Friday, August 21, 2009

Capital & Crisis Hotline -- Two Sells... and the Effects of Epic Stimulus

Agora Financial
Agora Financial's Capital & Crisis

Capital & Crisis Hotline -- Two Sells... and the Effects of Epic Stimulus
August 21, 2009

"Never before have so many government dollars been thrown at the economy to prevent a depression. When added together, the combined financial, monetary and fiscal stimuli in the US are more than the cost of the two World Wars and "The New Deal" combined."
-- Eric Sprott, Sprott Asset Management

Dear Capital & Crisis Reader,

What makes investing particularly difficult now is that the distortion in prices, as if reflected in a funhouse mirror. Normally market prices should reflect underlying demand and supply. As in a vegetable stand, the prices come from the buying and selling of people in the market.

But with all the artificial stimulus money floating around, you can never be sure of what you see. Is this a real recovery or is it an artificially ripened tomato, and hence an imposter? When the stimulus money stops flowing will the recession get worse?

It's hard to say, but let me give you a couple examples of distortions.

CNN's bailout tracker reports that US government stimulus has totaled $2.8 trillion so far this year, with another $8.2 trillion in commitments. Most of this money has gone to the financial sector. Some of it has gone to infrastructure projects and to consumers (cash for clunkers, for example).

That is a lot of money. It is hard to say how all of this spending has artificially boosted economic activity in some sectors of the economy. It is obvious that such spending cannot continue indefinitely.

This has also been a world-wide phenomenon. There isn't an economy of size that does not have some stimulus spending program in place. Governments are spending money they don't have. The result is widening budget deficits and higher debt levels.

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. That chart shows 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.

But this graph only tells a part of the story. China is one of the countries in "Emerging Asia." China supposedly grew in the first quarter at an annualized rate of 15%. Yet, the government also spent a lot of stimulus money. As Eric Sprott writes in his latest letter to shareholders:
"The Chinese have injected a stimulus equivalent to 64% of their first half 2008 GDP in the first half of 2009… The Chinese government has effectively spent and lent enough in six months to buy 122 Ford Class aircraft carriers at US$8.1 billion a piece. It is akin to the US government injecting (and US banks lending) almost $4.5 trillion USD to its citizens and businesses before July 2009…an ungodly sum that would impact every asset class under the sun. Is it any wonder then that the Shanghai stock exchange has more than doubled from trough to peak since its November lows?"
Let me remind you that GDP is a clumsy way to get at an economy's size. It is a figure that includes government spending. So, put another way, stimulus money this year is about 64% of the recorded economic activity in the first half of last year for China.

Where the Money is Going -- Commodities

In some ways, the Chinese government spent well -- investing in the commodities it craves. It's locked down oil and gas assets, iron ore contracts, interests in rare earths and more. It's put up power plants and laid down roads and pipelines. It's made long-term investments in Africa and Brazil. Some of that will pay dividends down the road, if not already.

For instance, in the first six months of this year China became Brazil's single largest export market. That's the first time that's ever happened. The Chinese and Brazilians are doing deals. For instance, China will lend $10 billion to Petrobras in return for 200,000 barrels of oil per day. China, in fact, has been active throughout South America, investing billions in mines, refineries, ports, and railroads.

These shifting patterns of trade always fascinate me. And we are living in an era of great change on that front, as new patterns emerge on a scale we have never seen.

It's clear that China will have enormous needs for commodities over time. In the short-term, we are surely seeing distortions from the stimulus money. But the long-term demand is there nonetheless and the Chinese have a lot of money to spend.

Global Infrastructure is Still Getting Older Everywhere

In fact, infrastructure needs -- especially in the areas of water and energy -- are becoming more of a headline issue than ever. Not a week goes by where I don't pick up a handful of stories of infrastructure falling apart somewhere. This, too, is a global story.

This week, for instance, there was a terrible accident in a Russian hydropower plant. Eleven people were killed and 65 were missing after water burst into a turbine room. It also destroyed the turbine. Besides the irremediable loss of life, it will take hundreds of millions of dollars and years to repair the demand.

As the FT reported, the accident "was a powerful reminder of Russia's dire need for hundreds of billions of roubles in investment in its crumbling Soviet-era infrastructure."

Putin's government put aside $200 billion for infrastructure in two oil windfall funds, but that money is already being tapped for social spending programs and to help make up budget deficits. As in many places, including in the U.S., money set aside for infrastructure has been essentially hijacked by the political process and diverted to other uses.

Another story this week comes from Britain. Britain faces huge deficits in energy and the risk of widespread blackouts. Its energy complex is old and strained. The Economist reports: "The nuclear stations are simply too old to carry on: most are over a quarter of a century old. Around half have already been shutdown and are being decommissioned."

About half of its electricity comes from natural gas, a legacy of its North Sea riches. But the North Sea peaked in 1999 and has been in steep decline ever since. Britain's coal plants struggle under new pollution control rules and the effects of age. It's an ugly situation that will cost a lot of money to fix.

The positive for investors is that there are several firms that are right in the sweet spot of this global infrastructure crisis. We own a few, such as ABB (ABB:nyse) and Flowserve (FLS:nyse).

Clearly, we could face some short-term risk as the effects of the stimulus spending start to wane. But the longer-term story is still in place.

With Flowserve, we've already doubled our money on the stock since March. Let's take some money off the table. There is so much good stuff going on here that I want to keep a foot in it. So, we'll hang on to the other half and look for bigger gains down the road.

Recommendation: Sell HALF of your Flowserve (FLS:nyse) position for a 102% gain. HOLD on to the other half.

*** Atlas Pipeline

This is the most painful sell recommendation I've ever had to write because I got it so spectacularly wrong. We should never have been in Atlas (APL:nyse) to begin with. There was far too much leverage here and a hedge book that did not protect investors well. You'd think pipelines would be a simple asset, but the layers of financial engineering made Atlas much more complicated than it appeared. I didn't understand it as well as I should have and it cost us.

My initial recommendation on Atlas, then, was flawed from the get go. To make matters worse, though, I stuck with it. In my defense, the company still owned important right-of-ways in the Marcellus Shale. But the financial difficulties forced Atlas to sell assets, including a 49% interest in this crown jewel.

And the dilution keeps coming. On Monday, Atlas announced it would issue another 2.7 million units to a group of institutional investors at a price of $6.35 per unit(!), which also gives these investors the right to another 2.7 million units over the next two years -- at the same price!

The shareholders will have to share the remaining value in the company with more and more people. Owning a share in Atlas is like having an interest in a slice of pizza that keeps getting cut into more and more slices.

This latest offering is the final straw, so to speak. I'm finally done with this long, ugly and twisted saga. I am sorry I ever recommended it and even sorrier I stuck with it for so long. All I can say is that I have learned some things in this experience and I promise to do better.

Recommendation: Sell Atlas Pipeline Partners (APL:nyse).

*** The Methanol Industry

This week I had a meeting with Gregory Dolan at the Methanol Institute. I picked up some fascinating things happening in the world of methanol, which affect our investment in Methanex (MEOH:nasdaq). I'll share the results of that conversation and some other research with you in your next issue. We're up about 53% on Methanex since we added it in April -- and we continue to enjoy a rich yield of nearly 6% on our purchase price.

Enjoy your weekend and I'll write you again soon.


Chris Mayer

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