“I think we are getting close to what could be a major turning point in these markets and some major trend changes”

Michael: Jack Crooks is with Black Swan Capital one of the premier services talking about the movement of currencies and many other things that come from that.

The Canadian dollars at 103.70 and the Yen at center stage, the Euro at 142. I’m sort of long term bearish on the Euro and looking for an entry point to play that on the way down. There is so much money to be made because of the violence of the currency moves.

Jack: You’re exactly right and I think we are getting close to what could be a major turning point in these markets and some major trend changes. You know you pointed the Japanese Yen. I think that move’s already started. You may be seeing it starting in the Swiss Franc. And these could be major long term moves and there’s a lot of money to be made if you can hang on to a long term trend in this market, that’s for sure.

Michael: It’s also become so much easier to trade currencies. Jack, you’re a 24/7 guy with your people at Black Swan Capital looking at these markets, but with the advent of exchange traded funds it’s brought the currency movements right down to people who understand how to buy a stock. There are exchange traded funds for every major currency in the world and you can play them either up or down. Currencies affects our everyday life and Canadians are buying up the United States because the Canadian dollar is above par. It’s just made it so possible for anyone to all play these currency markets.

Jack: Absolutely, the fact that these exchange traded funds have developed means it in and of itself currencies becomes another asset class to play. When your macro analysis lines up you can sit in these things and ride these long trends, because currencies really more so than any other asset class get moving in a direction, and they get in these what’s called self reinforcing price trends. So you can hang on an ETF and really benefit.

Michael: Everything is  compared to the US dollar, the Yen or the Euro. Those seem to be the three biggest games in town and where the money is to be made. You can make a lot of money in the Canadian dollar also but you’re playing it against those other currency trends it would seem to me. Those seems to be the dominant themes. What about you know right now?

Jack: You mentioned the majors but there’s so much going on in the exotic and developing world currencies and we are seeing more and more of that available in the exchange traded funds. They started a new Asia block currency fund available now in the exchange traded fund format which is pretty exciting because overall  the Asian block is extremely under valued on a long term fundamental basis. And I think that’s the type of long-term play that the average investor really makes sense for them.

No doubt about it, if you get the major themes right that’s what’s nice about trading currencies. You don’t have to get into the nitty gritty and analyze bank balance sheets and that type of thing. I think if you keep it on the global macro level and get the big picture right you’ll make money in currencies assuming you’re not going to try and trade intra day with high amounts of leverage. You don’t need to do that, in fact if you are going to use them as an asset class you shouldn’t do that. You should low leverage and just use them as any other type of investment class. 

Michael: What’s on your radar screen right now? What should we be looking for?

Jack: Ee are still watching the Euro and we are looking for an entry point to play it on the short side. We think that sooner or later the European Union has to pay the price here, they’ve been band-aiding and band-aiding and doing a lot of press releases, but they haven’t solved the problem. The problem is they are just not creating wealth in the periphery countries, and they are not going to be able to pay back their debt. The other problem is the four major core countries in Europe that are supposedly in good shape Germany, France, Belgium and Netherlands, their exposure to banks represents 125% of those four countries’ GDP.

The real problems go right to the core European banking system in a very, very big way. Sooner or later that will come to roost. But we don’t want to enter here because the fact is there’s extreme negative sentiment against the US dollar and there’s been some optimism over interest rate hikes in the European central bank. Regardless once we get through the  ECB central bank hikes we think the Euro is going to play to the downside. The other we love is the Japanese Yen.  Now we’ve been wrong on the Yen but I think we’re right now. Our story has been that sooner or later this fallacy that they can fund this 200% plus and growing debt to GDP ratio in Japan internally will go away. Japanese savers are approaching zero and the earthquake has made it worse.  Japanese are going to draw down more on their savings. The Japanese are going to have to turn to the external markets to fund this massive and growing debt problem, and we think finally that risk is going to flow into the Japanese Yen. We think it started with the intervention, that’s the trigger. So those are the two that we really love long term.

Michael: Longer term as you say Japan was already basket case thanks to demographics and a variety of other things. This is not going to do very much to help them move forward adding on 300, 400 billion more in debt.  

