Value.able

Participation in the stock market is at a low ebb – in this Australian article published 17 March 2012 Roger Montgomery explains how when you decide to re-enter the stock market his Value.able strategy will allow you to invest for value, and entirely avoid speculation.  Read here.

by Roger Montgomery Posted in In the Press, Investing Education, Value.able.

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By Praveen J on 9th January 2012 and updated Feb 20 2012

This year I have been given an opportunity to write about my experiences in applying what I have learnt as a Value.able graduate and Skaffold member. At the moment I am looking to invest in stocks with a market capitalisation under $2 billion (small to micro caps). Key MINIMUM criteria for me include: Return on Equity > 15%, Net Debt/Equity < 50%, and forecast change in Intrinsic Value > 5%. I will also be focussing on investment grade companies across ALL Industry Sectors/Groups that have Skaffold Quality Scores between A1 to A3, and B1 to B3. This will encompass my “investment universe” of stocks on the ASX. I will of course require a decent margin of safety, but I will be watching stocks that are trading close to their Intrinsic Value or at a small premium, in the event of a decline in price over the next 3 to 6 months. Initial screening using Skaffold reveals over 100 stocks, a more aggressive filter would reduce this number even further. Amongst the results are 10 stocks in the Basic Materials Sector and Gold & Silver Group, 6 of which are predominantly involved in gold exploration, development and production:

• Ramelius Resources (ASX:RMS)
• Medusa Mining Limited (ASX:MML)
• Silver Lake Resources (ASX:SLR)
• Dragon Mining (ASX:DRA)
• CGA Mining (ASX:CGX)
• Regis Resources Limited (ASX:RRL)

Table 1. Stocks listed by safety margin (highest to lowest, 9th January 2012) (Source: Skaffold):

Although Ramelius Resources (RMS) meets my initial screening criteria and is an A1 company, it has a NEGATIVE forecast EPS growth. So in this blog post I will be discussing and comparing Medusa Mining Limited (MML) and Silver Lake Resources (SLR). Here we have two companies that have commenced production of gold (they are making money), they are fundamentally healthy, they have good prospects for Intrinsic Value appreciation, AND are both trading at a discount to their Intrinsic Value. Being commodity businesses, the question I have to ask is whether either really have any competitive advantage. I will discuss this later.

Now in the context of the European sovereign debt crisis, anaemic growth in the US, and concerns of a slowdown in the Chinese economy, I am wary about investing directly in a small cap Australian mining company. However, in this case we are dealing with a commodity that may benefit in this time of uncertainty, with gold long being regarded as a “safe-haven”. Having said that, the future price of gold is still a significant element of risk. At the time of writing the price had dropped down to around US$1600/ounce, after a peak of close to US$1900/ounce in September 2011. Below are some charts of historical gold prices, I’m not going to try and analyse them, but they may serve as a point of discussion. Certainly investing in gold equities requires a bullish stance on the future price of gold in the medium to long term.

Figure 1. Spot gold price chart last 1 year:

Figure 2. Spot gold price chart long-term:

GOLD PRIMER:

Annual reports and AGM presentations for gold and other mining companies assume a level of pre-existing knowledge. Without this, they really make no sense at all. So let me start with some bare basics before I discuss each stock in detail:

What is an Element? An element is a pure chemical substance. You may have heard of something called the periodic table (maybe in your high school science class), this is actually a list of all chemical elements. Examples of elements include carbon, oxygen, aluminum, iron, copper, lead, and of course gold.

What is a Mineral? A mineral is a naturally occurring solid chemical substance that is a combination of elements.

What is an Ore? An Ore is a type of rock that contains minerals. Most individual elements are found in the form of a mineral, though there are some elements that can be found in their elemental state, gold is one of them. Gold is also found in combination with silver and occasionally copper.

What is an Ore Deposit? This is an accumulation of Ore.

JORC? This is the Joint Ore Reserves Committee. The Code for Reporting of Mineral Resources and Ore Reserves (the JORC Code) is widely accepted as a standard for professional reporting purposes.

What is a Mineral “Resource” and what is an Ore “Reserve”? These terms are often incorrectly used interchangeably, the exact JORC definitions are below:

Figure 3. Resources versus Reserves (Source: JORC):

RESOURCE; “A CONCENTRATION OR OCCURRENCE OF MATERIAL OF INTRINSIC ECONOMIC INTEREST IN OR ON THE EARTH’S CRUST IN SUCH FORM, QUALITY AND QUANTITY THAT THERE ARE REASONABLE PROSPECTS FOR EVENTUAL ECONOMIC EXTRACTION. THE LOCATION, QUANTITY, GRADE, GEOLOGICAL CHARACTERISTICS AND CONTINUITY OF A MINERAL RESOURCE ARE KNOWN, ESTIMATED OR INTERPRETED FROM SPECIFIC GEOLOGICAL EVIDENCE AND KNOWLEDGE. MINERAL RESOURCES ARE SUB-DIVIDED, IN ORDER OF INCREASING GEOLOGICAL CONFIDENCE, INTO INFERRED, INDICATED AND MEASURED CATEGORIES.”
RESERVE; “THE ECONOMICALLY MINEABLE PART OF A MEASURED AND/OR INDICATED MINERAL RESOURCE. IT INCLUDES DILUTING MATERIALS AND ALLOWANCES FOR LOSSES, WHICH MAY OCCUR WHEN THE MATERIAL IS MINED. APPROPRIATE ASSESSMENTS AND STUDIES HAVE BEEN CARRIED OUT, AND INCLUDE CONSIDERATION OF AND MODIFICATION BY REALISTICALLY ASSUMED MINING, METALLURGICAL, ECONOMIC, MARKETING, LEGAL, ENVIRONMENTAL, SOCIAL AND GOVERNMENTAL FACTORS. THESE ASSESSMENTS DEMONSTRATE AT THE TIME OF REPORTING THAT EXTRACTION COULD REASONABLY BE JUSTIFIED. ORE RESERVES ARE SUB-DIVIDED IN ORDER OF INCREASING CONFIDENCE INTO PROBABLE ORE RESERVES AND PROVED ORE RESERVES.”

What is the difference between high and low-grade gold Resource? There aren’t any fixed definitions that I could find, but generally < 4.0 grams/tonne is low-grade, >8.0 grams/tonne is high-grade, and everything in between is about average. A large amount of low-grade gold could be just as profitable as having high-grade gold, as it could be cheaper and easier to mine the low-grade gold (for example low-grades in “open pit” or near surface mines, versus high-grades in “narrow vein” or deep underground mines).

Stages of mining: exploration, development, or production? Exploration involves primarily drilling activity in order to discover ore deposits and then define the Resource and Reserve levels, as well as feasibility studies, development involves primarily engineering / construction work, and production involves the mining, processing at the mill, and selling of the commodity.

Junior, mid-tier, or senior gold producers? Junior gold producers are generally considered as those producing under 200,000 ounces per annum of gold, seniors over 1,000,000 ounces, and the mid-tier producers in between.

What is a mining tenement? This is basically a license/permit granted by the Government to undertake exploration, development, and/or mining activities in a specific area.

What are royalties? Royalties are an expense that needs to be paid to the State Government in Australia for any minerals that are mined. In Western Australia for example, royalties are 2.5% of the value of gold produced.

What are cash costs? This is the operating cost required to produce one ounce of gold. Average worldwide cash costs are around US$620/ounce. Cash costs do not include capital expenditure. TOTAL cash costs include royalties.

