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                                                                                                      S ®

                                        JAMES GRANT

                                                                       Vacation delecta
                                             To the readers
                                                                       of Grant’s:

                                        The attached
                                                          anthology of re
                                 yo u , b u t al so                           cent Grant’s pi
                                                    fo r yo u r fr ie n d                            eces is not only
                                sh ip m at es , b ro                      s— an d co -w or                                    for
                                                     th er s- in -l aw an                    k er s, cl ie n ts , cl
                                along, with our                            d m ai d s- of -h on                      as sm at es ,
                                                    compliments, to                             or , to o. P le as e
                                greater Grant’s                            any and all pros                             p as s it
                                                    family.                                    pective membe
                                                                                                                      rs of the
                                     We resume publ
                                                           ication with the
                                                                                issue dated Sept
                                                                                                      . 3.
                                     Sincerely yours,

                                      James Grant

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Vol. 28 Summer Break              Two Wall Street, New York, New York 10005 •                          AUGUST 20, 2010

Up the capital structure
   (December 15, 2006) The not very         market, they say, even the broad sub-                   default has risen. But there is some-
shocking news that low-rated tranch-        prime market, is hale and hearty. Bear                  thing about the sudden blight of delin-
es of poorly underwritten mortgages         Stearns, the top mortgage-backed se-                    quencies and foreclosures in the bot-
on depreciating houses are suscep-          curities underwriter, is an exponent                    tom of the 2006 mortgage barrel that
tible to loss has nonetheless man-          of this idea, as is Triad Guaranty                      doesn’t quite add up. Yes, the median
aged to shock. The cost of insuring         (Grant’s, June 16). Both are expand-                    house price has fallen by 3.5%. But
the lowliest such slice on the stan-        ing their businesses as if the bear                     the jobless rate stands at only 4.5%.
dard subprime reference index has           markets in mortgage debt and resi-                      Nominal interest rates—even follow-
climbed by 25% in seven short days,         dential real estate were already over                   ing 17 quarter-point jumps in the fed
according to the guardians of the           and done with—if, indeed, they ever                     funds rate—remain low. The Russell
untransparent mortgage derivatives          really got under way.                                   2000 Index the other day hit an all-
market. Grant’s has had much to say            The subprime arena is the Wal-                       time high. Blame for the distress at
about mortgage credit this year. Fol-       Mart Nation of American leveraged                       the fringes of subprime, we judge,
lowing is a speculation on 2007, if we      finance. Like the Wal-Mart customer,                    cannot be laid at the feet of the U.S.
have our timing right. In preview, we       it is a bellwether of financial distur-                 economy. It should, rather, attach to
find that, under some not very ad-          bance. Perhaps, it’s no accident that                   the lenders and borrowers who piled
verse assumptions,even higher-rated         the giant retailer’s sales have weak-                   debt on debt until the edifice sways
mortgage structures are vulnerable to       ened as the cost of insuring low-rated                  even in a dead calm.
infestation by credit termites. Insur-      subprime mortgage tranches against                        A common reaction to our descrip-
ance on these supposedly safe and
sound mortgage derivatives is avail-
able for a song.                                          When not-shocking news shocks
                                                    102                                                                            102
   We write not only for the well-                          closing prices of double-A and triple-B-minus
staffed professional investor who                   101
                                                            tranches of ABX.HE 06-2 index                              AA:
could actually buy protection on the
penthouse levels of an arcane mort-
gage index. Our intended audience is,               100                                                                            100
equally, the curious investment ama-
teur who ordinarily has no truck with                99                                                                             99
tranches and derivatives but is always
prepared to make an exception for a


                                                     98                                                                             98
$1 trillion market. Our hypothetical
layman should know that the experts,                 97                                                                             97
so-called, are almost as confused as he
is. Certainly, they are of many minds.
A few—a minority—believe that the                    96                                                              BBB-:          96
troubles now unfolding at the mar-
gins of subprime are the leading edge                95                                                                             95
of much deeper problems. We are in
that camp. The majority contend that                 94                                                                             94
the derangement of the BBB-minus-                   10/2/06 10/10 10/16         10/23    10/30   11/6   11/13   11/20 11/27     12/12
rated tranches is a fluke. The broad                      source: Markit Group, CDS IndexCo.
  SUBSCRIBE! - go to or call 212-809-7994                                                                              Summer Break-GRANT’S/AUGUST 20, 2010   2

                              Home sweet mortgaged home                                                                              September 30, overall U.S. mortgage
                100%                                                                                   100%                          issuance totaled a little more than
                              breakdown of year’s total mortgage issuance
                                                                                                                                     $1.5 trillion, according to UBS. Of
                                                                                                                                     this grand total, no less than 22.2%,
                         80                                                                            80                            or $342.4 billion, was subprime, i.e.,
                                                                                                                                     speculative grade (meaning, gener-
                                                                                                                                     ally, a FICO score of less than 620,
                                                                                                                                     100 points lower than the national
percentage of issuance

                                                                                                            percentage of issuance
                         60                                                                  agency:   60                            median). Another 17.5%, or $269.5
                                                                                                                                     billion, was Alt-A, the class between
                                                                                                                                     speculative and prime. At 39.7% of
                                                                                                                                     year-to-date issuance, the sum to-
                         40                                                                subprime:   40
                                                                                                                                     tal of subprime and Alt-A emissions
                                                                                  Alt-A:                                             thus begins to approach the 43.9%
                                                                                  17.5%                                              of the higher-quality mortgages that
                         20                                                                            20                            Fannie Mae and Freddie Mac are al-
                                                                                                                                     lowed to buy.
                                                                                           prime:                                       Credit quality in the U.S. residen-
                                                                                           11.2%                                     tial mortgage market has been in a
                          0                                                                             0                            long-term downtrend, which is an-
                              1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 3Q06                                            other way of saying that house prices
                              source: UBS                                                                                            and homeownership rates have been
                                                                                                                                     on a long-term uptrend. As recently
tions of the elaborate design, and not                               Mortgage traders speak lovingly of                              as 1994, again according to UBS,
especially generous yields, of asset-                             “the CDO bid.” It is mother’s milk to                              subprime issuance amounted to just
backed securities (ABS) is amaze-                                 the ABS market. Without it, fewer as-                              5.6% of total mortgage issuance, with
ment: “Who buys this stuff?” Grant’s                              set-backed structures could be built,                              Alt-A amounting to only 0.2%. Fan-
readers want to know. Yield pigs                                  and those that were would have to                                  nie, Freddie, Ginnie et al. had the
the world over, is the answer. “Who                               meet a much more conservative stan-                                mortgage-securitization field virtu-
creates and promotes it—and what                                  dard of design. The resulting pangs of                             ally to themselves—and because they
would cause them to stop?” is anoth-                              credit withdrawal would certainly be                               stamped their issuance with a federal
er oft-heard question. The answer to                              felt in the residential real-estate mar-                           guarantee (implied or actual), credit
that is Wall Street. Its mortgage mills                           ket. So the musing of a knowledge-                                 risk, from the investor’s standpoint,
create asset-backed securities like                               able salesman to whom colleague                                    was virtually nonexistent. “Since
the kind featured on page one of the                              Dan Gertner spoke the other day is                                 1994,” observes Gertner, the Grant’s
September 8 issue of Grant’s (“In-                                worth considering. “The CDO man-                                   special vice president in charge of
side ACE Securities’ HEL Trust,                                   agers have certainly stepped back,”                                mortgage complexities, “agency-eli-
Series 2005-HE5”). And the same                                   said our source (so knowledgeable                                  gible mortgage issuance has grown by
mills issue collateralized debt obli-                             is he that he asks to go nameless).                                a factor of 2.5, subprime issuance by a
gations, a.k.a. CDOs. It’s the CDOs                               He explained that what is worrying                                 factor of more than 19 times and Alt-A
that dependably buy the lower-rated                               the CDO managers has nothing to                                    by a factor of more than 500 times.”
ABS tranches.                                                     do with the macroeconomy. It is all                                   The long vigil of the mortgage
   Constant readers will recall that                              about microeconomics, particularly a                               bears for signs that they have not
CDOs are highly leveraged debt-ac-                                sudden paucity of buyers. “Clearly,”                               been imagining things has ended
quisition machines (Grant’s, June 2).                             our source went on, “the end buyer                                 with a succession of confidence-rat-
So it is all important to the subprime                            of this rubbish—whether it be the                                  tling news items. The first was the
market that new mortgage-packed                                   Middle East or, more likely, the Far                               shuttering of Texas-based Sebring
CDOs continue to come tumbling                                    East—has had second thoughts about                                 Capital Partners, a subprime and Alt-
down the Wall Street production lines                             home-equity loans and subprime in                                  A originator, on December 1. Sebring,
as, indeed, they have been: According                             general. I think that is key. If you                               with 325 employees and 10 years of
to the latest data, year-to-date CDO                              follow the money trail, it has implica-                            operating experience, was forced to
issuance totals $223.7 billion, no less                           tions for other asset markets as well.”                            turn off the lights after rising defaults
than 89% higher than in the like pe-                              Perhaps, the flies on the wall at the                              left it without a banker. Ownit Mort-
riod a year ago.                                                  upcoming talks between Chinese fi-                                 gage Solutions, a California subprime
   To sustain this pell-mell growth,                              nance officials and Treasury Secre-                                lender founded in 2003, followed Se-
the Street needs buyers, specifically                             tary Paulson will have the consider-                               bring into the darkness on Decem-
buyers of CDO equity. The equity                                  ation to leak the gist of any concerns                             ber 5. The Los Angeles Times quoted a
tranche is like the understander in a                             Chinese analysts harbor about the                                  valedictory Ownit press release that
human pyramid. Without him, there                                 subprime market.                                                   blamed Merrill Lynch for pulling the
can be no show. Upon a CDO’s eq-                                     The $1 trillion size of the market                              plug; Merrill held about 20% of Own-
uity is loaded tranches of lower-rated                            should push it to the top of any inter-                            it’s equity. Two days later, Fitch Rat-
ABS at a ratio of as much as 20:1.                                national financial agenda. Through                                 ings placed a subsidiary of AMC Mort-
SUBSCRIBE! - go to or call 212-809-7994                                                  Summer Break-GRANT’S/AUGUST 20, 2010   3

gage Services under surveillance for                       We will proceed to identify a few           one rating category?” Yes, the mort-
possible downgrade, citing a plunge                     slices of fat that have not yet fallen off     gages that pack the various tranches
in origination volume, rising credit                    the griddle—colleague Gertner has              are all subprime. But derivatives ar-
problems and a consequent knock                         spotted some excellent candidates              chitects convert subprime into invest-
to the profitability of the firm’s ser-                 for sale. First, though, a few helpful         ment-grade by armoring the higher
vicing business. In remarks that bear                   words of background.                           tranches with extra collateral. A tri-
on all subprime originators, the L.A.                      “ABX” is the basic index designa-           ple-A-rated subprime tranche is one
Times quoted John Bancroft, manag-                      tion, and that is simple enough. ABX.          reinforced with enough mortgages to
ing editor of Inside Mortgage Finance,                  HE is a fuller designation, and it is          make it impervious—supposedly—to
as follows: “These are companies that                   wholly misleading. “HE” signifies              loss. Remember that, in all such struc-
depend almost exclusively on new                        home equity, but you may put that              tures, income cascades down from the
loans for their earnings. That market                   out of your mind. This is an index             top while losses infiltrate up from the
grew rapidly in the last 10 years, but                  overwhelmingly of first liens; home-           bottom. The higher-rated tranches
it couldn’t last forever. Eventually,                   equity-type seconds may constitute             get paid first; the lower-rated ones
you reach just about every marginally                   no more than 10% of a given tranche.           bear the first loss.
qualified borrower you can.”                            The basic index consists of an equal-             The ABX.HE index series is a joint
    That not one borrower was left                      weighted static pool of 20 credit de-          production of CDS IndexCo and
behind is increasingly evident in                       fault swaps, or CDS, that reference            Markit Group Ltd. CDS IndexCo is
the market for lower-rated subprime                     U.S. subprime mortgage securities.             a consortium of 16 brokerage-house-
mortgage tranches. An index that                        Have you tripped over the words                cum-market-makers; Markit, which
references a particular subspecies of                   “credit default swaps”? Pick yourself          was founded in 2001, is a pricing,
mortgage slices—the ABX.HE 06-2                         up and dust yourself off. In effect,           asset-valuation and risk-management
BBB-minus—is the one that sudden-                       CDS are insurance policies on credit           data vendor. On the occasion of the
ly costs 25% more to insure against                     risks. They may, therefore, be viewed          launch of the first index series last
loss than it did at the end of Novem-                   as mirrors to the credit risk against          January, Bradford S. Levy, a Goldman
ber. Informants say that it is nearly                   which they offer protection.                   Sachs managing director and acting
impossible to buy credit protection                        The basic ABX.HE index contains             chairman of CDS IndexCo, explained
on poorly performing tranches of the                    five subindices, each of which tracks          what it was all about: “The CDS of
mortgage stack. Mr. Market, though                      a different grade of mortgage credit           [the] ABS market has grown at a
sometimes slow on the uptake, does                      quality. Which may lead you to won-            rapid pace over the past six months,
not have to be told twice that the fat’s                der: “If all the mortgages are sub-            and we have seen increasing appetite
in the fire.                                            prime, how can there be more than              among clients for a way to take a syn-

                                                                 Termites gnaw
                           performance of the constituents of the ABX.HE AA 06-2 index