Jack: No not at all, it’s not going to do well at all. You know it’s a situation where I think it’s finally going to trigger this idea that instead of the when the world gets risky the Japanese Yen becomes a risk averse currency, meaning it does well, I think we are going to see that start to swing around here just because of the whole decline in savings. I think the end of this theme of their ability to really fund their debt internally, and now we’ll see rising interest rates on their 10 and 20 year government bonds. When those rates start to move up in a significant way, then we know that it’s a change of tune in a very big way in Japan’s system.

Michael: So that’s really interesting, you’re looking for rising interest rates in Japan that will tell you that the Yen will get very vulnerable at that point. Jack let’s come back the US dollar. What about all the problems governments are having whether it’s California, Illinois, New Jersey or the federal  financial crisis?

Jack: I think all those things are a priced a little bit into the dollar though they are real problems, no doubt about it. But I think the big background theme on a relative basis is the dollar needs some type of yield support. I’m not talking about a big hike in rates but we are talking about an end to this QE2. Our view is if we finally get an end to this QE2, and we’ve started to hear rumors of this recently,  yet the Fed has come out and said no way.  Regardless if we start to see that change based on some improvement in the US economy, and we are starting to see improvement,if we get any type of yield differential move in US rates I think that just changes the dynamics. We can see the US start to improve as the risk levels start to get worse in Europe, and I think the US will outgrow both Europe and Japan and  for sure outgrow the UK. Those are the core countries that the US can do well against and we already know the Yen is weakening against the US dollar. So there are some plays there that suggest that the US dollar could be very strong even though it has warts because it is all relative. So we are just watching that yield support for the US dollar plus we watch the open interest numbers. 

Michael: Jack, you got us to load up on the Canadian dollar, and look at the size of that move. What do you think about the Canadian dollar right now?

Jack: Number one if you look at the sentiment on the Canadian Dollar its about a 94% bullish. When you get this type of sentiment extremes in currency markets that’s where you’ve seen turning points.

Michael: We just lost Jack on the line and we can’t reconnect with him. RECORDING STOPPED

You can sign up for Jack Crooks Black Swan’s services HERE including his free Currency Currents

Cash on Hand…An Investors’ Best Friend

Warren Buffett’s annual letter to shareholders came out recently. This is probably one of the most anticipated shareholder letters in the financial world. Everyone wants to know what the Oracle’s take on the world is. Also, because Berkshire is so large and spread across so many sectors – it owns 80-plus businesses now – his thoughts may give some insight into how the economy is doing.

His letter was the most optimistic letter we’ve seen in awhile – and maybe ever. Buffett said things such as “There is an abundance of [opportunity] in America” and its “best days lie ahead.”

Looking at his businesses, you can see from where that optimism might spring. Iscar, which makes metal tools, enjoyed a 41% increase in sales from a year ago. TTI, an electronics distributor, saw sales jump 45%. Burlington Northern, the railroad, reported a 43% jump in profits. And on and on it goes.

Forced to pick one indicator to judge the health of the economy, Buffett said it’d be rail car loadings. In 2010, rail car loadings were up 7.3% over 2009, which was the largest percentage increase since we have data (1988).

He also offered up the prediction that the housing market would recover within a year. A few of his businesses, such as carpet maker Shaw, are still way below where they were a few years ago.

So there you go. The Oracle is optimistic.

Now, I’ve learned a lot from Warren Buffett over the years. Studying his career is a must for investors. After all, he may be the greatest investor of all time. But this cheerfulness doesn’t sit well with me. I’m seeing too much of it everywhere. Perhaps Buffett will be right when looked at over a period of years. But in the near term, I see a lot of things that give me pause.

Some of these are just unassembled fragments, but consider…

The IPO market is off to its best start ever, according to Dealogic. So far, there has been $26 billion raised in new listings. And there is a backlog of $48 billion. So essentially, insiders are selling stock to public shareholders, who, so far, have lapped it up like hungry dogs.

Insiders are also selling stock of already public companies at a brisk rate. Insider selling itself is not a profitable signal to follow. In fact, academic studies have shown time and again that insider selling is not a worthy predictive signal. That makes sense because insiders can sell for all kinds of reasons. (This is in contrast to insider buying, which is a profitable signal to follow.) And we did get a very bearish level of insider sales last November, which did not materialize into a market correction of any kind. But it is unsettling, nonetheless. Insider sales outnumber insider buys by a ratio of nearly 40-to-1. Bad.

