Cashing Royalty Checks

Today’s letter begins at the end of line of thought, the beginning of which is littered with woe.

I refer to mushrooming evidence that things are not going well in the financial world. The dollar is going down. And when it goes down, it drags behind it, like climbers roped together on Everest, all its fellow wayfarers: stocks, bonds, the economy, pensions, jobs…as well as the pretensions, conceits and fantasies of the New Era.

This Winter of Woe may herald a green and fulsome spring…or it may be the beginning of many months, or even years, of despair and depression. I don’t know. But I am beginning to explore the dark, nether reaches of human economic history… “Could this be the beginning of something really big?”, I woke up asking myself the other day. Could it be big the way WWI was big – marking the end of one way of life and the beginning of the new one? Could it be result of mass communications and collective thinking… of big words and big empty thoughts?

Maria reminded of the big words that got the blame for WWI – militarization, nationalization, mechanization. Could another trio of Latinate abstractions – securitization, globalization, and derivatization – be the source of another sort of calamity…a financial one?

There is something about Latinate words in English – they are linguistic lies that hide more than they reveal. But that discussion is for another day…

Today’s very modest goal is to make that discussion an amusing and entertaining one. The world financial system may experience a catastrophic meltdown, but your appreciation of it will depend on your perspective. The collapse of the dot.coms, for example, is comedy to us. But it is tragic to those who hold the stock.

Likewise, we want to be entertained, rather than chagrined, by the next stage of this drama. To that end, I direct your attention to a study of the gold price done by Paul van Eden, quoted here many months ago. Van Eden noted that the price of gold varies inversely with the foreign exchange value of the dollar. As the dollar goes down on global markets, the price of gold goes up. Gold is the dollar’s nemesis.

Gold is an enigma. It is money…it is a store of value… and it is a useful commodity – all at the same time. When people have confidence in paper money – they don’t need gold as money, and it trades like a commodity. But when they begin to lose confidence in paper money and paper assets, gold’s monetary features become attractive.

“Gold is the only asset,” says Doug Casey, “that is not also someone else’s liability.” Recently, it was disclosed that Paul Allen, Bill Gate’s fellow multi-billionaire at Microsoft had placed a “collar” on $3.5 billion worth of his shares. In effect, Allen had a put option that protected him on the downside. Unlike the fantasy “Greenspan Put,” the Allen Put was real. But it meant that someone on the other side of the trade was taking a big loss. The speculator’s “asset” (the right to profit as MSFT shares rose in price) turned into a huge liability. As the credit bubble deflates, many of these speculators will go broke. Genius will fail. The speculators will go broke and be unable to make good on their commitments. Thus, not only the speculator’s asset will turn into a liability…but Paul Allen’s asset could be at risk too.

There are, of course, people who are long gold…and those who are short the metal. But unhedged gold has no creditors…no bills to pay…no `burn rate’…no balance of payments to worry about.

It is its eternal lifelessness that makes gold a valuable asset. It may go nowhere…but neither does it disappear. This quality is especially valuable when other forms of money run into the trouble and wealth disappears. Already, more than $3 trillion has disappeared from U.S. capital markets. Yet, except for a roll of coins I seem to have misplaced, not a single ounce of gold has been lost.

But how to invest in gold? How about a gold mining company that has no debt, a half billion in cash and which you can buy today for only about a half as much as it would have cost you a year ago? At a recent price – about C$15 – the company had cash and securities to cover nearly 50% of the market capitalization.

The company is Franco-Nevada, recently the subject of a review in Grant’s Interest Rate Observer. “The most prominent feature of the Franco-Nevada income statement,” report the Grants team, “other than its 45% net profit margin, is that its single largest expense is income taxes.”

