Wealth International, Limited (trustprofessionals.com) : Where There’s W.I.L., There’s A Way

W.I.L. Finance Digest :: April 2009, Part 3

This Week’s Entries :


The banks have been the spark plug of this powerful stock-market rally, but past may not be prologue.

How did the banks, so many of which seemed to be slouching toward extinction, get their act together to the point where they were in the black in January and February, wonders Alan Abelson. The profits were of the one-shot variety, says one piece of analysis, and they entailed a transfer of money from taxpayers to banks, with AIG acting as intermediary. Abelson finds this all to plausible ... as do we.

Abelson cites another analyst who notes that the groups that have paced the current market upswing have been financials and consumer cyclicals, in which speculators have net short positions. That strongly suggests that the rally has been partly fueled by shorts running for cover. The bogus bank earnings would be a convenient catalyst for the financials short squeeze.

The amazing Randi. We had never heard of the chap until last week, when we were indulging in an old habit that began way back when we were a copy boy (the journalistic equivalent of a galley slave) and took to passing some of the grudgingly little downtime allotted to us poring over the obituaries. Our interest was not born solely of innate ghoulishness, but nurtured also by the fact that an obit provides a highly compressed and often fascinating biography of those noteworthy souls who have recently departed from the ranks of the quick.

In this instance, the subject was not the Amazing Randi, but John Maddox, a British editor of considerable renown who transfigured a stuffy magazine named Nature into a scintillating science journal. Mr. Maddox, by all description an unflaggingly imaginative and energetic editor broadly versed in the sciences, was graced with a flair for the unorthodox and a sharp nose for bamboozle.

Back in the late 1980s, he published a piece by a French doctor claiming remarkable qualities for an antibody he had studied, but only on the condition that an independent group of investigators chosen by Mr. Maddox monitor the doctor’s experiments. Among the investigators he chose was the Amazing Randi (né James Randi), a professional magician whose knowledge of science may have been limited but whose knowledge of hocus-pocus was peerless. The poor doctor’s goose was cooked.

Mr. Maddox’s engaging inspiration got us to thinking, gee, would it not be great to have an Amazing Randi handy to help uncover the voodoo that has caused investors virtually en masse to suspend disbelief. We are referring, of course, to their marvelously revived tendency to slip on their rose-colored glasses, which for so long had been gathering dust on the shelf, when viewing corporate fortunes or the economy at large.

Take for example, dear old Goldman Sachs , which has enjoyed a mighty burst of enthusiasm among Street folk that has sent its shares sprinting to the vanguard of this smashing stock-market rally; an enthusiasm, moreover, that has spilled over to other banks and their financial kin. No argument, the firm has handsomely outperformed its few surviving rivals, none of which is blessed with Goldman’s deft trading skills or tight Washington connections.

Goldie reported earnings of $1.8 billion for the first quarter. In doing so, it got a lucky boost from its switch from a fiscal year ending November to a calendar year. The shift came in response to statutory fiat, as part of Goldman’s change to a commercial bank, a prerequisite to gaining eligibility for all those lovely billions in loans and guarantees the government has been showering on banks.

That $1.8 billion in March-quarter profits was a heap more than its analytical followers expected, and, as intimated, a sparkling demonstration of Goldman’s vaunted trading agility (from what we can gather, it made a bundle in part by timely shorting bonds). The switch in its fiscal year took December out of the first quarter and made it an isolated, stand-alone month, relegated to an inconspicuous assemblage of bleak figures far in the rear of the company’s 12-page earnings release.

As it happens, Goldman lost some $780 million in December, a tidy sum that obviously would have taken a lot of the gloss off its reported Q1 performance. And, who knows, it might have even drained some of the zing that the surprisingly good results lent the stock.

But, in any case, the very next day, the spoilsport credit watchers at Standard & Poor’s threw a bit of cold water on the shares by venturing that, in light of the soggy economy and unsettled capital markets, it would be “premature to conclude that a sustained turnaround” by Goldman was necessarily in the cards.

The financial sector, as even the most cursory spectator of the investment scene doubtless is aware, has provided the crucial spark to this powerful bear-market rally. And, in particular, the return from the very edge of the abyss by the banks in the opening months of this year has revived fast-swelling bullish sentiment.

The question naturally arises: How did the banks, so many of which seemed to be slouching toward extinction, get their act together to the point where they were in the black in January and February?

In search of an answer, we turned up an intriguing explanation for this magical metamorphosis by Zero Hedge, a savvy and punchy blog focusing on things financial. Not to keep you in suspense, Zero Hedge fingers AIG , that repository of financial ills and insatiable consumer of taxpayer pittances, as the agent of the banks’ miraculous recovery.

But not quite the way you might think. As Zero Hedge explains, AIG, desperate to hit up the Treasury for more moola, decided to throw in the towel and unwind its considerable portfolio of default-credit protection. In the process, the badly impaired insurer, unwittingly or not, “gifted the major bank counterparties with trades which were egregiously profitable to the banks.”

This would largely explain, according to Zero Hedge, why a number of major banks actually, as they claimed, were profitable in January and February. But the profits, it is quick to point out, are of the one-shot variety, and, ultimately, they entailed a transfer of money from taxpayers to banks, with AIG acting as intermediary.

Lacking any deep familiarity with the arcana of credit swaps and the like, we cannot swear to the accuracy of this analysis. But shy of conjuring up the Amazing Randi and have him unveil the truth, it strikes us as plausible – and easily as persuasive as many of the various explanations we have come across for the surprising and rather mysterious turn for the better by the banks.

If by chance it proves out, it just might act as a sobering influence, and not just on the financial sector.

Frankly, we are as bored with this bear market as anyone. And we fully understand, after a year of brutal pummeling, the frantic hopefulness with which investors respond to the inevitable bounce, especially when it is as robust as this one has been.

And we understand, too, their eagerness to grasp at the flimsiest hint of recovery and to strain to put a good face on every twist and turn of the economy, no matter how ugly. But we fear – as some tunesmith crooned long ago – wishing will not make it so.

There is nothing obviously wrong when investors, confronted by what seems to be a sold-out market and tired of sitting on their hands, decide to take a fling on a bear-market rally. And it certainly has been rewarding for virtually anyone who a month or so ago did just that. But an awful lot of folks do not have the time, the discipline, the nimbleness or the spare cash for that sort of hit-and-run investing.

And the danger resides in being carried away by a momentary spate of quick gains and turning a blind eye to the riskiness of the market, which now is a heck of a lot greater, if only because the advance has carried price/earnings ratios to elevated levels – something above 20 on the Standard & Poor’s 500 – or to the critical negatives in the economy.

David Rosenberg of Bank of America/Merrill Lynch (we can’t believe we said the whole thing) last week offered some worthwhile observations on the stock market and the economic landscape that just happen to buttress our own reservations.

He points out that the two groups that paced the sharp upswing were financials and consumer cyclicals, in which there are, respectively, net short positions of 5 billion and 2.7 billion shares. Which strongly suggests that not an insignificant part of the rally has been provided by shorts running for cover.

He also points out that the Russell 2000 small-cap index is up 36% since the March low, and has outperformed the S&P by some 980 basis points. As David says, “the last time it pulled such a massive rabbit out of the hat” was in the stretch from late November to early January, and the major averages proceeded to make new lows two months later.

Another amber light he spots is investor confidence. Over the past 5 weeks, he reports, Rasmussen, which takes a daily reading, has seen its investor-confidence index surge 32 points, an unprecedented climb in so short a span. This could be, he suspects, a “fly in the ointment for a sustained equity-market rally.”

David has four markers that will signal to him that the economy is finally making the turn and starting an extended expansion. The first is home prices. The second is the personal-savings rate. Marker No. 3 is the debt-service ratio, and No. 4 is the ratio of the coincident-to-lagging indicators of the Conference Board.

Aggregating those four markers, he calculates that we are roughly 44% of the way through the adjustment process. That is a tick up from where we were last month. However, the improvement, he laments, has been very modest and very slow.

We should add that he also stresses that it is critical for both the economy and the market that payrolls stop shrinking. All the talk about jobless claims “stabilizing” is so much poppycock, he snorts. That number of claims, he notes, is still consistent with monthly payroll losses of around 700,000. As with industrial production, which is also in a vicious slump, employment must stop falling before a recession typically ends.

“Call us when claims fall below 400,000,” he says, which is his estimate of “the cut-off for payroll expansion/contraction.”

Until then, he warns, “the recession will remain a reality. Rallies will be brief, no matter how violent, and green shoots are a forecast with a very wide error term attached to it.”


An Interview with Derek van Eck.

Derek van Eck is a principal of money manager Van Eck Associates, a well known name in the commodity/resource investing sector. Here is his current take on certain hard and soft commodities, which have seen some recovery this year after talking along with everything else last year.

Many commodities have had a nice run lately, including crude and copper, following a dreadful second half 2008. And Derek van Eck, a principal of New York money manager Van Eck Associates, sees more opportunities, thanks in no small part to demand from countries like China.

