Canadian Miners of Merit

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Nesbitt Burns Institutional Client Conference Call for December 22, 2005

Don Coxe
Chicago


”Hard Rock Rocks”




Thank you all for tuning in to the call, which comes to you, of course, a day early this week and a Happy Chanukah and a Merry Christmas to everybody out there.

The chart that we sent out was Rio Tinto and the comment was “Hard Rock Rocks”. I’d like to update the mining story and of course we’ve had a big mining story this morning with the announcement by Barrick, they’ve significantly improved their takeover deal with Placer and it’s been settled with all sides which means the three parties, Goldcorp, Placer and Barrick have knit the knot.

And you’ll notice from the upward revaluation in it that first of all the Barrick offer had not been doing well and what has to be the highest returns on drill holes in the history of mining occurred when Placer announced the results of drilling deep in their Campbell Red Lake mine and showed the connection to the adjoining Goldcorp property.

So my congratulations to the people at Placer and whoever the geologist was who came up with that, deserves some sort of award. If he worked for a technology company, he would be granted an option for ten years on a hundred million shares. I don’t think we do things that way in Canada, but anyway, it was a very interesting development.

But of course the story here is of the rest of the mining industry. And Rio Tinto is one of the Big Four: BHP Billiton, Rio Tinto, Anglo American and Phelps Dodge. And these companies are so powerful and their stock performance has been so great. But what’s interesting is that Rio Tinto announced this week a big stock buyback program which drove the stock up to a new all-time high. And what is interesting about this is that Rio has been saying all along that they’re not going to do any takeovers because values are excessive. So, they’re under pressure to do something because of course they’re accumulating cash at an unbelievable rate.

So the dilemma of Rio Tinto in doing a stock buyback, when your stock is already trading at an all-time high, is this: that if you believe values are too high because metal prices are about to fall, then, if you’re acting in the long-term interests of your stockholders, what you would not do is do a stock buyback now. You would wait until your forecast came true and the stock would retreat back down from these lofty levels and you would then be in a position to buy it in cheaply. And you would show what a great manager you were.

Because the stock is trading at what is a high P/E ratio for the group, it’s a P/E ratio of sixteen times earnings this year and the estimates are thirteen and a half times next year, but you must always be cautious because mining analysts tend to use such low metals forecasts. But as you see from the chart, this stock has been a tremendous performer.

But, I didn’t pick Rio Tinto alone for that, because frankly when I chose the stock chart for this, Rio Tinto had not yet announced the stock buyback. I chose that simply because I’ve tended to focus in the past on BHP Billiton, which has been sort of “my favorite” large-cap mining stock and I regularly quote from Chip Goodyear. And frankly, the only person I’ve been quoting from Rio Tinto is somebody that I met briefly at ___ Ayer’s Rock, Australia five years ago and who had just stepped down from running the operations at Rio Tinto in Australia for fourteen years. He told me then that the mining industry had, for twenty years, been run by guys who wanted to prove their virility by building bigger mines than their competitors did.

And so they all went out and built big mines to prove what real guys they were. And he said, finally they figured out that the stockholders didn’t benefit from that. And he looked me in the eye, and this was after several glasses of wine after sunset and he said, “Don, I can assure you that will never happen again.” And that was the first sign, for me, that the Triple Waterfall crash of base metals was about to be over.

And so, I think that the success of Rio Tinto since then…I was just pulling up a chart to see where the stock was, back then, as opposed to where we are today, and yes, it was a fabulous investment if you had jumped into it, which I neglected to do because I was interested in other stocks at the time. But if you’d bought it back at the time we were talking, you’d have been able to buy it for about $70 a share. And given that were up at about $180 now, that’s been a great investment.

But, my thesis is, of course, much bigger than that. The thesis is, that these stocks are now attracting investment attention, at long last. And that the values that are coming out there from the ground are being somewhat recognized in the marketplace, although they remain cheap.

