Marketdepth

Shoeshine's Modest Proposal

Last Thursday afternoon, I rushed into that print shop on West Pender for an important pick-up.  As fate would have it, the line-up was long.  And there was something vaguely familiar about the guy in front of me...

Mark Depp (of Marketdepth):  Shoeshine! What are you doing here?

Shoeshine:  Hello, Mr. Mark.  I was just running off some documents for the bankers.  Next week I am going to be making an unsolicited bid to buy BC Place stadium. 

MD: Buy BC Place stadium?  Are you going to run a sports team out of there?

Shoeshine:  Not at all.  This is a profit-seeking venture.  I am going to use the stadium to store wheat. 

Figure 1:  BC Place Stadium – 75 Million Bushel Capacity

 

MD:  Store wheat?  Have you been drinking your shoe polish again?

Shoeshine:  Au contraire, Mr. Mark.  As you well know, grains are amongst the most undervalued assets an investor can own these days. Try comparing wheat prices against equities, bonds or other commodities over the past 30 years and you will see it clearly.  Moreover demand is growing sharply in the emerging markets while the global supply picture is rather uncertain.

MD:  OK, I see why you might want to store some wheat.  But, why BC Place stadium? 

Shoeshine:  Filled to capacity, I reckon I could store 75 million bushels there, worth about half a billion dollars at current prices.  The most recent comparable stadium transaction was last November's sale of the Detroit Silverdome for $583,000.  Even if I paid ten times that amount, the stadium purchase only be 1% of the total wheat plus stadium investment. 

MD:  The Detroit Silverdome?  But this is Vancouver! 

Shoeshine:  I know, buying a Vancouver stadium is different than buying the Silverdome.  Detroit has very bad summer humidity.  If I bought BC Place, I would save considerably on climate control.  That's all worked into my offer price. 

MD:  But, Shoeshine, why don't you just buy exchange-traded funds like the Dow Jones-UBS Grains ETN (NYSE: JJG)? 

Shoeshine: With notes like those an investor runs into difficulty when the commodity is in contango. 

MD:  Contango?  Is that some kind of dance? 

Shoeshine:  No, it just means that the forward price curve of a commodity is upward-sloping.  If you own a fund like JJG that rolls over commodity futures, every time a contract expires the fund takes a hit by re-buying the same volume at a higher price. 

MD:  Is there any other reason to own the physical commodity instead of contracts? 

Shoeshine:  Well, it also reduces counterparty risk.  That's why precious metals investors typically pay a premium to net asset value to own a physical holder like Central Fund of Canada (TSX: CEF-A). 

MD:  I certainly see the logic.  But with all due respect, Shoeshine, what you are doing isn't investing.  Investing is owning businesses or real estate.  What you are proposing is better characterized as hoarding. 

Shoeshine:  Some people think that way, Mr. Mark.  But from my point of view, investing is merely the act of owning assets.  I care not whether I own capital assets or consumable assets.  I am just on the lookout for undervaluation. 

MD:  Yes, that makes sense to me, too.  Come to think of it, I have come across a scheme like this before.  Have you ever read a story about a fellow named Joseph?  The book was on the best seller lists for quite a while. 

Shoeshine:  Ah, Joseph.  A misunderstood character if ever one existed.  Some people call him a dream interpreter or a prophet.  In reality, he was just a very early hedge fund manager.  He was lucky to have such a deep pocketed backer in that pharaoh.  So, Mr. Mark, can I count on you to put up some money? 

MD:  I don't know.  If someone was going to sell me BC Place for a few million, I might want to consider turning it into a hotel/condo development. 

Shoeshine:  Mr. Mark, I am afraid you are hopelessly behind the times.  Now is the moment to turn your timeshares into ploughshares.  Join me and ride the great bull market in agricultural commodities.

Up With Wheat

In the 1974-75 hockey season, 24-year old Guy Lafleur had his breakthough season in the NHL, scoring 53 goals for les glorieux, the Montreal Canadiens.  To say he was popular would be a ridiculous understatement.  The best player in the game, in the world, Lafleur was more than human.  He was a god.  And in 1974, a god’s salary was $100,000.

