figure is now fifty percent worse ñ i.e. one point five million homes.

Assume that the average delinquent loan has a face value of about $180,000, and that a typical mortgage would have a term of from 15 to 30 years to maturity.  Under normal circumstances the borrower would be required to pay about $10,800 per year in interest and principal to amortize the loan.  Because of the variable rate mortgages this cost would be about $20000 per year per loan.

We are told that the housing crises is the cause of the current financial problems of the banking industry and  that fixing the housing crises is a critical first step in restoring financial stability to the economy. On a worst case basis presume that all delinquent mortgages are in default, which is not true because some of the borrowers could make partial payments or could pay if the terms of the mortgages were renegotiated.

The annual cost of the delinquent payments would be $30 billion.  Are we to believe that for a cost of less than $2.5 billion per month all of the defaults of all of the banks on all of the sub prime mortgages could be resolved?

Why then are we talking about payments to banks and financial institutions of more than a trillion dollars? Is there no one in Washington that does the math? Wait, you say, the problem is more difficult. You are right, other complications must be considered.

If the Federal government, on a temporary basis, guaranteed the monthly payments of the mortgages that are delinquent, the banks would have no reason to presume, as they do, that the outstanding balance of the loan is in default.  When banks make this presumption they deduct the total value of the loan from their reserves.  They declare this amount to be a loss which impacts their capital account. The formal declaration of loan default triggers a secondary default of derivative securities for which the sub prime mortgages are collateral. This in turn activates the credit default swaps obligations.

Housing market foreclosure proceedings and the subsequent sale of assets by public auction creates an environment of pure opportunism in which there is no floor price.  The structure of the market encourages instability and low pricing.  This procedure obviously has a negative affect on the whole real estate market.

With respect to renegotiation of troubled mortgages the method of evaluation of property is important.  In a stable, unemotional market the value of a home would be the replacement cost plus the value of the land.  Both factors can be reasonably determined by skilled evaluation. In some instances the land could, in fact, have only nominal value.  In any normal market the value thus determined should represent the minimum basic price at which a house would be sold and also the value for mortgage purposes.

Let us take a typical sub prime home with a 10 year variable rate loan, now at 11%, in the amount of $200,000 which is now under water by $50,000.  The ownerís monthly cost is $2507 per month.   If the calculated assessed value determined by the procedure proposed above is $170,000, a new 30 year fixed rate mortgage at 6% would cost $1049 per month.  The bank would now have a non toxic asset on its books equal to 85% of the original loan value. It is only the remaining 15% that is toxic.

What would be the cost of settling all 1500000 delinquent mortgages, using the same assumptions?   The total amount owing would be $255 billion which would convert into $217 billion of credit worthy loans and toxic assets of $38.25 billion.  Even in a worst case analysis this is the cost of stopping the housing slump, refinancing the banking system and restoring the credit markets to normality.  In total it represents only a few days of normal Federal Government spending.

A matter of great complexity would be the renegotiation of the terms of outstanding credit obligations so that the principal would be secure but the rates of return would be reduced. It took Canada many months to negotiate an arrangement to prevent the default of collateralized debt obligations.

So, maybe my calculations are a bit off.  Suppose the number of homes to be refinanced is double the amount calculated.  Suppose other uncertainties of equal magnitude exist. Nothing adds up to the trillions of dollars spent and proposed to be spent. The magnitude of these expenditures must inevitably lead to the deterioration of the US dollar as a currency.  And, if a significant portion of leveraged debt can be saved, AIG might not need more bail out money.

At this time, with unemployment of 8%, most wage earners are better off than they were a year ago  Oil and gas prices are down, clothing prices are at sale levels.  Cars are being sold at much reduced prices (5 years at 0% interest), housing prices will never again be as low as they are. It would cost only $100 billion per year to double unemployment benefits for the unemployed. Investors, and particularly retirees, have suffered greatly.  With stock prices at enticing fifteen year lows there is hope of some recovery but perhaps something should be done for them as well.

Would someone please kindly explain to me how my calculations can be so wrong! CNN has suggested that the cost of the recovery program proposed to date will be in excess of $2,4 trillion. Is there no one in Washington that can do simple math or is there some rule that rounds off any calculation to the nearest eleven zero figure.

John E. Conner

John Conner is a former Royal Canadian Air Force pilot, an economist and he’s founded and headed a company or two. He’s now retired and free to pour a shot at the Whiskey Bar now and then.

Math of Subprime Mortgage Default was originally featured on Whiskey and Gunpowder

Roubini’s four forces of Stag Deflation are: a slack in goods markets, a “recoupling” of the rest of the world with the U.S. recession, a slack in labor markets, and a sharp fall in commodity prices. These factors would, “reduce inflationary forces and lead to deflationary forces in the global economy,” he writes in an article in Forbes.

“Aggregate demand is now collapsing in the U.S. and advanced economies, and sharply decelerating in emerging markets,” he writes. “There is a huge excess capacity for the production of manufactured goods in the global economy, as the massive, and excessive, capital expenditure in China and Asia (Chinese real investment is now close to 50% of gross domestic product) has created an excess supply of goods that will remain unsold as global aggregate demand falls.”

