Mongolia – Finding its Feet Again

calf

Frontier markets and volatility go together like bacon and eggs. Bursting with energy, chaotic and often smelly they lurch about like a young calf finding its legs.

Mongolia could quite aptly be seen to be such a calf. Sometimes the calf lurches about and remains standing. Sometimes it falls over. Two years ago Mongolia fell over.

calf

How exactly do these things work?

To understand what originally drove Mongolia’s economy to post a blistering 17.3% growth rate in 2011 we need only look at the $6.6 billion investment into stage one of the enormous Oyu Tolgoi copper-gold project. OT, as it’s known, is owned 34% by the Mongolian Government with Turquoise Hill (TRQ) owning 66% of the project. Rio Tinto in turn controls TRQ by way of their 51% stake in TRQ.

In February of 2011 Turquoise Hill Resources hit $21.75, valuing the company at $43.8 billion.

What happens to Oyu Tolgoi has such a dramatic effect on the country as when in full operation the mine is expected to account for a third of the country’s GDP. This is truly unique. I don’t know of any other country in the world where a single project has such a dramatic impact on the economy.

To understand why TRQ came to be valued like Uber we need to understand that the Oyu Tolgoi mine is expected to produce as much as 195,000 tons of copper and up to 700,000 ounces of gold in concentrates next year. At current prices this equates to $846M of gold and $1.2B of copper.

In 2011, however, gold was trading at $1,800 and copper as high as $9,555 per tonne while today gold trades at $1,200 an ounce and copper $6,200 per tonne, so we can see that with those numbers another $1B would have been added back in 2011. You can see the graphical representation of TRQ’s share price together with the price of copper during this time frame.

Turquoise Hill ResourcesNow, anyone paying even a modicum of attention will see that TRQ has been oversold based only on the metrics of the copper and gold price. To understand why today TRQ is valued at just $9B and why the Mongolian economy has suffered while such riches sit on their doorstep we need only turn to – you guessed it – the government.

The Government of Mongolia managed to grind the project to a halt for 2 years as disputes raged. I won’t go into all the details, as there is ample commentary on the internet about the dispute. Suffice to say that government by their very nature are parasitic entities, most of whom are about as practical as a curly ruler. In this respect the Mongolian government did not disappoint, holding dear to some of the central tenets of the state everywhere, namely economic ignorance and plain stupidity.

What followed was a deafening roar as you could literally hear the money packing up and leaving on flights out of Chinggis Khaan airport. FDI collapsed to just $400 million last year, down from $4.5 billion in 2012, and the local currency, the tugrik, got body-slammed, falling from 1,200 to 1,900 against the dollar.

Fast forward to present day and the new president has just signed a landmark deal finally resolving all issues with Rio Tinto.

We have deep connections in the country and have a constant feed of information, and just over a month ago we received advance notification that things were turning around in Mongolia. I also hopped on the phone with our friend Harris Kupperman, the CEO of Mongolia Growth Group, to get his take on things. I recorded the call which you can listen to below.

When I wrote my last post on the topic I mentioned that we were picking up some TRQ which was then trading at $3.73. Today at $4.50 a few weeks later we have to ask ourselves the obvious question: Are we on the brink of another run? While I’m not going to scoff at over 80% in just over a month the truth is we don’t invest in frontier markets for 20% gains. We invest for thousands of percent gains.

Even though Mongolia fell over, like most calves, it is likely it will get back up again. Right now the odds seem to be decent that it is indeed doing so. It may be time to take a deeper look.

Assets are dirt cheap, the currency has been crushed and it looks like we’re about to have the $5.4 billion underground expansion of the OT project finally proceed.

We’re currently holding onto a small illiquid but traded company which has been growing 40% YoY in a really tough market for the last 2 years. They’ve been hit by the foreign exchange collapse but when, or indeed if capital begins coming back into the country then it’s companies such as this one which have the potential to really fly.

We’ll have more on this topic and what we’re looking at there in the future.

- Chris

“In value investing, money is made after the crash, not before.” – Mark Mobius

You Cannot Go Unprepared into This

Bond Yields - 10 Year Chart

A recent conversation I had with an exasperated parent of a teenager showed me how horribly things can turn out if parents have no discipline when raising kids. If parents have been spoiling poor little “Johnny Snotbrat” for most of his life and let him get away with murder at some point he may actually do just that.