If things were so rosy, would that ratio be so high?

Then, there is the surging price of grains and oil. The high price of food is a major destabilizing force in emerging markets, where there are large pools of poor people who spend a great deal of their income on food. When food prices rise 25% in India over a few months, that’s going to have an outsized effect.

This matters for investors because the market so far has floated on a sea of good earnings. And if you dig into those earnings, you can’t help but notice how many companies are reporting wonderful results because of booming business in Brazil or Russia or China or some such place. Emerging markets helped drive earnings. By contrast, the results from the US and Europe and Japan have enjoyed more muted recoveries.

I worry that the rising cost of food and raw materials will dampen those results in the coming quarters. So that’s bad.

So I think it’s a good time to be careful. In fact, Buffett had some very good advice in his letter when he started to talk about the effects of borrowed money.

“The fundamental principle of auto racing is that to finish first, you must first finish,” he writes. Using lots of debt makes finishing iffy. The Oracle continues:

“Unquestionably, some people have become very rich through the use of borrowed money. However, that’s also been a way to get very poor. When leverage works, it magnifies your gains. Your spouse thinks you’re clever, and your neighbors get envious. But leverage is addictive. Once having profited from its wonders, very few people retreat to more conservative practices. And as we all learned in third grade – and some relearned in 2008 – any series of positive numbers, however impressive the numbers may be, evaporates when multiplied by a single zero. History tells us that leverage all too often produces zeroes, even when it is employed by very smart people.”

Of course, this math applies to investing in stocks, which is why it is important to look at financial strength and balance sheets, as we do. Maybe we haven’t made as much money as we might have in the past two years if we had bet on more speculative, less ably financed companies. But over the long haul, we’re following a surer path. (And we’ve done pretty darn well as it is.)

Buffett also writes about a letter he found written by his grandfather to his son in 1939. “Ernest never went to business school – he never, in fact, finished high school – but he understood the importance of liquidity as a condition for assured survival,” Buffett writes.

Old Ernest gave his son Fred very good advice. He writes: “Over a period of a good many years I have known a great many people who at some time or another have suffered in various ways simply because they did not have ready cash… Thus, I feel that everyone should have a reserve.”

Buffett says Berkshire customarily keeps at least $20 billion on hand, “so that we can both withstand unprecedented insurance losses…and quickly seize acquisition or investment opportunities, even during times of financial turmoil.”

It’s a good way to run a business. It’s a good way to run your personal finances. And it’s a good way to run a portfolio.

So my advice to you is to keep a cash reserve.

As a long-term investor, I might share some of Buffett’s optimism. When I look over our names, I see a lot of people doing great things that could create substantial wealth this year and in the years to come.

At the same time, I think this market has a little air under it. I would never advocate selling simply because of a guess about the market’s direction. Calling tops and bottoms is a fool’s errand. But I do know that finding bargains is getting harder. Many valuations are full. Keep a cash reserve so that you are ready to take advantage of new opportunities when we get the inevitable dip in the market.

Regards,

Chris Mayer
for The Daily Reckoning

Chris Mayer studied finance at the University of Maryland, graduating magna cum laude. He went on to earn his MBA while embarking on a decade-long career in corporate banking. Chris has been quoted over a dozen times by MarketWatch, and has spoken on Forbes on Fox. He has also spoken on CNN Radio, and has made multiple CNBC appearances. Chris is the editor of Capital and Crisis and Mayer’s Special Situations, a monthly report that unearths unique and unconventional opportunities in smaller-cap stocks. In 2008, Chris authored Invest Like a Dealmaker: Secrets From a Former Banking Insider.

The Wikileaks/Financial Times revelations on significant gold buying interest in the Middle East — notably Iran’s central bank, Jordan’s central bank and Qatar’s sovereign wealth fund — brought to mind the story of Saudi Arabia’s King Ibn Saud and his sale of oil concessions to the major oil companies. In payment he received 35,000 British sovereigns — a coin many of you hold in your own sovereign wealth fund. The good king understood the difference between the value of gold and the value of a paper promise.

At the time (1933), the British sovereign’s value stood at $8.24 each, or $288,365 for the lot. The p

The Gold Report: Jared, welcome to your first interview with The Gold Report. Could you share how O-Cap Management works?