What is hedging? Agreeing on the sale price of a certain volume of gold ahead of producing it, it is done to protect the company from the short-term volatility of the market gold price, but will reduce return when the price is rising.

Quick comparison of gold producing companies… First of all, make sure you compare similar companies, i.e. a junior producer with another junior producer, not a junior with a senior. Look at the total amount of resources they have, quoted in ounces, look at the cash costs, and look at how much ounces they have produced per year, and what level is expected in the future. Look for companies that are actively drilling to expand their resource base and find new ore deposits. A company may have one site producing gold, another being developed, and several others under exploration. This ensures that when Resources deplete at one site, there are other potential mines in the wings.

ANALYSIS: MEDUSA MINING LIMITED (ASX:MML)

MML is an un-hedged gold producer listed on the ASX and LSX and is currently operating in the Philippines.

Figure 4. MML’s Skaffold Line (Source: Skaffold 6th January 2012):

Looking at the figure above we can see that the share price has been on the climb since early 2009. The ACTUAL Intrinsic Value (which is based on analyst forecasts) has also followed suit since then, and has generally remained above market price. Market price reached a peak of $8.35 in September 2011 but has since been on a downward slope. More importantly though, the ACTUAL Intrinsic Value is expected to continue rising. In this instance however, the AVERAGE Intrinsic Value (a more conservative estimate), which is based on past performance with an emphasis on the last 3 years, is not expected to rise as strongly. As this value does not necessarily take into account all possible future events, what I need to find out is what future prospects the company has that could have contributed to the analyst’s forecasts. Another important thing to consider is why has the market price dropped almost 50% in just a few months? I’ll come back to this last point later…

Currently MML’s production is focussed on the Co-O mine in the Mindanoa Island area. A second potential gold production centre is under exploration at the Bananghilig deposit. MML currently have JORC code compliant mineral Resource of 21.3 million tonnes, at a grade of 9.6 grams/tonne (g/t) at Co-O and 1.3 g/t at Bananghilig, for a total of 2.6 million ounces (mOz). The company aims to keep Resource and Reserve levels at the Co-O mine stable year to year (by replacing whatever is used up each year), and in doing so avoid spending too much money on expanding this base to levels that will not get mined for several years. Exploration budget for 2012FY is US$27 million. Gold production for 2011FY was 101,474 ounces. Total cash costs for 2011FY were an extraordinarily low US$189/ounce (includes royalties). This could be due to the fact that mining is done predominantly via hand-held equipment, and labour costs are low. The site is also adjacent to a highway with close access to the port, and has grid power via hydropower.

Production for 2012FY was expected to be around 90,000 to 100,000 ounces. This will be ramped up to 200,000 ounces per annum by 2014FY after completion of the Co-O mine expansion. Exploration continues at Bananghilig, MML are targeting production of 200,000 per annum at this site by 2016FY. Near future expansion related capital expenditure will be funded from existing cash rather than through capital raisings and debt facilities, which is great and not surprising given their huge operating margins. Having said that, with regards to Bananghilig, no announcement has been made yet regarding whether feasibility studies are to take place, and whether this deposit will go into production phase at all. Further to this, based on current Reserves at Co-O, its mine life is only about 5 years. The risk here is if they are unable to continue replenishing the Resource and Reserve base over the coming years to extend the mine life further. However published analyst research reports are suggesting a possible mine life of over 25 years, indeed a similar mine south of Co-O (Diwalwal) has been mining for 20 years. There is also the risk of political/social instability in this country. MML is targeting 400,000 ounces per annum of production of gold by 2016FY.

Figure 5. Production timetable in ounces (Source: MML AGM Presentation November 2011):

ANALYSIS: SILVER LAKE RESOURCES (ASX:SLR)

SLR is also an un-hedged gold producer that currently operates in 2 key regions of Mount Monger and Murchison in Western Australia, approximately 50km south east of Kalgoorlie.

Figure 6. SLR’s Skaffold Line (Source: Skaffold 6th January 2012):

From the figure above what I can see is that the market price has generally been above the ACTUAL Intrinsic Value, although it appears that a great opportunity to buy would have been at the start of 2011. The ACTUAL Intrinsic Value has increased significantly since then, and looks like rising quite rapidly over the coming few years. Market price reached a peak of $3.87 in December 2011, and in fact SLR was one of the best performing stocks on the ASX for the year, significantly outperforming the S&P ASX 200 Index. However, the market price has since dipped down, and a buying opportunity has once again presented itself! The AVERAGE Intrinsic Value is also rising, but as with MML, the growth here is more conservative. Note that as these two lines become closer together, our confidence in the Intrinsic Value estimate is increased.

SLR currently has 24.1 million tonnes of JORC Resource at grades of 8.9 (g/t) at Mount Monger and 2.8 g/t at Murchison for a total of 3.3 mOz as at June 2011. The company is aiming to build the Resource base for 2012FY to 5 mOz. In the last 2 financial years, they have increased this Resource base by 1 mOz each year. This has been via an extensive drilling programme each year that is part of their long-term exploration budget ($18 million per annum). Total production of gold for 2011FY was 63,425 ounces. Total cash costs for 2011FY were US$674/ounce (includes royalties). The Mount Monger operations are targeting production of 100,000 to 110,000 ounces for 2012FY. The company expects to ramp up production here to 200,000 ounces per annum by 2014, with an expected mine life > 10 years. The Murchison operations will start production in Q3 2013FY, and is expected to produce 100,000 ounces per annum (from 2014FY) with an 8-10 year mine life. Mining at these locations is predominantly underground. Open pit productions have recently commenced at their Wombola Dam site. SLR has also recently reported high-grade copper discoveries at their Hollandaire site within the Eelya Complex that could provide added value. SLR is targeting 300,000 ounces per annum of production of gold by 2014FY.

Figure 7. Production timetable in ounces (Source: SLR AGM Presentation November 2011):

REVENUE, NET PROFIT, CASH FLOW, RETURN ON EQUITY:

Figures 8 & 9. Comparison of Annual Revenue & Reported Net Profit:

Revenue levels for both companies look excellent, but we can clearly see that MML’s net profit figures are significantly larger than SLR’s, and is a reflection of their low operating costs. But as with any business, we need to delve deeper and look at their overall cash flow. With an impending “credit crunch” in 2012, and a degree of caution in the market with equity investing, a healthy cash flow could be essential in order for junior companies to be able to confidently fund their exploration and development activities.

Figure 10. MML Skaffold Cash Flow (Source: Skaffold 30th December 2011):

Figure 11. SLR Skaffold Cash Flow (Source: Skaffold 30th December 2011):

Both companies have rising levels of cash flow from operations (blue line). MML has an overall funding surplus (green line) that is increasing, and has also managed to pay dividends for 2011FY. Whilst at SLR the overall funding surplus is decreasing, to the point that there is now a funding GAP. This suggests that they have used up more cash in investments and financing than they have received directly from their operations. According to Skaffold, money to account for this spending has come from shareholder equity raisings and increased debt or a reduction in the cash at bank (if there is any). Looking at the Skaffold Data Table sheds more light on recent cash movements for each company…

MML generated a net cash flow of $90 million from its operating activities for 2011FY. However, it also spent a net cash flow of $49 million on investment activities, as well as $18 million for dividend payments (un-franked, low payout ratio). Investment activities were predominantly capital expenditure related to exploration, evaluation, and development activities. Despite the large amount of cash flow invested outside operating activities, after taking into account foreign exchange effects and equity capital movements (add ~ $5 million total), the company was able to increase it’s Bank Account balance by $28 million dollars. This left a 2011FY balance of $58 million (UP from $30 million 2010FY). SLR generated a net cash flow of $33 million from its operating activities for 2011FY. It also spent a net cash flow of $46 million on investment activities, clearly more than it’s operating cash flow. This is once again predominantly capital expenditure related to exploration, evaluation, and development activities. Consequently, despite a rise in revenue, net profit, and operating cash flow, the company actually had a net decrease in its Bank Account balance of $13 million, which left the 2011FY balance at $16million (DOWN from $29 million 2010FY).

