It takes water to produce energy and energy to produce clean water. That nexus creates a number of profit possibilities. Sometimes, they are not so obvious. But often, a company that possesses expertise in water treatment will possess a related expertise in the energy field. The connection between water and energy is at least as old as the process of pumping water into old oil fields to boost production.

But the connection between these two precious fluids is changing quite a bit.

Let’s take a look at one of the less-obvious connections…

You may not realize this, but two-thirds of oil discovered stays in the ground. The average recovery rate is only about 35%. What if we could recover more of the oil we’ve already discovered?

If the recovery rate improved to 50%, the world’s recoverable oil would increase by 1.2 trillion barrels. It would double today’s proven reserves, says the IEA. That much oil makes even a cynical old oilman catch a gleam in his eye and starts his heart aflutter. Indeed, lots of big brains churn away at this problem day and night.

“It’s the prize for the next half century,” says Howard Mayson, vice president for technology at British oil giant BP, quoted in this morning’s Wall Street Journal. BP relies heavily on enhanced-recovery methods. These methods aim to improve that oil recovery rate.

As The Wall Street Journal reports:

“Enhanced recovery is a lifeline for the biggest oil companies, such as Exxon Mobil Corp. and BP, which are under intense pressure from shareholders to keep ramping up production and gaining access to fresh reserves. But that’s hard to do when the companies are shut out of the oil-rich Middle East and places like Russia. So they rely more and more on existing fields, some of which have been producing oil already for decades.”

It is like squeezing a sponge ever tighter to extract the most of what you can get. The old method is to simply flood the reservoir with water. The idea is to create enough pressure to make it easier to pump the oil out. It is not very efficient, but it works for a time. It is also becoming a bigger problem to secure the water supply. That’s why we see oil companies buying water rights out West. Currently, the shale oil plays consume a lot of water.

Instead of using water, some companies will pump the reservoir with carbon dioxide. Companies used to store carbon dioxide in old unused reservoirs. Using this method of enhanced oil recovery, they put that carbon dioxide to work. BP uses this method out in its Prudhoe Bay reservoir, to great effect. Recovery rates there are 60%. Now Prudhoe Bay, which people in the 1980s once thought would cease pumping oil in 30 years, looks to be good for another 50 years.

The WSJ describes another method BP uses: “flooding reservoirs with polymers that expand like popcorn when they come into contact with hot rocks, thus flushing more oil out of difficult-to-reach nooks.”

The name of that polymer is BrightWater. One company has a patent on this material and makes it for a profit. That company is Nalco Holding (NLC:NYSE), a company I recommended several months ago to the subscribers of Capital & Crisis. BP uses BrightWater in Argentina and Pakistan. “BP says the additional oil the new technology will produce over the next 20 years is roughly equivalent to finding a major new field,” reports the WSJ.

“Nalco,” you say, “but isn’t Nalco is one of the world’s largest water purification companies for industrial companies?” This is what we mean by energy-water nexus. The two are related. And Nalco sits right in the middle of that nexus.

Last year, Nalco’s energy services segment was a bright spot. Sales grew 17% organically for the year. In the fourth quarter, sales were up 23% despite the steep oil price decline. In that segment is Nalco’s enhanced oil recovery (EOR) business.

CEO Erik Fyrwald commented on this business in a quarterly conference call. “We are in with a lot of oil companies explaining and talking to them about it,” he says. “We believe as oil prices come back up, [EOR will be a] really big growth opportunity, just delayed for a period of time.”

The delay stems from the fact that many oil companies slashed their exploration and production budgets last year, when oil and gas prices were falling. But it seems inevitable that as the big oil reservoirs dwindle, the EOR business will be big down the road. Of course, EOR is only one of the many valuable things Nalco does in the energy-water nexus. It is no wonder why Warren Buffett’s Berkshire Hathaway is the biggest shareholder.

Nalco is a long-term buy.

Regards,

Chris Mayer,
for The Daily Reckoning

A Few Words About Nalco originally appeared in the Daily Reckoning. The Daily Reckoning, a FREE daily e-letter, offers a "uniquely refreshing" perspective on the global economy, investing, and today's markets.

