Update Number 2 on my portfolio selected using Graham’s techniques

I’ve been a way for a while working on other projects. It’s encouraging that people still visit the site even though I haven’t posted for quite some time!

Anyway, as some of you will recall, on 5 December 2008, I selected a portfolio of 11 stocks using techniques detailed by Benjamin Graham in his book The Intelligent Investor.

The initial portfolio value was $1 million with approximately $90,909 invested in 11 companies as follows:

Company	Buy Price	No. of shares	5-Dec-08 Value	5-Jun-09 Value
Caltex	$6.18	14,710	$90,908	$189,759
Harvey Norman	$2.35	38,685	$90,910	$119,150
Soul Pattinson	$8.33	10,913	$90,905	$110,221
Sims Metal	$11.74	7,744	$90,915	$178,189
Flight Centre	$8.30	10,953	$90,910	$92,553
Hills Industries	$2.90	31,348	$90,909	$52,351
Beach Petroleum	$0.75	122,026	$91,520	$105,552
ASX	$31.60	2,877	$90,913	$107,312
Austereo	$1.11	82,271	$91,321	$131,634
WA Newspapers	$4.70	19,342	$90,907	$82,784
Milton Corporation	$14.02	6,484	$90,906	$97,260
Total			$1,001,024	$1,266,765

As can be seen above, as at 5 June 2009 this portfolio had appreciated by 26.5% to $1,266,765. The All Ordinaries Index had appreciated by 15.8% over the same period. The return from my portfolio doesn’t include dividends – this would increase the return further as most of the companies in the portfolio pay reasonably high dividends.

The performance of this portfolio to date is a testament to Graham and his techniques rather than any brilliance on my part. Graham wrote the book on investing and I’m just a follower.

If I had sat there and listened to all the doomsayers, I would have missed that 26.5% return completely. I may hand out some awards in a future post to some of the most misguided doomsayers who appeared on the scene during this financial crisis. Much of what has been said by these people is utterly absurd, but it did help frightened equity investors to dump stock in some very good companies at what is already being proven to have been silly prices. For this I thank you doomsayers.

Note: None of the above constitutes financial advice. You need to do your own research and consult appropriately qualified people for advice (where necessary).

The price of Guinness Peat Group shares makes no sense

Sir Ron Brierley and his team at investment company Guinness Peat Group (GPG) are some of the smartest investors that I have ever come across, and this makes the current share price for GPG somewhat puzzling.

For those who are unaware, GPG is an investment company domiciled in the UK but also listed in Australia and New Zealand. GPG’s chairman is Sir Ron Brierley (a New Zealander). Brierley is a legendary character to many in New Zealand and Australia due to his exploits over the past five decades (but especially in the 1980s as a corporate raider).

Brierley has always written very candidly in GPG reports – he gives his shareholders a clear picture of GPG and is also quick to admit to mistakes when they occur. Brierley in many ways is a complete contrast to the many charlatans (and young inexperienced money managers) who have appeared on the investment scene in recent years. Brierley and his team have vast investment experience, have made many millions and retain a significant proportion of their own net worth in GPG.

Brierley is an old fashioned value investor. GPG takes shareholdings in companies that it perceives are under-valued, badly managed or “better off dead than alive” (i.e. companies that should be liquidated to release value to shareholders). Sometimes a company qualifies on all three fronts. (Incidentally, it’s not lost on me that GPG itself now fits the exact profile that GPG looks for in other companies, i.e. a very under-valued situation).

GPG directors are well known for showing up at annual meetings of companies that they have interests in (and believe are under-performing) and giving the directors of those companies a very hard time.

GPG (under Brierley) began in 1990 with approximately ₤30 million in equity and as at

31 December 2008 it had ₤720 million (compared with ₤951 million one year earlier).

Every year, GPG issues one bonus share (for every 10 shares held). 2009 will be the 16^th year in succession that GPG has done this. What this means is that if a shareholder started in 1994 with 1,000 shares, they will have (after the 2009 bonus issue), 4,595 shares. This is not well understood by many people who simply look at the share price over time but don’t take into account the large number of bonus shares issued over the years.