A handy comparison chart provided by the interest rate observers shows that Franco-Nevada can hold its own in any company. Comparing the figures for the 9 years ending calendar 1999 (or fiscal 2000), Franco, at 27.4%, has greater annualized revenue growth per share than Intel and only slightly less than Microsoft. Its net income per share growth rate is three times Coca-Cola and 50% more than Fannie Mae. And its growth in book value per share is roughly the same as Fannie Mae, more than Intel and more than twice Coca Cola’s.

Yet, the share prices are hardly comparable. Recently, you could have bought five shares of Franco-Nevada for every share of Microsoft or Intel.

“What exactly does this enterprise do?” asks Grants. “It cashes royalty checks. It owns a portfolio of more than 60 royalties in six countries (some 87% of its revenues are derived from U.S. mines). Precious metals constitute almost 90% of the royalty-producing resource base, of which gold amounts to 75% to 80%. Platinum and palladium fill out the balance of the metals resources. Other assets include five million acres of undeveloped land…This land the company makes available for exploration and development by contract operators…”

“Even one meaningful success,” Grants quotes Steven Bregman of Contrarian Research, “could be enormously additive to the Franco-Nevada future cash flow and current net asset value.”

Cashing royalty checks must be a good business. “In the years 1991-2000,” Grants continues, “its average after-tax profit margin was no less than 57.1%.” And, Franco, “if it were ever blessed with a gold bull market, would earn considerably more than the already stunning returns it has managed to generate in a gold bear market.”

No one can predict the future – a point I make often and demonstrate frequently. But if this is one of those times when people lose confidence in paper assets – holding Franco-Nevada shares should make the whole spectacle more amusing.

Bill Bonner, Ouzilly, France December 27, 2000

Your unreconstructed gold bug

*** How long will the rally last? How far will it go? Probably not very long…and probably not very far.

*** Trading was light on the day after Christmas. The days between Christmas and New Year’s normally produce a good move to the upside. But yesterday, the techs started out in the wrong direction.

*** Broadcom, for example, was down about 12% by noon. Then, a guest on CNBC mentioned it as one of his Top Picks, and the shares went back to where the began the day. The Nasdaq even managed a small gain for the day – 23 points. Still, the Nasdaq is facing a 38% loss for the year – its worst year ever.

*** The Dow did better – up 56 points.

*** And in the humor category, TheStreet’s Internet Index fell another 3 points or so yesterday…bringing it down 72% for the year.

*** The most significant market event yesterday was the continued decline of the dollar. The euro rose over 93 cents.

*** All the things that went so right for the dollar a year ago, seem to be going in the other direction now. A year ago, a European investor might exchange his euros for dollars and send the money to Wall Street. He might reasonably expect a 17% capital gain on stocks – plus another 10% from a rising dollar.

*** But now, what can he expect? A 20% loss in the average leading mutual fund – as measured by Investors Business Daily – and a falling dollar! So, what does he do? He sells his U.S. dollar assets and converts the money back into euros.

*** This causes stocks to fall on Wall Street…and the dollar to fall too…which makes U.S. investments even less attractive to foreign investors.

*** Foreign investors, who cares about them? Well, $682 billion of capital flowed into the U.S. in the first 9 months of this year – a record. It funded the trade deficit, pushed up stocks and bonds, and levitated the dollar. Now, the tide has turned. The inflow is turning to outflow.

*** “The last 10- to 15- year period, in which U.S. dollar- denominated assets outperformed all others around the world has come to an end,” said Ray Dalio of Bridgewater Associates, interviewed by

*** Dalio had a number of things to say that seemed important, even prescient. The prevailing opinion is that the world faces a typical slowdown which will be managed by the Fed in the typical way. But, says Dalio, “we have a situation here that is a whole different dynamic…it has a life of its own. It is not as managed by the Fed as a typical business cycle and so when we talk about a recession this really won’t be one of those typical recessions.”

*** The typical way to manage a downswing is by lowering interest rates. The idea is simple enough: the cost of money (the interest rate) is supposed to be like the gas pedal on an automobile…money is like fuel…the more readily available it is, the faster the economy runs.