Jared Sturdivant: We are an investment fund, really a hybrid between private equity and a traditional hedge fund. We take a long-term approach to investing in public equities and pre-IPO private situations, as well as distressed debt or structured financings. Our investors have to be qualified.

TGR: Because you delve into private equity, do investors have to commit for a predefined period of time?

JS: Yes, we basically have a three- and five-year class. Generally, anything we own that is private is on its way to becoming public within 12 months or so; or in the case that it’s a debt security, matures within roughly 24 months.

TGR: So, you don’t commit to liquidate the fund at some future point?

JS: No. It’s an open-ended fund structure.

TGR: How did you get interested in private equity?

JS: My background is in bankruptcy and distressed investments. When the world started melting down in 2008 and 2009, we saw a real opportunity to buy great assets ahead of what we thought would be the perfect storm for an inflationary environment down the road. We decided to focus on hard, tangible assets—metals and mining, energy, real estate and infrastructure.

A lot of the traditional folks who invest in public markets typically can’t do illiquid investments. We wanted to structure a fund that could capture what we saw as a big part of the value chain, which is to own something that may be a little illiquid (quasi-private) or pre-IPO.

We also structure credit investments. A lot of times that involves structured, one-off financing that requires the ability to hold something illiquid. That’s really how O-Cap has gotten to my areas of interest. I’ve always had a fascination with investing and kind of cut my teeth on the distressed side, where we looked at companies that may have great assets but a bad balance sheet.

TGR: One more question about private equity before we move on. Is the main advantage the fact that these firms don’t have to report to investors every 12–13 weeks?

JS: Yes, it’s a big advantage. When a company is public—for better or worse—Wall Street’s always knocking on the door. It always has to be aware of what Wall Street is saying. They have to hold conference calls. Some public companies take on the burden of giving guidance, which is a bit of a distraction when it comes to running a business. We like it when we have great management teams that can really focus on operating assets instead of meeting the latest Wall Street estimates.

TGR: As I understand it, distressed opportunities could appear either as private or public equity. Do you have a favorite type of distressed asset?

JS: We love what we call “good assets, bad balance sheets” companies. When you restructure or recapitalize these companies, you can really garner a lot of value. You can right-size the company’s balance sheet with its assets. We’ve seen, over time, that you can create a lot of economic value for shareholders. Part of it has to do with timing. We really like to be the last dollar or financing before a mining company moves from exploration to production and, therefore, self-funding.

TGR: Those are stories where you have to go in and create the value. Is that right?

JS: Yes. You buy deep-value assets that wouldn’t have value if you weren’t restructuring the balance sheet. But a big part of the value-creation process is how the debt is restructured.

TGR: Do you short stocks?

JS: We do short stocks. I’d say the predominance of what we do is long biased.

TGR: Do you use derivatives?

JS: We do a little bit. Not a whole lot.

TGR: What’s the first thing you do when you’re beginning to perform due diligence on a new company?

JS: When we come across a company that we think is interesting, we do a data dive. We read the 10K and the Q and read as much as we can about the company. We read all the analyst reports, and then we set up a call with the management team. That’s our basic approach.

TGR: How often do you get to that point and realize you’d like to replace a company’s management?

JS: Unfortunately, we do come to those situations. I’d say 10%–15% of the time you come across situations where management is sort of the issue. From that point, you have to decide whether to go ahead with a bad management team, try to effectuate change or pass.

TGR: For the rest of our conversation, I’d like to talk about public companies because those could be of value to our readers. Do you have examples of companies that meet your criteria that you’ve taken a chance on?

JS: Sure. We look for two underlying components in an investment: Value and a catalyst. Typically, the catalyst is a restructuring of some sort. One company on the gold-/silver-mining side is Comstock Mining Inc. (OTCBB:LODE). What was interesting about Comstock (formerly known as GoldSpring) is that it had assembled a large area of land around the historic Comstock Lode Mining District in Nevada. Since the 1800s, that district has produced 8 million ounces (Moz.) of gold and 190 Moz. silver. Comstock put this big property together through debt financing. However, it was a penny stock and it was headed for bankruptcy.