You’ll have to bear with us a moment, dear reader, as we work out what this means. First, though, is Roubini right? Well, he’s certainly right that there’s a big fall in aggregate demand in the U.S. It’s obviously passing through to manufacturers and commodity producers (China and Australia). But won’t monetary and fiscal policy designed to combat deflation…you know…cause inflation?

Roubini takes that point head on. He says the liquidity measures taken on by the Fed to get credit flowing and recapitalise U.S. banks are not all inflationary. He says once liquidity is restored to the credit markets (banks begin lending, money market funds starts buying commercial paper again) the central bank can simply “mop up” excess liquidity before it seeps into the real economy to cause inflationary damage.

And what about the tendency of governments to fight debt deflation with inflation? Not a worry either, says Roubini. He says that most of the household debt in the U.S. is short-term variable rate debt that’s resistant to being “inflated away” by cranking up the printing presses. Is he right?

Well it all comes down to how much money the Fed and the Treasury are going to need before the recapitalisation of the American financial sector is over and how they plan to raise that money. The banks will probably need more capital than anyone’s expecting. And there are other landmines down the road.

In short, the Treasury and Fed will need more money. Roubini assumes the Fed can simply remove the lending backstops it’s provided once the market returns to normal. But what if it doesn’t and the Fed can’t? What happens next?

Governments get money three ways, taxing, borrowing, or printing it. You can rule out an increase in taxes large enough to fund the Fed’s needs. It won’t happen with an economy already contracting. Even if Obama raises taxes, it won’t be enough to meet the Fed’s immediate needs. That leaves borrowing and printing.

On September 17th, the U.S. Treasury announced a Supplementary Financing Program. It initiated the program at the request of the Federal Reserve. The Fed needed the Treasury to go out and sell more bonds so the Fed would have money to fund its various lending backstops. The Fed was nearly broke.

Since then, thanks largely to the huge flight to Treasuries sparked by deleveraging and the collapse of the dollar/yen carry trades, the Supplementary Financing Account set up by the Treasury has fed the Fed nearly $560 billion. Some of that may have gone to AIG. Some of it to Fannie and Freddie. Some may go to Chrysler, Ford, and GM. Who knows?

But the main point, from Roubini’s perspective, is that as long as the Fed can finance its lending with new borrowing from the Treasury, it’s not inflationary. The only thing that would make this armada of liquidity measures and loan guarantees and bailouts truly inflationary is if the Treasury couldn’t go out and sell new bonds to gullible foreign investors. As long as the Treasury can sell more bonds, the Fed can make more loans without sparking inflation.

But if we’re right and the bond bubble began bursting in late October, well then the Treasury’s line of credit with global savers is nearing an end. Global creditors will be reluctant to finance American deficits. In order to borrow, the Treasury is going to have pay much higher rates of interest to reflect the credit risk the U.S. government has become.

Trouble is, the U.S. can’t afford to borrow at higher interest rates right now. So that leaves the option Roubini thinks is least likely: printing money. The fancy term for it would be “monetizing the debt.”

That means the Fed would buy public debt issued by the U.S. Treasury with freshly printed money. And THAT, we reckon, is super inflationary. Any time you start rolling out new greenbacks to pay for new bonds which you give to corporations in exchange for their garbage securities, you’re going to damage the confidence people have in the currency (the U.S. dollar).

But then, Roubini has been right about an awful lot lately. It’s possible the Fed will not be forced to monetize the debt. It’s possible that a global contraction is truly deflationary. We don’t really know. But we’re not nearly as sanguine as Roubini that you can expand the monetary base as quickly as the Fed has and be confident it can all be mopped up later without causing inflation. Try getting motor oil out of an engine and back into the bottle.

Regards,

Dan Denning
November 05, 2008

Falling Commodities and Inflation in the Wings was originally featured on Whiskey and Gunpowder

“…Take a look at this chart of gold prices measured in the top 10 most important world currencies…”

So the spot gold price sank in October, dropping right back to 13-month lows at $683 an ounce.

After failing to breach $930, this collapse marked the third step lower from March’s all-time high of $1,032. And from a technical perspective, the Gold Chart looks horrible — recording lower lows and lower highs for the last six months and more.

Right? Well, fact is, the action has actually been greatly muted if we allow for the shocking volatility in gold’s No.1 competitor for “safe haven” funds, the almighty U.S. Dollar.

You see, like so much else, the market action just described only sets Gold in terms of the greenback (against which it has still tripled since July 1999).

Versus pretty much every other world currency, in contrast, gold in fact enjoyed a banner month this October — delivering gut-wrenching volatility plus new record highs — starting right here in London, home to the world’s $60 billion-a-day trade in wholesale Gold Bullion Bars (a.k.a. the “spot market”).

Mid-month, gold also leapt to new record highs for Australian, Canadian, Danish, Estonian, Hong Kong, Hungarian, Icelandic, New Zealand, Norwegian, South African, South Korean, Swedish, Turkish and Russian investors.

Oh, and the 350 million souls in the Eurozone. Plus the 1.1 billion people of India.

Gold Prices have of course slipped back — and sharply — against all major currencies since reaching €685 an ounce for European investors and savers on Oct. 10th. (That marked a near-tripling from the low of Jan. 2000.) In the spot market, gold’s now trading almost 13% lower as the month-end draws near.