His firm oversees close to $10 billion, about $3.3 billion of which is spread across Van Eck Global Hard Assets (ticker: GHAAX) and separate accounts run under the same strategy. Lead manager Van Eck, 44, still likes the outlook for copper, maintains that gold is an important hedge against inflation, and has become more bullish on agricultural commodities – corn and soybeans, in particular. He also sees an improving long-term outlook for energy, driven by supply constraints. The fund had a nasty 2008, losing nearly 45% versus the S&P North American Natural Resources Sector Index, off 42.8% in 2008.

But this year, the Hard Assets portfolio is up 9.91%, placing it in the top 22% of its Morningstar peer group of natural-resource funds. Its 3- and 5-year annual returns rank at the very top of the group. Barron’s caught up with van Eck last week.

Barron’s: Let us start with your view of commodities from 30,000 feet. Could you summarize some of the key issues?

Van Eck: We have been playing defense in the last several quarters, but now we are beginning to play some offense and see good opportunities. Commodities markets have changed. A year ago, some commodities were exploding in value. Oil was approaching $150 a barrel, and inflation was a major worry. Central banks were tightening credit, trying to slow inflation. China had engaged in a building program ahead of the Olympics, and they were building inventories of distillate, which is an oil product, to ensure enough back-up power. Index speculators were considered villains, and Congress was investigating commodities markets. The credit debacle was just building.

Then, commodities endured one of the greatest, most violent corrections in history, especially in the second half of last year. The credit collapse caused demand to collapse. There was inventory liquidation in every corner of the global economy. In some cases, commodity prices declined even more than they did during the Great Depression. Crude oil fell 75% from its peak to trough. Copper dropped 70%.

How do things look now for commodities?

The general outlook is improving, due to both cyclical and structural factors. The red light, which had been flashing, is now gradually turning green in some markets.

On the cyclical side, there is evidence that China’s growth troughed in the first quarter, and that it is likely to improve in coming quarters. In China, recent PMI [purchasing managers] data, electricity demand, real-estate transaction data and very strong loan and credit growth suggest a turnaround. And spending from government fiscal-stimulus programs is likely to continue.

In the OECD [Organization for Economic Cooperation and Development] countries, it appears that demand may be gradually stabilizing, thanks to the massive reflationary programs that have been instituted in various countries, including the U.S. This suggests an inventory-restocking cycle is ahead, increasing demand for commodities.

What about the credit crunch and its impact on commodities?

It abruptly slowed capital spending, resulting in a lack of supply growth in many commodity markets. On the structural side, there are issues of depletion and resource accessibility. For example, 60% to 70% of the world’s oil reserves are inaccessible to international oil companies.

Could you elaborate on what you see ahead for crude and natural gas?

There is lots of oil, both offshore and in terms of broad inventory. A massive amount of inventory must be worked through in crude and natural gas. But positive factors are probably gradually going to start overwhelming negative factors.

One key factor to think about is depletion. Five to 5 1/2 million barrels a day of oil need to be replenished annually, according to the International Energy Agency. So far, based on IEA estimates, energy demand is down about 5 million barrels a day from its [much higher] peak. But in another year or so, it seems unlikely that you are going get more demand destruction of that magnitude. So at some point, depletion works in your favor, and at some point oil prices start heading higher, probably owing more to supply constraints than to demand. We are seeing very few signs to date of demand increases except for marginal increases in India and China.

What about the overall impact of the different government stimulus programs?

These are massive and unprecedented reflationary programs. While in the short term, markets continue to grapple with concerns about solvency and deleveraging, the market will increasingly get concerned about an inflationary time bomb. This should lead to an inflationary premium for commodities.

So you see commodity prices stabilizing, along with a good chance of price appreciation from here, even with the recent gains?

Yes, we do, although commodities have moved a little bit ahead of their fundamentals. There are large inventory builds to work through, including those in crude oil and natural gas. In other markets, there is the potential of declining inventories. The biggest surprise in commodity markets this year has been copper, which is up roughly 50% year-to-date, mostly because of demand from China.

Are you still bullish on copper?

We think it is sustainable at these prices. That is a very out-of-consensus view. Most market participants would say prices are more likely to decline, but our view is that copper could hang around $2 a pound. Of course, that is not cheap anymore, and it is discounting most of the factors that have led to the price appreciation. It is hard to see a lot of upside, but it is more sustainable than many think.

Looking at agricultural commodities, there are some big losses over the last year, including wheat, down 43%, and corn, which has lost roughly 1/3 of its value.

The surprise on the agricultural side was the depth of demand destruction that took place in various markets like the feed market or the ethanol market.

Is that because people are eating less?

No, I don’t think that is much of a factor. Agricultural commodities are typically much less cyclical than, say, copper is. But there were some surprisingly poor demand numbers for agricultural commodities. Today, though, we are more positively orientated toward these commodities. There is probably 10% to 15% upside, based on less supply.

Is that across the board for agricultural commodities?

We are probably most optimistic on corn, and we are reasonably positive on soybeans for the short term. It becomes a weather bet, and then other factors come into the equation. China is aggressively stocking up on agricultural commodities, including corn and soybeans. So that has been a positive factor.

What is your assessment of emerging markets, which have had a strong start this year?

Emerging markets are going to lead the global economy for the next 5 years. It is not going to be the United States. It is not going to be Europe. Many emerging-market countries are very commodity intensive. They have got reasonably healthy banking systems, depending on where you are talking about, and you have got very strong stimuli from various players, including the Chinese government.

Are you concerned that this recent rally in the stock market could be a head-fake?

Absolutely. There is clearly a risk of that, and we are very aware that you need a healthy banking system globally to have strong, sustainable global growth. There is no doubt in our minds that the banking system still has holes that need to be filled. The banking sector needs – depending on which estimate you use – $200 billion to almost $1 trillion of additional capital. Some of these programs sponsored by the U.S. Treasury, the FDIC [Federal Deposit Insurance Corp.] and others have to work. If they do not, you do not have sustainable growth in the OECD countries, and there would still be risk in the commodity markets.

Moving on, what is your outlook for gold?

Gold is off roughly 10% from its high, which was about $1,000 per ounce about a year ago. Now, gold is caught in a vise. The U.S. banking system is still in pretty poor health, and the consumer is probably overleveraged. So you have a deflationary, deleveraging story, which is probably acting as an overhang on gold. Offsetting that is quantitative easing virtually everywhere in the world. So there is free money being printed in the U.S. and the U.K.

Which is the better scenario for gold?

The upside case for gold is more of an inflationary environment. I do not think anyone thinks inflation is a problem today, but a growing number of people think inflation is going to be a problem two to three years down the road. We are in that camp.

Gold typically trades in long cycles, up or down. Are we still in a secular up-cycle?

Yes, we think that is the case. Gold is taking a healthy pause right now; it needs to consolidate. There was a lot of fast money in gold when it came to the sovereign concerns [a few months ago]. Some of that fast money is now out of gold, which is a healthy phenomenon. But gold is increasingly accepted as its own asset class and as a separate currency. We [see gold hitting] new highs, over the next year or two, of around $1,500 an ounce.

Right now, you see more value in gold miners versus gold exposure via the GLD exchange-traded fund. Do any come to mind?

One is Randgold Resources [GOLD], a mid-tier gold producer focused on West Africa. The company is headed by D. Mark Bristow, a geologist who knows African geology and politics. They have developed two major mines in Mali, and have two more exciting development projects in the pipeline. What sets them apart from their peers is their uncanny ability to grow organically and to find gold deposits through exploration and drilling, rather than overpaying for somebody else’s discovery. The stock trades at $670 per ounce of reserves, roughly a 25% discount to gold.

What is an example of how you are playing alternative energy, another sector you like?

We are investing right now in what we call the transmission smart grid. That is the first stage of the potential growth of alternative energy. Today, the grid is very old, decrepit and inefficient. We lose roughly 10% of the power that is produced through old lines installed over the last 50 years.

The smart grid will lead to other alternative technology, such as solar power and wind, so transmission will be a growth area. We estimate it will grow 15% to 20% annually for the next several years.

Is there a company that fits that theme?

One is Quanta Services [PWR]. The consensus has it growing earnings next year by 30%, but we think they are going to win some awards for transmission infrastructure work to make that higher than 30%. You are paying a reasonable multiple for that kind of growth.

The stock trades at around 17 times the $1.30 analysts expect the company to earn next year. But we think there is great upside. More transmission awards and policy initiatives are expected, and a $10 billion dollar project announced by FERC [the Federal Energy Regulatory Commission] could possibly provide an opportunity for Quanta in the future.

This is an example of a company that is probably a little lost in the noise of the market today, with various participants talking about financial Armageddon.

How have you constructed your portfolio lately?

In the last quarter, we have been getting more aggressive and we have actually been putting money to work in more cyclical names – but we also have a lot of companies we consider to be solid growers with clean balance sheets and great assets that can grow their reserves.

What about an example?

Noble Energy [NBL], an independent exploration-and-production company, is a top holding in our portfolios. It has assets in the United States, and offshore in the Gulf of Mexico. It also has assets in Israel and Africa.

We believe Noble’s reserves will grow sharply over the next three to five years. Noble has a clean balance sheet, and continually has a higher return on capital than its peers do. So the company has reserve growth, and production growth over time. We do not have to worry about debt, in case things deteriorate considerably from here.

