Why I’m shorting TLT (Long-term treasuries ETF)

Basically, the US has very high debt and spending is out of control.  Bondholders are not going paid enough interest to compensate them for the risk that they are taking.

Congressional Budget Office

They issue reports on the projected US deficit.  Read them for yourself!  The issues I have with the reports is that:

  1. They don’t even predict an elimination of the budget deficit.
  2. Their predictions are based on assumptions that will likely turn out to be false.  (Such is the nature of the prediction game.)  If they were smarter, they would provide a range in their estimates.
  3. Historically, politicians always say that they are going to slowly eliminate the deficit.  But they never do.  Why do you think the US has so much debt in the first place?
    Or look at Greece.  The politicians have been hiding their problems for a long time and understating inflation.  But eventually the proverbial excrement will hit the fan and everybody will be panic selling their debt.

Obama’s advisors

Warren Buffet used to be one of Obama’s economic advisors.  His shareholder’s letters at Berkshire Hathaway outlines his thoughts on what the administration should do (lower health care costs / make the system more efficient, cut greenback emissions, etc.).  Needless to say, Obama does not listen to him.

So who is still one of Obama’s economic advisors?  Lawrence Summers.  Nothing against him as a human being, but he has a track record of failure.  At Harvard, he presided over Harvard’s failed gamble on interest rates.  As US treasury secretary, he helped to repeal the Glass-Stegal laws.  It turns out that wasn’t such a good idea as investment banks became “too big to fail” and did all sorts of crazy things.

Wasteful spending

The US military is funding the Taliban and Afghan warlords.  The US military outsources the trucking/delivery of its supplies to a select list of approved companies.  It is cheaper for these companies to pay off the Taliban and local warlords than to protect trucking convoys with troops.  (They also aren’t allowed to use heavier weaponry so they may find themselves outgunned.)

Now all governments and organizations are going to have wasteful spending to some degree.  But as far as I can tell, the politicians are aware of this counter-productive spending and are doing little about it.  It is going to be a little difficult for the US to pay off its debts when you have a system that doesn’t care about correcting its mistakes.

Some of the numbers

10-yr treasury yield: 2.125%
30-yr treasury coupon: 3.750%

Gross debt to GDP: ~98.60%
Revenue to GDP: ~30.83%
Spending to GDP: ~46.41%

Let’s suppose that the US government turns around and starts saving 30% of what it makes (this is the average household savings rates among some Asian countries).  The US will be in some incredible pain as government spending will have to drop from ~46% of GDP to ~21% of GDP.  The US would have to cut slightly more than half its spending (I am guessing that there would be riots in the street).  Then it would take a painful decade to get out of debt.  If the US government only saves 10%, spending will still have to drop drastically and it will take three painful decades to get out of debt.

Of course it will never happen.  It will probably end up like Greece, where the politicians keep running up the deficit while the citizens and media do not hold their governments accountable.  And there will be rioting, much like in Britain.  Historically this is the pattern and it does not look like the US will be the exception.

Disclosure: I am also long US stocks like Microsoft and Apple and a lot of commodity stocks (PG.TO, CLQ.TO, NOT.TO, NFD.A, MCF).

Mining as I understand it 3: How people make money

Trading/investing in/speculating on stocks

In my opinion, much of the return on commodities stocks will come from ‘speculating’ on commodity prices.  The underlying companies are usually leveraged to the price of commodities.  A 2X increase in the price of a commodity will usually lead to more than a 2X increase in operating profits of a mine.  If the costs of a mine are 50% of the current commodity price, then a doubling in prices will increase mine profits three times.

A small part of the return will come from buying the dips and selling the rallies.  (Because let’s face it- this is how most value investors make money.  They aren’t always good at picking stocks.)

And a small part of the return will come from stock picking.  But very few people are actually good at it.  You know, there are hedge fund managers out there who don’t bother reading 10-Ks.  And many of them invest in mining stocks without bothering to read some university textbooks on mine exploration and mine engineering.  Some people think that it’s a good idea to go long ATPG, without understanding how PUDs can be manipulated.

Royalties

There are two reasons why royalties can be very, very profitable.  (But only by people who really, really know what they’re doing.)

Firstly, they are a way to rip off companies which are badly in need of financing.  Companies in distress.  Or junior mining companies where the CEOs do things that don’t make a lot of sense for its investors.  And royalties offer the chance for due diligence, so it’s not as risky as investing in a stock where it’s really difficult to do due diligence.  NI 43-101 is not perfect as geologists can do subtle things as using a favorable interpolation method (this can make a 20% difference).