                         —credit support—                   ——days delinquent——                        real estate    total   months of
ABS deal                 original current                   30      60       90          foreclosure     owned     distressed seasoning
LBMLT 2006-1 14.15%                 17.38%         4.56%        2.47%      3.00%        4.91%          1.09%       16.03%                 9
CWL 2006-8     12.95                  13.45          3.10         1.25       0.29         1.67           0.05         6.36                6
MSAC 2006-WMC2 12.45                  12.57          3.66         2.21       1.40         2.37           0.00         9.64                6
ARSI 2006-W1   14.84                  19.03          2.77         1.57       1.45         4.95           0.79        11.53               10
FFML 2006-FF4  13.35                  15.33          2.80         1.04       0.69         2.64           0.60         7.77                7
ACE 2006-NC1             14.65        18.97          2.60        1.21        1.17         2.68          0.64          8.30               11
SVHE 2006-OPT5           15.13        16.35          3.26        1.26        0.68         1.28          0.00          6.48                5
SAIL 2006-4              10.90        12.33          4.06        2.24        0.76         2.70          0.04          9.80                6
GSAMP 2006-HE3           17.20        19.14          4.43        2.94        1.76         3.75          0.62         13.50                7
MLMI 2006-HE1            18.35        22.94          4.71        1.56        2.31         2.45          0.81         11.84               10
JPMAC 2006-FRE1          17.45        22.18          5.08        1.95        0.24         6.16          1.35         14.78               11
RASC 2006-KS3            14.90        16.88          3.83        1.84        1.22         3.59          0.57         11.05                8
RAMP 2006-NC2            12.95        15.22          3.70        1.72        0.81         5.24          0.70         12.17                6
HEAT 2006-4              12.90        14.73          3.53        1.90        1.02         2.38          0.05          8.88                5
BSABS 2006-HE3           16.65        20.01          4.03        2.46        2.70         4.63          0.24         14.06                9
MABS 2006-NC1            14.30        17.56          3.51        2.11        1.20         5.29          0.68         12.79              10
CARR 2006-NC1            16.40        19.95          2.92        1.12        1.18         3.46          0.30          8.98               9
SASC 2006-WF2            13.55        14.98          2.04        0.25        0.08         1.04          0.02          3.43               6
SABR 2006-OP1            11.40        16.02          2.48        0.49        1.12         2.88          0.40          7.37              11
MSC 2006-HE2              3.90        14.14          3.84        1.97        1.92         3.13          0.36         11.22               7
Average                  14.42        16.96          3.55        1.68        1.25         3.36          0.47         10.30              8.0
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thetic view on ABS. ABX is a direct                     the 2005 subprime mortgage crop as         course, there’s no telling when, or if,
response to that demand, and gives                      well? Our replies are, respectively,       the loans now troubled would go irre-
clients an efficient, standardized tool                 “no,” “no,” and “yes.”                     trievably bad. But given the wretched
with which to quickly gain exposure                        For evidence to support our affir-      performance of the collateral to date,
to this asset class.”                                   mative response to question No. 3,         the cost of insurance seems strik-
   In short, here was a new deriva-                     we invoke the September 28 Merrill         ingly cheap. “Nor is a cash loss the
tive index to fill the supposedly cry-                  Lynch “Review of the ABS Markets.”         only way to get paid,” Gertner points
ing need for a way to speculate on the                  In it, the Thundering Herd’s ABS re-       out. “Spreads could widen—as the
value of stacks of subprime mortgage                    search group posits that losses on re-     spreads on lower-rated tranches have
tranches. The first index series to                     cent subprime ABS issues could be big      already begun to do.”
be launched was the ABX.HE 06-1,                        enough to eat well into the structures’       For the time being, the bear mar-
and the mortgages from which it de-                     mezzanine levels, i.e., a principal loss   ket in subprime credit is tightly fo-
rives its value were originated in the                  on the order of 6% to 8%. This could       cused on the lowest tranche of the
second half of 2005. The next index                     occur if house prices do no worse next     2006 index. It would, to repeat, cost
made its appearance in July. This was                   year than move sideways. But the           you 380 basis points a year to insure
the ABX.HE 06-2; the mortgages to                       Merrill economics squad has forecast       it against credit loss. Better value, as
which it refers were originated in the                  a house-price decline of up to 5%. In      Gertner points out, is protection on
first half of 2006. The promoters say                   which case, the ABS researchers warn,      the BBB-minus tranche of the earlier
they intend to introduce a new series                   losses in subprime asset-backed struc-     index, the ABX.HE BBB-06-1. “If
every six months.                                       tures would spike into the double dig-     deterioration in subprime mortgage
   The index that keeps getting its                     its. Losses could infiltrate all the way   quality finds its way into the loans
name in the paper is the July edi-                      up to the A-rated mortgage stack, the      originated late in 2005, and I believe
tion. What makes it notorious is the                    researchers speculate. Just as rising      it will,” Gertner winds up, “then the
shockingly weak credit quality of the                   house prices tended to cover up afford-    cost of insurance will only steepen.”
early-2006 subprime mortgage co-                        ability and solvency problems, so fall-       As bull markets are said to climb a
hort. Not surprisingly, the weakest                     ing house prices would unmask them.        wall of worry, bear markets grow on a
of the five constituent subindices is                      It goes without saying that these       trellis of complacency. Is Mr. Market
the lowest-rated one, the BBB-minus                     excellent analysts are groping in the      yawning? A good sign—for the mort-
tranche. The aforementioned plunge                      dark. We all are. None of us, for ex-      gage bears.
of confidence in its creditworthiness                   ample, can be sure how long it might                          •
translated into a spike in the cost of                  take for delinquencies and foreclo-
insuring it against loss to 380 basis                   sures to translate into money losses.
points per annum from 300, all in the                   But some things are certain. With only     China channels
space of a week. No doubt the move                      a glance at the tote board, for example,
was exaggerated by the usual depop-                     we can know today’s odds on tomor-         ‘Monkeybrains’
ulation of year-end trading desks.                      row’s possible outcomes. Specifically,
   The bad news is oddly unconta-                       the probability of a default on the AA        (July 10, 2009) Too much debt got
gious so far. Nothing like that loss                    tranche of the ABX.HE 06-2 subindex        us into this mess, and too much debt
has been registered in the higher-                      is reckoned to be close to zero. You can   will see us out of it. Socialize the risk
rated subindices of the same ABX.                       buy credit protection on the AA slice      of a new cycle of open-throttle lend-
HE 06-2; the AA-rated tranche is                        of subprime mortgage exposure for a        ing and cling to the monetary system
little changed. Neither has the                         mere 13.8 basis points. That is, the       that assures a repeat crisis. Such,
ABX.HE 06-1 index—which, to re-                         cost of insuring $10 million in notional   approximately, is the global policy-
peat, references the late-2005 sub-                     value of the AA index will set you back    making consensus. Central bankers
prime cohort—been dragged down.                         a mere $13,800 a year. “Pretty cheap       and finance ministers have achieved
The BBB-minus tranche of the 06-1                       insurance,” Gertner notes. “But is         an uncommon meeting of the minds.
index trades around par. The an-                        there any chance of getting paid?”         The cure for what ails us is the hair
nual cost of insuring it against loss                      Gertner has made a study of the 20      of the dog that bit us, they prescribe,
amounts to just 270 basis points, 110                   ABS deals that constitute the ABX.         though not in exactly those words.
fewer basis points of risk premium                      HE 06-2 index. He pronounces their            It’s no small thing that China is es-
than assigned to the same tranche in                    performance to be lamentable. Af-          pecially enamored of the shot-and-a-
the 06-2 subindex.                                      ter just eight months of seasoning         beer-for-breakfast approach. Nothing
   Is the subprime mortgage class of                    on average, 10.3% of the constituent       about China is small or insignificant
2006 uniquely blighted? Were the                        mortgages are delinquent, in foreclo-      nowadays, since the Chinese economy
underwriting standards prevailing                       sure or classified as real estate owned.   is actually growing. It might, indeed,
during the first six months of the year                 (The runt of the ABS litter, the Long      account for 74% of worldwide GDP
uniquely slapdash? Or, are the re-                      Beach Mortgage Loan Trust 2006-1,          growth in the three years to 2010, the
markable losses borne on the unsea-                     shows 16% of the loans in one state        International Monetary Fund esti-
soned 2006 vintage simply the con-                      of distress or another.) Now, credit       mates. Since 2005, China has gener-
sequence of a bear market in house                      support for the AA-rated tranches, at      ated 73% of the global growth in oil
prices (and the preceding riot in easy                  17%, provides 6.7 percentage points        consumption and 77% of the global
credit) that sooner or later will corrupt               of insulation against loss—and, of         growth in coal consumption. By the
        SUBSCRIBE! - go to or call 212-809-7994                                                                        Summer Break-GRANT’S/AUGUST 20, 2010   5

     looks of things, it accounts for a fair                          er forms of financial artificial respira-                      ing managers’ survey registered 53.2,
     share of the growth in worldwide lux-                            tion by the governments of the G-20                            its fourth consecutive month over the
     ury-car consumption, too:                                        nations sum to the equivalent of 32%                           50% mark that indicates economy-
                                                                      of last year’s combined G-20 gross do-                         wide growth. The Shanghai A-share
        FRANKFURT (Dow Jones)—                                        mestic product, the IMF estimates.                             market jumped by 65% in the first
     BMW AG said Monday that sales at                                 That is on top of average fiscal stimu-                        half, to a level that fixes its value at
     its core BMW brand in China were up                              lus equivalent to 5.5% of GDP. So the                          31 times trailing net income, up from
     46% on the year in June at 8,033 cars,                           United States, implementing fiscal                             12.8 times at the October lows. Chi-
     fueled by strong demand for its X5                               and monetary stimulus worth nearly                             nese M-2 was 25.7% larger in May
     and X6 models.                                                   30% of GDP (Grant’s, April 3), is not                          than it was a year before. Chinese
        Sales in China for both the BMW                               far out of the interventionist main-                           officialdom is targeting 8% GDP
     and the compact Mini brand rose 44%                              stream. China is in a class by itself.                         growth this year, while the World
     on the year at 8,506 cars, a company                                In the 1930s, Western intellectu-                           Bank predicts 7.2%, of which, the
     spokesman said.                                                  als persuaded themselves that the                              organization says, six full percentage
                                                                      Soviet economic model was depres-                              points owe their existence to govern-
        Now unfolding is a preview of the                             sion-proof. Today, not a few investors                         ment stimulus. As between the 8%
     next, the future, credit collapse. Such                          marvel at the vigor of the modified                            government forecast and the 7.2%
     methods as China is employing—a                                  communist economic model of the                                non-government forecast, our money
     borrowing binge centrally planned                                People’s Republic. Credit may con-                             is on the government. Not only do the
     and directed—will eventually come                                tract in the United States, but it ex-                         cadres print the money, but they also
     to grief, as the readers of Grant’s                              pands—nay, explodes—in China. “If                              calculate the GDP. So, falling in with
     know full well. Indeed, in money                                 the rumored new lending figures for                            the Communist Party, we, too, pre-
     matters, nearly everything seems to                              June are accurate (for more, see Mi-                           dict 8% growth for 2009—barring an
     come to grief sooner or later. How-                              chael Pettis’s blog at,”                          early explosion in the Chinese bank-
     ever, it is equally true that, before the                        observes colleague Ian McCulley,                               ing system.
     grief, comes the laughter and levita-                            “Chinese banks will have lent 7 tril-                             New directives to Fannie Mae
     tion. Massive injections of money                                lion renminbi, or a little more than $1                        and Freddie Mac to refinance cer-
     and credit are always unsound. But                               trillion, in the first half of 2009, com-                      tain mortgages at up to 125% of ap-
     for stocks, commodities and credit,                              pared to Rmb4.9 trillion in all of 2008,                       praised home value reaffirm the U.S.
     they are bullish before they are bear-                           Rmb3.6 trillion in 2007 and Rmb3.2                             government’s membership in the
     ish. In the fad for “quantitative eas-                           trillion in 2006. New lending was ex-                          hair-of-the-dog bloc. But no credit-
     ing,” when might the laughter turn to                            ceptionally strong in the first three                          market intervention approaches the
     tears? How to prepare for that inflec-                           months of this year. It tapered off a                          one being mounted in Beijing. For
     tion point? How to see it coming?                                bit in April and May but appears to                            it, the world’s commodity producers
        China is not alone in seeding bad                             have roared back in June.”                                     say daily prayers of thanksgiving, and
     loans right on top of the previous                                  Complementary roars have issued                             their gratitude would truly be incalcu-
     cycle’s only partially harvested crop                            from China’s manufacturing indus-                              lable if only they knew how long the
     of desperate debts. Loan guarantees,                             tries and world commodity pits. Last                           Chinese could keep it going. Absent
     commercial paper purchases and oth-                              week, the People’s Republic purchas-                           Chinese stockpiling, where would
                                                                                                                                     commodity prices be? Without a
                                                                                                                                     functioning Chinese banking system,
                         Indispensable country?
                   80%                                                                                    80%                        where would the world economy be?
                           China’s actual and projected contributions to global GDP growth;                                             A superb primer on the risks of
                           three-year moving average (PPP basis)                                                                     China’s go-for-broke lending drive
                   70                                                                                     70
                                                                                  three years
                                                                                    three years                                      was published by Fitch Ratings on
                                                                                 to 2010: 74%
                                                                                   to 2010: 74%                                      May 20. Is it not passing strange, the
                   60                                                                                     60
                                                                                                                                     agency asks, that Chinese lending is
                                                                                                                                     accelerating even as Chinese corpo-
                   50                                                                                     50
GDP growth share

                                                                                                                  GDP growth share

                                                                                                                                     rate profits are shrinking? “Ordinar-
                                                                                                                                     ily, falling corporate earnings are met
                   40                                                                                     40                         with tightened lending, but in China,
                                                                                                                                     precisely the reverse is evident. . . .”
                   30                                                                                     30                         You would expect—and Fitch does
                                                                                                                                     anticipate—that the borrowers of
                                                                                                                                     these trillions of renminbi are not so
                   20                                                                                     20
                                                                                                                                     profitable as they were in the boom,
                                                                                                                                     and some will therefore struggle to
                   10                                                                                     10                         service their debts.
                                                                                                                                        Reading Fitch on China, we think
                    0                                                                                         0                      of the author Mark Singer on Okla-
                        1970    1975      1980     1985        1990   1995   2000     2005        2010 2014                          homa. In China, Fitch explains, credit
                         source: International Monetary Fund                                                                         losses don’t surface promptly on ac-
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count of “pervasive rolling over and
                                                                                        Preview of tomorrow’s crisis                                             10,000
maturity extension of loans when they
                                                                                          Chinese bank lending; rolling 12-month sums       Rmb8.62 trillion
fall due. This not only leads to under-
capturing of NPLs and delayed credit
costs, but also, by extension, inflated                                         8,000                                                                             8,000
capital. Consequently, in the short to
medium run, Chinese banks’ perfor-

                                                     in billions of renminbi

                                                                                                                                                                          in billions of renminbi
mance may continue to hold up well
as rapid loan growth drives up the de-                                          6,000                                                                             6,000
nominator of NPL ratios and boosts
profits via high volumes, but the me-
dium-term risk of a deterioration in                                            4,000                                                                             4,000
corporate portfolios is rising.”
   Neither did credit losses surface
right away at the Penn Square Bank,
Singer related in his 1985 tour de                                              2,000                                                                             2,000
force, “Funny Money.” Penn Square
originated oil-patch loans at its head-
quarters in an Oklahoma City shop-
                                                                                    0                                                                                 0
ping center during the boom of the                                                 3/01             4/03        4/05             3/07                          5/09
late 1970s and early 1980s. Interests                                                   source: The Bloomberg
in these credits it syndicated far and
wide. An alert loan buyer might have
taken a cautionary hint from Penn                                              rates. The secret, fully revealed dur-       already on the rise. Chinese loan offi-
Square’s super-fast growth and evi-                                            ing the subsequent bear market, was          cers work to a quota. They take their
dent undercapitalization, if not from                                          that the default rates were a direct         direction from their branch managers,
the nickname of its chief energy-                                              product of the issuance rates. Bor-          who report to the senior management,
lending officer—they called him                                                rowers didn’t default because of—to          which answers to the board of direc-
“Monkeybrains.” But the Continen-                                              adapt the Fitch formulation to that          tors—and the directors hang on the
tal Illinois National Bank & Trust                                             earlier time—the “pervasive rolling          words of the People’s Bank.
Co., of Chicago, one of Penn Square’s                                          over and maturity extension of bonds            The trouble these days is that too
top loan participants, seemingly sus-                                          as they fell due.” Drexel failed when        many motivated loan officers are
pected nothing until the Oklahoma                                              the junk market did.                         chasing too few creditworthy borrow-
bank failed in 1982. When Continen-                                               The idea that the government will         ers. Net interest margins at Chinese
tal Illinois itself became insolvent in                                        finally pick up the pieces may or may        banks are tightening on account of
1984—pulled down, in part, by its                                              not drive the typical mid-size Ameri-        the recession and the governmentally
Penn Square participations—a new                                               can bank to risk-taking from which           sponsored drive to lend their way to
chapter in the socialization of credit                                         it would otherwise shrink. In China,         prosperity. So loan officers push all
risk was opened. To save the Federal                                           however, there appears to be no doubt.       the harder. “For example,” as Fitch
Deposit Insurance Fund, the govern-                                            “Prior to the global crisis,” according      explains, “a branch manager is given
ment nationalized Continental, then                                            to Fitch, “domestic [Chinese] credit         an annual profit target of Rmb35 mil-
the nation’s seventh-largest bank,                                             conditions had been fairly tight; strict     lion. If the average loan margin is
with assets of $41 billion. Pure and                                           loan quotas had been put in place at         3.5%, he needs to lend Rmb1 billion
simple, it was too big to fail. Indeed,                                        the start of 2008 amid concerns about        to meet this goal. However, if the av-
Comptroller of the Currency C. Todd                                            inflation, and [corporations] and banks      erage margin declines to 2%, he now
Conover subsequently hinted, the                                               were increasingly employing off-bal-         needs Rmb1.75 billion to meet the
11 largest banks in the country were                                           ance-sheet transactions to complete          same objective. This is not the first
systemically irreplaceable. And so                                             deals. However, since the rollout of         time Chinese banks have faced a mar-
was born the too-big-to-fail doctrine.                                         the stimulus package [last November],        gin squeeze, but in the past the abil-
Whether or not it was an American                                              the climate has dramatically changed.        ity to raise credit volume was limited
invention, the policy today belongs                                            Projects that had been sidelined when        by quotas [i.e., central-bank-imposed
to the world. China, in particular, has                                        quotas were tight have been put into         quotas to restrict lending to combat
taken the idea and run with it.                                                action with the assumption that if           inflation]. Now, in a quota-less envi-
   Examining, first, the track of Chi-                                         problems arise, Beijing will likely step     ronment, that restraint is gone.”
nese bank lending and, second, the                                             in with assistance.”                            China has its Sheila Bair as well
trend in Chinese nonperforming                                                    If problems arise? As Fitch itself        as its Ben Bernanke, and the safety-
loans, the seasoned reader will re-                                            implies, the only question is when:          and-soundness bureaucracy in March
member not only Monkeybrains but                                               Nonperforming loans at foreign               urged banks to set aside in reserve
also Drexel Burnham Lambert. In                                                banks in China, “which are generally         150% of the par value of their bad
the mid-to-late 1980s, the American                                            believed to have stricter risk manage-       debts, up from 120%. But the direc-
junk-bond market combined break-                                               ment and oversight and are less will-        tive seems more in the way of a sug-
neck growth with muted default                                                 ing to roll over delinquent loans,” are      gestion than a ukase. Certainly, the
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                                                                                                                                       rates at the knees, central banks
                               Bad debt comes later                                                      20%                           punish thrift. Prolonging the lives
                                 Chinese nonperforming-loan ratio                                                                      of businesses that deserve to go out
                                                                                                                                       of business, they thwart the designs
                                                                                                                                       of the entrepreneurs who would, if
                         16                                                                              16                            they could, build something better.
                                                                                                                                       There’s no end of mischief in quanti-
                                                                                                                                       tative easing. On the other hand, it’s
percent of total loans

