Yesterday we aligned our interests with the management of Coeur d’Alene. This gold and silver mining company, like much of the mining sector, trades at a steep discount to our estimated NAV of $31 (based on Proved and Probable Reserves). In addition they’re generating $300-400MM of cash annually and the business looks to be going well. Until recently we believed the best way to bet with CDE was to own shares in the company; however, their debt issuance earlier this week makes it much more likely that the company will make acquisitions in the sector rather than buy back additional stock (they recently announced a $100MM buyback which was positive, but the $350MM debt issuance is cash that they really don’t need for their existing business and it doesn’t appear that they’re going to use this additional cash to return value to shareholders).

Since CEO Mitch Krebs owns so little stock, and former CEO Wheeler owns none, management has little to gain from a higher stock price. In addition, the incentive compensation plan in place at CDE clearly favors efficient production based on per ounce costs, a structure that firmly points management towards a bigger company with SG&A spread across larger revenues rather than increasing per share value.

Consequently, aligning with CDE management requires NOT owning stock in CDE but instead owning other mining stocks (through GDX for example) since any M&A activity in the sector is likely to be at the expense of CDE stockholders but may benefit the mining sector more broadly. We have no position in CDE but are invested in GDX. Mining companies have a well earned reputation of generating value for their executives while the owners do poorly. The chart below compares the return to investors in CDE since 1991 with the compensation earned by CEO Dennis Wheeler over that time. Clearly, providing labor to CDE was far better than providing capital.

Gold and silver miners have been underperforming precious metals for some time. As a result, many names in the sector are priced at substantial discounts to the net asset value (NAV) of their holdings. We have been invested in Coeur d’Alene (CDE) on and off for the past couple of years. The company has historically been a pure silver miner, but in recent years has been producing more gold and by next year gold revenues will probably surpass those from silver.

The company’s market cap is around $1.6 billion and it has debt of $122MM (although they just announced a note issuance – more on that later). They are operating quite well apart from a recent setback at their Kensington mine in Alaska where production was halted while they improved their infrastructure. But the company generated $1Bn in revenues last year for the first time, and looks capable of generating $350-450MM in free cashflow all while reducing their G&A and keeping capex at around $100-120MM.

Based on their proved and probable reserves, we calculate that the company could be worth almost $3BN, or $31 per share. Well-run mining companies provide positive optionality, in that if gold/silver prices rise the operating leverage inherent in their business model will cause their earnings to rise faster. Earlier this month we were happy to see that the company announced a share buyback of up to $100MM, about 6% of the outstandings. Although they don’t pay a dividend they’re returning some of their cashflow to shareholders.

Yesterday CDE announced an issuance of $350MM in senior notes. They have very little debt so the company’s balance sheet can certainly handle modestly more leverage. However, they don’t obviously need the money since their operations are generating plenty of cash. So now we’re going to see whether the principal-agent problem so prevalent in mining companies exists at CDE.

The most obvious use for the cash raised from the debt issuance is to buy back their underpriced stock. This would be an intelligent way to take advantage of interest rates maintained at extraordinary low levels and the cheap price of the company. Their SEC filing said, “The Company intends to use the net proceeds from the notes  offering to fund internal and external growth initiatives and for general corporate purposes.” This could mean they want to buy back additional shares, but the “…external growth initiatives…” also sounds suspiciously like an acquisition.

It’s hard to believe there could be anything better for CDE’s spare cash than to buy back their shares. The biggest impediment we can see to this is that senior management holds so little stock that they might be thinking more like agents than principals. CEO Mitch Krebs owns 74,812 shares according to their recent proxy statement, less than 0.1% of the company and currently worth just over $1MM. His total compensation for 2011 was $2.4MM. Mr. Krebs’ incentive compensation is generally tied to production-related metrics, so given his modest ownership of stock his incentives appear to be more closely aligned with a bigger operating company rather than a higher share price.

What CDE does with the proceeds of their debt issuance will provide some insight as to whether it’s better to provide labor to CDE (like Mr. Krebs) or capital (like his investors, including us). His financial incentives clearly direct him towards acquisitions. Perhaps some of the other large shareholders such as Vanguard and Dimensional Fund Advisors will make their views known. Or perhaps CDE will simply begin scooping up some of its cheap stock and return some value to its owners.

We are long CDE.