Let’s hear about one more pick.

Mariner Energy [ME], another E&P company. It is a neglected, misunderstood story. It combines top-quartile production growth with a very cheap valuation. Production growth should be approximately 15% to 30% this year, and we expect it to increase by 10% next year. The stock trades at 1.4 times 2009 cash flow and 3.2 times [earnings before interest, taxes, depreciation and amortization], well below its peers. That is based on crude being at $45 a barrel, compared with around $50 recently.

The investment opportunity comes from the market’s perception of this company as a high-cost, high-decline-rate Gulf of Mexico shelf operator. In reality, the company has a better reserve-life profile than many onshore operators, and it has had good success in its deepwater operations.

Thanks, Derek.


The legendary investor is sticking for now with the two Cs: China and commodities.

Jim Rogers has covered his short positions in financial stocks, but that does not mean he has switched to the long side. In fact the only stocks he is long in at all are in China’s stock market, and he is only a holder there – not a buyer – because of the strong performance of that market since it bottomed last year.

Rogers was surprised by the extent of the price decline in commodities, but never sold and is adding to his positions there – via his self-created commodities indexes. All in all not much has changed. We were slightly surprised to see he was avoiding all emerging stock markets save China’s.

Well, bank executives and investors can breathe a sigh of relief: Jim Rogers has covered the short positions on financial stocks he put in place ahead of last year’s massive meltdown.

But just because this influential investor is not betting that big banks will fall much further does not mean he is confident they will stage a lasting rally either. He feels similarly about U.S. stocks in general.

“I am skeptical about the rally, and the world economy for the next year or two or three,” he says. “But if stocks go down, I can make money with commodities.”

Rogers, now 66, gained fame as George Soros’s hedge-fund partner in the 1970s and 1980s. After retiring from professional money manager in his late 30s, the Alabama native tooled around Europe, Asia, Africa, and Latin America visiting emerging markets, one by one. His resulting book, Investment Biker, helped to popularize emerging market investing at the outset of a bull market for the sector.

He also helped to popularize commodity investing, which for decades was the province of niche investors. In the 1990s, he developed commodity indexes based on futures contracts that in recent years have been turned into exchange-traded funds available to all investors. His 2004 book, Hot Commodities, came ahead of a surge prices for energy, metals, and agriculture.

Since its inception in July 1998, the Rogers International Commodities Index has gained 158%, while the S&P 500 has fallen 23%. And that gain for the commodities index comes despite the fact that it has lost more than half of its value since last July. At these levels, Rogers has been a buyer.

These days, Rogers, now 66, is sticking close to home in Singapore with his wife, Paige Parker, and two small daughters. He is about to release his latest book, A Gift to My Children: A Father’s Lessons for Life and Investing (Random House), in which he encourages other people’s children to travel widely and learn Mandarin so they can reap the rewards of China’s economic boom.

Recently, Rogers talked to Barrons.com by phone from his Singapore home.

Q: When you last did a lengthy interview with Barron’s magazine a year ago (see “Light Years Ahead of the Crowd,” April 14, 2008) you were lightening up on emerging markets investments. Well, you called that one right. But now that many of those markets have fallen from their highs of recent years, are you more optimistic?

A: No. I have sold all emerging markets stock except the ones in China. I bought more Chinese shares in October and November during the panic, but I have not bought China or any other stock markets including the U.S. since then. I am not buying anything in China right now because the Chinese market ran up maybe 50% since last November. It has been the strongest market in the world in the past six months and I do not like jumping into something that has been that run up. Still, I am not thinking of selling these stocks either. I think if it goes down I will buy more. I think you will find that it is the single strongest market in the world since last fall.

In your latest book, you talk of China as the great investment opportunity of the 21st century, just as the U.S. was in the 20th century. What percentage of a typical American investor’s portfolio should be in China?

If they cannot even find China on a map, I do not think they should have anything in China. They should know something about China before they invest there. If they have the same convictions that I do then they should probably have a lot. If you asked me that question in 1909 about the U.S. stock market, I would have said to put 100% of your money in the U.S.

Might it make sense to have a greater weighting in a diversified mix of Chinese stocks than in U.S. stocks?

Well yes. Just as in 1909, if you were German or Chinese, you should have had the largest percentage of your money in the United States. The idea of investing is to make money, not to have some sort of political agenda.

That being said, you currently think Chinese stocks are bid-up now, so you are not buying at these levels. So what have you been buying lately?

I have been buying commodities through the Rogers commodity indexes I developed because my lawyer will not let me buy individual commodities. I recently bought the all four Rogers indexes – the Elements Rogers International Commodities Index [ticker: RJI] as well as the three specialty indexes, the International Metals [RJZ], the International Energy [RJN], and the International Agriculture [RJA]. That is how I invest in commodities and that is what I bought last week. I have been buying these shares since last fall and up to last week.

Though you got out of emerging markets last year before they fell hard, you seemed be caught by surprise by the fall-off in commodity prices last year. Is that right?

Yes, I was surprised. I did not expect commodities to go down that much and in retrospect it was a period of forced liquidation for many (professional) investors. You know AIG went bankrupt, which was huge in commodities. Lehman Brothers was big in commodities.

But at least I was shorting the investment banks at the time and other financials such as Citigroup and Fannie Mae. So I was hedged by being long commodities and short the other things such as financials and as you know most of them were down from 80% to 100%, so I more than made up on my shorts than I lost on my longs. So thank God for (the stock decline in) Citigroup and thank God for (the decline in) Fannie Mae.

Now despite the recent stock-market rally that started in March, many U.S. stocks are trading well off their 2007 highs. How come you see no value to this market?

I am not buying U.S. companies mainly because I think we may have seen a bottom but I do not think we have seen the bottom. I am skeptical about the rally, the world economy for the next year or two or three. But if stocks go down, I can make money with commodities. In the 1970s, commodities went through the roof even though stocks were a disaster. In the 1930s, commodities rallied first and went up the most long before stocks pulled it together.

Can you summarize the reasons for your bullishness about commodities?

It depends on the supply and demand. And we have had a dearth of supply. Nobody has invested in productive capacity for 25 or 30 years now. The inventories of food are the lowest they have been in 50 years and you have a shortage of farmers even right now because most farmers are old men because it has been such a horrible business for 30 years. And as for metals, nobody can get a loan to open a mine as you know. Who is going to give you money to open a zinc mine? It takes at least 10 years to open a mine so it is going to be 15 or 20 years before we see new mines come on. Nobody has been opening mines for 30 years and they are not going to. And in the meantime reserves are declining. As for oil, the International Energy Agency came out recently with a study showing that oil reserves worldwide were declining at the rate of 6% or 7% a year.

That does not mean that if suddenly the U.S. goes bankrupt that everything will not collapse in price. But I would rather be in commodities because it is the only thing I know where the fundamentals are improving. They are not improving for Citibank or General Motors but the supply situation in commodities is such that when demand comes back, then commodities are going to be the best place to be in my view.

What do you think of bonds?

I am anticipating shorting bonds – the U.S. long bond. It is about the only real bubble around that I can see right now – other than the U.S. dollar. I am not shorting bonds at this moment because I have shorted plenty of bubbles in my day, and I have learned that you better wait because they go up higher than any rational person can anticipate. But my plan is to short the long bond in the U.S. sometime in the foreseeable future.

I have read that you think the penchant of the last two presidential administrations for bailing out failing U.S. companies is a big mistake and will contribute to prolonging this recession. You argue that it is best to let these companies all go bankrupt. How bad can the economy get?

Yes, politicians are making mistakes. In Japan, the problem has lasted for 19 years. I hope that it does not last 19 years in the U.S. The approach that works is to let them (U.S. banks and automakers) collapse and clean out the system. The idea that phony accounting is the solution (through changes in mark-to-market rules) is ludicrous. And the idea that a debt problem and an excessive spending problem can be cured with more debt and more spending is ludicrous.

It is laughable on its face, but politicians think they have got to do something. Unfortunately, they are doing the wrong things and they are going to make it worse.

Thanks for your time.


Agrium has opportunity to grow as fertilizer demand rebounds.

Fertilizer stocks rode the commodities bull market to huge gains, and then tanked with commodities and everything else last year. They have risen substantially off their lows, but are still way off the old highs. Agrium is one of the leaders of the sector.

Agrium’s stock looks cheap at about 7 times this year’s earnings and 6 time next’s, but capital intensive cyclical stocks frequently sport low multiples without necessarily being cheap. The stock is also selling for 1.5 times book value, less than half its 5-year average – but that average strikes us as rich. The company’s increasing exposure to the farm retail market is probably to its benefit.

The promise of spring is everywhere – except in Agrium shares. Like other fertilizer companies, Calgary, Alberta-based Agrium rode the boom in crop prices to unprecedented heights, only to plummet last year when commodities, agricultural and otherwise, went bust. In less than a year, most fertilizer stocks lost more than 60% of their value, which for Agrium meant a nose dive to $22 from $113. The stock [ticker: AGU] now changes hands at 41.

