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Volume IV, Issue 7/ July 2010

Welcome Letter

Welcome Back.  It has been another busy month for Without Borders.  I have been spending a lot of time in Peru where there is opportunity a plenty these days.  From a pure lifestyle perspective, it is not an attractive option for me personally, despite its rich cultural and historic offerings.  It is, however, a great place for aspiring entrepreneurs with more hustle than money. It is also an exciting place to invest and speculate.  The country is simply awash in opportunities.  Therefore, this month will be part one of a two part series on Peru.  This month I will cover the politics and economics as well as its capital markets.  Next month we will focus on the entrepreneurial opportunities in Lima and the city of Cusco.

But first, we take a detour.  Before we get into our Peruvian discussion, lets talk about the state of the political economy, or Politiconomy as we like to call it, since there is no longer any real distinction between Politics and Economics.

As I have mentioned before, my wife was born and raised behind the iron curtain.  Whereas, I may from time to time rant about the trend towards socialism as unprecedented or shocking, she merely views it as a return to the ¨normal¨ behavior of governments.  When we first met I was a flag waving US Army Airborne Ranger celebrating our victory over communism.  My conviction that a new era of freedom and democracy was upon us was so absolute that when my wife’s suspicion of all government rose to the surface, I would assume a pedantic tone and explain how she just had the misfortune of growing up under an oppressive regime that did not respect individual liberty or democracy.

My wife, being far wiser than I, would merely shake her head and say, “You can never really trust a government because governments attract the worst elements in society.  Governments exist to protect those inside government”.  I remember the distain and pity I felt for such thinking as I arrogantly explained that in America the system was created to limit government.  Government in America is designed to be weak.  I would extol the virtues of the US Constitution as I pointed out how it empowered the individual and not the collective.  I would sanctimoniously point out that freedom of the press and freedom of speech would never allow the politicians and bureaucrats to lie to the people.  I would invariably remind her how in the Eastern Bloc the State owned media would run stories about how people were starving in the streets in America and Western Europe and how they would broadcast lies about external threats to scare people into supporting government.

I would explain that information technology would set people free and that with information came the power that would never let governments fool their people again.  I explained to her how in Western democracies opposing views keep the government in check and academia and the press would never tolerate the blatant distortion of facts to protect or further the agenda of those in power.

Imagine how silly I feel now.

As a general rule I don’t watch television. We don’t have television on our farm.  Most television shows are just bubble gum for the brain.  But just the other day I was in the conference room of a major bank in Lima.  I was early so they ushered me into the wood and flat paneled room where our meeting would take place.  As the receptionist poured coffee I noticed one TV was tuned to CNBC and the other to Bloomberg.  On screen number one an advisor to President Obama was spinning like a whirling Dervish dancer as he tried to explain away the most recent housing data.  On the other screen the CEO of a bailed out bank was extolling the strength of the recovery despite the record number of unemployed.  CNBC then had a terrorism “expert” on to discuss the latest threats and Bloomberg switched to the implications of state run healthcare.  I was struck by how little pretense existed and that the segments were little more than propaganda.  One shill after another spouted the script designed to affect public sentiment and the financial markets.   I felt like the guy who lived along the border between East and West Berlin who watched the newscast about the poverty and violence in the West while just outside the window and across the DMZ relative peace and prosperity was there for the viewing.  It was almost surreal.

As more coffee arrived I thought about those early conversations with my wife. I long ago came around to her way of thinking on government.   A life spent in small wars and in and around politics will do that.  As will a better understanding of economics.  Yet I am still shocked by the way the American government has been able to co-opt the masses with such ease.  Just think about it for a minute.  Economic Central Planning.  Media Subjugation.  Free Healthcare.  Government owned corporations run by the workers.  A constant external threat.  Blatant and Brilliant.   It sounds very Socialist but it is not.

In America the difference is that the powerful elite are not political party members but rather the banking and industrial elite who have managed to usher in a regulatory system which made them the majority partner with government in the running of the State.