For the past 60 years, corporate debt has grown faster than the economy – 4.1% annually for debt, compared with only 2.7% for the economy as a whole. In short, more and more debt went toward producing each dollar of GDP growth.

What if this 60-year trend reverses?

In fact, I think that is the likely scenario. The deleveraging will take some time…and it won’t be fun.

“Today’s overleveraged assets will become tomorrow’s underleveraged assets, and vice versa,” QB Partners, a hedge fund, explained in a recent letter to shareholders.

What will this new world look like? More people will save more money. And they will focus more on preserving that wealth than on making a big score. We’ve been here before. Michael Farrell, the chairman of Annaly, says the psychology of people will change as it did for those of 1930s, as he discussed on his company’s first-quarter conference call:

Exhausted by the uncertainties of the 1930s and 1940s, the older generation just felt lucky to be alive and they settled into a time of saving, preservation of capital and lowered expectations as consumers.

If that kind of financial orthodoxy takes root, then leveraged assets like real estate and bank balance sheets face a long period of stagnant returns as they continue to deliver – that is, as borrowers and lenders ratchet down the debt on these things. (I find it ridiculous that government officials want us to believe that the US banking system is OK at 25-to-1 leverage. The banking system’s insolvency will become more apparent as it continues to take losses from bad debts made during the bubble.)

Deleveraging puts pricing pressure on leveraged assets. Banks must raise capital, diluting their shareholders and hurting their stock prices. Real estate owners must sell property to raise capital to defend other properties, thus putting pricing pressures on real estate assets. And so on…

So as an investor, it will pay better to stick with the unlevered assets, which face no such head winds. After all, there is no pressure to sell an asset with no debt, no ticking clock. “What are the most underleveraged assets?” you ask. QB Partners gives the answer: hard assets and natural resources.

The ultimate unlevered hard asset may be humble old gold.

In fact, something important is happening in the gold markets right now. All through the 1990s to the present day, the world’s central banks were net sellers of gold. Europe’s central banks, for instance, have sold 3,800 tonnes of gold in the last 10 years. According to The Financial Times, this move has cost them $40 billion, and that’s with gold at $900 an ounce.

Well, too bad for them. But suddenly, that recent habit of selling gold is changing. Last year, central banks sold only 46 tonnes, which was the lowest amount in 10 years.

As the FT reports: “Sales in Europe have slowed to a crawl and fresh demand is emerging elsewhere and the financial crisis has helped to highlight gold’s value in turbulent times.” In fact, we may soon see central banks flip to net buyers of gold.

China has doubled its holdings of gold this year and is now the world’s fifth largest holder of the metal. China is likely to be a buyer of gold for years because its gold holdings are still very small relative to the size of its total reserves. Gold represents only 1.6% of China’s reserves, versus a global average of nearly 11%. To further diversify its reserves – just to get to average – would require significant amounts of gold.

In a post-2008, deleveraging world, it is the unleveraged assets that will outperform against those saddled with debt. It’s another plank in the case for gold, which just seems to get stronger with each passing month. “A new chapter has begun in the gold market,” the FT opines. Indeed, it has.

The International Monetary Fund, never known as a wise handler of money, is selling a bunch of gold. India bought half of it. A number of emerging market central banks are also upping their gold exposure. Maybe these CBs are onto something.

Russia’s gold holdings now make up 4% of its foreign reserves, compared with only 2.2% at the beginning of the year. Smaller central banks are also being crafty. Ecuador’s gold holdings have more than doubled since the start of the year – to 54.7 tons, from only 26.3 tons. Gold now represents 32% of that country’s reserves. Even Venezuela is buying gold. Gold now makes up 36% of its reserves, compared with only 23% in 2009.

So who is the sucker here?

Perhaps central bankers see more clearly than most what the effect of all their money creation will be. In recent months, we’ve seen a truly unprecedented boom in bank reserves. Bank reserves drive money creation. More money means money buys less – and the gold price should rise.

Then there is this chart of the Shadow Gold Price. In the old days of the Bretton Woods Agreement, countries had to maintain certain ratios of gold against their currencies. The Shadow Gold Price aims to replicate this discipline. So for the US, the Shadow Gold Price is Federal Reserve Bank liabilities (bank reserves) plus money in circulation divided by US gold holdings. Also on the chart, you can see the spot price of gold.