As of this week, the two mining stock groups, which are the base metals and the golds, ranked fourth and fifth in the Investor’s Business Daily survey of a hundred and ninety seven stock groups, based on their performance in the US stock market for the last six months.

So, the “Hard Rock Rocks” comes from the title of our August issue of Basic Points. And those with long memories will recall that we were in the midst of oil fever at that time, partly Katrina-induced and also partly as a result of a Wall Street analyst having predicted $105 oil and various other prominent figures predicting $100 oil. And we took the view then that this might be a good time to take some money off the table in the oils or certainly not to put any new money into them and to buy the mining stocks instead. And that’s worked out pretty well.

So, I thought by coming up to year-end, that we might sort of review that strategy as to if you’re putting new money in before year-end, which group would you favor and why? Because obviously the mining stocks are a small-cap group compared to the oils. All the mining stocks together aren’t worth as much as ExxonMobil. And so therefore from the standpoint of an investor, it’s a pretty obvious choice to invest in energy, but to invest in the mining stocks takes more of an effort.

First of all, you have very little research on it, that is, if you’re not a client of Nesbitt Burns. And the other problem you have is that, whereas everybody understands, to some extent, or they think they do, the energy dilemma, the case for the mining stocks is a much more complicated one.

And so, we’ve been urging these stocks partly because we think that the mispricing may now be greater within the mining stocks than it is within the oil stocks. And the theme of the Basic Points issue which was published on e-mail today, published at the close yesterday, actually, which is “The Twin Mispricings” about the commodity stock groups. We compare the oils and the mines and we point out of course the mining stocks have one-tenth the market cap of the oils. But there are still some very interesting values in there and there’s a lot of liquidity for institutional investors in the bigger-cap stocks in the group. So that it’s not a case that this group is just a collection of small-caps and that major institutional investors shouldn’t be involved.

But in the case of Canada, what we’ve had is massive consolidation. Look, this time last year the three biggest-cap base metal stocks in Canada were Noranda, Inco and Falconbridge. I don’t include Alcan in this because that’s a special difference, because aluminum is congealed electricity. Well, they’re all going to be one very shortly, unless Marc Rich’s boys pull off a bid to break up the coming merger between Falconbridge and Inco. Because Falconbridge and Noranda merged together about nine months ago.

So, as an institutional investor, you had in Canada, three big-cap mining stocks, now you’re going to be down to one. It’s a much bigger-cap mining stock, alright, but it’s a different company. And whereas the way things stood before, if you liked copper better than you liked nickel, you could buy Noranda first and Falconbridge second and Inco third. By the time these companies have all merged together, it’s going to be primarily nickel that drives the earnings.

Well, the point about this is to illustrate the fact that the mining companies realize that they have to bulk up a bit if they aren’t going to be swallowed up by very big companies. And that the China Minmetals deal which at this time last year, there was a tentative deal for Noranda to be bought by China Minmetals, and they just got too cute. And they were trying to do a deal in the high teens for Falconbridge and that turned out badly for them. Falconbridge is currently 29 and ½. And I just don’t think, though, that that’s the last time you’re going to see participation from the Chinese and pretty soon the Indians, in buying these companies.

Because as long as these companies trade at such modest price/earnings ratios and these companies collectively…take the big twenty-five mining companies of the world, which means you go from very big down to pretty modest…they own just about all the freely available copper, nickel, lead and zinc. I say, just about all because you have state-owned companies, like Codelco in Chile and the quasi-state-owned company, Norilsk Nickel.

But apart from those kinds of exceptions, what you’re looking at is that these kinds of companies have what is absolutely needed for the economic forecasts of China and India to be realized. So, if you are a planner in China or India and you’re coming out with these forecasts saying that you’re going to grow your people’s incomes by seven to nine percent a year, year after year, and if you have the view of Dr. ____ Singh of India who says we’re going to abolish poverty forever in the next ten years, well, you’ve got a problem.