Look closer, however, and it is apparent Agrium’s spring awakening is merely delayed. Demand for fertilizer, which tends to track corn prices, is likely to rebound as the global economy improves. In the meantime, the company is expanding its network of more than 870 retail farm centers in North and South America, in order to help reduce its dependence on commodity prices. A pitched battle for fertilizer rival CF Industries [CF] may be distracting investors from Agrium’s sunnier prospects, but a victory surely would make Wall Street take notice.

One thing is clear: Based on multiple metrics, Agrium is dirt cheap. The stock trades for just 6.8 times this year’s expected earnings of $6.11 a share and 5.8 times Wall Street’s 2010 forecast of $7.14, well below other fertilizer stocks – and the company’s historic multiple of 14 times future profits. The shares fetch one to 1.5 times book value, less than half their 5-year average.

Richard A. Kelertas, an analyst at Dundee Capital Markets, cited such discounts when he initiated coverage of Agrium in January with a Buy rating. He later raised his 12-month price target for the Toronto-listed shares to 61 Canadian dollars, some 21% above their recent C$50.47. (One Canadian dollar is about 82 U.S. cents.)

“The world has been on a wild ride, but agriculture probably has been the least wild of the bunch,” says 57-year-old Chief Executive Mike Wilson, a chemical engineer who has run Agrium since 2000. Global grain demand has increased steadily in the past 20 years, with consumption rising by about 40 million metric tons a year, he notes. Given a growing taste for grain-fed livestock among the emerging middle classes in countries such as China and India, the trend is apt to continue, Wilson adds.

Tracing its roots to 1931, Agrium is the 3rd-largest potash producer in North America. Agrium also makes and markets nitrogen- and phosphate-based plant nutrients, and is the leading agricultural-products retailer in the U.S. Its farm centers sell, among other products, seeds, insecticides – and fertilizer. The company is not “just a bet on fertilizer volume and prices,” says Lawrence Franko, a senior equity analyst at Delaware Investments in Philadelphia. “It is kind of a back-door way to piggyback on Monsanto’s [MON] success without paying a high valuation.”

Monsanto, a leader in genetically modified seeds, trades for about 20 times forward earnings.

With its purchase last May of distributor UAP, Agrium now owns 15% of the U.S. farm-retail market. Yet the company’s retail operations represent just a quarter of last year’s record $2.3 billion in earnings before interest, taxes, depreciation and amortization. Agrium aims to have retail plus its tiny advanced-technology business chip in half of EBITDA in the future, and perhaps as much as 70% when fertilizer is in a slump.

The expansion of the retail network has given Agrium greater earnings stability and demonstrated management’s skill at integrating acquired businesses. The company completed 9 acquisitions in the past five years, and typically achieves 25% more than forecast in savings from synergies, says Dundee’s Kelertas. Its latest annual report indicates Agrium surpassed its target of $20 million in first-year savings after buying UAP.

Agrium will need all its deal-making skills, and more, to win CF, based in Deerfield, Illinois. It stepped in after CF made a hostile run at another fertilizer company, Terra Industries [TRA]. CF rejected Agrium’s initial $3.6 billion cash and stock offer, which valued the company at $72 a share, a 30% premium to CF’s pre-offer price, calling it “grossly inadequate.” In late March, Agrium raised the cash portion of its bid by 10%, to 35 a share, and commenced an exchange offer for the shares.

RiskMetrics/ISS, a proxy-advisory firm, declined to support Agrium’s bid to have CF shareholders withhold votes on CF’s slate of three directors at its annual meeting ... But it has said it believes the Terra deal is “unlikely to be consummated and that Agrium may eventually acquire CF.”

Nothing would please CEO Wilson more. Owning CF would enhance Agrium’s position in the more cyclically sensitive nitrogen and phosphate markets, and be “complementary from a geographic standpoint.” Wilson demurred on CF’s bankers’ suggested purchase price of $100-plus per share, saying, “If that is such a compelling number, I am amazed they have not doubled their offer to Terra.” That bid stands at $2.1 billion; Terra trades near 29.

With or without CF, Wilson sees “lots of opportunity to grow.” He also predicts a stronger second half, citing pent-up demand from farmers, who held back on buying fertilizer last fall. U.S. farmers are expected to plant 85 million acres of corn this spring, one of the biggest plantings ever.

Just consider it fertilizer for Agrium’s shares.


A combination of bonds and high-yielding stocks protects Berwyn Income in down markets – and rewards it when the bull is in control.

We are partial to income investing and have posted many pieces pertinent to that style of money management in these pages. A good example of the approach done correctly is the Berwyn Income Fund, a bond-oriented fund which has the option to hold as much as 30% of its portfolio in high yielding stocks.

The record: An average annual return 6.15% in the 10 years ended April 14, while the S&P 500 lost 2.79% per year, dividends included, and its benchmark, the Lipper Income Index, returned a total 2.27% a year. Pretty darn good. Also the fund has no load and a low expense ratio. There is a lot here to like.

The Berwyn Income Fund has an enviable history of being in the right place at the right time, due to its unusual hybrid structure. Launched in 1987 by the Killen Group, of Berwyn, Pennsylvania, the bond-oriented fund was a welcome alternative for shell-shocked investors after that year’s notorious stock-market crash.

The fund not only got in near the ground floor of an historic bond-market rally, which it rode straight up for the next 20 years; it also has an equity kicker: By mandate, it can hold up to 30% of assets in high-yielding stocks, which helped it mightily as the stock market recovered and soared to unprecedented highs.

The income/equity combination has paid off far better than either strategy alone.

Indeed, the income/equity combination has paid off far better than either strategy alone, providing protection in down markets and upside when the bull is in control.

As a result, there was no lost decade for this fund: It returned an average annual 6.15% in the 10 years ended April 14, while the Standard & Poor’s 500 lost 2.79%, dividends included. The fund also beat its bogey, the Lipper Income Index, which returned a total 2.27% a year in the decadelong span.

Year-to-date through April 14, Berwyn Income (ticker: BERIX) is up 3.16%, beating 95% of its peers, even as the S&P has sunk more than 6% in that span. Over the past 12 months, the fund lost 5.48%, against the S&P’s 34.96% swoon, and outdistanced 95% of funds in the conservative allocation category. Berwyn also beat the market over 3 and 5 years, with total returns of 2.06% and 3.32%, respectively.

But you will not hear about any of this from a broker – as the fund, with assets of $285 million, has no marketing staff and carries no sales load. Its expense ratio is a modest 0.73%. “We don’t want the tail to wag the dog,” says co-manager Ed Killen, 57, whose brother, Robert, started the firm in 1983.

Berwyn owes much of its recent success to the managers’ move in 2007 to scale back on stocks and raise cash.

Berwyn owes much of its recent success to the managers’ move in 2007 to scale back on stocks and raise cash, another instance of catching a critical turning point. Normally, the fund’s cash position is between 2% and 5% of assets, but cash accounts for 7% to 8% of the portfolio today.

The fund has earned a vaunted five stars from Morningstar and top scores from Lipper for total and consistent returns, asset preservation and fees. When Berwyn Income was launched, says Killen, others were shunning the bond market, for fear that returns would not keep pace with inflation. Instead, inflation became a non-threat, bond yields plummeted and prices soared. “There has been a bull market in Treasuries since the 1980s,” he says.

When the managers identified a peak in equities in late 2007, they started buying Treasury and agency debt. Now value has shifted to corporate bonds. “Treasuries will suffer if inflation returns,” Killen says. “Corporates offer a degree of protection because of their higher yields.”

The fund owns investment-grade and high-yield bonds, including convertibles, which hedge funds were dumping last fall. “The sweet spot for the fund right now is in triple- to single-B-rated bonds,” Killen says.

One of Berwyn Income’s biggest holdings is American Equity Investment Life (AEL), an annuity and life-insurance outfit. The managers started buying the convertible 5.25% due Dec. 6, 2024, in early 2008, and kept buying through the autumn. “We were able to buy AEL bonds at a yield to put in excess of 20%,” says George Cipolloni, 34, who manages the fund with Killen.

The yield shot up after the Securities and Exchange Commission ruled that indexed annuities should be treated as securities, not insurance products. That raised fears that the West Des Moines, Iowa-based company would have to spend to retrain its staff, or hire new staff licensed to sell securities. Investors also fretted about potential losses in the company’s investment portfolio. Like Berwyn, American Equity considered the bonds a steal. It bought back $78 million last fall of the $260 million issue, at about a 40% discount to the original issue price. That bolstered its equity when other life insurers’ equity was eroding.

The fund’s managers like the insurer so much that they bought its stock as well, at about $3.87 a share. Shares now trade at about $5, versus their 52-week high of 11.63. Analysts think American Equity will earn $1.52 a share in 2009 and $1.62 in 2010.

Another big holding is the School Specialty 3.75% convertibles (SCHS), due Nov. 30, 2026. “The market took the price of the bond down, because tighter state budgets could hurt earnings,” says Cipolloni. He concedes there may be pressure on earnings, but says the company’s ability to generate free cash will help it repurchase debt in the open market. School Specialty supplies educational material.

In the drug sector, the fund last fall scooped up Valeant Pharmaceuticals’ (VRX) 3% convertible due Aug. 16, 2010. The specialty-pharmaceuticals company has more cash than debt, and was actively buying back its debt late last year. Yet, Berwyn was able to capture yields close to 15%.