                                                                                                              percent of total loans
                         12                                                                              12                            an ill monetary wind that blows no
                                                                                                                                       portfolio any good. Beijing has been
                                                                                                                                       lifting prices in resource markets.
                                                                                                                                       “The round of oil-field auctions in
                          8                                                  all banks: 2.04%             8                            Baghdad last week,” McCulley points
                                                                                                                                       out, “is a sign of things to come, as
                                                                                                                                       China National Petroleum Co. was
                                                                                                                                       part of a winning BP-led bid, while
                          4                                               foreign banks: 1.09%            4
                                                                                                                                       most other Western majors walked
                                                                                                                                       away complaining of unfair terms.
                                                                                                                                       (China National has a separate deal
                          0                                                                               0                            to develop other Iraqi fields.) Sinopec
                               3/04          3/05      3/06           3/07           3/08         3/09                                 is buying Addax Petroleum, with re-
                               source: The Bloomberg                                                                                   serves in West Africa and Iraq, in an
                                                                                                                                       $8.8 billion deal, and, according to
stock market does not believe that the                              able for inflation projections, giving                             The Wall Street Journal, is paying $16
evil end to the new credit boom is yet                              priority to output gaps.”                                          per barrel of proven and probable re-
in sight. In Hong Kong, the big three                                  So the economists give intellectual                             serves, more than triple the valuation
Chinese banks—Industrial & Com-                                     cover to the money printing. For the                               of other deals in the region.” Western
mercial Bank of China, Bank of China                                “mature market economies,” we ad-                                  companies may answer to their share-
and China Construction Bank—trade                                   vise a return to the basics, starting                              holders, but as an energy consultant
at price-to-book multiples of 2.5, 1.7                              with the very definitional threshold                               put it to the Financial Times last week,
and 2.5, respectively.                                              of the problem. Inflation is not “too                              “The Chinese companies are answer-
   We are as bearish on the multiples                               much money chasing too few goods,”                                 ing to politicians who have an aggres-
as we are on the stated book values.                                but too much money, period. What                                   sive strategy of resource capture.”
On the other hand, the stock market                                 the fatal, redundant increment of cash                                The properly skeptical observer is
is as sanguine about Chinese bank                                   chooses to pursue varies from cycle to                             in a quandary. China holds perhaps
stocks as economists are compla-                                    cycle. In pursuit, however, it never                               $1.5 trillion of low-yielding Treasurys
cent about Chinese inflation. The                                   fails to distort something. Lately, the                            and U.S. agency securities. You’d ex-
late Milton Friedman handed us not                                  money has been chasing investment                                  pect it to be edging out of two-year
so much a postulate as a divine law                                 assets rather than goods and services.                             notes and Fannies and Freddies into
when he said that “[i]nflation is al-                               In Shanghai, it is chasing A-shares.                               resource investments, even if it had
ways and everywhere a monetary                                      Globally, this year, it has pushed up,                             no doubts about the dollar. But it does
phenomenon.” But a new generation                                   or contributed to the pushing, of the                              have doubts, which it has taken to ex-
of central bankers and economists is                                prices of lead, copper and nickel by                               pressing in deeds as well as in words.
having its doubts. “Some worry that                                 75%, 71% and 50%, respectively.                                    On Monday, a Shanghai municipal
the rapid growth of money and credit                                Who knows? Maybe the central banks                                 government finance official called
will lead to inflation,” the Beijing of-                            have prevented some prices from fall-                              a press conference to announce the
fice of the World Bank advises in its                               ing further than they otherwise would                              decision of three local companies to
June Quarterly Update. “However,                                    have done. Central bankers, however,                               begin settling import and export con-
with a lot of [spare] capacity in China                             to generalize across the profession, re-                           tracts in renminbi rather than dollars.
and world-wide putting downward                                     fuse even to imagine the problem in                                From offstage, a Singapore currency
pressure on raw material prices un-                                 these terms. They are content rather                               analyst declared, according to Bloom-
likely to soar soon, substantial gener-                             to assert that, owing to the prodigious                            berg, “This is a first step on the long
alized price pressures seem unlikely                                gap between output and potential                                   road towards that target of making the
any time soon.” An asterisk at the                                  output in recession-wracked econo-                                 [renminbi] a global reserve currency.
end of that sentence leads the read-                                mies, their actions have instigated no                             That’s probably going to take five
er to a footnote in which the World                                 inflation but have forestalled defla-                              years or more.”
Bank economists finish the argument:                                tion. Self-congratulations ringing in                                 It could be a long, hard road if Chi-
“The relationship between monetary                                  their ears, they are prepared to crank                             na’s Monkeybrains banking system
aggregates and inflation is complex.                                the presses even faster when duty                                  follows the Penn Square-type trajec-
That is why central banks in mature                                 next calls. What’s the harm in it? they                            tory, as we expect it will. Besides,
market economies have largely aban-                                 seem to ask.                                                       Bloomberg News, in the very same
doned using money as a guiding vari-                                   In fact, by cutting off interest                                dispatch, relates that the dollar’s
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share of official vault space climbed                          mulative trade surplus through May,                     Men-style vendor to the energy in-
to 65%, or $2.6 trillion, up 100 basis                         which is actually ahead of last year’s                  dustry.
points on an admittedly incomplete                             record-setting pace.”                                      Lufkin, 107 years young, is a lead-
sample set, in the first three months                             A good-size portion of the Trea-                     er in the field of artificial lifting—its
of the year. And it quotes He Yafei,                           surys and agencies that America’s                       technology restores to aging wells
China’s deputy foreign minister,                               creditor nations accumulate is held                     what nature is gradually taking away.
speaking in Rome on Sunday: “The                               for safekeeping at the Federal Re-                      Its oil-field segment manufactures
dollar will maintain its role for ‘many                        serve Bank of New York. We track                        pumping units, or “horse’s heads,”
years to come.’”                                               these custody holdings on pages six                     as the roughnecks affectionately call
   So saying, He came to the root of                           and seven of Grant’s; the Fed disclos-                  them. Lufkin installs pumping units,
the problem. The dollar’s “role” in                            es them every Thursday. Strange to                      services them and fine-tunes them
the world—its exalted status as a re-                          relate, they have grown, not shrunk,                    with computer automation equip-
serve currency—is what has facilitat-                          in the past three months, at an annual                  ment.
ed the piling up of debts on one side                          rate of 27%.                                               A second Lufkin business segment,
of the Pacific and U.S. Treasury as-                              All in all, the world is reverting                   the power-transmission division,
sets on the other. It is the dollar’s role                     to pre-crisis form. Central banks are                   makes and services gearboxes for
that has allowed the United States to                          monetizing dollars, subsidizing credit                  industrial applications. For energy-
consume much more than it produces                             and socializing risks, and the People’s                 related work, it produces high-speed
and to finance the difference in the                           Bank is outdoing all others in this                     gearboxes. An exacting work is this, as
currency that it alone may lawfully                            direction. Certain it is that these un-                 the gearing runs at up to 4,500 revolu-
print. China ships merchandise to us;                          precedented monetary maneuvers                          tions per minute. For less demanding
we ship dollars to China. These dol-                           will come to a sorry and dramatic end.                  applications, there is a Lufkin line of
lars wind up at the doorstep of the                            What we are struggling to divine is                     low-speed gearboxes.
People’s Bank, which creates the                               the timeline. Watch this space.                            A little like the stock market itself,
renminbi with which to absorb them.                                                           •                        Lufkin’s shares are neither very rich
And what does the bank do with its                                                                                     nor very cheap. They are quoted at
greenbacks? Why, it invests them in                                                                                    10.8 times earnings (and peak earn-
the securities of the U.S. government.                         Lift for Lufkin                                         ings, at that) and 20 times the average
Note, please, that the dollars might as                                                                                earnings of the past 10 years. They
well have never left home. Note also                              (August 7, 2009) It’s not only we,                   trade at 1.7 times book with a divi-
that their transit instigates credit cre-                      the people, who are aging. Oil and gas                  dend yield of 2.1%. At $47 a share, the
ation in China, some of which, though                          fields, too, are getting gray around the                stock is half of its record-high price
not all, may be neutralized, or “steril-                       temples. To erase unsightly blem-                       set almost 12 months ago. Revenues
ized,” by the People’s Bank. Under a                           ishes and prolong productive life are                   and net income peaked in the fourth
proper gold standard, creditor coun-                           yearnings that have launched many                       quarter of 2008 at $230.6 million and
tries gain reserves while debtor coun-                         a profitable business. Following is a                   $26.6 million, respectively. Second-
tries lose them. Built into that system                        bullish analysis of Lufkin Industries                   quarter revenues and net income, at
is a balancing mechanism. New un-                              (LUFK on the Nasdaq), a Just-for-                       $123.7 million and $4.5 million, were
der the paper-money arrangements
of recent decades is a kind of intrinsic
                                                                                Counting down
imbalance. The major debtor country                                     4,500                                                                             4,500
loses no reserves even as the debtor                                               oil and gas rig count; North American average
countries gain them.                                                    4,000                                                                             4,000
   Our Great Recession has restored a
small measure of balance to the inter-                                  3,500                                                                             3,500
national financial traffic. U.S. imports
have fallen further than U.S. exports,                                  3,000                                                                             3,000
thus reducing the U.S. current-ac-
                                                       number of rigs

                                                                                                                                                                  number of rigs

count deficit for the first quarter to                                  2,500                                                                             2,500
$101.5 billion vs. the year-ago reading
of $179 billion. The second-quarter                                     2,000                                                                             2,000
shortfall was the smallest in abso-
lute terms since the fourth quarter of                                  1,500                                                           July 31,          1,500
2001, and the smallest as a percent-                                                                                                      948
age of GDP—2.9%—since the first                                         1,000                                                                             1,000
quarter of 1999. Yet, still, China accu-
mulates dollar bills. “Despite a year-                                   500                                                                               500
over-year drop in exports of 26.4%,”
McCulley notes, “and the American                                          0                                                                                 0
consumer’s newfound taste for thrift,                                      1949            1959        1969     1979         1989         1999        2009
China has posted an $89 billion cu-                                             source: Baker Hughes
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                                                                                    Lufkin Industries
down from year-earlier levels by 29%
and 79%. They fell in a heap with the                                    (in $ thousands, except per-share data)
oil price and the rig count. One year                                               12 mos. to
ago, according to Baker Hughes, 1,951
                                                                                     6/30/09         2008            2007             2006
rigs were at work in North America.
There were just 876 in May. At last                     Sales                         $702,513     $741,194       $555,806          $526,122
count, in July, there were 948.                         Cost of goods sold            (515,575)    (527,120)      (393,538)         (374,922)
   “Compounding the fall in demand                      SG&A                           (75,256)     (71,974)       (57,582)          (50,752)
for our products,” CEO John F. Glick                    Other income (expenses)        (10,864)       (5,688)         4,772             1,474
told listeners-in on the July earnings                  Taxes                          (36,180)     (48,387)       (37,673)          (30,650)
call, “is the high level of inventory in                Net income                       64,638       88,025         71,785            71,272
our major customers’ storage yards.                     Earnings per share                 4.35          5.92          4.92              4.83
Since customers purchased much of                       Sales backlog                   162,260      317,486        199,032           183,929
that inventory and put it in place in
the second half of 2008 in anticipation                 Cash and cash equivalents       86,300      107,756          95,748           57,797
of having a number of rigs under con-                   Receivables                       Na        139,144          90,696           90,585
tract, the pace for drawing down that                   Inventories                       Na        128,627          92,914           85,630
inventory will be slow. We believe it                   Total assets                   519,092      530,718         500,656          429,069
may take at least two more quarters
                                                        Current liabilities               Na         88,813          68,314           61,495
for those inventories to be worked
                                                        Long-term debt                   2,300        —               —                —
down, assuming the rig count remains
                                                        Shareholders’ equity           418,928      413,937         384,653          328,140
roughly at current levels. Until that
happens, new orders will remain well
below those record levels we saw last                   Share price                     $47.06
year.” To adjust, the front office re-                  Dividend                           2.1%
duced the oil-field manufacturing                       Market cap                    $699,349
head count by 38% in Canada and by                      Price/book                         1.7x
68% in the United States.                               Price/earnings                    10.8
   Admittedly, the bull story may not
be quite self-evident. Rather, we                       of gas, 4,500 feet of oil and 4,500        opening-day remarks by the host na-
think, it’s implicit in the profile of the              feet of water would, therefore, be         tion’s minister of oil and gas. “Dr.
world’s waning oil fields. In the full                  3,500 psi (1,000*0.05+4,500*0.333          Ali Mirza,” said the press release,
bloom of youth, an oil or gas well may                  +4,500*0.433). In order for the well       “stressed the important role played
exhibit what the engineers call natu-                   to produce via natural lift, the reser-    by artificial lift in crude oil produc-
ral lift. Whether or not a well can use                 voir pressure would need to be great-      tion by pointing out that over 50% of
a Lufkin pumping unit depends on                        er than 3,500 psi. If the reservoir        the world’s oil wells currently utilize
comparative fluid pressures. Pressure                   pressure were, say, 4,000 psi, fluids      some form of artificial lift technology.
within the energy-bearing reservoir is                  would flow toward the well bore and        Citing the local situation, he added
one such variable. Pressure created                     make their way to the surface—no           that more than 60% of oil wells in
by the column of oil or gas or water                    assistance required. If the reservoir      Bahrain also use these technologies,
inside the well bore is another. This                   pressure were only 3,000 psi, the col-     contributing about 50% of the king-
second kind of pressure is known as                     umn of fluid would need to be lifted       dom’s total oil production.”
the hydraulic head. When the hydrau-                    artificially out of the well bore by a        How does Lufkin, with a market
lic head is greater than the pressure in                pump. New wells may or may not             cap of only $699 million, shine in
the reservoir, the oil or gas can’t get                 have sufficient pressure to produce        the firmament of artificial lifting?
to the surface under its own power. It                  naturally. But, as wells age, reservoir    Customer satisfaction surveys hold a
needs a lift, in the shape of a device                  pressure declines and artificial lift      clue. Thus, in 2007, Lufkin earned a
to reduce the hydraulic head to some                    becomes necessary.”                        kind of four-star honorable mention
value lower than the pressure prevail-                     Oil fields may age, but they only       in the biennial Customer Satisfac-
ing in the reservoir. Enter Lufkin.                     reluctantly retire. Twenty-four mil-       tion Survey published by Energy-
   “In an oil well,” colleague Dan                      lion barrels a day, or 35% of global       Point Research. Specifically, it won
Gertner advises, “there are gen-                        production, flow from fields that be-      the maximum number of plaudits
erally three fluids inside the well                     gan operations before 1970. It’s a sign    for companies that did not garner
bore—natural gas, oil and water. A                      of the times that artificial lifting has   enough evaluations to be eligible for
100-foot column of gas exerts a force                   become a hot topic even in the Mid-        the primary rankings. In 2005, when
of about five pounds per square                         dle East, where, proverbially, once        it did so qualify, Lufkin ranked third
inch; a 100-foot column of oil ex-                      upon a time, black gold gushed from        in a field of 28.
erts about 33.3 psi; and a 100-foot                     a hole you just punched in the sand.          “They are clearly a player in arti-
column of fresh water, about 43.3                       The fifth Middle East Artificial Lift      ficial lift,” Doug Sheridan, manag-
psi. The bottom-hole pressure in a                      Forum, a three-day event held in Ma-       ing partner of EnergyPoint Research,
10,000-foot well bore with 1,000 feet                   nama, Bahrain, in February, featured       tells Gertner. “[T]hat is a pretty nar-
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row area of expertise, so what hap-                     was the office Natco bull, and he has                            The burden of the following anal-
pens is they have to live and die by                    this to say, in closing, about Lufkin:                        ysis is that Mr. Market was a little
their success with that product and                     “I view Lufkin much as I did Natco.                           hasty. Iconix, which owns and li-
service. So it has to be good. As op-                   Both companies have a narrow fo-                              censes a portfolio of established con-
posed to an integrated service pro-                     cus and highly satisfied customers                            sumer brands, may yet have a future,
vider, like Schlumberger, [which]                       (Natco was ranked fourth in the 2005                          assuming the consumer does. About
can really say, ‘Well, we may be aver-                  EnergyPoint survey), and both are                             this contingency, admittedly, there
age in some areas, but we are really                    positioned to capitalize on the engi-                         are doubts. In a recent single edition
good in others, so we accept the aver-                  neering problems associated with the                          of The Wall Street Journal—that of Oc-
age or below-average areas and look                     aging of the world’s oil production.                          tober 8—there’s fully a week’s worth
at us from an entire package.’ A guy                    Like Natco, Lufkin has the financial                          of bad news. Thus, holiday spending
whose job is focused on trying to in-                   strength to survive lean times. I have                        will be 1% less than last year’s, which
crease production at a well using ar-                   not seen Lufkin mentioned as a take-                          was 3.4% lower than the prior year’s,
tificial lift ends up being frustrated                  over candidate, but it would be a good                        according to the National Retail Fed-
with some of the integrated provid-                     fit with a larger oil-field service com-                      eration; this year’s tally of retail-store
ers. Lufkin does not suffer from that.                  pany. After all, none of these fields is                      closings (8,300 through September) is
As a matter of fact, they execute very                  getting any younger.”                                         greater than all of last year’s (6,900),
well. They are very well regarded, not                                                                                according to the Federal Reserve; and
only in terms of sales, but also execu-
                                                                                             •                        10.3% of retail space at U.S. shopping
tion. One of the things that you see                                                                                  centers was vacant in the third quar-
that is really important in this sector is              House of brands                                               ter, up from 8.4% in the third quarter
after-sales support. Meaning, how did                                                                                 of 2008, according to Reis Inc.
it work out? What do we need to do                         (October 16, 2009) Into Mr. Mar-                              Iconix, we are about to contend,
to make sure you get the results you                    ket’s quavering hands, the manage-                            is likely to ride out the slump and
were looking for? And what can we do                    ment of Iconix Brand Group (ICON                              prosper in the upturn. What the com-
to be accountable to you for what your                  on the Nasdaq) consigned a press                              pany does for a living takes a little ex-
expectations were for us?”                              release dated September 30. “The                              plaining. It buys intangible things—
   London-listed John Wood Group                        company,” the text read, “is revising                         brands—and licenses others to sell
(with a market cap of $2.5 billion) and                 its full year 2009 revenue guidance to                        them. It is the beau ideal of the “tan-
Weatherford International (valued at                    a range of approximately $215 million                         gible-lite” business highlighted in the
$13.3 billion on the Big Board) are                     to $220 million from prior guidance of                        April 17 issue of Grant’s. Brands may
Lufkin’s principal investor-owned                       $223 million to $230 million.” Actu-                          or may not endure, but at least they
comps, and there’s not much differ-                     ally, management added, the evident                           don’t require painting, new software
ence in valuation among the three.                      revenue miss represented a 5% rev-                            or retrofitting with new power trains.
Lufkin’s principal distinguishing fi-                   enue increase from the comparable                             They are lighter than air. Some 77%
nancial feature is its balance sheet. As                period a year ago. But it was no good:                        of Iconix’s assets are of this nature—
against $419 million in book equity, it                 The confession drilled the share price                        goodwill, trademarks, etc.—which ob-
has just $2.3 million in long-term debt.                for 21%, wiping out $237 million of                           viates the risks associated with inven-
Wood and Weatherford show debt-to-                      stock-market capitalization.                                  tories and manufacturing operations.
equity ratios of 37.5% and 65.7%, re-
spectively. Such debt as Lufkin has is                                          What’s in a brand?
                                                                          $27                                                                                $27
not homegrown but imported. It was,                                               Iconix stock price
specifically, affixed to International                                     24                                                                                 24
Lift Systems, a maker, installer and
servicer of so-called plunger lift sys-                                    21                                                                                 21
tems, which Lufkin acquired for $45
million in March—a month when not                                          18                                                                                 18
many other companies had the cour-
                                                        price per share