And when dealing with junior miners, royalties offer added protection from the CEO doing awful things to its shareholders.  The royalty holder is not affected by share dilution, overpaid CEOs, CEOs wasting money on promotion, excess overhead (e.g. liability insurance for insiders), takeunders, etc.

Secondly, they are leveraged to big increases in commodity prices.  If a commodity price skyrockets, then naturally the mining company will want to do more exploration on its property and to expand production.  The royalty holder benefits from all this without having to put up any capital.  (Though not all royalties have this feature.)  This is kind of like an out-of-the-money call option and sometimes people seriously underestimate its value.

On the other hand, sometimes there are downsides to mineral royalties.  The mining company may try to underpay its royalties.  (This happened to Terra Nova, which went to court.)

If a royalty is too large, it discourages mine expansion whereas a smaller one would not.

Examples of successful royalty strategies

Pierre Lassonde + Seymour Schulich / Franco-Nevada

Altius Minerals (ALS.TO)

Labrador Iron Ore Royalty Corporation (LIF.UN) – They don’t even do anything fancy.  Most of the asset value is in their royalty, plus an equity stake in the mine covered by the royalty.  On the other hand, this company was rather lucky as iron ore prices have skyrocketed.

Kevin McArthur / “Tip of the iceberg”

Kevin McArthur is the ex-CEO of Goldcorp and now runs Tahoe.  He is interviewed by The Globe and Mail here.  He seems to attribute his success to finding tip-of-iceberg opportunities.  As I understand it, this means buying properties that have a lot of exploration potential.  This probably comes in the form of extensions to the existing deposit.

Mining as I understand it 2: How people will lose a lot of money

Fraud, deception

  1. Fraud, e.g. Bre-X.  Junior mining companies are almost always extremely promotional.  Many of them will try to deceive investors into paying more for shares of the company than they otherwise would.  Some of these forms of deception ARE NOT STRICTLY ILLEGAL.  Or if it is, the perpetrators aren’t ever going to get punished for it.  Some companies will pretend like they have an operating mine when they don’t.  They buy ore concentrates and then resell them (UUU, GORO, etc.).  This allows them to issue press releases that state concentrate sales.  One might wrongly assume that the concentrate is the output of an operating mine.
  2. Employee fraud.  In the case of Bear Lake Gold, it seems that the project geologist decided to commit fraud knowing that he would get caught.  He also doesn’t seem to have profited from the fraud (other than short-term professional acclaim) and he probably will never be working as a geologist again.  Crazy stuff can happen.
  3. Accidental mistakes.  Or “accidental” mistakes, depending on how cynical you are.  Canada Lithium for example had to significantly reduce its mineral reserves due to errors on the geologist’s part.  To be fair, it could have been an honest mistake.  And Canada Lithium’s management was rather vindictive and childish in their press release in how it mentioned the geologist by name.  (They want to push the blame on her.)
  4. Overstated NI 43-101 reports.  NI 43-101 regulations came about due to the Bre-X fraud.  Its proponents set standards on technical disclosures in order to try to prevent future frauds.  However, sometimes people will try to game these regulations.  Canada Lithium for example (they went by a different name back then) issued a technical report on one of its properties stating that it had several thousand ounces of gold.  The next quarter, the property was written down to almost 0 (i.e. it is worthless).

DISCLOSURE:  I own shares in Canada Lithium.  Yes, I am long.  At around 46 cents, it trades at close to cash and this is ignoring the value of the lithium deposit (whatever it is).

Commodities bear market

(I could definitely be wrong here.)  We are currently in a bull market for commodities.  Several years from now, it will turn into a bear market for commodities.  Retail investors will own commodity stocks because “they hedge against inflation”.  They will own gold “to protect against fear and uncertainty”.  These beliefs will have an element of truth to them.  However, they will become part of conventional wisdom and people will not question their validity (at least, their portfolios won’t).

Degenerate gamblers will discover commodity futures.  Loose regulations around them allow gamblers to be ridiculously leveraged.  They will be much more popular than they are now.  You are going to see the return of CTAs (commodity trading advisors), which are sort of like the mutual funds of commodity futures.  (They are regulated by the CFTC and not the SEC.)  Physical bars of gold will be considered a legitimate asset class.  People will make board games about trading commodities (I played one when I was very little; it sucked).  Grandmothers and shoeshine boys will own commodities.  That will be the time to sell.

Valuation-wise, you will see new companies that are over-leveraged (i.e. unsafe levels of leverage) and chasing extremely marginal opportunities.  Then a crash in the commodities market will wipe out all the overleveraged players and the bubble will slowly deflate.

