Sunday, December 03, 2006

The Big Picture for Investors

One of the people that has had a major influence on my thinking about the economy, the market and portfolio strategy over the past few years is Don Coxe. Don is Chairman of Harris Investment Management and is responsible for Global Portfolio Strategy at BMO Capital Markets. I began following Don's work shortly after I discovered the world of base metals towards the end of 2002. Since that time, I have enjoyed listening to his weekly conference calls and reading his monthly publications of Basic Points.

I did not intend to become the unofficial transcriber of the conference calls, but backed into it first by trying to take detailed notes which then morphed into a full-blown transcription. I now have a colleague that shares the effort, but it is still a time-consuming undertaking. I have pasted the most recent call below. He's not brief in his comments, but I find it is usually worth the effort. What I find particularly valuable about Don's work is that he always applies his broad and deep insights to actionable recommendations. Enjoy...

Nesbitt Burns Institutional Client Conference Call for December 1, 2006

Don Coxe

December 1st, 2006

“Endangered Species”

Thank you all for tuning into the call which comes to you not from India but from Chicago. And, yes, I had a spectacular experience in the intervening month since we’ve communicated with each other. That will be all unfolding in the December issue of Basic Points, but what we want to talk about today, focus on the big acquisition that has been made while we were away, which was the agreement for Phelps Dodge to be acquired by Freeport. And the chart that we faxed out was Phelps Dodge and our tag line was “Endangered Species”.

So, what we want to do is reiterate, I think, the importance of the thesis we’ve had for the last few years, which is, that what the mining industry in this cycle will not be doing is anything like what it did in previous cycles and therefore that the fundamental valuation of these stocks continue to be out of whack and that the people who best understand that are other mining companies. And so what we have though is a situation where there just are not going to be many of them left.

Assuming this acquisition goes through, and there’s been rumors that either BHP or Rio Tinto or even Anglo American might come in and top the bid, but if we assume that’s not the case, then what we’ll have is there’ll be only one metal mining stock left in the S&P, which will be Freeport McMoran. And meanwhile, of course, in Canada, the two biggest metal mining stocks have been taken off the market, Inco and Falconbridge. And so that what we have is a situation in which if you have the kind of bullish attitude toward the base metal industry that we have been espousing for all this time, the range of options to you keep shrinking.

So on the one hand of course, we are pleased when the company who is left standing, which has the most conspicuously dubious management is being acquired, that Phelps Dodge, who managed to blow about a billion dollars of the stockholders money in betting against the price of copper going up and then proceeded to shock the market by joining in in a bid to acquire both Inco and Falconbridge based on the assumption that metals prices are going to stay high for years.

So, that, plus the fact that the company is committing to spending what they say is a billion dollars in developing a gigantic copper ore body in the Congo. And Freeport has said that their experience in operating mines in Indonesia, fits them for managing a mine in the Congo. What I think the truth of the matter is, is that the value of unhedged reserves in the ground in Arizona and in Chile that Phelps Dodge has, plus the fact that they’re buying it at about six times earnings, means that they can ignore this Congo operation entirely and still be buying it very very cheap.

But for those of you who have been listening to these calls faithfully over the years, then I assume that on the lines is a significant percentage of all the public stockholders in Phelps Dodge. And the question arises then, what do you do with the proceeds?

So now we look at the broader stock market and the US stock market which was on a tear is now suddenly starting to show signs of doubt about the US economy. Now we had these signs of doubt coming up from time to time in the last six months, but while I was away the stock market proceeded to put those aside. It also ignored the election outcome. Now this is the first election that I can recall in a long time where the Republicans getting clobbered by Democrats produced a rising stock market.

You can argue that that was the right outcome and certainly if there ever was a Congressional delegation that deserved to get a kick in the behind for its behavior it was the Congressional Republicans. But we’ve got a lot of stock market history that at least on a near-term basis that the investor class and that’s a group who gets polled in all the elections and that’s a group who owns ten thousand dollars or more of common stocks, the investor class has been second only to one subset of the population and that is those who go to church at least once a week, as being loyal Republicans.

