Investing in the Age of Scarcity

In just the last couple of months, commodity stock prices have melted like ice cream on a hot summer day. Chris Mayer has been burning the phone line and firing off e-mails to people in the field about what they see. What he found, below.

"Gastown, Vancouver’s oldest neighborhood…founded on the shoulders of desperate alcoholics by an entrepreneurial bar owner."
– Anthony Bourdain, No Reservations

It might be too much to say Vancouver got its start with a bunch of alcoholics, but there’s no denying that Jack Deighton, or ‘Gassy Jack,’ as he was known, had a hand in making the city.

As legend has it, Gassy Jack, a garrulous Yorkshire-born steamship operator, arrived in 1867 with a yellow dog, a First Nations wife and a barrel of whiskey. He solicited help from workers by telling them if they helped him build a tavern, he’d give them free drinks. So they did, and within 24 hours, the Globe Saloon was open for business, slaking the thirst of a rough frontier crowd of miners, trappers and loggers.

When a little village grew up around the saloon, Gastown was born.

This is where modern Vancouver began. Today, Gastown is the old section of the city. You can stroll down its cobblestone streets adorned with antique street lamps and stop off at one of the many bars and restaurants. You can see the old steam clock on Water Street, a local landmark. (But it’s kind of a sham, because the steam clock is actually powered by electricity. It was also built in 1977, despite its antique look.) There are also some shops hocking the usual kitschy fare like faux totem poles and snow globes.

Salute the bronze statue of Gassy Jack, standing atop a whiskey barrel, in Maple Square. Then head over to my favorite microbrewery in the city, Steamworks, and order a Lions Gate Lager and a brick-oven pizza.

As you wipe the beer foam from your lips, you can think about the story of early wealth creation in Vancouver. Spanish explorers in search of the Northwest Passage arrived in the 18th century. You can still see their influence in street names such as Cordova, Cardero and Valdez. The British explorer Capt. James Cook also hit the west coast of Vancouver Island, looking for the Northwest Passage. Vancouver, though, gets its name from George Vancouver, who sailed the inlet in 1792.

Eventually, a number of early explorers, including Simon Fraser and Alexander MacKenzie, helped map the region’s interior. In 1824, the Hudson Bay Co. began running fur trading posts out here. In 1858, prospectors found gold on the banks of the Fraser and Thompson rivers. The first sawmills along the Fraser River opened up in 1860. And there you have the triumvirate that drew adventurers and entrepreneurs from all over – furs, gold and timber. Into that swirl stepped Gassy Jack.

I like the city of Vancouver and enjoy going there every year for my publisher’s big annual conference. This year’s theme tackled investing in the age of scarcity. Perfectly appropriate for the market we find ourselves in.

Gassy Jack and all those early explorers, adventurers, prospectors, loggers and miners did their part to spice up the 19th century. As with most of the history of the Americas, fortunes bloomed as men beat paths to nature’s riches. It was the basic stuff – metals, timber and other commodities – that made men rich. The voracious appetites fueled by the Industrial Revolution and rising urbanization created enormous demand for the natural storehouse of riches in the largely untapped Americas. If you were bold and talented (and lucky), you could strike out on some open valley or inviting hillside or promising riverbank – and dig or plant or pan your way to fame and fortune.

Despite all the advances and promises of the 21st century, we still need those basics. We’ve always needed them, but there is new urgency to the quest. The motor for that demand is a sort of second Industrial Revolution, in China and India, in particular. But it’s a revolution that broadens out to many emerging markets. The analogy is not lost on certain investors.

Jeremy Grantham heads up GMO, a respected money manager. Grantham has been largely spot on in the big-picture sense of staying bearish on stocks for the last eight years or so. He is bullish long term on commodities. In his latest quarterly letter, Grantham makes some good points about the future of commodities and emerging markets.