On Wednesday the Federal Reserve released their third set of detailed interest rate forecasts this year. Following Ben Bernanke’s philosophy of open communication, the FOMC publishes forecasts for short term rates from each voting member. While they don’t link a name with each number, you can see what members expect short term rates will be at the end of this year, 2013, 2014 and over the long run (whose start is not defined).

In effect you can construct a crude yield curve incorporating their collective outlook. Comparing their yield curve with the market is fascinating, although market yields and implied rate forecasts have been steadily diverging from those issued by the Fed. In fact, the Fed’s own forecast has been remarkably stable even while ten year treasury yields have traversed a 1% range reaching 2.5% before falling recently to 1.5%. The chart below is derived from the average of all FOMC member’s rate forecasts at year-end. So there’s a clear discrepancy between the Fed’s statement that short term rates will remain low through the end of 2014 and the six FOMC members who expect rates to be higher (three of whom target hikes as soon as next year). At the same time that the Fed extended Operation Twist to the end of this year, they reaffirmed that the long run equilibrium short term rate is around 4%. Long term bonds continue to trade at yields that defy that forecast. The Long Run is still some ways off, but today’s bond buyers are fairly warned.

There is growing evidence that the “Fiscal Cliff”, looming in January 2013, will take a toll on the economy before its arrival. Although reports suggest that both parties are discussing a resolution to the sudden tax hikes and spending cuts that will take place under current law on January 1st next year, there’s little tangible evidence of such. There is growing evidence that companies are managing their businesses by incorporating this uncertainty into today’s spending decisions. It occurs to me that, while most economic forecasts project a substantial (3%+) GDP hit in 1Q13 IF no action is taken, few have considered that waiting until December’s lame-duck session of Congress to do the inevitable is quite likely to depress growth in the meantime. The non-partisan view surely blames both sides for placing the purity of their own political beliefs ahead of the pragmatism of removing at least one element of uncertainty.

The comments from many Congressmen that the planned tax hikes and spending cuts will assuredly be rolled back would be more credible if they didn’t insist on waiting until the last possible moment do do so.

For our part, we remain generally fully invested across our strategies. Owning steady, dividend paying stocks combined with a beta neutral hedge provides an uncorrelated source of return while markets are being buffeted around. Our most recent decisions have been to exit the last remaining shares of Family Dollar (FDO) which no longer provides compelling value given its recent increase in price. We have added modestly to Coeur d’Alene (CDE) which recently announced a share buyback given the large discount of its stock price to the estimated net asset value of its gold and silver reserves.

We have largely exited the short Euro position which has been held in our Fixed Income strategy as useful protection for the holdings of bank debt (given their equity sensitivity). It worked well for quite a while, but a few weeks ago I heard a reporter from the New York Times confidently announce on a radio interview that the Euro was going down and Greece would soon exit. Short Euro is probably too widely held, and isn’t that interesting any more.

Disclosure: Author is Long CDE

Last week I gave the second in a series of presentations I’ve been invited to make to the Tiger 21 group. Tiger 21 is an association of wealthy entrepreneurs that engage in “peer-to-peer” learning on issues that they have in common. Criteria for membership include a minimum investable assets of $30 million and payment of $30K in annual dues. Membership is by invitation only. The members have diverse backgrounds and sources of wealth, but one thing that brings them together is the search for unbiased investment advice. Most if not all members are regularly subject to marketing pitches from well-intentioned bankers seeking their investment in hedge funds, private equity and other illiquid, long-lived investments with their promise of recurring fee revenue for the banks over many years.

As I run through the basic Math of my book and explain why hedge fund investors in aggregate have not done that well, invariably an expression of understanding passes across the room as the audience grasps how one-sided the game can be. Generally groups like this have not made money in hedge funds, but they often blame poor manager selection and don’t focus on the structural disadvantages (fees, lack of transparency and illiquidity) that are stacked against them. They have an uneasy feeling that hedge funds haven’t been as good as is popularly believed, but the knowledge that the only group that’s made money is the managers is invariably met with much cynicism as countless meetings with hedge fund industry proponents are recalled.

Most of the Tiger 21 members I have met are self-made, and they well understand the profit motive and how to exploit a market opportunity. But even this unapologetically capitalist crowd is taken aback as the staggering imbalance between results for the clients compared with the managers sinks in. Perhaps never before in history has the inclusion of a diversified hedge fund portfolio been so challenged as an integral part of the ultra high net worth approach to investing.