And so, I haven’t seen how those who go to church once a week voted in the election because we were away for all of that, but it’s quite apparent that the investor class has become disenchanted and has assumed that the Democrats are going to be a cleansing force. And certainly on the evidence there’s nothing that you can argue hard with that proposition. But still, it was an interesting outcome that the stock market would be so strong after this.

Charles Rangel is going to be head of the Ways and Means Committee, and he is…you know he’s one of the old bulls of the Democratic Party. He’s always been one of my favorite Democrats because he’s such a colorful character. When they had the Democratic National Convention in Chicago ten years ago and he was being interviewed and he said “When I die, I want to be buried in Chicago so I can remain active in politics.” And that reflects the reality that the most conspicuously Democratic constituency in so many elections in Chicago, most notably the one in 1960, is a graveyard vote. But it’s good to have somebody who’s that candid about it. And he is a very attractive figure and you don’t stay in Washington as long as he has without learning how things are done.

So, I think in that sense, that the voters, the investors are probably doing the right thing in saying “Well, there will be lots of talk and so forth, but there’s not going to be anything radical done.” And so we look at the economy itself then. And we have been adopting, as you know, an attitude that the best way to play this is to be underweight US equities compared to global equities, particularly emerging markets and within equities to be way overweight the commodity stocks. But given that they are cyclicals, that what you do is you hedge, in a balanced portfolio, by owning long zero coupon bonds.

So that was the strategy that we’ve been annunciating over and over and over. And in looking at what happened while we were away, what seemed to happen was that you really didn’t need the hedge, but both sides of the hedge did very well, thank you. We’ve got a strong bond market and yet we also have a strong commodities market. And although the commodity stocks have fluctuated quite a bit, when I look at their prices, they’re pretty much where they were and they;’ve done reasonably well against the overall stock market.

So ordinarily with a hedge, you only expect to win on one side of it. So I don’t think that’s going to last. But what the currency markets are saying is that the US economy is going to be slow relative to other major industrial areas. If you take the latest figures out of the Euro zone, we have that rare experience where on a six month basis now, if you take their numbers and one assumes that they’ll get revised and massaged so one is cautious about taking them, the Euro zone has been growing faster than the US economy in that time. And since it has been more or less an article of faith that the Euro zone is a zone of stasis and the US is a dynamic and progressive area, that’s at least a blow to the American ego, but it’s also been reflected in the value of the American Dollar.

And the DX index, which is the one that’s measured against all of the major currencies is hovering near its long term support and if it breaks through that we’ve got a fairly high risk situation out there.

Now, what’s happened is the strength, though, has not been the Canadian Dollar. Because Canada is seen to have two arguments against it. One is that it’s a commodity currency and the other is that a third or so of Canadian GDP is exports to the US. So if you’re bet is that you want to get out of the weakening US economy at a time the Euro zone is as strong as its been relative to the US in many a year, you buy the Euro and then you can also buy the Yen. And the strength of the Yen is, I think, one reason why the US bond market has been so good. Because what that means is, at least at the margin, that The Great Symbiosis is intact.

Which is, that Japan and China will be buying Dollars. And although you never get the figures on these cash flows until well after the event, the fact that the Yen has moved up at the same time as the Ten Year Note has moved up, is the kind of related performance that we’ve seen a good part of the last few years. I’;ve been reading some of the markets commentary since I’ve been back and one of the thihngs they’re expressing is amazement that the US long bond market has done so well. The TLTs as I follow them are at a new high. And they’re saying “But gold is way up, so how can this be? If gold is up and the Dollar is down and the US economy is underperforming then why if the US Dollar is down, why would anybody be buying long US bonds?