The important thing here is that you see how massive amounts of money creation have barely made an impact at all in the gold price – so far. Gold is fundamentally cheap compared with all the money added to the system in recent months.

As Paul Brodsky and Lee Quaintance of the hedge fund QB Partners write:

“If one allows for even a small probability of a future monetary system that reflects more honest/tangible money, then a quick glance at the graph above makes it easy to conclude that spot gold is fundamentally cheap. Even if this is too far a stretch for market participants skeptical of such a radical change in monetary policy, it is reasonable to conclude that the prices of spot gold and the Shadow Gold Price should converge somewhat over time.”

They note that the spot gold price has never been so cheap compared with the Shadow Gold Price. For parity to set in, gold would have to trade for $16,000 per ounce! No one is predicting $16,000 per ounce gold. In any case, it shows you the risk of holding paper – and bonds – on the eve of a massive devaluation of the dollar. Maybe the central bankers of Russia, Venezuela and Ecuador understand all of this better than they let on and that’s why they are buyers of gold.

It seems pretty obvious to me that if you create a lot of money, you are going to destroy the value of that money. And in that case, you want to own something other than that money.

Regards,

Chris Mayer,
for The Daily Reckoning

Another Reason to Buy (More) Gold originally appeared in the Daily Reckoning. The Daily Reckoning, a FREE daily e-letter, offers a "uniquely refreshing" perspective on the global economy, investing, and today's markets.

And there are lots of speculators. Optimism prevails. In this, it’s no different from the early U.S. ‘bucket shops’ written about famously by Edwin Lefèvre and others, where the working Joe would gamble on stocks, hoping to get rich.

There are also few dividend payers of any significance in the Indian stock market. A 4% yield is a lot. It makes sense, though, given that India is a rapidly growing market. Reinvesting the money is often a better choice than paying a dividend.

The most frustrating thing is that the market is still mostly closed to U.S. investors. We simply can’t buy the stocks on the Bombay Stock Exchange, for example. There are some that list in the United States and are easy to buy. Beyond specific stocks, the best way to invest in India is through a fund that can own all these stocks that you otherwise can’t buy. I’d expect this to be an up-and-down idea, but over the long haul, such a fund ought to beat U.S. market returns by a solid margin.

Finally, there are indirect plays on what India — and the rest of the emerging markets — need. We are invested in energy and fertilizers, for instance, two things such markets will need in abundance. I’m also looking again at various infrastructure plays — companies building stuff the world needs — here and everywhere.

The Warren Buffett of India originally appeared in the Daily Reckoning. The Daily Reckoning, a FREE daily e-letter, offers a "uniquely refreshing" perspective on the global economy, investing, and today's markets.

That looks impossible against China’s arable land base, which has been in decline since 1988 — this despite the fact that China subsidizes agriculture. Another reason is the low level of water resources in China. (See the nearby chart ‘Who Has Water… And Who Doesn’t.’) Soybeans require a lot of water — 1,500 tonnes of water for one tonne of soybeans.

This chart is telling. Who has lots of water? Brazil. So it is no surprise to discover that the increase in demand for soybeans from China has largely been met by increasing soybean acreage planted in Brazil. (Brazil is the second-largest exporter of soybeans in the world, behind the United States and ahead of Argentina and Paraguay.)

The easiest way for China to get around its water shortage is to import soybeans. By importing soybeans, Passport calculates that China is effectively importing 14% of its water needs.

So now we are in a position to connect some dots. China’s increasing population and affluence will drive its soybean imports. These imports will come mainly from Brazil. And Brazil, as it converts more arable land to producing farmland, will need a lot of potash and phosphate.

What is true of soybeans is also true of wheat and corn and rice and other agricultural commodities. We’ll need more of all of them. And all of them face the same challenges for water and land. All of them require lots of fertilizer.

Getting China Clean Water originally appeared in the Daily Reckoning. The Daily Reckoning, a FREE daily e-letter, offers a "uniquely refreshing" perspective on the global economy, investing, and today's markets.

