All I had to do was deposit a minimum of $180. I got the one-year time deposit, which means I have to leave the money alone for a year. But if I decide I want my money back sooner, I still get the “default interest rate” of 4%. That’s a lot more than I get back home, which is pretty much nothing.

You can open such an account too. But it’s not easy. If it were easy, then the opportunity would’ve disappeared already. And there is a catch.

What’s the catch? Well, it’s in a bank in Mongolia. And there is no deposit insurance. It’s a speculation on a booming country and a currency — the Mongolian tugrik — that could be one of the best performers against the U.S. dollar over the next year or two.

I think of it as buying a stock that pays me 16% per year with the potential for added capital gains if the tugrik rises against the dollar. In what follows, I’ll tell you more about my trade and how you can do it too.

Since peaking at around 1,600 tugriks to the dollar in 2009, the “tog” (the “o” being pronounced like the “o” in “toad”), as it is called in the streets of Ulaanbaatar, appreciated to 1,200 in early 2011. (It was the world’s best-performing currency against the U.S. dollar in 2010.) It’s weakened since to about 1,318 per U.S. dollar, creating an opportunity.

The Mongolian economy is a resource-driven story. As such, the fall in commodity prices for most of the second half of 2011 and the first half of 2012 has also hit commodity currencies. Moreover, it’s an election year in Mongolia. The inevitable political drama has also taken a bit of the starch out of the tog.

But the growth in Mongolia seems virtually assured, and that’s bound to put a lot of upward pressure on the tog, as people need it to pay workers, settle contracts, etc. The law requires all transactions settle in togs. Hence, as the economy grows and transactions multiply, the demand for togs should be strong as well.

I know I’ve written to you a lot about Mongolia’s growth. I feel I’m repeating myself a bit. But if I had to distill it down to an essence, it’d be this: Mongolia has about an $8 billion economy. There is $13 billion going toward the development of just the seven largest mining projects by 2013. The economy could easily double in the next couple of years. It is the fastest-growing economy in the world.

As has happened in other resource economies — think Australia — the currency should appreciate.

There are risks, of course.

A lot of people worry about what happens to Mongolia if China goes kaput. After all, Mongolia’s resources feed China’s. As one investor put it to me, “Mongolia is an umbilical cord to China.”

Logically, China would cut its consumption of commodities. But it would cut first those coming from distant and more-costly suppliers, such as Australia. Mongolia is the low-cost producer. Mongolia is just across the northern border of China. That should insulate it some from commodity price declines and falling demand.

There are other risks. The currency exchange rate could move against you for whatever reason — excessive money printing or something else. Or you could have a banking crisis and lose your deposit altogether. But you take these kinds of risks in speculative stocks anyway. That’s why I think of owning tugrik deposits as owning a speculative stock that pays 16%. I’m OK with that.

Why are interest rates so high? The economy is starved for capital. Banks have huge demand for loans, but not much capacity to lend. The capital markets are not developed. The stock market is still a toddler. And there is no venture capitalist community or the other deep pools of capital that exist in the West. The great mining projects suck up most of the capital.

That is why rates are so high. There is tremendous competition for funds. Over time, rates should ease as more capital flows into the country. For now, though, there is a great window of opportunity.

I’m bullish on the tugrik and I like the idea of owning a 16% deposit. I would risk only money you can afford to lose — just as if you were speculating on some mining stock. But my bet is that this account will outperform those speculative penny stocks you like to dabble in.

You can open a brokerage account and a bank account without physically being in Mongolia. I’d suggest you do both at the same time. The brokerage account will allow you to buy Mongolian stocks if you choose to do so at some point. There is no cost to opening an account, so you might as well do both. I did.

How to do it?

Here is a checklist of what you’ll need:

• A notarized copy of your passport/ID
• An Individual Account Opening Form
• A Power of Attorney form, for the trader to sign order tickets
• A bank deposit account form
• A photo.

Golomt Bank is one of the largest banks in the country. (I met with three of the four.) Of these, Golomt seems to offer the easiest process for you, assuming you are not going to Ulaanbaatar anytime soon. My contacts are at Golomt Securities, the newly opened brokerage arm of the bank. They are eager for business, and I’ve found them responsive. (Keep in mind the time difference between wherever you are and Mongolia.)

Regards,

Chris Mayer

How to Open a Bank Account that Pays 16% was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

This was the second weekend we went hunting. It’s been a fascinating experience so far, and what I’ve found tells me the housing recovery is not too far off, despite all the dire talk to the contrary. The investment implications are many and varied.

Being bullish on housing is a contrarian view. In a recent national survey, 37% of homeowners say they think buying a house is a “risky investment.” And 86% think prices will either stay flat or fall.

This is a big difference from four or five years ago. But people always tend to gauge the future based on their recent experience, like trying to predict the weather tomorrow based on what it was yesterday.

In 1958, for instance, the Federal Reserve did a survey in which they found 58% of respondents thought owning real estate was a bad idea. Of course, folks said that based on recent experience. In 1920, if you bought a home in the US, odds are it was worth about half what you paid for it two decades later. In many instances, it wasn’t until 1960 that housing prices got above pre-Depression levels. In this context, the feelings of people in 1958 were reasonable… but their predictions were wrong.

So too people in the year 2011 will rue their bearishness on housing.