Because in order to do all this, what you’ve got to do is you’ve got to house the new middle class. And you’ve got to give them one of the accoutrements of the middle class, which is cars. And you aren’t going to be able to do this without driving up the price of the metals. And so you’re in the position that if you just play it in a free-market-naïve deal and simply bid for the metals, then you’re going to watch the stock price of the companies that produce this going up and it’s going to be because of your success.

At some point, I think you’re going to scratch your head and say, this isn’t a very good deal for me. We have these forecasts, which any idiot looking at them is going to say, it means much, much higher metal prices for years to come. And that when there is a recession they’re going to go down much less than would have otherwise because the game has changed for the metals industry.

And it just happens that there’s so many dumb capitalists out there who have just looked at the performance of these stocks over the previous twenty years who’ve said “Well, I’m not going to touch them”, that you say “Wait a minute, at such point as they register that we’re likely to carry out our forecasts, they’re going to say, how do I play this? What’s the best way to play China and India together?” And oddly enough, it’s the base metal stocks.

Now, we’ve had a really amusing development on that front in the last two weeks. As faithful listeners and as readers of Basic Points know, I’m sort of Action Central for reports distributed by that cottage industry that’s developed on Wall Street, the China Crash Industry. So, clients send in to me, reports from these various anointed experts on China. They’ve been doing this for the last three years. And the reports have been unanimous, saying that the Chinese figures are not to be believed, Chinese figures on GDP. They’re overstating their growth and they’re heading for a crash. And these are always done from the standpoint of experts and they have reports coming to us saying this kind of thing.

Well I’ve chosen to take the attitude that there’s just too much evidence the other way. And there’s some people on this call who’ve been out to China themselves who’ve reported to me and frankly to carry off a scheme of fraud on the scale they’re talking about is beyond the abilities of any Marxist government or indeed, anybody else.

So, I’ve taken the view that China was doing at least that well and maybe even better. Now this has been presented from a position of cussedness, really, which was that these self-anointed experts, I thought, were just creating big prestigious jobs for themselves out of nowhere on Wall Street, because they knew more than anybody else did, allegedly.

Well, it turns out the Chinese figures were wrong. Ha! They’ve restated them upwards by 16.8%. And this is because…are you ready for this…this is because their previous statistics were oriented toward industrial production. And this time they did the work on the service industry and they discovered they had a whole middle class out there that didn’t count before.

And so, the difference between the economic statistics they had before and the ones they have now are because of all these middle-class people who are in various service industries. Now this is exactly, as some of you’ll know, what we’ve been taking the view was inevitable. And we were citing this book, which we’ve recommended before by an American transplant who’s lived in Toronto for thirty or forty years, Jane Jacobs, Cities and the Wealth of Nations. And what she talked about, the progress from poverty to wealth, in countries that she contrasted those who stayed in a pure export strategy such as Argentina, and they failed, and those who developed a middle-class and went to import substitution and by growth of wealth of the middle class and doing things at home, they became wealthier.

Well, it turns out that China is well along in this process. And, of course, it’s the middle class people who, in getting their homes and cars, create the demand for metals. Now the part of the argument that I’ve had with those who’ve been skeptical of our call on the base metals is they say, “Well the only reason for that is because of their capital spending boom and capital spending is an unsustainable 46% of GDP.”

Well, once you restate the GDP numbers, although capital spending is still very high as a percentage of the economy, it’s at levels that have been seen in previous growth spurts in other Asian countries before, such as Taiwan and South Korea and even Japan.

So that the argument was, of those who were telling us that this whole Chinese thing was a gigantic fraud, a crucial part of their argument was that the 46% of GDP showed that the economy was wildly overheated, that they were building stuff that nobody needed and they were heading for collapse. And there are some goldbugs out there who believe that. And that one of the reasons they were making the argument for rushing into gold, was that they said once it became apparent that China was going to collapse, that the Chinese were going to bid up the price of gold.

