BLOOMBERG EDITION

Vol. 30, No. 2

Two Wall Street, New York, New York 10005 www.grantspub.com

jaNuary 27, 2012

They ask for nothing

Last week, the U.S. Treasury auctioned 10-year inflation-protected notes at a 0.046% negative real yield, while Her Majestys Treasury issued four-year conventional notes at a 0.893% nominal yield. Twelve-month T-bills denominated in dollars and yen fetch 10 basis points and 12 basis points, respectively, while the German government, borrowing for the same 12 months in a currency that may or may not be around in the next 12 months, pays 13 basis points. Nothing percent is the topic under review. The opportunities to earn nothing in securities denominated in unredeemable scrip, i.e., todays paper money, is one point of focus. The theory of investments returning nothing is another. The contribution of central banks to nothingness and the special case of zero-yielding Japan are others. In preview, Grants is bearish on nothing, bullish on more than nothing. Seekers after no returnexcept for the always welcome return of principaldont have far to look. Money market funds are a rich mine of zeropercent opportunity. Whether its government funds, prime funds or taxexempt funds, the return on offer is one basis point orat a stretchtwo. According to the Money Fund Report, $2.692 trillion is self-incarcerated at those non-rates. For any who are unwilling to accept one or two basis points but still refuse to accept, for example, 351 basis points available on the common dividend of Johnson & Johnson, the U.S. Treasury yield curve presents many choices, including the two-year note priced to yield one-quarter of 1%. In times past, bond salesmen talked about how much a security yielded. Now they talk about how little. In this market environment, Treasurys prove to be of unprecedented value, the Financial Times quoted a sell-side analyst as saying on Friday. If unprecedented means what it seems to mean, the analyst makes a novel case. He is saying that a dozen basis points of return in 2012 trump more than a dozen full percentage points of return at the tail end of the great bond bear market of 1946-81. He says, said the FT, trying to explain, Treasurys give investors an option at a time of great uncertainty by deferring an investment decision on the riskiest assets such as equities. Only consider the two-year note, the analyst himself continued: Two years from now, we will find ourselves in a completely different market environment, in which banks, hedge funds and other participants play a different role, new security products are traded and relative value opportunities may exist in a currently unknown form and shape. Surviving until then is key. Treasurys help you do so. For ourselves, we repeat the wise words of the investor Joe Rosenberg, as quoted in the Dec. 5 Barrons: You can have cheap equity prices or good news, but you cant have both at the same time. For the patient and not overly leveraged investor, trouble is a friend, provided it isnt cataclysmic. Do todays troubles qualify? Or are they the kindtroubles with a capital Tthat will make prophets out of the nothing-percent bulls? A century ago, Congress convened hearings to expose the concentration of financial power among the big New York City banks. Under questioning, one of the witnesses, George F. Baker, 72-year-old chairman of the eminently solvent and profitable First National Bank of New York, admitted that too many financial resources were probably controlled by too few private hands. However, he went on, In good hands, I do not see that it would do any harm. If it got into bad hands, it would be very bad. The interrogating lawyer, Samuel Untermyer, seized on that concession. If it got into bad hands, he asked hopefully, it would wreck the country? Yes, but I do not believe it could get into bad hands, Baker replied. And presently he added, I do not think bad hands could manage it. They could not retain the deposits nor the securities. This was in 1912, two years before the Federal Reserve opened for business, 21 years before the founding of the Federal Deposit Insurance Corp. and 59 years before the jettisoning of
(Continued on page 2)

Just one more unconscionable bonus, and I wouldve been golden.

2 GRANTS/JANUARY 27, 2012

(Continued from page 1)

BLOOMBERG EDITION

5%

Road to zero
12-month obligations of select sovereign bonds

5%

4 U.S. Germany Japan

-1

6/08

6/09

6/10

6/11

1/20/12

-1

source: The Bloomberg

the last remnants of the gold standard. It was 70-odd years before the enunciation of the doctrine that some American banks are too big to fail. In the world in which Baker and J.P. Morgan did business, bad hands couldnt successfully compete. Today, if employed by a too-big-to-fail bank, bad hands can flourish. Governmental dispensations like unchecked money printing and the zero-percent funds rate help them over the cyclical rough patches. However, to subsidize something is to get more of it. Subsidies to bad banking have materially increased the number of bad banks. These are the sunshine institutions, solvent in the booms, needy in the busts. In Europe, cyclically solvent banks must number in the hundreds. You can infer as much by the enormous bulge in lending by the European Central Bank. When governments not led by Angela Merkel lost the markets confidence, so did the banks that owned those governments notes and bonds. Standing on their own, the suspect institutions couldnt fund themselves. Tellingly, interbank lending virtually stoppedthe bankers knew all about each other. The not-needy banks implemented their own nothing-percent trade by depositing excess cash in the ECB rather than risking it in the wholesale funding markets. As for the needy banks, to borrow Bakers phrase, they could not retain the deposits nor the securities. We Americans wake up dreading to hear the news from across the pond

because Europes crisis hits home. Its the crisis of the welfare state of credit. If the system of heavy public borrowing financed by fiat currencies and semi-socialized banking is doomed, what about us? Its our system too. Here, at least, the overused phrase systemic crisis is actually descriptive. In December, the ECB extended 489 billion in three-year loans to more than 500 European banks against an encyclopedic list of eligible collateral. Long-term refinancing options LTROs to the cognoscentiis the name of this massive monetary initiative. On Jan. 20, the ECBs balance sheet footed
2,750 2,500 2,250 in billions of euros 2,000 1,750 1,500 1,250 1,000

