Agora Financial’s Rude Awakening

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Baltimore, Maryland

• A profitable market distortion for the intrepid investor,
• Portfolio protection against the gradual creep of inflation,
• French lovers, German police, Swiss organizers and plenty more…

Eric Fry, reporting from Laguna Beach, California…

You’ve probably all heard that old joke about heaven and hell:

In heaven; the police are British, the chefs are French, the mechanics are German, your lover is Italian and it’s all organized by the Swiss.

In hell; the police are German, the chefs are British, the mechanics are French, your lover is Swiss and it’s all organized by the Italians.

Alternative versions of this joke identify the chefs in heaven as Italian and the lovers as French.

Surprisingly, no version of this joke identifies the lovers in heaven as Swiss. Your editor, who is of Swiss heritage, would protest that stereotypes don’t always hold true. He is, for example, as disorganized as any Italian. On the other hand, he is probably no worse a lover than most Germans. But these are grievances he will address some other day.

Today, your editor’s mission is not to argue, but to praise…Specifically, to praise the French. As the preceding joke implies, the French excel at disciplines and art forms that delight the senses. By reputation, they are expert chefs; expert lovers; expert fashion designers; expert perfume creators; and expert winemakers.

If this flattering reputation is to be believed, the French are very good at doing almost anything. But now we learn that the French are also very good at doing nothing. In fact, they do nothing better than anyone. According to a new survey by UBS, they work fewer hours per capita than anyone else in the world.

“Once again, the French have blown away the competition,” observe Vincent Fernando and John Carney for Business Insider. “People work an average of 1,902 hours per year in the surveyed cities but they work much longer in Asian and Middle Eastern cities… People in Lyon and Paris, by contrast, spend the least amount of time at work according to the global comparison: 1,582 and 1,594 hours per year respectively…”

“Think about it,” Fernando and Carney reason, “Nationmaster ranks France as #18 in terms of GDP per capita, at $36,500 per person, yet France works much less than most developed nations. They achieve their high standard of living while working 16% less hours than the average world citizen…

The French produce $25.10 of GDP per capita per hour, Fernando and Carney calculate, While Americans only achieve $24.60 of GDP/Capita/Hour.

“Winning is not about working hard,” the Business Insider article concludes. “It’s about working smart… and less. As the French know well.”

When investing, working smart also tends to succeed better than working hard. And working smart is never more essential than when inflation rears its ugly head.

The hard-working investor can sometimes spend years trying to coax a respectable return from financial assets, only to discover that inflation erased some or all of the accumulated “gains.” The smart-working investor realizes that a successful long-term strategy must attempt to deliver returns greater than what inflation takes away.

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The Coming Takeover Boom
By Chris Mayer

“Work eight hours and sleep eight hours and make sure that they are not the same hours.”

– T. Boone Pickens

Inflation can do tricky things to markets. It creates distortions. In those distortions, an intrepid investor can find some big moneymaking ideas. I think we’ve got one opening up in oil and gas, and it is not without precedent in financial markets. In fact, it’s starting to look a little like the tail end of the 1970s in some respects.

In the spring of 1969, the Dow Jones industrial average stood at 969. By 1982, the Dow hit 1,071. That’s thirteen years of going nowhere. (We’ve had 10 years or so of going nowhere, though the ride between the poles has been anything but boring).

The problem is inflation makes that performance look better than it really was, like when a crooked judge makes a fight look close with a split decision even when the one fighter can barely walk to his corner and everybody in the building knows it was a rout.

Adjusted for inflation, or the weak dollar, the Dow was really more like 400. That makes it one of the worst stretches for the market since the 1930s.

The consumer price index, that flawed measure of inflation, doubled from 1960 to 1982. This is why a generation of people grew to believe that the best way to buy a house was to borrow all you could afford. And for a time, that looked brilliant. As Robert Sobel relates in a history of the period, a modest suburban home going for $30,000 in 1969 sold for $300,000 13 years later. With a lot of debt, your returns were much greater.

Of course, that kind of thinking eventually got us into a heap of trouble, as we now know.

But that period of time also had an effect on Corporate America’s balance sheets. When a company buys an asset, say a factory, it records its cost on its books. It will then depreciate this asset over time. So the value of the factory on its books will decline over time.