Chattem (CHTT), a maker of over-the-counter toiletries, is in similarly healthy shape, with a long history of rising earnings, good cash flow and a willingness to pay down debt. In this case Berwyn bought a single-B-rated bond, the 7% due March 1, 2014

In the equity portion of the fund, Killen and Cipolloni aim to buy good businesses at prices that significantly discount companies’ long-term earnings power. Although the managers are bottom-up investors, they also study interest rates, the slope of the Treasury yield curve, and employment and economic trends. They steered clear of homebuilders at mid-decade, since they believed that easy and irresponsible lending were significant contributors to the industry’s earnings, and thought that couldn't continue.

The contrarian Killen has been buying financial shares. One pick is Long Island-based Suffolk Bancorp (SUBK), which avoided the subprime fiasco. “They know exactly to whom they are lending, so they have not had the loan losses that other banks have had, and their earnings have increased where other banks have faltered,” he says. Not that that has helped the stock, which trades at around 25, after falling by nearly 50%. The fund’s been buying SUBK shares since 2007, at an average cost of 27.12.

Killen is willing to look at any stock that pays a dividend, and Suffolk surely qualifies; it pays 88 cents a share, for a current yield of 3.5%. “Although we generally prefer stocks with a higher dividend yield over those with a lower yield, the crucial issue is the sustainability of the dividend,” he says.

Of the 25 dividend-paying stocks in the portfolio, 16 have raised their payouts in the past year.

These are dark days for dividend payers, as Barron’s dividend columnist Shirley A. Lazo noted recently (“Negativity Reigns,” April 6). This year’s first quarter marked the worst 3-month stretch for dividend activity in more than 50 years. But Killen and Cipolloni have shown they know how to suss out dividend growers, which tend to be safe – or safer – havens in bad times. Of the 25 dividend-paying stocks in the portfolio, 16 have raised their payouts in the past year.

One is Kimberly Clark (KMB), the Dallas-based maker of Kleenex, Huggies and other household products. “The company’s long-term return on capital is attractive,” Cipolloni says. “The stock got depressed from a P/E [price/earnings multiple] perspective; the P/E is now about 12, down from 21 in 2006. We had an opportunity to buy a great company at a cheap price.”

Berwyn paid an average of 50.73 for shares that recently fetched around 49. Analysts expect the company to earn $4.15 a share in 2009, up from last year’s $4.04. The 2010 consensus estimate is $4.56.

A long history of sound management attracted Berwyn Income’s managers to Ennis (EBF), a business-forms company based in Midlothian, Texas. Although earnings are expected to fall this year and next, Killen and Cipolloni consider that less important than return on assets, around 9% in the past three years, and return on equity, in the teens for the past decade.

Killen and Cipolloni say the biggest risk to Berwyn is a rise in interest rates, which would unleash a bear market in bonds. Their track record, however, suggests they will see it coming – and be prepared.


Many investors wrongly consider stable-value funds a stand-in for cash. Now, credit-market woes are exposing the funds’ real risks

As a mania progresses it insinuates itself into areas one might not expect, until it reaches the point where only those who conciously innoculate themselves against its effects escape – and sometimes not even them. Everyone notices stocks in favored industries, e.g., dot-com stocks in the late 1990s, selling at absurd prices. Less obvious but more insidious is when during times of abundant liquidity securities which otherwise would be distained are granted membership in the fellowship of the respectable. Otherwise conservative money managers, for example, decide to step outside their circle of competence and “enhance” the yields on their “cash”. Everyone else is doing it, so maybe what looks foolish is not so foolish after all. They reach down the quality spectrum without realizing how far they are reaching, forgetting Will Rogers’ advice to worry about return of capital before return on capital.

During the mortgage finance bubble that came to a decisive and ignominious end last year, managers of so-called “stable-value” funds reached for yield by buying mortgage-backed securities. We all know what happened to the price of those securities as a class. Stable-value funds typically “guarantee” that investors will be able to withdraw funds at par value. However, investors discovered that, similarly to money market funds, the ability to promise no loss of principal is compromised during dislocated markets. As when a natural disaster hits, “insurance” is no stronger than the insurer.

How extensive are the losses stemming from credit market problems? One analyst estimates that up to a quarter of the industry’s funds have a market value below 90% of book value. Things could obviously be worse, but that is a big loss for what was regarded as a cash equivalent. Moral: “Stability” does not exist as some disembodied ideal. It exists by dint of the ability of the stabilizer to stabilize, and that alone, when times get tough.

Stable-value funds often are the most conservative investment option offered in retirement plans, and holders tend to view them as high-yielding cash substitutes. The funds typically carry insurance guarantees that enable investors who withdraw or transfer their money to do so at the assets’ book value, or the value of the investments at the time they were purchased by the fund, plus credited interest.

In recent years, however, some of these supposedly conservative funds reached for higher yields, despite the higher risk – and now are sitting on market losses amid credit-market turmoil. That may force them to lower the interest rates they offer investors, and limit the ability of retirement-plan sponsors to transfer the plans to other stable-value providers.

In rare cases where plan contracts are prematurely terminated and insurance is discontinued, investors could receive the current market value of the assets, instead of book value, which is higher. A Chrysler fund that liquidated earlier this year paid employees and retirees only 89 cents on the dollar.

Market losses could become a headache for ING Group, some of whose stable-value separate accounts are trading at sharp discounts to book. The giant Dutch financial-services company (ticker: ING) manages about $60 billion of stable-value funds; about 10%, or $6 billion, is invested in a “core-plus” fixed-income strategy that aims to beat the Barclays Capital U.S. Aggregate Bond Index by roughly one percentage point over a credit cycle.

The Barclays index reflects a 40% investment in mortgage-backed securities, 25% in Treasuries, 18% in corporate bonds, and 4% in commercial mortgage-backed securities. That allocation might seem too aggressive for a product that some stable-value-plan sponsors restrict to government and agency-backed debt, but ING’s strategy went even further. Each account has its own asset weighting, and is uniquely managed. At least some core-plus accounts, however, invested roughly 56% in mortgage-backed securities, almost 7% in commercial-mortgage-backed securities, about 30% in corporates and only 14% in Treasuries at year end. They could also invest up to 20% of funds in high-yield or emerging-market debt.

The deferred-compensation plan of the City of San Jose, California, invested in the ING Stable Value core-plus option and had a market value of $194.2 million at the end of the first quarter – 17% below the $232.6 million book value of the plan’s holdings. San Francisco’s Employees’ Retirement System had a similar experience with an ING product. At year end, the market value of this retirement-plan option was 15% below book value. The fund no longer is managed by ING.

The San Jose account had about 20% invested in collateralized mortgage obligations as part of its allocation to mortgage-backed securities, and about 9% invested in financial companies’ debt as part of its corporate-bond allocation, plan documents indicate. The same was true of San Francisco, according to market sources. Both investments suffered losses.

It is unclear how many other stable-value funds have suffered market losses, as there is no public listing of the funds’ market value. Stable-value funds are considered insurance products, not investment securities, and thus are not required to disclose market value nightly, unlike money-market funds. Nor are stable-value funds registered with the Securities and Exchange Commission.

Chris Tobe, a senior consultant with Breidenbach Capital Consulting, estimates that up to a quarter of the industry’s funds have a market value below 90% of book value. The losses resulted from the funds’ investing in residential and commercial mortgage-backed securities, he says.

ING says investors who withdrew or transferred money from these accounts did not experience losses, because the insurance that ING provides while managing the accounts helps cover any shortfall between book and market value. In an e-mail response to Barron’s queries, an ING representative wrote: “Even for plans that experienced a high degree of portfolio-level volatility, the insurance protections available through our product preserve participant-account principal and credited interest. Further, our guarantees of principal and accumulated interest in participants’ accounts remain in place, and we stand by those guarantees to all of our stable-value clients. As markets recover, we are confident that any plan sponsors whose plans may have experienced market-to-book-value deficits will see improvements in the long-term in the valuation of their stable-value investment portfolios.”

ING also notes that plan sponsors decide how their stable-value plans are invested. It says it offers the sponsors up to six investment options, ranging from conservative Treasury portfolios to the most aggressive option, the core-plus fixed-income portfolio.

City of San Jose risk manager John Dam confirmed that ING’s pitch in 2006 offered many different strategies. The city opted for the core-plus offering because in 2006 it had the best 10-year return on investment. But Carol Cypert, the deferred-compensation manager for the San Francisco Employees’ Retirement System, says that the core-plus strategy was the only separate-account structure offered in ING’s proposal to San Francisco.

While investors who cashed out of either fund got their money at book value, those still invested may earn less interest. That is because a drop in market value can prompt the fund’s manager to lower the crediting rate, or interest rate applied to accounts. If the manager offers a crediting rate below the cash return on the fund’s investments, the excess cash can be applied to the fund’s market value.

In the case of the San Francisco fund, ING offered to lower the fund’s future crediting rate to 1.74%, from last year’s 5.15%. In San Jose, it lowered the crediting rate to 3% from the 5% it previously had paid. By mandate, some funds have a minimal crediting rate, but the San Francisco plan did not. The same holds for Morgan Stanley, which offers a stable-value plan among its 401(k) options that was yielding nothing as the end of last year.