 

This summer, 24-year old Mason Raymond, a promising forward who scored 23 goals for the Vancouver Canucks last year, signed a two season contract extension.  Although over the years, your correspondent has switched his allegiance to the Canucks, I am not so partisan as to declare Raymond a deity. Yet in the 2010-11 season, Raymond will earn $2.5 million, or 25 times Lafleur’s 1974 salary.

  

  

Figure 1:  In 1974, Lafleur Earned $100,000

 
 

In 1974, the year that the Knight Street bridge was completed (at a total cost of $15 million, including approaches), the average price of a detached house in the city of Vancouver was $40,000.  In 2010, the year that the Vancouver Art Gallery announced plans for a new downtown home (at an estimated cost of $350 million), the average price of a detached house in the city of Vancouver is $1 million, an increase of 25 times from 1974.

  

It all seems proportional, does it not?  Yet, I have a final comparison.  In 1974, a bushel of  Kansas wheat, weighing about 60 pounds and providing the main raw material for about 90 loaves of bread, changed hands regularly at $5.  On the first of July, 2010, thirty-six years later, the Kansas City Board of Trade recorded the cash price of a bushel of wheat at $4.91.

  

It is hard to believe, but a bushel of wheat, even after a rather healthy price spike in the summer of 2010 is within 40% of the nominal price from January 1974.  On either a relative or absolute basis, these prices do not make sense to me.  Wheat has to rise.

  

  

Figure 2:  Kansas City Wheat Contract Price (Per Bushel)

Year	Jan. Opening Price ($US)	Dec. Closing Price ($US)
1970	$1.38	$1.54
1974	$5.26	$4.28
1980	$4.50	$4.95
1990	$4.07	$2.89
2000	$2.77	$3.59
2010	$5.47	$7.20 (Aug 10)

Source: KCBOT

  

  

While this post is generally a bull call on wheat, it also is worth considering the likelihood that hockey player salaries (which more generally might be a proxy for discretionary consumer spending in North America) may need to fall.  To return to the Lafleur vs Raymond example for a moment, if we priced Lafleur’s 1974 salary in terms of bushels of wheat, he earned 20,000 bushels per year.  The relatively unheralded Raymond earns 500,000 bushels of wheat in 2010, or the equivalent of the total harvest from 10,000 acres of prime US farmland.  No doubt there have been kings who earned less.

  

  

Figure 3:  Mason Raymond— 23 Goals, 500,000 bushels per year

 

 

The Case for Wheat

  

Sometimes investment ideas are very complicated.  Sometimes not so.  The basic thesis that wheat and other grain prices have to rise (both in relative terms and in nominal terms) is one of those not so complicated ideas.  Money supply has increased approximately 10x from 1974, moving a lot of other prices with it.  Wheat, over that period is up only 40%.  Something’s got to give.

  

  

Figure 4:  US Money Supply – Upwards and Onwards

  Source: St. Louis Fed 

  

  

In terms of supply and demand, there are certain factors which might trigger an upward mean-reversion for wheat prices.   If global warming might change weather patterns unpredictably, then probability suggests that some of those changes might have negative supply effects on field crop production in breadbasket regions like Kansas, Saskatchewan or the Ukraine.  Uncertain production equals higher prices.

  

Likewise, wheat’s demand equation may change somewhat going forward.  I think the development of a middle class in the old “third world” may include a much broader demand for items such as hamburgers and baguettes.  Particularly as enriched diets include more meat protein, the demand for feed grains should grow rapidly, supporting higher grain prices.

  

Other factors that may have held down wheat prices, such as government farm subsidies, and liberal trade in agricultural products, may not always continue to hold sway.  Russia's export ban on grain this summer due to drought conditions reminds us that trade restrictions and geopolitics have often interfered with normal market economics in the grain business, sometimes resulting in price rises.

  

  

How to Capitalize

  

There are a few exchange-traded funds that provide direct grains exposure.  The i-Path UBS Grains Sub-Index ETF is one (NYSE:JJG). A Canadian grains ETF offered by Horizons is closing down, possibly a bullish indicator.