In 1995 you could have purchased GPG shares at prices ranging from A$0.446 to $A0.71 per share. Let’s say 10,000 shares were purchased in 1995 at A$0.58 (about the mid point of the selling range for that year), this would have cost $5,800. Once the 2009 bonus issue is made, that 1995 shareholder will have 41,770 shares, (assuming that the 1995 bonus issue was received). Those shares would be worth $22,556 as at 13 March 2009 – even after the current crisis in equities markets. That’s approximately 10.2 percent compound per annum (excluding dividends). For comparison, the All Ordinaries index (Australia) has returned approximately 4.0 percent compound per annum over the same period (31st March 1995 to 13^th March 2009).

It should also be noted that if the increase in book value of GPG (as opposed to share price) was used to calculate the return, GPG’s compound return per annum would be much higher than 10.2 percent. Companies like Berkshire Hathaway have always used the increase in book value not share price when measuring their returns.

GPG pays a standard one pence per share dividend every year. Because of the bonus issue, the actual dividend paid grows at 10% every year. Once again, a very simple concept but not very well understood by people.

Apart from the thread manufacturer Coats (which is wholly owned by GPG), the rest of the equity in the company largely comprises of cash and marketable securities. GPG released a report showing that the book value of each share was A$1.12 on 22 December 2008, versus a 13^th March 2009 share price of A$0.54.

Even if one was to play devil’s advocate and value Coats at half of what it’s on the GPG books at (an improbably low valuation) and then factor in a 10% decline in the value of the equity portfolio since 31 December 2008, a valuation of $A0.85 would still be obtained. Comfortably more than prices of A$0.40 to A$0.55 at which GPG has been recently trading.

Have mistakes been made by GPG? Yes they have.

Coats has been much more time consuming and difficult to restructure than was initially anticipated. In addition, GPG should have pulled the plug on Capral Aluminium a few years ago instead of continuing to support a company that is simply not profitable anymore. The entry into CSR was ill-timed and the attempt to build a major shareholding in Tattersalls has resulted in significant loss (although this was primarily due to the incredibly inequitable policies of the Victorian Labor Government more than anything else).

On the positive side there have also been many exceedingly good investments made by GPG (too numerous to mention). In order to grow equity by 24 times in 18 years, great skill is obviously needed.

Sir Ron Brierley had previously advised of his intention to stand down as chairman of GPG in 2010, however, given the current state of affairs in financial markets, it wouldn’t surprise me to see him extend his chairmanship for a little longer. GPG will want to wait for some level of recovery in markets before it eventually liquidates its investments and this is probably some years off.

Note: None of the above constitutes financial advice. You need to do your own research and consult appropriately qualified people for advice (where necessary).

Berkshire Hathaway moves to limit free speech at annual meeting

Warren Buffett’s 2008 letter to shareholders was another classic piece of writing by the best investor we have ever seen. However, I was very surprised when I got to this part of the letter (the text in bold is my emphasis):

This year we will be making important changes in how we handle the meeting’s question periods. In recent years, we have received only a handful of questions directly related to Berkshire and its operations. Last year there were practically none. So we need to steer the discussion back to Berkshire’s businesses.

In our first change, several financial journalists from organizations representing newspapers,

magazines and television will participate in the question-and-answer period, asking Charlie and me questions that shareholders have submitted by e-mail. The journalists and their e-mail addresses are: Carol Loomis, of Fortune, who may be emailed at cloomis@fortunemail.com; Becky Quick, of CNBC, at BerkshireQuestions@cnbc.com, and Andrew Ross Sorkin, of The New York Times, at arsorkin@nytimes.com. From the questions submitted, each journalist will choose the dozen or so he or she decides are the most interesting and important. (In your e-mail, let the journalist know if you would like your name mentioned if your question is selected.)

Neither Charlie nor I will get so much as a clue about the questions to be asked. We know the

journalists will pick some tough ones and that’s the way we like it.

In our second change, we will have a drawing at 8:15 at each microphone for those shareholders hoping to ask questions themselves. At the meeting, I will alternate the questions asked by the journalists with those from the winning shareholders. At least half the questions – those selected by the panel from your submissions – are therefore certain to be Berkshire-related. We will meanwhile continue to get some good – and perhaps entertaining – questions from the audience as well.

Personally I think it’s outrageous that shareholders are being asked to submit questions to journalists (at least two of whom are friends of Buffett) who will then decide if it’s worthy enough to ask at the meeting. Who are the owners of the company?