And notable by its absence from the rogues’ gallery of fast-sinking currency zones listed above is the Chinese Yuan, as well. More spectacularly, the world-destroying Japanese Yen has squashed the price of gold since turning sharply higher against everything — real estate, global equities, emerging-market debt, even the Tokyo Nikkei — in mid-July.

But if we really are witnessing a global currency crisis led by the destructive reversal of the Yen Carry Trade (and it certainly looks like it from inside a wallet of Sterling or New Zealand Dollars, let alone Forints or Krona), then just what kind of fight is gold putting up as the apparent “ultimate” safe-guard against currency shocks?

Regular visitors to BullionVault may recall a chart we offered in August this year, a chart showing the Gold Price in terms of the world’s top 10 currencies by economic output. It’s not perfect; the GDP weightings for 2008 will need revising, perhaps, when this year’s full-year data becomes available early next year.

But as a measure of truly globalized gold prices, it both softens the U.S. Dollar’s long slide of 2002-2008 on the currency markets, as well as tempering this month’s intemperate highs in gold bullion vs. the Aussie, Loonie, HK Dollar, Forint, Kiwi, Krone, Rand, Won, Lira, Ruble, Euro, Pound Sterling, Rupee and various Kronas.

You can’t help but spot the volatility — otherwise known as “My gold just crapped out!”

The way “quant jocks” figure the violence in asset prices, in fact, the daily volatility in this global gold price has more than doubled since August to a three-decade record.

You might also note, however, that gold really has risen sharply against all major world currencies so far this decade, not just the U.S. Dollar. And no one should imagine it will be an easy ride — whether up or down — from here.

There’s too much at stake when you try to measure that $60 billion daily turnover in physical gold against the $3.2 trillion daily turnover in official government currencies.

Regards,
Adrian Ash

November 03, 2008

Greg’s Endnote: What Adrian doesn’t know about storing gold offshore isn’t worth knowing.

And just a quick reminder to all Whiskey Shooters: Our discount offer for your “Personal Bailout Plan” ends tomorrow when we will have a new President-elect…but the same old growing deficits. Those deficits are going to be more economic trouble than anything we’ve ever seen; don’t be caught unprepared.

Gold Versus the World’s Top 10 Currencies was originally featured on Whiskey and Gunpowder

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

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

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

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

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

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

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

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

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

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

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

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

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

I have recommended stocks that are deeply involved in the megatrend of infrastructure. Companies like ABB Ltd. (ABB: NYSE), the world’s largest builder of power grids, and Astec Industries (ASTE: NASDAQ), a leading manufacture of road-building equipment. Plus, I have also recommended companies that own the basic commodities the world will need — copper, oil, natural gas and more.

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

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

Regards,
Chris Mayer
September 15, 2008

Asian Infrastructure was originally featured on Whiskey and Gunpowder

Drug companies large and small have renewed their interest in one specific health care sector. It’s a true form of preventative medicine — a rapidly growing field that’s already decimated countless dangerous and deadly diseases.

Now biotechs and Big Pharma are in a race against time. Their mission is clear: Rid the world of the onslaught of superbugs and diseases that could cause the next great epidemic. And they’ll use second-generation technology to create some of the world’s most powerful drug saviors.

There’s money to be made in this field — and it hasn’t gone unnoticed by some of the planet’s top investors.

George Soros’ resume is nothing short of impressive. His legendary Quantum Fund returned investors an average 42.5 percent per year for 10 years — a total of 3,365 percent gains. In 2007, he raked in a staggering $2.9 billion, making him the Street’s No.1 earner for the year…

And then there’s Warren Buffett — an investor who needs no introduction. An initial $10,000 investment in Buffett’s famous holding company Berkshire Hathaway would have been worth more than $1.2 million at the end of last year…

Sure, they’ve made their money by occasionally taking different routes. However, Soros and Buffett are “sharing” some intriguing ideas these days, according to James Altucher, managing director of Formula Capital and author of Trade Like Warren Buffett. The two moguls are putting up big bucks for health care, he says, with a concentration on vaccines…

This bit of info may go against perceptions of Buffett as the ultimate value investor. Altucher claims this is a common misconception. Rather, Buffett is what he calls a “long-term demographic investor.”

That’s why Buffett and Soros are investing in health care and biotech stocks like GlaxoSmithKlein, Johnson & Johnson and Sanofi Aventis. These companies have a lot in common — most importantly, they are the world’s most prolific developers of vaccine treatments.

I’ve found an opportunity Warren Buffett can’t get his hands on — an opportunity to get in on not one, but two emerging biotechs in a race to create the ultimate cancer vaccine.

For years, the vaccine landscape was ruled by the basics — measles, mumps and rubella. And, of course, annual flu shots for the elderly and those affected with immune disorders. The market for vaccines was relatively stagnant. In 2005, vaccines accounted for less than three percent of the global pharmaceutical industry, according to the Wharton School of business.

It just wasn’t very profitable to make cheap flu shots. And the antiquated process of incubating the inactive viruses to go into the shots is time-consuming, and the shots are easily contaminated.