to 2.706 trillion, up by 37% from a year ago. Over the past three months, the assets of the ECB have been growing at an annual rate of 90%. Italian banks availed themselves of the ECBs accommodation more than the banks of any other euro-zone nation, and Monte dei Pacshi di Siena was the most eager Italian borrower of them all, based on its takings as a percentage of 2012-13 funding requirements. According to an excellent new Morgan Stanley study of the situation (Dont underestimate the impact of the LTROs, dated Jan. 18), MPS secured 100% of this years financing and most of next years, 10 billion altogether. The oldest surviving bank in the world, as management characterizes the 540-year-old institution, survived the Great Recession with the help of a 1.9 billion infusion from the Italian government. It may be said that MPS is not (and possibly never was) a purely capitalist institution, its founding charter providing for loans to poor or miserable or needy persons. Yet it may also be said that any crisis that can rock the oldest surviving bank to its ancient foundations tells you something about the quality of banking in the era in which the crisis occurred. LTRO isnt, and couldnt be, the cure for our manifold sins and suffering. A taker-upper of a three-year loan from the ECB pays just 1%, its true, while short-dated Greek debt fetches as much as 392%. But the borrowing bank is under no regulatory obligation to commit
2,750 2,500 2,250 in billions of euros 2,000 1,750 1,500 1,250 1,000

yield

And more where that came from

European Central Banks total assets

yield

1/5/07

1/2/08

1/2/09

1/1/10

1/7/11

1/20/12

source: European Central Bank

Copyright 2012 by Grants Financial Publishing, Inc. Reproduction or retransmission in any form, without written permission, is a violation of Federal Statute.

BLOOMBERG EDITION
GRANTS/JANUARY 27, 2012

its ECB-dispensed funds to purchase Greek, Italian or French debt. Even if the banks do find the carry trade enticing at the February three-year LTRO, write the Morgan Stanley analysts, they will have little incentive to buy bonds beyond a three-year average maturity (e.g. could include some five years in the mix but unlikely 10 years). It also leaves open an intriguing question of who will buy euro sovereign bonds beyond the sugar highs of the December and February three-year LTROs. It may mean beyond February more bearish trades should be put back on in the sovereign curves. We still expect that the ECB will cut the Refi rate by a further 50 basis points during the spring; and will probably need to step in during the summer with full-blown QE (direct buying of government and corporate debt). It may be that a Greek restructuring calls for a quicker need to backstop Italy and Spain with greater vigour. However, in the absence of the Bakers and the Morgans and the gold standard under which they operated, someone had to do something. In 2012, Morgan Stanley estimates, 470 billion of senior unsecured debt falls due. In no economy is a systemwide banking collapse a mere footnote. In Europe, where 80% of the credit is drawn from banks, the authorities would move heaven and earth to forestall such a disaster. The relatively undeveloped state of the capital markets (and the absolutely impoverished state of the labor market, with the euro zone unemployment rate standing at 10.3%) make imperative a clear and functioning bank lending channel, as the cognoscenti also say. Next month comes a second round of LTROs, which may elicit borrowings of 400 billion or more, possibly much more. Note, please, the matter-of-fact tone of the just-quoted Morgan forecast concerning a radical acceleration in the ECBs already muscular rate of credit creation. Clearly, the ECB is a misunderstood institution. Though politicians complain about its alleged reluctance to go all-in on monetary ease, the ECB has actually pursued through other means the kinds of policies identified with the Fed and the Bank of England. Eschewing QE, it has instead performed LTROs. It has created the purchasing power with which the Continents used-up commercial banks can buy sovereign debt, rather

thanas would occur under QEthe central bank buying that debt outright. But the effect is the same. New liquidity and new credit are brought into the world but withouta key pointa corresponding increase in new goods and new services. Taking as it does a conservative, shall we call it, approach to money and banking, this publication sometimes glides too easily over mainstream 21stcentury doctrine. In the matter of central bank policy, the view of many an

established and thoughtful practitioner is that the Ben Bernankes and Mario Draghis should keep printing, that no harm will come if they do but that great harm may result if they dont, that harm taking the shape of a deflationary depression. Willem Buiter, chief economist of Citigroup, is one of these modern thought leaders. Potentially infinite money creation is clearly inflationary, Buiter, a former member of the Bank of Englands Monetary Policy

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4 GRANTS/JANUARY 27, 2012

BLOOMBERG EDITION

160 150 140 130 index level 120 110 100 90 80 70

Not so high, in fact

real/effective yen-dollar exchange rate (2010=100)