This is not Socialism.  Socialism is a system where the State owns and controls the means of economic production. The system today is a variant of Fascism.  Fascism is the system whereby the State directs the economic activity of privately owned industry.  Today’s system in the west is not true Fascism because in true Fascism the balance of power lies with the State yet in today’s system the balance lies with the largest corporations.  Besides, you can’t use the word Fascism without evoking images of jackbooted racists.

Ron Paul and others have started calling today’s system Corporatism.   They define Corporatism as a system where businesses are nominally in private hands, but are in fact controlled by the government.  In a corporatist state, officialdom acts in collusion with their favored business interests to design polices that give those interests a monopoly position, to the detriment of both competitors and consumers.   But this is only one part of the entitlement driven system that eventually destroys all democracies.

I don’t like the term Corporatism because it implies that somehow corporations in general are a negative force.  And corporations and Capitalism are so closely linked that the name will only confuse the already ignorant and malleable masses.  It is not corporations that are bad.  It is an environment, which allows for political influence to manifest itself through regulation that has caused many of today’s problems. We need to rally against the regulatory bodies that distort markets by creating barriers to entry and stifle innovation and competition.

Regulatory bodies are mostly faceless and unaccountable.  The heads of regulatory agencies don’t have to stand for election.  Bureaucrats who are mostly clock punching functionaries, incapable of understanding their cog or the overall machine, staff these agencies.  These agencies are expensive and wasteful.  They are a literally a tax on society.  Without exception, these agencies could be reduced by more than three quarters or eliminated entirely.  Most of the functions these agencies perform could and would be provided by the private sector in a way that would not use force to ensure compliance.  Yet, although my Libertarian philosophy detests the waste and inefficiency of these agencies it is their contribution to the abdication of personal responsibility that is more bothersome.

The global politiconomic system is on the verge of collapse in no small part because of these agencies.  They are the main distributors of unwarranted largess in the form of handouts and subsidies.  It was foolish to believe that government could legislate and regulate the business cycle, just ask China and Russia, who are now trying to roll with it, instead of subdue it.  It is more foolish to think that government, through regulatory bodies staffed by people who wear short sleeved shirts with a tie, could assume the responsibly of hundreds of millions of people.  Yet this is the mentality of the masses;

• I don’t have to think about what I eat.  I pay my taxes. The Department of Health and the Food and Drug Administration are there so I can assume that if it is legal it must also be safe to ingest.
• I don’t have to think about educating my kids.  I pay taxes.  The Department of Education will ensure the education is extemporary.
• I don’t have to think about my retirement.  I pay taxes. I have Social Security and a 401K in an SEC regulated mutual fund.
• I don’t have to worry about the strength of the currency.  I pay taxes. The Department of the Treasury and the FED do that.
• I don’t have to worry about what happens to the poor in the community.  I pay taxes.  The Department of Housing and Urban Development and the Department of Labor will deal with that.

The list goes on and the argument is fundamentally flawed for no other reason than the majority of voters do not pay taxes.  The mere idea that the government replaces the need to be responsible for one’s own life and community is disturbing on many levels beyond the financial costs of these agencies.

And when it comes to corporate responsibility the abdication is much worse.  Banks and big businesses would have you believe that it was the “system” that broke down.  It was not their decisions that were flawed.  After all, the SEC, the Federal Reserve, the Department of the Treasury, the FDIC, numerous congressional committees and countless other local and state regulatory agencies were aware of what was going on and they did not see the crisis coming.  Greenspan and Bernanke told everyone there was nothing to worry about so they were not really required to ensure their balance sheet was in good shape.

But beyond the cost of these agencies and their contribution to the abdication of personal responsibility, what bothers me most about these agencies is the barriers to progress they present.

The cost of regulatory compliance is the single largest barrier to entry for small innovative companies in any regulated industry.   According to the Office of Management and Budget, a never to be trusted lackey of the executive branch, federal regulatory compliance costs American manufacturers $380 Billion per year and the regulatory compliance costs are “disproportionately burdensome for businesses with less than 500 million in annual revenue”.  Large companies lobby Washington for more regulation not less.  It is a misnomer that Drug companies want less involvement from the FDA.  The FDA is what keeps small innovative companies from entering the market.   Airlines routinely lobby for more regulation, as do the largest Banks.  They just lobby for the type of regulation that reduces competition and favors institutions with economies of scale.  That is why the recent financial bill was fought tooth and nail; because it would have reduced barriers for smaller more nimble firms.