MML’s last capital raising was in February 2009 for $20 million, about 3 years ago now. SLR’s last capital raising was as recently as November 2011 for $70 million, this was to help develop their Murchison project and accelerate copper exploration activities. Prior to this it had conducted capital raisings of $19 million during 2010FY and $30 million during 2008FY. Although neither company has significant debt, I think this reiterates that MML is in a better cash flow position at this stage. It appears that continued capital raisings have been required by SLR to help meet ongoing investment demands, unfortunately this could dilute shareholder ownership. Even if capital raisings were issued at a price above equity per share, I would prefer if they were able to fund their investments predominantly from existing cash flow.

A LITTLE ABOUT CAPITAL EXPENDITURE:

As I learnt with these examples, gold mining companies spend a great deal of their retained earnings and cash flow on exploring for gold and developing new mines. These expenses do not go immediately into the Income Statement, instead you will see the total expenditure in the Balance Sheet, as an Asset! These companies may have exploration happening at multiple different sites at any one time, if drilling results prove unsatisfactory, or mining is deemed not technically or financially feasible, part of these expenses will be written-down, and will affect future reported Net Profit. Similarly, cumulative exploration and development expenses will become incurred or amortised only once the mine goes into production. All this capital expenditure is not yet generating any profit, yet it adds to the equity. So unless the company is generating sufficiently higher profits each year from the mines that are in production (e.g. by producing more ounces of gold, at a higher average price, or doing it more efficiently), the Return on Equity will decline. From looking at the annual reports, I noted that MML had listed capital expenditure of US$116 million for 2011FY, and SLR A$76 million. Cleary these are highly capital-intensive businesses, though at the very least it gives their competition a high barrier to entry.

RETURN ON EQUITY:

Figure 12. MML Skaffold Capital History (Source: Skaffold 6th January 2012):

Figure 13. SLR Skaffold Capital History (Source: Skaffold 6th January 2012):

The Skaffold Capital History for MML tells me that although its Net Profits (green line) are forecast to rise over from the next few years, the shareholder equity is expected to rise even more, and thus Return on Equity (blue line) is forecast to decline from 45% 2011FY to 33% in 2014FY. Although a Return on Equity of 33% is still excellent. On the other hand, SLR’s Return on Equity is forecast to rise from 19% 2011FY, and remain stable at around 36% until 2014FY. I suspect that a stable Return on Equity is difficult to achieve in this industry given that there are often several projects on the go at different stages, some generating profits and others not, but at the very least the overall returns must always be high.

FINAL COMMENTS:

What attracts me to MML are its high margins and excellent cash flow that should insulate it against any significant changes in the gold price. A number of things may have contributed to the fall in market price, macroeconomic factors aside. Certainly the market price plunge happened not long after a mining fatality in October 2011. This, along with increased development to prepare the Co-O mine for higher production has resulted in lower production guidance for 2012FY. There was also some weather damage from a tropical storm to parts of their mill in December 2011, the scope of the effect on production will be available in the December 2011 Quarterly. Regardless, these are abnormal once-off events that should not impact on the long-term prospects of the company. For me the key is whether the Bananghalig deposit has a large enough Resource base, and whether it will be mined, as this will determine whether MML can grow from a junior to a mid-tier producer.

The advantage that SLR offers is that it already has a second mine that has progressed further in the development phase, and will commence production earlier. Though there are two things that concern me at this stage. The first being the relatively high operating costs that make SLR far more sensitive to gold price volatility. And the second is the company’s cash flow, and in particular its requirement for capital raisings to fund exploration and development activities. Having said that, forecast EPS Growth is 217%, and I expect that this should improve cash flow over the coming few years. Further to this, as with MML, the management team appears to have significant experience behind it, and in SLR’s case I noted that all the Directors hold significant shareholdings in the company, each owning over 4 million fully paid ordinary shares each.

But is either of these companies truly extraordinary? What does this mean? Well Chapter 5 in Value.able tells me that in an extraordinary business I must find the following factors; Bright long-term prospects, high Return on Equity driven by sustainable competitive advantage, solid cash flow, little or no debt, and first-class management. I think that MML comes closest to meeting all these factors, but others might disagree. The key factor for me is having a sustainable competitive advantage. In the Co-O mine they are sitting on a Resource that could last over 25 years, is extraordinarily low in operating cost, and could generate an enormous amount of cash that could easily fund future expansions, and perhaps even acquisitions. In a business that can be highly capital-intensive, the ability to fund exploration and development with cash flow rather than capital raisings and debt is a great advantage. The question mark of course is how sustainable this will be. And of course, I am no Geologist! What I do know is that this is a fundamentally healthy and profitable business, and despite this, the market is significantly undervaluing it. If I were to invest in this business, I would need to accept that there is level of risk involved, but by buying it at a significant margin of safety, and allocating such an investment in a reasonable manner within my portfolio, I think this risk could be significantly reduced.

POD’s (points of discussion):

1. Has gold’s bull run come to an end, or will it rise to new highs?
2. In your opinion, do MML or SLR have any sustainable competitive advantage?
3. What are the benefits/risks of mining in the Philippines versus Australia?

Since writing this post there have been a number of key announcements made by each company. Their share price’s and safety margins have also changed. Most notably, MML has now downgraded its 2012FY production guidance to 75,000 ounces, citing delays due to effects of tropical storms and torrential rain in December 2011 and January 2012. Also, SLR has announced a the acquisition of Phillips River Mining.

LINKS:

Skaffold
www.skaffold.com

World Gold Council
www.gold.org

JORC
www.jorc.org

DISCLOSURE:

I do not hold any shares in any of the companies mentioned in this blog post.

by Roger Montgomery Posted in Insightful Insights, Value.able.

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Do BHP Billiton (BHP), Fortescue Metals (FMG), Seek (SEK), Bluescope Steel (BSL), GR Engineering (GNG), CSL (CSL), Peak Resources (PEK), Harvey Norman, (HNN), Buru Energy (BRU), The Reject Shop (TRS), ASG Group (ASZ), Tatts Group (TTS) and  Webject (WEB) make Roger’s coveted A1 grade?  Watch this edition of  Sky Business’ Your Money Your Call broadcast 29 February 2012 to find out.  Watch here.

by Roger Montgomery Posted in Companies, Energy / Resources, Investing Education, TV Appearances, Value.able.

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We are pleased to make the following Announcement. Chris Mackay, Hamish Douglass and I worked patiently to bring this together. I am delighted to see it announced. By way of background, in addition to their roles at Magellan Financial Group, Hamish Douglass is a member of the Foreign Investment Review Board and a member of the Takeovers Panel.  Chris Mackay sits on the Financial Sector Advisory Council that is one of the main conduits of industry insights to the Treasurer and is on the board of James Packer’s Consolidated Media. Thank you.

Posted by Roger Montgomery, Value.able author, Skaffold Chairman and Fund Manager, 29 February 2012.

by Roger Montgomery Posted in Value.able.