160 150 140 130 index level 120 110 100 90 80

1/90

1/95

1/00

1/05

1/10 12/11

70

source: Bank of Japan

Committee, acknowledges in a Sept. 9 report, but as we have argued before, even the non-inflationary loss absorption of the ECB/Eurosystem assuming that its money creation will not exceed the level consistent with the ECBs price stability mandateis likely in the range of 3 trillion. Since we take the ECBs commitment to price stability seriously, we regard these 3 trillion rather than infinity as the right constraint on the institutions potential contribution to the resolution of the euro areas sovereign and banking crises. Since that writing, the ECB has created 620 billion. And without alarming the economics department of Citigroup, the Bank of Draghi may materialize 2.4 trillion more euros. Insofar as the Citi economists speak for the othersand Citi is usually not in the vanguard of radical opinionthe ECB might only have begun to print. We reason that the looming euro zone liquidity crisis is over for the time being. The euro zone banks will get both funding and forbearance. There will be more than enough euros to go around. Reasoning in this fashion, we conclude that the nothing-percent trade is yesterdays big idea. As the world comes to accept that a euro zone banking crisis is off the menu of immediate risks, there could be a shift, if not a stampede, into assets yielding more than nothing. We thus restate our preference for cheap equities over

the non-yielding alternative. Cheap gold-mining equities seem especially attractive, given the habitual central bank response to meeting crises with new emissions of paper. It may not be easy persuading the bulls on nothing that something is, in fact, more remunerative, even safer. Japanese sovereign debt, a mainstay of the worldwide stock of non-yielding assets, came in for a downgrade to double-A-plus from triple-A by the domestic ratings agency, Rating and Investment Information, on Dec. 21. But the announcement made no waves in the immense placid sea of nominal-yielding JGBs. Noise, was the reaction to the demotion by the Nomura chief investment strategist. Now comes word that, as of Sept. 30, ownership of Japanese debt by nonJapanese residents stood at a record 75.7 trillion, or $974 billion, much of which, according to the Financial Times, was in the form of zero-percent-yielding T-bills. [I]t is understandable, the FT reported, that foreign money-market funds would seek shelter in a market where bids are almost always at least twice the amount offered, and where the views of credit rating agencies seem to have no effect on prices. It is not so blindingly understandable to anyone who appraises the value of short-dated Japanese paper based on Japans ratio of debt to GDP (an estimated 233% last year, as against 100% for the United States

and 83% for Germany), never mind by nonexistent nominal Japanese yields or by the unfavorable trend in the Japanese current account. But the stockpiling of yen-denominated scrip becomes more than comprehensible to a bull on the Japanese currency notably, to a yen bull who happens to be a Japan bear. One investor who fits this unusual description is Hugh Hendry, chief investment officer of Eclectica Asset Management, London. Having made its mercantilist bed, Hendry contends, Japan must now lie in it. For almost a half century, the Japanese private sector has been accumulating non-yen assets. Today, it holds a pile of non-yen claims equivalent to a years Japanese GDP or more, i.e., on the order of at least $5.9 trillion. And handy it is in times of trouble say, in the wake of the Lehman bankruptcy, or of last years tsunami and earthquake. However, the very act of repatriating dollars or euros tends to elevate the yen exchange rate, which is exactly the opposite of what Japans exporters want. Its an exquisitely ironic problem, Hendry relates: the more foreign exchange the private sector brings home, the more the yen tends to appreciate, and the less price-competitive the very same private sector becomes. At 77.7 yen to the dollar, Hendry proceeds, the currency only seems uncomfortably high. In fact, it traded near that level in April 1995 after the Kobe earthquake. If the exchange rate had merely reflected Japans superior inflation record from that day to this, yen/dollar would be quoted in the 50s today. And it will, Hendry predicts, finally trade in the 50s or 60s, at which crisis level the lights will go out in Japanese industry. But, in response to the implosion of Japanese automaking, steelmaking and chemical manufacturing, the lights will go on at the Bank of Japan. Only at such an acute level of exchange-rateinduced pain, Hendry says, will the Japanese authorities show the world how QE is really done. Then, and only then, will the bear market in the Japanese currency and in the Japanese bond market begin in earnest. And perhaps, at that interesting juncture, the nothing-to-maturity trade will finally and definitively turn unprofitable.

BLOOMBERG EDITION
GRANTS/JANUARY 27, 2012

The right price

No claim as to cause and effect, but Newt Gingrich won South Carolina the day after he promised to name Lewis E. Lehrman and James Grant to co-chair a commission to study the feasibility of Americas return to the gold standard. If, of course, he gets to the White House. While I am not presently committed to any one version of reform, declared the former Speaker of the House of Representatives, if elected I will be eager to work with Lew Lehrman and Jim Grant in achieving a dollar that once again can hold its purchasing power for many decades to come. The fundamental conclusions of a Lehrman-Grant commission to consider a return to the gold standard may be foregone: Were for it. As for the technique of getting from fiat currency to the real McCoy, thats a harder nut. No less a statesman than Winston Churchill bungled the job in Britain in 1925. In place today is a dollar undefined and uncollateralized. On the near horizon, let us say, is a dollar defined as a weight of gold and exchangeable on rants indemand into that metallic collateral. a beautifully-bound hardcover edition. Moving from fiat currency to the real thing is the topic under discussion. It happens that Lehrman has written a book on how to get from here to there: The True Gold Standard: A Monetary Reform Plan without Official Reserve Currencies. A member of President Reagans Gold Commission in 1981, the senior co-chairman of the prospective Gingrich gold commission sat down last week for a chat with the junior co-chairman. The gold standard is what the world needs now, the commissioners-in-theory agree. Reason, history and common sense command it. The gold standard tends to deliver price stability over the long run. It tends to check the over-issuance of credit. It tends to favor no one nation but to knit the nations together. A human contrivance, it has its limits, of course. However, as Lehrman has said, it is the least imperfect monetary system devised. And it has been proved in human history, the only laboratory that counts, not on the blackboards of Cambridge and Oxford. And gold is the ideal monetary medium, the prospective commissioners also concur. It isnt consumed, its

