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There'd Be Days Like This

(Guest Commentary by Rick Konrad – May 6, 2011)

Dear Subscribers and Readers,

For those who want to learn more about picking stocks, evaluating companies, industry trends, and other issues related to the stock market, we have brought in Mr. Rick Konrad to pen a guest commentary.  Rick has been our regular guest commentator for several years and offers his unique insights to us twice a month.  We highly appreciate your investment insights and general wisdom, Rick!

In this commentary, Rick briefly discusses the recent mini-crash in commodities, with a focus on precious metals.  He postulates that some of the weakness may be attributed to proposed selling by the German governing coalition of gold reserves of distressed Euro Zone countries to cover the costs of their respective bailouts.  Rick also discusses the recent Canadian electoral results, and why this may be bullish for Canadian small businesses.  Finally, Rick discusses proposed legislation to effective raise taxes on MLPs in the US, and why mortgage REITs may be a better option for those who are seeking for income.  Without further ado, following is Rick's biography:

Rick is author of the excellent investment blog “Value Discipline,” founder of “Value Architects Asset Management”, and is a regular guest commentator on MarketThoughts.com (please see “Investment Thinking a la Wayne Gretzky” for his last commentary).  Prior to his founding Value Architects, Rick was a professional portfolio manager for institutional investors for over 25 years.  A more complete profile of Rick is available on his blog.  You can also email Rick at the following address if you have any questions or thoughts after reading his commentary.  Rick is a very genuine teacher of the financial markets and treats it very seriously.  Rick has also run the education program for the CFA Society in Toronto (which is the third largest CFA society in the world besides the New York and London Societies) and had graded CFA examinations.

Disclaimer: This commentary is solely meant for education purposes and is not intended as investment advice.  Please note that the opinions expressed in this commentary are those of the individual author and do not necessarily represent the opinion of MarketThoughts LLC or its management.


Momma said there'd be days like this, there'd be days like this Momma said- The Shirelles

In the early 1960's, one of the first all-girl singing groups, the Shirelles, hit the charts with the tune, "Momma Said There'd be Days like This". This was undoubtedly one of those days that tested the patience of clients and their advisors.

Commodities were severely beaten up, led by the precious metals but also followed by oil. Commodities dropped the most in two years and the S&P GSCI index of 24 raw materials has been falling for four days led by silver, crude, and heating oil.

The S&P energy index which in mid April had been up over 17%, handily beating the S&P's then 4% advance, still is ahead of the broad index but by barely 3%, having lost 1000 basis points of relative advantage.

Hot money has been on this trend where managed money funds held a net 1.49 million contracts in future and options in 18 commodities, a full 57% higher than a year earlier according to US Commodity Futures Trading Commission data.

Clearly a lot of people have been riding this particular train whether in the commodities themselves, the ETFs, or the corresponding stocks. The CME has lifted margin requirements on silver contracts four times since the end of April to dampen speculation which of course has triggered margin calls.

Recent stories about the central bank of Mexico buying 100 tonnes of gold were overtaken by a far more interesting story:

Bloomberg reported that "A budget expert from Germany's governing coalition and his counterpart from the biggest opposition party urged Portugal to consider selling some of its gold reserves to ease its debt problems. Norbert Barthle, the Christian Democrats' budget spokesman and Carsten Schneider from the opposition Social Democrats want a review of Portugal's request for aid to include gold and other potential asset sales."

This potential linkage of aid to a reckoning of gold reserves held by the central bank is a very new development. Gold represents almost 90% of Portugal's reserves at last count not to mention additional gold reserves held by Greece and potentially Spain which could also come to market if this suggestion were to take hold.

Conversely, it may be possible for Eurozone central banks to "pool" their Gold reserves to back a European Monetary Fund aimed at rescuing Greece et al from fiscal crisis.  At some point this policy could lead to the transference of gold from developed to developing countries as part of a more global solution to the growing fiscal problems that the world currently faces.

In another surprise for today, the European central bank is now taking a "wait and see" attitude in the wake of its April rate hike and that it might only resume such upward adjustments after its June meeting. Trichet certainly seemed less hawkish than usual and this change in tone rallied the dollar and weakened the euro. Describing central bank policy as "never precommitted” Mr. Trichet helped reverse some established currency carry trades.

One of the recent bright notes, and after a day like this, most of us can use one, was the Canadian election results.