                                                                                                                                                                   price per share

age or wherewithal to shop for acqui-                                      15                                                                                 15
sitions. “They provide an entry for
Lufkin into the offshore market for                                        12                                                                                 12
artificial lift wells,” said the buyer’s
press release, “including deepwater                                         9                                                                                  9
plays, and they expand our reach into
the artificial lift market.”                                                6                                                                                  6
   We write in praise of Lufkin a
little more than two months after                                           3                                                                                  3
Natco Group (Grant’s, January 23)
was scooped up by Cameron Inter-                                            0                                                                                  0
national at a 30% premium to the                                          1/30/04         1/31/05       1/31/06   1/31/07        1/31/08      1/30/09 10/13/09
prevailing Natco share price. Gertner                                           source: The Bloomberg
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The tangible-lite business model is                     Iconix brand has been around for 52       doubled, to 71 million from 28 mil-
geared to producing high EBITDA                         years), and the company works to          lion shares, and its debt has grown to
margins (in the 70s in this case) and                   keep them fresh. Gisele Bundchen,         $576 million from $25 million. Among
lots of cash. Management forecasts                      Britney Spears, Brooke Shields and        these obligations are $240 million of
free cash flow this year of $125 mil-                   Tony Romo are among the celebrities       convertible notes, the 1.875s of June
lion or so on revenues of $225 million                  who have sprinkled stardust on Ico-       2012, unsecured and convertible at
or so. Of course, there are correspond-                 nix’s wares.                              $27.56 a share. “Balancing that debt,”
ing risks. Brands, like the ether, can                     Iconix may license a wholesale sup-    observes colleague Dan Gertner, “is
go pfft, and there is only so much                      plier to sell authorized products to      $500 million of guaranteed minimum
comfort in knowing that the company                     stores within an approved channel of      royalty payments for current licenses,
is quoted in the stock market at book                   distribution. Or it may license a sin-    excluding any renewals, and $216
value. By writing down its $1.2 billion                 gle retailer to sell a range of branded   million of cash. Guaranteed minimum
of intangibles to zero, management                      products within a certain geographi-      royalty payments are due regardless
would eliminate that book value 1.4                     cal area. For instance, Kohl’s has an     of the amount of sales. Such guar-
times over.                                             exclusive license to sell the Candie’s    anteed payments have recently ac-
   Iconix owns 18 brands with $8 bil-                   brand in the United States across two-    counted for 70% of royalty payments.
lion in annual sales. The list is as                    dozen product categories. Similarly,      Besides Kohl’s, Target and Wal-Mart,
follows: Candie’s, Bongo, Badgley                       Target has Mossimo and Wal-Mart           top licensees include K-Mart/Sears
Mischka, Joe Boxer, Rampage, Mudd,                      has Ocean Pacific, Danskin and Start-     and Li & Fung. The expiration of the
London Fog, Mossimo, Ocean Pacific,                     er. Direct-to-retail licenses accounted   licenses is staggered over the next
Danskin, Rocawear, Cannon, Royal                        for 50.5% of Iconix’s revenues in the     five years.”
Velvet, Fieldcrest, Charisma, Starter,                  first half of this year, almost double       On the second-quarter conference
Waverly and Ed Hardy. These brands                      the year-ago volume. Retailers like       call, Iconix management talked up
the company licenses to designers,                      holding the proprietary rights to a na-   its ambitions to make acquisitions
manufacturers, distributors and re-                     tional brand without the risk of being    and to expand overseas. “On the in-
tailers. Licensees pay a royalty based                  undercut by a nearby competitor.          ternational front this quarter,” said
on net sales and a certain amount, in                      Brands don’t come for free, as the     CEO Neil Cole, “we signed our third
addition, for marketing and adver-                      growth in Iconix’s balance sheet at-      deal in China for our Rocawear brand.
tising. Brands may not literally rust,                  tests. Since year-end 2004, the com-      Between Rampage, London Fog and
but they do grow stale (the average                     pany’s share count has more than          Rocawear, we epxect our brands to
                                                                                                  have well over 500 stores in China
                                                                                                  within the next three years. To reiter-
                                        Iconix Brand Group                                        ate our China strategy, we are target-
                           (in $ thousands, except per-share data)                                ing the masses. And rather than open-
                                      12 mos. to                                                  ing up a handful of stores in a few
                                                                                                  major cities, our partners anticipate
                                       6/30/09               2008         2007          2006
                                                                                                  opening up hundreds of stores in the
Licensing                               $216,303            $216,761    $160,004      $80,694     densely populated non-major cities
SG&A                                     (70,423)            (73,816)    (44,254)     (24,527)    all over greater China.” This sound-
Other income (expenses)                     (365)             (1,421)       6,039      (2,494)    ed bullish, indeed, although Cole is
Net interest                             (30,151)            (32,598)    (25,512)     (13,837)    not so personally bullish that he did
Taxes                                    (41,425)            (38,773)    (32,522)      (7,335)    not choose to sell 650,000 of his own
Net income                                 73,939              70,153      63,755       32,501    shares in connection with a recent
Earnings per diluted share                   1.14                1.15        1.04         0.72    secondary offering (the sale leaves
                                                                                                  him with 2.6 million shares, or 3.6% of
Cash and restricted cash                 216,057               83,145      68,458       68,458    the outstanding; insiders collectively
Receivables                               57,909               47,054      29,757       14,548    hold 7.1% of shares outstanding).
Prepaid advertising                       13,406               14,375       5,397        2,704       Iconix trades at 12 times its down-
Property and equipment                     6,067                6,719       1,293        1,384    wardly revised 2009 earnings estimate
Goodwill                                 165,001              144,725     128,898       93,593    and 10.9 times the Street’s 2010 fore-
Trademarks and intangibles             1,056,966            1,060,460   1,038,201      467,688
                                                                                                  cast of $1.20 per diluted share, i.e.,
                                                                                                  roughly half the multiples command-
Total assets                           1,592,251            1,420,259   1,336,130      696,244
                                                                                                  ed by the larger retailers with which
Current liabilities                       74,051              103,193      76,410       35,705
                                                                                                  Iconix does business and roughly half,
Long-term debt                           516,700              594,664     649,590      140,676
                                                                                                  as well, of the valuations of such de-
Shareholders’ equity                     864,539              613,526     527,920      465,457    sign houses as Polo Ralph Lauren and
                                                                                                  Guess? Inc. “The Iconix share price,”
Share price                               $13.02                                                  Gertner winds up, “moves up grudg-
Market cap                               928,316                                                  ingly on good news and is thrown
Price/book                                    1.1x                                                for a loop by bad news (witness the
Price/earnings                              11.5                                                  reaction to the slight revenue miss).
SUBSCRIBE! - go to or call 212-809-7994                                             Summer Break-GRANT’S/AUGUST 20, 2010   12

There are plenty of signs urging cau-                   its rate of rise was too fast. The cen-    bills because they were worth $100.
tion when it comes to the American                      tral banks of India, Mauritius and Sri     General Electric commercial paper,
consumer, but the stock seems to be                     Lanka had very publicly bought gold        on the other hand, was worth par with
priced for worry. Add the safety of a                   instead of U.S. Treasurys. The Indian      a Treasur y guarantee, a little less—
guaranteed royalty stream to a reason-                  government, first of the three out of      perhaps a great deal less—without
able valuation, and a bullish investor                  the gate, had relieved the Interna-        one. Way back when, under our be-
may be allowed to contemplate the                       tional Monetary Fund of 200 metric         loved gold standard, monetary value
possibility of something going right.”                  tons at an average price just below        was intrinsic in the money itself. Un-
                                                        $1,050 to the ounce. China must be         der the law, you could exchange dol-
                       •                                next in line, some bulls reasoned.         lars for gold, and gold for dollars, at
                                                        Others took a simpler approach to the      a fixed rate. Growth in the world’s
Warm thoughts on a cold                                 valuation problem. The charts looked       monetary base was under the control
                                                        good, they said.                           of mining engineers as much as it was
metal                                                      Then the price stopped going up         of bankers. The dollar was anchored
                                                        and started going down—and now             and so, to a degree, was dollar-denom-
   (February 19, 2010) Earnings sea-                    we’re bullish again. Our approach to       inated credit. But not since 1971 has
son is almost over, but for GLD it                      the valuation question is different        any currency been so endowed. Mon-
never began. Not since the earth’s                      from the chart readers’ but almost as      etary value, rather, is conferred by
crust cooled has the 79th element in                    simple. Gold is a monetary asset, we       governments under the direction of
the Periodic Table earned a dime.                       reason. It competes with other mon-        the kind of people who participate in
Yet that hasn’t stopped SPDR Gold                       etary assets, notably with paper cur-      the panel discussions at Davos, Swit-
Trust, a.k.a. GLD, from becoming an                     rencies. And it competes, too, with        zerland. Gold may be hard to value,
institutionally recognized investment                   credit, which is the promise to pay        but you can tell it’s worth something
asset. Still, the question hangs in the                 money. In Europe, especially, gold         just by looking at it. The euro, too,
air: What’s an ounce worth?                             shines brighter every day next to the      is hard to value, but it is inherently
   Now begins a reappraisal of our                      competition, either to the coin of the     worth nothing, absent a government
Nov. 27 reconsideration. That es-                       realm or to the sovereign obligations      to stand behind it.
say, skeptical in tone, ran under the                   denominated in that coin.                     By this line of argument, the crisis
headline, “Cool thoughts on a mol-                         Money is intrinsically valuable,        of the euro should be hugely bullish
ten metal.” Its thesis was not that the                 which sets it apart from credit, which     for the gold price, denominated ei-
gold price was too high (who knows                      may or may not be valuable. During         ther in dollars or euros. What could be
how high is too high?), but rather that                 the late crisis, people wanted $100        better for bullion than trouble for the

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            made-up European money that not                                                 Flatline at Wiki central bank
            only circulates on the Continent but                                1,200                                                                                                        1,200
            also claims a 28% share of the world’s                                             SPDR Gold Trust holdings
            central-bank vault space (compared                                                                                                                Feb.9, 2010:
                                                                                                                                                             Feb. 9, 2010:
            with 62% for the U.S. dollar)? But                                  1,000                                                                      1,106 metric tons
                                                                                                                                                          1,106 metric tonnes                1,000
            the euro’s weakness is the dollar’s
            reciprocal strength, and an appreciat-
            ing dollar exchange rate convention-                                      800                                                                                                       800
            ally implies a depreciating dollar gold

                                                                     in metric tons

                                                                                                                                                                                                       in metric tons
            price. Then, again, not much about
            this juncture in world monetary af-                                       600                                                                                                       600
            fairs is conventional.
               We say we are bullish, but we have
            no idea where the price is going. And                                     400                                                                                                       400
            neither do you, whoever you are. The
            gold price, it has sometimes seemed
            to us, is the reciprocal of the world’s                                   200                                                                                                       200
            faith in the judgment of Ben S. Ber-
            nanke. The greater the trust, the
            lower the price, and vice versa. You                                        0                                                                                                          0
            would suppose, after all the blood,                                       11/18/04          11/30/05       11/30/06                         11/30/07       11/28/08      11/30/09
            sweat and tears of the past three                                               source: The World Gold Council
            years, that the market would not trust
            the chairman of the Federal Open                             with research coverage. Trained to                                                 A recent report from one of the gov-
            Market Committee further than it                             divine the net present value of a fu-                                           ernment-supported New York banks
            could throw him. Yet the gold price                          ture stream of earnings, the analysts                                           lays out the bearish case on the metal
            is not $3,000 but one-third of that. It                      have cast around for a quantitative                                             that used to line that institution’s
            makes you humble, if you happen to                           approach to a sack of Krugerrands.                                              vaults in the days when it was inde-
            be in the soothsaying business. The                          “Undaunted,” colleague Ian McCul-                                               pendently solvent. The authors of
            dollar system will come a cropper, we                        ley notes, “the sell side, needing to                                           the study—who, let the record show,
            believe, but it will evidently do so on                      fill pages with ‘rigorous’ analysis, has                                        were not the ones who ran the bank
            its own schedule, not ours. Maybe                            cooked up all manner of correlation                                             into the ground—argue that the gold
            the euro system will lead the way to                         and regression studies connecting the                                           market has lost a number of its bull-
            chaos. The outer limit on the preci-                         gold price to real interest rates, mon-                                         ish props. “Investors and speculators
            sion of our forecast is contained in the                     ey supply, inflation, inflation expec-                                          are the main driver of the gold price,”
            phrase, “We are bullish on gold.”                            tations, investment demand and the                                              they write. “There is no support at
               The gold bull market is a decade                          dollar exchange rate. But no matter                                             current prices from mine and scrap
            old, but only recently has the Street                        how hard the analysts try, gold still                                           supply (which is rising), or fabrica-
            begun to flatter the barbarous relic                         doesn’t yield anything.”                                                        tion demand (which is plummeting),
                                                                                                                                                         in our view. U.S. dollar weakness and
                                                                                                                                                         increased money supply has been the
                        After the pullback                                                                                                               main driver of investment demand
        $1,200                                                                                                               $1,200
                          gold price                                                                                                                     and speculative flows, we believe,
                                                                                            Feb.12, 2010:
                                                                                            Feb. 16, 2010:                                               and any strength in the U.S. dollar is
              1,100                                                                            $1,117
                                                                                               $1,083                         1,100
                                                                                                                                                         the main risk to prices.” And if the
                                                                                                                                                         rising dollar exchange rate isn’t bad
              1,000                                                                                                           1,000
                                                                                                                                                         enough, the bulls confront benign in-
                                                                                                                                                         flation, rising mine supply, a rhetori-
                  900                                                                                                          900                       cally stern Fed, a worrying swoon in
price per ounce