*** This quaint mechanical metaphor lodges in the mass mind like a campaign slogan – simple, memorable and moronic. When the economy turns sluggish, people imagine that Greenspan and his fellow central bankers need only press harder on the monetary pedal. And often, this appears to be the case.

*** But “25, 50, or 75 basis point cuts do not pull economies out of recessions,” says Dalio. The minimum rate cut necessary, according to Dalio, is 290 points (2.9%). The average recession since WWII took 550 basis points to fix. But there was nothing average about the boom of the last 15 years…nothing average about stock market valuations…and nothing average about the slowdown that lies ahead.

*** “There are 650 basis points between here and zero” says Ed Yardeni. But even that may not be enough. As I point out with tedious regularity – the Japanese took their interest rates down to zero – and still could not get their economy moving.

*** Alan Greenspan, says Dalio, “is viewed as a miracle worker…and he isn’t. Events are likely to turn out worse than the conventional wisdom…”

*** You may recall, also, the dominant idea of `90s investing – that since price movements were random…and since stocks always go up over the long run…the thing to do was to buy and hold, regardless of price. Dalio’s comment: “History shows that investors who have bought growth stocks without regard to the price they pay for growth have done very poorly.”

*** IBM rose sharply on Friday, after an analyst urged investors to “back up the truck.” But by Tuesday, rumors were flying that the company would warn of softer sales and earnings. So, it turned into a Big Blue day – with the shares down 5%.

*** “Overstocked Retailers Must Slash Prices” proclaims an Atlanta headline. Wal-Mart said that its sales too were coming in “below plan.” Investors took a 4% discount on WMT shares.

*** Amazon, meanwhile, believes it will hit its $1 billion sales target for the year. But only, as one analyst put it, “by selling stuff below cost.” Amazon is now down 85% since Jeff Bezos was named TIME’s Man of the Year last January.

*** Anyone interested in an extremely ugly stock might want to take a look at W R Grace. “GRA,” reports a recent issue of Grant’s Interest Rate Observer, “was quoted at a P/E only slightly greater than one.” Even more shocking… “multiplying Tuesday’s closing price, 1 5/8ths, times the 65 million shares outstanding,” continues Grants, “yielded a market cap of about $100 million. Grace had year-end assets of more than $2.5 billion.”

*** Red Herring reports that 260 of the 350 IPOs of the year 2000 are in the red. IPOs from the nation’s top 16 investment banks lost an average of 28% from their offer price. If you’d bought them at the end of the first day of trading, your loss would be 48%. Goldman Sachs’ 47 IPOs, for example, are down 16%… Forget buy and hold. The trick was to buy at the offer price…and sell into the first day trading hype. If you’d done that with all of Morgan Stanley’s 30 IPOs you would have mad a 93% profit. If you’d held them until Dec. 20, you’d have lost 24%.

*** Insiders sold tech and shares when they hit their peaks back in March. Now those shares are down 80% and more. And guess what? The insiders are selling even more! The Richmond Times Dispatch reports that insiders unloaded shares in Vignette Corp. in March at $100. Recently, insiders dumped even more shares – at prices as low as $15.

*** The New York Times reports that law firms are building up their bankruptcy departments. “Demand is soaring” said one lawyer. “A huge wave is coming,” said the surfer attorney, “and we want to make sure we catch that wave.”

*** Natural gas is selling at its highest price in 10 years. Oil gained 46 cents yesterday, following OPEC’s announcement that it would cut production by 500,000 barrels per day.

*** “Whether or not OPEC realizes it,” writes John Myers of Outstanding Investments, “the biggest factor impacting oil prices is not a conspiracy by Western governments but a much more direct threat that cannot be blackmailed into submission – a North American recession.”

*** Nothing much to report on the home front. I am stumbling on roller blades, scooters, and remote controlled cars – or getting run down by them. One of the few advantages of a chateau is that there are long corridors and big rooms, in which the kids race around as though they were in a skating rink.

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