Oil, The New Reserve Currency

Oil, The New Reserve Currency
By Chris Mayer

I borrowed the title of today's column from Robert Friend,
the successful international investor at Recon Capital. At
last week's Grant's Investment Conference, Friend used this
title to provide a context for his bullish remarks about
oil and oil stocks.

He's a big fan of the integrated oil stocks, especially
Marathon Oil, because they are still valued as if oil were
trading for $40 a barrel. But if, as Friend believes, oil
deserves to trade near $60, the stocks of most integrated
oil companies offer great bargains.

Friend is also bullish on Brazil, both its stocks and its
currency. [If you harbor a soft spot for Brazilian
investments, you might want to check out the October 11,
2004 column from our archives entitled, "The Caipirinha
Connection"] Brazil's currency, the real, has appreciated
over the last several months, crushing the "hard"
currencies of Canada and Australia, as well as trouncing
the British pound and Euro.

Vale do Rio Doce (NYSE:RIO) is Friend's favorite investment
in the country that introduced the Samba and the g-string
to the rest of the world. "Vale" is the largest iron
producer in the world and maintains vast reserves of iron
ore, bauxite, copper/gold, kaolin, manganese, nickel and
potash. It is also the largest logistics and transport
company in Brazil.

Paying Homage to the "Barbarous Relic"

Like Friend, John Hathaway, manager of the Tocqueville Gold
Fund, advocated investing in the resource
sector...particularly in gold.

He launched into his presentation by displaying the image
of the Zimbabwe dollar. In 1999, about six Zimbabwe dollars
were worth one U.S. greenback. Today, it would take 50,000
Zimbabwe dollars to buy one U.S. dollar.

The U.S. is not Zimbabwe, of course, and Hathaway in no way
meant to imply that it was. But he did mean to imply that
the endgame for the U.S. dollar might closely resemble that
of its Zimbabwean counterpart. The greenback is a dying
currency, says Hathaway, which loses a little more of its
value with each passing year.

All paper currencies, Hathaway asserts, succumb to "a
process of monetary elimination." That's why gold continues
to excel throughout the ages...and that's also why Hathaway
believes gold is on the verge of a major new bull market.

The Federal Reserve...Gold's Best Friend

James Grant, the conference host and keynote speaker,
presented a talk entitled "Man's Inner Bubble," which, he
pointed out, had nothing to do with gastrointestinal
functions.

In the span of forty very entertaining and amusing minutes,
Grant argued that easy credit fuels EVERY U.S. asset
bubble, and that the Federal Reserve is the original source
of all easy credit. Therefore, the world might be much
better off without the Federal Reserve...or a Federal
Reserve Chairman.

Grant pointed out that before the creation of the Federal
Reserve in 1913, prices "sometimes sagged." Throughout the
19th century, therefore, prices tended to drift lower – as
productivity gains and innovation drove the cost of living
down. Post-1913, however, the Federal Reserve has presided
over the continuous depreciation of the U.S. dollar.

The appointment of Ben "Helicopter-drop" Bernanke as the
new Fed Chief will likely accelerate this trend. In fact,
any Fed Chief who thinks that the Federal Reserve is an
inflation-fighter ought to be lashed to a mast and forced
to stare at the following chart until his eyeballs burn
with memory of it.


The key difference between the pre-Federal Reserve American
economy of the 19th century and the post-1913 variety is
that the pre-fed dollar derived its value from a strict
connection to gold. Indeed, many dollars were actually
minted in gold itself. Such a tether limited the production
of new dollars and served to contain inflation...But the
last remaining tether to monetary responsibility snapped in
1971, when President Nixon eliminated any connection
whatsoever between dollars and gold.

To help the audience appreciate the dubious benefit of the
Federal Reserve's stewardship, Grant presented a snapshot
of life circa 1890, compared to today. First, there were
some stark differences. Inflation was a negative 1.2% in
1890. The population of the country was 62 million. The
Federal Government was in surplus. There were 25
professional baseball teams, spread over 3 leagues.
Railroad stocks dominated the Dow Jones Industrial Average
(with 10 of the 12 stocks).

But, there were also some remarkable, and ominous,
similarities.

Interest rates were low. High-grade bonds yielded only
3.68% and the savings rate was 4%. Investors, groping for
yield, took bigger risks causing a boom in speculative
Western securities.

Grant shared some quotes from Hallie Farmer (published in
1924), in a report published in the Mississippi Valley
Historical Review. Credit was easy and lending standards
were loose. "Competition existed not between borrowers but
between lenders," Farmer notes.

This created a boon for debtors. An example from Farmer:
"All the [rail] roads offered lands at low prices and one
easy terms...The Union Pacific offered eleven years'
credit. One-tenth of the purchase price was to be paid at
the time of sale; deferred payments bore interest charges
at 6%, but for the first three years the purchaser was
required to pay interest only."

Sound familiar? It's not so far removed from the
unconventional mortgages we see in our mortgage bubble
today. There was a boom in housing then as well, with the
total mortgages outstanding nearly tripling from 1880 to
1890.

In the 1890s, too, they had their share of securities
fraud. Grant related how the bonds of Capitola township in
Dakota were sold to Eastern investors and changed hands
many times before it was discovered that no such township
existed.

Farmer's diagnosis of 1890 applies today. "The prosperity
of the period was a prosperity based upon credit," he
wrote.