Then, an investor by the name of John Winfield bought up a lot of the debt, consolidated and converted it into a preferred structure. He could’ve filed bankruptcy for Comstock but restructured the company and kept it public instead. He effectively transitioned that debt to a preferred stock, which prevented a Chapter 11 process. Shortly thereafter, the company did a major refinancing. It financed US$35M of new convertible preferred stock to outside investors. This, along with hiring new CEO Corrado De Gasperis, was a major game-changer. It saved the company from bankruptcy.

Corrado laid out three aggressive targets, which we thought were very attractive. The first was to increase the gold-equivalent ounces (Au Eq.) from 1 Moz. to +3 Moz. The second was to enter production in the second half of 2011. And, the third was to get 2012 production up to 24 Moz. Au Eq.

What we really like about the situation is that you’re buying an exploration company that is converting to a producing company that’s growing resources substantially. We think it will have cash costs of $450–$500/oz., so Comstock could do US$20M in cash flow next year very easily. And, the company’s got two projects. The Dayton Phase 1 drilling program is now hitting bonanza-type grades, so there’s a lot of resource upside as the property continues to get drilled.

We looked at this and said, “Wow this is interesting.” Not only do you have a company going from an explorer to a producer, but also you have a new management team with great plans for a resource upgrade. Comstock also has an AMEX listing coming in May, which is another tangible catalyst.

When you look at the valuation, if Comstock gets valued like a producer, you’ve got multiple upsides from here. If the company continues to grow the resource base, once it starts producing 3, 4 or 5 Moz., Comstock really starts showing up on the radar of acquirers. We think that’s attractive.

TGR: Will Comstock have to go back to the market for financing?

JS: No, the company is fully financed. Its last financing for US$35M provided all the financing it’ll need to take Comstock through production and even provides another US$15M for additional exploration. If this company gets valued at US$200/oz., which is pretty conservative, and gets to its 3.25-Moz. target that Corrado set, you’re talking about a US$7 stock.

TGR: And that would be before a takeout premium.

JS: Right, that’s not a takeout premium. What we saw is a situation wherein a company was transitioning from an exploration to a production company and had restructured its balance sheet with no further capital needs. That gives you a chance to be the last dollar in before it makes that transition. We think Comstock will be valued like a production company, eventually, and you’re going to get that upside. So, we’re pretty happy with that transition.

TGR: Is there any significant risk?

JS: Anytime you’re with a resource company, it’s probably not a good thing if the commodity price goes down. We think this project has been derisked. It is in a historic mining district that has produced a lot of resource, and recent drilling has firmed up the resource base. We don’t think there’s a lot of risk to the resource per se, but commodities always carry risk.

TGR: Assuming, for the sake of argument, that gold could slide to US$1,000/oz., could Comstock still have upside?

JS: Yes. When your cash costs are US$450, you’ve got a big margin and you’re a relatively low-cost producer.

TGR: Very good. Can you tell us about another opportunity that meets your criteria?

JS: Sure. One company that’s a bit of a complicated situation is Palladon Ventures Ltd. (TSX.V:PLL). This is an iron ore holding company that owns a minority position in CML Metals, Inc. (a private company). CML Metals has the largest and highest-grade iron ore deposit west of the Mississippi. Its Iron Mountain project is located west of Cedar City, Utah. Again, it’s another historic mining district that used to be controlled by U.S. Steel Corp. (NYSE:X) and the Geneva Steel Mill. Since 1869, 80 million metric tons (Mt.) of iron ore have been pulled out of this project. It has a great asset base. Palladon has resources of 40 Mt., grading 45% iron at its Mountain Lion deposit. The company has an even larger +100 Mt. resource at some contiguous deposits.

Up until March 2010, this was a bankruptcy candidate. It had great assets but, due to a previous CEO who had a habit of overpromising and under-delivering, the company took on debt and didn’t execute on the logistics to get the ore moving. Eventually, it defaulted under its term loan. The term-loan owner did a debt-for-equity exchange, which diluted the public shareholders. Now, the original shareholders own a minority piece—roughly 18% of the actual assets.

TGR: This is quite diluted. So, the only way to play it is to own the holding company?

JS: That is correct. You need to own the holding company. So now, Palladon has no debt because the exchange took care of it.

I should say that the company is shipping run-of-mine ore. It’s just pulling it out of the ground and shipping 2 Mt./year and making a little money on that. Palladon also has first-class partners; it ships to Chinese counterparts that market to Chinese steel companies. And it ships out of the West Coast, using Union Pacific as its rail line—all top-notch partners.