rarely destroyed and its famously difficult to discover and mine. You know its money just by looking at it. For the very reason that elements from Cleopatras bangles might be found today in someones molar, a given years production of gold has no meaningful effect on the size of the global gold inventory. According to Thomson Reuters GFMS, 2010 production of 2,709 metric tons stands in contrast to estimated aboveground stocks of 166,600 metric tons. For every ounce produced, 61 already existed. If slow and steady is the way of the gold standard, fast and furious is the tempo of the fiat regime. To the end

of achieving a 2%-per-annum rate of inflation, the central banks of the United States, the European Union and the United Kingdom are printing money at rates many times faster than 2%. If theres any rhyme or reason to the system, the Gingrich commission pledges to reveal it. Anyway, the world supply of gold expanded by an average of 1.7% a year from 1900 through 2009, according to the U.S. Geological Survey. The growth wasnt steady but spotty. In the 1930s, as mining costs plunged, production boomed, with output climbing at the
(Continued on page 8)

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6 GRANTS/JANUARY 27, 2012

BLOOMBERG EDITION

Credit Creation
40

Central bank sleeping pill

Chicago Board Options Exchange vs. Merrill Lynch Option Volatility

Federal reserve Balance sheet

(in millions of dollars)
The Fed buys and sells securities Securities held outright $2,602,187 Held under repurchase agreements 0 and lends Borrowingsnet 8,598 and expands or contracts its other assets Maiden Lane, float and other assets 292,976 The grand total of all its assets is: federal reserve Bank Credit $2,903,761 Foreign central banks also buy, or monetize, governments: Foreign central bank holdings of Treasurys and agencies $3,391,653
VIX Index

35

Jan. 18, 2012

Jan. 11, 2012 $2,594,818 0 8,837 279,235 $2,882,890

Jan. 19, 2011 $2,206,539 0 26,629 183,140 $2,416,308

30

25

20

15

11/1/11
source: The Bloomberg

12/1/11

$3,397,718

$3,343,203

Money soothe
Evan Lorenz writes: Since the prior issue of Grants, Japan has tapped an additional $6.5 billion from the Federal Reserves central bank liquidity swap facility for a grand total of $20.5 billion. As to why Japans banks suddenly find themselves starved of dollars, one can only guess. Maybe its because, as Bloomberg reported on Jan. 23, the Japanese are filling the void in Asia left by the retreat of the undercapitalized French. Or, perhaps, international providers of dollars, e.g., money market mutual funds, are getting worried. Or maybe the legendary Mrs. Watanabe finds herself with fewer dollars as Japan becomes a net importer of goods and services. In the first 11 months of 2011, the Japanese trade deficit totaled 2.9 trillion ($37.9 billion). To fund the shortfall, Japan must run down its formidable stock of foreign assets, which, as noted elsewhere in these pages, tends to strengthen the yenand enlarge the trade deficit. The 24/7 hum of the global monetary printing presses seems to be soothing rather than not; since the announcement of liquidity-enhancing measures on Nov. 30, the price of volatility has plummeted. The CBOE Market Volatility Index (VIX), a measure of implied volatility on S&P 500 options, has declined to 18.91

Bank oF Japan Balance sheet

(in billions of yen)
Jan. 20, 2012 Dec. 20, 2011 Jan. 20, 2011 The BoJ buys Japanese govt. bonds Bonds purchased 81,339 89,003 76,366 and lends Loans and discounts 37,995 39,496 41,452 and expands or contracts its other assets Other assets 13,424 12,651 8,371 Its assets total: 132,758 141,150 126,189

MOVEMENT OF THE YIELD CURVE

5.0% 4.5 4.0 3.5 3.0 yields 2.5 2.0 1.5 1.0 0.5 0.0 1/24/2012 10/26/2011 1/24/2011

5.0% 4.5 4.0 3.5 3.0 2.5 2.0 1.5 1.0 0.5 0.0 yields

3 month

6 month

2 year

5 year

10 year

30 year

source: The Bloomberg

BLOOMBERG EDITION
GRANTS/JANUARY 27, 2012

Cause & effeCt

120 110

SPX Volatility Index (left scale) Estimate MOVE Index (right scale)

annualized rates oF GroWth

Federal Reserve Bank credit Foreign central bank holdings of govts. Bank Of Japan Commercial and industrial loans (Dec.) Commercial bank credit (Dec.) Primary dealer repurchase agreements Asset-backed commercial paper Currency M-1 M-2 Money zero maturity

(latest data, weekly or monthly, in percent)

3 months 9.3% -1.7 9.5 11.8 6.2 -24.8 47.6 12.5 6.4 3.9 7.8 6 months 3.5% -1.9 10.9 11.9 5.1 -8.5 -36.3 8.6 24.3 11.4 10.0 12 months 20.1% 2.1 9.5 10.2 2.3 -0.7 -2.7 9.3 19.7 9.9 9.5
MOVE Index