The UK-based hedge fund lobbying group the Alternative Investment Manager’s Association (AIMA) was moved by my book to commission a defence of their paymasters by KPMG. It was somewhat misleading, in that its support of hedge funds was based on the 9% return that an investor starting in 1994 would have earned from an equally weighted portfolio, rebalanced every year. Of course no such investor plausibly exists, and holding an equally weighted portfolio isn’t possible for all investors (since hedge funds are not equally sized). And in 1994 although hedge fund investors did well there weren’t many of them. The industry was very small. If you’re going to recommend hedge funds why not consider how ALL the investors have done and not just a hypothetical one that was lucky enough to earn the good returns of the 90s (when hedge funds were a far better deal for clients). I posted my response shortly after KPMG’s report was published.

Meanwhile, where are all the happy clients who should be voicing their agreement with AIMA’s marketing brochure? Why is it that the only people advocating hedge funds are the people whose job it is to promote them in the first place? Has AIMA sensibly not sought endorsements from actual investors? Or have they tried and failed? Have they struggled to find any happy clients (although I could help them out as I know quite a few; it’s not that nobody made money, just the aggregate).

The Capital Asset Pricing Model (CAPM), that cornerstone of modern financial theory, teaches that a diversified portfolio is the best way to invest in any asset class since the market doesn’t reward idiosyncratic, or stock-specific risk. This is the most efficient way to achieve the systematic return of the asset class the investor is targeting. But it’s based on the not trivial assumption that the systematic return, or in other words the return on that particular market, is something worth having. Since the average $ invested in hedge funds would have been better in treasury bills, the thoughtful hedge fund investor might be advised to sprint away from anything that promises the average industry return. In my opinion the only way to justify hedge fund investments is if you’re good at selecting hedge fund managers.

You can invest in stocks and not be a stock picker; if you can’t pick hedge funds stay away. And the corollary is that IF you are skilled at picked hedge funds then diversification is not your friend. The more hedge funds you have the less likely you are to do any better than average. In my experience, the people who are happiest with their hedge fund investments only have a couple. The problem for the hedge fund industry is that two hedge funds should of course command a far smaller percentage of an investor’s portfolio than a more diverse selection. We wouldn’t need such a big hedge fund industry. That is how investors should use hedge funds. Will anyone else in the industry tell them?

The Equity Risk Premium has once again drifted up to all-time high levels in recent weeks. The S&P500 has an earnings yield of around 7.9% (assuming S&P earnings of $105 versus current price of 1,330). Ten year treasuries are 1.6%, so the resulting 6.3% spread is back at levels not seen since the early 70s. Yields remain excessively low; JPMorgan pointed out this weekend in their Global Data Watch publication that the yield curve implies negative real rates on government debt going out for ten years, an outcome outside even the experience of Japan. Whatever you think of stocks, bonds have to be a worse bet.

The Math is as follows: a 1.9% dividend yield on the S&P500 will, assuming 4% annual dividend growth (the 50 year average is 5%) deliver almost five times the return as ten year treasuries – assuming (perhaps crucially) no change in dividend yields in ten years. Or put another way, the holder of ten year treasuries could sell them, place 22% of the proceeds in stocks with the rest in riskless/returnless treasury bills and get to the same place, with 4/5ths of his capital available for other opportunities.

Once you figure in taxes (35% on treasury interest versus 15% on dividends) you only need put 17% of the proceeds from selling the treasuries into stocks. This is how distorted bond yields are – and they’re likely to remain so. Recent weakness in economic data, most notably the June payroll data, may result in further Fed buying of long term bonds. They wouldn’t recommend you do this yourself, as I wrote some weeks ago. The Fed is relentlessly driving the return out of bonds.

Investors have good reason to be cautious. This weekend’s Spanish bank bailout seemed inevitable and also inconclusive at the same time. Few believe the Euro’s fundamental problems have been solved. At the same time, in the U.S. current law requires a series of tax increases and spending cuts starting on January 1. The so-called “fiscal cliff” is estimated to be as much as a 3% hit to GDP and an instant recession. Few believe this will actually happen, reasoning that Congress will roll everything back another year and rely on the 2012 election results to settle the fiscal policy argument once and for all. However, while it seems sensible to assume Congress will act in this fashion, there seems little urgency to do so until the lame-duck session following the November elections. Meanwhile, hiring and capital expenditure decision that rely on some reasonable assumptions about positive GDP growth next year are increasingly at risk. One thing on which supporters of both parties can surely agree is that leaving resolution of near term fiscal policy to so late in the year is irresponsible. The Price of Fear is set in part by our elected representatives in Washington, DC.