I’ve always found that a somewhat circular argument, because if the Chinese are so broke, how do they buy gold? But, you know, with the paranoid types, it’s best not to try to argue with them. It’s best just to shrug your shoulders and to say, “Look, we really can’t talk about this.”

So, the reason I come back to it now, is that the restatement by China is truly historic. This is the first economic census they’ve done and what it shows you is that, although the emphasis has been, definitely, on the massive capital spending boom and the preparations for the Olympics and all those things that everybody knows about, but meanwhile what’s been happening is there’s this internal upgrading of society itself. And when you add millions of people to the middle-class, which they’ve just done, it explains why it is that we’ve had this big move to two dollars in copper.

See, one of the problems that I had about a lot of the people who were saying it’s all capital spending, was that the capital spending that they pointed to was so steel-heavy. And I said, well that doesn’t necessarily tie in to what’s happening in copper then. Well then of course they had an answer for that, which was, that copper prices were being manipulated.

And they said – to my amazement – they even had their argument that this story about the trader, Mr. Liu, who had shorted copper, that this was actually a brilliant new scheme from China to sucker in fools like me, into believing that copper prices were going to go up. And then what they were going to do is unload the millions of tonnes of copper that they had secretly hidden away. And some pretty respectable people have fallen for that viewpoint.

Well, now that we know that there’s more middle-class, we also know that there’s less copper. Because, as soon as you go into a dwelling that’s got electricity and basic appliances, then what you’ve got is big, big demand for copper. And this is different than the capex and the infrastructure spending which is more steel-oriented.

So, therefore, I would take the view that the easiest way to look forward is to say that “Sure, Chinese and Indian economic statistics are dubious, but boy, when you see the restatement of GDP in the US and the monthly payroll numbers even, that even with the armies of bureaucrats that we have over here in honest bureaucracies, that mistakes get made. But the trendline is what counts. And the trendline is that we’ve got self-sustaining growth over there. And therefore, what we have then, is this tiny market capitalization of companies that somehow or other, must develop the resources that are absolutely going to be needed as they keep adding new middle-class dwellings.

So, hard rock rocks. Hard rock rocks because, whereas base metals are not a big deal once you have an advanced economic system you spend your money on other things primarily as opposed to something that uses copper, nickel, lead and zinc. But when you’re getting there, along the way you have tremendous need for it.

So, this…we are still in the early stages then of the story. And I really believe that the good base metal companies remain a core investment. And this is notwithstanding the fact that next year there’s a very good chance we’re going to have a significant economic slowdown.

And I would take the view that investors should start to adopt a five-year view, which means they will gradually phase in their positions. But you should - even they’ve been skeptical about it - have at least a core position in some of these fine companies. Because it’s quite obvious that this industry is going to make more money than the people who run it thought. And although one of the ways they’re going to give money to stockholders is in buybacks, what that implies is that these stocks are not going to get cheaper.

As for the precious metals, what we’ve had is another demonstration of the importance of what we call The Great Symbiosis, or the Beijing-Tokyo axis. Because we had this $70 run-up in gold and the pullback once the Yen, it was quite apparent, was heading for that magic 122 area and then pulled back to 116. We took gold back down below 500, the magic number. And we’ve had a very good rally since then back through 500, as we see the Yen settling down in the midst of its trading range, which is around the 116 level. And so, not that there aren’t other developments effecting gold from a day-in, day-out basis, but this is really reassuring that that currency regime is in place.

Now, a client e-mailed a criticism of our viewpoint on this saying “Well, wait a minute, you talked in terms of a 122 being a line in the sand, but that got violated big time. That got violated big time back in late ’01 and in early ’02. And I hadn’t explained that point recently, so I’ll come back to it for those who have not been following it for a long time.