100 MOVE 90

80 VIX 70

1/3/12

1/24/12

es the nerves
from over 30. The Merrill Option Volatility Estimate (MOVE Index), a measure of bond volatility, has declined to 81.6 basis points from over 100. Just in timeif, that is, the focus of your concern is on the worlds second-largest economy. What do Japan, the U.S., Spain and Ireland have in common, posed Bank of Japan deputy governor Kiyohiko G. Nishimura at a June 20 University of Cambridge conference. Why, each of these countries saw a boom in asset prices as their inverse dependency ratio increasedi.e., as the ratio of workingage population to the non-working-age (dependent) population pushed higher. The demographic tailwind did not cause the bubble, but, rather, supplied fertile ground for the excessive optimism that led many economic agents to take a highly leveraged position to multiply their returns, Nishimura asserted. By the same token, the eventual sharp reversal of the ratio made resolution of accumulated financial excesses particularly difficult, he said. Notable, therefore, is the news that the proportion of working-age Chinese (ages 15 to 64) declined by 0.1% to 74.4% in 2011, as well as this possibly related fact: Chinas largest property developer, Vanke, last month registered a 30.3% year-over-year plunge in sales.

reFlation/deFlation Watch
FTSE Xinhua 600 Banks Index Moodys Industrial Metals Index Silver Oil Soybeans Rogers Intl Commodity Index Gold (London p.m. fix) CRB raw industrial spot index ECRI Future Inflation Gauge Factory capacity utilization rate CUSIP requests

Latest week 8,935.82 2,057.23 $31.68 $98.46 $11.87 3,715 $1,653.00 533.71 (Dec.) 98.6 (Dec.) 78.1 (Dec.) 1,770

Prior week 8,589.82 1,998.71 $29.52 $98.70 $11.58 3,673 $1,635.50 527.46 (Nov.) 98.4 (Nov.) 77.8 (Nov.) 1,923

Year ago 8,635.71 2,353.59 $27.47 $88.86 $14.14 3,929 $1,345.50 595.31 (Dec.) 101.2 (Dec.) 76.8 (Dec.) 1,607

CREDIT SPREADS
800 700 600 800

in basis points

500 400 300 200 100 0 -100

latest three months ago year ago

700 600 500 400 300 200 100 0

in basis points

10-year swap

TED spread

Aa bond index

Baa bond index

bank loans*

high-yield index

-100

*spread over three-month Libor sources: The Bloomberg, Standard & Poors LCD

8 GRANTS/JANUARY 27, 2012

(Continued from page 5)

BLOOMBERG EDITION

rate of 7.3% a year. In the 2000s, as mining costs soaredover the past few years at rates in excess of 20% a yearproduction actually declined, at the rate of 1.1% a year. Still, over the long run, the co-commissioners agree, the Newmonts and the Barricks of the world are more dependable sources of monetary matter than the Federal Reserves of the world. All of which is preface to taking a stab at setting orjust as important at this stage of the gamethinking about setting the rate of conversion. Gold bugs, gold bulls and others with a horse in the monetary race have given the subject some thought and much discussion. Howeveryour editor is about to hand his friend a well-deserved bouquetnobody has studied it so well or so long as Lehrman. By all means, read his book ($9.95 on Amazon).

Delzoria Coleman, Circulation Manager John DAlberto, Sales & Marketing

Grants is published every other Friday, 24 times a year, by Grants Financial Publishing Inc. Offices at Two Wall Street, New York, N.Y. 10005. Telephone: (212) 809-7994; Fax: (212) 809-8492. First-class postage is paid at New York, N.Y. Annual subscription rate is $965 in the United States and Canada; $1,005 to all other areas. Single issues, $75 each. Group, bulk and gift subscription rates are available on request. Visit our Web site at www.grantspub.com. Copyright 2012 Grants Financial Publishing Inc. All rights reserved. Grants and Grants Interest Rate Observer are registered trademarks of Grants Financial Publishing, Inc. Copyright warning and notice: It is a violation of federal copyright law to reproduce or distribute all or part of this publication to anyone (including but not limited to others in the same company or group) by any means, including but not limited to photocopying, printing, faxing, scanning, e-mailing, and Web site posting. The Copyright Act imposes liability of up to $150,000 per issue for infringement. Information concerning possible copyright infringement will be gratefully received. See www.grantspub.com/terms.php for additional information. Subscribers may circulate the one original issue received in the mail from Grants, for example, using a circulation/routing slip. Multiple copy discounts and limited (one-time) reprint arrangements also may be available upon inquiry.

James Grant, Editor Ruth Hlavacek, Copy Editor Evan Lorenz, CFA, Analyst David Peligal, Analyst Charles Grant, Analyst Hank Blaustein, Illustrator John McCarthy, Art Director Eric I. Whitehead, Controller

The prime objective, says the author, is to avoid the British error of restoring convertibility at a rate so high as to pressure nominal wages. Churchill, taking bad advice, pegged the pound at preWorld War I gold parity, thereby forcing down incomes, gumming up business and setting up an undifferentiated contempt of the gold standard in British intellectual circles that to this day seasons the pages of the Financial Times. The deflationary error is easily avoided, Lehrman observes. The essential steps include these: No. 1, announce a date certain for resumption of gold convertibility, likely two or three years down the road. No. 2, invite the market to undertake the work of discovering a price. No. 3, assemble the statistics with which to calculate average and marginal all-in costs of gold mining in the United States and elsewhere. No. 4, armed with those data, override the markets price if it seems too low to afford the higher-cost miners the margin with which to make an acceptable return. As the gold standard is an international monetary mechanism, the wages of no participating nation should come under pressure owing to a poorly calculated conversion rate. After the pre-resumption marketprice discovery period is complete, writes Lehrman in his book, the gold value of the dollar should be established at a level, depending on economic circumstances, not less than the weighted average of the marginal costs of production, measured in dol3,000