It’s hard to envisage that any other publicly listed company would avoid a shareholder backlash over such a proposal.

If you own some “A” shares, you have made a significant investment in Berkshire and you are now told that a journalist will decide whether your question is interesting and important. That doesn’t seem right to me.

This proposal coming now is all the more unfortunate given that many shareholders will want to ask questions regarding the financial crisis as well as Berkshire’s recent share purchasing activities and they will now have a much diminished chance of doing so.

I know that in previous meetings there were questions being asked which had nothing to do with Berkshire Hathaway. I know Buffett doesn’t want to answer these types of questions and that’s ok, just say “no comment”. But please don’t limit your shareholders’ ability to ask questions – they should be allowed to ask whatever questions they like (free from journalistic interference).

There will always be questions that are not related to the company’s business, anyone who has been to these meetings knows that.

I was once in a very long meeting where one shareholder asked perhaps a dozen questions of Rupert Murdoch. The shareholder was actually a journalist with a very small holding in the company and was just using the event as an opportunity to ask lots of provocative questions in order to get a reaction for an online article that he was writing. To his credit, Mr. Murdoch remained very good natured and attempted to answer the questions as best he could. I never thought I would say this, but on that front, maybe Warren could take a leaf out of Rupert Murdoch’s book.

As an aside, can you imagine the tough questions that Carol Loomis and Becky Quick are going to choose to ask? Some of the interviews that Becky Quick has conducted with Buffett leave a lot to be desired. The very fact that Buffett has agreed to so many interviews with her clearly shows that he is very comfortable that she will not ask any “tough” questions.

A better way to handle questions, given the huge number of people attending the Berkshire meeting, would be to give all shareholders the opportunity to write down one question (well in advance of the meeting) which could then be aggregated and from which a certain number of questions could be chosen at random by an independent person. Those questions could then be asked by the journalists. At least this way, the journalists’ opinions on the worthiness of questions are not required and a random draw gives everyone a chance that their question may be asked – no matter what that question is.

The other problem of course with Berkshire’s proposed method is that if the journalists receive 10,000 e-mails they are highly unlikely to read all of them! Would you attempt to read thousands of e-mails? These people actually have other jobs to do. Many questions will therefore have absolutely no chance of being asked regardless of whether they are “interesting and important” or not.

You can also put money on the fact that many non shareholders will submit questions by e-mail – are they going to check every e-mail address back to a shareholder list? Is this even possible? What if I know the names of various Berkshire shareholders (which I do), I could create bogus e-mail addresses and submit questions on their behalf. I have no intention of doing this, but I simply ask the question: who knows who is who?

On another matter, I don’t see why Berkshire Hathaway shouldn’t make available a pod (or vod) cast of part of its annual meeting (maybe have a one hour pod cast of the highlights).

Many people can’t get to Omaha, Nebraska and many others who are not shareholders follow Berkshire closely. Obviously, many companies now use pod and vod casts as an effective means of communication with shareholders (and other interested parties) that cannot make it to a meeting.

There always seems to be this silly level of secrecy at Berkshire meetings. No video, no recording devices, despite the fact that Buffett and Munger never provide any information that could possibly be detrimental to Berkshire (if reported). Absolutely nothing would be given away through a pod cast. Even if they were to make comments of a sensitive nature (as I said, they never do), those comments could simply be taken out of the pod cast.

Given that there are two very prominent IT people on the Berkshire Hathaway board of directors, there doesn’t seem to be any legitimate excuse for not making better use of technology at Berkshire.

There are always those people who attempt to provide a transcript of the meeting (on their web sites) and they furiously write down as much as they can (probably missing half of what’s said, actually misquoting Buffett or Munger in parts and detracting from their own enjoyment of the meeting). So come on Warren, let’s give those people a break and let’s get Berkshire into the 21^st century.

Jim Rogers and his Hot Commodities

To use a Charlie Munger analogy, Jim Rogers reminds me of “a man with a hammer”. To a man with a hammer, every problem looks like a nail. Jim has a hammer (his own commodities index) and every commodity looks to him like a nail.

Jim Rogers founded the Quantum Fund (an early hedge fund) with George Soros in the early 1970s. The Quantum Fund increased in value by approximately 4,200% during the 1970s.