Most plan sponsors do not publicize the market values of their stable-value funds, but investors can obtain the information by inquiring. If the market value is below stated book, chances are the fund will be under pressure to reduce the crediting rate. Likewise, if the plan sponsor opts to terminate the contract and change stable-value providers, it may be difficult to find a new insurance guarantee.

As its stable-value fund deteriorated in value, San Francisco had several choices. It could stay with ING, which was offering a reduced 1.74% crediting rate. It could hire a new manager for incoming money, and enter into a “book-value settlement” with ING for existing funds, under which ING would continue to manage the assets for up to 10 years, giving most of the bonds in the portfolio a chance to mature instead of selling them in the current market at a loss. In those 10 years, ING would continue to guarantee that investors receive book value on withdrawals or transfers, but the crediting rate could fall to zero.

Lastly, the city could opt to move its investments, at market value, to another manager, which it did after determining that Great-West Life and Annuity Insurance offered lower fees, enhanced education tools and a more conservative approach, says San Francisco’s Cypert. It also separated the triple-A-rated, government-backed securities from the troubled ING assets, investing new money in the former. The troubled assets are being “repositioned” as the market permits, but the city was unable to find a new insurer to guarantee the distressed assets.

Stable-value funds have mushroomed into a $520 billion business, according to the Stable Value Investment Association. They are likely to remain an important component of 401(k) and other retirement plans. Given the credit markets’ troubles, investors should understand the risks inherent in such vehicles. Above all, they should recognize that these funds only look like cash.


Nintendo is cheap, especially for a company whose profits could jump 40% this year.

We are not video game players, but follow the industry with some interest and amusement. Nintendo shares have recently tanked on reduced profit expectations for the fiscal year recently ended and loss of market share to rivals in the home Japanese market.

Video console and game makers do not tend to get assigned high multiples despite being in an ologopolistic market and the high cash generated by a successful game. This is not an industry where you can sit back and clip coupons produced by past successes for very long. But at 10 times fiscal year (ending March) 2010 earnings and a yield slightly under 5%, and with more cash than debt on its balance sheet, is the company too cheap? We cannot rule that out.

Shares of Nintendo, maker of the Wii videogame player, have been in free fall, much like a not-so-Super Mario whose leap has left him short of landing on one of the mushrooms in the Japanese company’s most famous game.

Nintendo’s American depositary receipts (ticker: NTDOY), 8 of which equal 1 Tokyo-traded share, early [April 17] afternoon were at 33.50 – about 50%% below where they stood a year ago and down over 25% this year. In contrast, shares of rival game-console makers Microsoft (MSFT) and Sony (SNE) have both tracked the tech market’s slight 2009 gain.

The drop in Nintendo seems overdone. Says Wedbush Morgan Securities analyst Michael Pachter: “When you look at the underlying numbers, no company globally is performing better than Nintendo‘ Pachter has a 12-month target of about 60 on the ADRs. Sterne Agee analyst Arvind Bhatia sees “terrific comeback potential” for the shares.

Kyoto-based Nintendo (the name means “Leave Luck to Heaven”) was originally a maker of playing cards and later the owner of a cab company and a “love hotel.” But in the 1970s, it turned to electronic games, eventually coming out with the Nintendo Entertainment System, which plugged into a TV and let users play Super Mario Bros., the best-selling game of all time.

The company’s most recent home console, the Wii, which uses motion-sensing controllers to produce screen action in sports games like tennis, bowling and golf, has sold 10 million units in the U.S. and 50 million worldwide, considerably more than its rivals. Nintendo also makes the DS handheld game player; the latest version, the $170 DSi, was the most pre-ordered game console in history before its introduction this month.

Why, then, have Nintendo shares been battered?

In January, Nintendo, Japan’s 3rd-largest company by stock-market valuation, posted a 21% gain for its 3rd quarter, but cut its guidance for fiscal 2009, which ended in March. It projected an operating profit of $5.3 billion, equal to about $2.25 per American depositary receipt, well below prior expectations of $6.3 billion.

Part of the problem was the company’s newly conservative expectations for Wii sales (offset by higher hopes for the DSi). Also key is the impact of the strong yen, which makes those consoles less price-competitive in the U.S. and Europe and cuts the value of overseas earnings.

Some on Wall Street suspect that the company beat its targets in the year just ended, delivering an operating profit near $5.6 billion and ADR earnings around $2.50. For fiscal 2010, they see ADR net exceeding $3.60.

More recently, investors were shocked to hear that the Wii had been outsold in Japan by Sony’s PlayStation 3 in March, due mainly to the release of two hot PS3 games: Yakuza 3 from Sega Sammy (6460.Tokyo) and Resident Evil 5 from Capcom (9697.Tokyo). Neither game was available for the Wii. It was the first time since late 2007 that Nintendo was #2 at home.

81% of total sales are outside Japan.

Since then, most press coverage has focused on the weak outlook for Japan’s economy. When January-February sales of videogame software and hardware in Japan rose “only” 11% year over year – lower than in years past – fear grew that Asian demand for videogames is waning. Throw in the general worries over the global recession, and the result was very ugly for Nintendo shares. However, over 50% of Nintendo’s stockholders and most of its influential analysts are Japanese and very locally focused. Pachter says that this has led them to overlook the still-bright outlook for Nintendo in markets outside Japan, which produce 81% of its total sales.

Videogame sales remain strong in the West. For many American gamers – typically around 30 years old – a $50 videogame is not too expensive, even in hard times. Last week, researcher NPD Group said that combined U.S. 1st-quarter game software and hardware sales were flat with the record year-earlier $4.25 billion, but that console sales were up 1%, led by Nintendo and Microsoft. Combined March sales slid 17%, mainly because the launches of some particularly hot-selling Wii games began in March 2008. They continued through June, meaning that some industry softness is likely over the next few months. That would present a buying opportunity.

But strong growth should resume in the second half.

But strong growth should resume in the second half. “People who buy videogames have no idea we are in recession,” asserts Pachter. From October through February, U.S. videogame sales rose about 11%, in dollar terms. Nintendo would not comment for this article, but at a recent convention, Reggie Fils-Aime, CEO of its U.S. unit, said: “Over that same time period, Nintendo is up over 50%. Let me put it a different way: the total industry has grown just over $1 billion during that time frame. Nintendo has grown over $3 billion. So do the math. We are accounting for more than 100% of the industry growth.” The introduction of souped-up Wii controllers and several new games this summer should help sales.

In addition, some investors are ignoring Nintendo’s solid balance sheet – it has $9.5 billion in cash and securities, versus $4.3 billion in debt – and its annual dividend of $1.58 per ADR. And Nintendo certainly has the financial flexibility to hike the payout or buy back stock.

At $33.50, Nintendo ADRs were trading under 10 times likely 2010 earnings – not much for an outfit whose profits should jump 45% this year. Nintendo faces challenges, but the path to success often looks more perilous than it is – as Super Mario knows and patient U.S. investors will learn.


An Indian election pending will cause a fifth of the world’s population to remain mired in poverty or to move rapidly towards economic growth and prosperity.

Martin Hutchinson considers the forthcoming election in India “the world’s most important”: “At one extreme of possible results, India can continue its progress as an emerging market with Chinese-style growth rates and a population that is expected to exceed China’s by 2025. Such an India would be a highly important strategic balance to China, and a magnificent ally for the United States and Europe, balancing China and Russia’s authoritarian leanings. Most important, over the next generation, it would lift 1/5 of the world’s population out of poverty.”

“At the other extreme, India can suffer a financial crisis that ends the current spurt of growth, followed by a reversion to the “Hindu rate of growth” leaving the country mired in poverty, a problem rather than a solution to the world’s geopoliticians, with conflict with nuclear-armed Pakistan an ever-present possibility and its myriad inhabitants everlastingly impoverished.”

Relatively little rested economically on the result of last November’s U.S. presidential election. John McCain was politically well towards the big-government wing of the Republican party, while President Barack Obama, after an initial burst of public spending will be forced by economic reality to retrench during his remaining years in office. There is, however, an election pending which will have a far more important economic effect on the fate of mankind, causing a fifth of the world’s population to remain mired in poverty or to move rapidly towards economic growth and prosperity. That election is in India.

The British colonial oppressors did a fairly decent job in India, but they got one thing horribly wrong: their exit. Apart from causing a civil war with 500,000 casualties, they essentially handed the country on a plate to the leftist Congress Party, run by economic illiterates (not that British economic policy between Neville Chamberlain and Margaret Thatcher was that much better). As a result, India suffered for the next four decades in an economic backwater with around 1% per capita economic growth and an endless proliferation of bureaucracy, the “permit raj.”

There was a gradual easing of controls in the 1980s and a somewhat more vigorous one after 1991 under Prime Minister Narasimha Rao and his finance minister Manmohan Singh, but Indian economic growth thereafter appeared to relapse back into its usual torpor until the advent in 1998 of the Bharatiya Janata Party (BJP) government led by Atal Bihari Vajpayee. The Vajpayee government pursued market-opening policies with considerably more vigor than any of its predecessors, with the result that by 2004 Indian growth was running around 8% annually and the country had been included among Goldman Sachs’ BRIC group of emerging markets that would in future dominate the planet.