I hopped in and we zipped through traffic. At one point, he crossed over the double-yellow line daring oncoming traffic. “You don’t see any taxicab get away with that!” he hollered back at me after blowing through a red light. Just like being in Asia again!

It was a different way to look at Manhattan, with its towering skyscrapers as far as the eye could see. Somehow, it all seemed a lot bigger in a rickshaw. Hard to believe that within six years, New York will no longer be among the world’s five largest cities.

The new top five? Tokyo is No. 1, with a population (35 million) greater than all of Canada. Then follows Mumbai, Sao Paulo, Delhi…and Dhaka. Dhaka? Yes, Dhaka. It’s the capital of Bangladesh.

There are some big changes afoot in the world’s cities. These changes will create enormous opportunities for investors that a previous generation could barely imagine.

Consider some of these notes from National Geographic Traveler:

• In the past 20 years, the world added about 3 million people a week to its urban populations

• More than half of the world’s populations live in cities and more two-thirds will by 2030

• The fastest growing cities are all overseas: India has 40 cities with more than a million people; some Chinese cities are growing at more than 10% per year; and Africa’s population should double by 2050.

“All cities are cities of the moment,” says Richard Wurman, the celebrated American architect says. He is right. No city stays on top for long. In the year 1000, the most populous city in the world was Cordova, Spain. Beijing was tops in 1500 and 1800. London was the biggest in 1900, New York the biggest in 1950. Today, Tokyo.

The pace of urbanization is particularly swift in China and India. More than 25 million people move to cities each year. Some of the numbers are hard to fathom. As US Global Investors points out in a recent presentation, China will add more people in 15 years than the entire population of the United States.

“There will be up to 50,000 new skyscrapers,” the company notes, “the equivalent of building 10 New Yorks. There could be up to 170 new mass transit systems. There are only about 70 in Europe today.”

This massive population shift has enormous effects on infrastructure spending. Trillions of dollars will have to go toward building power systems, roads, water and wastewater systems, ports and more.

It’s like what the US went through in the early 20th century – only on a much more massive scale. Historian Scott Nelson likens the current period to the Long Depression of 1873-96 vintage. Then, a banking crisis toppled Wall Street, too. Unemployment in New York hit 25%. But the Long Depression also paved the way for rising industries such as railroads, oil and steel and spawned a period of innovation and industrial growth.

As Richard Florida comments in The Atlantic:

In 1870… America’s population overwhelmingly lived in the countryside. By 1900, the economic geography had been transformed from a patchwork of farm plots and small mercantile towns to a landscape increasingly dominated by giant factory cities like Chicago, Cleveland, Pittsburgh, Detroit and Buffalo.

Depressions destroy some things and make others anew. Before the Great Depression, few Americans owned a home. But government policies created the long-term mortgage that led to the rise of the suburbs and homeownership of nearly 70% by 2004. The malaise of the 1970s created the Rust Belt, but also saw explosive growth in the Sun Belt.

Now imagine a transformation very much like America’s from 1870-1900, as people moved off farms and into cities. Especially imagine it on a global scale in China and India. Future historians will wonder how we couldn’t see this great boom unfolding before our eyes – the boom in the building of cities.

This trend creates awesome opportunities for companies that make the bricks and sticks that create cities. Some of the companies that seem especially well positioned to benefit for the “City boom” are Flowserve Corp. (NYSE: FLS), ABB Ltd. (NYSE: ABB), Northwest Pipe (Nasdaq: NWPX) and Astec Industries (Nasdaq: ASTE).

I am bullish on the cheap stocks of debt-light companies that keep civilization a going concern.

Regards,

Chris Mayer,
for The Daily Reckoning

When Pipes Go “Boom!” originally appeared in the Daily Reckoning. The Daily Reckoning, a FREE daily e-letter, offers a "uniquely refreshing" perspective on the global economy, investing, and today's markets.

They were valuable because they helped frame where we are in the mortgage crisis, which has been the main shark in the water over the past couple of years. You should know where that shark is and whether or not it is hungry. The chart below shows you the ferocious fish may still have an appetite.

