So speculative betting on gold going higher now equals a record-busting 752-tonne position in Comex futures and options, yet this is not a bubble according to Michael Pento of Deltaga.

Let’s say otherwise. Let’s say that gold prices, surging by almost $100-per-ounce in barely a month, are very much in a bubble…blown up by near-zero interest rates worldwide and a sharply negative cost of borrowing after inflation. Were that the case, the question before potential and existing investors would be simple:

Is this “irrational exuberance” or a “permanently high plateau”?

Alan Greenspan applied the former to US price/earnings in Dec. 1996; Irving Fisher said the latter of US equities in Oct. 1929. Both were looking at what history would decide were clearly bubbles in hindsight. But Greenspan was three years and 105% early.

Fisher spoke less than 72 hours before the Great Crash began…

Buying gold always looks “irrational” to most financial advisors and commentators, because it doesn’t pay an income or yield.

No matter that gold has beaten all other asset classes bar none since the start of the decade. People looking to buy gold (the blue line of Google searches above) have been underwhelmed with content and analysis online, despite outstripping the volume of “buy stocks” searches (in red) for nearly five years.

Gold buyers have also averaged 20% gains year-on-year since this point in 2004. That compares with -0.6% on average from shares, but so what? Check the spike in “buy stocks” stories highlighted by Google Trends’ lower chart during October last year. Just when gold turned sharply higher – and stocks still had another 40% to fall – the news-flow focused on bottom-fishing in equities.

Gold’s productive value is also judged to be nil next to foodstuffs, energy or base metals – materials that vanish in use and thus display a clear supply/demand dynamic. Whereas all the gold mined in history—being indestructible—is still with us today…some 165,000 or so tonnes. That makes a fundamental case for gold built on tight supply, rising demand absurd. Nor can TV or newspaper journalists get used to applying “exuberance” to gold, the ultimate in gloom-and-doom insurance outside your local gun-store.

But while permanent plateaus are harder to find in finance than geology, gold’s peg-legged clambering of the last nine years most certainly puts it higher than it started.

What’s powering the Stannah Stair-Lift today? In a word, leverage.

Liquidity (meaning “leverage”, as 2008 proved) has flooded back into the big investment houses, thanks to tax-funded injections, quantitative easing, and central-bank asset guarantees.

Near-zero interest rates sure help as well. And that, in turn, has enabled what we used to call investment banks to revive their prime broking services, offering to deal whatever leverage-hungry clients want most, and financing the trade with that ultra-cheap money.

The most leverage-hungry clients, outside of the banks’ own proprietary trading desks, remain hedge funds – hedge funds which doubled in number from 2003 to end-2007 (Hedge Fund Review), growing their assets under management from $600bn (Goldman Sachs’ estimate) to $2.9 trillion (HedgeFund.net) before hitting the credit crunch precisely as Bear Stearns blew up.

Just as the long-run bull market in gold threatened to keel over on this sudden withdrawal of derivatives leverage, however, the physical appeal of owning gold – or a near proxy, at least – came into its own.

Physical gold investment surged in the back-half of 2008 and early 2009, rising 150% from July-to-Dec. 2007 before adding two-thirds of that fresh record between Jan-and-March this year alone. (Data courtesy of the World Gold Council.) And now that deflation seems to be tipping ever-so-smartly into inflation – and the surge in ETF, coin and bar demand has eased off – leverage is back just in time for gold’s typical autumn move higher, a pattern seen 20 years in the last 40 and delivering some 15% gains on average this decade between Sept. and Feb. even for cautious investors buying on cash, rather than margin.

Inflation, deflation, who cares? Whether it’s exuberant hedgies or panicked private investors with something to lose, this “bubble” in gold – if that’s what you choose to call it after a decade of beating everything else, and four years after it broke sharply higher versus all currencies, not just the Dollar – just keeps expanding.

Sub-zero real rates of interest sure help. Media hype, to date, is missing. When those two factors reverse, buying gold may well become irrational – and whatever plateau it’s reached might well give way.

Regards,
Adrian Ash
BullionVault

September 21, 2009

Gold: A Permanently Exuberant Plateau was originally featured on Whiskey and Gunpowder

The noodle company got itself into some trouble. To simplify the story greatly, it basically lost a lot of money using derivatives to bet on dollar-rupiah movements. The loss suffered was, in fact, more than the capital of the company itself. At one point, Das writes: “What this had to do with producing noodles was a mystery.”