In an exhibition of voter ingratitude unequaled since the British electorate threw out Winston Churchill in 1945 [perhaps they finally gave him the credit for his role in getting them into WWII], the Indian electorate in 2004 rejected Vajpayee and the BJP so strongly that a Congress-dominated coalition was formed under Manmohan Singh. There was much talk of further economic reform, but in reality reform essentially ceased, although economic growth didn’t. However, like all Congress governments the Manmohan Singh administration proved to be addicted to public spending and fiscal indiscipline, with the spending outcome for the 2008-09 fiscal year being fully 20% above the budget estimate for that year. Since most Indian states also run budget deficits, the overall Indian fiscal deficit has widened in the global downturn to around 12% of Gross Domestic Product.

Under present policies the Indian economy is an accident waiting to happen.

The Economist poll of forecasters predicts Indian growth of 5% in 2009 and 6.4% in 2010, but if the fiscal deficit persists at these levels, that growth will almost certainly be curtailed by financing difficulties. Indian inflation in the 12 months to February ran at 9.6%, while 3-month interest rates are currently at 4.5%. In spite of India’s magnificent export successes in last decade, the current account deficit is already running at 3.7% of GDP. In other words, under present policies the Indian economy is an accident waiting to happen, with an inflationary crisis and seizure of financial markets the most likely form for the breakdown – the rupee is already down 20% against the U.S. dollar in the last year, and could easily collapse if things went wrong enough.

The potential of the Indian economy remains enormous, if only the country can find a proper government.

Nevertheless, the potential of the Indian economy remains enormous, if only the country can find a proper government. The announcement last week of Tata Motors’ new $2,000 Nano automobile demonstrates why. The combination of a vast supply of extremely cheap labor and a domestic market that can provide manufacturers a large enough domestic market for their products for economies of scale to be achieved is rare. Outside India and China, emerging market automobile producers have the enormous problem of an inadequate domestic market, so are forced to rely on export markets, in which it is very difficult to achieve enough volume quickly. Malaysia’s Proton automobile company had most of the advantages of Tata, but without an adequate domestic market it was never able to expand enough to make itself truly internationally competitive.

However, the Tata saga also demonstrates India’s problems. Tata had originally intended to launch the Nano last October, manufacturing it at Singur, in the state of West Bengal. It had obtained permission from the Communist government of West Bengal and had spent $350 million on the plant. Nevertheless, in early October, it was forced by local protests led by West Bengal’s opposition party, the Congress offshoot Trinamool Congress, to abandon the plant and transfer production to a new factory in Gujarat, which will not be ready until 2010. Meanwhile, Tata is being forced to manufacture Nanos at its plant in Pantnagar, a facility that will only allow annual production of 50,000 Nanos, compared with the 250,000 that Tata believed it could sell in its first year (and with 51,000 advance orders in the first ten days from the product’s official launch, Tata’s estimate of the Nano’s sales potential may even have been low.)

At one extreme of possible results, India can continue its progress as an emerging market with Chinese-style growth rates and a population that is expected to exceed China’s by 2025.

The stakes in the Indian election are thus high. At one extreme of possible results, India can continue its progress as an emerging market with Chinese-style growth rates and a population that is expected to exceed China’s by 2025. Such an India would be a highly important strategic balance to China, and a magnificent ally for the United States and Europe, balancing China and Russia’s authoritarian leanings. Most important, over the next generation, it would lift 1/5 of the world’s population out of poverty.

At the other extreme, India can suffer a financial crisis that ends the current spurt of growth, followed by a reversion to the “Hindu rate of growth” leaving the country mired in poverty, a problem rather than a solution to the world’s geopoliticians, with conflict with nuclear-armed Pakistan an ever-present possibility and its myriad inhabitants everlastingly impoverished.

The Indian election takes place in five phases between April 16 and May 13. The chance of the optimal outcome must be reckoned as slender. Vajpayee has retired from politics (he is 85) and the new BJP leader Lal Krishna Advani (himself 81) is not particularly economically oriented and has a history of Hindu extremism that may prove highly off-putting to Moslem voters and somewhat off-putting to moderates. Nevertheless, the reformist former finance minister (2002-04) Jaswant Singh is still active in the party, leading the opposition in the upper house of parliament and in this election standing for election in Darjeeling, West Bengal (at 71, he is a stripling by Indian political standards.)

The economic failings of the Manmohan Singh government have not yet become fully apparent. India is in the “stimulus” phase of excessive public spending when it creates spurious economic growth but has not yet run up against the financial constraints, nor made its disadvantage in accelerating inflation and “crowding out” private investment fully apparent. Thus, a BJP absolute majority or a position so close to a majority that it could easily govern with the adherence only of like-minded free-market parties in the National Democratic Alliance, is not very likely.

The most likely outcome is a renewal of the Congress-dominated coalition, which is currently leading in opinion polls but without an absolute majority. Manmohan Singh would presumably continue as nominal prime minister, although at 76 and in recovery from a January 2009 heart surgery, he may become increasingly a figurehead, deferring to Sonia Gandhi and her son Rahul, 38, the natural next leader of the dynastically-dominated Congress. (Rahul is the son, grandson and great grandson of Congress Party Indian prime ministers). Since Congress is likely to expand only modestly from its current 150 seats (out of 545), even if Manmohan Singh wished to return to his 1990s reformism, he would be unable to do so because the coalition would include the communists or other anti-market elements. Rahul is Western-educated and has worked for the Monitor strategic consultancy, but his family tradition of state control make him an unlikely reformist, although in spite of his youth he would probably be more able to control the left of a Congress coalition than Manmohan Singh.

Given the weakness of Congress and BJP, it may well be that neither Advani nor Manmohan Singh will be able to form a government, with regional parties holding the majority of seats in parliament. A group of those parties, mostly left-oriented, have formed a Third Front, which would most likely ally with Congress, although its leader Mayawati, chief minister of Uttar Pradesh, might be an alternative prime ministerial candidate. Mayawati has held no non-political jobs other than schoolteacher; it is thus interesting that in 2007-08, she was the highest taxpayer among Indian politicians, paying 260 million rupee ($5.2 million) in tax.

Prospects are grim.

It is a pretty grim prospect. The chances are that after the dust clears in mid-May, India will elect another anti-market government, or possibly submerge itself for a couple of years in political squabbling. In either case, its stellar growth record is likely to come to an unpleasant end.

Given the abdication of Russia also from serious pretensions as a growth market, the BRIC group of emerging growth markets will in that event have narrowed itself to BC. With the United States, Europe and Japan also mired in low growth and excessive budget deficits, the 2010s are likely to be a miserable global decade.


Commodity ETFs Are Growing Fast

It all started with a gold index.

Demand for a new breed of commodity investment that burst onto the scene earlier this decade has increased exponentially: exchange-traded funds. The first major commodity ETF, since renamed SPDR Gold Shares, appeared in 2004. Just five years later, assets of 19 U.S.-listed ETFs total $47 billion, according to Dominic Maister, director of U.S. ETF research at Morgan Stanley.

The ETFs let investors buy shares which trade like stocks but which track commodity prices or indexes, giving a broader class of participants access to commodity investing. Exchange-traded products (ETPs) encourage participation by offering low fees, they do not require the transport or storage of physical commodities, and they demand less capital than investors typically need to invest in futures.

“Commodities are an area where ETFs have helped democratize investing,” says Scott Burns, director of ETF analysis with Morningstar. “[They have] given financial advisers, individual investors and smaller money-management shops access to a lot of areas they previously were barred from.”

The broader category of ETPs includes ETFs, exchange-traded notes and exchange-traded commodities. In 2003, global commodity ETP assets totaled $400 million, says Amrita Sen, Barclays Capital commodity analyst. As of first-quarter 2009, Barclays estimates assets in some 200 global exchange-traded products totaled $64 billion, versus $60 billion in traditional commodity indexes.

Precious metals now account for 77% of ETPs, especially as gold investment soared during the financial-market meltdown, Sen says. SPDR Gold Shares [ticker: GLD] is the largest commodity ETF, with assets as of last week of $32 billion. Holdings of 1,127.37 metric tons made it a larger gold holder than all but a few central banks. The iShares Silver Trust [SLV] had assets of $3.3 billion, and iShares Comex Gold Trust [IAU] held $1.9 billion.

Investors should note: There are two types of ETFs – those backed by physical commodities in storage, such as the largest precious-metals ETFs, and those that are not, says Maister. With GLD, investors buy shares that track gold, minus 0.40% for expenses: “They buy physical gold, stick it in a vault and charge you 40 basis points a year. The 40 basis points is the only tracking error.”

It is harder to store oil and grains indefinitely. So ETFs that include these commodities access the market through futures contracts, say Maister and Burns. But this means more potential for a tracking error, adds Maister. ETFs utilizing futures are likely to show greater deviations from changes in spot prices.

Sen notes that even if oil goes up, investors can lose out periodically, when nearby futures are more expensive than the next month out. An ETF may have to sell the front month at a lower price than it pays for the next during rollover. The plus of such ETFs is that they let those with less capital invest in oil without going it alone in futures, and without the worry of stock-picking the wrong name.