The Dollar bull market, against all other currencies, began in 1995. And the Dollar eventually rose 45% on a trade-weighted basis. Now, the final orgiastic rush to the top came as we were getting down for the Euro’s expiration, which was January 31st of ‘02. Up until January 31st, you could trade in your various European currencies, your Lira, your French Francs, your Deutschemarks, your Gilders, you could trade them in for Euros. But once past that date, if you tried to trade them in, they had expired and you had to get special permission and so forth. So January 31st was the expiry date.

But when people found out about that there was an expiry date, they also found out, Jacque Delours stuck this in, that if there was a substantial amount – this was left up to the individual governments to define it, but it was like a few thousand dollars worth – where you had the previous currency, there was a note sent to the Minister of Finance of your country that you were trading these currencies in for the new Euros.

Now Jacque Delours, bureaucrat to the core, chuckled that this is where they were going to get all those tax cheaters, particularly the Italians, although he allowed as though he estimated there may be some in France too, who had all this money hidden under the mattress or under floorboards. And this was even a problem for Russians, because a huge percentage of European currencies were stuck under the floorboards across the former Soviet Union.

Well, what these people did, was the logical thing. They simply took the money to the foreign exchange wickets and there is such a basic tradition there that there’s no documents filed with governments when you hand them in and you take paper currencies back. And what they bought was Dollars, because that was what you did, that was the other side of the trade. Naturally, you would not take back another European currency because you were going to have to cash it in anyway. So what we had was a huge surge to the top. And the Dollar immediately started its bear market. If ever there was a case in which you knew the top of a bull market, it was January 31st of ‘02 for the Dollar.

Now, why is this important for The Great Symbiosis? Was that the powerful part of The Great Symbiosis came in when it was necessary for China and Japan to start buying Dollars to prevent the Dollar from collapsing. That’s when the real muscle came in. Well, as long as the Dollar was doing nothing but going up and because Japan was deeply affected with deflation and China’s economic growth rate was so strong, China was able to tolerate some brief bits of deviation.

But once it was necessary, for the two of them to get together and buy, to support the Dollar when the Dollar was just going down, down, down, then what you had was you had that line in the sand reassert itself. So we come back to why it was so important in November, then, and why we had that first rush through $500 and all the way up, was, it looked like that we were going to have a breakdown – and this was being reinforced by such public displays of acrimony in those so-called spontaneous demonstrations in China against the Japanese embassy and Japanese corporate installations.

So that’s the background there. Now, we got a $10 move this time because there are other reasons why I think at year-end that people may decide gold is a good asset to own. But, the Fear Factor is taken out of it. And the Fear Factor is that we’re not going to have a global currency crisis. As long as the Yen is trading in that range, I think you can look forward to, as I say, having merry holiday celebrations and even doing what I’m going to be doing, is going to a two-week vacation starting January 4th in the Caribbean. Because the underpinnings of the financial system should stay in place.

So with that, that’s the summing up of why it is that a combination of base metal stocks and gold mining stocks should be in everybody’s portfolio.

I put it open to questions.



Caller 1: Good morning, Don.

Don Coxe: Good morning, Stephen.

Caller 1: Yeah, this is not a question as such, but a comment, affecting the base metals is the whole idea of pollution and what goes on. And we’ve got some major spills now in China, for their largest zinc smelter. This is going to have some effect on the prices.

Don Coxe: Very good point. Thank you, Stephen. I also thank you for the material that you send to me. I’m delighted with your help. You are one of a group of people out there who make my research easier.

Yes, this is exactly…I mean, those of you who missed that splendid nine-page, nine full pages, series back in October in the New York Times about the pollution problems of the mining industry worldwide, particularly the gold mining industry, that’s worth going back and archiving. Because what it illustrates is the problems this industry faces and another reason why it is that it’s so difficult to get permits for new mines and why a company, in effect, like Rio Tinto might say it’s better to buy in stock because I’m buying in ore reserves then. And the Chinese so mindlessly expanded their plants, not worrying about these things.