Now we’re looking at a transition to a different kind of vaccine. In fact, we saw the wave of next-generation vaccines hit the development pipeline as early as three years ago. Professors at Wharton saw the transition coming:

“In the past, a lot of attention was paid to the childhood vaccines, but more and more research and development is focusing on vaccines for adolescents and young adults, or even on adult vaccines for diseases such as cancer,” Wharton health care systems professor Patricia Danzon commented more than two years ago. “The health system approach to vaccines really has to adapt to accommodate these new products.”

This quote appears very prophetic today. Just look at Merck’s recent success…

Merck’s most recent quarter, reported in May 2008, saw revenue rising to $5.8 billion, with much of its sales growth attributed to Gardasil, the company’s blockbuster cervical cancer vaccine.

Merck, along with many of the other major drug companies, is in the process of developing numerous vaccine treatments for a variety of diseases — some common, some deadly. But there is also a select group of micro caps poised to make major medical breakthroughs with their proprietary vaccine technology.

One of these companies is a biotechnology company focused on active cellular immunotherapy. Essentially, this is a method of using a patient’s own cells to stimulate the body’s immune system to attack a cancer cell as if it were a virus or bacteria.

You see, that’s the main problem with the human immune system and the current methods of cancer treatments. The immune system doesn’t fight cancer cells, because it doesn’t recognize them as a threat. And chemotherapy attacks and kills all cells, even healthy ones. Now a better treatment is in the works — one that teaches the body to target the cancer cells.

Using active cellular immunotherapy, this company has developed a vaccine that trains the immune system to recognize and eliminate prostate cancer cells. The company is also looking at tweaking the drug to fight other types of cancer, including breast, ovarian and colorectal cancers.

Clinical trials have shown that administering the treatment to patients with late-stage cancer prolongs life by about four months. These few months may not sound significant, but they’re a start. And these results are impressing leading doctors of cancer research.

Regards,
Greg Guenthner
July 23, 2008

Small-Cap Vaccines was originally featured on Whiskey and Gunpowder

And today’s aviation industry has a big crisis on its hands. As a percentage of airline costs, fuel is now about 35 percent of the total — up from only 13 percent at the start of the decade. It is the airline industry’s No. 1 expense. The cost of fuel puts enormous pressure on the industry. At the same time, regulators are pushing for cleaner planes with fewer emissions.

“The price of oil has challenged and changed all realities for the aviation industry,” says Tim Clark president of Emirates, a Dubai-based carrier. “This is the greatest crisis in aviation’s history — bigger than the Gulf wars, Sept. 11, SARS and past oil shocks.”

If oil prices stay where they are and nothing else changes, the airline industry will lose about $6 billion this year, compared with a profit of $5.6 billion last year. Many airlines will be taking that familiar stroll into the bankruptcy courts. Globally, 24 airlines have already filed in just last the seven months.

The industry is trying — and will try — lots of different tactics to fend off elimination. One of these is to push for more fuel-efficient aircraft. And that is the opportunity for investors to cash in on this crisis.

It starts with the jet engine. Recently, the Wall Street Journal published “Jet Engine Makers Launch New War” — all about the drive for new fuel-efficient engines. The piece notes that airlines worldwide want to replace their existing fleets with next-generation planes, not the current oil-guzzling models. The goal of the jet engine makers — or rather, the mandate put to them by their customers — is to deliver at least double-digit gains in fuel-efficiency.

As the WSJ reports: “Developing fuel-efficient engines requires the use of exotic alloys and ceramic coatings that can cope with internal engine temperatures that would be above the melting points of untreated metal components.”

Enter cobalt. It’s a tough metal with a high melting point of 2,700 degrees Fahrenheit. This higher melting point allows it to maintain its strength at higher temperatures than other metals can. Cobalt alloys have higher melting points than either nickel or iron alloys.

As a result, one of the main uses of cobalt is in superalloys such as those that jet engine makers need. In fact, the making of superalloys consumed about a quarter of global cobalt production, of which about 75 percent wound up in aircraft.

Cobalt would seem to have a nice backdrop of long-term demand. But it doesn’t stop there. Defense spending is also on the rise globally. A Financial Times report on aerospace notes that India, China, Brazil and certain Middle Eastern countries are all upping their defense spending. India alone may spend $40 billion in 2009.

Cobalt is an important part of all that, too. In fact, the U.S. and the Soviet Union used to stockpile cobalt for defense purposes. Those stockpiles are long gone, but the role cobalt plays in defense still exists.

As exciting as the aerospace angle is, a potentially bigger market could be batteries for hybrid cars. As I pointed out in the last issue, there are 5-10 pounds of cobalt in a typical hybrid car battery. Hybrid car sales will probably hit 500,000 cars this year. And that is growing rapidly.

Kitco recently noted that cobalt holds an electric charge better than almost any other metal. That makes it hard to replace, even at $50 per pound. “And the current electric batteries work so well,” Kitco notes, “[that] there is little incentive to change their structure (and other metal prices have skyrocketed, as well as cobalt — nothing is cheap anymore).”

With the failure of banks and the troubles of big financials such as Fannie Mae, cobalt seems a nice place to be. A while ago, I recommended a “cobalt play” to the readers of my investment service, Mayer’s Special Situations. The name of the stocks is OM Group (OMG: NYSE). I should warn you that the stock is a bit speculative. But let me share a few of the particulars…

OMG carries a seemingly absurd valuation. It’s not often that you find profitable and growing companies with no net debt trading for big discounts to book value. The specialty chemical industry — a tribe to which OMG belongs — is undergoing heavy consolidation. Companies are getting bought out left and right. Dow Chemical bought Rohm and Haas for a 74 percent premium. And then Ashland came along and bought Hercules for a 38 percent premium.