Stephen Harper, the Prime Minister of Canada and head of the Conservative Party won a decisive victory in Monday's federal election.  The Conservative Party finally won a majority government after five years of minority government, capturing 167 seats, twelve more than needed to form a majority.

In a parliamentary system, a minority government is formed when no party has a clear majority and hence a coalition government is formed to rule. Naturally, such a government is viewed as somewhat unstable because alliances between parties can dissolve when disagreements occur. Consequently, yesterday's majority result ensures a stable government that can operate until the next election is called, which can be as long as four years away.

What is stunning about the results is the decimation of the Liberal Party, in many ways a party that is analogous to the Democratic Party in the US. Until this election, the Liberal Party has either run government or served as the Opposition Party. The Liberal Party was led by Michael Ignatieff, a former human rights professor at Harvard. Generally viewed as lacking charisma, Ignatieff led a rather weak campaign and the Liberals were reduced to less than 19% of the popular vote and 34 seats, a historic low in the 308 seat parliament. For perspective, in 2000, the Liberal Party controlled 172 seats. The complete collapse of the Liberals has redrawn the political map of the country, leading to Ignatieff's resignation and the rise of Canada's socialist party, the NDP (New Democratic Party) as the official opposition.

The NDP, under the leadership of Jack Layton, has held power in various provinces at times during the last fifty years but has never held sway at the federal level. The party's biggest wins came from Quebec, where it became the default choice for voters fed up with the Bloc Québécois. The NDP is viewed as a left-leaning socialist party with strong labor backing. At 102 seats, they achieve considerable visibility as a legitimate opposition party rather than a fragmentary or marginal party as they have sometimes been considered.

The Bloc Quebecois, a federal party that is dedicated to sovereign rights for the province of Quebec, and a remnant of previous separation movements, also practically disappeared from view winning just four of 75 Quebec ridings.

What does this mean for investors? Prime Minister Harper gains a lot of flexibility and latitude to implement economic policy. The platform is definitely conservative and right of center. Expect corporate income taxes in Canada to drop to 15%, the lowest in the G-7 as compared to our 35%. Foreign ownership rules which precluded the takeover of Potash Corp may well be modified. Having a majority will make it easier for Harper to balance the budget. He will be able to schedule government spending cuts over four years instead of worrying that this would alarm voters.

The Conservative Party much like Reagan Republicanism is a strong supporter of free trade. It is likely that Canada will establish a Canada-European Union Free Trade Pact by 2012 to be followed by a Canada-India Free Trade Pact. These two Free Trade Agreements between Canada and the EU and Canada and India will give Canadian businesses greater access to markets totaling more than 1.7 billion people with a combined GDP of $20 trillion, potentially creating thousands of jobs for Canadians.

Much like in the US, the Canadian economy depends on the small business sector for the lion's share of job creation. An important part of the party platform is a promise to reduce red tape and paperwork for small business. Every time government proposes a new regulation, it must eliminate at least one existing one. Are you listening Obama bureaucrats??

Bottom-line, investors should welcome the clarity of the outcome that this election has provided. The risk hurdle that comes with minority governments has been removed. Though some may worry that a left-leaning party is in opposition, the party has lost its ability to be the balance of power in a minority government. Certainly, the conservative party platform appears to be very pro-business.

Some bitter memories about Canadian investing are still harbored by US and Canadian investors alike. Changes in tax policy in Canada which were implemented over a four year period resulted in what became known as the Halloween massacre, since the policy was announced on Oct 31, 2006. Essentially, Canadian investment trust structure was obsolesced that night, and despite a four year period for investment trusts to adjust their corporate structures to conventional “C-type “ corporations, most investors had no patience and ran for the exits. The very next day, the Canadian investment trusts lost an average of 30%. Over the next couple of years, many trusts received takeover bids or were taken private in LBOs. Having had four years to prepare for the inevitable conversion, many simply reduced their payout ratios and evolved into tax-paying Canadian corporations. After all, the assets remained unchanged; what had changed was the capital structure that had supported the assets. The underlying businesses were generally strong in producing regular and recurring cash flows. After all, they had supported significant monthly payouts for some time.

A similar shock may be awaiting master limited partnerships in the US. Rumors have abounded that the Treasury Department is looking into the possibility of having MLPs above a certain size (apparently $50 million in gross receipts) become taxable corporations.