The beauty of markets is how they self-correct, when allowed to do so. The housing bubble popped in 2008. Prices collapsed. The bust shredded the balance sheets of many an American family and did violence to their credit ratings. Today, foreclosures and short sales chew through the inventory of homes, re-pricing them and putting the assets on better financial footings. The prices of homes are now at realistic levels, supported by the rental market and more in tune with what people can afford.

In fact, rental rates have been rising. In 12 of the 27 largest metropolitan markets in the US, it is cheaper to buy than to rent. In some markets, the gap is pretty wide. In Atlanta, monthly rental rates average $840. By contrast, mortgage payments, including taxes and insurance, average $539. So there is a good opportunity there for investors.

Real estate is intensely local, of course. Housing markets are multifaceted prisms. It is hard to generalize. But clearly, there is value out there.

One individual I know runs a partnership that has purchased 87 homes in Georgia and North Carolina during the last year. When he leases out these homes, his firm averages a 16.5% gross yield. That’s annual rent divided by purchase price, plus closing costs and estimated repair costs. And that is without leverage, net of all expenses, and includes estimates for vacancy and maintenance.

This is what the big-picture guys miss. Economists can talk all they want about how a housing recovery is years away. Maybe so, but the opportunity to invest and make good money is now. In a world of 2% Treasury rates, 16.5% gross ain’t bad.

I’m not seeing those kinds of yields in my home market, but more- modest cash yields are still attractive. I fully intend to put a mortgage on my properties, locking in rates that are the lowest in six decades. Don’t forget rental rates can rise over time, while the mortgage is fixed. When housing prices rise, you can really make a killing.

Why does this opportunity exist? To me, it’s clear, especially now, after bidding unsuccessfully on one property and hunting for others. It’s simply because, in the post-bubble rubble, there aren’t that many people with the kind of clean credit and cash that can afford to be investors in residential real estate. Nor is there much appetite for it. But there are plenty of people with good-enough credit and cash to rent. Even so, we’re finding competition from other investors for the properties we’ve looked at. We’re not the only ones who have sat down and done the math.

Now, I am not saying a housing boom is about to happen. There is more wood to chop before we get there. But I am saying that American housing as an asset looks cheap. And I think the free competitive forces at work are improving the market. It’s not getting worse. The bottom is in. Where rental markets are supportive of current pricing, I don’t see much downside.

This has all kinds of investment implications beyond just buying a house and renting it. There is a lot of money that will go toward renovations as this process unfolds. Spending on home improvements is at a multi-decade low, well below the long-term historical trendline. This suggests a recovery in the future.

The housing recovery is likely to be a long-term story. But here’s an early prediction: In the ashes of the bust, a phoenix shall rise. That phoenix is the humble American home.

Regards,

Chris Mayer

On The Trail Of The Housing Recovery was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

But the investment seasons turn. Today some smart investors are once again saying you should a buy house. John Paulson is one of them.

You may know him as the man who turned the greatest trade of all time. Betting against the housing market, he netted a cool billion dollars for himself in 2007. One fund he managed rose 590% that year. Today, he is one of the richest men in America.

His advice today is very different. “If you don’t own a home, buy one,” Paulson said. “If you own one home, buy another one, and if you own two homes, buy a third and lend your relatives the money to buy a home.”

That’s a strong endorsement. It sounds similar to the advice another investor gave his audience in 1971, at the dawn of another inflationary age. It was Adam Smith (George Goodman) on The Dick Cavett Show. Here is a snippet from that conversation:

Smith: The best investment you can make is a house. That one is easy.

Cavett: A house? We were talking about the stock market. Investments…

Smith: You asked me the best investment. There are always individual stocks that will go up more, but you don’t want to give tips on a television show. For most people, the best investment is a house.

Cavett: I already own a house. Now what?

Smith: Buy another one.

It was good advice. In the 1970s, U.S. stocks returned about 5% annually, which failed to keep pace with inflation. Still, it was an up-and-down ride. In 1974, the stock market fell 49%. But here are the average selling prices for existing homes in the 1970s as inflation heated up:

• 1972   —   $30,000

• 1973   —   $32,900

• 1974   —   $35,800

• 1975   —   $39,000

• 1976   —   $42,200

• 1977   —   $47,900

• 1978   —   $55,500

• 1979   —   $64,200

You can see that housing held up pretty well. And think about the effect of a mortgage on 80% of that house in 1972. That would mean $6,000 in equity, a sum that went up fivefold in eight years. It’s hard to find a better inflation fighter than that. Granted, today’s market is different, but still.

Apart from this, you might also reflect on the fact that it is quite absurd today to think that anyone can buy an average house for any of these prices — and that, too, is the point. The average price today is $257,500 — even after the great collapse in the last few years.

“If you have a 7% mortgage and your house is worth half a million dollars,” Adam Smith writes, “you may gripe about shoes and lamb chops and tuitions like everybody else, but your heart isn’t in it.” Your heart won’t be in it because you’ll be in fine fettle with your house.

Of course, you can do a lot better than 7% today. For the first time, the rate on 30-year mortgages slipped below that on the 30-year Treasury bond. You can get a 30-year mortgage at little more than 4% today.

Factoring in mortgage rates, housing affordability is back to where it was in September 1996. Then mortgage rates were 8% and the average price of a home was $171,600. As Murray Stahl writes: “One can actually buy a home for a monthly payment that is not very many dollars different from the monthly payment one would have needed in September 1996, when rates were significantly higher.”

Adjusted for inflation, Stahl points out that the payment for an average-priced home today is about 30% lower than it was 14 years ago.