Of course, things probably won’t work out this way.  Or maybe it will, but I will be totally wrong in my timing about when the bear market begins.

Mining as I understand it

How the resource exploitation process works

Exploration

First you have to find an economic ore deposit.  Exploration geologists look at all the previous mines and look at any patterns that exist (e.g. a lot of deposits are found near existing mines).  They also utilize scientific knowledge about how ore deposits form (e.g. diamonds can only form under high heat and high pressure; they only end up near the surface if stuff from deep down is ejected upwards, e.g. in kimberlites).

In addition to drilling, geologists may look for things associated with ore deposits.  They may go looking for anomalies in gravity, induced polarization, etc.  While ore deposits can cause such anomalies, all sorts of other rock configurations can also cause anomalies.  So the geologists will drill a lot of holes and find a lot of duds.  They most basic method is old school prospecting.  You walk around the surface looking for rocks.  Certain types of rocks are likely to host valuable minerals.  Some rocks obviously contain ore just by looking at it if you are familiar with the different types of rocks.  Nowadays geologists will sample surface rock and get the samples assayed for minerals that aren’t visible to the eye (e.g. economic amounts of gold).  They may also look for “indicator” materials- stuff that correlates to certain types of ore deposits.  And they may look for boulder trains that may lead to a deposit elsewhere.

Most of the really obvious ore has been found.  Finding future deposits will only get harder and harder.  On the other hand, technology may introduce new technologies that make low-grade deposits economic.  We may also discover new technologies to help in exploration.

One thing to note about mineral exploration is that the chance of finding an economic deposit is very, very low.  Many geologists will never find a deposit in their entire professional careers.

Pre-feasibility and feasibility studies

In this stage, a mine engineer will evaluate the various technical parameters that determine whether or not a deposit is economic.  The more important ones are:

  1. Size of the deposit.
  2. Mining method.  Underground mining typically costs three times that of open-pit.  However, various underground mining methods differ in their cost (the cheaper ones sometimes cannot be used).
  3. Mining dilution.  If the ore deposit is very narrow (only a few meters), mining machines will have to move a lot of waste rock.
  4. Ore processing / metallurgy.  For some ores, the metals cannot be easily (cost-effectively) recovered.  Some ores have impurities that cost money to remove (e.g. arsenic, sulphur, etc.).
  5. Infrastructure.  Mines need roads, access to ports (sometimes), power, water, etc.
  6. Royalties, taxes, etc.  Sometimes prospectors and former joint venture partners will have royalties on the property and these need to be factored in.

Other parameters (that are mostly the investor’s job) are:

  1. Political risk.  Some mines may have difficulty due to NIMBY groups.  For example, in Australia a lead mine was shutdown after it started production due to residents’ pressure on their politicians.
    Some foreign countries are run by corrupt regimes that demand high payments from mining companies.  They may escalate these requests in the future (a deal is not a deal).  Leaders (sometimes socialist, sometimes not) may appropriate foreign assets.  Even in the US and Canada (considered to be the lowest-risk countries), foreign takeovers are often blocked while domestic ones are ok.  It doesn’t even make sense because a country can appropriate the assets of foreign countries; it is a good idea for them to follow the host countries’ rules and regulations (though some do not).
  2. Future commodity prices and exchange rates.

More exploration drilling usually occurs during this stage.  If even more ore is discovered (this is a good thing), the mining plan may be changed.  Mine construction may be intentionally delayed to avoid building a mine and processing facilities that is not ideal for the deposit.

Financing

The feasibility study may determine that the ideal level of investment is higher than what the mining company can afford.  So the mining company can sell the asset to another company with more money.  Or they can raise money through selling equity, rights offerings, selling royalties on the property, raising debt, etc.

Sometimes there are government-related/government-sponsored entities that will make dumb loans to mining companies (e.g. they don’t charge enough interest relative to the risk).  Their mandate may be to help economies develop.  In practice, government workers who do their job poorly tend to get to keep their jobs.

Mine construction

Hopefully there are no cost overruns.  A companies’ management may have incentives to understate the cost of mine construction to make the economics appear more attractive.

Mine production

It usually takes 5-10 years (sometimes more!) for a mine to actually start operating.  Mining companies are usually very overoptimistic about when a mine will actually start operating.

By this time, commodity prices may be very different and this will affect the economics of a mine.

As the end if a mine’s life comes closer, there is an incentive to find more ore near the processing plant since all the infrastructure is in place and paid for.