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Their is something prescient in the name John Deason and Richard Oates gave to their 1869 gold nugget the ‘Welcome Stranger’ and the one Kevin Hillier gave to his 875 troy ounce find ‘The Hand of Faith’.  Today’s gold price is indeed very welcome to gold bugs and there is plenty of faith needed that prices will rise even further.  But gold bugs have received a terse warning from none other than Warren Buffett who has just released Berkshire’s 2011 letter.  For those of you who believe gold (A.K.A. the barbarous relic) is the best investment you won’t find any more support from Warren this year than any other (with the exception of his 1999 dalliance into silver) . You can find his complete letter here: Berkshire 2011 Annual Report.

Here’s the section on gold:

“The second major category of investments involves assets that will never produce anything, but that are purchased in the buyer’s hope that someone else – who also knows that the assets will be forever unproductive – will pay more for them in the future. Tulips, of all things, briefly became a favorite of such buyers in the 17th century.

This type of investment requires an expanding pool of buyers, who, in turn, are enticed because they believe the buying pool will expand still further. Owners are not inspired by what the asset itself can produce – it will remain lifeless forever – but rather by the belief that others will desire it even more avidly in the future.

The major asset in this category is gold, currently a huge favorite of investors who fear almost all other assets, especially paper money (of whose value, as noted, they are right to be fearful). Gold, however, has two significant shortcomings, being neither of much use nor procreative. True, gold has some industrial and decorative utility, but the demand for these purposes is both limited and incapable of soaking up new production. Meanwhile, if you own one ounce of gold for an eternity, you will still own one ounce at its end.

What motivates most gold purchasers is their belief that the ranks of the fearful will grow. During the past decade that belief has proved correct. Beyond that, the rising price has on its own generated additional buying enthusiasm, attracting purchasers who see the rise as validating an investment thesis.

As “bandwagon” investors join any party, they create their own truth – for a while. Over the past 15 years, both Internet stocks and houses have demonstrated the extraordinary excesses that can be created by combining an initially sensible thesis with well-publicized rising prices. In these bubbles, an army of originally skeptical investors succumbed to the “proof” delivered by the market, and the pool of buyers – for a time – expanded sufficiently to keep the bandwagon rolling. But bubbles blown large enough inevitably pop. And then the old proverb is confirmed once again: “What the wise man does in the beginning, the fool does in the end.”

Today the world’s gold stock is about 170,000 metric tons. If all of this gold were melded together, it would form a cube of about 68 feet per side. (Picture it fitting comfortably within a baseball infield.) At $1,750 per ounce – gold’s price as I write this – its value would be $9.6 trillion. Call this cube pile A. Let’s now create a pile B costing an equal amount. For that, we could buy all U.S. cropland (400 million acres with output of about $200 billion annually), plus 16 Exxon Mobils (the world’s most profitable company, one earning more than $40 billion annually). After these purchases, we would have about $1 trillion left over for walking-around money (no sense feeling strapped after this buying binge).

Can you imagine an investor with $9.6 trillion selecting pile A over pile B? Beyond the staggering valuation given the existing stock of gold, current prices make today’s annual production of gold command about $160 billion. Buyers – whether jewelry and industrial users, frightened individuals, or speculators – must continually absorb this additional supply to merely maintain an equilibrium at present prices.

A century from now the 400 million acres of farmland will have produced staggering amounts of corn, wheat, cotton, and other crops – and will continue to produce that valuable bounty, whatever the currency may be. Exxon Mobil will probably have delivered trillions of dollars in dividends to its owners and will also hold assets worth many more trillions (and, remember, you get 16 Exxons). The 170,000 tons of gold will be unchanged in size and still incapable of producing anything. You can fondle the cube, but it will not respond.

Admittedly, when people a century from now are fearful, it’s likely many will still rush to gold. I’m confident, however, that the $9.6 trillion current valuation of pile A will compound over the century at a rate far inferior to that achieved by pile B.”

Before simply believing Warren WILL be right…There’s this in the annual report as well: “Last year, I told you that “a housing recovery will probably begin within a year or so.” I was dead wrong”

A much older quote that summarizes Buffett’s long-held view is this one “It gets dug out in Africa or some place. Then we melt it down, dig another hole, bury it again and pay people to stand around guarding it. It has no utility. Anyone watching from Mars would be scratching their head.”

In my earlier post on this subject HERE, I note; “But I trust you can see the irony in claiming gold is ‘useless’ and yet it can buy [all the agricultural land in the United States, sixteen companies as valuable as Exxon and a trillion dollars in walking-around money].

For those of you who are interested in two alternative perspectives, (assuming the debasing of fiat money across the globe is not enough to encourage you), I thought you might find some of what you need in the following points, and also Warren Buffett’s father’s views. (Note: we only own three or four gold stocks all of which have rising production profiles and do not require ever increasing gold prices to support the returns on equity that justify much higher valuations.  So we aren’t quite in the ‘carried-away’ camp even though some have doubled in price.  This latter development delights us in this market).

And now a short commercial break…

Here are two Skaffold screenshots, each gold stocks we currently own.  If you are a member of Skaffold, you should be able to pick them right away.  If you aren’t a member, what are you waiting for?  Head over to www.skaffold.com and become a member today.

And now back to our regular programming…

From gold’s mouth itself;

Let’s start with the basics of my enduring characteristics. I have some characteristics that no other matter on Earth has…

I cannot be:

Printed (ask a miner how long it takes to find me and dig me up)
Counterfeited (you can try, but a scale will catch it every time)
Inflated (I can’t be reproduced)

I cannot be destroyed by;

Fire (it takes heat at least 1945.4° F. to melt me)
Water (I don’t rust or tarnish)
Time (my coins remain recognizable after a thousand years)

I don’t need:

Feeding (like cattle)
Fertilizer (like corn)
Maintenance (like printing presses)

I have no:

Time limit (most metal is still in existence)
Counterparty risk (remember MF Global?)
Shelf life (I never expire)

As a metal, I am uniquely:

Malleable (I spread without cracking)
Ductile (I stretch without breaking)
Beautiful (just ask an Indian bride)

As money, I am:

Liquid (easily convertible to cash)
Portable (you can conveniently hold $50,000 in one hand)
Divisible (you can use me in tiny fractions)
Consistent (I am the same in any quantity, at any place)
Private (no one has to know you own me)

From an entirely different perspective on gold it may be worth reading the Hon. Howard Buffett.  Congressman Buffett argues that without a redeemable currency, an individual’s freedoms both financial and more broadly is dependent on politicians. He goes on to observe that fiat (paper) money systems tend to collapse eventually, producing economic chaos. His argument that the US should return to the gold standard was not adopted.

Human Freedom Rests of Gold Redeemable Money
Posted Thursday, May 6, 1948

By HON. HOWARD BUFFETT

U. S. Congressman from Nebraska
Reprinted from The Commercial and Financial Chronicle 5/6/48

Is there a connection between Human Freedom and A Gold Redeemable Money? At first glance it would seem that money belongs to the world of economics and human freedom to the political sphere.

But when you recall that one of the first moves by Lenin, Mussolini and Hitler was to outlaw individual ownership of gold, you begin to sense that there may be some connection between money, redeemable in gold, and the rare prize known as human liberty.

Also, when you find that Lenin declared and demonstrated that a sure way to overturn the existing social order and bring about communism was by printing press paper money, then again you are impressed with the possibility of a relationship between a gold-backed money and human freedom.

In that case then certainly you and I as Americans should know the connection. We must find it even if money is a difficult and tricky subject. I suppose that if most people were asked for their views on money the almost universal answer would be that they didn’t have enough of it.