The advice of Paulson and Smith starts to make sense now, doesn’t it?

Essentially, real estate is a way to buy now and pay later. It is a way to short (or bet against) the dollar. And the case for housing extends to other property types, too. Owners of quality real estate are getting deals on mortgages that we are unlikely to see for a generation.

Regards,
Chris Mayer
Whiskey & Gunpowder

January 5, 2011

Cheap Houses Hedge Inflation Risk was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

I think it is coming. In fact, in many ways, it’s already here, just not yet widely recognized. The deflationists still hold sway in the bond market, where investors happily accept puny yields.

The deflationists argue that the dollar will buy more tomorrow than it does today. It is inflation’s opposite. When most people talk about inflation and deflation, this is what they mean. This definition would pain the old economists who were more careful in their use of language.

Be that as it may, deflation today is an argument facing death by a thousand cuts. Every day, evidence rolls showing that the dollar is buying less. Today’s Wall Street Journal points to the whale in the aquarium. One headline reads, “From Cereal to Helicopters, Commodity Costs Exert Pressure.”

The article goes on to point out what is painfully obvious to anyone who follows commodities and companies. The cost of nearly everything is going up.

General Mills will boost the price of a quarter of its cereals to reflect rising prices for grains. Kraft is raising prices. Domino’s Pizza hasn’t said it will yet, but it did say the price of cheese is up 29% from a year ago. Profit margins are suffering in the meantime.

There is a long list of companies battling rising costs of the commodities. As the Journal notes:

“Corn is up 44%, milk is up 6.5%, hot rolled coil steel is up 4%, copper is up 29% and oil is up 14% from a year ago… Across Corporate America, more companies are wrestling with when and how much to raise prices as raw materials costs climb.”

Still, the Journal’s article had no discernible effect on the optimistic bondholders. (Or I should I write “bag holders”? For soon, they will be left holding the bag.) The bond market seemed bored and yields inched up just a touch today, such that the 10-year note pays a whopping 2.506%.

By the time the bond market says inflation is here, it will be too late — too late for bondholders.

In the meantime, the prices of gold and silver are up too. All of these things point to the obvious: The dollar is buying less.

Why?

Let us the count the ways. There is the U.S. government bleeding red ink and heavily in debt. Both portend bad things ahead. How will they square the circle? The easiest — and the most politically expedient — way is to print more money.

There is the jawboning going between central banks of the world all trying to cheapen their currencies. The rationale is to stimulate exports, but don’t be fooled. The real effect of a cheapened currency is that your dollar will buy less.

There are kinds of fancy names for what the Fed is doing — “quantitative easing” comes to mind. But at bottom, they all mean the Fed will create more money.

I was at Grant’s Fall Conference in NYC this week. Jim Grant, the host and editor of the excellent newsletter Grant’s Interest Rate Observer, said: “Don’t you sometimes get the feeling that the economists are pulling our leg? A bartender would call it watering the whiskey.”

That is a good way to think about it. More dollar printing simply dilutes the buying power of all dollars. And so we see today the beginnings, the mere sprouts, of a fully fledged inflation. It can and will get much worse.

Don’t pay attention to that thing called the Consumer Price Index, or CPI. It is running at about 2%. It is an engineered figure and not to be trusted. Oskar Morgenstern, who along with John von Neumann contributed so much to game theory, once described it as a “mere index of doubtful validity,” as Grant relayed.

Nonetheless, on the basis of this suspect fluff, the Fed tells us inflation is under control. In fact, it is complaining that the inflation rate may be too low. As Grant quipped, “That’s like the New York Police Department complaining about the lack of crimes.”

Bernanke would have us believe the Fed can calibrate inflation within tolerances of 100 basis points. But it way overestimates its powers. Once the inflation train gets going, it will be very hard to slow down. One day, the Fed will wish inflation were only 2%.

Regards,
Chris Mayer
Whiskey & Gunpowder

October 29, 2010

Inflation Is Already Here with Lots More to Come was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

Yet this is not unusual for Big Oil these days. In fact, most are making big bets on natural gas.

Exxon Mobil completed eight projects last year. Seven of them were for natural gas projects — not oil. Of the three scheduled this year, two of them are gas. ConocoPhillips paid $5 billion for Origen, an Australian gas company.

Meanwhile, Chevron hammers away at its mammoth liquefied natural gas plant off the coast of Australia, at a total cost of more than $40 billion. (Liquefied natural gas, or LNG, is easier to transport.) Most of the oil giants are also slamming billion-dollar fistfuls to pick up shale gas acreage in places such as the Marcellus in Appalachia.

This shift creates new opportunities for investors. But before we get to those, let’s try to understand what’s happening.

There are several things at work here. One is that new oil deposits, like pitchers who can hit, are becoming harder to find. They are also costlier. The Kashagan oil field, which was supposed to be a great find in the Caspian Sea, is seven years behind schedule and billions of dollars over budget. Another factor at work is that 90% of the world’s oil reserves are in the hands of national oil companies. They are off-limits for the likes of Exxon and others.

By contrast, natural gas deposits are more plentiful. They are also getting cheaper to develop. The cost to build an offshore LNG terminal is about half of what it was only two years ago. The big LNG plants can be just as expensive as anything in the oil world, but — unlike oil — these projects don’t usually go forward unless there are long-term contracts in hand to support them. Some of these contracts go for 20-year terms. This makes the business more appealing to the majors, who don’t have to sweat the huge ups and downs they endure in the oil markets.