So I think that the answer to that is first of all asset allocators within pure US Dollar portfolios, like the kind that Harris Investment Management manages and then more importantly though on a global basis what you have is that it still remains in Japan’s and China’s interest to cushion the fall of the Dollar. And although they keep talking about diversifying their currency exposure, insofar as their currencies are being managed strategically as opposed to maximizing profits in them, then they’ll be buying Dollars rather than Euros. And the Euro’s getting all the support it needs from genuine investors as opposed to those who have other skin in the game.

Well, anytime you’ve got a situation where oil is no longer looking like it’s going to touch fifty dollars and copper holding well above three dollars and zinc and other metals…nickel trading at all-time records, what you have is confirmation that the global economy, that is the economy outside the US, may well be stronger than people had thought and in which case what happens is that those people who had dumped the commodity stocks are going to be getting back in to them.

And now we come back to our theme. There are only a few names that large-cap investors can buy. There’s only been two base metal companies in the S&P ever since they took Inco out of it, when they created purely national S&Ps, when they became involved with Canada and Europe and so forth. So they kicked Inco out of the S&P, so that left Freeport and Phelps Dodge and we’re going to be down to Freeport.

Within the Canadian market, so few, and even when you start looking abroad, there’s been so much consolidation that for large-cap investors there are few options. And Freeport McMoran has the problem that, at least up until now, that their reserves were entirely in an area of the world that has political risk associated with it, namely Indonesia. Now they happen to be in a good island in Indonesia, from a political risk standpoint, but the central government is an unknown quantity and there’s allegations that they’ve been paying the cost of Indonesian troops to protect the mines and those things, I don’t know if those stories are true but you don’t operate what is the second biggest income generator for the Indonesian government, second only to Mobil’s natural gas operation, you don’t operate that in Indonesia without having a, shall we say, complex relationship with the people in Jakarta.

So, what Freeport is accomplishing here, and I think it’s a great acquisition for them, is that their total reserve picture now, will be balanced between areas of political risk. So if we assume that the United States and Chile are about as good as it gets in mining, so we assign those a Triple A status and then we put Indonesia in at a Double B Minus status and if we take the Congo in as Zed Plus status, then what we have overall is, you’ve got a company that’s going to have the largest copper reserves in the world outside the Chilean government’s Codelco and maybe as big as Codelco, with production on three continents, debt-free, that can be put on after the acquisition but that can be paid off in a hurry. So it’s going to be a core investment for global investors in looking at their bet on copper.

Now BHP is going to have Olympic Dam operating flat out which will mean that they will be a major factor, but since BHP has so many operations and with over a third of their revenues coming from oil and gas, it’s not a pure play.

Meanwhile, for Canadian investors, and for a lot of Canadians I’ve talked to, Phelps was their biggest foreign mine. Their attitude was, I don’t need to invest outside Canada to get exposure to the mining industry. Well, when Inco and Falconbridge get taken away, what that leaves you with is Teck Cominco, a wonderful company, but it’s very diversified and they didn’t get involved in the nickel mining operation despite their attempts. So they have a copper mine in BC, but it’s a short duration ore body. And beyond that, what they are is basically zinc and coal and they’re getting in to the oil sands, with gold it’s a fine portfolio, but it’s one…that’s the big-cap stock left in Canada. Beyond that then, you get in to middle and small-cap stocks and I’m no expert, but we’ve got lots of people who are. But it’s going to be difficult for major investors to put significant amounts of capital into the Lionore’s and FNX’s and Inmet Mining’s that are sort of left in the Canadian market.

Well it doesn't take much exposure to the third world to understand that the demands for commodities are going to continue to increase. So when you look at the market cap that's out there of the companies that are left standing in relation to the demand there is going to be over the next ten years for their products, we have what I still believe, and even more so believe, is the greatest mismatch between the value of the companies who have to find, develop and produce the metals that are needed and the demand out there from economies who absolutely have to have these metals.