The largest ETFs using futures include PowerShares DB Commodity Index Tracking Fund [DBC], $1.9 billion; PowerShares DB Agriculture Fund [DBA], $1.7 billion; and United States Oil Fund [USO], $2.8 billion.

Leavened Outlook for Wheat

Wheat crops are running late and wet, but chances for another fiery futures rally are looking sogg.

Cool, wet weather in the northern U.S. plains is delaying spring wheat planting. But chances for another fiery futures rally are looking soggy.

Minneapolis Grain Exchange hard red spring-wheat futures stormed to record highs last year when poor weather slashed global production and drained grain reserves. Worries that late planting will reduce yields for the 2009 crop have supported the market recently, with MGE wheat building its premium over Chicago Board of Trade wheat amid expectations of a decline in seeded acreage.

However, world wheat supplies are plentiful this time around, which should keep a lid on prices, traders say. Canada, for one, is a major spring-wheat producer and has large supplies on hand after last year’s big crop.

“You don’t have that underlying groundswell of support to really allow Minneapolis to be the blow-off top,” says Louise Gartner, an analyst for Spectrum Commodities, a risk-management and brokerage firm. “You will have adequate supplies of quality milling wheat.”

Hard red spring wheat, prized for its high protein content, is used to make bread. The CBOT, a global benchmark for wheat prices, trades soft red winter wheat, used to make pastries and snack foods.

The spread between MGE July wheat and CBOT July wheat narrowed to 88¾ cents Friday from a recent peak of 96 3/4 cents on April 8 as near-term weather forecasts called for drier weather in the northern Plains. MGE July wheat traded around $6.25 a bushel, down 75% from the record $25 that the nearby spring-wheat contract hit in February 2008.

The anticipated drier weather has some analysts backing off recommendations to avoid taking short positions, or bets that prices will fall, in MGE wheat. Indeed, the MGE/CBOT spread should narrow further if forecasts stay dry, says Rich Feltes, senior vice president of research for MF Global. He advises traders to get out of long MGE wheat positions, or bets that prices will rise, when the spread narrows to 81 cents.

The abundance of soil moisture could eventually benefit crop development, if farmers are able to get in their fields soon enough, traders say. Still, concerns remain that delayed planting will take a toll on yields. “We are still very susceptible to planting delays, which could still occur in May” if the weather is wet, Feltes says.

Spring-wheat planting was 2% complete as of April 12, below the 5-year average of 11%, according to government data. The statewide average starting date for fieldwork in North Dakota, the top spring-wheat state, is seen at May 2, more than two weeks behind the 5-year average.

“Delayed planting in the spring can play havoc in the fall,” as the possibility of early wintry conditions can lead to unpredictable yields, says Shawn Hackett, president of Hackett Financial Advisors. “The reality is hard spring-wheat farmers know this and usually will abandon acres to plant other crops.”

History suggests 500,000 to 1 million acres of spring wheat could be planted with other crops, such as soybeans, due to poor conditions, Hackett says. A breakout move above $6.82 in MGE July wheat could set the market soaring, he says.

The Last Word on Bear Stearns

House of Cards, by William D. Cohan, reviewed.

If you are looking for the particular moment when Wall Street’s masters of the universe fell to earth, you could do worse than peruse this reflection by the long-time chairman and chief executive of the now-departed Bear Stearns, Jimmy Cayne.

“But certain things really ... bothered me plenty. It’s just that for some clerk to make a decision based on what, your own personal feeling about whether or not they’re a good credit? Who the f--- asked you? You’re not an elected official. You’re a clerk. Believe me, you’re a clerk.” The fuller quote is even more colorful.

The occasion that made Cayne so “spitting angry,” in the words of author Cohan, was the recollection that just after a collapsing Bear fell into the arms of JPMorgan Chase for $2 a share (later raised to $10), the Federal Reserve, in a historic move, opened its discount window directly to securities firms such as Bear Stearns, and not just to banks.

But Timothy Geithner – then president of the Federal Reserve Bank of New York, now U.S. Treasury Secretary – said that in his view, Bear Stearns in its last hours as an independent company was not creditworthy and would not have been able to borrow from the central bank, even if the liberalization had come earlier.

Geithner is the “clerk” of whom Cayne speaks so disparagingly. Oh, how the mighty have fallen. All of Cayne’s riches and toughness and arrogance couldn’t save him and the other 14,000 Bear employees from the ascendancy of the “clerks.”

The first 100 pages or so of this overly long book tell the detailed story of Bear Stearns’s final days. It is a gripping and well-told tale, if so recent (March 2008) that its outlines are well known. Relying on many ex-Bear executives, Cohan does a good job of adding interesting details about the dramatic and rumor-driven maelstrom into which the venerable company fell.

Overly leveraged, laden with mortgage securities and dependent on wholesale financing that, as the author notes, works fine until it doesn’t, Bear was the first major casualty of our ongoing subprime-started credit crisis and recession.

“The problem that Bear Stearns and other financials face is a great unwind of leverage,” wrote the uncannily prescient analyst Meredith Whitney, then employed by Oppenheimer. “A company is only as solvent as the perception of its solvency.”

Cohan takes us from Bear’s collapse back through its history, as seen mainly through the personalities of its tough, smart and opportunistic leaders, Cy Lewis, Alan “Ace” Greenberg and Cayne. Bear was Wall Street with no facade, no curtains on the windows. It was a ruthless meritocracy that was about making as much money as possible. Pure and simple.

Cohan quotes a 1993 Wall Street Journal article by Michael Siconolfi (one of numerous press and television reporting citations in the book, including reporting by Barron’s) in which Bear Stearns is compared with the Oakland Raiders football team, long a group of talented but often tainted players who came together to forge great success on the field.

And even if their competitors turned up their noses at Bear’s bare-knuckle aggressiveness, the firm for many years turned in lavish results, and lavished riches on its leaders.

The book’s main problem is that the author is too fond of his research and gives us too much detail. The tale of the demise of Bear Stearns Asset Management’s mortgage-backed hedge funds, another milestone in misery, is many pages too long. The book would have benefited from more analysis and significantly less granularity.

The collapse and merger of Bear Stearns happened just a year ago. It is a testament to how much has changed since that its glory days already seem historic.

What if There Were No Fed?

Among Bernanke’s sins of omission: A blameless Fed.

During the Watergate hearings Pulitzer Prize winning cartoonist Paul Szep (we think it was him) published a cartoon showing a caricature of a young Richard Nixon standing next to a chopped down cherry tree, holding an axe in his hand. Nixon was saying to his glowering father: “I cannot tell a lie. I didn’t do it.”

Evidently Ben Bernanke and Alan Greenspan took the cartoon literally.

There were many sins of omission in Federal Reserve Chairman Ben S. Bernanke’s “Passover speech” last week on the financial crisis. In the spirit of the “traditional Passover meal ... when the youngest child asks four questions,” Bernanke chose to ask and answer “four important questions” of his own, not all of them satisfactorily.

At the end of the speech, the Fed chief was surely right to note “tentative signs that the sharp decline in economic activity may be slowing.” One of those signs was last week’s retail sales update from the Census Bureau, and “tentative” certainly applied. Nominal-dollar retail sales fell in March by 1.1%, defying consensus expectations of a small increase.

But the same report showed an upward revision to February. So even with March’s decline, there has been a broad rise in retail sales from December to March. And, after adjusting for inflation, the three-month growth rate of total retail sales ran about 1.6% through March.

The March decline is also subject to revision; this “advance” report is only an “early estimate.” The revision could go either way, of course. But even so, the ICSI/Goldman Sachs weekly chain-store index has been up smartly through early April, indicating that the March weakness may be nothing more than normal monthly volatility. Growth in retail sales should be considered against continued massive inventory liquidation. And those two divergent trends hold out the possibility that manufacturing production will start to make a comeback – a point that Bernanke neglected to mention.

Nor was that the only omission. Consider only the first of the four questions he asks and attempts to answer – “How Did We Get Here?”

He begins by informing us that “the role of banks and other financial institutions is to take the savings generated by households and businesses and put them to use by making loans and investments.” But he neglects to mention that this can happen only in an unfettered market. In this market, financial institutions are in league with the central bank; loans are routinely made independent of savings decisions. Instead, it is the central bank’s power to expand money and credit that determines lending rates, and there is evidence that Bernanke’s predecessor, Alan Greenspan, engaged in just such a form of credit expansion. For an extended period, the short-term interest rate was fixed at a level that no free market could permit – below the rate of price inflation, which helped fuel the unsustainable boom in housing.

I say it only “helped” in order to give due allowance to the culprit Bernanke goes on to blame: “savings inflows from abroad ... [of which] one important consequence was a housing boom in the United States. ...” Even if he is right to place all the blame on this “surplus of available funds” (for an opposing view, try Chapter Two in Thomas Woods’s book Meltdown), he never asks whether much of the foreign “savings” was itself a product of central banks’ printing presses around the world.

What might have happened in a world without central banking? In a speech that referred to the “exodus to the Promised Land,” that radical question might have been Bernanke’s first. But not when you yourself are the financial pharaoh.