With contracts in hand, the gas business is just one of putting together an Erector Set. As The Economist notes, “The gas business is really an infrastructure business: drill wells, build gas plants, install pipelines and accrue profits.”

But there is more. The world’s use of natural gas is growing faster than its use of oil. The IEA’s guess is that oil consumption grows half a percent a year. Natural gas consumption, by contrast, should rise more than 50% in the next 20 years. Total, the big French oil company, is even more bullish. It estimates that China will use much more natural gas than is commonly assumed. Only a lack of infrastructure keeps China’s appetite for natural gas under wraps. But China is in the process of building that infrastructure today. It is only a matter of time before the nat gas markets feel its impact.

Finally, natural gas is cleaner burning. There is a lot of talk of carbon taxes of one kind or another, not only in the U.S., but abroad. I believe it is matter of when, not if, governments punish dirtier fuels. Natural gas will benefit.

However, I don’t expect the price of natural gas to rise in a big way anytime soon. There is simply too much of it. Natural gas producers are all expanding production. Most are spending more to expand production than their cash flow supports. This is happening even though most look like they don’t make any money at $4 nat gas. (A recent survey put the industry average at $5.74.) This doesn’t bode well for the price of natural gas in the short term. As beaten up as it is, it could stay here for a while, or even go lower.

And so we hold only one pure play on natural because it is a low-cost producer with no debt, so it can still create shareholder value in a low-price environment.

Longer term, the current low nat gas price is not sustainable, as most of the industry seems to lose money at these prices. As old contracts (made when natural gas prices were higher) roll off, these producers will start to shut down production.

The following chart shows the cost curve for the lower 48 states in the U.S. These producers need $7 gas to make money. If this is right, then our pure natural gas company in Capital & Crisis will make a lot of money.

This is because logic dictates that we should expect the price of nat gas to gravitate toward the cost of the marginal producers. (And since our company’s costs are under $2, it stands to make a lot of money when gas turns around. I’m content to wait it out…and buy more).

But let’s get back to natural gas in broad terms. Even though pricing looks unexciting in the near term, demand looks healthy long term. The world will burn more natural gas in cars and buses of the future than it does today. It will burn more natural gas to heat and cool homes than it does today. It will rely more on natural gas to provide electricity.

Long-term investors should treat these things as inevitable. Big Oil certainly is. And we are already building the infrastructure to support all of that future growth today. The best way to play this latter trend is in another idea we already own.

Regards,
Chris Mayer
Whiskey & Gunpowder

September 20, 2010

How to Profit When Big Oil Bets on Natural Gas was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

These changes began as Africa opened up its markets. The trend is unmistakable. Many governments have sold off lots of state-owned enterprises, for instance. Nigeria alone privatized 116 entities between 1999–2006. Generally speaking, governments have lowered corporate taxes and beefed up their legal systems. They’ve loosened up on barriers to trade. And inflation rates have fallen. The average inflation rate dropped from 22% in the 1990s, to 8% after 2000. Foreign debts dropped by one quarter. Budget deficits fell by two-thirds.

This is like laying a seedbed for investors to thrive. So the money started to come and settle in Africa. Foreign investment in Africa is up sevenfold since 2000, to $9 billion. Africa’s economy is now about as big as Brazil’s or Russia’s. The continent is young and urbanizing and growing. By 2050, one out of every five people on the planet will hail from Africa.

These things are fairly shocking. The trends are diametrically opposed to what we are seeing in the aging Western economies. Yet there is still a long way to go. The shackles are only starting to come off Africa. And we know from long experience that when people are free, they grow rich.

The proof is in the pudding. Africans increasingly join the world’s consumers. According to McKinsey & Co., in the next few years, the number of households earning more than $5,000 should top 100 million. (This $5,000 benchmark is when most Africans will spend more than half their income on nonfood items.) Already, Africa has more middle-class households — defined as having $20,000 in annual income — than India. And India has more people.

Everyone who has done business in Africa says it is a hard to place to make a dollar. Yet people are figuring out ways. There are a number of studies on this point. One recent study tracked publicly traded companies operating in Africa from 2002–2007. It found that the average return on equity for African companies was two-thirds higher than for comparable companies operating in the sexy markets of China, India, Indonesia and Vietnam. Another survey of U.S. companies showed that they enjoyed their best returns when they invested in Africa compared to any other region.

These investments are in many different sectors, though Africa has always been a resource story to most investors. No doubt, this is an exciting part of the puzzle that is Africa: the long list of commodities in which Africa is amazingly rich. For instance, about 40% of the world’s gold is in Africa. And this is just what we know about. For the most part, Africa is unexplored.

As Paul Collier points out in The Plundered Planet, the typical Western country has $114,000 of subsoil assets per square kilometer on average. This is despite more than two centuries of intense exploration and extraction. In Africa, the number is about $23,000 of known subsoil assets. As Collier concludes, “It is highly unlikely that this massive difference is due to a corresponding difference in what is actually there. Rather, the difference in known assets is likely to indicate an offsetting difference in what is awaiting discovery.”

It means a long resource boom in Africa could be in the cards.

As I say, there are reasons for skepticism. Collier, too, notes the struggles of the 1970s commodities boom. The oil boom of 1973–83, for example, didn’t do Nigeria a lot of good. But the 2003–08 boom was another story altogether. Nigeria is now free of debt and has $70 billion of foreign-exchange reserves. As Collier says, “The contrast between Nigeria’s dysfunctional management of its first oil boom of 1973–83 and its brilliant management of the second boom of 2003–08 cautions against the gloomy cynicism that until recently bedeviled investor thinking about Africa.”