Recently, the company announced new financing by Credit Suisse to build a concentrate plant onsite. When it gets this asset in place by the first quarter of 2012, it should have positive cash flow and will make a margin of US$60 –$80/ton. With that kind of margin on 2 Mt., you have a company doing US$120M–$160M of EBITDA (earnings before interest, taxes, depreciation and amortization).

Even when you adjust for today’s ownership of just 18% of that, you’re buying in at about 1.5x EBITDA. This is for a company that we think is highly attractive as an acquisition candidate, as well. If you look at Cliffs Natural Resources Inc. (NYSE:CLF), which recently announced the acquisition of Consolidated Thompson Iron Mines, Ltd., another iron ore company, for about 6.5x EBITDA, we think there’s tremendous upside here.

TGR: So, how much will its margins increase by owning more of its own supply chain?

JS: Currently, the company’s margins are roughly US$5–US$10 per ton. That will go to US$60—$80/t by owning the concentrate facility.

TGR: Very interesting. Any other names you’d like to mention?

JS: For those who are willing to look at pure exploration companies, we think Paramount Gold and Silver Corp. (TSX:PZG; NYSE.A:PZG) is attractive. Last year, the company bought X-Cal Resources, which brought it the historic Sleeper Gold Project in Nevada. Its other asset is the San Miguel Project, in about 465,697 acres in the Sierra Madre Occidental Gold and Silver Belt in Mexico. San Miguel has a resource of about 2.6 Moz. of gold. Coeur d’Alene Mines Corp. (TSX:CDM; NYSE:CDE) is developing a contiguous property with 3 Moz.

We think the Sleeper Project has a lot of blue-sky potential and has the potential to hit real bonanza grades. An interesting little tidbit is that the Sleeper Project owns the water rights to Fronteer Gold Inc.’s (TSX:FRG; NYSE.A:FRG) Sandman Project, which Newmont Mining Corp. (NYSE:NEM) just bought. When you look at the total combined resource of nearly 5 Moz., we think Paramount will make a nice takeout candidate for Newmont, Coeur d’Alene or another company down the road.

TGR: So, Paramount has the geographic tie-in. . .

JS: Right. It’s in the mining-friendly districts of Nevada and the San Miguel district of Mexico. The properties are contiguous to two large companies that we think would consider the company an attractive acquisition. We’re seeing that big companies like Newmont need to feed their mills. They have to do acquisitions to keep their mills active. It’s a big operating cost to have a mill that’s not running at full capacity. That is one of the reasons we think Newmont bought Fronteer’s Sandman Project. Paramount is a little more speculative, but we think it has a lot of potential as an exploration-upside takeout candidate.

TGR: Why do you consider Paramount more speculative?

JS: Paramount will need another financing round, at some point. It’s a pure exploration company, and exploration companies have a habit of spending cash and needing more.

TGR: You have a very interesting business model, Jared. I hope we get another opportunity to speak with you in the future.

Jared Sturdivant is portfolio manager and managing partner of O-Cap Management, LP, an opportunistic investment vehicle focused on special situations investing in both public and private markets. The firm has ownership interests in the U.S., Canada, Brazil and Western Europe, with a particular focus on hard-asset industries, including energy, metals and mining, infrastructure and real estate. Previously, Mr. Sturdivant was a managing director at JANA Partners, a multibillion-dollar investment fund, where he focused on global special situations and distressed investing. He graduated with a BA in finance from the University of Texas at Austin.

Streetwise – The Gold Report is Copyright © 2011 by Streetwise Reports LLC. All rights are reserved. Streetwise Reports LLC hereby grants an unrestricted license to use or disseminate this copyrighted material (i) only in whole (and always including this disclaimer), but (ii) never in part.

“Tail risk (the risk of large losses) is dramatically underestimated by many investors and the tools we have available to manage such risks are hopelessly inadequate. Financial theory which is taught at business schools and universities all over the world is plainly wrong.”

This week we turn to my friend Niels Jensen of Absolute Return Partners in London for our Outside the Box offering, in which he looks at tail risk, Modern Portfolio Theory, and a risk he identifies as Birthday Risk. It is a lively and easy read, which is also designed to make you think about your basic investment principles.

Your loving NYC weather today analyst,

John Mauldin, Editor
Outside the Box