The reader should note that the only way one can get a 4,200% appreciation in anything over such a short period of time is by using significant leverage and then making some very good calls. Leverage is never mentioned when the returns of the Quantum Fund are recited.

As a prelude to the article below have a look at the following two charts. The first chart shows the compound return per annum of oil, gold and the S&P 500 (excluding dividends) as well as showing the US inflation rate (CPI) in each decade from the 1950s to 2008.

The second chart shows the cumulative value of $1,000 invested at the beginning of 1950 in oil, gold and the S&P 500 (excluding dividends). Also shown is the cumulative increase in $1,000 needed to keep pace with US inflation (CPI). The value of that $1,000 is at the end of each decade (31 December 2008 for the current decade).

I won’t comment on the charts, they speak for themselves (particularly the second chart).

Some quotes from Jim Rogers (in italics) and my comments below:

I think agricultural commodities are probably going to do better than others for the moment because many agricultural prices are still very, very low on a historical basis. Sugar is still 80% below its all time high, just to give you an idea. Cotton is 60% below its all time historical high. You know, there are not many things that are 80% below where they were 35 years ago. Sugar futures are one of them.

Why are sugar futures 80% below where they were 35 years ago? Simple answer: There is plenty of sugar being produced. Absent supply disruptions (due to weather events or diversion to ethanol production), there is no logical reason why sugar futures will rally to historic highs. The fact that sugar futures are 80% below their high of 35 years ago clearly demonstrates what a poor investment sugar has been over time.

Always in the past, when people have printed huge amounts of money or spent money they didn't have, it has led to higher inflation and higher prices. In my view, that's certainly going to happen again this time. Oil prices are down at the moment, but that's temporary. And you're going to see higher prices, especially of commodities, because the fundamentals of commodities are enhanced by what's happening.

If the fundamentals of commodities are enhanced by what's happening, why have they all fallen by similar (or greater) percentages to that of the world’s stock markets? (I’m excluding some precious metals). Answer: Because you simply cannot have a global recession and at the same time have significant demand for commodities. That makes sense doesn’t it? Sure, people start to view precious metals as a safe haven during a crisis, but they’re sure not viewing zinc or nickel as a safe haven are they? Demand for base metals is dependent on the health of the economy and the global economy has a bad case of the flu.

Agriculture is the best place – one of the few places - where I would put money in the investment markets right now. I’d buy agriculture. I’d buy the renminbi, the Swiss franc, the Japanese yen, but beyond that, there’s not much I see that I would be buying.

Everybody should become a farmer. Farming is going to be one of the greatest industries of our time for the next 20 to 30 years. It's going to be the 29-year-old farmers who have the Lamborghinis.

I’ve always said that anything that relies totally upon weather conditions and keeping diseases and insects at bay is risky (just ask a farmer if you want proof). Agriculture is extremely important but lots of people have suffered enormously trying to make a decent living out of it. If agriculture is such a wealth creator, why do so many farmers periodically need assistance from the government to make ends meet?

I still own my US dollars. I plan to get out of the US dollar some time this year. It seems that the short covering rally, it is an artificial rally, people are forced to cover their shorts in the US dollar and there were huge short positions.

The United States is in serious trouble, the people in Washington do not have a clue of what is going on. In two years this has been brewing and for two years they have been making mistakes. So the US is going to have its worst economic time since the 1930`s.

It's pretty embarrassing for President Obama, who doesn't seem to have a clue what's going on—which would make sense from his background.

All the US had to do was put Jim in charge – he would have fixed everything! He managed a hedge fund so he could manage the whole US economy!

Jim has actually written the US off. It’s all about China for him. Jim: Don’t write the US off just yet. Most of the technological innovations of the 20^th century came out of the US – there is no reason why that will not continue. Japan, South Korea and China are good at taking US technology/products and improving upon them as well as producing them very efficiently. But remember, someone had to invent those products to begin with and those people were Americans. It’s technological progress that creates enormous wealth – far greater wealth than cultivating corn or sugar.

And finally, Jim also thinks that anyone can profitably invest in commodities (the words are emblazoned on the front cover of his book Hot Commodities). I say nonsense.

If you have Jim’s timing skills (Jim says he isn’t a timer, but he is) you could make a fortune in anything, but saying that the average person in the street can become a successful commodities investor is just not true.