It shows you that we are past the viscous subprime crisis, when that shark chewed through the balance sheets of a number of banks and financial institutions, in some cases devouring them whole. However, it is not yet safe to get back in the water:

There are these other slices of mortgages that are not quite as risky as subprime that reset in the next couple of years. Years 2010 and 2011 face big resets in so-called Alt-A and Option ARM loans. What this means is more write-downs and more losses for banks and others who hold these mortgages.

Making all this worse is the fact that the housing has not yet recovered. The T2 duo made the case that the current “stabilization” of the housing market is a head fake. Mostly, it’s due to huge government support of the housing market. But there is still a large inventory of homes out there. And with these resets coming due, we’ve still got a large amount of foreclosures on the horizon.

All the while, the unemployment numbers are still poor. The T2 duo calls the unemployment situation the “most severe since the Great Depression.” The US economy has shed over 8 million jobs in this recession and unemployment – officially – is nearly 10%.

Plus, it’s not like the average US consumer is in a good position to sail through this crisis. Household liabilities are still high, as this next chart shows:

US consumers need to save and rebuild their financial strength. This is why the savings rate is on the rise. This is why, for the first time since the 1950s, household credit debt declined.

As investors, it seems clear that any idea that depends on discretionary consumer spending – say, buying trendy new sweaters or watches or expensive shoes – faces some big head winds. Better to the stick with the necessities, I say.

Also, it looks like the bounce in the stock prices of overleveraged banks and financial institutions is premature. Most bank stocks should be sold, not bought. The bounce in home building stocks looks ridiculous in light of what they have to look forward to. The T2 duo actually recommended shorting the home building stocks through the iShares Dow Jones US Home Construction ETF (ITB). By shorting it, you make money when the stock prices of the home builders go down.

They made a compelling case, of which I will highlight a few things. Exhibit A would be the fact that the average new home has been on the market for 12.9 months. Exhibit B is that we have about 2-3 years of existing home sales just to absorb the vacancies that exist. According to T2, about 6% of all homes built this decade are vacant.

Exhibit C is that the home builders themselves have too much debt and too much inventory relative to their thin equity cushions. The home builders are in the position of trying to hold up a bowling ball with a sheet of paper…in the rain.

Lastly, the home builder stocks are almost universally expensive on a price-to-book basis, as this chart shows:

Stocks with lots of debt, too much inventory and an awful market don’t deserve premiums over book value. Discounts are more like it.

So there you go. I like the idea of shorting the home builders. At the very least, I wouldn’t buy one. I’d also stay away from banks and financial institutions that hold mortgage assets. American real estate is not worth zero, as Dobson said, but it can be worth a lot less than today’s price.

I recommend staying with the sorts of companies that own essential assets and/or sell essential items. As I like to say, stick with what keeps civilization a going concern. And avoid any stock that is dependent on regular access to the credit markets. As we saw in 2008, a mortgage crisis can shut down the credit markets. We don’t want to be held hostage by lenders in that situation, so stick with excellent financial conditions.

Regards,

Chris Mayer,
for The Daily Reckoning

The Housing Bust – The Final Chapter originally appeared in the Daily Reckoning. The Daily Reckoning, a FREE daily e-letter, offers a "uniquely refreshing" perspective on the global economy, investing, and today's markets.

Last summer, Cameron Intl. announced it would acquire Natco Group for $780 million, or about 9 times trailing EBITDA. (EBITDA stands for earnings before interest, taxes, depreciation and amortization. It’s a good rough measure of earnings power to use when comparing firms across a sector.)

It’s been a while since we’ve seen some headline-grabbing acquisitions in this space. It’s about time. Last summer, Precision Drilling bought Grey Wolf, a clunky land driller with old rigs, for 5.1 times EBITDA. And before that, we had a spate of deals north of 10 times EBITDA, including Hydril’s purchase of Tenaris.

In the same view, we can buy Tesco – a quality oil field services company known for its cutting-edge technology – for under 3 times EBITDA. If Natco went for 9 times EBITDA, this one ought to go for no less. And that would mean a gain of 226% from here. Even without the acquisition, though, there is lot to like. Let’s talk technology for a minute to understand just what Tesco does so well.