One of the reasons why zinc was an underperformer for years, was the Chinese were net zinc exporters. Well, of course, now they’re finding out that those plants weren’t well designed. So, good point, that the mining industry is one with a history of pollution, that’s one of the points we made in the essay in August, that this is an industry with a lot of history and a lot of it’s very bad. And some of this is being litigated right now.

I will tell you that I had dinner recently with a long-standing friend of mine who went through high school together who became Chairman of the Department of Geology of a major university. We were talking about the manpower problem now in the mining industry, that there weren’t enough geologists. And he talked about how the enrollments declined during the 90’s and he said we noticed that not only we’re getting fewer students, but the mix of those that were enrolling changed. We got students who came into geology because they wanted to be engineers but they were really poor in mathematics, or relatively poor and we didn’t have as much emphasis on it as they did for Electrical Engineering or Mechanical so they’d get an Engineering degree with us.

But the most important point was, he said “I think something like a half of our current class are in there, not because they want to build mines but because they want to protect the world against the mining industry. They are greens who want to be forensic experts so they can testify at trials and participate with NGO’s and governments in constraining the mining industry.”

So, what this means is that the problems of this industry, of those who are not running their mines well, have just begun. So thank you for that point, Stephen.

Any other questions?

Caller 2: Don, quick question on that China and their domestic market. I’ve been hearing for a long time now about their necessity to exporting to the US primarily until their domestic market is such that they can almost self-fund themselves. You have made a comment earlier that they have reached that stage. Do you think that that’s the case?

Don Coxe: No. I didn’t want to suggest that they’ve become independent of exports but what Jane Jacobs point was, that Japan, within, after about twenty years of growth, managed to move away from reliance primarily on exports and development of their own middle class. And so their share of GDP from exports dropped. Japan’s is only about ten percent of the GDP is reliance on exports and that’s been that way for some years. And so, China is behind the curve on this, further back, but it’s that pattern in place.

And remember, my call on the base metal stocks is that this is a fifteen year call because the Triple Waterfall crash of technology will last about another fifteen years, which means that the mining stocks which are inversely correlated to tech stocks should be outperforming. But then in addition, we have the fact that there’s these hundreds of millions of people that are going to be joining the middle class in China and India. And this process will be self-reinforcing.

So this is a long-term call. And what it says is by the year 2020, the relationship in the Chinese economy of capex to total economy and exports to total economy are going to look much more like Japan’s than they do a Third World economy. And so, what that’s going to mean, of course, a displacement in which metals are most in demand. So that’s the importance of this announcement this week of that undiscovered middle class.

This is a characteristic example of the way you organize bureaucracies. That everybody was wanting to prove how great they were at exporting and building things and the idea that you had all these people in soft occupations, that wasn’t something for the Commissars to brag about. Well now they are.

So it turns out that they’re there and their number is growing and they’re going to have a bigger share of GDP. What it means is, it’s now the fourth biggest economy in the world. And this was simply by a restatement and finding these new middle class people. And I guess another way to have found them would have been taking the move of copper from about a buck and a quarter to two dollars. Because you couldn’t explain that on the basis of capex. Thank you.

Thank you all for tuning in. The call next week will be, once again, on Thursday. And so it will be Thursday the 29th. In the meantime, have a great weekend.



Don Coxe Profile from the BMO websites:


Donald G. M. Coxe is Chairman and Chief Strategist of Harris Investment Management, and Chairman of Jones Heward Investments. Mr. Coxe has 27 years experience in institutional investing, including a decade as CEO of a Canadian investment counseling firm and six years on Wall Street as a 'sell-side' portfolio strategist advising institutional investors. In addition, Mr. Coxe has experience with pension fund planning, including liability analysis, and tactical asset allocation. His educational background includes an undergraduate degree from the University of Toronto and a law degree from Osgoode Hall Law School. Don joined Harris in September, 1993.

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