                                                                                                                                      price per ounce

                                                                                                                                                         U.S. monetary growth and an evident
                  800                                                                                                          800                       peaking in the level of gold reserves
                                                                                                                                                         held in the London vaults of the
                  700                                                                                                          700                       SPDR Gold Trust.
                                                                                                                                                            “Wiki central bank,” this publica-
                                                                                                                                                         tion has coined the GLD hoard. Even
                  600                                                                                                          600
                                                                                                                                                         if no government has the courage of
                                                                                                                                                         our convictions, any brokerage-house
                  500                                                                                                          500                       customer can choose to go on his or
                                                                                                                                                         her own personal gold standard. And
                  400                                                                                                          400                       it seemed as if a people’s gold stan-
                   1/06        7/06      1/07     7/07       1/08               7/08            1/09         7/09   1/10                                 dard were in the making during the
                        source: The Bloomberg                                                                                                            pounding heart of the financial crisis.
   SUBSCRIBE! - go to or call 212-809-7994                                                                                                           Summer Break-GRANT’S/AUGUST 20, 2010   14

On the day the Fed bailed out AIG,                                                                      Old faithful
                                                                                               $8,000                                                                                                    $8,000
Sept. 16, 2008, GLD held 614 metric                                                                       worldwide monetary reserve assets                                         $7.62 trillion
tons; by March 2009, the stockpile
had nearly doubled, to 1,127 metric                                                             7,000                                                                                                     7,000
tons. In dollar terms, it more than
doubled in those six months, to $33                                                             6,000                                                                                                     6,000
billion from $15 billion. But, lately,
there has been stagnation, or shrink-

                                                                      in billions of dollars

                                                                                                                                                                                                                   in billions of dollars
                                                                                                5,000                                                                                                     5,000
age: to 1,106 metric tons at last report
from a peak of 1,134 metric tons in
                                                                                                4,000                                                                                                     4,000
June 2009. In point of fact, the GLD
vaults have relinquished relatively lit-
tle bullion compared to losses in pre-                                                          3,000                                                                                                     3,000
vious bouts of gold-price weakness
(thus, from March to May 2008, they                                                             2,000                                                                                                     2,000
surrendered 12%, compared to just
2.4% from June 2009 to this point in                                                            1,000                                                                                                     1,000
2010). However, the analysts whose
work we have been quoting see the
                                                                                                   0                                                                                                           0
vault as half empty, not half full. In-
                                                                                                    3/03          3/04          3/05                   3/06          3/07       3/08         3/09    12/09
vestors, they contend, “are no longer
                                                                                                        source: The Bloomberg
concerned with counterparty risk and
collapse of financial systems, but con-                                                 aged, lurking in the shadows) that is                                       International Settlements, German
tinue to want exposure [to] gold as a                                                   prone to inflation and deflation at one                                     banks have exposures of $43 billion to
U.S. dollar hedge, inflation hedge and                                                  and the same time. The greatest gen-                                        Greece, $47 billion to Portugal, $240
interest-rate hedge.”                                                                   eration? In devising infernal financial                                     billion to Spain, $193 billion to Ire-
   While we can’t speak for all inves-                                                  machines, we’re the one.                                                    land and $209 billion to Italy. French
tors, we can speak for ourselves. We                                                      The United States properly takes                                          banks have exposures of $79 billion to
buy gold as an investment in mon-                                                       top honors for frenzied finance, but                                        Greece, $36 billion to Portugal, $185
etary disorder. Fractional-reserve                                                      Europe is no slouch, either. “The real                                      billion to Spain, $69 billion to Ireland
banking systems are historically prone                                                  problem on the Continent,” McCul-                                           and $489 billion to Italy. For compari-
to runs and deflationary contraction.                                                   ley relates, “is not so much the ability                                    son, the German banks have $625 bil-
Paper-money systems are inherently                                                      of France and Germany to backstop                                           lion of capital, the French banks, $620
prone to inflation. Our modern finan-                                                   the debt of some of the weaker euro-                                        billion. As a percentage of GDP, Ger-
ciers have created something new                                                        zone sovereigns, but, rather, whether                                       man banks’ exposure to the weaker
under the sun. They have devised a                                                      France and Germany can backstop                                             euro-zone members amounts to 22%;
paper-money-cum-fractional-reserve-                                                     the various exposures that their banks                                      for the French banks, the equivalent
banking-system (with yet another                                                        have accumulated. According to                                              figure is 32%. Of course, one could
credit structure, also highly lever-                                                    third-quarter data from the Bank for                                        calculate the exposures of Citi and
                                                                                                                                                                    J.P. Morgan to California. The point
                              After a drought, a gush                                                                                                               is that throughout this crisis, govern-
                        15%                                                                                                            15%                          ments have moved an ever-growing
                                change in global mine supply of gold
                                                                                                                                                                    body of liabilities to public-sector
                        12                                                                                                             12                           balance sheets from private ones. At
                                                                                                                                                                    some point, there isn’t much more
                         9                                                                                                              9                           debt you can pile on already over-
                                                                                                                                                                    burdened national treasuries. The
                                                                                                                                                                    burden might eventually have to fall
annual rate of change

                                                                                                                                            annual rate of change

                         6                                                                                                              6
                                                                                                                                                                    on central banks, which—unlike gold
                                                                                                                                                                    miners—can create money on a com-
                         3                                                                                                              3                           puter keyboard.”
                                                                                                                                                                       Many a discouraged gold bull is
                         0                                                                                                              0                           tapping his or her foot for the return
                                                                                                                                                                    of last autumn’s thrilling season of
                        -3                                                                                                             -3                           central bank gold buying. Two weeks
                                                                                                                                                                    ago, when the price fell within $20
                                                                                                                                                                    of the $1,042-to-$1,049-an-ounce
                        -6                                                                                                             -6
                                                                                                                                                                    range that India had paid the IMF,
                                                                                                                                                                    Andy Smith, analyst at Bache Com-
                        -9                                                                                                             -9                           modities Ltd., London, raised a ques-
                         1973       1977      1981      1985   1989   1993                          1997       2001      2005     2009                              tion: If the price broke lower, would
                             source: U.S. Geological Survey                                                                                                         the Indian authorities buy more? “If
SUBSCRIBE! - go to or call 212-809-7994                                                                      Summer Break-GRANT’S/AUGUST 20, 2010   15

they don’t,” he replied in anticipa-                              skew,’ as the options adepts express                      for instance, constitute a speculation
tion, “then November’s purchase was                               the foregoing concept, is the flattest,                   on a certain kind of economy, not
more a trade than an expression of                                or most favorable towards call buy-                       an investment. The yield is too low
long-term intent.”                                                ers, since the fall of 2008. It can’t be                  to afford a margin of safety. So, too,
   So far, the gold price has forced                              said that the options market is exactly                   with Lufkin. At 58.3 times trailing
neither India’s hand nor China’s.                                 bearish on gold, at least compared to                     net income and 2.9 times book (and
Chinese monetary authorities own                                  the S&P 500, where June SPY puts                          at a yield of just 1.2%), the shares are
1,054 metric tons of the shiny, not-                              struck at 25% out of the money are                        a speculation on higher oil prices and/
dollar monetary asset, worth $37 bil-                             some 15 times more expensive than                         or on the continued growth in the
lion at today’s prices, or 1.5% of over-                          equivalent calls. But the gold options                    population of aging, lower-quality oil
all foreign-exchange holdings of $2.4                             market is definitely less frothy than it                  fields. If the economy collapses in a
trillion. So the People’s Republic of                             has been in a while. Even John Paul-                      deflationary heap, or if the oil price
China and Grant’s Interest Rate Observ-                           son’s new gold fund apparently raised                     revisits $150, you’ll be glad you hung
er are once more at loggerheads. We                               only $90 million, a huge whiff from                       on to your long bonds and LUFK.
are betting heavily on fractures in the                           the whisper number.”                                         Texas-based Lufkin, 108 years old,
world’s dollar-centric paper currency                                We don’t whisper but speak out                         makes equipment to boost the per-
system. China, on the other hand, is                              loud: Expecting monetary turmoil,                         formance of superannuated oil wells.
betting rather more heavily on stabil-                            we’re bullish on the legacy monetary                      It produces and services gas lift and
ity. Then, again to judge by the re-                              asset.                                                    plunger equipment as well as horse’s
cent 13-F filing of China Investment                                                                •                       heads, a.k.a. pumping units. Sepa-
Corp., a sovereign wealth fund under                                                                                        rately, it manufactures and services
the wing of the State Council, the                                                                                          gearboxes for industrial applications,
Chinese may be reconsidering. The                                 Goodbye, good Lufkin                                      including high-speed units for en-
filing disclosed ownership of 1.45 mil-                                                                                     ergy-related operations. High speed
lion shares of GLD and noted further                                 (April 14, 2010) “A little like                        really means “high,” i.e., more than
that 42% of the portfolio is invested                             the stock market itself,” said we of                      4,500 revolutions per minute. Oil-
in metals stocks.                                                 Lufkin Industries in the issue of                         field equipment accounts for 70% of
   To our mind, however, central                                  Grant’s dated Aug. 7, 2009, “Lufkin’s                     revenues, power-transmission devic-
bank buying of gold is not the world                              shares are neither very rich nor very                     es for the rest.
monetary authorities’ main contribu-                              cheap.” Update: Lufkin’s shares are                          Lufkin and its shareholders thrive
tion to a higher gold price. Rather,                              very rich. While this fact does not                       on high oil prices, economic growth—
they do their part just by going to                               necessarily make them an imperative                       and dissipating oil deposits. Whether
work in the morning—by targeting                                  sale, it does—by the lights of Graham                     or not the so-called peak oil thesis is
interest rates or inflation rates or im-                          and Dodd—transform them from an                           on the mark, it’s music to the ears of
plementing what is euphemistically                                investment into a speculation.                            the Lufkin bulls. No coincidence that
known as quantitative easing. Global                                 These days, every thinking inves-                      only one month separated the 2008
mine supply rose by 4% in 2009, and                               tor—Lufkin bull or not—wrestles                           oil-price high ($147.27 a barrel, in July
large North American-headquartered                                with the treetop valuations widely                        2008) from the Lufkin share-price
miners are expected to boost output                               in place. Treasurys at today’s levels,                    peak ($95.23, in late August). And it
at a compound annual rate of 2.6%
until 2016, according to data from
Deutsche Bank. Compared to the
                                                                                       On the rebound
                                                                               4,000                                                                            4,000
1%-per-year rate of decline in global                                                   average North American rig count
supply since 2000, Deutsche is fore-                                           3,500                                                                            3,500
casting a veritable gusher. But no
geological monetary asset has ever
gushed like the paper or electronic                                            3,000                                                                            3,000
kind. Thus, worldwide foreign ex-
                                                       number of active rigs

                                                                                                                                                                          number of active rigs

change reserves, which consist mainly                                          2,500                                                                            2,500
of dollars, are currently showing year-
over-year growth of 16%.                                                       2,000                                                                            2,000
   Cheering, too, are signs that the
gold bulls are on the defensive. At the                                        1,500                                                                            1,500
frothy November peak, out-of-the-
money gold calls were three times
more expensive than out-of-the-                                                1,000                                                                            1,000
money puts. Months of discouraging
price action has bled away much of                                              500                                                                                 500
that premium. “Indeed,” McCulley
ends up, “now the equivalent out-of-                                              0                                                                                   0
the-money calls trade at less than two                                            1949            1959        1969   1979         1998        1999           2010
times the price of puts. The ‘volatility                                               source: Baker Hughes
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was around that time that the domes-                               and 2008. But the Lufkin share price                              eral, we are bullish on Asian curren-
tic rotary-rig count hit 2,031, the most                           appears to have internalized that pos-                            cies in terms of the U.S. dollar, and we
since early 1985. The financial crisis                             sibility already. It trades at 14.5 times                         are bullish on gold, the legacy mon-
cut all three data—share price, oil                                all-time peak earnings, compared to                               etary asset that nowadays doubles as
price, rig count—down to size, but all                             7.9 times last August, and 35.3 times                             an option on monetary upheaval, in
have recovered from the 2009 lows,                                 the average earnings of the past 10                               terms of all currencies. On monetary
LUFK bouncing especially high.                                     years, compared to 20 times last Au-                              tumult, we are especially bullish.
   Thus, while the share price is only                             gust.”                                                               Though widely separated by dis-
10% below its all-time high, the oil                                  Lufkin is a top-flight company, all                            tance, the two dollars, Hong Kong’s
price and rig count are 27.1% and                                  right—and now with valuations to                                  and Singapore’s, are linked by the
27.9%, respectively, below their lev-                              match.                                                            rules and conventions of the reserve-
els of August 2008. “And as far as                                                                                                   currency system. At the beating
Lufkin goes,” colleague Dan Gertner
                                                                                                      •                              heart of the system is a certain North
points out, “margins, prices received                                                                                                American power unto which is given
and order backlogs have yet to rescale                             Three-dollar tale                                                 the right to print the world’s main
the lofty heights of 2007-08.” Gross                                                                                                 money in such quantities as it finds
margins in the oil-field segment were                                 (April 30, 2010) The readers of                                convenient to its own purposes. Be-
20.6% in the fourth quarter, an im-                                Grant’s already know what the Fed-                                cause other countries choose to coun-
provement from 15% in the third but                                eral Open Market Committee said                                   ter these monetary emissions with
significantly below the 28.9% posted                               on Wednesday. The editor of Grant’s                               more printing of their own, the finan-
in the fourth quarter of 2008. On a                                happens to know in advance what the                               cial world is susceptible to alternat-
consolidated basis, gross margins                                  FOMC didn’t say. “Recognizing its                                 ing cycles of inflation and deflation.
for the fourth quarter were 20.8%                                  responsibilities as the steward of the                            As best as can be ascertained, the
vs. 30.5% a year ago and 21% in the                                world’s principal reserve currency,” it                           world today is celebrating its deliver-
third quarter of 2009. Listening to the                            certainly didn’t say, “the committee                              ance from deflation by embarking on
February earnings call, you can hear                               has voted to raise the funds rate to 3%                           a new inflation. Pleasantly, the initial
the analysts trying to coax the right                              from 0% to 0.25% to relieve the in-                               symptoms of the new cycle are taking
encouraging words from a somewhat                                  flationary pressures building in those                            the form of higher prices for stocks,
reluctant front office. They were not                              Asian economies whose currencies                                  bonds and real estate. The monetary
wholly successful. In response to a                                are linked to the dollar.” Probably,                              mechanics of these ebbs and flows are
leading question about margins, for                                the thought never crossed its mind.                               well known to constant readers. For
example, CEO John F. Glick replied                                    Now unfolding is a report on those                             late arrivals, a short refresher course
that the expected pickup in utiliza-                               pressures and a speculation on what                               follows.
tion rates might restore one-third of                              they mean. In preview, we expect the                                 Living large, the United States pays
the lost margin. “But I think there’s                              Singapore dollar to appreciate and the                            its bills in the green money that only
still going to be pricing pressure out                             Hong Kong dollar to appreciate—or,                                it may lawfully print. America’s for-
there that will keep us from getting                               just possibly, to depreciate. Holding                             eign vendors exchange those pieces
back to the level we saw in ’08.”                                  a certain kind of currency option, one                            of paper for local currency at the first
   Prices received in the oil-field seg-                           would be paid in either case. In gen-                             opportunity. If you were the CFO of
ment of the business, said Glick in re-
sponse to another question, have fall-
                                                                                        Currency management 101
en by 15% to 20%, and in some cases                                         $2,800                                                                                      $2,800
as much as 25%, from the boom-time                                                        China’s foreign-exchange reserves
highs. Concerning the companywide                                               2,450                                                                                    2,450
order backlog, it stood at $140.3 mil-
lion at year-end 2009, up by $6.4 mil-
                                                                                2,100                                                                                    2,100
lion from the third quarter, but down
by $177 million, or 55%, from year-
                                                       in billions of dollars

                                                                                                                                                                                   in billions of dollars

end 2008.                                                                       1,750                                                                                    1,750
   “Last August,” Gertner observes,
“Lufkin was trading at 10.8 times                                               1,400                                                                                    1,400
near-peak earnings and at 1.7 times
book (and at a yield of 2.1%). Af-                                              1,050                                                                                    1,050
ter an 82% price levitation, today’s
valuations might be characterized
                                                                                 700                                                                                        700
as stretched. A believer in higher oil
prices stemming from a growing con-
tribution to world oil production from                                           350                                                                                        350
lower-quality and aging fields (count
me in this group) would assume that                                                0                                                                                           0
margins, prices and backlogs will re-                                              3/05       9/05    3/06      9/06   3/07   9/07    3/08    9/08    3/09   9/09    3/10
turn to the high-cotton days of 2007                                                    source: The Bloomberg
      SUBSCRIBE! - go to or call 212-809-7994                                                                        Summer Break-GRANT’S/AUGUST 20, 2010   17