So, my view then on endangered species, is that if you could have been in the St. Louis zoo in about 1908 if I remember, and suddenly realized that you had the last twelve passenger pigeons left alive, you'd have done everything you could to get them to breed. Instead they didn't think about that and they all died. So, here we have an industry that is absolutely necessary, that is crucial to the expansions that are going on in the dynamic economies of the world. Still crucial by the way - yes, admittedly because of the US housing situation, copper demand in this country is falling - but what we've got is a trivial market capitalization. And it can only get more intensified as a result of this merger.

So I counsel you that you should probably be thinking about it, those of you who have the Phelps or those of you who got out of the group entirely when Inco and Falconbridge were taken away, that you probably shouldn't be waiting too long to get that money redeployed within the group.

As far as the golds are concerned - and what we have always said was that you buy the golds for a matter of insurance - but there again what we're looking at is a factor of political risk. Glamis got taken out on the basis that they've got a big, big new mine in what has been deemed to be a political risk free country, Mexico. However, it's sad to report that all of a sudden Mexico is going from the absolutely safe area, to one where one has to ask a few questions.

And meanwhile in Latin America, we've got Hugo Chavez coming up for another ratification vote and one way or another he's going to be reconfirmed and he's going to be more of a problem than ever. And that leads us to the final group that we've talked about a lot and where there's been some news which was adverse - namely the oil sands stocks - because of the change in Canadian tax laws the second biggest market cap company of that group, the Canadian Oil Sands stock was hit and we'll be dealing more with that later I'm not in a position to comment on it now, but what this also illustrates is the endangered species concept. There are only a few oil sands stocks. And the news out of Russia, it gets even worse in terms of security.

So, as we come into this festive season where people are feeling positive about things, I think that it's a good time to take out the idea of the Sierra Club and the conservationists which say protect endangered species, but in this case you protect them in your own interest. That's it. Any questions?


Question 1 (Douglas Elmore): Good morning, Don and welcome back. We have, we’re told by Craig Miller, a lot of Southwestern Resources which is a gold, silver and base metals company with properties in Yunan province in China in our retail system. And I'm worried about China and Peru, as I think I should be, and I just wonder if you can comment on that 'cause he's warned us that China wants to limit the number of juniors operating in China and rather have large-cap companies, which could make this a takeover target possibly. The geology seems to be there. So that's the China story. And then as far as Peru goes, I keep massaging my concerns by thinking that the Bank of Nova Scotia’s big in South America and in Peru by its banks, but should I feel comfortable. I just wondered what your thoughts might be about mining in China

DC: Okay, well, we'll talk about Peru first. There was a big sigh of relief in the mining industry when the supposed good guy, Garcia, won the election. And his C.V. included being associated with something like 5,000% inflation when he had previously been in power, but he was supposedly somebody who had learned from his experience. What was interesting that within a couple of weeks the mining industry expressed its gratitude for being saved from a foam-flecked Chavista, by announcing a voluntary grant of 3/4 of a billion dollars for education and health in the provinces where they operate. This is an epiphany, indeed.

The people in the mining industry that I know are fine people but that they all of a sudden discovered their enthusiasm for making gifts of these proportions and that they're not doing it. They're not building the hospitals and they're not building the schools but it's going to the government which shall we say reduces somewhat the amount of sense of charity that you might have in this whole but it suggests that maybe there was some coercion subtle or otherwise. Now, if you assume that there was some sort of coercion and this becomes a form of danegeld and what we know about it is you never stop. Once you've paid the danegeld, you never get rid of the Dane. So Peru I think, has at least a big question mark over it.

China, I am not in a position to comment there. I am in a position to comment on the treatment of mining companies in India but that's not what you asked. I'm of the view that the Chinese like to either deal with situations where it's Chinese companies who control the assets or deal with very big companies that go into joint ventures and do all the work and put up the capital and Chinese companies get a free ride. And none of this suggests to me that a small-cap company can assume that it’s going to be able to maintain things all the way through to production and they're going to get all the required licenses. Let's just say that there is a risk factor there which is truly unquantifiable and that this is not, therefore, a complete alternative as an investment.