Exactly!

Unfortunately, this kind of story riddles the markets today like worms in an otherwise worthy cut of swordfish. There are so many of these incidences and they are ruining companies and investors across the world. It takes a nasty crisis like the one we are in to expose all these things. And the rot is extensive.

I want to share with you three little-reported events and one historical example that all show how pervasive this mindless risk-taking became during the last few years. They would be almost comical if they weren’t true.

First, consider the sad example of several Mexican and South American companies that made, large, company-jeopardizing currency bets. For example, Mexico’s third largest retailer, Controladora Commercial Mexicana (COMERCIUBC: MXK), recently filed for bankruptcy after losing so much money speculating in the forex markets. What does currency speculating have to do with selling tortillas, milk and eggs? Nothing. That’s the point.

Similarly, Sadia (SDA: NYSE), a poultry producer; Cemex (CEMEXCPO: MXK), a cement outfit; and Gruma in tortillas – all lost huge amounts of money on currency bets. Aracruz Cellulose (ARA: NYSE), the much admired pulp giant of Brazil, owes more than $2 billion to its banks for making bets on currencies that went sour. What was once a great franchise has been brought to its knees. It will take years to pay that back and debt payments now make up 40% of its pre-tax earnings.

The second example of mindless risk-taking is the story of so-called “portable alpha.” Apparently, the brain trusts that run pension funds thought this strategy sounded like a good idea. What is it? I still don’t understand it fully. But it basically amounts to a leveraged bet on the stock market. If you lose, you lose big as many pension funds are finding out. So now the Pennsylvania state employees’ pension fund, for instance, will have to take a multi-billion bath on this exotic investment strategy.

As the Wall Street Journal reports: “The stock-market downturn could force the Pennsylvania state employees’ pension fund to make cash payments of $2.5 billion or more to trading partners on Wall Street.” The fund has only $27 billion in total. At least, it had $27 billion.

Several other funds have reported billion dollar losses on portable alpha strategies. I can only imagine how many more institutional investors are in the same boat. The people running these things and advising these people should all find other work.

The third example is so-called “accumulators,” which is another kind of tactic for placing highly leveraged bet on stocks, currencies or commodities. I don’t want to get into the details. It’s so complicated; it would take me a page to explain it. Just know that, like “portable alpha” if you are wrong, you lose big.

And yet all kinds of wealthy individuals and businesses have gotten wrapped up in these things. Accumulator losses are showing up in some unlikely places. For instance, VeraSun Energy Corp. (VSUNQ: OTC), which makes ethanol, filed for bankruptcy in part because of big losses on accumulators tied to the price of corn. Citi Pacific (CIY: ASX), a Chinese conglomerate, lost $2 billion on accumulator contracts linked to currencies.

Billions and billions of dollars lost on nonsense. There was no reason for anybody to buy these things – especially when they clearly did not understand the risks involved. The losses are so bad in Hong Kong that Any Xie, an independent economist, said recently that “Accumulators are ruining Hong Kong.”

I’ll offer one other example of this kind of recklessness that is both a historical and contemporary study: Goldman Sachs.

I just recently finished perusing Charles Ellis’ new history The Partnership: The Making of Goldman Sachs. I was particularly interested in the early history of Goldman Sachs. I thought I would come away thinking how Goldman Sachs used to be a simpler business. I thought Goldman’s history would show how it took prudent risks with adequate equity backing those risks. My conclusion would then be that the current crop of leaders at Goldman were just reckless and ruined a franchise that had been around since the 1880s.

In fact, that’s not what I learned at all. From Goldman’s earliest days as a commercial paper specialist it operated with minimal capital. All through its history, it has been a business that took big risks and often took huge losses. That Goldman even exists at all today is something of a financial miracle.

In reading this history, I was struck by how the company found itself in the soup again and again and again. In the 1920s, one of the biggest speculative busts was in investment trusts in which a small amount of capital supported a spider’s web of investments in other companies. Guess who had the biggest blow-up of them all?

Goldman was big in this through a subsidiary called Goldman Sachs Trading Corporation, which basically lost everything for its investors. Ellis writes:

“While all the investment trusts suffered, Goldman Sachs Trading Corporation – because it was so large and so highly leveraged…became one of the largest, swiftest, and most complete investment disasters of the twentieth century.”