                    Inflatable houses                                                                                               intracorporate accounting to see that
              200                                                                                               200                 something is wrong with our bubble-
                      Hong Kong and Singapore house price index (December 1995=100)                                                 propagating monetary system. Its
                                                                                                                                    main blemish is obvious (that is, its
              175                                                                                               175                 main non-euro-related blemish). It is
                                                                                                                                    the fact that Asian central banks find
                                                                                                                                    it necessary to keep stuffing their
              150                                                                           Hong Kong:          150                 vaults with dollars. They buy them
                                                                                                                                    because, absent such purchases, the
                                                                                                                                    dollar would weaken. Or, to say the
index level

                                                                                                                      index level
              125                                                                                               125                 same thing, Asian currencies would
                                                                                                                                    appreciate. At year-end 2007, China
                                                                                                                                    held forex reserves on the order of
              100                                                                                               100                 $1.5 trillion. One year later, its hoard
                                                                                                                                    totaled $1.9 trillion. At last report,
                                                                                                                                    which was at the end of March, it
               75                                                                                Singapore:      75                 amounted to $2.4 trillion. Such is the
                                                                                                                                    pattern throughout Asia, relates the
                                                                                                                                    Asia Development Bank. During the
               50                                                                                                50                 panic of 2008, the pace of dollar buy-
               Q495         Q497        Q499    Q401        Q403                   Q405        Q407           Q110                  ing tailed off. But it picked up in the
                    source: The Bloomberg                                                                                           second quarter of 2009, “and the re-
                                                                                                                                    gional stock of foreign exchange has
     the Shanghai Garden Hose & Lawn                               the American people, have our cake                               become even higher than before the
     Ornament Corp., what would you do                             and eat it, too.                                                 crisis. . . . This trend suggests a high
     with a wad of Ben Franklins? You                                 No schematic diagram of transpa-                              degree of exchange rate management
     need renminbi. It’s in the course of                          cific monetary flows can capture every                           in the region.”
     that exchange, dollars for renminbi,                          detail. You may object, for instance,                               Mark well the previous sentence.
     that the inflationary impulse begins                          that although America collectively                               Asian central banks and their govern-
     to throb.                                                     imports more than it exports, no small                           ments buy dollars to please them-
        As likely as not, the dollars in                           part of those imports is essentially                             selves. They buy them to manage
     which America’s vendors are paid                              American, being produced in Asia by                              the value of their currencies against
     wind up in the vaults of the local cen-                       U.S. multinationals. The problem, if                             the dollar and, therefore, the com-
     tral bank—for instance, the People’s                          there is one, you may therefore con-                             petitiveness of their exports denomi-
     Bank of China. Though China’s is an                           clude, lies not with American con-                               nated in dollars. If America consumes
     authoritarian government, the PBOC                            sumers but with macroeconomic stat-                              much more than it produces, its Asian
     does not just commandeer the busi-                            isticians. They can’t keep up with the                           creditors willingly produce much
     nessmen’s greenbacks. Rather, it                              fast-changing global economy.                                    more than they consume. The tightly
     buys them with renminbi, which it                                But it takes no special insight into                          grouped appreciation of a half dozen
     gets in the same way the Fed gets
     dollars. It prints them.
        What the People’s Bank does with
                                                                                  Up, up and away
                                                                           1.55                                                                                         1.55
     its newly acquired dollars constitutes                                         Asian currencies vs. the dollar (Jan. 1, 2009=1)
     another jolt of monetary electricity.                                 1.50                                                                                         1.50
     It invests them in U.S. Treasury and                                  1.45
                                                                                          Singapore dollar       Thai baht
     agency securities. It might not choose                                               Taiwanese dollar       Malaysian ringgit
     to invest in U.S. securities so readily                               1.40           Japanese yen           Indonesian rupiah                                      1.40
     if the United States paid its bills in                                1.35
                                                                                          Korean won
     gold. But we do not. We pay in our
     own special money, which our oblig-                                   1.30                                                                                         1.30
                                                             index level

                                                                                                                                                                               index level

     ing Asian creditors return to us in the                               1.25                                                                                         1.25
     shape of dollar-denominated invest-
     ments. It’s as if the dollars never left                              1.20                                                                                         1.20
     home. Meanwhile, the newly printed                                    1.15                                                                                         1.15
     renminbi circulate in China (less
     whatever portion of that currency the                                 1.10                                                                                         1.10
     central bank chooses to neutralize, or                                1.05                                                                                         1.05
     “sterilize,” through open-market op-
     erations). So the Chinese money sup-                                  1.00                                                                                         1.00
     ply grows and the American money                                      0.95                                                                                         0.95
     supply doesn’t shrink. Asset prices                                     3/6/09        5/1            7/3         9/4             11/6     1/1/10        3/5    4/16
     climb on both sides of the world. We,                                        source: The Bloomberg
SUBSCRIBE! - go to or call 212-809-7994                                                                                 Summer Break-GRANT’S/AUGUST 20, 2010      18

Asian currencies, the Singapore dollar                  Residential mortgage loans show                                                   In the 12 months to March, Singa-
included, is the expression of these                    16.5% growth in the 12 months, dur-                                            pore’s consumer prices were higher
facts in the foreign exchange market.                   ing which time an index of house and                                           by just 1.6%. However, since infla-
   Conferring our highest monetary                      residential property prices increased                                          tion takes many forms, there is only
accolade on the Singapore dollar, we                    by 25%.”                                                                       so much consolation to be taken
have pronounced it one of the least                        In Singapore, as, indeed, through-                                          from that fact. “Interest rates are low
bad paper currencies (e.g., Grant’s,                    out Asia, prophets of a V-shaped, rip-                                         enough that nearly any size mortgage
April 16, 2009). Forex traders rubbed                   roaring recovery look like geniuses.                                           can be made to seem affordable,”
their eyes last week as the city-state                  Top to bottom, 2008-09, the city-                                              McCulley reports. “I went to the
disclosed that first-quarter GDP                        state’s exports fell by 42% and its im-                                        United Overseas Bank’s Web site to
bounded higher by 13.1%, measured                       ports by 41%. But collapse has given                                           play with the calculator that lets you
year-over-year, or by 32.1% measured                    way to resurgence, with container                                              see how much you can afford to bor-
sequentially, quarter to quarter, at an                 traffic showing 16% year-over-year                                             row based on your income. I plugged
annualized rate. With an open econo-                    growth in the first quarter. Over the                                          in S$8,000 a month—the equivalent
my heavily engaged in trade, Singa-                     past 12 months, non-oil exports have                                           of US$5,800. I indicated that I had
pore manages its monetary policy not                    soared by 27%, tech exports by 39%                                             no debt (i.e., no non-mortgage debt)
with interest rates but with a compos-                  and industrial production by 43%.                                              and chose a 35-year repayment term.
ite foreign exchange rate. The Sing                     “With the Q1 expansion,” observes                                              The maximum amount I could bor-
dollar’s nominal effective exchange                     the MAS, “the Singapore economy                                                row was S$800,000, which means the
rate, a.k.a. “S$NEER,” is that trade-                   has now fully recovered the output                                             bank is comfortable making a mort-
weighted rate, and in the wake of the                   lost during the recession, and eco-                                            gage loan exceeding eight times my
stupendous GDP news, the Monetary                       nomic activity in a broad range of                                             indicated annual gross income. Even
Authority of Singapore disclosed that                   industries has exceeded its peak. As                                           in the United States, back in the roar-
it would allow S$NEER to creep                          a result, the economy’s output gap                                             ing mid-2000s, a ratio like that would
higher. As an immediate effect of this                  turned positive in Q1 2010.”                                                   have made a WaMu lending officer
policy, the Sing dollar gained 1.4% on                     That means, the MAS estimates,                                              blink. What makes this stretch ‘af-
the greenback. It’s only the start, we                  the Singapore economy is humming                                               fordable’ is that the bank is charging
believe.                                                fast enough to risk overheating. Spe-                                          an interest rate of roughly 125 to 150
   Before the MAS’ disclosure on                        cifically, it is growing fast enough to                                        basis points over the three-month
April 14, zero-percent appreciation                     tax the existing structure of produc-                                          swap rate, or less than 2% all-in, for
was the policy. Coupled with an over-                   tion to the point of generating a rising                                       a monthly payment of only S$2,500 a
night interest rate of just 0.1%, the                   rate of inflation. Let us assume that                                          month—until rates go up, of course.”
city-state’s monetary policy was fabu-                  the diagnostics are on the beam. In                                               Then, again, McCulley relates, un-
lously accommodative. Consequently                      the face of this inflationary red light,                                       usual are loan-to-value ratios above
fabulous in their turn were local mon-                  the little-city-that-could continues to                                        80%, and the ratio of household
etary growth, the local residential                     maintain that 10 basis-point money                                             debt to GDP, at 72%, is well below
real-estate market and a host of lo-                    rate that it willingly (now, perhaps,                                          the peak reading of 95% set in 2003.
cal economic indicators that, like the                  reluctantly) imports from the United                                           Besides, this is Singapore, where
new GDP data, look for all the world                    States.                                                                        the government bosses the citizenry
like typos.
   Thus, relates colleague Ian Mc-                                                        Money printing has consequences
Culley, “M-1 shows year-over-year                                               10%                                                                                         10%
growth of 17.5%, M-2 of 9.8% and do-                                                        consumer price indices for Hong Kong, Singapore and China
mestic credit of 8%. Forex reserves,
which stand at $196 billion—im-                                                     8                                                               2.4%                        8
mense for an economy with a $177
billion GDP—have climbed by 16%                                                                                                                        Hong Kong:
in the past 12 months. While these                                                  6                                                                    2.0%                   6
                                                            year-over-year change

                                                                                                                                                                                    year-over-year change

numbers don’t exactly rise to the lev-
el of China’s, they are notable for a
financial and trading center that suf-                                              4                                                                          1.6%             4
fered a 10% GDP decline in the re-
cession. Especially striking is the re-
sumption of bank lending, something                                                 2                                                                                           2
that Europe and the United States
have been unable to achieve. In the
past 12 months, Singaporean loans                                                   0                                                                                           0
have risen by 5% and overall banking
assets by 8%. Stock-market margin
loans pace lending growth, up by 78%                                                -2                                                                                      -2
year-over-year, a period in which the                                                    3/05   9/05    3/06      9/06   3/07   9/07    3/08    9/08    3/09     9/09    3/10
Singapore stock market rose by 61%.                                                       source: The Bloomberg
SUBSCRIBE! - go to or call 212-809-7994                                                                     Summer Break-GRANT’S/AUGUST 20, 2010   19

in ways unimaginable even to the                                 by exchanging dollars for the local                       of HSBC in Hong Kong, as saying
busybody mayor of New York City.                                 monetary product. The Sing dollar,                        that local economic growth is accel-
But rules and regulations—such as                                as the accompanying graph points up,                      erating and that first-quarter GDP
prohibiting the sale of certain kinds                            is part of an exchange-rate grouping                      growth, due for unveiling on May 14,
of apartments until the owners have                              that includes the yen, Taiwanese dol-                     will likely come in at 8% (in calen-
occupied them for three years—can                                lar, Thai baht and Malaysian ringgit.                     dar 2009, it contracted by 2.7%). In
stem only so much of the monetary                                Each has appreciated against the dol-                     the past 12 months, Hong Kong M-1
torrent. Visible even from Wall Street                           lar on the order of 10% since March                       has grown by 36% and its mortgage
is a glaring disparity between the in-                           of last year.                                             loans by 12.2%. Foreign exchange
visible bank rate and the white-hot                                 Which brings us to the Hong Kong                       reserves—read “dollars”—are higher
economy. If the FOMC on Wednes-                                  dollar, in which we believe we have                       by 39%. Property prices are on fire,
day astounded the world by saying                                identified a speculation high on po-                      up 6% so far this year after a 27%
what we previously insisted it would                             tential and low on risk. As you know,                     gain in 2009, reaching their highest
never say in a million years, Singa-                             under the currency-board system in                        level since the 1997-98 Asian finan-
pore’s monetary problems would be                                place in the former Crown colony                          cial meltdown. Yet, on account of
well on their way to a solution. But                             since 1983, the Hong Kong Monetary                        the zero-percent fed funds rate, the
because the chances of that are, let                             Authority backs each one of its dollars                   Hong Kong wholesale funding rate is
us say, remote, the MAS must weigh                               with one of Ben Bernanke’s. For all                       also approximately zero percent—just
other options. If the local economy                              intents and purposes, the Hong Kong                       what a boomtown needs.
continues to thrive and if the Fed re-                           and American currencies are inter-                           And what do the city fathers have
fuses to budge, Singapore will have                              changeable.                                               to say about this combustible state of
little choice but to put its dollar on a                            Is that system an anachronism?                         affairs? “The rise in property prices
faster track of appreciation.                                    Hong Kong, after all, is today a “spe-                    since last year,” John Tsang, Hong
   In exchange-rate policy, Asia is                              cial administrative region” of the Peo-                   Kong’s financial secretary, told law-
split between countries that cast their                          ple’s Republic. Like mainland China,                      makers on April 21, “is largely attrib-
monetary lot with the U.S. dollar                                of which it is a political and economic                   utable to an environment with ex-
and those that have chosen to keep                               appendage, Hong Kong references                           tremely low interest rates, abundant
some distance from it. Thus, since                               the value of its currency to the dol-                     liquidity and a relatively low supply
March 2009, the South Korean won                                 lar. The difference is that China, by                     of flats coinciding together.” Tsang
has appreciated against the green-                               dint of its tightly controlled capital                    called this alignment of the stars an
back by 40% and the Indonesian ru-                               account, does not import, in toto, the                    anomaly. “As the global economy
piah by 34%. These currencies are,                               policy of the Federal Reserve.                            recovers,” he went on, “countries
however, outliers. The Sing dollar,                                 Hong Kong’s dilemma is, there-                         around the world will start exiting
ahead by just 10%, is more typical                               fore, greater and more pressing than                      from their measures against the finan-
of the region’s exchange-rate expe-                              Singapore’s. Like Singapore, Hong                         cial tsunami. Liquidity will be with-
rience. Most Asian currencies have                               Kong is not a natural candidate for a                     drawn and interest rates will reverse
crept, rather than zoomed, higher,                               zero-percent funds rate. Earlier this                     to a more normal level.” Tsang may
because the relevant monetary au-                                month, Dow Jones Newswires quot-                          so hope, but the western-most Fed-
thorities have suppressed their rise                             ed Mark McCombe, chief executive                          eral Reserve district is San Francisco.
                                                                                                                           Exactly no part of the Fed’s councils
                           Drama to follow                                                                                 is concerned with the overheating of
                      5%                                                                          5%                       foreign economies that choose to im-
                             implied volatility of Hong Kong dollar two-year options                                       port American-made interest rates.
                                                                                                                              Echoing his counterparts in Singa-
                                                                                                                           pore, Tsang sought to cut the intoxi-
                      4                                                                           4
                                                                                                                           cating power of minuscule interest
                                                                                                                           rates with cautionary words. “I appeal
                                                                                                                           to citizens and small investors who
                                                                                                                           would like to buy a flat,” he said, “to
 implied volatility

                                                                                                      implied volatility

                      3                                                                           3
                                                                                                                           carefully assess the impact of future
                                                                                                                           interest rate hikes on their ability to
                                                                                                                           repay their mortgages. . . . Small in-
                      2                                                                           2                        vestors should assess their own capa-
                                                                                                                           bilities and future incomes, including
                                                                                                                           the stability of their jobs, before mak-
                      1                                                                           1
                                                                                                                           ing what is possibly the biggest in-
                                                                                                                           vestment decision of their lives.” Still
                                                                                                                           and all, Bank of China Hong Kong is
                                                                                                                           advertising floating-rate mortgages at
                      0                                                                           0                        loan-to-value ratios of up to 95%.
                          4/05           4/06        4/07          4/08          4/09        4/26/10                          No FOMC hawk is more impatient
                           source: The Bloomberg                                                                           than Tsang to get on with the job of
SUBSCRIBE! - go to or call 212-809-7994                                                                               Summer Break-GRANT’S/AUGUST 20, 2010   20

