Agora Financial’s Rude Awakening

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Laguna Beach, California

·      When a 370-point Dow drubbing feels like a kiss,
·      Down 13% in September…eve AFTER calling Lehman’s demise,
·      Grab royalties on 80 mining contracts with this one company and more…

Eric Fry, reporting from Laguna Beach, California…

I’ve got some good news and some bad news…

The good news is that my kitten is recovering nicely from her broken leg. The bad news is: Everything else.

While my almost-healthy kitten was “chill-axing” in the shade yesterday, the Dow Jones Industrial Average was imploding. The venerable benchmark of American share prices sliced through 100-point increments like a guillotine through wet toilet paper. Only after the Dow had dropped 800 points did the masses of panicked sellers take a well-deserved rest.

Ever so slowly, the stock market regained its footing and inched its way toward less-devastating losses.

By the close of the New York trading session, the Dow had dropped “only” 370 points. It almost felt like a gain! I was reminded of an old song lyric from The Motels, “He hit me…and it felt like a kiss.”

How difficult is the current investment environment? Let me count the ways…

1)            Every stock market in the world is losing value.
2)            Almost every asset class in the world is losing value.
3)            At least two of the assets that are rinsing in value – the dollar and T-bonds – are assets that seem particularly vulnerable to a selloff.
4)            Hedges like gold are not gaining in value
5)            Many of the world’s most successful AND most bearish hedge fund managers have been losing lots of money.
6)            Even investors who have been carrying lots of cash in their portfolios – and/or have begun investing very recently – have still suffered large losses.

Let’s begin our troubling tale of woe with observation #6. This observation strikes particularly close to home because it describes your editor’s approximate investment results. He has been very bearish, as faithful Rude readers could attest. He has also been very cautious; he has been lightly invested and even when he has invested, he has favored commodity-focused investments.

So let’s cut to the chase: Is your editor happy? No, he is not. The joy he derives from his kitten’s recovering leg does not quite erase the agony of his recent stock market losses.

Let’s re-phrase the question. Is your editor satisfied with his relative investment performance? No, he is not. He is delighted that he has “beaten the S&P” by a comfortable margin – in other words, things could be much worse – but double-digit losses are never very satisfying. So let’s examine the highlight reel and consider what lessons we might learn.

Specifically, let’s examine your editor’s relationship with Enerplus Resources Fund (NYSE: ERF), a Canadian oil and gas investment trust. In January of this year, your editor purchased a few shares of ERF for $35.53. As oil and gas prices soared, the stock advanced. But once oil prices soared above $140 a barrel, your editor began to worry about the possibility of a short-term selloff. So he began peeling off his holdings of ERF. He made his initial sale above $50 and sold out the rest of his position at lower prices. And, of course, he had received several plump dividends in the mean time. All well and good.

But then along came the stock market selloff of October 2008.

Enerplus shares closed the second day of October at $37.03, for an indicated yield of more than 15%. Surely the selling in this stock had been overdone, your editor thought to himself. So when the stock dropped more than $2 the following morning, he stepped in to buy some. Yesterday, the stock dropped another $4, handing your editor an immediate loss of more than 13%!

Enerplus might drop another $4 tomorrow. Your editor has no idea. And neither does he have any idea whether an investor ought to buy Enerplus or to sell it. He only knows that the best purchases to have made recently were no purchases. The financial markets are merciless and utterly unforgiving. Enerplus yields 17%…and so what? It could fall another 10% tomorrow anyway.

Enerplus is only one of the many curiosities that populate the investment landscape. Treasury bonds are another.

If an infallible clairvoyant had told you that the world’s central banks would embark upon the greatest reflationary campaign since the Weimar Republic, would you have expected long-term government bonds to rally and gold to slump?

And if an infallible clairvoyant had told you that Lehman Brothers would go bankrupt and that AIG, Washington Mutual and Wachovia would go to near-bankruptcy, would you have expected the dollar to rally and commodities to slump?

Almost no one “got it right” during the last few weeks. Even many of the bears have gotten it wrong.

David Einhorn, the “guy who called Lehman Brothers,” lost nearly 13% in the month of September alone. Einhorn, as we have reported here in the Rude Awakening, correctly predicted Lehman’s path toward bankruptcy, and shorted the stock to profit from this outcome. Is it not a bit ironic, therefore, that Einhorn’s fund lost 12.8% in the very same month that Lehman filed for bankruptcy? If he got that call so right, what else did he get so wrong?

Einhorn has plenty of company. Lots of successful – and bearish – hedge fund managers have produced large losses in 2008. Even if a hedge fund manager got the short side right, there simply wasn’t anything to “get right” on the long side. According to Bloomberg News, “Stock hedge funds fell an average of 8.6% in September, the biggest one-month loss since Hedge Fund Research Inc. began collecting data in 1990.” Maybe that’s about to change.

Maybe – and we are merely guessing now – the investment sentiment around the globe has become so utterly negative that, from a contrarian perspective, a positive move is all but certain. The chart below depicts the historic inverse relationship between the S&P 500 Index and the VIX Index – aka, the “fear gauge.”

[Ed. Note: The VIX measures the implied volatilities of various options on the S&P 500 Index. Because the VIX is based on real-time option prices, it reflects investors' consensus view of future expected stock market volatility. "During periods of financial stress, which are often accompanied by steep market declines," the CBOE Website explains, "option prices - and VIX - tend to rise. The greater the fear, the higher the VIX level. As investor fear subsides, option prices tend to decline, which in turn causes VIX to decline."]