One more point from Collier. In a piece called “The Case for Investing in Africa,” he points out that investors have small exposure to Africa in their portfolios. Yet given the West’s stagnant state and the rapidly growing African economies, this could change. “At present, the typical investment portfolio has massive exposure to the [Westernized] countries and negligible exposure to Africa,” Collier writes. “This looks unlikely to be appropriate for the coming decades.”

There are many ways to invest in Africa. Right now, I’m attracted to certain African gold outfits that are super cheap.

From the bird’s-eye view, there are three main gold basins in Africa. The most famous is in South Africa. This area has been in decline for a long time. Plus, many of the mines are deep underground and high cost. I’m not interested in the South Africans. The other two regions, though, are more promising and growing — West Africa and the Tanzanian regions. In fact, few gold bugs realize this, but the rest of Africa produces more gold than the once-prolific South Africa.

In the past, “the rest of Africa” has been a scary place for investors. That’s starting to change, too. The Fraser Institute scores, widely tracked by investors, attempt to rank mining jurisdictions by attractiveness based on standards of governance and the like. African rankings have improved. Countries such as Mali and Tanzania now rank ahead of South Africa. They are on par with China, Russia and Peru.

So gold miners — and investors — face a choice. You can pay up and stay in friendly jurisdictions working more-challenging ore bodies with lower grades. Or you can take a greater risk for the relatively unexplored potential of Africa.

Right now, I think investors ought to give a hard look to African gold miners. There are sizable companies here with quality assets. They also have good track records managing the risks of being in Africa. The exploratory upside makes for a mouthwatering prize. And most are so much cheaper than their beloved Western counterparts that it is worth the risk.

Regards,
Chris Mayer
Whiskey & Gunpowder

August 30, 2010

Why Investors Need to Look at Africa Right Now was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

Brazil impressed Zweig with its enormous size — it is bigger than the continental U.S. — and impressive landscapes. He also saw what many saw before him. “Here lies immeasurable wealth of soil that has never been plowed or cultivated,” he wrote, “and beneath it are ores, minerals and natural resources that have not in the least been used up nor even extensively explored.”

And so it remains today. As I say, Zweig was not the first to find charm in these sunny lands. A long line of travelers and adventurers have said much the same thing. But it took a long time to get going, so much so that it became a joke: “Brazil, the land of the future and always will be.”

Still, natural resource booms did help settle and build Brazil, as Zweig observes. Booms in lumber, sugar and cotton settled the north and created Bahia, Recife, Olinda, Pernambuco and Ceará. Gold settled Minas Gerais. Coffee raised São Paulo. Rubber gave life to Manaus and Belem. And on and on…

Today, though, Brazil seems to be putting it all together and the old joke has gone stale. Brazil is the leading exporter of a long list of agricultural commodities. Then there are the big oil discoveries off its coastline. And there is the ample soil and water, as I’ve written about before. Brazil’s net debt is at a level that in the words of the Financial Times, “makes much of the developed world green with envy.”

Meanwhile, unemployment is low. The economy is growing 8–10% a year. Poverty from 2004–08 fell by half. Meanwhile, a growing middle class continues to make its presence felt — retail sales rose 30% in March alone. “There’s nowhere else in the world that’s had the dramatic change in the middle class like Brazil, not even China,” says one analyst quoted in The Wall Street Journal recently. “You’ve got an unfathomable amount of money there.”

So what are the investment opportunities in Brazil today? I’ll have a better handle on things in the coming months as I spend some time down there. But I have some initial thoughts to share here.

For a long time, Brazil was not a place to trust with one’s money. But the rules these days are friendlier for investors. Yes, the laws are still complicated and taxes are still high. Labor laws are still outdated and often inflexible. Overall, Brazil is still not a great place to do business. It ranks 129 out of the 183 nations tracked by the World Bank. Yet it still has come a long way. As one partner at a leading international law firm put it, “For the first time in the history of Brazil, we have an excellent environment for investment.”

There are plenty of places to look for those investments. Where are the needs most critical? In a word: infrastructure.

Sewage facilities are inadequate. The FT opines that here the “need for investment is perhaps greater than any other sector.” While some 80% of Brazilians have access to clean water, less than half have access to a sewage system. And Brazil treats less than a third of its wastewater.

Roads are notoriously bad. Only 10% or so are even paved. As a result, freight costs eat up a third of the value of what’s shipped. Sometimes, the freight never arrives. Recently, a McDonald’s had to go a day without serving french fries because the supply truck never made it in. The roads affect most everyone since the roads handle some 68% of Brazil’s transport needs.

The ports and rail links also feel the strain of a booming economy. Brazil’s biggest port, at Santos near São Paulo, handles only a 10th of the traffic of big Asian ports like Hong Kong.

Brazil Needs Lots of Steel

Another way to see these claims of weak infrastructure is to look at Brazilian steel use, which is very low. Brazilians consume only about 100 kilograms of steel per person. That number has barely moved since 1980! The Chinese consumed 30 kilogram of steel in 1980 and now consume 300 kilograms per person. European countries often top 500 kilograms. South Koreans use 1,200 kilograms per person! So there is a lot of room for steel consumption to grow in Brazil.