Regardless of what Jim says, trading commodities futures is very risky. The average person who wants to try their hand at trading commodities will be competing against people who do it for a living. Suffice to say, these professionals are far more skilled at it than some “average Joe” reading one of Jim’s books.

However, I will agree with Jim that index investing is the sensible way to go if you really do want to get involved with commodities (or anything else for that matter).

Mohnish Pabrai: Guru No More

In a post last year “Is Mohnish Pabrai the Real Deal”, I raised a few concerns regarding Pabrai’s core investing principles as enunciated in his book The Dhandho Investor.

My two concerns were his advice to readers to buy distressed businesses in distressed industries and to run concentrated portfolios (i.e. portfolios lacking what would be considered conventionally adequate diversification).

In addition, I made the following comments:

If you take Pabrai’s advice and place a significant amount of your portfolio in an investment that you assessed as having a 90% chance of success and in reality that investment only had a 55% chance of success, you could wipe out a significant part of your portfolio very easily. It’s just bad advice.

I also feel that if Pabrai keeps loading up on distressed businesses in distressed industries, it’s only a matter of time before he makes some very serious mistakes (if he hasn’t made them already).

Pabrai’s result for 2008 was a loss of 60% against a loss of 37% for the S&P 500 (as reported in the Pabrai Investment Funds letter of January 16 2009).

Now, I’m no genius and I’m sure that many readers of this blog were also able to arrive at the same conclusions that I did. The mistakes that I referred to above were mistakes that Pabrai was making all along, but it took the events of 2008 to expose them for all to see.

As far as I’m concerned, that result revokes Pabrai’s “guru” status for the time being. Wiping out 60% of investors’ funds in a year and under-performing the S&P 500 by 23% is just not acceptable.

The Pabrai Investment Funds letter of January 16 2009 actually reveals several things that are disconcerting to me.

Firstly, Pabrai had no grasp of how the effects of the financial crisis were to impact his portfolios. Rather than moving significant funds out of equities in early 2008, Pabrai remained close to fully invested with portfolios that had 80% of their funds in only 10 positions! Pabrai admits this was a mistake, but how can someone who is supposedly as savvy as Pabrai is not have realized that a long time ago?

Very concentrated portfolios are usually the hallmarks of misplaced confidence by the portfolio manager. Lots of these money managers think they have skills that are on a par with the truly great investors of this world. Therefore, they reason, it would be a mistake for them to adequately diversify – it would only reduce their returns. Well, we’ve all seen plenty of people who thought like that brought back down to Earth with a resounding thud!

Secondly, the average aggregated annual compound return from the three Pabrai funds is only 1.3% (since inception of each fund). If you had put equal amounts of money into each of Pabrai’s three funds at their inception, you would have got 1.3% per annum. Investors would have made better returns investing in risk free government bonds.

I’m reminded of one of the investing rules that appeared in the book Contrarian Investment Strategies: The Next Generation by David Dreman:

Don’t be influenced by the short-term record of a money manager, broker, analyst, or advisor, no matter how impressive.

The law of averages indicates that many experts will have excellent records – usually playing popular trends – often for months and sometimes for several years, only to stumble disastrously later. If you buy the record just after a period of spectacular performance, chances are the letter writer or manager will not sustain it.

There is enormous wisdom in those two quotes that is all too often forgotten by investors.

Thirdly, Pabrai appears to have changed from a bottom-up stock picker to a macro-economic forecaster. Pabrai believes that inflation will increase significantly and believes that investing in mining companies and commodities in general will keep his portfolios insulated from the effects of inflation, he says:

If someone has a printing press running on overdrive, the best way to protect one’s wealth is to own hard assets (low-cost oil barrels in the ground, low-cost iron-ore reserves etc.). We now own loads of these types of assets.

Many of these commodities are scarce and face very high demand growth from India, China etc. Those growth engines have slowed down temporarily, but they will be back on track in the next few years.

Obviously there is no guarantee that these countries will “be back on track in the next few years” and to say so unequivocally is a very brave call. Does anyone think Japan (an enormous market for commodities) will be back on track in the next few years?

Someone recently said on an investing blog: “When everyone thinks something is certain to happen, it normally doesn’t.” How true.

But of equal importance is the subtle shift in strategy. Pabrai is now designing his portfolios based on a macro-economic view of the world (which may or may not be proven correct). This is in contrast to the traditional process of analyzing individual companies on their own merits and generally ignoring economic predictions.