Companies that make low-margin chemicals are looking to beef up on companies that make high-margin, or specialty, chemicals. Because OMG is cheap and very profitable, it has to be on someone’s radar. I hope that it doesn’t get bought out. I think we’ll do better holding the stock. But the deal-happy scene in the chemical business is another potential backstop of value here.

Hard to believe that anyone could buy all of OMG for anything less than at least book — which is $36 per share. And even that would bring howls of protest. After all, the stock was in the $50s for much of the past year. We will see.

In any event, let’s bring this back around to the aviation crisis. A familiar theme in the pages of my letters over the years has been this Templetonian notion of focusing on the opportunities that problems present. The late great John Templeton made this idea a key component of his investment — and life — philosophy.

The high price of oil is a big problem for many industries.

So if you have a good way to mitigate the high price of oil, you have a business. I think the big winners over the next few years are going to be those companies that have a solution to the high price of oil. Those companies have products that other people will pay up for, because fuel-efficiency is a must. The aerospace industry must become more fuel-efficient.

Cobalt alloys will be a big part of that trend.

Regards,
Chris Mayer
July 22, 2003

P.S.: Cobalt alloys are certainly going to be a big part of the coming efficiency renaissance in energy. But there has also been another breakthrough recently that could be the biggest moneymaking opportunity available to you. Some are already calling this energy breakthrough a “miracle” and for good reason too. My readers of Mayer’s Special Situations have already been told about this.

Fuel Efficient Airlines was originally featured on Whiskey and Gunpowder

For some industries, such as airlines, finding a more fuel-efficient way to do business is a matter of survival. According to a recent Financial Times article, it’s “triggered a massive jump in the price of obscure and scarce metals that are used to improve the fuel economy of jet engines.”

The quest for fuel-efficiency goes beyond just the airlines, of course. It extends to rail cars and automobiles, to power plants and high-speed drilling. Vanadium’s primary use: to strengthen steel. Combine it with titanium and you get the best strength-to-weight ratio of any engineered material. That makes it practically irreplaceable in aerospace and other industries. Companies also use vanadium to produce sulfuric acid, and in nuclear power plants. Vanadium also promises new advances in battery technology. Giant vanadium batteries power wind farms and solar power plants.

In the great infrastructure boom, vanadium takes its place at the table of other rare and obscure metals that are growing much more important. The price of vanadium, as with many of these metals, is way up. For most of last year, vanadium cost $40 per kilogram. In February, it hit $90 per kilogram. It has since come back some, but it rallied to over $80 again recently.

The rocketing vanadium price is no mystery. Demand is strong, while supplies are constrained. A big part of the supply constraint lies in South Africa. That’s because a massive electricity shortage is preventing many mines from operating at full capacity. As the CEO of Windimurra Vanadium, an Australian mining company, put it: “The market is very sensitive to power supply issues. Large South African miners are facing up to 15 percent restrictions to their power supply… The supply of vanadium will remain tight, and that’s factoring in a best scenario for South African producers, which is no guarantee.” In March, Xstrata, which produces about 12 percent of the world’s vanadium, said it would cut its deliveries by 10-15 percent in the second quarter. And Highveld, the world’s biggest producer of vanadium, said in February that power outages posed a “considerable threat” to future output.

The vanadium market also has some interesting quirks. For example, 98 percent of the world’s vanadium comes from only three countries — China, Russia and South Africa. South Africa, we know, has power issues. China’s Sichuan province, devastated by earthquake, was also a rich vanadium producer. Moreover, China is becoming as much a consumer of vanadium as a producer. So vanadium exports from China are dropping. Last year, China ended its export credits for vanadium because it needed the metal more at home. This year, China went further and put an export tariff in place.

China’s vanadium use per quantity of steel is still well behind the curve compared with the U.S.’ If China were to use as much vanadium as U.S. steel producers, the vanadium market would face a one-third increase in demand. That’s a pretty nice long-term tail wind for vanadium.

Russia’s Evraz Group is the world’s largest producer of vanadium, with about 27 percent of supply. I think it’s safe to say that Russia has been an uneven producer of certain commodities. And as the Russians like to change the rules of the game as it suits them, I would not rely too heavily on Russian supply. And finally, there are no stockpiles of vanadium or substitutes of equal quality.

So where are the opportunities?

It’s tough to find a good pure play that is easy to buy. Most of the producers are in China or South Africa or Australia. And these producers make lots of other metals. You wouldn’t buy Xstrata just because you like vanadium. You’d also have to understand a host of other metals that contribute much more to Xstrata’s bottom line than vanadium. One interesting company is Denison Mines. Vanadium could represent up to a third of Denison Mines’ revenues in 2008. The problem with Denison is that it is mainly a uranium play. To invest in Denison, you have to like uranium; you get the vanadium exposure as a bonus. Denison is probably cheap, although I haven’t looked at it in great detail.