The loss to Goldman Sachs itself was enormous. It basically wiped out thirty years of profits and eliminated the “fruits of all the labors of a generation.”

Fast forward to 1970 and the biggest bankruptcy in the country at that time. You find Goldman was waist-deep in it. Penn Central at the time of its bankruptcy in 1970 was the eighth largest corporation in the country. Again, Ellis writes: “the loss it [Penn Central] threatened to impose on Goldman Sachs was not only larger than any prior loss, it was larger than Goldman Sachs.”

And so it is today, that the company once again finds itself in the middle of yet another big crisis that threatens its very existence. I don’t know about you, but I have to wonder about all the brains at Goldman Sachs and all the people who say what a great firm it is. Seems to me, for such a bunch of supposed geniuses, they routinely shoot themselves in the foot, time and time again. You don’t find Berkshire Hathaway fighting for its life every decade.

All of these anecdotes scream at me to avoid the complex and the leveraged, which often means a potential for a mega-loss if you’re wrong. The problem is these kinds of bets infect many companies, as I’ve shown, even when they have nothing to do with the core business. Even otherwise seemingly simple enterprises, like making tortillas or producing chicken, have been hurt.

The advice I have is not novel, but bears repeating since so many seem to forget it. Stay away from anything you don’t understand. (All those folks who lost money with Madoff in his $50 billion Ponzi scheme would’ve saved themselves a lot of money just with this single insight.) And avoid excessive leverage. It’s one thing to lose money. It’s another thing to lose it taking on stupid and pointless risks.

Regards,
Chris Mayer

January 8, 2009

Mindless Risk Taking was originally featured on Whiskey and Gunpowder

As Byron points out, the advantages of “going private” are numerous and growing. I want to expand on Byron’s ideas by contrasting the capital structure of two well-known companies — cell phone maker Motorola and offshore driller GlobalSantaFe — and why private equity and merger activity is likely to continue bidding up drillers.

Most private equity deals seek to optimize the target company’s capital structure, or the appropriate mix of debt and equity claims.

Debt holders have a priority claim on the company’s assets, while equity holders have a residual claim. If things go wrong, debt holders are first in line at bankruptcy court, but their exposure to the good times is basically limited to a fixed stream of payments. Equity holders are left with nothing if the company a) goes bankrupt and b) there’s nothing left after creditors liquidate what’s left of the assets in an attempt to recoup as much of their principal as possible. But equity holders enjoy all the extra cash flow when business is booming.

When used appropriately, debt, or “leverage,” can greatly enhance shareholder returns. Private equity, aka “leveraged buyout,” funds generally look for businesses with solid competitive positions that consistently generate cash. Private equity deals are heating up into a craze because the supply of cheap credit appears to have no limit (until all of a sudden, everyone discovers that there is, in fact, a limit).

Private equity funds first pool together their capital. Then they leverage their buying power by layering debt on top of their capital. This allows them to buy much larger businesses — and streams of future cash flow — than they otherwise could buy outright with their limited funds. Returning to the concept of capital structure, the debt holders get paid a fixed 5-6% per year and the equity holders have a claim on the rest, whether it ends up being a total loss or a stream of cash that’s even larger than they anticipated.

Motorola’s Levering Shareholders’ Exposure to Creative Destruction

Motorola’s recent disappointments have been numerous. A glut of cell phones is building in the supply chain and the fallout is not going to be pretty. Wireless carriers are giving them away with minimal contract commitments. The title of this article on Bloomberg yesterday says it all: “Motorola’s Zander ‘Running Out of Scapegoats’ as Profit Fades”:

“Earnings and revenue this year will be ’substantially’ below its forecasts because of plunging mobile phone prices, Schaumburg, Ill.-based Motorola said yesterday. Zander, who already is cutting 3,500 jobs, said the company will overhaul marketing and product design to make its prices competitive without sacrificing earnings.

“The world’s second biggest maker of mobile phones also named a new president and detailed a plan to step up its share buyback program amid a proxy fight with shareholder Carl Icahn.

“Instead of sparking optimism, the news set off criticism of Zander’s choice for the promotion and a product plan that investors said didn’t show enough concern for bigger rival Nokia Oyj’s recent advances in the market.”

Bloomberg then describes Motorola’s big management shake-up in the wake of this ugly news:

“Motorola’s choice for its new president and chief operating officer, Greg Brown, who runs the networks and enterprise unit that sells networking devices to companies and government agencies, also drew fire.