His conclusion first: ‘In the short term, slowing world economic growth combines with credit, currency and inflation problems to dominate the outlook and offer poor prospects for emerging markets and commodities. Longer term, the reverse is true, and they look like the assets to own.’

It is mostly the long term (looking out a couple of years) that interests me, although I obviously don’t aim to step into any immediate problems if I can help it.

Longer-term backing for commodities demand comes from two sources, Grantham says:

‘The first is that if enough people enter economic take-off at approximately the same time, as 2.3 billion Chinese and Indians have now done, then the pressure on resources might happen to increase marginal costs slightly faster than technology could offset them.’

This has already happened. It’s why the price of oil, for example, is so much higher than historical averages. All that demand hits very quickly, but it takes time to bring new supply to market. In the interim, higher prices result.

This seems well-known already. Most investors realize that behind the commodities boom stands surging demand from countries such as China – former ‘runts’ now muscling in on the global dinner table.

The second reason is more interesting. Grantham believes that the global growth spurt has come at the expense of eating away at some hard-to-replace resources:

‘Underground water resources that currently sustain some of our most productive land but, like a metronome, tick off a reduction of several feet each year; rain-fed waters that, although renewable, are finite and already so overused that previously valuable lakes retreat to sometimes disastrous local effects and river volumes, once seemingly limitless, are now fought over; subsoil, which took thousands of years to form, is depleted through casual use (in the Midwest, for every bushel of wheat produced, it is said that a bushel of subsoil is lost. Our farmers are in the mining business! Yes, the soil is incredibly deep, but it is still finite); high-grade mineral ores are fully developed, the very best are long gone and all are irreplaceable; previously fertile land has often been overgrazed and turned into desert.’

At Mayer’s Special Situations, we’ve been on the water beat since this publication began in summer 2006. We’ve also watched the agricultural boom unfold, and we’ve picked up nice profits along the way. We are, in fact, still invested in these ideas.

Along with these ideas, oil, natural gas and base metals all have become more difficult and expensive to produce. Recently, we’ve had to sit through a pretty tough correction on the commodity names. Stocks in these sectors have sold off in a big way this summer, as I’ve noted. Based purely on fundamentals, though, these stocks haven’t looked this cheap in years.

But short term, such drawdowns are common on the way to eventual higher prices. Grantham, too, says as much:

‘The prices of commodities are likely to crack short term, but this will be just a tease. In the next decades, the prices of all future raw materials will be priced as just what they are: irreplaceable. Oil, for example, will never again be priced on the marginal cost of pumping a marginal barrel from some giant Saudi oil field, as has been the practice for most of the last 100 years of oil production. Real cost is always replacement cost, and oil, a precious feedstock for chemicals and fertilizers, simply cannot be replaced.’

I don’t take as hard a plumb line as old Grantham does. I believe there is, even now, lots of room for innovation and replacement. Oil, for example, is replaceable in a broad sense. We can get energy from a broad array of sources. But it’s not an easy or painless transition.

Slowing economic growth is the bigger issue. That’s problematic for most commodities, short term. The market, though, is probably punishing the commodity companies too severely. That creates some interesting opportunities.

You can more easily pick up stocks trading for discounts to readily ascertainable net asset values now than anytime in the last five years, in my view. It doesn’t mean making money in commodities is a lock or that it will be easy. Lots can go wrong with individual companies, and the drawdowns will probably be more than most investors can stomach. But longer term, looking out a few years, I think an investor will be happy with the portfolio assembled in the doubtful summer days of 2008.


Chris Mayer
for The Daily Reckoning
September 09, 2008

Chris is a veteran of the banking industry, specifically in the area of corporate lending. A financial writer since 1998, Mr. Mayer’s essays have appeared in a wide variety of publications, from the Daily Article series to here in The Daily Reckoning. He is the editor of Mayer’s Special Situations and Capital & Crisis – formerly the Fleet Street Letter.

Chris also recently wrote a book: Invest Like a Dealmaker: Secrets from a Former Banking Insider.