It’s no wonder that the area where the economy has grown and entrepreneurship has flourished is in unregulated industries.   The cause of the crisis was not too little regulation, it was the assumption that existing regulation allowed for the abdication of personal or corporate responsibility.  Regulation is a crutch and a barrier to entry.  The solution is less government regulation.

The Tea Party folks, though mostly well intentioned, are doing all of us a disservice by calling Obama a Socialist.  He is not.  The debate should promote the understanding that for many years there has not been a free-market in the US.  Don’t let the financial crisis be in any way tied to the free market.  Since government controls the private sector through taxes, regulations, and subsidies, and has done so for decades it is folly to say that Free Market Capitalism was at the heart of the crisis.  If you must enter the debate then focus on the nexus of big corporations and big government regulatory agencies.  Don´t allow the disastrous results of decades of government growth and regulated industry influence to be ascribed incorrectly to free market capitalism or used as a justification for more government expansion.   If you choose not to enter the debate there is always room for new freedom fighters in Fitzroy McLeanistan.

There endeth the rage against the machine.  Now we proceed to the Peruvian frontier where greener entrepreneurial pastures await.

In This Edition

While in Peru we looked at all types of investments, but certainly the extractive industries dominate the landscape.  A couple months ago Carlos Andres of the Frontier Research Report brought to your attention a junior gold company operating in Peru that is now trading 30% higher than when he first recommended it.  This month we bring you a large producing mining company with a bright future.  As we will explain in the Actionable Intelligence portion of the letter there are several market events converging that will create a once in a decade buying opportunity.   We will also talk a bit about Brazil and what we learned from a recent trip about the Politiconomy and how it affects your portfolio.

And as I look at the clock and the calendar I now admit to myself and you, dear subscriber, that my horrid work habits have once again made a looming deadline all but fanciful.  To that end let me close this Welcome Letter with a ditty that just hit my inbox.  A cigar smoking and scotch swilling friend, subscriber, plastic surgeon, and intellectual adventurer extraordinaire we call Doc penned it;

Tonga Awaits

Waiting here in Tonga,
We’re running out of light.
Without Borders has a deadline
That’s getting mighty tight.
Fitz is banging at the keyboard.
His Mac’s a smokin’, too.
All he wants now
Is to get this damn thing through.
The natives are getting restless and
The cauldron is stoked to boil.
The Editor doubles his efforts
As the drums begin to beat.
He hits the send key at the last second
And avoids being the tribe’s cooked meat.

- Doc

That my friends is the work of a true Renisance Man.  Doc is a bon vivant welcome at my humidor or liquor cabinet any time and anywhere.

Yours in Exploration,

Fitzroy McLean
Chief Bon Vivant and Speculator

Dispatch: Peru Part 1- Politics and Economy

Recent History

We don’t have time or space to delve into the rich cultural history of Peru.  Incas. Gold.  Atahualpa. Conquistadors.  Pizarro.  Brutal conquest.  It is a fascinating history and we don’t mean to give it short shrift, but as investors, speculators and intellectual adventurers we are more interested in the recent past, and more importantly the way the country is trending today.   However, to understand the trading culture that still dominates the Peruvian economy, we need to start after Peru´s independence from Spain in 1824.

Peru´s rise to economic prominence in the Americas all started with a big pile a shit.  Literally bird shit.  Guano to be precise.  Guano is a mineral rich fertilizer capable of improving the cultivating powers of almost any soil.  In the agricultural age it was a matter of national security.  Just ask President Millard Fillmore.  In his 1850 State of the Union address he said.

“Peruvian guano has become so desirable an article to the agricultural interest of the United States that it is the duty of the Government to employ all the means properly in its power for the purpose of causing that article to be imported into the country at a reasonable price.”

Shortly thereafter Congress passed the Guano Islands Act, which authorized U.S. imperialist expansion in search of guano.

