Agora Financial’s Rude Awakening

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Laguna Beach, California

• Gold tumbles again as investors get a breather in the stock market,
• A 20-fold jump in CDS prices…and what it does NOT mean,
• Potash: up 300% first time around…and here we go again…

Eric Fry, reporting from Laguna Beach, California…

All the technical charts and all the investor sentiment indicators agree: Gold is “overbought” and the stock market is “oversold.” Therefore, gold should tumble and stocks should rally…at least for a while.

And so it has come to pass…

During the last two trading days, gold slumped more than $40 an ounce, while the Dow Jones Industrial Average recovered 155 of the 7,000 points it has lost since October, 2007. Bravo for the gold-bears/stock bulls contingent! They finally notched a victory.

But what sort of victory did they achieve?

The gold-bears/stock-bulls contingent believes a major turning point is nigh. They believe their two days of success has produced a victory as pivotal as the Union Army’s at Gettysburg. But we suspect the gold-bear/stock-bulls have achieved a victory as pivotal as the Cheyenne’s at Little Big Horn.

The enemy has been stunned, but not defeated.

The forces that drove gold higher and stocks lower remain in control. So no investor should assume that the war is over. The underlying economic trends do not seem likely to change any time soon. The credit crisis does not study technical charts or read investor sentiment indicators. It does what it does. And what the credit crisis does best is destroy credit-based enterprises…and reward the buyers of non-credit-based assets like gold.

Despite all the devastation that has descended upon the financial markets, most investors still retain their confidence in “stocks for the long haul.” We would offer no argument; only a reminder: The long haul can be very long. As a case in point, Japan’s Nikkei Index is still 80% below the peak it achieved in 1989. Twenty years is a long time.

Your editors have no interest in promoting doom and gloom. But neither do they have an interest in promoting the idea that every dip in the stock market is a buying opportunity. We don’t believe that. For the record, even at 7,270, the Dow’s downside interests us more than its upside.

We confess; we run the risk of retaining our bearish views for too long. But we are still comfortable with that risk. Buying selective securities; yes. Buying the broad stock market; no.

Many stock market commentators are still beset by the “down from”syndrome. Stocks seem cheap because they are down from 14,000, not because they are absolutely cheap. They are cheap looking back, but they still might be VERY expensive looking forward.

In other news, the cost of buying a five-year credit default swap (CDS) to insure against the possible default of U.S. Treasury bonds reached 100 basis points for the first time yesterday. In English, the price of insuring $10,000,000 worth of Treasury bonds for five years now costs $100,000 –up from just $5,000 one year ago.

Your editors do not exactly know what the 20-fold jump in CDS prices means, but we are pretty sure we know what it does NOT mean. It does NOT mean that the U.S. government is becoming MORE credit-worthy.

As the nearby chart indicates, the price of insuring Treasury debt against default now costs more than the price of insuring the debt of almost any AA or A+ rated company in the country. In other words, the Treasury is not quite as AAA as it should be, according to the buyers of credit default swaps.

But fear not, CDS on Treasury debt remains well below the price of comparable CDS on Bulgarian, Argentinean and Latvian debt. Additionally, as your editor’s brother pointed out, the pricing of CDS on Treasury debt provides a perverse sort of optimism –the buyer of the CDS believes that the counter-party of the CDS would actually survive a default by the U.S. government. In other words, the buyers believe that the financial system is stronger than the government itself.

We aren’t convinced. The financial system has barely survived the bankruptcy of Lehman Bros. And as far as we can tell, the U.S. government is a slightly larger and more significant entity. So we are dubious that any financial institution would have the capacity to pay up if the U.S. government went belly up.

But for those investors who never buy CDS and who do not worry about the cost of insuring against a default by Uncle Sam, Chris Mayer has something to suggest. In today’s column, Chris examines a company that makes fertilizer. It is the sort of company that provides a product that is essential in both good times and bad. But that’s only one of the reasons Chris is a fan. Read on…

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Buy Fertilizer
By Chris Mayer

The last time I recommended a fertilizer stock to the subscribers of my investment letter, Capital & Crisis, we tripled our money in 33 months. I’m hoping for a repeat this time around.

The basic idea is simple: The demand for food is rising, and hence so is the demand for fertilizer, which is essential to crop production. As farmers work with ever-decreasing amounts of good arable land, the need to boost crop yields is paramount. Fertilizers are a key part of doing just that.

The two draught horses pulling fertilizer demand are growing populations and an increase in demand for meat. The latter has an exponential effect on the grain markets. For example, it takes about 7 pounds of grain to produce 1 pound of beef. The ratios are 4:1 for pork and 2:1 for poultry.

And as I pointed out last month, the credit crisis makes it more difficult for farmers to get credit to buy equipment, seed and fertilizers. The market, in response, killed the stock prices of the fertilizer producers – more than discounting a potential soft spring season in 2009. But what it sets up is a real boom in fertilizer pricing on the back half of 2009 as grain prices recover, the debt markets ease and the unfolding food crisis takes hold once again. All the while, global inventories of grain still dwell near record lows.

That’s the lay of the land in a big-picture sense. And that’s why I urged the subscribers of Capital & Crisis to buy the shares of Potash Corp. a few weeks back, when the stock was trading below $50 a share. Today, this blue chip fertilizer company sells for $80 a share, which means that it is not nearly as compelling a value. Nevertheless, even at the current quote, this is a stock that deserves at least an honorable mention.