“‘There’s not a single senior Motorola executive that had more predictions go wrong,’ said Albert Lin, an analyst at American Technology Research in San Francisco, of Brown. He rates the shares ‘neutral’ and said he doesn’t own them.

“Motorola also said Chief Financial Officer David Devonshire will retire. Director Thomas Meredith will be acting CFO.

“Motorola expects a loss of 7-9 cents a share, its first loss since 2004, on revenue of $9.2-9.3 billion this quarter. Motorola didn’t provide new full-year figures.

“‘I never would have thought that they would go into a money-losing situation,’ Lin said.”

Lin “never would have thought that they would go into a money-losing situation.” This statement is puzzling because it’s not that hard to imagine a situation where Motorola goes into the red. Short product cycles and high R&D spending requirements can combine to produce red ink very quickly when business sours.

In recent months, Motorola shareholders had gotten excited about the leveraged recapitalization efforts of Carl Icahn. Mr. Icahn has been branded with the title “corporate raider,” yet his tactics have a record of creating value for shareholders when management and the board of directors slack off on this responsibility.

The recent cell phone boom left Motorola with plenty of excess cash that Icahn believes it doesn’t need. Since Motorola’s business doesn’t entail managing a multibillion-dollar bond portfolio, Icahn is pressuring the company to disburse all excess cash to shareholders through share buybacks (allowing for enough of a cash cushion to fund operations through the rapidly approaching down cycle).

Here’s a suggestion to Mr. Icahn: Why not consider targeting one of the many cheap offshore drillers? Most have already booked up their rigs for a few years under long-term contracts at very attractive dayrates. These contracts provide very visible cash flows, so perhaps a recapitalization is in order?

You have a business for which the underlying assets are increasing in value, not deflating. State-of-the-art drilling equipment has not yet succumbed to the global deflationary pressures we see in businesses like cell phone and chip manufacturing. Cell phone manufacturing capacity is overbuilt yet still receives more and more capital investment worldwide — good for consumers, bad for producers. But offshore drillers emerged out of a 20-year recession just a few years ago.

Furthermore, while earnings visibility is very low at most technology companies, several offshore drillers know the next few years of earnings with a fair degree of confidence. To top it off, they’ll have very valuable rig fleets at the end of the high-visibility period. Who knows what the cell phone industry will look like?

Technology businesses are not considered as “capital intensive” as drillers, but in my view, the ever-present challenge of technology obsolescence more than offsets this. Carl Icahn’s efforts may pay off for shareholders in 2007, but they will magnify, or leverage, the shrinking shareholder base (shrinking due to share buybacks) to the downside of technology’s creative destruction.

Examining the Effects of GlobalSantaFe’s Cash Flow on Its Balance Sheet

When you buy a stock, you are essentially buying a claim on the company’s assets and the cash that those assets generate when they are put to productive use. If you look at the assets on a balance sheet from the bottom up, you see that the least liquid assets are toward the bottom and the most liquid assets are closer to the top. Management’s top job is to extract as much value out of these assets as possible, gradually converting them to cash over long periods of time:

Using this “back-of-the-envelope” model, I forecast what the trends in GSF’s cash flow and balance sheet will look like in the future. These financials are certainly easier to project than Motorola’s. This model has the following conservative assumptions: revenues peak in 2008 and slowly decline, net profit margins peak at 35% in 2007 and slowly decline, and annual capital requirements (working capital and capital expenditures) remain in the range of 17-22% of revenue:

The key estimate this model provides, highlighted in yellow, is “free cash flow,” which is defined as net cash from operations minus capital expenditures.

A more accurate measure of free cash flow is net cash from operations minus maintenance capital expenditures. Free cash flow is a measure of the cash available to fund dividends, share buybacks, and growth projects after accounting for the spending necessary to maintain the existing business.

My model estimates a free cash flow peak of $1.6 billion in 2008, followed by a slow decline. But I’m confident that free cash flow will be higher than this because the estimate highlighted in yellow includes capital expenditures high enough to fund an expansion of GSF’s rig fleet, which will in turn add to GSF’s future cash flows. I’m assuming that all excess cash is returned to shareholders via stock buybacks. This produces the compelling returns I outline in the bottom row of the table. These share buybacks can be accelerated if more debt is issued (a “recapitalization”).