Today's prosperity is no different, says Grant. Easy credit
fueled the stock market bubble, the housing bubble and
every other bubble – great and small – that the Greenspan
Fed has nurtured. And presumably, as America's bubble
economy deflates, the dollar's value will suffer...despite
the very best efforts of the Federal Reserve and its new
"inflation-fighting" chairman.

But let's not forget that bad news for the buck is gold
news for the gold price and the oil price and for the price
of every other hard asset. Make way for the "new reserve
currencies."

Intrinsic value: The right price to pay

A great company at a fair price'
Nobody really knows the specific principles that Warren Buffett applies when deciding the price he will pay for a share investment. We do know that he has said on several occasions that it is better to buy a 'great company at a fair price than a fair company at a great price'.
This tends to agree with the view of Benjamin Graham who often referred to primary and secondary stocks. He believed that, although paying too high a price for any stock was foolish, the risk was higher when the stock was of secondary grade.
Patience
The other thing that Warren Buffett counsels, when deciding on investment purchases, is patience. He has said that he is prepared to wait forever to buy a stock at the right price.
There is a seeming disparity of views between Graham and Buffett on diversification. Benjamin Graham was a firm believer, even in relation to stock purchases at bargain prices, in spreading the risk over a number of share investments. Warren Buffett, on the other hand, appears to take a different view: concentrate on just a few stocks.

What Warren Buffett says about diversification

In 1992, Buffett said that his investment strategy did not rely upon spreading his risk over a large number of stocks; he preferred to have his investments in a limited number of companies.
'Many pundits would therefore say the [this] strategy must be riskier than that employed by more conventional investors. We disagree. We believe that a policy of portfolio concentration may well decrease risk if it raises, as it should, both the intensity with which an investor thinks about a business and the comfort-level he must feel with its economic characteristics before buying into it.'

No real difference between Benjamin Graham and Warren Buffett

The differences between Graham and Buffett on stock diversification are perhaps not as wide as they might seem. Graham spoke of diversification primarily in relation to second grade stocks and it is arguable that the Buffett approach to stock selection results in the purchase of quality stocks only.

Berkshire Hathaway holdings

In addition, consideration of Berkshire Hathaway holdings in 2002 suggests that although Buffett may not necessarily believe in diversification in the number of companies that it owns, its investments certainly cross a broad spectrum of industry areas. They include:
Manufacturing and distribution – underwear, children's clothing, farm equipment, shoes, razor blades, soft drinks;
Retail – furniture, kitchenware
Insurance
Financial and accounting products and services
Flight operations
Gas pipelines
Real estate brokerage
Construction related industries
Media

Intrinsic value

Both Warren Buffett and Benjamin Graham talk about the intrinsic value of a business, or a share in it. That is, to buy a business, or a share in it, at a fair price. But, having regard to the possibility of error in calculating intrinsic value, the careful of investor should provide a margin of error by only buying the business, or shares, at a substantial discount to the intrinsic value.
Buffett is said to look for a 25 per cent discount, but who really knows?
Defining intrinsic value
Buffett's concept, in looking at intrinsic value, is that it values what can be taken out of the business. He has quoted investment guru John Burr Williams who defined value like this:
'The value of any stock, bond or business today is determined by the cash inflows and outflows – discounted at an appropriate interest rate – that can be expected to occur during the remaining life of the asset.' – The Theory of Investment Value.
The difference for Buffett in calculating the value of bonds and shares is that the investor knows the eventual price of the bond when it matures but has to guess the price of the share at some future date.

Discounted Cash Flow (DCF)

This method of valuation is often referred to as the Discounted Cash Flow (DCF) valuation method, but, as Buffett has said in relation to shares, it is not easy to predict future cash flows and this is why he sticks to investment in companies that are consistent, well managed, and simple to understand. A company that is hard to understand or that changes frequently does not allow for easy prediction of future earnings and outgoings.
What Warren Buffett says about predicting future cash flows
In 1992, Warren Buffett said that:
'Leaving question of price aside, the best business to own is one that over an extended period can employ large amounts of capital at very high rates of return. The worst company to own is one that must, or will, do the opposite – that is, consistently employ ever-greater amounts of capital at very low rates of return.'
It is well worth reading Buffet's analogy relating DCF to a university education in his 1994 Letter to Shareholders.
So, it would seem that the intrinsic value of a share in a company relates to the DCF that can be expected from the investment. There are formulas for working out discounted cash flows and they can be complex but they give a result.

Explanations of DCF

The best explanation that we have read of DCF is by Lawrence A Cunningham in his outstanding book How to think like Benjamin Graham and invest like Warren Buffett.
A good online explanation is available here.
How Warren Buffet determines a fair price
The real secret of Warren Buffett is the methods that he uses, some of which are known from his remarks, and some of which are not, that allow him to predict cash flows with some probability.
Various books about Warren Buffett give their explanations as to how he calculates the price that he is prepared to pay for a share with the desired margin of safety.
Mary Buffett and David Clarke pose a series of tests, based on past growth rates, returns on equity, book value and government bond price averages.
Robert G Hagstrom Jnr in The Warren Buffet Way gives explanatory tables of past Berkshire Hathaway purchases using a DCF model and owner earnings.
Ultimately, the investor must decide upon their own methods of arriving at the intrinsic value of a share and the margin of error that they want for themselves.

Tata chemicals is poised for move

The diagram is self explanatory, check on the move of this stok.

regards,

RP