“Whenever any citizen of the United States discovers a deposit of guano on any island, rock, or key, not within the lawful jurisdiction of any other government, and not occupied by the citizens of any other government, and takes peaceable possession thereof, and occupies the same, such island, rock, or key may, at the discretion of the President, be considered as appertaining to the United States.”

No that is not how Puerto Rico came to be.  But the act did contribute to a guano rush of sorts.  In 1858, Great Britain alone imported 300,000 tons of Peruvian guano.  The British Empire completely monopolized the Peruvian guano trade, causing much pain for the agricultural southern states in America.  The Guano Act, therefore, was aimed at helping American Clippers compete.

This golden age of guano was a tremendous boon for Peru allowing the country to pay off all of its foreign debt.  During the 40-year period between 1840 and 1880 the country exported 20 million tons of guano, earning around US $2 billion in profit. Unfortunately, Peru immediately began again to borrow recklessly on international markets, and successively hiked up the price of guano to pay for the new loans.  Not a good idea.

In the United Kingdom, where the Industrial Revolution was at full bore, chemists were busily unlocking the secrets of how to manufacture fertilizer.  Price hikes for Peruvian guano offered a kick in the pants, as Antony Gibbs & Sons, the British firm that owned the rights to the Peruvian guano trade, were all too cognizant.  Back in Britain a professor of chemistry, James Johnson wrote Gibs & Sons a letter thanking them for providing a “great national service in providing so valuable natural production to imitate.”  Within three years, chemists had learned to make their own fertilizer “superphosphate” and agricultural production in Europe and North America doubled within fifteen years.  The guano trade collapsed and ironically has only recently come back to profitability with the rise of organic farming.  We would not recommend you pack your bags just yet for the next Guano Rush because the Peruvian government severely restricts the movement of guano and keeps the price artificially low by mandating its production be used for domestic ventures.

With the collapse of the guano trade the government of Peru found itself deeply in debt and living well beyond its means.  Regional Governors had built palaces for themselves and promised wealth and easy living for the peasantry.  When the money dried up, the government turned to the old standby of blaming an outside enemy for their woes.

The late 1800s and early 1900s were marred by wars with Chile and internal fighting.  This lasted up until the Great Depression.  Like most other South American countries in the latter half of the 20th century the economies ebbed and flowed with the commodities, government policies, and the twists and turns of the Cold War.  In the 70s and 80s Peru’s economy suffered under military dictatorships as they fought with Communist rebel groups most notably the Shining Path.  Inflation, violence, narcotics trafficking and political murders defined the last days of the cold war as each superpower poured money into the country to destabilize the region or fight the growing socialist movements that were less about socialism and more about resisting the power of the elite families that vied for power.

Then came Alberto Fujimori. The Lima born Fujimori is now languishing in a Peruvian jail serving a 25 year sentence for bribery and human rights violations.  Like Pinochet in neighboring Chile, Fujimori used brutal tactics to quell opposition of all sorts.  He attacked the Shining Path and any who supported the guerillas with what we could euphemistically categorize as an expansive definition of acceptable collateral damage.   Amnesty International and the United Nations condemned his campaign to root out the insurgents.  While we suspect there is some truth to the claims of ¨death squads¨ and a ¨systematic reign of terror¨ it would likely pale in comparison to the US sponsored efforts in Colombia over the last two decades.

Fujimori attacked economic foes with the same violence of action.  When he took office inflation was over 3000% and the country was bankrupt.  In a program he called Fujishock, price controls were eliminated, industry privatized, taxes lowered and import and export tariffs reduced by 75%.  Although painful for the populace initially, the Peruvian economy recovered quickly as foreign investment and local investment poured into the private sector.  Inflation subsided and GDP growth topped 20% per year between 1990 and 1994.