Potash Corp. produces all three of main nutrients in the fertilizer world – nitrogen, phosphate and potash. This company has a particular abundance of potash, of which it is the largest producer in the world.

Of all the nutrients, potash is the most attractive from an investment point of view. It is the most supply constrained and it yields the richest profit margins. Good deposits of potash are rare. Only 12 countries produce it, but farmers the world over use potash to produce nearly everything.

There are no big new sources of supply coming online anytime soon. Potash also has the least amount of government involvement, thereby lowering political risk. Let’s take a look at this behemoth.

Potash Corp. of Saskatchewan (POT: NYSE) has large and low-cost operations primarily in Canada. As the name suggests, potash is the mainstay of its business. It’s also on a growth spurt, with plans to take production from 10 million tons to 18 million tons over the next five years to meet growing demand. Incredibly, Potash Corp.’s growth alone will make up more than half of world’s new potash supply over the next five years.

Supply is tight, and Potash Corp. has potash in spades. Its reserves are enormous and its mines have long lives – 60-80 years. This is why some call Potash Corp. the “Saudi Arabia of potash.” The costs to build assets comparable to Potash’s are flat-out massive. We can construct a bottoms-up net asset value based on these costs (“replacement value”). Here is a summary of estimated costs to build new capacity, excluding infrastructure costs outside your plant’s gates (i.e., rail, roads, ports, etc.).

• Potash – $1.4 billion per million tons

• Nitrogen – $1 billion per million tons

• Phosphate – $1.5 billion per million tons.

These estimates don’t account for time, either. It takes five to seven years to bring on a new potash mine. It takes three years for nitrogen and three to four years for phosphate. According to CEO William Doyle, project costs could easily top $2 billion on a one million ton potash facility, after infrastructure costs. The costs for competitors form a daunting moat – as does the scarcity of quality potash.

But before we assemble Potash Corp’s net asset value using these estimates, we also have to account for its investment portfolio. Potash Corp. has a number of interesting investments in other companies that make the stock even cheaper than it first appears.

The company owns interests in SQM, a Chilean potash producer (32%); Arab Potash Co. (28%); ICL, an Israeli fertilizer company (10%); and Sinofert of China (20%).

In a September presentation, management disclosed that these investments were worth $23 per share.

SQM is publicly traded. That makes it easy to update – not so for the others. But let’s assume that after the brutal months of October and November, Potash Corp’s portfolio of fertilizer-related investments is worth only $10 per share.

Now we can assemble a basic NAV estimate:

I believe my NAV is conservative on a number of fronts. For example, potash capacity will rapidly grow to 18 million tons, and I haven’t accounted for that. I’ve also been draconian with the investment portfolio, which may be worth twice the price. In any event, I think $100 per share is a conservative rough estimate of NAV.

Excluding this kind of analysis, Potash Corp. also trades at historic lows on earnings and cash flow. It should generate at least $12 per share in earnings this year. At $80 per share, the stock trades for only 7 times earnings. That gives you a lot of room for error.

Potash Corp. throws off gobs of cash flow. For the first nine months of this year, Potash Corp. generated in excess of $2 billion in free cash flow – after capital spending! Most of this free cash went toward repurchasing stock. And the business is not capital-intensive. Management says the business needs only $260 million per year to sustain it. What Potash Corp. spends above this is for growth and is discretionary.

Besides, don’t discount Potash Corp.’s growth potential. In five years, with its expansion plans, the company could earn $25 billion in gross profit in a single year. The whole market cap is only $18 billion today. It could be a five-bagger over that time.

Your biggest risk is if fertilizer prices collapse, in particular the price for potash. One big indicator will be what Chinese buyers pay in spring 2009. But the share price already more than discounts the possibility of a dramatic fall in prices, which seems small given the broader trends I’ve outlined.

Right now, the shares seem quite cheap. “If you think about where our share price is today, we are priced for global depression, not just recession,” President Bill Doyle said in the latest conference call. “It’s as though…people around the world are going to eat bark off of trees. We don’t think that’s the case.”

I’m inclined to agree. Potash is exactly the kind of stock you should be buying now. There is a lot of short-term fear of the credit crisis. But the long-term story that underpins this investment is rock solid. And the company itself owns best-in-class assets.

Joel’s Note: We’ll keep this note short and simple. Chris recommended Potash at $62 in December. It now trades above $80. During that time, the broader markets are down between 10-14%. In other words, you don’t have to spend your time rearranging the deckchairs on the Titanic. There ARE great stocks with plenty of upside out there. To get on board with Chris’premium Capital & Crisis newsletter (1-year subscription less than the price of a half-decent steak dinner) follow this report through to the sign up page at the end.

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[Rude Endnote: The Dow dropped another 80 points yesterday to close at 7,270. Er…it’s better than a number beginning with “6”…if that’s at all consoling.

Over in Asia, Japan’s Nikkei 225 barely budged overnight while Hong Kong’s Hang Seng dipped just over 0.8%. Heavy selling in China pushed most indexes there down between 3-5%, including the CSI 300 measure, which ended the session 4.9% in the red.

Back in Europe, most markets are trading slightly higher. London’s FTSE is up almost 1.5% as we write. France’s CAC and Germany’s DAX are 1.57% and 2.25% higher respectively.

In the commodity pits, oil is up slightly and hangs on around $43.35 per barrel. Your gold stash sells this morning for $941 an ounce, down $11 overnight.

Good luck out there. We’ll see you tomorrow.

Until then…

Cheers,

Joel Bowman

The Rude Awakening
aussiejoel@the-rude-awakening.com