You know, when you invest in gold mines, the risks you have are that the US dollar will be strong, that we will have neither inflation nor deflation, that the global economy will be strong and that people won't feel they need insurance and that therefore that there will not be an enthusiasm for gold. So those are enough risks it seemed to me without getting involved in it, because of what you are talking about political risks. The people that I know that have been goldbugs forever, are people who have a hatred of politics and politicians which is truly visceral. And that's because they assume that the central bankers of the G7 are collectively set out along with the politicians to debase and debauch the major currencies.

Well, if you have that kind of attitude towards governments that are democratically elected and where there is a lot of ways of analyzing how things are done seems to me that it is sort of perverse to go out and be putting your money into an area where you are dependent on Chinese politicians and Chinese bureaucrats' good faith. So those are the concerns I would have. Thanks for the question.

Next question?

Question (Noel Loehmer): Don, hi. I've been wanting to ask you this question. My overall question is, what will the effect of a falling US dollar have on growth in emerging markets and demand for resources in emerging markets. The question revolves around, starting with Stephanie Pomboy's comment that the deteriorating US credit environment that she expects from a housing bust will send liquidity in retreat. And if the US economy slows and rates fall, the US dollar will fall and the question also revolves around the idea that many emerging markets have currencies linked to the US dollar. So if their currencies are not inflation…if the economies are not inflated by the value of the US dollar but in fact are deflated by a falling US dollar then will that slow down their economies and will that slow down world demand for resources

DC: Well. there's a lot of subtext to your question. Let me just take sort of an overall view that as a general rule that we've known back over the decades, a falling US dollar providing it doesn't set off a huge rise in inflation, is good for emerging markets because emerging markets have a disproportionate percentage of their foreign debt in dollars And so therefore what it does is it reduces their carrying costs or indeed it improves their balance sheets. And that a strong US dollar is fundamentally negative for emerging markets.

And if you look at what happened in the debt crises of the last 30 years, that's been a very good rule. That what causes when you have this rule of that an emerging market is one that you cannot emerge from in an emergency, all of those occurred at a time of a strengthening US dollar. So if we have a gentle slide in the US dollar that doesn't send the global inflation rate up, then that's actually, for emerging markets as overall asset class, is good news.

Now you may say "Well, wait a minute they are exporting one way or another to the US," well it depends then we've got to start talking about the specifics of each economy as to what kinds of products they send to the US, that sort of thing. It's very complex. But what we can say without any question is that a very strong US dollar fundamentally reduces the amount of global liquidity. Because the way you measure global liquidity is in dollar terms.

So therefore, you look at an emerging economy and you take the money supply growth measured in their own currency as to what percentage growth there's been. Well if their currency has strengthened against the dollar then dollar-adjusted liquidity has grown. And that's actually a good way to look at it because again I'm just frankly looking at India, what happens in this kind of environment is it makes it easier for them to acquire assets abroad. It makes it easier for their people to travel abroad. All sorts of good things happen.

So I would not be concerned, given the fact that overall global inflation, I mean you look at Brazil which is 3 to 3 1/2% I mean the idea of Brazilian inflation being at that level is almost supernatural. The overall picture in the world of inflation is reassuring leaving the obvious disaster areas like Zimbabwe out of the calculation. So, of the things to worry about with a falling US dollar, I think low on your list should be emerging markets. I think that in general you can say based on four decades of history, that that will be likely at least modestly stimulative to the economies and a net benefit. Thank you. Any other questions?

Question (Robert Rosetti): Hi, Don, how are you doing and welcome back. You just covered what I wanted to talk about so, thanks again.

DC: Very good. Any other questions?

Question (Stephen Ottridge): Just wanted to get back to you with your view on the Congo. I think that when you're rating it with a "Z" whatever, that's rather the old page one news of the past and I think that you've got to look at the page 16 news of them having had quite a successful election. I saw the BBC news coverage on it talking about it's an absolute miracle and then there was another piece in the province of Ituri some more rebels have given up there. I don't think you should have it rated that far down the scale.