Our most recent investment has been to increase our position in Coeur d’Alene. Based on our analysis we think it’s valued at around a 30% discount to the net asset value of its reserves, in common with most miners. Having some exposure to gold and silver at a discount is one way to protect against higher inflation, since that will increasingly appear an attractive solution for most people’s problems (there are more debtors than creditors in the world). In addition, CDE recently announced a stock buyback of $100M< around 6% of their equity market capitalization.

May 17^th, 2012 was the 30^th anniversary of my arrival in the U.S. On that day back in 1982 aged 19 I arrived for the first time in New York City fully expecting to be mugged as soon as I stepped off the plane such was the city’s reputation at that time. Although I grew up in England I had spent Summers in Toronto with my father as a teenager and the contrast between middle class North American life and strike-plagued Britain in the 70s could scarcely have been sharper. The IMF had come to Britain’s rescue while I was in school, and gloomy prognostications on the economy were the norm. America was dynamic, exhilarating, the world’s focal point in so many ways. I concluded that the future lay west, and New York’s financial markets drew me here. I needed to move to the U.S. more than anything I’d ever wanted – like all immigrants, I found a way to make it happen. I was part of the biggest wave of immigration the U.S. had seen since the huge influx of new citizens leading up to World War I in 1914. I became a permanent resident in 1985 and a citizen five years later, the shortest possible route for one with no family connections or refugee status.

During those thirty years I have never once doubted that I made the right move. The passage of time has balanced my perspective; London’s a great city too, and I’m very proud of my English heritage. While I doubt I’ll ever live there again, I love returning and one doesn’t always have to focus on the future; nostalgia can be wonderful too. But few Americans appreciate how their country appears to those on the outside wanting to get in. I remember well my urgent desire to go where the prospects were greatest. From afar, perceived through its culture, its impact on world events and unfailingly wealthy American tourists, one sees a place of huge opportunity, excitement, energy, surprises, danger and optimism. It’s an enthralling vision for anyone looking for those things.

In assessing the balance of potential investment returns and risks around the world, my experience is that many non-U.S. investors hold a keener appreciation for the power of the American story. You can talk to wealthy people from almost every corner of the world save North America and you’ll learn they need only reach back a couple of generations to recall war and existential threats, loss of democracy and civil rights, periods of lawlessness and moments when the future was most dire. The comparatively long political stability, rule of law and military security enjoyed in the U.S. are far better appreciated by those who haven’t always lived here. In addition, the dynamic economy fueled in part by a steady influx of type-A immigrants is widely envied. President Reagan was my first president, and his sunny optimism was uplifting for Americans as well as this immigrant just arrived from the Old World. It was then, and is always, Morning in America.

Which is not to discount America’s many challenges, of which the fiscal and political ones remain seemingly insoluble and therefore threaten much that is great. Top-down investment analysis can easily arrive at pessimistic conclusions. The Math of America’s federal and state deficits defy easy solutions, and increasingly partisan politics seems determined to court disaster by avoiding compromise.

Except that (and here’s the still starry-eyed immigrant talking) things have always worked out in the past, and they probably will this time too. It didn’t take me long after I moved here to recognize the difference between the European and American reaction to the insurmountable. Europeans glumly accept what they cannot change; Americans eventually get angry, and the national psyche dictates that when confronted with an apparently overwhelming challenge a commensurate response dedicating attention and enormous resources alters the path of history.

Successful investing combines a belief in a positive future with a healthy respect for the possibility that in the short run things may not work out as expected. The world’s a big place to be sure, but a constructive outlook expressed through U.S. companies represents a sound long-term approach to growing one’s savings faster than inflation. Market timing is ephemeral at best; our analysis of securities is bottom-up, focused on good businesses with low debt that we believe are attractively priced. The risk profile of our portfolios is largely driven by the opportunity set among the individual situations we’ve analyzed. Of the big picture we are perennially cautious optimists. To be so is to remain squarely on the right side of 236 years of history.