This teenager is now causing serious harm to family, acquaintances and the police. I’ve seen this happen before.

The parents – in their desire to keep the calm – let “Johnny” get away with bad behavior. This is somewhat manageable when Johnny is still small. But quite quickly Johnny grows in size and brattiness, and becomes a truly unruly brute who threatens to do serious damage. Every scuffle has always resulted in letting Johnny have his way, appeasing and keeping the calm.

Now, fast forward a few years later and Johnny is 6 ft 5, has hair on his chest and is out of control!

I’ll do my best to keep out of the way of Johnny Snotbrat but there is another event brewing and this one is going to have a vastly greater impact on us all.

Central bankers, the proud parents of the largest debt bubble this world has ever seen, have tried to spoil and appease the markets when they deserved to be disciplined. Instead of allowing the markets to correct themselves and showing discipline, central bankers flooded the world with liquidity and soaked up many problems.

In doing so they’ve created a truly wild monster both in the sovereign debt markets directly, and indirectly in the corporate debt markets as market participants seeking some sort of yield (heck, any sort of yield) have been driven down the risk curve. I detailed this recently in a post discussing the terrible misconception that many people have about a so-called global deleveraging post 2008. It never happened!

Central bankers have created this bastard of a neighbour punching, head-butting, sister shagging teenager which requires continuous feeding. But feeding him more just makes him more dangerous. The last few weeks have seen this wild creature flexing his muscles and when he truly gets out of control he’s going to start tearing people’s heads off.

Bond Yields - 10 Year Chart

Above you’ll see the last 10 years in the respective bond markets of the US, Germany and Japan – the most important bond markets in the world today.

Bond Yields - 1-Year Chart

Let’s now take a look at the above chart showing the same bonds since the beginning of this year.

Bond yields are rising sharply on the long end of the curve (long duration bonds) in favour of the short end. This is a rational move. Liquidity is crashing on all the long dated maturities and as you can see yields are breaking out. It makes perfect sense to sell the long end of the yield curve given the fundamentals. What we’re witnessing is that cash flooding into the shorter duration maturities. I’m going to nab a quote which I used last week here, originally from Howard Marks of Oaktree Capital as it’s really critical to assessing risk.

It’s often a mistake to say a particular asset is either liquid or illiquid. Usually an asset isn’t “liquid” or “illiquid” by its nature. Liquidity is ephemeral: it can come and go.

Is this the beginning of the loss of faith in government paper?

We’ve discussed at length how we believe the first move to be a rush to the US dollar. We detailed this in a special US Dollar Bull Market Report on our favourite ways to trade this trend.

Since we first published the report some months back our positions have moved in our favour, though over the past few weeks there has been a pullback – something that is healthy and to be expected.

When I look at the above graphs and the fact that volatility in many of the long dated option positions we recommended has dropped again I believe the market is offering us up another fantastic opportunity to add to these positions.

The bond market is beginning to crack at the periphery (Greece and Italy) and is now showing stress on the long end of the curve.

If there is one thing that I think I’ve learned when it comes to sell offs it’s that you can be an hour early to the party but never a minute late.

There is a crisis coming and we’ll be sitting around watching each of the world’s central bankers attempting to deal with the fallout of their own creation. It promises to be entertaining:

  • The Brits, being British, will get all hot and flushed and then splutter and pardon with a few “crikey’s” and “goshes”
  • The Europeans will handle this by blaming each other, but mostly the Germans
  • The Germans, in turn will flush the sauerkraut with a large beer, don their lederhosen and get on with fixing the problem. This particular problem will be akin to wrestling a man eating tiger in a Japanese nuclear power station: impossible. Not even German technology will fix this!
  • The French will set up a committee to investigate how they may be able to tax individuals on losing money rather than making it, never acknowledging their own part in the fiasco.
  • The Japanese. Well, they’ll do the honorable thing and fall on their sword. Seppuku!
  • And the Americans will search the nation to find the man with the shiniest teeth, put him on Oprah where he’ll open his arms in an apology and reassure everyone that everything will be fine, even though it won’t.

Let’s get ready for the show but for goodness sake make sure you’re prepared for it!

- Chris

“By failing to prepare, you are preparing to fail.” – Benjamin Franklin

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