In a free country the monetary unit rests upon a fixed foundation of gold or gold and silver independent of the ruling politicians. Our dollar was that kind of money before 1933. Under that system paper currency is redeemable for a certain weight of gold, at the free option and choice of the holder of paper money.

Redemption Right Insures Stability
That redemption right gives money a large degree of stability. The owner of such gold redeemable currency has economic independence. He can move around either within or without his country because his money holdings have accepted value anywhere.

For example, I hold here what is called a $20 gold piece. Before 1933, if you possessed paper money you could exchange it at your option for gold coin. This gold coin had a recognizable and definite value all over the world. It does so today. In most countries of the world this gold piece, if you have enough of them, will give you much independence. But today the ownership of such gold pieces as money in this country, Russia, and all divers other places is outlawed.

The subject of a Hitler or a Stalin is a serf by the mere fact that his money can be called in and depreciated at the whim of his rulers. That actually happened in Russia a few months ago, when the Russian people, holding cash, had to turn it in — 10 old rubles and receive back one new ruble.

I hold here a small packet of this second kind of money – printing press paper money — technically known as fiat money because its value is arbitrarily fixed by rulers or statute. The amount of this money in numerals is very large. This little packet amounts to CNC $680,000. It cost me $5 at regular exchange rates. I understand I got clipped on the deal. I could have gotten $2½ million if I had purchased in the black market. But you can readily see that this Chinese money, which is a fine grade of paper money, gives the individual who owns it no independence, because it has no redemptive value.

Under such conditions the individual citizen is deprived of freedom of movement. He is prevented from laying away purchasing power for the future. He becomes dependent upon the goodwill of the politicians for his daily bread. Unless he lives on land that will sustain him, freedom for him does not exist.
You have heard a lot of oratory on inflation from politicians in both parties. Actually that oratory and the inflation maneuvering around here are mostly sly efforts designed to lay the blame on the other party’s doorstep. All our politicians regularly announce their intention to stop inflation. I believe I can show that until they move to restore your right to own gold that talk is hogwash.

Paper Systems End in Collapse
But first let me clear away a bit of underbrush. I will not take time to review the history of paper money experiments. So far as I can discover, paper money systems have always wound up with collapse and economic chaos.
Here somebody might like to interrupt and ask if we are not now on the gold standard. That is true, internationally, but not domestically. Even though there is a lot of gold buried down at Fort Knox, that gold is not subject to demand by American citizens. It could all be shipped out of this country without the people having any chance to prevent it. That is not probable in the near future, for a small trickle of gold is still coming in. But it can happen in the future. This gold is temporarily and theoretically partial security for our paper currency. But in reality it is not.

Also, currently, we are enjoying a large surplus in tax revenues, but this happy condition is only a phenomenon of postwar inflation and our global WPA. It cannot be relied upon as an accurate gauge of our financial condition. So we should disregard the current flush treasury in considering this problem.

From 1930-1946 your government went into the red every year and the debt steadily mounted. Various plans have been proposed to reverse this spiral of debt. One is that a fixed amount of tax revenue each year would go for debt reduction. Another is that Congress be prohibited by statute from appropriating more than anticipated revenues in peacetime. Still another is that 10% of the taxes be set aside each year for debt reduction.
All of these proposals look good. But they are unrealistic under our paper money system. They will not stand against postwar spending pressures. The accuracy of this conclusion has already been demonstrated.

The Budget and Paper Money
Under the streamlining Act passed by Congress in 1946, the Senate and the House were required to fix a maximum budget each year. In 1947 the Senate and the House could not reach an agreement on this maximum budget so that the law was ignored.

On March 4 this year the House and Senate agreed on a budget of $37½ billion. Appropriations already passed or on the docket will most certainly take expenditures past the $40 billion mark. The statute providing for a maximum budget has fallen by the wayside even in the first two years it has been operating and in a period of prosperity.

There is only one way that these spending pressures can be halted, and that is to restore the final decision on public spending to the producers of the nation. The producers of wealth — taxpayers — must regain their right to obtain gold in exchange for the fruits of their labor. This restoration would give the people the final say-so on governmental spending, and would enable wealth producers to control the issuance of paper money and bonds.

I do not ask you to accept this contention outright. But if you look at the political facts of life, I think you will agree that this action is the only genuine cure. There is a parallel between business and politics which quickly illustrates the weakness in political control of money.

Each of you is in business to make profits. If your firm does not make profits, it goes out of business. If I were to bring a product to you and say, this item is splendid for your customers, but you would have to sell it without profit, or even at a loss that would put you out of business. — well, I would get thrown out of your office, perhaps politely, but certainly quickly. Your business must have profits.

In politics votes have a similar vital importance to an elected official. That situation is not ideal, but it exists, probably because generally no one gives up power willingly.

Perhaps you are right now saying to yourself: “That’s just what I have always thought. The politicians are thinking of votes when they ought to think about the future of the country. What we need is a Congress with some ‘guts.’ If we elected a Congress with intestinal fortitude, it would stop the spending all right!”

I went to Washington with exactly that hope and belief. But I have had to discard it as unrealistic. Why? Because an economy Congressman under our printingpress money system is in the position of a fireman running into a burning building with a hose that is not connected with the water plug. His courage may be commendable, but he is not hooked up right at the other end of the line. So it is now with a Congressman working for economy. There is no sustained hookup with the taxpayers to give him strength.

When the people’s right to restrain public spending by demanding gold coin was taken from them, the automatic flow of strength from the grass-roots to enforce economy in Washington was disconnected. I’ll come back to this later.

In January you heard the President’s message to Congress or at least you heard about it. It made Harry Hopkins, in memory, look like Old Scrooge himself.
Truman’s State of the Union message was “pie-in-the-sky” for everybody except business. These promises were to be expected under our paper currency system. Why? Because his continuance in office depends upon pleasing a majority of the pressure groups.

Before you judge him too harshly for that performance, let us speculate on his thinking. Certainly he can persuade himself that the Republicans would do the same thing if they were In power. Already he has characterized our talk of economy as “just conversation.” To date we have been proving him right. Neither the President nor the Republican Congress is under real compulsion to cut Federal spending. And so neither one does so, and the people are largely helpless.

But it was not always this way.
Before 1933 the people themselves had an effective way to demand economy. Before 1933, whenever the people became disturbed over Federal spending, they could go to the banks, redeem their paper currency in gold, and wait for common sense to return to Washington.

Raids on Treasury
That happened on various occasions and conditions sometimes became strained, but nothing occurred like the ultimate consequences of paper money inflation.
Today Congress is constantly besieged by minority groups seeking benefits from the public treasury. Often these groups. control enough votes in many Congressional districts to change the outcome of elections. And so Congressmen find it difficult to persuade themselves not to give in to pressure groups. With no bad immediate consequence it becomes expedient to accede to a spending demand. The Treasury is seemingly inexhaustible. Besides the unorganized taxpayers back home may not notice this particular expenditure — and so it goes.

Let’s take a quick look at just the payroll pressure elements. On June 30, 1932, there were 2,196,151 people receiving regular monthly checks from the Federal Treasury. On June 30, 1947, this number had risen to the fantastic total of 14,416,393 persons.

This 14½ million figure does not include about 2 million receiving either unemployment benefits of soil conservation checks. However, it includes about 2 million GI’s getting schooling or on-the-job-training. Excluding them, the total is about 12½ million or 500% more than in 1932. If each beneficiary accounted for four votes (and only half exhibited this payroll allegiance response) this group would account for 25 million votes, almost by itself enough votes to win any national election.