“removing excess stimulus.” What to                               dollar options. With prices so cheap,                              $5.08 from $8. No, come to think of it,
do? The unthinkable is one possibil-                              you could make money simply from                                   not “unfortunately.” From the Gra-
ity. By abandoning the dollar peg,                                an increase in implied volatility, per-                            ham and Dodd vantage point, a good
Tsang could raise local interest rates,                           haps as a result of a Chinese revalua-                             investment has become cheaper. The
thereby getting a jump on the next                                tion or—to return to thoughts outside                              word is “fortunately.”
inflation before it has had a chance                              the box—devaluation.”                                                 Make no mistake: It’s the destiny
to get out of control—if that time has                               On Wednesday, the FOMC will ut-                                 of PDLI to become much cheaper.
not already passed.                                               ter its pronouncements as if it were                               The company’s business is managing
   In the prior issue of Grant’s, we al-                          setting interest rates for the 50 states                           and licensing a patent portfolio. Since
lowed ourselves to speculate that the                             alone. The truth is that it makes                                  the patents expire in 2013 and 2014,
renminbi/dollar exchange rate might                               monetary policy for most of Asia.                                  the company, along with its share
as easily move to the downside as to                              That Asia is booming isn’t exactly the                             price, will finally dry up and blow
the upside. But let us say, for argu-                             Fed’s problem. But it could be the                                 away. What might happen on the road
ment’s sake, that the conventional                                currency speculator’s opportunity.                                 to extinction is the question before
view is correct. We’ll assume that an                                                                                                the house.
upward revision is in the cards. What,
                                                                                     •                                                  PDLI got its start in 1986 as Pro-
then, for the Hong Kong dollar? A re-                                                                                                tein Design Labs, “a biopharmaceuti-
ciprocal upward adjustment? An end                                Profitably wasting away                                            cal company focused on discovering,
to the beloved currency board?                                                                                                       developing and commercializing in-
   “The possibility of a change in                                   (June 11, 2010) Some manage-                                    novative therapies for severe or life-
currency regimes,” McCulley notes,                                ments suffer a bear market in silence,                             threatening illnesses.” And those
“is something to consider, especially                             but not the front office of PDL Bio-                               things it did do. It was issued seven
given the clear focus the authorities                             Pharma (PDLI on the Nasdaq). It                                    patents between 1996 and 2000, cov-
in the government and monetary                                    would like you to know that, unlike                                ering the humanization of antibodies.
board have placed on preventing                                   the typical biotech company, PDLI                                  The “Queen et al.” patents they are
bubbles in Hong Kong. Even better                                 earns a profit, pays a dividend and                                called after Dr. Cary L. Queen, from
is that the market thinks there is no                             refuses to invest in R&D. “Also,                                   whose brain they principally sprang.
chance of fundamental change. U.S.                                frankly,” CEO John McLaughlin re-                                  Certain rights under those patents are
dollar/Hong Kong dollar volatility                                marked at a JMP Securities research                                what PDLI licenses to biotechnology
on currency options is within a hair’s                            conference last month, “if somebody                                and pharmaceutical companies. The
breadth of all-time lows. You can                                 wants to make an attractive offer for                              business model is simplicity itself:
buy two-year calls struck 10% out of                              the company, it’s for sale.”                                       In come the royalty payments; out go
the money for 17 basis points (going                                 Now resumes the bullish analysis                                the dividends.
out five years will cost you 47 basis                             begun in the issue of Grant’s dated                                   The science behind the royalty
points). Or, taking an agnostic view                              July 24, 2009. “High-yield equity”                                 income is a little more complex. An-
of the direction of change, you could                             was the headline over the first install-                           tibodies are the company’s stock in
buy a strangle with strikes set 10%                               ment, and the sentiment was right as                               trade. An antibody is a protein found
out of the money on either side, up                               far as it went. From that day til this,                            in blood and bodily fluids that com-
or down, two years out for 33 basis                               PDLI paid out $2.67 a share in divi-                               bats invading bacteria and viruses. In
points. HSBC and Barclays, among                                  dends. Unfortunately, in the same 11                               the laboratory, scientists can create
others, make markets in Hong Kong                                 months, the share price dropped to                                 antibodies by injecting tumor cells
                                                                                                                                     into mice. The object of the exercise
                                     A picture of health                                                                             is to produce mission-specific anti-
                          $350,000                                                              $350,000                             bodies, e.g., ones that attack cancer
                                       PDLI royalty revenues
                                                                                                                                     cells. Because the mouse-bred anti-
                           300,000                                                               300,000                             bodies are tailor-made for mice, they
                                                                                                                                     must be adapted for use in people,
                                                   other                                                                             i.e., “humanized.” Which is where
                           250,000                 Tysabri                                       250,000
                                                                                                                                     the PDLI patents come in.
in thousands of dollars

                                                                                                           in thousands of dollars

                                                   Lucentis                                                                             The humanized antibodies are used
                           200,000                 Synagis                                       200,000                             in therapies for the treatment of can-
                                                                                                                                     cer, blindness, multiple sclerosis and
                           150,000                                                               150,000                             rheumatoid arthritis. They are embed-
                                                                                                                                     ded in seven marketed drugs (see the
                                                                                                                                     nearby table) and in drugs undergoing
                           100,000                                                               100,000
                                                                                                                                     Phase 3 trials for the treatment of Al-
                                                                                                                                     zheimer’s and Type 1 diabetes.
                            50,000                                                                50,000                                The PDLI investment story could
                                                                                                                                     be a case study in the attention span
                                0                                                                     0                              of markets. An April 29 disclosure
                                     1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009                                          of flat revenue in the first quarter,
                                     source: company                                                                                 measured year-over-year, was the
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apparent catalyst for a 22% drop in                     the record show, owns the stock) has      to pay down debt, and, second, to re-
the share price. Revenues were flat                     updated the earnings model he pro-        turn cash to shareholders in a timely
because PDLI has stopped receiv-                        duced last summer. “The major inputs      manner (i.e., to avoid building a cash
ing royalty income for Synagis, an                      are the same,” he relates: “royalties/    mountain).
infectious-disease-preventing drug                      license-agreement revenues, general          “The major driver of PDLI’s re-
manufactured by MedImmune. The                          and administrative expenses, inter-       sults is revenue growth,” Gertner
royalty income stopped because                          est expenses, taxes and dividends. I      continues. “In the past four years,
MedImmune, which had been duti-                         made my projections out to 2015, the      royalties and license-agreement rev-
fully paying PDLI and its predeces-                     year after the last of the patents ex-    enues have grown by 26% a year. For
sor for 10 years, decided to contest                    pire. I assumed 5% annual growth in       my base case, I assumed no revenue
the patent. “Nobody could have seen                     G&A expense and a 35% federal tax         growth in 2010 on account of the
this coming,” the now-standard line                     rate (in Nevada, where the company        aforementioned MedImmune dis-
spoken by the great and the good of                     is domiciled, there is no corporate       pute. And I assumed that revenues in
American finance to excuse them-                        income tax). I assumed that the com-      2015 will be one-quarter of 2014 rev-
selves for culpability in the debt col-                 pany will repurchase its debt—two         enues, since the company is paid with
lapse, cannot reasonably be invoked                     convertible bonds outstanding worth       a one quarter lag. Thus, drug sales in
in the case of the PDLI revenue miss.                   $344 million that it has been buying      the fourth quarter of 2014 would gen-
Management itself warned about it                       in the open market and a $300 million     erate royalty income in the first quar-
on the 2009 first-quarter conference                    securitization outstanding—over the       ter of 2015.”
call (Grant’s, July 24). The real news                  next three years, thereby reducing           To earn back today’s share price
in PDLI’s first-quarter financials was                  and finally eliminating interest ex-      in dividend payments alone, Gertner
its 35% year-over-year increase in rev-                 pense. And I assumed that dividends       finds, revenues would have to grow
enues apart from Synagis.                               were paid with two tactical objectives    by an annual rate of 5.6%, or less
   Colleague Dan Gertner (who, let                      in view: first, to build up enough cash   than one-sixth of the year-over-year
                                                                                                  growth shown in the first quarter, ex-
                                                                                                  Synagis. A second table indicates the
                                         PLDI royalties                                           interplay between revenue growth
                                                                                                  and expected rates of return. Thus,
product                  licensee               status                    indications             with a 15% annual increase in PDLI’s
                                                                                                  top line, an investor would earn a 11%
Avastin                   Roche                 approved               colorectal cancer          return on his or her dwindling prin-
                                                                          lung cancer             cipal, dwindling because PDLI, like
                                                                    metastatic breast cancer      a gold mine, is a wasting asset. Top-
                                                                         glioblastoma             line growth of 25% would generate an
                                                                     metastatic renal cell        annual return of 19%.
                                                 Phase 3                ovarian cancer               “[T]he most important of our pat-
                                                                             gastric              ents expire in December of 2014,”
                                                                        prostate cancer           said CEO McLaughlin at the confer-
                                                                      adjuvant settings           ence last month, “but, in fact, we an-
                                                                                                  ticipate we will get paid longer than
Herceptin                 Roche                 approved             breast HER2+ cancer          that period of time, and the reason for
                                                                       HER2+ stomach              that is, under patent law, you are paid
                                                                 and gastro-esophageal cancers    for product that is made or sold. So if
Trastuzumab-DM1           Roche           Phase 2 and Phase 3        Breast HER2+ cancer          our product is sold after the patent
                                                                                                  expiry, but made prior to it, we get
Lucentis                  Roche                 approved             macular degeneration         paid.” To cook up a bulk batch of an-
                                                 Phase 3                vein occlusion            tibodies requires five months. Qual-
                                                                       macular edema              ity-tested and frozen, the material is
                                                                                                  held in inventory. No just-in-time
Xolair                    Roche                approved             moderate-severe asthma        for the consumers of this commodity;
                                            label expansion            pediatric asthma           they typically keep 12 to 24 months’
Tysabri                    Elan                 approved               multiple sclerosis         worth on hand. It’s therefore not un-
                                                                                                  reasonable to expect that PDLI will
Actemra               Roche/Chugai              approved              rheumatoid arthritis        continue to receive royalties through
                                                                                                  2015 and into 2016. Gertner’s base
Mylotarg                  Wyeth                 approved            acute myeloid leukemia
                                                                                                  case makes no allowances for this pos-
Bapineuzumab         Elan/J&J/Pfizer             Phase 3              Alzheimer’s disease         sible source of out-year dividends.
                                                                                                     Another potential source of pleas-
Solanezumab              Eli Lilly               Phase 3              Alzheimer’s disease         ant surprise is the demonstrated
Teplizumab               Eli Lilly               Phase 3        newly diagnosed Type 1 diabetes   growth in the sale of Genentech drugs
                                                                                                  from which PDLI draws royalty in-
Synagis               MedImmune                 approved                in legal dispute          come. Measured at annual rates over
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the past three years, revenues are up                       Potential PDLI returns                      the customers would not stint on in-
by 38.2% for Avastin, 20.8% for Her-                                                                    ventory building. In that happy case,
ceptin, 132% for Lucentis and 23.2%                             annual                   break-even     PDLI’s financial extinction could be
for Xolair. With Genentech, PDLI has                        revenue growth              discount rate   pushed back a couple of years. Phase 2
struck a tiered royalty agreement for                                                                   results were positive for the Alzheim-
products sold or manufactured in the                             0%                         -6%         er’s drug produced by the Elan/J&J/
United States. The rate is 3% for the                            6                           0          Pfizer consortium. Results featured
first $1.5 billion in sales, declining to                       10                           6          a 9% reduction in amyloid-beta, or
1% for sales over $4 billion. However,                          15                          11          plaque, deposits for treated patients
for products sold and manufactured                              20                          15          vs. a 15% increase in plaque deposits
outside the 50 states, Genentech pays                           25                          19          for placebo-administered patients.
a flat 3% rate. Happily, for PDLI and                           30                          23             What else might go right? Or, to ask
its shareholders, the foreign-made                                                                      the question in the CFA-approved
and sold share of Genentech products                    source: Grant’s estimates                       fashion, how many other free options
jumped to 19% in the first quarter                                                                      might be embedded in that $5.08
from 7% in the first quarter of 2009                    for new Alzheimer’s drugs are under             share price? One is the potential for a
and from 12% for the full 12 months                     way under the aegis of Elan/J&J/Pfiz-           revenue-generating resolution in the
of 2009. Hopeful, too, is the fact that                 er and Eli Lilly. Results are expected          MedImmune affair. Before PDLI,
Roche Holding AG, Genentech’s                           in 2012. The Alzheimer’s drugs have             MedImmune had dealt with three
parent, is building plants in Singa-                    blockbuster potential, Larson reck-             other licensors on Synagis (i.e., Ge-
pore and Germany. Concerning the                        ons. Royalties—to make that specu-              nentech, Celltech and Centocor/J&J).
growth in the overseas portion of Ge-                   lative leap—would be less than 5%               It sued each of them for one reason or
nentech’s sales, Cris Larson, PDLI’s                    of sales. Based on the indications of           another and settled each case, either
chief financial officer, tells Gertner,                 experimental success, the sponsoring            on the courthouse steps or on appeal.
“I will say that the trend is continu-                  companies would build inventories               Maybe it will settle with PDLI.
ing and from everything that we can                     of some of the antibodies covered by               Altogether, from where we sit, the
tell, it will continue.”                                PDLI royalty agreements. “The good              risk/return calculus over the next four
   Besides the applications for which                   news, again,” Larson advises Gertner,           years is little changed from last sum-
the drugs have been accepted, one or                    “as they build inventory, we will con-          mer. The downside is a mid-to-high
more may be approved for new appli-                     tinue to get royalty after the patents          single-digit return, the upside some-
cations. Thus, Avastin is in Phase 3                    expire, because of the inventory in the         thing along the lines of 30%. A kind
trials for four new cancer indications.                 freezer.” In the expectation of heavy           of gold mine, perhaps.
Lucentis is in Phase 3 trials for two                   sales—assuming the kind of success                                  •
different eye diseases. Phase 3 trials                  that one can’t reasonably assume—

                    See you at the

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Mobile payout                                           pean business moderated as the year
                                                        wore on, to 2% in the fourth quarter
                                                                                                     munications remain an essential ele-
                                                                                                     ment in most people’s lives.”
                                                        from 5.4% in the second.                        Not so long ago, even a Great Re-
   (June 25, 2010) To the list of big-cap                  “Unquestionably,” continues Sir           cession might not have slowed the cell
stocks that may produce a better return                 John, “this has been the most difficult      phone business’ meteoric growth. But
than the obligations of America’s mega-                 economic environment in which your           now that most people in most coun-
cap government, we hereby add Vo-                       company has ever operated. Against           tries have a phone seemingly growing
dafone Group Plc, the London-based                      this background, I am very pleased           out of their ears, the macro economy
mobile telecom giant. Vodafone is a                     to report that the group delivered an        comes more into play, as does regula-
globe-girdling blue chip that happens                   adjusted operating profit of £11.5 bil-      tory policy, especially in India. Voda-
to gird a little too much of the euro zone              lion (down 2.5%) and generated £7.2          fone bought its way into India with its
for the stock market’s liking. For that                 billion of free cash flow (up 26.5%). .      $10.7 billion purchase of Hutchison
reason and others, the shares (listed in                . . The telecommunications sector as         Telecom International’s Indian sub-
London, VOD LN, and in New York                         a whole has seen declining revenue           sidiary in 2007. It was a hearty price,
via an ADR, VOD US) are quoted at                       through this period, but we have not         as we said at the time (Grant’s, Oct.
nine times earnings and at a ratio of en-               seen the extremely steep declines in         19, 2007), though—as Vodafone must
terprise value to earnings before inter-                revenue experienced by some other            have reasoned—the growth opportu-
est, taxes, depreciation and amortiza-                  sectors of the economy—mobile com-           nity was hearty, too. And so it turned
tion of 7.3; they yield 5.8%.
   We say “they yield” without mean-
ing to imply that there is anything                                              Vodafone Group Plc
firm, settled or contractual about the                          (in millions of British pounds, except per-share data)
dividend rate. It’s contingent on forc-                                                     Year ended
es too numerous to imagine, let alone
                                                                                             3/31/10   3/31/09             3/31/08       3/31/07
mention, even if the chairman of the                    Revenue                               £44,472        £41,017       £35,478      £31,104
Vodafone board, Sir John Bond, writ-                    Cost of sales                         (29,439)       (25,842)      (21,890)     (18,725)
ing in the new annual report, did go                    Gross profit                           15,033         15,175         13,588       12,379
on record saying, “The Board is . . .                   Selling and distribution expenses      (2,981)        (2,738)       (2,511)      (2,136)
targeting to maintain growth in divi-                   Administrative expenses                (5,328)        (4,771)       (3,878)      (3,437)
dends per share at no less than 7% per                  Share of result in associates            4,742         4,091          2,876        2,728
annum for the next three years.” You                    Impairment losses, net                 (2,100)        (5,900)              -    (11,600)
don’t hear Timothy Geithner making                      Other income and expense                   114              –           (28)         502
that kind of pledge. The Treasury’s                     Operating profit                         9,480         5,857         10,047      (1,564)
principal aspiration, as a matter of                    Nonoperating income and expense            (10)           (44)          254            4
fact, appears to be that the U.S. dol-                  Investment income                          716           795            714          789
lar should command fewer and fewer                      Financing costs                        (1,512)        (2,419)       (2,014)      (1,612)
units of the Chinese renminbi.                          Profit before taxation                   8,674         4,189          9,001      (2,383)
   Though Vodafone operates in                          Income-tax expense                         (56)       (1,109)       (2,245)      (2,423)
Western Europe, Eastern Europe,                         Profit for financial year                8,618         3,080          6,756      (5,297)
Africa, the Middle East, Asia and                       Minority interest                          (27)             2             96         129
North America (by dint of its 45%                       Profit to shareholders                    8,645        3,078          6,660      (5,426)
ownership of Verizon Wireless), it’s                    Diluted earnings per share              16.36p          5.81p        12.50p      (9.84)p
old Europe that furnishes 67% of its                    Goodwill                              £51,838        £53,958       £51,336       £40,567
£44 billion top line and 74% of its £15                 Property, plant and equipment          20,642         19,250         16,735       13,444
billion EBITDA. Germany, contrib-                       Investments in associates              36,377         34,715         22,545       20,227
uting 18% of companywide revenue                        Non-current assets                    142,766        139,670       118,546        96,804
and 21% of EBITDA, is the No. 1                         Trade and other receivables             8,784          7,662          6,551        5,023
market. Italy is No. 2, followed by                     Cash and cash equivalents               4,423          4,878          1,699        7,481
Spain and the United Kingdom. As                        Current assets                         14,219         13,029          8,724       12,813
investors do not need to be reminded,                   Total assets                          156,985        152,699       127,270       109,617
these are not the world’s growth mec-                   Long-term borrowings                   28,632         31,749         22,662       17,798
cas (nor are the Netherlands, Greece,                   Non-current liabilities                37,559         39,975         28,826       23,378
Portugal, Albania and Malta, in which                   Short-term borrowings                  11,163          9,624          4,532        4,817
Vodafone also operates). European-                      Trade and other payables               14,082         13,398         11,962        8,774
generated revenue did grow by 0.8%                      Current liabilities                    28,616         27,947         21,973       18,946
in the fiscal year ended March 31.                      Total liabilities                      66,175         67,922        50,799        42,324
However, before the flattering effects                  Shareholders’ equity                   90,381         86,162         78,043       67,067
of currency movements and other                         Shares outstanding (millions)          52,663
nonoperating factors, it fell by 4.1%,                  Price per share                          £1.43
with Spain and the U.K. leading the                     Market cap                           75,308.09
downside charge. But—a mitigating                       Price/earnings                            8.71x
fact—the rate of decline in the Euro-                   Price/book                                0.83
SUBSCRIBE! - go to or call 212-809-7994                                                                         Summer Break-GRANT’S/AUGUST 20, 2010     24