I also wonder what skills Pabrai brings to the valuation of iron ore mines, zinc miners, molybdenum producers and the like? How does he know he’s buying them at low cost? Valuing these types of assets requires very specialist knowledge and skills and I’m not convinced that someone with no background in the industry has those skills.

As is widely known in my country (with its plethora of mining companies), low price-earnings ratios in the mining sector are much more indicative of over-valuation than under-valuation because low price-earnings ratios are normally achieved at the peak of the earnings cycle.

Pabrai says:

… the best assets to own in an inflationary world are businesses whose products are inflation

indexed – where prices can be raised at or above the rate of inflation. In addition if a

business has done large amounts of capex using old dollars and does not have much

need for capex at new dollars, yet can sell products at inflated prices, it is likely a home

run. Such a business has a minimal need to take on additional debt. It is a beneficiary

of both high interest rates and high inflation.

There are few if any businesses that are beneficiaries of both high interest rates and high inflation.

Once again this is probably just Pabrai attempting to copy Buffett. In the 1970s and very early 1980s, Buffett purchased several companies in the mining/metals sector as a perceived inflation hedge – Handy & Harman, Alcoa, Kaiser Aluminum & Chemical Corp, Cleveland-Cliffs Iron Company etc.

With the exception of Handy & Harman, these investments didn’t really serve the purpose for which they were intended despite the high inflation rate of the period and the fact that they were hand picked by the best investor we have ever seen.

For anyone who is truly convinced that commodity prices will rise, history shows that they would be much better served by investing in the commodities directly rather than trying to select individual companies that may or may not do well (even if they prove correct in their analysis). Commodity prices themselves can never go to zero – prices of shares in commodity producers can and sometimes do!

Pabrai still seems incredibly confident despite having wiped out 60% of his investors’ funds, which when combined with redemptions has seen Pabrai’s funds under management shrink from $600 million at the beginning of 2007 to only $209 million at the beginning of 2009.

It strikes me that for someone with such a small amount of money under management and such a short history as a money manager, Pabrai has certainly attracted far more attention to himself than is actually warranted. Of course the media will continue to report Pabrai’s magnificent record without having realized that he no longer has a magnificent record.

I will continue to follow Pabrai’s progress with much interest. I hope that 2009 turns out to be a better year for him (and his investors).

Gold as an Investment: The Risks

In my last post on the investment consultant Harry Schultz, I noted that Schultz had advised investors to place half their funds in blue chip gold mining stocks and gold bullion.

The reasons for this were the massive spending programs instituted by governments around the world which Schultz (and many others) expect to eventually result in significant inflation. Significant inflation generally means currency devaluation and corresponding gold price appreciation.

But what are the risks of following Schultz’s advice? There are a few risks that investors should be aware of.

Gold is an inherently volatile commodity. Commodities tend to do things that people don’t expect them to do. Just think of the oil price falling all the way from $147 a barrel to the $30-$40 range. Who would have thought that would happen and who would have thought it would happen so quickly? If you’re going to dabble in commodity markets you have to expect (and have a tolerance) for significant volatility.

But more importantly, we are currently in a gold price appreciation cycle that has already been underway for approximately seven years. How much longer that cycle will run is anyone’s guess. The important thing to be aware of though is that the cycle is already mature and the really astute investors have already made large profits in gold because they were buying 5-7 years ago.

Lots of people who don’t understand the dynamics of the gold market are currently buying gold for the sole reason that it has gone up significantly in recent times. Than in itself is not a reason to buy anything.

In my opinion, gold prices are just beginning to show some of the hallmarks of a bubble, and I readily acknowledge that the bubble may get a lot bigger yet before it deflates.

It should be remembered that practically all bubbles form initially for sound fundamental reasons. But as the bubble takes shape and grows, the fundamental reasons are gradually swept away as market participants attempt to profit from rises that are not based on real demand. In so doing, market participants interfere in an otherwise “natural” process and cause much more severe peaks and troughs to occur than would otherwise be observed. When the bubble pops, it usually happens very quickly and dramatically.

This of course is one of the foundations of George Soros’s theory of reflexivity and the recent fluctuations in the oil price are a textbook example of what Soros refers to. Reflexivity of course should be obvious to any reasonably intelligent investor and I don’t think that Soros needed to write books on the subject.