lar terms, such that the level of wages would not fall. . . . This methodology is grounded by the fact that the value of the gold monetary system itselfafter 40 years of gold price suppression and inconvertible paper currencies should be restored to a proportional level in the hierarchy of prices and wages such that the level of nominal wages does not fall. Lehrman, financially disinterested in the gold trade, may not feel the pain of his partner and confrere, who does, indeed, own bullion and mining shares. Speaking for the goldbugs, the editor of Grants admits he wouldnt mind seeing the gold price spike to $10,000 an ounce. Speaking, however, as a prospective monetary statesman, he anticipates no such leap. More likely, should America actually choose convertibility, there would be a conversion rate of between $2,000 and $3,000 an ounce. At $2,500, to pick a statesman-like compromise, the official American gold stock of 261.5 million (unaudited) ounces would command a dollar value of $653.7 billion, a number equivalent to 29% of M-1 (currency and checking deposits) and 25% of the adjusted monetary base (currency and bank reserves). Britain, the de facto manager of the classical gold standard in its 19th-century heyday, made do with a much thinner reserve. Cover alone, however, does not close the discussion. The proper conversion rate is one that answers another need.
3,000

Not printing but mining

worldwide production and trend growth in long-term gold production

2,500 production trend growth

2,500

2,000 in metric tons

2,000 in metric tons

1,500

1,500

1,000

1,000

500

500

1900

1920

1940

1960

1980

2000 2009

source: U.S. Geological Survey

BLOOMBERG EDITION
GRANTS/JANUARY 27, 2012

S&P 500 index level

It must be high enough to provide the operational headway needed to encourage the mining industry and other productive enterprises. As things stand, the mining business looks well encouraged. Among the 17 constituent companies in the NYSE Arca Gold Bugs Index, operating margins in the third quarter of 2011 range from as little as 14.4% for Harmony, a high-cost South African producer, to more than 50% for the lower-cost North Americans. However, the outpouring of dollars, euros, pounds, renminbi, etc. has had its predictable effect on gold-mining costs. From 2005 to date, according to Gold Fields and a J.P. Morgan study of an eight-company sample, costs have climbed at a 23% compound annual rate. At that speed, they would almost double in three years. All-in costs of producing an ounce of gold, according to the same sources, today stand at $1,371 an ounce. All together, a conversion rate on the order of $2,500 an ounce seems well within the realm of possibility. It will be askedwe put the question to our colleaguewhether it is enough simply to avoid deflation in setting a gold conversion rate. Is there not a symmetrical risk of inflation by setting too low a conversion rate? Not at all, Lehrman replies, as it has been proven throughout monetary history. Under a gold standard, there is no such thing as inflation. When people mine gold for the monetary standard, and monetize it in exchange for currency or demand deposits with which to make investments, yes, the relative price of gold might have risen. But that is different from inflation where no real good has been produced in the zero-cost marginal production of money arbitrarily created by the Federal Reserve or any other central bank. Its a different process . . . its a different kind of price-level movement. Its a movement of relative prices of real goods, he winds up. Its not a demand being made by fictitious money issued by a central bank for goods and services which have not yet been supplied.

development company. Ordinary mortals must steel themselves. Bullish for the long run, though no promises for the short run, was our call in 2009, and so it remains today: Eat an apple every day, and youll likely be around for the payoff. Ruefully but hopefully, we return to Tejon, owner of the largest private tract of land in the Golden State, 270,000 acres situated 60 miles north of Los Angeles and 15 miles east of Bakersfield. Tejon raises wine grapes, almonds, pistachios, wheat and alfalfa, along with energy, truck stops, warehousesand lawsuits. Thwarted in the courts, Tejon missed the great real-estate levitation of the early 2000s. Still vexed by the environmental lobbies, the company could yet miss the next up cycle, the starting date of which has yet to be announced (though to judge by the action in homebuilding stocks, someone must think its already here). If beautiful vistas were monetizable, Tejon might be in the S&P 500 already. If well-conceived plans and managerial persistence were monetizable, ditto. But the owner of these wide-open spaces and the steadfast author of these winning architectural renderings is a case study in delayed gratification. At $26.80 a share, Tejon common is quoted just about where it was a dozen years ago. There is no sellside coverage and, as far as that goes, no dividend. Virtually no debt, either. In the fullness of time, Tejon Ranch anticipates the construction of a pair
1,700

of upscale residential communities, Centennial and Tejon Mountain Village, as well as continued growth in an existing 1,450-acre industrial park. The question, especially with respect to the first named projects, is when. On paper, Tejon Mountain Village comprises golf courses, riding trails, retail space, 750 hotel rooms and up to 3,450 residences, all set on 26,000 acres of rolling ranchland (of which 5,000 would be disturbable for building). But on paper it remains. For one thing, there are environmental hoops. The Center for Biological Diversity is challenging the California Environmental Quality Act review of the impact report for Tejon Mountain Village. And, the U.S. Fish and Wildlife Service is expected to say yea or nay, perhaps within the next year, to a Tejon Mountain Village Habitat Conservation Plan. For another thing, the economy is punk. Pending the return of prosperity, say Tejon and its development partner, DMB Associates, the project will remain on ice. Centennial, to consist of 6,000 buildable acres set on a total of 12,000 acres, is still more of a gleam in the corporate eye. In 2002, Tejon filed a plan with Los Angeles County to build a masterplanned community 30 miles north of Valencia; there would be as many as 23,000 residences. Ten years on, there are none, as the project remains stuck in the formative stages of permitting. Groundwater is the issue in dispute. Tejon Ranch has a market capitalization of $536 million. No doubt, the
$65