  

Another option is to own grain terminal operations like Viterra (TSX:VT) or Archer Daniels Midland (NYSE:ADM).  The advantage of the terminal operators is that their businesses are positively leveraged to grain commodity prices.  I discussed this issue at length a few years ago with a very old (and lonely) Merrill Lynch grains analyst.  With reference to the 1970’s, he noted that when grain prices rose, producers preferred to store more inventory and elevators filled up.  In such an environment, terminal operators gain both from rising inventory values and rising throughput charges on reduced storage capacity.

  

  

Figure 5:  Archer Daniels Midland Share Price History

 

It is true that we have witnessed a great many lean years in the grains business.  Yet from a valuation point of view, it seems unlikely that wheat can move any way but up, particularly relative to some of the rocketing asset classes of the past decades.  For investors in grains, seven fat years may be on their way.

A Call from the Deep

Last Friday evening I went to see a game at the rebuilt stadium.  Feeling a little thirsty, I took a beer from a passing vendor.  It was a hot night and I quaffed my brew quickly.  As I looked into the empty cup, however, I did a double-take.  There on the bottom of the cup was a round red sticker.  It was his signal.  Wasting no time, I hurried down below the bleachers to the old exit tunnel.  Even before I saw him, the smell of his smouldering cigarette announced his presence…

 

 

DEEP THROAT:  It’s starting.

 

ME:  What’s starting, Deep Throat?  You’re not talking about the game are you?

 

DEEP: I wish I was.  No, I’m talking about the Vancouver real estate melt-down.

 

 

Figure 1: “It’s starting,” he said

 

 

ME: Melt-down?  Prices are barely off from the peak.  I know, Vancouver’s average house price-to-household income ratio of 9.3x is insane, given that the US bubble peak was 5.0x, but I can’t see what will force it to come down.

 

DEEP:  Look at the American market bust, kid.  It started with lower unit sales.  Lower sales led to higher inventories.  Higher inventories led to lower prices.  Now look at Vancouver.  June sales declined over 30% against higher listings.  And July activity is even slower.

 

ME: OK, so a seller’s market has become balanced.  But look at the interest rates, Deep.  Floating mortgages are being offered  below 2% .  How can a market break down when it costs almost nothing to finance your house?

 

DEEP:  I agree it seems odd, but that’s what happened in the US.  The teaser-rate mortgages were still widely available back when the market topped in Q3 2006.  The real catalyst was that they ran out of buyers.

 

ME:  So is that what the 10 year high  in Vancouver apartment vacancy rates that we saw in the spring was about?

 

DEEP:  Now you’re getting it.  In a normal market, record prices occur at times of tight occupancy.  But with bubbles you get a kind of “black hole effect.”  At the top of the technology bubble, investors dumped cheap stocks to chase Nortel.  At the height of a housing bubble even marginal renters get swept into home ownership.

 

ME:  But what about the Olympics?  That ought to provide some sort of boost for Vancouver housing from foreign buyers.

 

DEEP:  If there are foreign buyers, where are they?  Judging from newspaper accounts, Olympic Village condos are not moving.  That doesn’t seem to indicate massive inflows of foreign money.  Maybe the foreigners are selling.

 

ME:  OK Deep, you got me.  So let’s say we’re in the early days of a correction.  How long until the bottom?  And how far down do we go?

 

DEEP:  Seattle’s down about 25% from the peak.   Los Angeles, San Francisco and San Diego are each off about 35%.  I can’t see why Vancouver, which is at least equally pricy, couldn’t do as much.

 

ME:  But wait, Deep Throat, can’t the government prop the market up?

 

DEEP:  They might try, but what have they got left to do?  The government already guarantees most Canadian mortgage loans.  They might hand out money, but that could backfire if it scares the bond market or if the fresh money chases the wrong assets.

 

ME:  But if the market goes off even 25% you know what this town’s going to look like.  What should I do?

 

DEEP:  It’s easy to worry, but as an investor you have to think about opportunity.  If a bank has a book of bad loans, sell it short.  Plus, a housing bust might push the loonie a lot lower.   A lower C$ implies higher precious metals and higher wheat amongst other things.  Find the silver lining kid and hold on tight.

 

 

At that moment, a giant roar erupted from the crowd above.  I looked back up the tunnel to check the scoreboard. When, I turned back, Deep Throat was gone.  In his wake he left only a faint smell of tobacco and, as always, some unanswered questions.