Some of the best ideas are just in the prospecting stage or emerging as producers. There are a few in Australia, including Windimurra Vanadium and Reed Resources. Both have big vanadium resources and could each eventually represent 6-8 percent of global production.

One of my favorite vanadium ideas I’m keeping an eye on is Largo Resources (LGO.V: CDNX). Largo has the world’s highest-grade vanadium mine, in Brazil. It’s close to infrastructure and located in a mining-friendly state. The company should have a completed feasibility study in July. Production should start in 2010. It’s highly speculative, but promising.

The company also has a molybdenum and tungsten project in the Yukon, called Northern Dance. These metals are also important in infrastructure.

Scarcity is a great thing when you are an investor. Finding companies that own something scarce — with good long-term demand behind it — is a winning formula for finding good ideas.

Regards,
Chris Mayer
July 15, 2008

P.S.: Finding an interesting and scarce metal to invest in like vanadium is certainly an idea worth looking into. But that isn’t where the resource profits you could be making end. Recently, an amazing resource breakthrough occurred that some people are already calling a miracle. This breakthrough has come from the use of two new technologies that have made possible what was once thought to be impossible.

Investing in Vanadium was originally featured on Whiskey and Gunpowder

Gold is a classic example. Its price tends to rise during times of stock market distress. But very few investments can rival gold’s long history of non-correlation. Imposters abound. The imposters might move independently of the overall market for months or years at a time, thereby creating the impression that they are non-correlated. But when the markets really turn nasty, investors often learn that their “non-correlated” asset tumbles just as sharply as an S&P 500 Index fund.

However, some investors think they’ve found a reliable new non-correlated asset: “frontier markets.” Merrill Lynch recently created an index not only to track them, but for investors to buy and sell them.

Frontier markets include Pakistan, Kuwait, the United Arab Emirates (UAE) and other markets throughout Africa and the Middle East. They also include Vietnam, Kazakhstan, Cyprus and others. They are individually too small for institutions to invest in, but cobble them together in a new index that allows you to buy and sell the basket and… well, then you have something.

Merrill Lynch’s new Frontier Index tracks the 50 largest companies in 17 frontier markets. Even so, the market value of all these companies combined is only about $330 billion – or about that of General Electric. Right now, the index heavily tilts toward the Middle East, with 50% of the index in the region. Asia is the second largest component, with 23%, followed by Europe at 14% and Africa at 13%.

As for industry groups, banks usually are among the biggest companies in any emerging market. So banks and financial service companies represent about 65% of the index. Oil and gas is the next largest sector, weighing in at 13%. As far as countries go, the top three are the UAE (23%), Kuwait (18%) and Pakistan (14%).

So far, these frontier markets have lived up to their advance billing of not following the broader markets. Since Sept. 30, for example, the frontier markets actually gained 31% while the broader market lost ground. Merrill Lynch backtested the index several years and found that between February 2000-December 2007, the index return’s correlation with the S&P 500 was only 32%. Basically, that means that about two-thirds of the time, the frontier markets zigged while the S&P 500 zagged.

I love the idea of frontier investing, because I’m an optimist when it comes to global trade and booming overseas markets. Maybe it’s my globe-trotting that’s skewed my view. But when I travel overseas, I see great opportunity. I see people building businesses. I see the impact of global market forces on local energy, food and resource markets. I see the world getting smaller.

I’m long-term bullish on markets such as the UAE, Kuwait, Vietnam and others. But I also realize that the ride in some of these markets will be absolutely gut-wrenching. Just look at Vietnam.

The Vietnamese economy is growing somewhere between 7-9% per year. It is a cheaper place to do business than many other parts of Asia. Hence, Vietnam continues to attract a strong flow of investment.

While I liked what I saw going on there, I found no direct investment ideas for us. The market is just too small and illiquid. Heck, before March 2002, the market traded only on alternate days. Moreover, as with most of these frontier markets, Vietnam suffers from poor disclosures and low transparency. When you invest here, you’re really not sure what you’re getting.

I remember listening to Carlo Cannell, a very good investor at Cannell Capital, talk about his trip to Vietnam and his investments there. This was back in May 2007. The theme was investing in the dark. In Vietnam, he basically made many blind bets on lots of companies, figuring enough of them would work out.

But the market has tanked since then.

Perspective, though, is everything in markets. That chart looks nasty, with a near 50% drop from the high in less than a year. But as recently as July 2005, the index was only 250. You’d still have more than doubled your money in less than three years. In 2000, it was only 100. Investors are still up sixfold from 2000, which is a lot better than an investment in the S&P 500 Index. And that’s really the key to the whole frontier market idea. As an investor, what’s most important is what happens over the years.

I’m skeptical of the idea of frontier markets as an “non-correlated asset” for all seasons. Links between these small markets and their bigger brothers are probably stronger now than in the past. Vietnam, for example, depends heavily on foreign investment. Vietnam’s currency, the dong, is still linked with the dollar. So we have to be careful in taking the past and saying the future will work the same way.

On their own merits, as growing economies, I like frontier markets for the long haul. Unfortunately, only institutions can buy Merrill’s index for now. But individual investors can still invest in frontier markets through mutual funds. The recently launched T. Rowe Africa & Middle East Fund (TRAMX) is one. Just be sure you can stomach the major gyrations that come with working the frontier of investing.