Besides these direct payroll voters, there are a large number of State, county and local employees whose compensation in part comes from Federal subsidies and grants-in-aid.

Then there are many other kinds of pressure groups. There are businesses that are being enriched by national defense spending and foreign handouts. These firms, because of the money they can spend on propaganda, may be the most dangerous of all.

If the Marshall Plan meant $100 million worth of profitable business for your firm, wouldn’t you Invest a few thousands or so to successfully propagandize for the Marshall Plan? And if you were a foreign government, getting billions, perhaps you could persuade your prospective suppliers here to lend a hand in putting that deal through Congress.

Taxpayer the Forgotten Man
Far away from Congress is the real forgotten man, the taxpayer who foots the bill. He is in a different spot from the tax-eater or the business that makes millions from spending schemes. He cannot afford to spend his time trying to oppose Federal expenditures. He has to earn his own living and carry the burden of taxes as well.

But for most beneficiaries a Federal paycheck soon becomes vital in his life. He usually will spend his full energies if necessary to hang onto this income.
The taxpayer is completely outmatched in such an unequal contest. Always heretofore he possessed an equalizer. If government finances weren’t run according to his idea of soundness he had an individual right to protect himself by obtaining gold.

With a restoration of the gold standard, Congress would have to again resist handouts. That would work this way. If Congress seemed receptive to reckless spending schemes, depositors’ demands over the country for gold would soon become serious. That alarm in turn would quickly be reflected in the halls of Congress. The legislators would learn from the banks back home and from the Treasury officials that confidence in the Treasury was endangered.

Congress would be forced to confront spending demands with firmness. The gold standard acted as a silent watchdog to prevent unlimited public spending.

I have only briefly outlined the inability of Congress to resist spending pressures during periods of prosperity. What Congress would do when a depression comes is a question I leave to your imagination. I have not time to portray the end of the road of all paper money experiments.

It is worse than just the high prices that you have heard about. Monetary chaos was followed in Germany by a Hitler; in Russia by all-out Bolshevism; and in other nations by more or less tyranny. It can take a nation to communism without external influences. Suppose the frugal savings of the humble people of America continue to deteriorate in the next 10 years as they have in the past 10 years? Some day the people will almost certainly flock to “a man on horseback” who says he will stop inflation by price-fixing, wage-fixing, and rationing. When currency loses its exchange value the processes of production and distribution are demoralized.

For example, we still have rent-fixing and rental housing remains a desperate situation.

For a long time shrewd people have been quietly hoarding tangibles in one way or another. Eventually, this individual movement into tangibles will become a general stampede unless corrective action comes soon.

Is Time Propitious
Most opponents of free coinage of gold admit that that restoration is essential, but claim the time is not propitious. Some argue that there would be a scramble for gold and our enormous gold reserves would soon be exhausted.

Actually this argument simply points up the case. If there is so little confidence in our currency that restoration of gold coin would cause our gold stocks to disappear, then we must act promptly.

The danger was recently highlighted by Mr. Allan Sproul, President of the Federal Reserve Bank of New York, who said:
“Without our support (the Federal Reserve System), under present conditions, almost any sale of government bonds, undertaken for whatever purpose, laudable or otherwise, would be likely to find an almost bottomless market on the first day support was withdrawn.”

Our finances will never be brought into order until Congress is compelled to do so. Making our money redeemable in gold will create this compulsion.
The paper money disease has been a pleasant habit thus far and will not he dropped voluntarily any more than a dope user will without a struggle give up narcotics. But in each case the end of the road is not a desirable prospect.

I can find no evidence to support a hope that our fiat paper money venture will fare better ultimately than such experiments in other lands. Because of our economic strength the paper money disease here may take many years to run its course.

But we can be approaching the critical stage. When that day arrives, our political rulers will probably find that foreign war and ruthless regimentation is the cunning alternative to domestic strife. That was the way out for the paper-money economy of Hitler and others.

In these remarks I have only touched the high points of this problem. I hope that I have given you enough information to challenge you to make a serious study of it.

I warn you that politicians of both parties will oppose the restoration of gold, although they may outwardly seemingly favor it. Also those elements here and abroad who are getting rich from the continued American inflation will oppose a return to sound money. You must be prepared to meet their opposition intelligently and vigorously. They have had 15 years of unbroken victory.
But, unless you are willing to surrender your children and your country to galloping inflation, war and slavery, then this cause demands your support. For if human liberty is to survive in America, we must win the battle to restore honest money.

There is no more important challenge facing us than this issue — the restoration of your freedom to secure gold in exchange for the fruits of your labors.
I am internationally accepted, last for thousands of years, and probably most important, you can’t make any more of me.”

Posted by Roger Montgomery, Value.able author, Skaffold Chairman and Fund Manager, 26 February 2012.

by Roger Montgomery Posted in Energy / Resources, Insightful Insights, Skaffold, Value.able.

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We all know retail businesses are swimming against the tide. We have written about that subject here at the blog on many occasions and below is a brief list of more recent posts:

We are not investors in momentum or sentiment however this blog allows me to share our thoughts with you and we are noticing a shift in investor sentiment now. The stock market indices with exposure to resources are underperforming the indices without. The industrial indices are rising at a faster rate and falling at a slower rate than their resource-rich bretheren.  Today is a classic example, This tells us that a shift is afoot. If you have been reading this blog regularly, you will know that we are also not enthusiastic about Iron Ore prices and believe prices of $100 per tonne or less are possible in coming years.  On air, I have explained that is our reason for not purchasing BHP despite optimistic earnings forecasts by analysts.

I think the lower-iron-ore price story is catching on and quietly but surely investors are reducing their relative weighting to resource heavyweights.

With that in mind, it could be that most down-in-the-dumps retail sector that now holds a few gems. Next week we’ll explore the results of the reporting season but for today I thought we should revisit The Reject SHop following its half year results.

Here’s the list of recent posts covering retail stocks and the retail sector.

http://rogermontgomery.com/invest-in-kfc-or-just-eat-it/
http://rogermontgomery.com/is-it-just-harvey-norman-or-bricks-mortar-retailing-generally/
http://rogermontgomery.com/are-bargains-available-at-woolworths/
http://rogermontgomery.com/now-waving-drowning/
http://rogermontgomery.com/not-so-high-at-jb-hi-fi/
http://rogermontgomery.com/dumped-by-the-wave-of-fashion/

Way back in September 2009, I published my reason for selling The Reject Shop:

“I can’t stop thinking that the value of the business just cannot rise at a fast enough clip to justify the current price. I really don’t like trading things that I have bought but I don’t think the value of the business can continue to rise indefinitely. With a share price of $13.45 (intraday today) and a valuation of $11.27, the shares are 24% above their intrinsic value. This combination of factors tells me we are safer in cash.”

Like many value investors, I was a little premature and the price first rallied to more than $17.00.  Since then the price has steadily declined to $11.80 after hitting a low of $9.12.

More recently – in December – I wrote:

“The Reject Shop still enjoys its high brand awareness but, as is typical in many store roll out stories, as the offer matures the later sites are less profitable than the early sites.

This doesn’t fully explain the fact that during a period in the economy where one would expect a bargain offering to shine, it hasn’t. Eighty percent of Australians still know the brand but I believe consumer experience and mismanagement has done it some damage.

According to one report, 20% of the population believe the company offers rubbish – cheap Chinese junk that quickly breaks after use and fills our tips. It’s the very reputation China itself is trying, but frequently failing, to shake off.