Exploration drilling may occur when a mine is operating.  Some exploration drilling may be deferred until an underground shaft is built.  Drilling very deep is expensive and drills will slowly start going off target the further the drilling gets.  Starting underground lowers the exploration cost.

All these things mean that the plan for a mine will likely change several times over the course of its life.

Sanofi / Genzyme Contingent Value Rights (GCVRZ)

See a different writeup on GCVRZ here for some background: http://www.valueinvestorsclub.com/value2/Idea/ViewIdea/53388

In my opinion, they are only slightly undervalued (maybe 20-30% at $1.03/CVR) and here’s why.

Drug potential

Now that the first set of phase III trial results are in, it seems that:

PRO

Efficacy better than the traditional CRABs/ABCRs for relapses. (The phase III trial only compared efficacy to Rebif.  But it is likely that doctors and patients will extrapolate.)

?Efficacy only slightly better in terms of disability.  However, the phase III results weren’t great as this was not statistically significant.

Arguably more convenient that most other treatments on the market.  You have to sit in a hospital for 5 days while on all sorts of drugs (with a small chance of being well enough during the infusions to be able to go home).  This may not be so bad compared to constant injections with Rebif, monthly injections with Tysabri, etc.

CON

One person died during phase II trials from ITP.  This will be a huge cloud over this drug.

Major side effects… a chance of developing thyroid problems / Grave’s disease (treatable) and a heightened chance of developing ITP.  While ITP is treatable in theory, its mortality rate is not zero (e.g. as demonstrated in the phase II trials).

So here’s my quick analysis of the drug.  Its efficacy and mortality rate is similar to that of Tysabri.  In the initial phases, I feel that doctors and patients will rate Tysabri as safer because it has been around longer and therefore the long-term effects are better understood.  Over time, the tide will likely shift the other way as ITP is better understood than dying from PML with Tysabri (there is no cure for PML…).  So I make the simplifying assumption that Lemtrada will perform similar to Tysabri.

Tysabri is on track to doing about $1.3billion/year sales 7 years after its FDA approval.  If Lemtrada performs similarly to Tysabri, then it has a chance of hitting the $3 sales milestone of >$1.8billion sales after you figure in inflation.  It has an EXTREMELY low chance of hitting the $2 sales milestone of $400million sales during the launch year(s).  Tysabri never had sales that were that strong during its launch phase (and was even pulled off the market due to safety concerns over PML).  Sanofi may also have an incentive to sabotage/defer/stop sales during this initial period to avoid paying the $2/CVR.

Of course, it is likely that Lemtrada and Tysabri will split some of its market share as they are similar in risk/benefit.  So I wouldn’t count on the $3 milestone as being a sure thing.

Another way of looking at it is to realize that the payouts are rather lofty goals in the context of the drug industry.  A blockbuster drug is defined as one that makes $1billion/yr in sales.  Tysabri took several years to reach that point.  And the drug industry is having a very difficult time cranking out blockbuster drugs.

Bottom Line

At this point, I would say that analyzing future sales of Lemtrada is very hard.  I’m not that smart.  But I don’t see a margin of safety here.  FDA approval at 90% probability gives almost 90 cents of value.  The $3 sales milestone will take several years to materialize and its present value is worth tens of cents depending on what probability and discount rate you use.  But how much do I really know about pharmaceuticals?  In my opinion, these rights are easier to evaluate than a pharmaceutical company.  This market doesn’t look that inefficient.

Other factors

– Devaluation of the US dollar is slightly favorable for CVR holders.  Of course, this is a two steps forwards one step back kind of thing.  While the higher payoffs are easy to trigger, you will receive US dollars that aren’t worth a lot.

– Lemtrada is not cheap.  Some think that the treatment will be $60k.  Most people simply cannot afford this without health insurance.  Future changes to the health insurance industry may help or hurt sales of Lemtrada.  I don’t understand the industry well enough to know what will happen.

– I could be understating the potential of Lemtrada???  Maybe it is God’s gift to MS sufferers that cures the disease and reverses its effects, as Genzyme’s pre-marketing efforts would like you to believe.

– To be fair, a comparison to Tysabri may not be a great idea as doctors have to weed out patients who are susceptible to PML.  As well, you can only get Tysabri from a doctor who are part of its restricted distribution program (again, so people won’t die from PML).

– Sanofi is allowed to repurchase these rights.  After 2014, it can force all rights holders to sell their rights if they under $0.45 for a period of time.  This could be unfairly used against rights holders???

– Tax treatment is uncertain.