I’m also watching the activities of individual companies in these markets. This may be a safer way to go – a back door into the frontier markets, you might say. Many of our companies are in these markets one way or another. Take Hutchison Telecom (NYSE: HTX), for example. It’s got businesses in Vietnam, Ghana, Sri Lanka and Indonesia.

In any case, I think frontier markets will have a bigger role to play in portfolios in the years ahead, whether they are truly non-correlated or not. Worst case, you’ll lose money in many different languages, not just English.

Regards,
Chris Mayer
June 13, 2008

P.S. Even though the Frontier Index is relatively new, investing in frontier markets is not. Many smart investors took their money to non-correlated assets and have been able to make a fortune while people here are losing everything. New millionaires are being made everyday, and as bad as things seem, there’s still money to be made.

Frontier Markets was originally featured on Whiskey and Gunpowder

Fareed Zakaria, editor of the Newsweek international edition, notes that China added more to global economic growth in 2007 than the U.S. That’s the first time a country other than the U.S. has contributed more to global GDP since at least the 1930s. This little history-making milestone typifies a growing list of Chinese economic achievements… and American shortcomings. “On issue after issue,” Zakaria writes, “China has become the second most important country on the planet.”

China is no longer the scrawny puncher that might grow up to be a contender; it has arrived. It is a bona fide heavyweight… and it has the potential to throw even harder punches. Jim Rogers, the celebrated globe-trotting investor and writer, believes the 21st century will belong to China in the same way the 20th century belonged to the U.S. In Roger’s new book, A Bull in China, he expands on this thesis. His conclusion is as simple and direct as scotch on the rocks or a quarterback sneak: “Get out of the dollar, teach your children Chinese, and buy commodities.”

As Rogers says, owning a piece of the things that China’s hot economy simply can’t do without seems like a good idea. One thing it certainly can’t do without is oil. In fact, the thirsty dragon in the East has caused most of the increased demand for oil during the past few years.

The Chinese economy has been growing at a rapid rate in recent years and that has fueled the desire for Chinese to start acting more like their Western counterparts. Once bicycle bound, the streets of China are now cluttered with millions of automobiles.

These millions of new drivers demand oil and are taking the precious resource out of the hands of consumers in Europe and America. This has been a major factor in rising energy costs around the globe. You see, oil is a finite resource, and with a skyrocketing demand, the price has risen exponentially.

Of course, this isn’t the only reason for rising oil costs, but it certainly has helped. That’s why you cannot look into the economic situation in China without examining the staggering effects it has over global oil supply and demand. That’s why we’ll analyze the Chinese emergence with a bend toward oil stocks.

My favorite oil play is Canadian Natural Resources, a stock I recommended one year ago to the subscribers of my investment letter Capital & Crisis. The stock has tacked on about 93% since then. But I think its advance is far from over. This year, Canadian Natural’s huge Horizon Oil Sands project will start pumping out oil for the first time. Unlike conventional oil assets, this one could produce steady cash flow for decades.

In addition to one of the largest oil sands projects on the planet, Canadian owns a vast amount of other energy assets in Canada, West Africa, and the North Sea. Overall, Canadian Natural should gush $2 billion in free cash flow in 2008. The company could double that number in 2009 as the Horizon project expands. If Canadian Natural actually achieves these cash flow totals, its stock could be worth twice what it trades for today.

The stock is not risk free, of course. Oil prices could sink. Tax regimes could get uglier (especially the fickle Canadian tax regime). Currency fluctuations could undermine investment returns. But overall, if you want to own an emerging energy behemoth, Canadian Natural is very strong candidate.

In searching for investments for our well-scrubbed Capital & Crisis portfolio, I look for four things, and Canadian Natural has them all:

1.  A rock-solid financial condition, preferably backed by tangible assets. (Canadian took on debt to acquire Anadarko’s Canadian assets. But ample cash flow means the new debt presents little danger)
2.  An understandable business, including detailed disclosures
3.  Good owner-operators, preferably with a track record of creating wealth
4.  A healthy discount from what private owners would pay to own the whole thing.

That’s what I look for. It is not an easy mission to fulfill. So when we find good investments, it’s important we ride them for all they are worth. Canadian Natural is one of those.

Regards,
Chris Mayer

P.S. China isn’t the only economy on the rise. There are other parts of the world that are joining our global economy. As these countries rise, investment opportunities will sprout up everywhere. This could be one of the largest moneymaking boom periods since the turn of the last century. New millionaires are being made everyday.

Chinese Oil Effect was originally featured on Whiskey and Gunpowder

At the end of the Second World War, Germany was an “emerging market.” It was industrializing rapidly and producing brisk economic growth. Today, Germany is a mature “developed market” that grows slowly if it grows at all. Today, China is the new Germany. The industrial dynamism that produced Germany’s post-war success is moving to the East…piece by piece.

The Ruhr Valley was the heart of Germany’s industrial might. For more than 200 years, the smokestacks in this northwest corner of Germany pounded out the steel and iron that would form the backbone of the nation’s industry. And when the war drums rumbled, these factories supplied imperial Germany with its field guns, armored tanks and shells.

Prosperous communities grew up around these old blast furnaces and mills. People took pride in the stuff they could make with their hands. Tens of thousands found work in the factories of the Ruhr. Generations passed with the knowledge that their sons and daughters could make a life here and carry on the legacy of such a place. For a long time, that was the way it went.