Tesco designs, makes, sells, rents and services top drives. A top drive is a motor that sits on top of rig and spins the drill. I don’t want to get too geeked up in the technical aspects of this – if you’re interested, there is plenty of detailed information on the company’s Web site. The key thing to know is that top drives power the directional and horizontal drilling rigs that access unconventional natural gas reserves – all those shale plays. As more and more supply comes from shale plays, unconventional wells will grow much faster than conventional ones. Hence, a nice backdrop of demand for Tesco’s top drives.

This is a big market with an installed base of over 3,000 top drives around the world. As time goes by, more and more rigs will have top drives, which provide some growth opportunities even if the total number of rigs stays flat. In particular, there is more opportunity in the land rigs than offshore.

Most of these existing top drives are from National Oilwell Varco. Tesco is No. 2. And Canrig, a division of Nabors, is No. 3. Tesco also rents top drives. In this business, it is top dog, with a rental fleet of about 126 top drives.

As for casing services, Tesco has a proprietary service that allows a driller to drill and case a well simultaneously. Casing a well means putting steel pipe down the well bore so the thing doesn’t collapse on itself. The ability to drill and case at the same time cuts in half the number of days needed to complete a well. It’s a big timesaver, and many expect the industry to adopt Tesco’s technology, which would be a big boon to Tesco.

This casing technology really makes Tesco stand out from the pack. There is no other company with Tesco’s technology. Tesco thinks that the market for this technology is in the billions. Currently, it’s only about $50 million and growing. We’ve got a long runway here, though I think someone will buyout Tesco before too long.

I want to emphasize that these products are highly engineered and complex. Tesco owns a portfolio of over 80 patents and is developing another 120 patents to protect its proprietary applications. This is why I think of Tesco practically as a tech stock. And it’s why Tesco deserves a premium valuation and remains a great acquisition for somebody. A much larger company, like a National Oilwell Varco, could take this know-how and apply it more widely over a larger customer base and push these products through its bigger distribution network.

About half of Tesco’s business is from outside the US, which is holding up better than the US market in this mess. This recession also plays well to Tesco’s strengths, because its tools cut the time needed to drill and complete a well, and help its customers make more money.

Also, Tesco’s customers are mostly large firms – BP, EnCana, Petrobras, Occidental and the like. They are not the little guys who are going belly up. Tesco’s customers are likely to remain active even in a relatively low-price environment.

As far as the financials go, there is not a lot to worry about here. The company has a strong balance sheet. Cash was $20.4 million at the end of the second quarter and debt was only $44 million. Tesco produces good cash flow and has low capital spending requirements – and most of that is discretionary. Management intends to finish the year with zero debt. So we have a company able to build cash even in this tough environment.

There are 38 million shares outstanding, and the stock trades for $8.50 as I write. That’s a market cap of $319 million. Add in the net debt of $24.6 million and you can have the whole company for $345 million today (enterprise value, or EV). This year, the company will generate EBITDA of about $75–100 million. (Last year, EBITDA was $109 million). On a trailing EBITDA basis, Tesco trades for about 3.2 times EBITDA. Comparable companies would include Weatherford, Cameron, National Oilwell Varco and Natco, among others. As I pointed out earlier, Cameron bought Natco for 9 times trailing EBITDA. That kind of multiple gets you a $25 stock price for Tesco.

But you don’t need the acquisition to make money when you buy at 4 times EBITDA or better. Cameron, for example, trades for 6 times EBITDA today. Even just getting back to a more normal historical multiple would put Tesco’s stock closer to $15. It’s just very cheap, especially when you consider the bright future ahead of it. It wasn’t that long ago when people were talking about Tesco as a $40 stock.

This is not the retail sector, in which we have to figure out whether or not Tesco’s next hot bluejeans are going to sell or whether customers will like the new store formats. We’re talking about stuff you need to produce the oil and gas that keeps civilization a going concern. We’re talking about highly engineered products that save customers a lot of dough. We’re talking about a company that benefits from one of the great stories of our time: going ever deeper to reach untapped reservoirs of hydrocarbons once thought inaccessible. It’s a heroic effort and the companies that can do it are going to make a lot of money – and so are their shareholders.

An added bonus: The executives and directors own 18% of the stock. So they have every incentive to maximize the value here. I’m betting they will.