As you can see, extreme highs in the VIX Index tend to coincide with extreme lows in the S&P 500. Yesterday’s intraday high of 58.24 on the VIX set a new all-time record. Can a stock market rally be far behind?

The trick is to identify the stocks that will soar once the market stabilizes. The trick is to buy the babies, not merely the bathwater. International Royalty Corp. (ROY, $2.34) might be a baby worth buying. Chris Mayer, editor of Mayer’s Special Situations, liked the stock when it was selling for twice its current price. He likes it more now. Read on for the details.
 
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A Good, Cheap Stock
By Chris Mayer

When panic guides the financial markets, reason is an orphan. It enjoys no comfort whatsoever. It wanders aimlessly – wondering when it sorrows might end.

But the sorrows do end eventually. Reason does ultimately reunite with profitable investment results. Therefore, the successful investor clings to well-reasoned tactics, even when the stock market calls him crazy. At the moment, the stock market is calling a lot of investors crazy. But successful investors use such moments to capitalize upon the stock market’s lunacy. They use these moments to buy good stocks on the cheap.

International Royalty Corp seems like a good stock that has become way too cheap.
International Royalty Corp. (ROY) is like a big bucket of call options on more than 80 mining projects. But the great thing about these options is that they don’t expire. Only one of ROY’s projects is really producing big cash flow. A few gold mines come online in 2008. And then you have 78 other properties that could pay off down the road.

ROY is a unique company. It doesn’t operate any mines. It doesn’t own any mines. What it does is acquire royalties. Basically, ROY is like a venture capitalist of mining companies. It provides funding. Early in a mine’s life, before anybody is sure what might come of it, a miner might go to investors and partners and look for ways to spread the risk a bit.

Enter ROY. The management team at ROY takes a look at the property and runs it through their hurdles. If they like it, they come back and say something like, “OK, we’ll give you $10 million. In exchange, you pay us 3% on the gross price, minus shipping and insurance costs, of everything that comes out of this mine for the life of the mine.” Also, ROY points out, it’s up to the miner to run the place. “It’s still your mine, Mr. Miner, and any other money required will have to come out of your pocket.”

The miner says yea or nay. If it agrees, it gets its money and starts work on the mine. It may be years before the mine produces anything. It may never produce much of anything at all. Or it could turn into a huge mine… in which case, ROY’s little initial investment pays off big.

This is what happened with Voisey’s Bay, which turned into a huge nickel mine. The miner in this case is a giant - Companhia Vale do Rio Doce (CVRD). No one knows just how much nickel CVRD will get out of Voisey’s Bay. But right now, Voisey’s Bay is one of CVRD’s core assets. CVRD has sunk nearly a billion dollars into it. The mine should produce for 20-25 years yet.

Voisey’s Bay beckons comparisons with Goldstrike, a fabulous gold mine owned by Newmont. A little royalty company called Franco Nevada had the royalty on that mine. It went up 50-fold over a decade. Shareholders who sunk some money in Franco Nevada and just sat on it got rich.

Some call Voisey’s Bay the Goldstrike of nickel…

And ROY has a piece of it. Every ounce of nickel that CVRD pulls out, ROY gets a cut. Doesn’t matter if CVRD makes money or not. Doesn’t matter what happens to mining costs. When CVRD pulls nickel out of Voisey’s Bay, a piece of the proceeds goes right in ROY’s pockets.

This makes ROY a straight-up play on metals. Higher nickel prices mean more money for ROY. More volume through the mine means more money for ROY. It’s price and volume, and that’s it.

Well, that’s not all…

Because ROY owns a portfolio of royalties, not just Voisey’s Bay. Most of them don’t produce anything right now. But they may. And most certainly, some will. Recently, ROY picked up another 16 royalties from mining giant Rio Tinto for $61 million in cash. It was a big acquisition for ROY, boosting its total portfolio by 20%. Now ROY owns a portfolio of over 80 royalty properties.

And so what?

Now that commodity prices are tanking, ROY’s share price is also tanking. This looks like a buying opportunity to me. Commodity prices will recover eventually. And when they do, ROY’s stock should provide ample rewards.

[Joel's Note: When Mr. Market abandons reason, it’s mighty difficult to keep a focused head, not to mention a subdued temper. A day after last Monday’s horrific market BASE jump, Chris wrote to his subscribers with a few calming words and an even keeled, rational response for them to chew on. The gist of the email was to not let emotion overcome decision making and, as always, to keep an eye out for opportunities that blossom from the carnage.

For Chris, a career value investor, tumbling markets present great opportunities to grab stocks on the cheap. ROY is one of those ideas worth checking out. So are the dozen or so others that Chris has on the boil right now too. You can get in right now for “cents on the dollar” prices and, when rationality does return to the game, you’ll be up big. To ensure you’re on Chris’ next investment alert list, click here. 

In other news, Asian stocks sold off again overnight. The Hang Seng finished the session down 3.58% while Japan’s Nikkei 225 dipped another 3.03%. Gold sits around $880, up over $20, and a barrel of the world’s grease changes hands for right on $90.

Finally, the dollar index sits at a lofty 81.086. That’s almost high enough for Bernanke to start unloading a few billion more from the chopper. Look out below!

Until next time…

Cheers,

Joel Bowman

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