Here’s the key point I want to make about GSF and all the other contract drillers: Free cash flows will be so high that most of them must buy back hefty amounts of stock, raise dividends, or expand their rigs fleet quickly to avoid having too much cash pile up on their balance sheets. This is a nice problem for any company to have, but it puts them right in the cross hairs of private equity funds, aggressive peer acquirers, and activist investors like Carl Icahn.

Spreadsheets Must Pay Attention to the Outside World

Free cash flow models are only as good as the assumptions on which they are based. So investors must remember to test a model’s assumptions when they see one. The “micro” analysis of projecting financial statements into the future cannot be separated from the “macro” analysis vital to these projections. The assumptions underlying my GlobalSantaFe model would have to be thrown out the window if, in fact, a huge glut of oil supply were about to come on the market and stay there for a few years.

But my research over the past few months indicates that the odds of this occurring are very low. Peak Oil has already occurred in many areas of the world including the U.S., the British and Norwegian sectors of the North Sea, and now Mexico.

What happens in every country after passing peak production? Demand for drilling skyrockets. The North Sea has been a very active offshore drilling market in recent years, and there’s no sign of a slowdown.

GlobalSantaFe maintains an indicator of industry health called the SCORE (Summary of Current Offshore Rig Economics). It compares the profitability of offshore rig dayrates with the profitability of dayrates during the 1981 peak of the offshore drilling cycle. When the SCORE index is at 100, dayrates equal “the sum of daily cash operating costs plus approximately $700 per day per million dollars invested.” (Source: GlobalSantaFe):

Approaching this in a simpler way — the profit generated by a typical offshore rig when the SCORE is 100 means that its owner is recouping his capital outlay in just four years. In the 130s, you can imagine how quickly rig owners like GSF are “monetizing” their rig fleets.

As for oil demand, it’s important to remember that higher prices are more likely to slow demand growth, rather than reverse it. Global oil demand hasn’t contracted on a year-over-year basis since the early 1980s. John Segner, portfolio manager of the AIM Energy Fund, puts these numbers into context in a recent Barron’s interview:

“China is still using only 6.5 million barrels of oil per day. We are using 20 million barrels per day here in the United States. China is 25% of the world population. The Chinese are getting off bicycles. They want air conditioning. They are getting housing. If China slows, it would just be a bump in the road. Oil-demand growth could slow down, but the chance of it going below 86 million barrels [per day], say, next year? I just don’t see that happening. And I don’t see a lot of capacity growth. Supply-demand is still going to be tight.

“Energy [investments are] going to do very well. The multiples have been contracting for the better part of 12 months. And we are toward the end of that correction more than we are at the beginning of it.”

Drilling Rigs Will Inflate Faster Than Houses

Amid the rumors of a $100 billion private equity bid for Home Depot, I find it surprising that there has been little private equity interest in exploration and production (E&P) or oil field service companies.

Perhaps financial engineering could unlock some value for Home Depot shareholders, but there is only so much you can do with a large retailing business model. Plus, the company is still exposed to the housing bubble’s hangover. It’s impossible to quantify just how much “spec” building and home equity refinancing money found its way into Home Depot cash registers over the past three years.

HD’s price-to-earnings ratio when business is firing on all cylinders is a lot lower than when it’s not — especially when you think about the effect of spreading lower sales across a high fixed cost structure (big box stores) and the financial burden of holding slower-turning inventory.

Home Depot may be a good buyout someday, but I think potential buyers can get a better price at some point over the next two years.

Think about the “leveraged” income strategy employed by most landlords. Assume that a landlord purchases an apartment building with a 10% down payment and a 90% mortgage. If rents provide enough income to offset mortgage interest and maintenance, the landlord is left in a position where his equity goes up and down by a factor of 10-to-1 with each fluctuation in the value of the apartment building.

Leveraged exposure to a long-term real estate bull market is how most real estate moguls have made their billions. If an opportunity comes along to borrow money at a low fixed interest rate and buy a cheap asset that is both inflating in value and throwing off income, it’s hard to lose.

Why not consider contract drilling businesses?

I’d bet that a fleet of drilling rigs will inflate in value at a faster pace than physical buildings over the next 10 years. I’d also bet that quite a few savvy investors recognize this and we’ll see more mergers, acquisitions, and private equity transactions as the energy bull market continues to roll on.

Good investing,
Dan Amoss, CFA

March 27, 2007

Levered Technology, Unlevered Drillers was originally featured on Whiskey and Gunpowder