Regards,

Chris Mayer,
for The Daily Reckoning

Tesco is a “Buy” originally appeared in the Daily Reckoning. The Daily Reckoning, a FREE daily e-letter, offers a "uniquely refreshing" perspective on the global economy, investing, and today's markets.

I think that attention will eventually carry it to a price of $2,000-3,000 pretty easily — maybe more. So far, gold has had a steady march up since 2000. The last leg, the mania phase, always has a rapid and explosive move before it’s all over. We’re not there yet.

As for what will pull gold back down, I think a strong economic recovery could derail gold’s story for a time, but as long as the U.S. dollar makes its way to new depths over time, I think the gold price will drift higher.

Most people think of gold as an inflation hedge. To me, it is more than that. Gold is primarily a bet against the creditworthiness of the issuers of paper currencies. In other words, as the creditworthiness of the U.S. government weakens — thanks to high debts and deficits — gold will be a strong asset… and gold stocks ought to be one way to juice the return you get from gold. Our two gold stocks are up 80% and 40% since we bought them earlier this year. If we get any pullback in gold, I’ll be a buyer.

When to Sell Your Gold originally appeared in the Daily Reckoning. The Daily Reckoning, a FREE daily e-letter, offers a "uniquely refreshing" perspective on the global economy, investing, and today's markets.

This doesn’t mean all emerging markets have young populations. If you look at the so-called dependency ratios by country, you see that Russia and China quickly get old. In fact, their dependency ratios will surpass the UK’s over the next two decades. The really young populations, at least among the big emerging markets, are in India and Brazil.

This chart, again from Absolute Return, shows you how many people are aged 65 or older for every 100 people aged 15-64. So if the ratio is 40, it means that there are 40 people aged 65 or older for every 100 people aged 15-64 (the working-age population).

Low numbers mean lots of working people supporting the elderly. Higher numbers mean there are fewer people working to support the elderly. The theory goes that the younger populations with lower dependency issues will grow faster than those older populations.

So looking at this chart, you can see the clear winners through 2030 in the demographic game – India and Brazil. The US, perhaps surprisingly, doesn’t look so bad. Of course, the ages here are somewhat arbitrary. It seems to me that one way out of the problem is that people simply work longer. Why retire at 65?

Fiscal Fountain of Youth originally appeared in the Daily Reckoning. The Daily Reckoning, a FREE daily e-letter, offers a "uniquely refreshing" perspective on the global economy, investing, and today's markets.

In markets, one of the most watched and ongoing match races is the one between Emerging (or developing) Markets and Developed Markets. The former include China, India, Brazil and others. The latter include the US, the EU and Japan. Which one do we bet on and when?

It’s a particularly good question now, as we pick through the smoldering ashes of the 2008 bust. Emerging markets have had a hot 10-year run, even if you include the crackup in 2008. In fact, even if you had invested in the MSCI Emerging Markets ETF (NYSE: EEM) on Jan. 1, 2008, you would be sitting on a profit today. By contrast, the S&P 500 Index has delivered a double-digit loss over the same timeframe.

The emerging markets have snapped back surprisingly quickly. As Jonathan Anderson, a UBS strategist put it, “Not even the worst economic crisis in the postwar era has been able to derail [them].” In financial markets, ideas, like thoroughbreds, run hot and cold. Past performance doesn’t necessarily decide the issue any more than it does in horse racing. But it turns out there is a pretty reliable way to handicap the race between Emerging and Developed Markets.

The “handicapper” in this case is the aforementioned Mr. Anderson, who wrote about his findings in the Far Eastern Economic Review. His title, “Emerging Markets Poised to Perform,” hints at his conclusion.

It all comes down to those old financial constructs called balance sheets. In essence, a balance sheet shows you what you own versus what you owe. These are snapshots in time, a measure of financial health, like an EKG of one’s heart rate. You can often spot trouble here before it becomes fatal.

In my investment services, I always seek out companies with strong balance sheets – the sorts of companies that own much, but owe little. Enterprises like theses have the ability to withstand adversity better than those with weak balance sheets. A strong balance sheet also means that a company can fund its growth independently and more securely, without having to rely on fickle lenders.