Lakshmi Mittal, the CEO of the world’s largest steel company, summed it up well. “The level of consumption is well below the country’s potential. It also indicates a lack of infrastructure investment in the last two decades.”

Some of this is in the process of being fixed. Brazil has a huge port in the works near Rio, called Acu Super Port. It is a mammoth project — nearly two miles long, it will hold 10 deep-water berths. Brazil also has plans for more roads, a high-speed rail line between São Paulo and Rio and more.

The best way to invest in rising Brazilian steel use is through native companies. That’s because the Brazilians are among the lowest-cost producers of steel in the world. Brazil sits on some of the lowest-cost and highest-grade iron ore and coking coal deposits in the world. Power costs are low thanks to hydropower, which provides four-fifths of Brazil’s electricity. And the relative isolation of the Brazilian market from other big steel producers gives the home team a big advantage in freight costs.

The only tricky thing is the Brazilian real, a currency that has been strong of late and raises the cost of Brazilian steel. (We are a far cry from 1990, when Brazilian inflation peaked at 2,950%!) Finally, and somewhat ridiculously, Brazil still has import duties on steel.

Another fact that bodes well for steel use: Energy consumption is also remarkably low. Brazil consumes about 1.2 tonnes of oil equivalent per capita per year. That’s less than half what Portugal and Poland use. And they are among the poorer members of the EU. The U.S. uses 7.8 tonnes. Building a new and needed energy infrastructure for Brazil’s expanding economy will consume a lot of steel.

Steel is just one idea, but there are many other sectors to invest in in the country. From a big-picture standpoint, it’s hard not to like Brazil. As Zweig wrote, “In its geology, this gigantic empire lacks hardly any kind of ore, stone or plant.” Finally, it looks like Brazil is taking advantage of its space. (Things would end badly for Zweig, though. Even Brazil couldn’t beat back the demons. He committed suicide in Brazil in 1942.)

Regards,
Chris Mayer
Whiskey & Gunpowder

August 11, 2010

Why You Should Buy What Brazil Needs was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

This is why things like auditors and listing requirements and boards of directors are so important. This is why due diligence is important: asking questions, talking to people on the ground. They give some assurance to investors that what they see is real and not a fraud.

Sometimes the lines can be very fuzzy. And sometimes the taint of fraud dogs a market, making all the stocks of that market cheap, whether they are fraudulent or not. Such a market is also very susceptible to rumor.

I think the market for the U.S.-listed China-based companies has that taint. That explains the very cheap multiples that many such companies trade for. I’m talking about price-to-earnings ratios of 5–8 times for companies growing 20–30% a year.

But investors will have to be careful, as there seem to be a lot of questionable apples in the bin. And they will have to do quality due diligence to stand up to rumor and extreme price volatility.

There have been several cases of fudged numbers. I wrote about Fuqi Intl. before. It is a China-based jeweler whose stock trades on the Nasdaq. The stock dropped 37% one day in March after the company announced it would have to restate past results. The stock has continued to drop since. The stock was $30 per share and is about $6 today.

There have been other grim casualties. But the pace of digging up scams seems to have quickened. I’ve been trading e-mails with my Beijing contacts for weeks. One veteran hedge fund manager, who would like to remain anonymous, told me how he was “very worried.” There are too many scams, which is not good for the market. He said, “Another big development is these detailed negative research reports. There are three–four quality reports coming out each month from different outfits. This is compared to maybe only two–three reports all of last year!”

A company called China Marine Food has recently been fending off challenges to its accounting. A website called Chinese Company Analyst performs detailed financial analysis of Chinese companies. In a highly detailed report, it contends that China Marine Food is a fraud. I can’t do justice to the report here, but here is a damning snippet:

“I question how [the company] could generate $7.6 million of revenue, $1.7 million of net income and $1.2 million of operating cash flow in its first five months of operations with (i) $44,000 of startup capital it received from its original founder, [and] (ii) $414 of capex…”

China Marine Food dropped more than 20% on the day these allegations came to light. The stock has continued to fall. The company has defended its accounting. It may or may not be a fraud, but the evidence seems to suggest that all is not quite as it seems.

Most recently, another case has come up with Orient Paper. This is a company I put on my watch list after one of my Beijing contacts told me about it. It seemed to have great fundamentals and traded very cheaply.

I never looked at it in detail, but I remember thinking it seemed fishy that the stock of an operating company could go from $1.50 to $15 within a year. That just doesn’t happen. Resource companies can make that kind of leap — you have a new discovery or the underlying commodity takes a big jump. But it is rare that a basic operating company involved in something like paper becomes a ten-bagger in a year’s time.

On June 28, a company called Muddy Waters released its “inaugural report” on Orient Paper contending that it was a fraud. The stock closed at $8.33 before the report. It dropped 13% that day, but the snowball was only just getting started. Two days later, the stock hit $4.11.

But this is one where the line is:

Fuzzy.

The Muddy Waters report is detailed. The authors of the report talked to suppliers. Some of the suppliers offer a very different view of Orient Paper’s capacity than what Orient Paper claims. Muddy Waters tried to track down customers. Some of these they found did not exist or were small mom and pop shops. Yet Orient Paper reports millions of dollars in sales from such customers. Muddy Waters tried to match SEC filings with tax filings in China. They claimed to find major discrepancies. There are pictures of site visits showing old machines. There are other observations about the number of employees and trucks and more.

It all adds up to a pretty damning dossier.