The other reason for damage to the brand is confusion brought on by mismanagement. Several years ago the average unit price was about $9 and basket size was $11, but over the years one cannot help but have noticed many higher-priced items creeping into the stores.”

Value investors are often early to buy and early to sell but over the long run, being certain of a good return is safer than being hopeful of an exceptional one and so, when it comes to buying decisions a demonstrated record is often essential.

In TRS’s FY12 earnings guidance, the company noted “Significant expenditure on increasing brand awareness”.  This is a real shame because at the time the company float The Reject Shop enjoyed 90% brand recognition and thats why its store roll out was working so well – shoppers knew the company, the store and the offer even though they had never been into a store in their area.

The company has provided earnings guidance for the full year 2012 of $20.5 to $22 million and while some smart analysts will note this is a 53 week year – we don’t care about such arbitrary lines in the sand.  Our approach to investing is involves treating any purchase and ownership as if we owned the whole company.  In that light and over the long term it doesn’t matter whether there are 52 weeks in a year or 52.5 or 53.

Thirteen analysts cover the stock and this week, eight have upgraded (only one downgraded) their forecasts for 2012 (remember the downgrade could be an error on the part of teh analyst rather than the company disappointing) .  I still believe the business will mature but there could be some value in the turnaround and a stabilisation of strong cash flows, and returns on equity over the next few years around 35%.  This is the rate of return on equity the company generated on $21 million of equity in 2005 (its intrinsic value then was around $4.00).  Today the company is expected to return to 35% returns on equity but on 3 times the equity.  You should be able to estimate the intrinsic value from those metrics.

There have been terrific results amongst our fund holdings such as Credit Corp, Seek, Breville Group, ARB, Decmil and Maca.  Have you been encouraged by any of the results?  Start a discussion by clicking on the Comments button below.

Posted by Roger Montgomery, Value.able author, Skaffold Chairman and Fund Manager, 24 February 2012.

by Roger Montgomery Posted in Companies, Consumer discretionary, Value.able.

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In his ASX Investor Hour presentation of 21 February 2012, Roger argues that whether you invest on the basis of fundamentals or technical analysis, your buying and selling decisions should always be made in the light of your valuation of the company. Roger explains the factors he takes into account in assessing the value of companies, the systems he uses to do those valuations and talks about some of the companies that he currently regards as good value.  Watch video here and view the slides here.

by Roger Montgomery Posted in Insightful Insights, Investing Education, TV Appearances, Value.able.

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Investor Point:  Andrew observes that companies in fast changing industries are prone to misguided adventures with shareholders funds after they mature (which they do very quickly in a country with a population of a mere 23 million).

(if you’d like to contribute a post send it to roger@rogermontgomery.com with the word CONTRIBUTION in the subject line)

The internet list companies have long been considered favourites of some of the community here (including myself). Their ability to generate lots of free cash and earnings against very little equity makes them prime considerations as a company some would like to own, especially as some have great competitive moats around them. However, is there an inherent risk that needs to be considered and compensated for when choosing to value and/or invest in these companies? This is a question I have been considering as of late and would like some help to answer.

Valuing companies is a forward looking exercise and so we must make certain decisions and adjustments based on how we think this company will grow over the years.

A company must be able to earn attractive rates of return on the incremental capital it puts to work. As a company moves further along on its life cycle this gets harder to do. When a company reaches maturity, earning these attractive returns becomes even more difficult and organic growth opportunities dry up. A company must then look for other avenues of growth and/or use its capital wisely to increase shareholder value whether it’s through increased dividends or share buy backs.

Usually a company can grow organically by opening up new stores for example, however you cannot do this on the internet. This lack of organic growth opportunities causes the growth stage of the business to be shorter and therefore the maturity stage to come around in a quicker timeframe than a tangible business. The lack of costs needed to operate this kind of business also means that when these companies reach maturity, there is very little scope to increase profits by becoming leaner.

This only leaves the option of new product offerings, purchased growth (M&A) and/or offshore expansion as the remaining avenues for growth. All of these options have risk to both the company and investor and could see real damage done to the return on equity of the business if not done well (for example paying too much for another company).

The growth versus profitability conundrum is one that has seen many companies go down a route, which leaves the investor worse off.

It is my opinion that acquisitions cannot be seen as abnormal or opportunistic exercises for these internet businesses. They are, instead, an inevitable result of the companies journey through the life cycle and therefore needs to be considered when making investment and valuation decisions. As an investor cannot know exactly when and where this acquisition will be made nor how much it will cost until it happens it therefore clouds the waters of valuation.

As has been said many times, it is better to be conservative and wrong than optimistic than wrong and one could easily use more conservative inputs to compensate for this unknown. Another option to consider is that there is a higher implied risk for this investment and there for an investor should ask for a higher required return (higher risk premium) or seek much larger margins of safety.

The investor cannot with the same certainty be able to invest in these companies over a long-term time horizon as some other businesses as the expected life cycle of such a business is shorter and involve constant corporate activity, which will require a meaningful amount of analysis. So far the main companies (REA, SEK, WEB, CRZ, WTF) have been negotiating the path reasonably well and hopefully that continues. However, some have been especially active in purchasing growth and/or going offshore. If this continues it is my opinion that the risk becomes higher as the risk of management error (paying too much etc) becomes greater.

Posted by Andrew

Postscript:  Paying too much for the companies themselves is also possible (see valuation/price chart below for WEB)!

Posted by Andrew L with permission of Roger Montgomery, Value.able and Skaffoldauthor and Fund Manager, 21 February 2012.

by Roger Montgomery Posted in Value.able.

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This piece by Satyajit Das was just sent to us and we thought it worth sharing.

Why Europe’s Plan to End the Debt Crisis Can’t and Won’t Work

The most recent summit failed to reach even the lowest expectations. Euro-Zone leaders displayed poor understanding of the problems, confused strategies, political bickering and infighting as well as inability to take decisive steps and stick to a course of actions.

The actions need to try to stabilize the European debt crisis are well recognized. Countries like Greece need to restructure its debt to reduce the amount owed – a euphemism for default. Banks suffering large losses as a result of these debt write-downs need to be stabilized by injecting new capital and ensuring access to funding to avoid insolvency.

A firewall needs to be erected to quarantine Spain and Italy as well as, increasingly, Belgium, France and Germany from the further spread of the debt crisis. Steps must be taken to return Europe to sustainable growth as soon as possible.

Even if all these measures could be implemented as soon as possible, success is not assured. But without them, the chance of a disorderly collapse is increasingly significant.

What’s Chinese for Begging Bowl

Another option proposed is to enhance the European Financial Stability Fund using resources from private and public financial institutions and investors through Special Purpose Vehicles (SPV). Few details are available currently.

The idea seems to be to raise money from emerging nations with large foreign exchange reserves, such as China, or sovereign wealth funds. The EFSF would provide the equity in the SPV with the investors providing senior debt to increase the funds capacity. The scheme appears reminiscent of leveraged investment vehicles such as collateralized debt obligations (CDOs) and Structured Investment Vehicles (SIVs).

Support for the idea amongst potential investors is uncertain. French President Sarkozy solicited Chinese support by a direct appeal to Chinese President Hu Jintao. China’s position remains guarded in the absence of additional information. The Chinese position to date has been that Europe must get its house in order first and then China will assist. The current European position is different – China must give money to Europe to get its house in order.

China has considerable “skin in this game.” Europe is China’s biggest trading partner. China has around $800-1,000 billion invested in euros and European government bonds. Continuation of the European debt problems will have serious effects on China’s economy and its investments.