DC: Well, thank you, Stephen. My attitude towards the Congo is based on having followed things in that country since 1961 and that there have been all sorts of times where people have said "This time they're going to get it right." And I hope that's the case but it's not the kind of thing where I would want to bet a serious amount of personal money on the fact that this time it will be stable. And if it is a miracle, then it is truly a miracle. But I'm not sure what price/earnings ratio one should have on the assumption that the miracles will continue and I hope it works out that way. And I wasn't trying to be deliberately scornful but it's been an ongoing tragedy ever since Patrice Lumumba took over from the Belgians. And so, all bad stories eventually come to an end. And maybe this is a good story and if so this will be the second best news to come out of Africa in the last 15 years. The first of course being what's happened in South Africa. Let's hope that's what it is, but my "Z" rating is based on four decades where all hopes ended up getting dashed.

SO: But isn't that rather like the Phelps Dodge management? Copper has always been down low so it will always be low into the future?

DC: Well, you've got a good argument and I hope you're right, okay? I guess that my basic bias is to…I think that my enthusiasm for these commodity stocks means by definition, that I'm saying that you should be willing to take on what the markets think is a significant amount of commodity price risk and invest in them. And that I think I can get some kind of handle on. The political risk is something where I try to stay away from it if I can.

Maybe we’re going to get forced in to it. If all these companies get bought up and there's nothing but the Congo’s and Zimbabwe’s to invest in, then we're going to have to get good at that. But at the moment at least what I'm saying is if we can stick to the rule of investing in unhedged reserves in the ground in politically secure areas of the world, if you can find the ways of doing that, then that's what you should do. And particularly if you only have to pay price/earnings ratios like 5 to 9 times earnings for it. If we can get to the stage where you're paying 30 times earnings for copper in Arizona and 3 times earnings for copper in the Congo, maybe that's the time to make your move. Thanks, Stephen. Any other questions?

Operator: There are no further questions, Mr Coxe.

DC: Thank you all for tuning in. We'll talk to you at the regular time next week.

Don Coxe profile from the BMO websites:

Donald G.M. Coxe is Chairman and Chief Strategist of Harris Investment Management, and Chairman of Jones Heward Investments. Mr. Coxe has 27 years experience in institutional investing, including a decade as CEO of a Canadian investment counseling firm and six years on Wall Street as a 'sell-side' portfolio strategist advising institutional investors. In addition, Mr. Coxe has experience with pension fund planning, including liability analysis, and tactical asset allocation. His educational background includes an undergraduate degree from the University of Toronto and a law degree from Osgoode Hall Law School. Don joined Harris in September, 1993.

Vocabulary Builder

Danegeld: The Danegeld was an English tribute raised to pay off Viking raiders (usually led by the Danish kings) to save the land from being ravaged by the raiders. The term has come to be used as a warning and a criticism of paying any coercive payment whether in money or kind.


Anonymous said...

Dear SlowLane,

thank you for the transcript. Great service. I was also a regular listener to Don until they made the broadcast "client only". I then tried to become a client, but unfortunately, being a non-canadian, non-US citizen, it didn't work.

You mention at the beginning of the transcript that you/other people have done comments/transcripts of the calls before. Could you drop me an e-mail with the link, please (



Anonymous said...

Dear SlowLane,

thank you for the transcript. Great service. I was also a regular listener to Don until they made the broadcast "client only". I then tried to become a client, but unfortunately, being a non-canadian, non-US citizen, it didn't work.

You mention at the beginning of the transcript that you/other people have done comments/transcripts of the calls before. Could you drop me an e-mail with the link, please (



Titan_of_Metals said...

Interesting presentation.

I liked the comment about how it's a bit perverse to be a gold bug and therefore dislike big government in the U.S. but then invest in companies operating in the proverbial "3rd world" or even China.