Yet there is another side. Rick Pearson, one of my Beijing contacts, also visited Orient Paper. In fact, he was on the same site visit as the Muddy Waters’ crew. More incredibly, Pearson knows the authors of the Muddy Waters report, both old classmates of his.

Pearson wrote up his views for TheStreet.com. He has a totally different view of the company. He bought the stock after the report! As he writes:

I was quickly on the phone to the company, to its IR firm and to other major investors who own the stock. Everyone was equally shocked by the report, and the company vowed to respond immediately. I know a number of investors who have toured ONP, met management and invested in public and private offerings by the company. The investors have all expressed interest in buying at these levels.

Pearson was also critical of the due diligence of his former classmates, who apparently asked few questions of management on the visit and didn’t speak Mandarin. He felt like they were there to “check a box” to say they’d visited the company.

Pearson’s piece must’ve helped settle the market, because it rose 44% the day his piece came out, to back over $7 per share. (The fact that the stock moved so much during this whole period shows how little investors really knew about the company. This is why I say you have to have strong due diligence. Otherwise, you’ll wind up locking in losses on the merest rumor, to which Chinese companies seem susceptible at the moment.)

So what does all this mean? I don’t know if Orient Paper is a fraud. I have a lot of respect for Pearson’s research and expertise. He was a former investment banker. He lives in Beijing. He speaks Mandarin. And this — U.S.-listed, China-based stocks — is his métier.

I suspect that Orient Paper’s accounting is not entirely up to snuff. I suspect it’s probably not a high-quality company (that doesn’t mean that you can’t make money in it). I don’t really know. As I say, I have not done my own due diligence on Orient Paper.

But the point of this piece is really to show you how tricky the market for U.S.-listed China-based stocks is right now. It also helps explain the low valuations we see. Don’t just assume that a China-based stock is a bargain because it trades for 6 times earnings and is growing 30% a year. It may not be quite what it seems.

Regards,
Chris Mayer
Whiskey & Gunpowder

August 2, 2010

Successful Investing in China Despite the Risks was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

But first, a brief trip down memory lane…

You may recall how the economy fell out of bed in 2008. This was not some disaster one read about only in the papers or watched from a safe distance on TV. It affected nearly everything.

I remember making a trip to an investment conference in Manhattan that I go to every year. The big difference this time was that I could stay at the swanky hotel that hosted it. Normally, a $450-a-night hotel — before taxes — one could, in 2008, book a room for half that price — off the rack. And then were plenty of rooms available. A more enterprising soul, with the help of Priceline.com, could stay at a 4-star hotel for $99 a night.

I’ll also never forget eating at an Italian restaurant in Manhattan where they were giving the wine away for free. I guess they wanted to bring warm bodies in there any way they could and hoped somebody would order a dessert so the kitchen could at least earn some kind of profit margin.

Such deals in hotels and restaurants, where such deals were once unthinkable, reflected the hurt of an imploding stock market, of layoffs and of a general popping of a bubble brought to an ugly close.

Farming also felt the effects of the bust. Crop prices still promised a good return for farmers, but financing was harder to come by. Farming is a capital-intensive business. You need to spend a lot of money before you see a dime. So farmers often put off expansion simply because money is so tight.

Say you were a farmer in Saskatchewan and you wanted to add acres to your farm to take advantage of market prices. You’d have to purchase or rent more land. You’d probably need new tractors and combines to handle the extra workload. You’d need more on-farm storage. You’d need fertilizer and seed and chemicals.

How much would all that cost? Recently, I spoke with Brad Farquhar, vice president of Assiniboia Capital Corp., which runs the largest farmland fund in Canada. He said it is normal for farming expansion to cost $150–300 per acre. That means a 2,000-acre expansion needs an investment of $300,000–600,000.

Some farmers have the financial capacity to do that on their own, but most typically turn to a local bank or credit union. In the meltdown days, it was tough for anybody to get a loan. Even now, credit is not as easy as it was in the palmy days of no-doc loans and no-money-down. Lenders are cautious.

So while a farmer could make an extra $100 an acre in revenues for every $30–50 an acre spent in fertilizer, he doesn’t necessarily do it. In fact, farmers cut back on fertilizer in the meltdown days, from which we are only now rebounding. Then, too, there are timing issues. Nitrogen fertilizer is often cheapest in July, right when farmers have maxed out on their borrowing capacity. That means that they can’t take advantage of the lower prices.

These funding gaps are where Brad’s Assiniboia steps in to fill the void. They provide the funding as an investor, with the profits shared between the farmer and Assiniboia. The firm has a simple truism as its mantra: “The returns are highest where capital is scarce.” Saskatchewan farming (and agriculture generally, at least at the farm level) is one such place.

You’d think something like this would’ve evolved sooner. But it was a new concept when the firm began approaching farmers in 2009. As Brad describes it, after a lot of time at farmers’ kitchen tables and hundreds of cups of coffee later, farmers began to sign up for Assiniboia’s program. In fact, Assiniboia now has 36,000 acres of farmland from this offer in 2009.

His firm is high on canola now. Why canola? Brad points to a list of reasons. One, canola is not controlled by the Canadian Wheat Board, which fixes prices for wheat and barley. Another is that there is a futures market in canola in Winnipeg, which gives them tradeable market prices. (Crop insurance is done through the provincial fund.)

Finally, the heart of canola country is right in Assiniboia’s backyard, in Saskatchewan. It’s like the Silicon Valley of canola. Brad also points out that “recent genetic developments are pushing yields to whole new levels.” These breakthroughs are happening in Saskatchewan and lead to better economics.