The Chinese leadership also has to consider the internal political reaction to increased investment in Europe. Chinese foreign investments, including in foreign financial institutions in 2007 and 2008, have incurred losses. China’s leaders face criticism from a large section of population for having invested Chinese savings poorly. China’s officials will not want to be seen to risk even more capital on a potentially lost cause. It is not clear that the EU proposal has sufficient chances of success to encourage China increasing its exposure to Europe, especially as relatively wealthy European countries, like Germany and France, are unwilling to put up more money and are seeking to limit their exposure.

China also faces domestic problems – inflation (partly as a result of the weak currency policies of the developed nations) and attendant wage pressures that are reducing its competitiveness, serious bad debt problems in their banking system and pressure to accommodate the economic aspirations of an increasingly restive population. China’s flexibility to act may be limited.

But China seems desperate to be seen as a “global power.” Ego might seduce them into committing more money.

Contributions from China and other emerging countries will not resolve the problems. China’s contribution, expected to be around euro 70 billion, is small relative to the total requirements. As its foreign exchange reserves have risen in recent years, China has purchased substantial volumes of euro-denominated assets, both directly and via bonds issued by the EFSF, without preventing peripheral European bond yields rising. The need for this special scheme is also not clear as the Chinese can presumably invest directly if they wish to and see value in doing so.

Any Chinese involvement would probably require additional support from the Euro-zone countries, which may be opposed by Germany and other nations. China is inherently risk averse and will seek to negotiate additional political concessions, such as reducing pressure on the revaluation of the Renminbi, trade and currency sanctions and criticism on human rights issues. It is not clear whether these will be acceptable.

The negotiating stance of China is evident from its desire to denominate any funding in Renminbi. The EFSF have not ruled this out. The idea is dangerous, as Europe would incur currency risk, becoming exposed to an appreciating Renminbi, adding to its long list of problems.

The entire proposal smacks of desperation and belief in a simple, quick solution where no such option exists.

At best, the plan provides funds to tide over the immediate funding problems of weaker Euro-Zone members. It does little to deal with the Euro-Zone’s structural problems. There is still the risk that Europe enters a prolonged period of low growth or recession. The plan does not address the economic divergences that exist within the Euro-Zone or ease the painful adjustment processes that weaker members will still have to undergo within the constraints of the single currency. These problems are far more difficult to fix than the task of finding buyers for the required amount of government debt.

Balancing Imbalances

The EU refuses to deal with fundamental problems. The austerity and balanced budget measures, reinforced and reiterated in the plan, cannot deal with the primary problem – the deflation of the debt-fuelled bubble.

The EU is seeking to enforce the rarely adhered to rules for membership of the euro, the Stability and Growth Pact requires a deficit no larger than 3% in any one year and a Debt to GDP ratio no larger than 60%. Based on 2010 figures, Austria, Belgium, Cyprus, France, Ireland, Italy, Portugal, Spain and Greece do not meet one or both of these tests on current measures. Only Germany, Finland and the Netherlands are in compliance and would pass in 2013 on current projections.

Strict enforcement of this rule about deficits would prevent counter-cyclical spending by governments undermining economic recovery and lock the Euro-Zone into a death spiral of budget deficits, further budget cuts and low growth.

The problem is compounded by the competitiveness gap between Northern and Southern countries, estimated at 30% difference in costs. The EU’s refusal to contemplate a break-up or restructuring of the euro makes dealing with this problem difficult.

For many of the weaker countries, the best option would be to devalue their currency in the same way that the U.S. and Britain are debasing dollars and sterling respectively. Unable to devalue or control interest rates, these weaker countries are trapped in a vicious and ultimately self-defeating cycle of cost reduction.

An additional problem is the internal imbalances exemplified by Germany’s large intra-Euro-Zone trade surplus at the expense of deficit states, especially the Club Med countries like Greece, Portugal, Spain and Italy. German reluctance to boosting spending and imports makes any chance of resolving the crisis even more remote.

German hypocrisy, in this regard, is problematic. German banks lent money to many countries to finance exports, which benefited Germany. Germany also gained export competitiveness from a weaker euro–an exchange rate of euro 1 = U.S. $ 2.00 would be a realistic exchange rate if the euro were to be a purely German currency. Reluctance to confront these problems makes a comprehensive resolution of the crisis difficult.

Endgame

In chess, endgames require using the few pieces left on the board to achieve a result. Strategic concerns in endgames are different to those earlier in the game. The King becomes an attacking piece. Pawns become more important because of the potential to promote it to a queen. Endgames are more limited and finite than say openings.

The plan has bought time, though far less than generally assumed. As the details are analysed, weaknesses, unless remedied, will be quickly exposed.

The European debt endgame remains the same: fiscal union (greater integration of finances where Germany and the stronger economies subsidize the weaker economies); debt monetization (the ECB prints money); or sovereign defaults.

The accepted view is that, in the final analysis, Germany will embrace fiscal integration or allow the printing of money. This assumes that a cost-benefit analysis indicates that this would be less costly than a disorderly break-up of the Euro-Zone. This ignores a deep-seated German mistrust of modern finance as well as a strong belief in a hard currency and stable money. Based on their own history, Germans believe this is essential to economic and social stability. It would be unsurprising to see Germany refuse the type of monetary accommodation and open-ended commitment necessary to resolve the crisis by either fiscal union or debt monetization.

Unless restructuring of the euro, fiscal union and debt monetization is removed from the verboten list, sovereign defaults may be the only option available.

Regards,

Satyajit Das

And Ray Dalio’s piece will give you a terrific framework to help you understand what Satyajit is talking about, where we are, how we got here and where we are going…Click Here

Posted by Roger Montgomery, Value.able and Skaffoldauthor and Fund Manager, 9 February 2012.

by Roger Montgomery Posted in Value.able.

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Click on the above IMAGE to see a larger and clearer version of the screenshot from Skaffold.

The ability to turn off and tune out the noise of the market is a key to success.  I don’t know whether the market will keep rallying amid improving US economic data in the short term while ignoring long term structural European banking and credit issues that is now ‘old news’.  I do believe that the market reacts to new ideas while always keeping an eye on old ideas.  European deterioration was new for a while and now its not.  The ‘new news’ today is that the US economy is improving.  Europe is, as I say, old news.  But old news gets recycled when the new news the short termists are focusing on becomes old news itself.  if you are keeping up, you are doing well.  One expects that eventually the appetite for stocks could weaken when news of a resurgent US becomes old and unresolved structural issues return to become news again.

Putting that aside, here is a list of six companies that popped up in Skaffold (click here to join) today when I looked for A1, A2, A3 and B1 companies trading at a better than 15% discount to estimated intrinsic value.  I then selected for no debt (net cash), forecast EPS growth and expected positive growth in estimated intrinsic value.  You will note that I have left out the names of the companies that make the grade. There’s a good reason which I will discuss in a moment…

As an aside if you would like to see how the stocks in your portfolio compare to the Skaffold universe you can CLICK HERE and enter your five stocks directly into Skaffold.  Once you have done that I imagine you won’t want to invest without it.

…To start a discussion about what is good value in the market right now, have a go at suggesting what the six stocks in the above list are.  If you can get all six right in one go, I will ask the team to send a signed copy of my book Value.able to the first correct answer.

If you simply want to discuss a value opportunity you have uncovered go ahead by clicking the Leave a Comment button below.

Posted by Roger Montgomery, Value.able and Skaffold author and Fund Manager, 6 February 2012.

by Roger Montgomery Posted in Value.able.

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• POSTED IN Value.able