‘Taxpayers take on trillions in risk,’ says the headline in yesterday’s USA Today.

‘You can call it a bailout, you can call it a safety net or you can call it a rescue package,’ the paper quoted a research director at Argus Research, ‘but the bottom line is the American taxpayer is left footing the bill.’

The story is breathtaking. Staggering. Dumbfounding. But there it is – the biggest nationalization in history. Freddie and Fannie finance 3 out of 4 new mortgages. And now, the mortgage industry depends neither on willing buyers and sellers…nor on willing lenders and borrowers…but on the U.S. government. The Land of the Free has put its housing under the control of the state! Yes, there is still plenty of room for private initiative and private decision-making. But, ultimately, millions of Americans now depend on the U.S. government for the roofs over their heads.

We checked the U.S. Constitution for clarification. We were looking for a provision stating that the ‘U.S. Federal Government shall enter the mortgage finance business and use taxpayers’ money to rescue irresponsible lenders and dimwit homeowners from their own mistakes.’ It wasn’t there. But so what? If there is anything the government can’t do, we have yet to find it.

Of course, the idea of taxpayers bailing out the mortgage finance industry is ridiculous; taxpayers can’t even finance existing federal obligations. Not even close. This year for example, they’ll be a half trillion short. If you figured it properly, the deficit would be trillions more.

The government is in the business of stacking one monumental fraud on top of another…trying to give everyone the idea that he can live at someone else’s expense. Sooner or later, the whole mountain of flimflam falls down.

‘But don’t interpret a new bailout plan for mortgage investors as a sign that the financial stock bear market is over,’ warns Strategic Short Report’s Dan Amoss.

‘It’s not – at least for banks holding the worst credit exposures. Over time, these institutions will have to confess losses; take write-downs; and raise new, dilutive capital. Many will be taken over by the FDIC, which wipes out shareholders.’

But even with the warnings, investors were encouraged by the bailout anyway.

‘World markets soar after Freddie, Fannie bailouts,’ the AP reported.

The Dow rose 289 points yesterday. The dollar rose – to $1.41 per euro. And gold rose a little too – to $807.

Meanwhile, the Federal Highway Trust Fund went broke. Most likely, there will be many more where that came from.

*** Hmmm…even with the Fannie and Freddie bailout (briefly) propping up Wall Street, today it looks like there is no joy in Mudville, after all. Following the bailout news yesterday, stocks surged…but today is a different story. One the U.S. is more accustomed to.

This morning, the National Association of REALTORS released data from the Pending Home Sales Index, which projects home sales based on contracts signed during a given month (sounds like a fun job). The index for July fell to 86.5 down from the previous month’s reading, and down 6.7% from the same month in 2007.

Also affecting Wall Street this morning are lower oil prices. Even in peak hurricane season, prices for crude are staying in the $105 zone – much lower that the highs the United States faced in July.

All signs point to a sluggish economy, but here is the icing on the cake: the Congressional Budget Office says that the government will run a record $407 billion budget deficit this year…and there’s a very real possibility of it going even higher once you figure in Fannie and Freddie.

‘The economy is likely to experience at least several more months of very slow growth,’ the new report said. ‘Whether this period will ultimately be designated a recession or not is still uncertain, but the increase in the unemployment rate and the pace of economic growth are similar to conditions during previous periods of mild recession.’

But will these high numbers have any effect on Obama’s or McCain’s economic plans? Well, if this is any indication, both parties claim that they will extend Bush’s tax cuts if elected.

However, as the CBO points out, and we point out in I.O.U.S.A. – even if the Bush tax cuts were to expire in 2010, that would only solve about 10% of the United States’ financial hole. As David Walker says in the film:

‘When many Americans think of debt and deficits, their knee-jerk reaction is to blame the war in Iraq, or defense spending. Some people think that we can solve the country’s financial problems by stopping fraud, waste and abuse, or by canceling the Bush tax cuts. The truth is, the United States could do all three of these things and still wouldn’t come close to solving the nation’s fiscal challenges.