Twelve years of nothing

S&P 500 index (left scale) vs. Tejon Ranch share price (right scale)
S&P 500: 1,314.65 1,312.82

1,500

55

TRC share price

1,300

45

1,100

35

Not fast money

Saints, proverbially long on patience, are exactly suited to the pace of progress at Tejon Ranch (TRC on the Big Board), the California real-estate

900 TRC: $26.80

25

700

9/99

9/01

9/03

9/05

9/07

9/09

1/24/12

15

source: The Bloomberg

10 GRANTS/JANUARY 27, 2012

BLOOMBERG EDITION

projected but unbuilt residential and resort communities command some significant monetary value. Then again, time is money, even when the funds rate is stuck at zero. Concerning Tejon Mountain Village and Centennial, Robert Stine, Tejons president and CEO, tells colleague David Peligal, there is at least a year of infrastructure construction that would need to be going on before youd have a lot to sell or a block of lots to present to a builder. The decision to pull the triggerto begin with the infrastructure, such as roads and utilities, and for everything to get under wayis a year before youd have any product available for sale. For the moment, its certainly not going to be in 2012. And 2013, well have to wait and see. Take Centennial alone, Peligal goes on. Last week came news that CalPERS is selling a portfolio of 28 housing communities, including 16,300 home sites and thousands of acres of land in 11 states, of between $500 million and $600 million. This would value each home site (only the site) at about $35,000 a lot. Clearly, Centennial would be worth more than $35,000 per. But there are, as yet, no finished lotsindeed, no permits to proceed with the creation of unfinished lots. One can imagine the sequence of events by which Centennial, and Tejon Mountain Village, too, would go from corporate dream to reality. But one must imagine. We believe that the development value for both Tejon Mountain Village and Centen-

nial, on a net present value basis, is worth considerably more than the current market value of the stock, attests one holder. So does Grants, underscoring the verb believe. The third leg of the value stool, Peligal proceeds, is Tejon Ranch Commerce Center, a very fancy name for an industrial park situated at the junction of Interstate 5 and Highway 99, smack dab in the middle of California. From this location, you can reach 97% of the customers in California in a single-day truck turn. If youre trying to cover northern and southern California and any of the 11 Western states, youd be hard pressed to find a better location. Theres nothing hypothetical about the Tejon industrial park: IKEA, Famous Footwear, In-N-Out Burger (a personal favorite) and Tejons own truck stop, branded the Petro and TA Travel Center, are among the tenants. On Nov. 7 came news that Caterpillar was purchasing 46 acres within the industrial park to build a 400,000-square-foot distribution facility. And just this month, Dollar General Corp. became a lessor of 439,000 square feet in a warehouse owned by Tejon Ranch and Rockefeller Group Development Corp. By owning some of the buildings at Tejon Ranch Commerce Center, says Stine, referring to the industrial park by its full-dress name, over the long run we want to generate a cash flow and an income stream from the income-producing real estate. In both of the big travel centerswhich is a

(in $ thousands, except per-share data)

12 mos. to 9/30/2011 12/31/10
$36,553 6,270 541 4,175 $0.22 288,091 290 276,652

Tejon Ranch Co.

Total oper. revenues $55,545 Income (loss) from ops. before joint ventures 14,158 464 Equity in j.v. earnings Net inc. (loss) to common 9,463 Net inc. (loss) per share, dil. $0.46 Total assets Long-term debt Equity Price per share Shares outs. (millions) Market cap Price/earnings

12/31/09
$29,936 (6,161) 374 (3,377) $(0.19) 234,744 325 214,381

12/31/08
$42,639 3,929 2,227 4,112 $0.23 187,072 358 173,306

12/31/07
$35,908 920 10,580 7,333 0.42 175,503 389 165,054

311,696 262 295,272 $26.80 20.0 536.0 58.3x

nice word for the truck stops that we ownwe generate very nice cash flow out of our 60% ownership of both of those operations, and, again, it diversifies our revenue sources. A glance at the table shows the growth in revenues as well as the irregularity of the occurrence in income. The jiggly net profits line looks as if it had drunk one too many lattes. You can understand the absence of analyst coverage. Theres no predicting what the next year, never mind quarter, might serve up. Besides, Tejon Ranch issues no debt. It raises such capital as it needs through rights offerings. It carries its land on the balance sheet at 1936 values. It holds no conference calls. Clearly, Peligal continues, the lions share of the value in Tejon Ranch is going to come from Tejon Mountain Village, Centennial and the industrial park. But there are many other pieces to the puzzle. In fact, it is largely the variety of those pieces, and the potential for finding a winning lottery ticket among them, that makes the investment story so interesting. All in all, relates the chief financial officer, Allen Lyda, including our land and off of our land, we probably have at least 70,000 acres, plus or minus, of oil royalty rights. We own those mineral rights. . . . In general, adds Stine, the company has been in no rush to sell any of its mineral rights, which is why in some cases land that, over the last 20 to 30 years, the company once owned but sold for various reasons, weve retained all the mineral rights. This is why we still get revenues on land that we literally dont own the fee title to. Its no secret, adds Peligal, that Occidental Petroleum, the biggest onshore oil producer in the continental United States, wants to increase its production in Californiathe companys Elk Hills and Buena Vista oil fields are situated less than 25 miles from Tejon property. One can assume that OXY is carefully monitoring what is happening in its own backyard. And it is a fact that the company has drilled four new wells on Tejon acreage. The Tejon Ranch portfolio is a bag of possibilities. It includes a powerplant lease; a corporate acquaintance with the newly recognized Tejon Indian Tribe of California, which is said to be weighing its options to enter