MLPs like REITs or BDCs at present pay no corporate taxes so long as over 90% of the income flows through to shareholders. In addition, shareholders, or more correctly, limited partners have the ability to take advantage of certain tax credits and deductions on their individual income taxes since the MLPs, being non-taxable, cannot take advantage of these features.

Many factors influence returns on energy assets--and therefore the distributions that we receive as limited partners. Energy prices are an obvious driving force that affects everything from the profitability of oil and gas wells, shutting in of low productivity wells, to throughput at processing plants and pipelines. Weakness in oil prices in the last few days have done little to help.

As with all capital projects or securities, an important element of valuation is the cost of capital. The lower that interest costs go and the higher that equity prices go, the lower the cost of money to finance the building and buying of cash-generating assets. And the lower the cost of money, the more profitable even the lowest-risk projects can become. Were MLPs subject to corporate taxation, this would raise the cost of capital and hence lower their valuations. In addition, many projects that may be contemplated under one scenario would be rejected under a taxable scenario. This also has implications for potential future dilution of existing MLPs which have frequently raised additional equity. The more expensive the financing, the less distributable cash flow will be produced by buying or building assets. More units would have to be issued to raise the same amount of money. Consequently, more dilution for the cash flow added. Conversely, the less expensive the equity financing--i.e., the higher the price offered to investors--the less dilution.

An organizing body composed mainly of MLPs, the National Association of Publicly Traded Partnerships (NAPTP) sent an e-mail to its members last Friday, citing the potential change for corporate taxation as something that was being tabled within the Treasury Department. At this point, it's not clear whether the Treasury Dept ultimately will introduce such a proposal. Though there do not appear to be any concrete proposals that have been published, sources have told the NAPTP that this could be some weeks away. Nevertheless, many limited partners have chosen to vote with their feet and are exiting these units.

Rationally, such a change would need to pass through this gridlocked Congress. Though “Big Oil” is clearly a target of the Obama administration, it is somewhat difficult to imagine that MLPs can be viewed in the same light.

MLPs do account for the lion's share of spending on energy-related infrastructure, including natural gas pipelines and storage facilities that are crucial to US energy independence. Measures that would raise the cost of capital for such projects would threaten their progress.

If MLPs were to be taxed at the corporate level, my rough guess as to the amount of revenue that would be raised is something of the order of $5 Billion…not exactly meaningful given the dimensions of the fiscal problems.

MLPs at times can be very volatile trades with fairly broad swings. The presence of this rumor has only increased the volatility. For those of you who need a reliable source of fixed income, I would suggest trimming back positions, just in case there is some validity. I would much prefer seeing fixed income coming from mortgage REITs such as MFA Financial (MFA), or Cypress Sharpridge (CYS). Higher risk investors may want to consider business development corporations such as Golub Capital (GBDC) or Ares Capital (ARCC).  Generally, these flow-through securities offer higher yields and I think, somewhat higher capital appreciation potential.

For those with very high risk tolerances who may wish to bet that potential changes in taxation of MLPs won't have a ghost of a chance in Congress, I would suggest a recent addition to the MLP world, Tesoro Logistics LP (TLLP). With the backing of Tesoro Corp, an independent refiner in the US, Tesoro Logistics operates two businesses: an oil gathering system in the Bakken Shale/Williston Basin area of North Dakota and Montana, and a system of  refined products terminals and a storage facility in the western US. As we know, the Bakken Shale area has been a hot area for exploration. Exploration success has resulted in oil production growth from roughly 100,000 barrels per day five years ago to 400,000 barrels per day.

Production is terrific, but moving it is tough. There is very little pipeline capacity in the area. TLLP has a 700-mile pipeline gathering system in the region that collects production from individual oil wells. All told, the MLP's gathering system is set up to deliver up 70,000 barrels per day of oil crude to Tesoro Corp's refinery in Mandan, N.D. The Mandan facility, though quite small, is being expanded to accommodate all of the MLP's gathering capacity.

Tesoro Logistics' contracts with its general partner should enable it to achieve its minimum quarterly distribution of $0.3375 per unit for a yield of 5.9%. I think the distribution, barring any tax change, could grow.

Disclaimer: I, my family or clients own positions in MFA, CYS, GBDC, and ARCC.

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