‘The U.S. already has $11 trillion in fiscal liabilities, including public debt. To this amount, add the current unfunded obligations for Social Security benefits of about $7 trillion. Then add Medicare’s unfunded promise: $34 trillion, of which about $26 trillion relates to Medicare (parts A&B) and about $8 trillion relates to Medicare D, the new prescription drug benefit which some claimed would save money in overall Medicare costs. Add another trillion in miscellaneous items and you get $53 trillion. The United States would need $53 trillion invested today, which is about $175,000 per person, to deliver on the government’s obligations and promises. How much of this $53 trillion do we have? Nada.’

If you have seen the documentary – spread the word! Encourage your family, friends, co-workers or random people you meet on the street to go see the movie that The New York Times called ‘Yet another movie that everyone should see…’

*** Back to the bailout that shook the nation…

‘Does this really promise big change in the course of U.S. financial markets?’ wonders friend and colleague Chris Mayer.

‘After all, both companies trade on the New York Stock Exchange. The basic idea is that these companies supposedly belong to shareholders. These shareholders are owners just like the guy who owns the gas station on the corner or the husband and wife team that runs the French bistro on Main Street.

‘But Fannie and Freddie were never really private companies like these others. Entrepreneurs usually start businesses. Congress created the mortgage giants by charter (hence, they are called government-sponsored enterprises, or GSEs). And the two giants enjoyed many advantages from that parentage. Fannie and Freddie have long operated in a sort of limbo as a result, neither fish nor fowl. Both carry the implicit guarantee that if something went truly wrong, the government would come along and make it right.

‘And so it has. Bondholders are happy today. Stockholders are not. As I write, Fannie Mae is down 80% today. Freddie Mac is down 75%. I have no flag in either camp, but I certainly have no sympathy for the stockholders. Anyone who gave them a fair look could see that both GSEs were ticking time bombs.

‘In fact, I wrote an essay for the Mises Institute titled ‘Mortgage Market Socialism’ way back in 2002. I pointed out the dangers of the growth of these GSEs far outpacing that of the mortgage market. If I may quote: ‘The longer the GSEs are able to expand as they have, the more certain it becomes that someday taxpayers will have to bear the cost of such excess.’

‘This is one of those times when I am not happy to have gotten it right. Taxpayers – of which I am one – will now pay for these mistakes. Yet despite all of the hubbub in the papers, this is nothing new.

‘This action by the U.S. government does not really signify any sea change in financial markets. It’s just another step in a long journey on the same path. If you read financial history, you come to appreciate this overwhelmingly powerful trend.’

You can read more from Chris in today’s guest essay, below. In the meantime, check out the special offer Chris has made available to his Mayer’s Special Situation subscribers. You won’t want to miss out on this exclusive opportunity…and you only have until midnight tomorrow night to get in.

*** Colleague Alex Green has written a marvelous new book – called The Gone Fishin’ Portfolio. We mentioned it yesterday. Today, we offer a little more detail.

Investment strategies that are complicated almost never work. Either they are inherently parasitic (like hedge funds) or self-destructively dangerous (like betting on currency moves) or you forget what you are doing and blow them up yourself. The best strategies are extremely simple – as Warren Buffett has proven.

Alex Green, director of investment at the Oxford Club, proposes a very simple approach. You just develop the discipline of putting money in simple, low-cost investment vehicles – such as ETFs and no-load funds. All you have to do is to rebalance your portfolio only once a year, and stick with it. It’s not the kind of investment strategy that makes the investment industry rich. It’s not the kind that gives you hot tips you can share with your neighbors. But it is the kind of strategy that turns you into the millionaire of your neighborhood.

That’s it for us today. Until tomorrow,

Bill Bonner

The Daily Reckoning