As investing star, Martin Whitman, wrote in his most recent shareholder letter: “Don’t invest in the common stocks of companies which need relatively continual access to capital markets, especially credit markets… Even the strongest, best-quality issuers can be brought down, or almost brought down, if they continually have to refinance.” Unfortunately, many investors learned this lesson the hard way during last year’s severe credit crisis.

As it turns out, balance sheet strength is also very important for entire nations. But that’s hardly a surprise. Countries that owe a lot of money tend not to grow as much or as reliably as those with healthy balance sheets. Anderson created a “stress index” to measure the financial health of entire nations. A country with high debt levels and deficits earns a high stress index score. He then plotted this index (inverted) against a rolling average of GDP growth, a rough measure of economic growth.

Guess what? There’s a close connection between the two.

So one way to explain the growth of emerging markets is to consider the strength of their balance sheets. When they have healthy balance sheets, they grow faster than when they have weak balance sheets.

You can see that the last time the emerging markets had a long stretch in the sun was in the 1960s and 1970s. Emerging markets grew 5% or better. As Anderson notes, not a single emerging market – not Africa, not even the Soviet Bloc – failed to post 5% annual growth during this time. And you’ll also note that the balance sheets were healthy.

As a result, emerging markets sailed through the first global oil shock in 1973-75 without much trouble. The developed world, by contrast, suffered the pain of a deep recession. Investors who stuck with their emerging market stocks throughout this period reaped big rewards.

According to Anderson, “Between 1965–1980 the dollar-adjusted return on nascent equity markets in Mexico, Hong Kong, Taiwan, Brazil, South Africa and other lower-income nations ran into the hundreds of percent – while indexes in the US and Europe were essentially flat over the same 15-year period.”

Of course, as I say, these things run hot and cold. The emerging markets “imploded” after the 1980-82 recession. A dozen different countries reported inflation rates north of 100%. As Anderson points out, 20 currencies lost 50% of their value each year. From 1980-99, emerging markets struggled mightily and barely grew. And as you see from the chart, their balance sheets went south as well.

Emerging Market returns during this period were poor overall. A dollar invested in emerging markets in 1990 was still worth only about a dollar 10 years later. In 2000, though, the game changed again. Emerging markets opened up. They cleaned up their debts. And the emerging markets went on a tear that continues today.

In general, emerging markets still have healthy balance sheets today. In fact, they are as strong as they’ve been in 50 years. At some point, that will swing the other way, as these things always do. At some point, there will be too much debt and too much leverage. But for now, that condition seems a ways off.

As Anderson concludes, “All the preconditions are in place for a protracted period of strong economic growth.” He guesses 5-6%, which would crush the Developed World’s growth rates. In fact, the superior (and diverging) growth rates of the Emerging economies are already very visible.

First up, take a look this graph, from The Economist, which shows the industrial production of emerging Asia compared to the United States.

Looks like Asia is recovering pretty well. The chart above clearly illustrates the “decoupling” that became such a hot topic of discussion last year. The idea was that the Emerging markets would not necessarily follow lockstep with the Western countries.

The Developed World suffers through what Richard Koo, the chief economist at Nomura Research in Tokyo, calls a “balance sheet recession.” The Western world suffers from too much debt. That fact shifts the focus from making profits to repaying debt, according to Koo. Debt repayment will continue until the West repairs its balance sheets, a process that takes years to correct, as Japan’s long recession shows.

So the same dynamics that make emerging markets look good, work in reverse for the Developed World. According to Anderson’s model, the stressed balance sheets of the Developed World predict slow growth.

As investors, then, we’ll have to continue to look to the emerging markets for growth. The market never ladles out its rewards evenly, though. To drill down further, the big winner is really Asia and its big markets of China, India and Indonesia.

Anderson estimates that these regions could grow 7% or more annually, well above the tepid rates of developed markets and better than most emerging markets. “This is a very hefty gap,” he writes, “and one that is very likely to continue to reward investors who take advantage of the opportunity.”

Regards,

Chris Mayer,
for The Daily Reckoning

Emerging Markets in the New World Disorder originally appeared in the Daily Reckoning. The Daily Reckoning, a FREE daily e-letter, offers a "uniquely refreshing" perspective on the global economy, investing, and today's markets.