BLOOMBERG EDITION
GRANTS/JANUARY 27, 2012

11

the casino business; the sale of hunting rights, a business temporarily suspended after an investigation disclosed the illegal taking of mountain lions (Stine issued a profuse apology); limestone mining; and farming. On a back-of-the-envelope guess, we reckon the farmland alone might be worth $75 million. Last but not least in the enumeration of the assets and the excellences of Tejon Ranch is the managements clear-eyed philosophy of finance. Knowing that excess debt is often the death of many companies, especially those that are land-based, Stine wrote to the shareholders in 2010, we were, and are still, committed to maintaining a healthy balance sheet to ensure that the value we build for shareholders is real and enduring. As for the shareholders, given the slow rate of realization of the companys undoubted value, the longer they endure, the better.

Above its weight

Singing the song of Graham and Dodd, the portfolio managers of the Africa Opportunity Fund, Francis Daniels and Robert Knapp, had this message to their shareholders at the end of a morethan-respectable year: We remain focused on investing, at historically low valuations, in companies with minimal debt that sell goods and services in short supply. Now begins an admiring review of a tiny enterprise. Listed in London, the Africa Opportunity Fund (AOF) had, at year-end, 42.6 million shares outstanding, net assets of $39.7 million and a market capitalization of $31.3 million. In a not-great year for investing anywhere, NAV increased by 1.6%, including dividends. The share price fell by 10.4%. At Tuesdays closing price, the discount to year-end NAV stood at 19%. Attendees at the fall 2010 Grants Conference will remember Daniels mentioning Shoprite Holdings Ltd., the largest, fastest-moving consumer goods retailer in Africa, as he put it (Grants, Oct. 29, 2010). In 2011, Lusaka (Zambia)-listed Shoprite, his biggest position, was up by a cool 79%. As for 2012, Daniels says hes bullish on Africa and bearishhes a fully paid-up subscriberon central banks

and the Peoples Republic of China. A big difference between value investing in a continental market like the United States and value investing among 53 countries is [that] I have to think a lot about currency, Daniels said, speaking on the phone from Johannesburg. Its not just that there are 53 countries, its that in a lot of countries the economies are very dependent on a few commodities. Or theyre countries which have very little manufacturing and import a lot, and therefore a sharp devaluation of the currency has a dramatic impact on the cost of living. Working both top-down and bottomup, Daniels picks companies, countries, currencies and industries. He can go long or short, invest in debt or equity, buy listed and unlisted securities and enter into arbitrage operations. As hard as it is to navigate the monetary and macroeconomic rocks and shoals, there are benefits to investing where others mainly choose not to commit, he went on: If one asks, Is there a place on earth where the writ of the central bankers does not run or runs with faint ink? the answer has to be yes, in many an African country. If a country like Zimbabwe does not have its own currency and lacks a currency board like Hong Kong, there is no writ to ponder. If a country like Cote dIvoire, recovering from civil war, closes its banks for a few months, there is too little money for the monetary transmission mechanism to function in a classical manner. Fur-

thermore, unlike east Asian economies, African countries tend to have modest foreign-exchange reserve levels, limiting the capacity of central banks to intervene against market forces. In the absence of money printing, capital tends to be scarce, Daniels pointed out; so much the better for people with capital. Asked for a favorite name, he mentioned Okomu Oil (OKOMUOIL on the Lagos Stock Exchange), a developer of palm-oil plantations and processor of palm oil, a commodity about which Grants cant seem to stop writing (see the prior issue). On the one hand, Okomu is tiny and illiquid (a $71.9 million market cap with a 50.4% majority stake held by Indufina SA of Belgium). On the other hand, the stock is valued at 3.8 times earnings. If you happen to look at its report, said Daniels, youll find that its net margins are close to 40%. In fact, I commented to some friends of mine that it has the kind of metrics that youd associate more with an Apple. In sum, wrote Daniels in a followup e-mail message, there are quite a few profitable companies valued as if they had reached U.S. levels of maturity, that [in fact] have several years of growth ahead of them. They have large market shares, high returns on assets and equity, little to no debt and trade at P/Es of 12 or less. I have to worry about currency collapses, the euro, elections, droughts and floods, but there is more than adequate compensation.

7 6 earnings per share in Nigerian naira full-year EPS* share price 5 4 3 2 1 0

45 40 price per share in Nigerian naira 35 30 25 20 15 10

Picture of value
Okomu Oil share price (left scale) vs. earnings per share (right scale

1/5/07

1/4/08

1/2/09

1/1/10

1/7/11

1/20/12

*analyst estimate for 2011 source: The Bloomberg

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