But as is almost always the case in Latin American politics, progress cannot be accepted lightly.  Opposition parties have a role to play on the political stage and since outsider Fujimori´s new party held less than 3% of the legislature, he was always fighting a losing battle.  So in a flash of political theater, even by South American standards, Fujimori launched a coup against himself.  He convinced the military to take over the government to break the political stalemate.  The military then dissolved congress and reappointed Fujimori as head of state.  According to a poll commissioned by the International Herald Tribune at the time over 81% of Peruvians supported the coup.  Not surprisingly, neighboring governments and the international bureaucrats condemned the process. Eighteen months after the coup, Fujimori called for new elections and this time he and his supporters won a clear majority.  They revamped the Peruvian Constitution and continued to move the country towards a free market economy and Fujimori won two more elections.  Scandal after scandal filled the airwaves in 2000 and Fujimori´s popularity plummeted.  While on a state visit to Brunei it became clear that Fujimori would likely stand trial should he return so he flew to Japan and literally faxed his resignation to Lima.

His successors conducted criminal proceedings against him while he lived with friends in Japan.  Fujimori claimed that he knew nothing of the brutal tactics employed in the countryside and blamed any excessive violence on his Intelligence Chief.  Japan refused to extradite and by 2005 Peru had all but given up on any chance to take custody of Fujimori.

But then with a hubris found only in politics, Fujimori took close aim at his feet.  He applied for a new Peruvian passport in Tokyo and declared himself a Presidential candidate in the 2006 elections.  He returned to Peru to be tried and to his surprise was convicted and imprisoned even though public opinion polls indicated in 2007 that over 40% of Peruvians would vote for him if he ran for president.

Despite the controversy surrounding his time in office there is no question that his policies reintegrated Peru into the global economy.  The standard of living has improved dramatically and the peasant class outside of Lima still reveres Fujimori for bringing them within the system and providing them with an opportunity to improve their lot in life.  He is seen as the anti establishment politician that broke the stranglehold of the rich families that controlled Peru for so long.  Like Pinochet in Chile he is unique because he broke the iron grip of the oligarchy and not with socialism or communist rhetoric but with free market principles.  We are not lionizing Fujimori or Pinochet but the economic growth in both Peru and Chile combined with the six fold increase in per capita GDP compare starkly to the efforts of the socialist leaning populists in places like Nicaragua, Equador, Venezuela, and Bolivia.

Hernando de Soto

Peru is home to one of the great economists of the last thirty years in Hernando de Soto.  While not a market anarchist or Austrian economist, de Soto has conducted landmark research into the role of government in society.  His conclusions were that the most important role of government was to provide a mechanism to enforce contracts and protect property rights.  In the 1990s when most of Latin America was embracing the monetarist policies dictated by the World Bank and IMF, de Soto warned that monetary policy and public finance was of marginal importance if contract law and property rights were not firmly embedded in the foundation of society.  His work on wealth accumulation and the politics of poverty were adopted successfully in Chile, Peru and Brazil.  If you are unfamiliar with his work we recommend his book, The Mystery of Capital.  This short video is also worth your time.

The Economy Today

Since 2002 the Peruvian economy has been growing, as you would expect, in line with the demand for commodities.  The country actively courts foreign investment.  Commodities dominate the economy with hydrocarbons and minerals topping the list.  But more important than the sectors of the economy is the political climate because in South America like in North America and Europe today, politics and economics are inseparable.

Peru’s past two pro-business, yet center-left governments, have steered the country toward record economic growth, greater transparency, and rapid decentralization.  The dilution of power at the federal level and the empowerment of local governments have been a boon for the country.  Governors compete with one another for foreign investment and actively court industry.  Peru has matured politically to the point where analysts and investors are beginning to talk about another regional powerhouse creeping up alongside Brazil.  Just last month, Peru´s sovereign debt was upgraded to investment grade.

Despite pressure from indigenous groups for greater equality, no one is pushing for nationalization in Peru.  In fact it is just the opposite.  Regional areas controlled by indigenous leaders have lobbied successfully for the privatization of state owned firms because they believe it will increase investment and reduce the power of the Lima based families of European decent.  We met with local thought leaders and politicians and not one spouted the nationalist rhetoric so common across the border in Bolivia or in Venezuela.  In Lima we met with a politician and a priest from  Cusco in the Andean highlands.  We sounded them out about Evo Morales´ policies and they both scoffed at the idea Peru would lurch left in the coming election.