However, reflexivity as applied to commodities is especially important because commodity prices are determined by global supply and demand fundamentals with significant interference from speculative trading activity in order to attempt to manipulate outcomes (i.e. make outsized profits).

Speculative traders have no use for the underlying commodities that they trade - their demand is artificial. Therefore, speculative traders can artificially increase (and decrease) prices to levels that they would never reach if these traders were absent from the market (once again, oil is a good recent example).

You can always assess an industrial company’s balance sheet and look at the type of industry it operates in and assess the reliability of its cash flows, but how do you determine what a fair price for a commodity is? It’s much more difficult.

An average investor has far more chance of predicting the cash flows for a stable business (a difficult task in itself) than they have of determining what the demand and supply fundamentals for the gold market are (or any other commodity market for that matter).

Investing in gold mining stocks has its own unique set of risks.

Firstly, there is geopolitical risk associated with gold mines in many parts of the world. Countries like the United States, Australia and Canada are very safe and stable; many parts of Africa (for example) are not. Of course, you can limit your investments to companies that only operate mines in politically stable parts of the world. This seems sensible to me.

Secondly, gold mining companies usually use derivatives to decrease the risk of their operations. However, it’s quite possible for gold miners to make serious mistakes with their hedging and derivative strategies and this can lead to adverse results for companies that get it wrong. In extreme cases, a company can end up collapsing as a result (it has happened).

Thirdly, many gold mining stocks do not pay dividends. You are therefore totally dependent on capital appreciation for your return – it’s a risk. (Investing in gold bullion not only provides no income, it actually incurs storage costs.)

Fourthly, production costs at mines can vary widely from one year to the next due to factors that the mining companies can’t control. For example, when the price of oil skyrocketed, most miners also watched their production costs skyrocket because many use diesel generators for their power source (they have to in remote areas where most mines are located). The recent falls in the oil price are of course of great benefit to gold miners.

I think the arguments put forward by Harry Schultz and others for an increased gold price are logical. However, I also realize that macro-economic forecasts are difficult to make with accuracy. Many economists get things wrong (often dramatically so) and anyone who places their faith in such forecasts (or forecasters) does so at their own risk.

While I said in my last post that I would be prepared to allocate a small percentage of my portfolio to gold, this still has to be assessed against what is available to me in the equities markets (non-gold sectors). I believe that there are still more attractive opportunities in the non-gold sectors of the equity markets.

While Schultz has a lot of credibility, I wouldn’t want to go betting half my portfolio on a rising gold price (as Schultz suggests his readers do). It’s just too much of a risk to take. A little in gold is fine, but gambling half my funds is not something I would ever do.

Note: None of the above constitutes financial advice. You need to do your own research and consult appropriately qualified people for advice (where necessary).

Harry D. Schultz: Buy Gold

Most people have never heard of Dr. Harry D. Schultz. I first heard of him many years ago when I was flicking through a copy of the Guinness Book of Records where he was listed as the highest paid investment consultant in the world (he appeared in many subsequent editions).

In 1981 he was charging $US2,000 for a one hour consultation on weekdays and $US3,000 for an hour on weekends. He currently charges $US3,500 on weekdays and $US4,900 on weekends. Harry Schultz is still the highest paid investment consultant in the world. He has published 23 books (most of which are now out of print).

Harry Schultz writes an international investment newsletter (the Harry Schultz Letter) that was first published in 1964. Each newsletter contains a great deal of information and you can subscribe to it for $US382 for one year. Apparently he has subscribers in 80 countries.

Dr. Schultz himself is based in Switzerland but has lived in no fewer than 18 countries.

Some quotes from his 9 December 2007 letter (on his web site):

Fannie Mae & Freddie Mac will crash.

This is not a time to seek profits, but to protect what you have. Profits will come from precious metals & the Swiss Franc. The Swiss Franc is the safest currency. Don’t worry about interest, worry about safety.

Biggest danger to you is having cash, time deposits, CD’s in banks, as warned before. They can be lost in bank closures, or at best frozen for 6 months to 3 years. Some banks already quietly closed. It’s govt policy not to reveal any bank vulnerability in case it scares off possible buyers of a bank—so you will never get a warning. Safest is switch to shortest-term govt bonds (90-day if possible) of any 1st world country.