out to be. Post-acquisition, Vodafone’s                                               Low margin, high volume
Indian subscriber population has in-                                            700                                                                                700
                                                                                        India’s cellular telephone subscribers                   601 million
creased to more than 100 million from
28 million. The trouble is that, un-                                            600                                                                                600
der the Indian government’s licens-
ing policies, as many as 15 cell phone
providers compete in the same Indian                                            500                                                                                500
market. Thus, in the past year, while

                                                        number of subscribers

                                                                                                                                                                            number of subscribers
Vodafone’s subscribers jumped by
                                                                                400                                                                                400
60%, its Indian revenues were up by
only 18%. Referring to the ferocious
competition implied by those num-                                               300                                                                                300
bers, as well as to looming outlays for
cap-ex, an analyst quoted by Bloom-
berg last month characterized Voda-                                             200                                                                                200
fone’s Indian adventure as a “fiasco.”
Fiasco or not, Vodafone remains the                                             100                                                                                100
No. 2 entrant in a country that is add-
ing 20 million new subscribers a month
and has only just crossed the 50% over-                                           0                                                                                    0
                                                                                 5/02        5/03      5/04   5/05      5/06       5/07      5/08       5/09    4/10
all penetration mark, compared with
100% and more penetration in devel-                                                   source: The Bloomberg
oped markets and 70% or less in most
emerging markets. “Looking out over                          of debt. As its outstanding obligation                            businesses would have to be valued at
a longer time horizon,” colleague Ian                        totals $23 billion, it would take only                            a 3.6 multiple. On a global basis, mul-
McCulley observes, “the current price                        six or seven more quarters to extin-                              tiples have compressed in the past
war should eventually lead to weaker                         guish it—if that were the goal. But it                            three years. Big mobile phone opera-
players exiting the field, leaving Voda-                     makes no sense to de-lever the com-                               tors trade at between four and five
fone’s business in good shape. There                         pany completely given its growing                                 times EBITDA in developed mar-
are worse things in the world than be-                       cash flow and healthy margins. From                               kets and at six or seven multiples in
ing the No. 2 mobile provider in a 1.2                       this line of thinking, it would follow                            emerging ones. Still, an implied—and
billion-person country growing GDP                           that there could be action on the Veri-                           very hypothetical—multiple of three
at 7% a year.”                                               zon Wireless dividend within the next                             or so does seem cheap.”
   If India is not Vodafone’s crown                          nine to 12 months. The market would                                  It will be said that big, dividend-pay-
jewel, Verizon Wireless just might                           likely begin to mark up the value of                              ing brutes like Vodafone have cheap-
be. As noted, Vodafone owns 45% of                           Vodafone’s stake in the Verizon sub                               ened in the stock market because,
the Verizon mobile provider (Verizon                         if Vodafone began to receive a regular                            when the Bush tax cuts die their ex-
Communications, the parent, has the                          cash distribution. Any M&A—Veri-                                  pected death in 2011, dividend income
rest). For good reason, Verizon Wire-                        zon Communications buying out Vo-                                 will be taxed as ordinary income, not at
less is an investor fan favorite. Its                        dafone, a spin-out, a merger—would                                the current favored 15% rate. Those in
subscriber base is growing, its finan-                       also likely lead to value realization for                         today’s top 39.6% federal bracket are,
cial health is glowing and its average                       the Vodafone shareholders.                                        therefore, staring at a meaningful cut
monthly revenue per user—no less                                “Note, please,” McCulley goes on,                              in dividend income. In the case of Vo-
than $50—is amazing. For perspec-                            “that the 45% Verizon Wireless inter-                             dafone, one’s after-tax dividend return
tive, Vodafone’s German operations                           est goes unreflected in Vodafone’s                                would drop to 3.6% from 4.9% (without
pull in $20 per user per month. So far                       EBITDA line and thus in that mea-                                 regard to state income tax). Then, again,
iPhone-less, Verizon Wireless would                          sure of valuation. As it is, Vodafone                             corporate managements are nothing if
shine even brighter were it to obtain                        changes hands at 7.3 times enterprise                             not adaptive. If dividend income holds
that shiny new Apple toy.                                    value to EBITDA. Say that the Ve-                                 less after-tax allure than capital gains,
   “While Vodafone booked over £4                            rizon sub could generate $25 billion                              share buybacks might return front and
billion of operating income as a result                      of EBITDA this year. At a multiple                                center. Besides, Treasury coupon pay-
of its 45% share in Verizon Wireless,”                       of six, that would be worth $150 bil-                             ments are already taxed as ordinary in-
McCulley notes, “it received divi-                           lion. Subtract $22 billion in net debt,                           come and that hasn’t slowed down the
dends worth only £1 billion, roughly                         and you’re left with an equity value of                           bond bulls. Tuesday’s two-year note
enough to cover its tax liabilities.                         $128 billion. Vodafone’s share would                              auction was hammered down at a yield
It’s Verizon’s corporate policy to pay                       be £39 billion. The implication of                                of 0.74% (the coupon was five-eighths
down debt with free cash flow, not                           that number is that the rest of Voda-                             of 1%, the lowest on record). Whatever
return it to the shareholders. But                           fone’s businesses trade at a 4.6 times                            that yield amounts to after tax, it’s low-
there’s only so much debt to repay. In                       multiple (and not the 7.3 multiple at                             er than the payout that the board of Vo-
the first quarter, the Verizon sub gen-                      which it does trade). If Verizon Wire-                            dafone is striving so mightily to deliver.
erated $4.8 billion in free cash flow,                       less were valued higher, say, at an                                                    •
with which it paid down $3.2 billion                         eight multiple, the rest of Vodafone’s
SUBSCRIBE! - go to or call 212-809-7994                                                                                     Summer Break-GRANT’S/AUGUST 20, 2010   25

For the long run                                                                              If next decade’s growth in book value
                                                                                             and dividends match previous decade...
   (July 9, 2010) “Nobody is going to                                                                   price/book at                         annual             dividend yield
buy cigarettes anymore,” Nasir Ess,                                                                     current price                        dividend           at current price
the owner of a Harlem deli, com-                                         Exxon Mobil                         0.94x                              $3.27                    5.80%
plained to the New York Daily News                                       Johnson & Johnson                   1.02                                6.83                   11.60
the other day about crazily spiraling                                    United Technologies                 1.05                                6.24                    9.72
tobacco taxes. “You can buy crack                                        Intel Corp.                         1.63                                5.69                   29.84
for $10.” So saying, Ess put his fin-                                    3M Co.                              1.89                                3.72                    4.81
ger on the investment conundrum                                          Kraft Foods                         1.14                                7.55                   27.27
of the cycle. “Safety first,” your not-                                  General Dynamics                    0.45                                4.81                    8.20
so-helpful investment adviser may                                        Kimberly-Clark                      3.40                                5.53                    9.12
admonish, but what’s safe, and why?                                      ConAgra Foods                       1.17                                0.77                    3.33
Bonds, stocks and gold are the items                                     Coca-Cola Co.                       2.02                                3.89                    7.79
under consideration.
   In 2003 or thereabouts, tax-exempt                                    source: Grant’s calculations
bonds secured by anticipated rev-
enues from the Master Settlement
Agreement (MSA) with Philip Morris                                          But the smokers’ addiction to                                  needs to be reminded how rarely
and other tobacco companies seemed                                       nicotine met its match in the states’                             the light of prediction illuminates
as safe as houses (houses were not                                       addiction to taxing and spending.                                 the darkness of the future. But if we
then known to be unsafe). The ciga-                                      Excise taxes have risen to the point                              can’t predict, we can at least observe.
rette companies had pledged to pay                                       where smokers are buying cigarettes                                  In recent issues, we have ob-
46 states a king’s ransom, perhaps as                                    one at a time or doing without. In                                served that the equities of well-
much as $200 billion over 25 years,                                      New York City, a loosie will set you                              financed, high-yielding U.S. multi-
depending on tobacco consumption,                                        back 75 cents, a legal pack by $13                                nationals are selling at some of the
inflation and other imponderables.                                       and up, including $6.85 in taxes, of                              lowest valuations in years. Many
Eager to realize the present value of                                    which $1.60 per pack was slapped                                  outyield the 10-year Treasury note.
this anticipated windfall, Ohio, Cali-                                   on only last week. “Most of the                                   You may object that a dividend yield
fornia and New Jersey, among other                                       bond structures they support were                                 is hostage to its volatile share price
states, refashioned their claims on the                                  devised assuming modest declines                                  and that big, long-established, div-
MSA into bonds; $56 billion came to                                      in tobacco consumption over time                                  idend-paying companies are forever
market. “[T]here was a widespread                                        and rising settlement payments,”                                  reinventing themselves as shrink-
belief,” as The Bond Buyer noted last                                    The Bond Buyer said. “That scenario                               ing, dividend-cutting corporate has-
week, “that demand for cigarettes                                        is now in doubt, with cigarette con-                              beens. Five years ago, what seemed
was inelastic—meaning smokers                                            sumption plunging 9.3% last year                                  a surer thing than AIG?
were so hopelessly addicted that they                                    by one measure—about five times                                      Let the record show, therefore,
would keep buying cigarettes even if                                     more than forecast.”                                              that there are no sure things. But
prices rose.”                                                               No constant reader of Grant’s                                  there are cycles, and blue chip eq-
                                                                                                                                           uities are in that phase of the cycle
                                  J&J for the long run                                                                                     technically known as “the outs.” A
 $100,000                                                                                                      $10                         CFA will tell you that lower interest
                                  J&J’s sales, earnings, equity (left scale)
                                  and dividends (right scale)                                                                              rates imply higher price-earnings
                                                                                                                                           multiples, not lower ones. That is
                                                                                                               1                           so, doctrine has it, because lower in-
                                            sales                                                                                          terest rates, when used to discount
                                            net earnings                                                                                   future earnings, make that stream of
                                            shareholders’ equity                                                                           income look larger than it would if
                                                                                                                      dividend per share
 in millions of dollars

                                            annual dividends                                                                               a higher rate of interest were used
                           100                                                                                                             to discount it. But, in recent years,
                                                                                                                                           P/Es have been falling in tandem
                                                                                                               0.01                        with interest rates. It could be that
                            10                                                                                                             this multiple compression presages
                                                                                                                                           lower profit margins, slower growth
                                                                                                                                           or a more punitive regulatory envi-
                                                                                                               0.01                        ronment. Or it could be that sagging
                                                                                                                                           P/Es are simply the mirrors to a de-
                                                                                                                                           moralized world. Or it might just be
                             0                                                                                 0.0001                      that the world is at last coming to re-
                             1897 1907 1917 1927 1937 1947 1957 1967 1977 1987 1997 2007                                                   alize that P/Es were previously too
                               source: Johnson & Johnson, Moody’s                    2009                                                  high. In any case, today’s multiples,
SUBSCRIBE! - go to or call 212-809-7994                                           Summer Break-GRANT’S/AUGUST 20, 2010   26

in comparison with decades of his-                      another blue chip, Johnson & John-       keep up with JNJ’s 12.1% per annum
tory, look low.                                         son’s business has been running          record of internal compounding? “At
   When Grant’s served up Johnson &                     rings around its share price. Thus,      3%,” Gertner ventures, “it would be
Johnson a couple of issues ago as an                    since 2000, the company has seen         arithmetically impossible—unless,
example of a blue chip bargain, we                      annual growth in sales, net income       of course, one successfully traded in
did not have at hand the statistical                    and book value of 8.5%, 11.5% and        and out of the market. Just to get a
treasure trove that we subsequently                     12.1%, respectively, while the divi-     12.1% capital gain on the current, on-
discovered. Thus, from the compa-                       dend grew by 13.5% per annum. In         the-run 10-year note would require a
ny’s founding in 1886 to 2009, sales                    contrast, the share price inched up      plunge in the 10-year yield to 1.6%.
increased to $61.9 billion from $0.1                    by only 3.3% a year.                     Another year or two of 12.1% capital
million, or by 11.6% a year. Report-                       And how would it look in 2020, you    gains could be had, but before long
ed earnings, which began a decade                       may be wondering, if the next decade     the wall of zero percent would loom.
later, mounted to $12.2 billion from                    delivered business results identical     Here is another way to think about
$0.19 million, or by 10.4% a year.                      to those of the 2000s while the share    it: Say that you bought a 3%, 10-year
JNJ, which paid a maiden dividend                       price stood still? We present the re-    Treasury at par and that the 10-year
in a split-adjusted sum of $0.00015                     sults nearby. Johnson & Johnson          yield immediately dropped to zero.
per share in 1944, the year it went                     would be selling at a hair higher than   Why would anyone pay more than
public, paid $1.93 a share in 2009, a                   book value and yielding 11.6%. To        $130 for that 10-year note? That is,
rate of growth from point A to point                    keep up with the projected internal      for the privilege of receiving 10 years
B of 15.7% per annum. Shareholders’                     compounding of JNJ’s book value,         of $3-per-$100 coupons plus prin-
equity grew to $50.6 billion in 2009                    the gold price would have to reach       cipal over the allotted decade, dis-
from $38 million in 1943, or by 11.5%                   $3,777 an ounce from today’s $1,200.     counted at zero percent?”
per annum.                                              To match the previous 10-year com-          Never say never, we say. Our all
   Johnson & Johnson, in fact, is the                   pounded growth in the book value of      too fallible central bankers could
archetype of an increasingly familiar                   General Dynamics, to pick another        easily send the gold price to heaven
type, namely, the lightly leveraged,                    example, the gold price would have       or the 10-year Treasury to the moon.
time-tested corporate giant that                        to reach $4,897 an ounce.                But the world turns and Armageddon
looks as if it has another couple of                       And Treasurys? How might these        is usually a no-show. Cast-off blue
decades of life in it (at least) but is                 darlings of our Age of Anxiety fare      chips, you have friends at Grant’s.
valued as if for trouble. Like many                     over the next 10 years? Could they                           •

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