Peru has enjoyed an average annual economic growth rate of 7% since 2001 and per capita income has doubled.  Official rates of poverty plummeted from 50 percent to 35 percent in roughly the same time and the locals we spoke to argued that the poverty rate is even lower than estimated because many people are getting wealthier working off of the books.

While we don´t think there is a serious threat of a Leftist taking power we are still keeping a close eye on next year´s election.  Keiko Fujimori, the popular conservative daughter of the jailed former president is leading the latest polls with 27% of the vote, just ahead of Lima mayor Luis Castañeda.  Both are free market advocates and Fujimora has an MBA from Columbia.  Castañeda  Ollanta Humala, the radical leftwing candidate who narrowly lost out to the current President Alan García in 2006, is a distant third with less than 6%.  Then there is a the dark horse candidate who is not yet a candidate.

Finance Minister Mercedes Araoz is quietly building a following in the business community as an outsider who can navigate the Peruvian political situation and garner the respect of the international financial community.  Although she has held two ministerial level positions in Garcia´s government she is not a member of his party nor is she considered political at all.  An economist who graduated from the University of Miami, Araoz plays the part of the reluctant public servant.  She is a hardliner when it comes to public spending and an inflation hawk.  She navigated the financial crisis as well as any other finance minister in Latin America and better than any in Europe.  She is an advocate of free trade and has successfully negotiated trade agreements with China, the US and Europe.  Some of her supporters tell us she is likely to run as an independent candidate.  This would be good for Peru.

Carretera Transoceanica: Bigger than the Panama Canal?

We already like what we see in Peru.  It is an open market with vast mineral resources and a government that seems to want to encourage the private sector.  That alone puts it on our radar.

However, it is the Carretera Transoceaonica or Transatlantic Highway that really has our attention.  Peruvians, from all walks of life – from the farmers and bartenders to the politicians and mining magnates – predict that the construction of the new road, between their Pacific coast and the east coast of Brazil, will replace the Panama Canal as the main passage for trade between rising superpower China and the mineral rich mountains and fertile plains of Peru and Brazil.  Add into the equation newly discovered oil and gas deposits in both countries and Peru is in a position to control the crossroads of Latin American trade.

Environmentalists fear that the road will harm the rainforest and the governments of both Brazil and Peru are taking their concerns seriously.  But not too seriously.  Both governments recognize that the road, and the trade it supports, will help millions climb several rungs on the social economic ladder.  The Brazilian engineering and construction giant Odebrecth has the overall responsibility for the project, which will span 2,500 kilometers.

The economic impact of this road network is hard to overestimate.

Political and Social Risks

Peru’s rapid ascent is not a given. In some of its historically neglected mountain and jungle areas, social unrest lurks just beneath the surface, ready to thwart progress if people in those regions don’t feel more a part of the economic boom.  In June, clashes between indigenous protesters and armed forces killed more than 30 in the worst political violence since the Shining Path’s campaign of terror in the 1990s.

Native groups say the confrontation, which led to the resignation of Peru’s prime minister and the exile of a top indigenous leader, took place because the government refused to consult them before opening up their ancestral lands to oil and gas exploration.

Peru’s Congress quickly repealed two decrees by President Garcia that were aimed at opening wide swaths of the Peruvian Amazon to logging, dams, and oil drilling, and Garcia admitted that his failure to properly consult with indigenous groups on these matters was a mistake.  Still, Garcia remains committed to the energy exploration that he and many others believe is crucial for the development of the nation.  With half of the country identified as indigenous, such conflicts are likely to come up again.

This is problematic but not alarming.  As we interviewed people it was readily apparent that the indigenous leaders did not want to stop the development of resource projects, they were just pissed that the decisions were being made in Lima.  There is a palatable ¨us¨ vs. ¨them¨ vibe in Peru, but unlike in Chile or Bolivia ¨us¨ and ¨them¨ does not appear to be racial.  Lines seem to be drawn along the lines of Lima vs. the rest of the country.  Peru can be roughly divided into three parts; Lima and the coastal cities, the Andean Highlands, and the Amazon.   Each region is culturally and geographically different.  This has been a source of tension yet it seems the recent devolution of power from the federal government to the regional governments is making progress.  Half of all taxes collected through resource concessions and export duties now go to regional governments.  Every local leader, every journalist and even the granola crunching tree hugging druids working for NGOs we talked to admitted that the decentralization process was working.  The conflict seemed to be internal strife as opposing local interest groups jockeyed for largess.  Then again that is what Sinatra said about Castro.