But the winds of change patiently grind away at even the most impressive of advantages. In the early 1990s, the industrious workers of Asia powered the mortar and pestle that would crush the Ruhr’s traditional way of life.

It was a slow process, but the endgame was not hard to see. While the South Koreans became the most efficient producers of steel in the world, German workers were agitating for a 35-hour workweek. While the Chinese worked all day in their mills and new factories sprouted up like spring peepers all through China, Germany increased taxes and expanded its bloated government programs.

By the turn of the millennium, no one could ignore the stark reality any longer. The mills and factories of the Ruhr started to close — forever. In his terrific book, China Shakes the World, James Kynge tells the story of ThyssenKrupp’s steel mill in Dortmund, one of the largest in Germany. The Germans called it the Phoenix, inspired by its rise from the ashes of bombing raids in World War II.

Within a month of ThyssenKrupp closing the mill, a Chinese company bought it with the idea of disassembling the entire mill and taking it to China, near the mouth of the Yangtze River. Soon after this Chinese company bought the mill, 1,000 Chinese workers arrived in Germany to begin the process of taking the plant apart and bringing it to China. The Germans got an up-close lesson in why they could not compete. The Chinese worked seven days a week for 12 hours a day. The Germans started to complain. So the Chinese, in deference to local law, took one day off.

In the end, the Chinese dismantled the mill in less than one year — a full two years ahead of the time ThyssenKrupp initially thought it would take.

When the Chinese departed, they left the makeshift dormitories and kitchens they occupied for a year neat and clean. There was, however, a single pair of black boots left in one of the dormitories. The boots carried the brand name Phoenix, which was the same name of the plant the Chinese just took apart. The boots also carried the label “Made in China.” Kynge writes, “Nobody could tell, however, whether the single pair of forgotten boots was an oversight or an intentional pun.”

Over 5,000 miles away, the Chinese rebuilt the steel mill exactly as it was in Germany. As Kynge writes: “Altogether, 275,000 tons of equipment had been shipped, along with 44 tons of documents that explained the intricacies of the reassembly process.” Doing all of this was still cheaper — by about 60% — than building a new mill. Plus, in China, the demand for steel was such that the mill could start producing steel immediately at full capacity.

As recently as 1975, China’s entire output of steel could not match this one mill in Dortmund. Now, the Dortmund plant itself stands in China. And in Germany, you have a dying industrial city, unemployed steelworkers and the scarred earth where the mill once stood. Germany is thinking of turning the site into parkland and perhaps creating a lake and marina. But as one burly steelworker says in Kynge’s book: “Do we look like yachtsmen to you?”

This remarkable vignette captures, on many levels, how the game has changed. Comfortable workers in the factories and mills of America and Western Europe have no idea what they are up against. Even so, the nature of global competition keeps shifting. We tend to think of emerging markets, such as China, as occupying a place down on the food chain of the global economy. We tend to think of these places as sources for cheap labor and natural resources. But more and more, these emerging markets are home to world-class companies in all kinds of industries.

This is the thesis of Antoine van Agtmael, author of a new book called, The Emerging Markets Century. Agtmael is the man who coined the phrase “emerging markets” to describe growing, but less-developed economies such as China, India, Brazil, Argentina, Mexico, Thailand and other places. Before him, we called these markets “third-world” — which brings to mind many negative associations. To sell the idea, Agtmael came up with “emerging markets.”

I saw Agtmael give a presentation in Washington, D.C., one evening. I’ve also since read his new book. Agtmael spent 30 years in these kinds of markets. “I have helped IranAir lease airplanes and hire crews in Ethiopia, was involved in financing Ghana’s cocoa exports,” he writes, “and grew wise to the ways — many of them laughably one-sided — that developed nations interacted with what were in many cases recent European colonies.”

Agtmael selected 25 companies to profile in his book. All of them exemplify best practices and are widely recognized as leaders in their industries. All of them call an emerging market home.

Agtmael writes about spending time in High Tech Computer Corp.’s research lab in Taiwan in 2005 and how “Suddenly, my BlackBerry looked like a Model T.” He writes about how the regional jets we fly are made in Brazil (by Embraer). How computers are now not just made in China, but designed there. How Indian and Slovenian labs produce proprietary new drugs. And on and on it goes.

The world has changed in a profound way, but the typical investor probably doesn’t appreciate this fully. One more nugget from Agtmael: In 1988, when he started his fund, there were only 20 emerging market companies with sales of more than $1 billion. Most of these were banks or commodity companies. (Overwhelmingly, they were located in Taiwan.) Today, there are over 270 companies with over $1 billion in sales, and 38 with more than $10 billion.

Many of them are high-tech companies or provide consumer products and services. This bolsters Agtmael’s point that many of today’s emerging market stars do not rely on cheap labor, abundant natural resources or protective government policies. Instead, they have developed competitive advantages in technology, design, logistics and other areas.

Agtmael also gives his tips for investing in emerging markets. The most important of these may simply be this: “Don’t be afraid to invest in them.”

Regards,
Chris Mayer
June 3, 2008

Emerging Economies was originally featured on Whiskey and Gunpowder