Huge profits possible in mid-08-09 buying foreclosed homes at 15-20% (?) of value. If you buy them, be prepared to hold them for a long while.

CNBC & Bloomberg swing from saying things are getting better or worse every 2 hours. Don’t expect wisdom. Remember the saying: “If a jackass looks into a mirror, a jackass looks back out.” Judge the source. Trust not easily.

Soon one or all of the Middle East oil exporters will end their US$-peg or $-oil pricing, & switch to a basket of currencies or euros. They must, for survival. That will unofficially end US$ status as a reserve currency. On that date the $ will probably fall 10-15% in a day.

During 2008 a lot of what Harry Schultz predicted in 2007 actually occurred. Many other commentators were still very bullish in late 2007 – they were wrong and Schultz was right.

In essence, Schultz is a chartist who uses fundamentals, as the following quote reveals:

When investing, don't think in terms of absolutes, think in terms of probabilities. We want to do everything possible to "load the deck" to our advantage. Charts are the pros' secret weapon for doing exactly that. Charts allow us to minimize risk. While we do pay attention to fundamentals, (e.g., industry group, sales, earnings/share, return on equity, profit margins, geopolitics. etc.), they can't tell us when is the best time to "pull the trigger," nor when to take profits or cut losses. If you don't use charts, you're just guessing.

I’ve never embraced charting myself (and I never will). It’s true that price trends can be used to guide the timing of purchases or sales. There is no point buying something if the price is consistently trending downwards, best to wait for the trend to stop and then buy. Of course as you know, that’s much easier said than done and far more difficult to do in real-time than it looks in hindsight.

According to Hulbert Financial Digest, Schultz’s tips have underperformed the US market over the last 10 years – not a good result for the highest paid investment consultant in the world.

However, the very fact that Harry Schultz has so many subscribers means that they are getting some value from his letter. If the comments in his 9 December 2007 letter are any indication of his predictive ability, he certainly has it, but maybe he has trouble capitalizing on it (?).

So what is Schultz saying at the moment?

He’s advising readers to buy gold. He believes that the gold price will rise significantly in the next few years due to the expected inflation caused by massive Government spending globally.

Schultz recommends that readers of his letter put half their money in first world government bonds (but not US bonds) and the other half in blue chip gold stocks and gold bullion. Interesting isn’t it?

Have a look at the table below:

	Compound return per annum
Period	Gold	S&P 500
1950-1959	-1.4%	13.6%
1960-1969	0.0%	4.4%
1970-1979	32.2%	1.6%
1980-1989	-2.9%	12.6%
1990-1999	-4.0%	15.3%
2000-2008	13.5%	-4.8%
Overall	5.4%	7.0%

The table shows quite clearly that when equities do badly, gold usually does well and vice versa.

Gold has appreciated by approximately 5.4% per annum compound over the last 59 years (it’s not a great result). Also note that the return shown above from the S&P 500 doesn’t include dividends.

The big question is: Has gold already had its good run this time round or will it keep going up (if and when inflation starts to become a serious problem?).

If you do decide to bet on gold, you have a few options.

Firstly, you could find a few blue chip gold stocks and allocate some of your portfolio to them (in Australia there are approximately 300 listed companies classified as gold miners – very few of them could be classified as blue chip).

Secondly, in Australia, the Perth Mint will sell and store gold for you (this includes those resident outside of Australia). Gold storage accounts are guaranteed by the Western Australian Government (which has a AAA credit rating).

Thirdly, and perhaps an even better option than the above is to buy Gold Exchange Traded Funds (ETFs) or Gold Exchange Traded Commodities (ETCs) on the stock exchange.

Schultz believes that 2009 will be a year of deflation followed by significant inflation in 2010. If he is in fact correct, gold should increase in price, but who knows for sure?

I may be willing to allocate a small percentage of my portfolio to gold just in case Schultz is right. The arguments for an increased gold price seem reasonably logical to me, what is less clear is where exactly in the gold price cycle we currently are.

For those interested in gold, there are some good articles in the gold markets section of: www.contrarianprofits.com

In case you’re wondering, I’m not a subscriber to the Schultz letter and of course have no financial interest in it.

The Harry Schultz Letter site: www.hsletter.com

Note: None of the above constitutes financial advice. You need to do your own research and consult appropriately qualified people for advice (where necessary).