Winning Ideas in a Losing Market

We both reached for the check. “No, no, I invited you,” I said. “I’ll pay.” But then my guest made an offer I couldn’t refuse.

“Come on, we’re in markets. Let’s flip for it.”

Well, how could I resist that? Everyone in markets — from careful investor to highflying speculator — learns to live with chance, and even to relish it. It’s part of the thrill of markets (and life); you just never know how things might play out.

So we flipped. I called heads. Heads it was. And Frank Holmes paid for dinner.

Frank is the CEO and chief investment officer of US Global Investors (NASDAQ:GROW), which is a mutual fund company with a slate of award-winning funds. He’s a well-traveled investor, too, and we swapped stories of our travels. He told me about a recent trip to Sri Lanka, where his firm was looking at palm oil plantations.

We met at Cookshop in Chelsea, Manhattan — a restaurant that favors seasonally available and locally sourced ingredients prepared simply. (We had the excellent split-roasted chicken, cooked over a wood fire. Worth a visit if you are in the area.) We had a great conversation that ranged over seemingly everything.

One of the things we talked about was S-curves, which is kind of the “House Specialty” at US Global. Holmes explained what this macro scenario is and why his firm relentlessly seeks them out. Take a look at the chart below, which shows you a generic curve. The main thing here is to invest in the middle part of the curve, when growth accelerates.

An S-Curve

It’s a simple idea, which is part of its appeal. And there are many historical examples — in population growth, oil consumption and demand for cars, among many other things. It’s loosely based on an idea by economist Simon Kuznets, who found long cycles (around 20 years) of boom times around an increase in infrastructure spending.

One historical example is the US interstate highway system in the 1950s. The highway system created a much more mobile society and had a profound effect on businesses. Think about what it meant for truckers, retailers and managing inventories. Travel time between Cleveland and New York City, for example, declined by a third. But the highways also produced brand new opportunities that did not exist previously. New motels, gas stations and restaurants sprang up across the entire country.

“We try to take a look at this model and look at emerging countries and go back and forth in history and try to identify where they are on this S-curve,” Frank said.

What’s driving the big S-curves of today’s economy? Population growth is one thing. It took over a century for world population to move from 1 billion to 2 billion (from roughly 1805-1927), but only 40 years to go from 3 billion to 6 billion (from 1960-2000).

“What’s significant here is that in the 1970s, the world’s population was half of what it is today,” Frank pointed out. “China and India had no global footprints then.” Russia was behind the Iron Curtain. Today, they are embracing an infrastructure build-out that will be as dramatic in effect as the interstate highway system was for the US.

You will find we’re in the middle of similar demand curves today in cars, electricity, steel, oil and more…

Frank made some interesting points about cars. In developing markets, most people pay for cars with cash. “Loyalty for car buyers in the US and Europe is not to the car buyers,” Frank said, “but to who will give them the money, because over 90% of all cars have a note against them. But in Africa…it is a cash trade.” That leaves them less sensitive to global financial markets. So in 2008, when the world was falling apart, Nigeria actually had positive growth. So did Mozambique. These were predominantly cash economies.

Another way to get at the S-curve model is to think of water. It can be a solid, liquid or gas. There is a temperature at which dramatic things happen. “The same thing happens with demographics, consumption or GDP per capita,” Frank maintained. There is a certain point at which dramatic changes take place and put you on the steeply sloped part of the S-curve.

Government policy drives a lot in this analysis, and Frank mentioned it often. Government is a precursor to change. “China has gone from a communist country to a socialist country that’s slowly moving toward capitalism,” he said. The S-curve in China began with Deng Xiaoping and the opening up of China. The largest real estate transfer in the world was when China gave citizens plots of land. “This was very significant,” Frank notes, “even though these leases are for 40-60 years, because it’s a transfer of wealth, which the Chinese are able to borrow against, sell and trade.”

Greater freedoms led to the creation of a rising middle class. Today, China has the second-largest number of billionaires in the world. “These are not oligarchs, like in Russia” Frank pointed out. “These are people that are basically getting Pizza Huts.” They are entrepreneurs, starting businesses and growing them. “What happens when you get 60 million people making $100,000 a year? What does it change?”

It changes a lot. It means a lot of people want air conditioners and cars and homes. It means a lot more coal and steel and metals. The power of TV and the Internet helps fuel this desire. “Everyone in the world wants what we have. They can see it. And they want that dream. They are willing to work 60, 70 hours a week to get that,” Frank explained. “They are not out picketing on Wall Street.”

So how does this tie back into making money in markets around the world?

US Global starts with a comparison between the E-7 and G-7 countries (essentially, the big emerging markets versus the big developed markets). The E-7 countries have half the world’s population, but only 20% of the world’s output. The G-7 is the opposite.

Frank looks for certain things, like a favorable tax policy or an infrastructure spending plan. “We create a relative valuation model to see where shifts are happening around the world,” he said. With this view, US Global can also plot other countries and compare them to the G-7 and E-7 framework so that he remains in the most favorable situations.

There are many interesting insights that come from such work. For instance, Frank’s plotted out the infrastructure spending plans of the E-7. It’s a huge amount of money — some $6 trillion over the next three years alone — that will fuel commodity demand. He mentioned China’s high-speed rail as something that “will change everything.” Again, the highway analogy comes to mind. The rail system will span 24,000 miles and link up 240 cities and 700 million people. Think of all the trade that will unlock, just as with the US highway system, only on a much bigger scale.

The final proof for these things is, as they say, in the eating. In searching for S-curves, Frank and his team have uncovered many gems to put up the kind of performance numbers they have. US Global Investors was an early investor in the new Colombia, for instance. It seeded Pacific Rubiales at 25 cents per share. Today, it’s C$22 per share and has been as high as C$35 per share.

Finding gems like that makes it all worth it. If you had put $10,000 with Frank’s Global Resources Fund in 2000, you’d have nearly $60,000 today. And that was during a rough decade for stocks. (If you had put the $10,000 in the S&P 500, you’d have about $11,000 today.) This goes to show you — if you can get past the noise and paralyzing fear, there are plenty of opportunities out there in all kinds of markets.


Chris Mayer,
for The Daily Reckoning

The Daily Reckoning