Besides, the profit hook is enticing. “Average crops should provide good returns, but any above-average production or commodity price makes the return numbers take off,” Brad says. “And the majority of the downside is covered by crop insurance. So it’s like having a perpetual call option on canola.”

Brad prepared the next chart, which shows a few scenarios of how a share in his limited partnership (LP) might fare depending on crop yield and price. You can see that a low yield and a low price make for a poor result. But the range of outcomes skews to the upside. A bumper crop and a strong price could hand you a 101% gain. (Note: In the table, “bu” stands for bushel.)

We also harp on ownership in these pages, and one other thing I like about this model is that farmers have skin in the game. About half or more of the profits will go to them, so they have every incentive to make it work.

Assiniboia is raising a new fund now with an expected closing date of July 30. This fund would invest in Saskatchewan during the 2011, 2012 and 2013 growing seasons. Overall, it’s a four-year commitment and the fund would wind up in 2014, when you would get your initial investment back.

If you are interested in learning more about the fund, contact Brad Farquhar at brad@assiniboiacapital.com. Note: The minimum investment is $25,000. I think it’s another fine way to participate in agriculture without actually having to do any farming by your own hand.

Thanks for reading.

Regards,
Chris Mayer
Whiskey & Gunpowder

July 19, 2010

Potential 101% Gains in Canola Farming was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

This is O’Malley’s playground. He has probably bought and sold more refineries than any man alive. He knows them like an old chef knows the inside of his kitchen.

O’Malley got rich by following a reliable formula. He bought refineries when they were cheap — castoffs, unloved by Big Oil — trading for less than the cost to build them. Later, he sold them for billions.

For example, in the aftermath of the 1987 crash, he picked up a 26% stake in Tosco, then a tiny refinery. O’Malley eventually turned Tosco into the largest independent refiner in America. He sold it to Phillips Petroleum (now ConocoPhillips) for $7 billion.

Two weeks after he closed that deal in 2002, he took over Premcor, becoming its top executive. He did it all over again, using Premcor as a vehicle to buy refineries on the cheap. Four years later, he sold Premcor to Valero for $6.9 billion.

His is the Midas touch in the refinery space. And he’s mostly laid low since 2007. But now he is back again, buying a Delaware refinery he once owned and sold to Valero. The deal is worth $220 million and is the first purchase of a new $2 billion fund created to buy U.S. refineries. O’Malley says he’ll look at any U.S. refinery on the market.

In other words, it looks like O’Malley is going for the hat trick — trying to get rich three times in the same game.

It’s a contrarian bet, as most people think ill of the refining industry. It’s plagued by costly regulations, weak profit margins and lower demand for motor fuel. But you don’t get to buy stuff below replacement value when times are rosy. As David Foley, an investor with O’Malley put it, “Last time we did it, we made six times our money.”

Based on his track record, I would not ignore O’Malley’s play here. Clearly, he thinks the industry has hit bottom. And there are good reasons to think so, as we’ll see.

One reason comes from Barry Bannister, an analyst at Stifel Nicolaus. He shows how peaking oil prices on a year-over-year basis are usually a catalyst for better refining margins. (See chart below. “WTI” is “West Texas intermediate,” a common benchmark for crude oil.)

Higher refining margins means more profits for refiners. Higher profits usually mean higher stock prices follow. Valero, the bellwether refinery stock, is down about 75% from its all-time high in 2008, which reflects the collapse of refining margins. So an uptick in refining margins will likely work wonders for Valero’s stock price, like rains greening a desert.

Besides owning a refinery, another way to play the revival is by owning stock in a company which builds and upgrades them, an E&C, or engineering and construction, company. There is one such stock in the Capital & Crisis portfolio. It has more exposure to the downstream, or refining sector, than other E&Cs. Yet it has a better balance sheet and is more consistently profitable than the refinery stocks. It also has greening potential, as it is also about three quarters off its 2008 high.

It also has its own favorable cyclical winds working, as Bannister shows. Bannister does the best work on the E&Cs in the business that I know of. What I enjoy is his study of past cycles. In one of his historical studies, he found a reliable pattern in our stock’s book-to-bill ratio.

Book-to-bill means how much work a company books (or sells) over how much it bills (or completes). A book-to-bill ratio over 1 means the business is expanding. If it is under 1, it is shrinking.

Bannister found that the book-to-bill ratio for our company experiences major peaks followed by about two-year sharp declines, followed by about two-year sharp recoveries. Such a dating puts the bottom somewhere in mid-2010 — right about now — as a backlog shows signs of picking up. Bannister believes the bottom is in. Such dating also puts the next peak off in 2012, plenty of time to make hay now.

Another way to see this is in the E&C firms as a family. Take a look at the chart below. Note where we are today, lingering in the basement. But if history follows — and this history goes way back — then we are looking at a move to the penthouse ahead.

Bannister forecasts a total backlog of $5.75 billion in 2011. Backlog correlates well with the stock. (More work on the backlog implies higher future earnings.) A $5.75 billion backlog would equate to a solid 40% gain.

If O’Malley, the refining investing whiz, is right, as I think he will be, refinery margins will rebound. That will warm the hearts of refinery owners everywhere, but it will also put a smile on the face of this stock’s owners too.

Regards,
Chris Mayer
Whiskey & Gunpowder

July 14, 2010

Taking Advantage of the Oil Refining Slump was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.