In a period of high inflation, its book value will be understated. The cost of a similar factory will be a lot higher in dollar terms, though the company will still show the old figure.

In other words, during periods of inflation, book values understate the true value of corporate assets. This happened in the 1960-82 period. Combine that phenomenon with a stagnant stock market and, eventually, you get some very cheap stocks. This is exactly what happened during the inflationary 1970s. Thus, by the early 1980s, stocks were quite cheap indeed.

In fact, by July 1984, S&P reported that 30% of the stocks on the NYSE traded below net tangible book value. The old value mavens like Ben Graham would have had a field day.

What happened next, though, is what interests us especially. The low stock prices kicked off a takeover boom. The 1980s takeover mania was the busiest since the “age of Morgan at the turn of the century,” Sobel reports in his The Age of Giant Corporations. The 1980s was the age of the LBO, Barbarians at the Gate, Michael Milken and the corporate raider.

The oil industry also had its takeover boom. In fact, the outlines of the 1980s oil and gas industry look similar to today’s. In 1970s, there was a drilling boom as people thought that oil and gas prices would rise indefinitely. That collapsed and then you had oil and gas companies sitting on huge reserves they built up during the boom.

So in a time when it cost $15 a barrel to get oil out the ground, many oil companies traded for $5 a barrel in proven reserves. Getty Oil traded for $72 per share, with assets of $250 per share. Marathon’s stock went for $68, even though each share had $210 in assets backing it up. And on and on it went.

Enter T. Boone Pickens. An Oklahoma-born geologist, Pickens was well aware of the value of these companies. He started going after them and making millions of dollars as bidding wars ensued. He lost several of these, but still cleared millions in profits.

There was a roll call of takeovers in the industry during this time — Shell bought Belridge Oil for $3.6 billion, DuPont bought Conoco for $7.4 billion and U.S. Steel took out Marathon for $6.5 billion. (Yes, U.S. Steel thought it would be smart to diversify). These were some of the bigger deals.

I won’t go too much into the history of this period, and perhaps I’ve already gone into too much detail. But I think something similar may be unfolding in today’s market.

In oil and gas, we have many companies trading cheaply in the wake of a drilling boom gone bust. What we need now is a T. Boone Pickens to shake things up.

When I look at some of my favorite oil and gas stocks, like Contango Oil & Gas (MCF:amex), I see stocks trading for far less than what it would cost you to find those reserves. If I were a natural gas producer, I’d look to pick up stocks like these, rather than drill new wells. At some point, I think that will happen and we’ll see lots of buyouts in the oil and gas sector.

Natural gas is very cheap right now, but it won’t always be the case. In a new research report by Tudor Pickering Holt & Co., a very good firm specializing in energy, $7.50 natural gas prices is forecast for next year! That’s pretty bold considering natural gas is under $3.00.

The firm bases this prediction on a comprehensive, bottoms-up model that takes into account rig count, decline rates on existing wells and other variables. According to Tudor Pickering, “The die is cast for 2010” — there is no way to get around a dramatic decline in natural gas production next year. And even assuming tepid demand for natural gas, we’re going to have a very different picture in natural gas next year.

After that, Tudor Pickering predicts the market will get full again by 2011. If it is right, we have a great window to make money between now and probably the middle of 2010 in natural gas.

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[Rude Endnote: European and Asian markets parted ways overnight after Wall Street declined slightly yesterday.

Here in Asia, China’s CSI 300 added half a percent after positive manufacturing figures were released for the month of August. Japan’s Nikkei 225 also finished higher, adding one third of a percent, while Hong Kong’s Hang Seng and the Aussie All Ordinaries climbed too, up 0.75% each by the close.

In Europe, markets were down slightly last we checked. London’s FTSE was the best of a bad bunch, down roughly 1% by lunch there, while Germany’s DAX and France’s CAC were lower by 1.45 and 1.75% respectively.

In the commodity pits, oil firmed on the China demand story. A barrel of the world’s goo goes this morning for seventy dollars and change. Gold was down about a buck for the day at $950 per ounce.

Check in again tomorrow for more.

Until then…

Cheers,

Joel Bowman

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