The Lima Stock Exchange: Bolsa de Valores de Lima

In the late 90´s and early part of the last decade as I wandered the globe, I would invariably investigate the local stock exchanges.  I´ve bought shares in thirteen countries.  Sometimes they were bought literally over the counter.  I remember buying shares in Bucharest.  I walked into the old exchange building and placed my order with a broker who just happened to be in the lobby.  The broker literally walked over to a filing cabinet and returned with my new shares in his hand.  I handed him cash for the shares and wrote the transaction down in an old fashioned ledger.  Then he walked over to a computer with two 5 1/2 inch disk drives and entered my details into a spreadsheet. He then asked me where I would like my dividend checks mailed.  I walked out with those shares in my hand and had the dividend checks sent to the local bank where I had hours before opened an account.

By about 2005 I stopped doing this type of thing for several reasons.  First the ridiculous laws and regulations passed by my government made it so painful for me to open an account that the first sight of my passport had bankers and brokers shaking their heads.  Secondly, stock markets around the world became overpriced for my taste.  I like to buy things that are incredibly cheap and by 2006 or so, money was flowing everywhere and all assets were too expensive.  These out of the way markets from Romania to Sri Lanka became boomtown casinos.  Not my idea of a worthy speculation at all.  Lastly, technology and the fact that the best managed companies from emerging and frontier markets started listing in places like London New York, Toronto, Sydney and Hong Kong made it possible for me to buy most of the shares worth buying from my laptop.

So it has been a while since I visited a frontier stock exchange to see what was going on.  Having watched the financial crisis suck foreign capital out of many of these frontier markets, I made it a point to check out the Bolsa de Valores de Lima.

What I discovered was encouraging.  The largest sector on the exchange is mining.  The largest stock by market capitalization is the zinc/lead/silver miner Volcan with a market capitalization of nearly six billion US dollars.  But Volcan despite its massive deposits is a base metal play and trades at a PE of nearly 145.  Next on the list is Cerro Verde, a publicly listed JV between Freeport-McMoRan  (53.5%), Sumitomo (21%), Buenaventura (18.5%) and the openly traded 7% that is found in the BVL.  Cerro Verde has a market capitalization of 2.2 billion dollars and trades at a PE of 10.  This is interesting but it too is primarily a base metal (copper) play and the shares trade on very small volume in Lima.

There are other miners on the list that we find more attractive including Buenaventura (NYSE:BVN), this month’s actionable intelligence and Southern Copper (NYSE:SCCO) which both trade in New York.

Austral Group is a large fishing and food company that has a market capitalization of nearly 200 million dollars and trades at a PE of just over 9 times 2009 earnings.  They are involved in every aspect of the fishing industry from seafood to soaps and pay a healthy 7.4% dividend.  The shares are down 25% this year.  We bought some.

Credicorp (NYSE: BAP), Peru´s largest bank trades as an ADR on the NYSE.  The shares are trading at a 52 week high and although we like the company and we have been in their bank and marveled at their use of technology allowing customers to bank by phone and gain micro loans at ATMs we would want to see the price come back before we jumped in.  At nearly three billion in market capitalization and a PE of 15 we think there are better places to put capital to work.

What makes the Bolsa in Lima exciting to us is the freewheeling nature of the market for smaller stocks.  Some shares trade by appointment while others swing five or ten percent a day most days.  There are lots of small cap companies that range from cement producers like Pacasmayo and Cementos Lima to food producer Alicorp and sugar growers Pomalca and Andahuasi.  All of the above are trading at PEs below 10 and yielding more than 5% .  The local oil refiner Relapasa is trading at less than four times 2009 earnings.  These companies were exciting enough for us to open a local account and start investing in Peru.  Peru is growing.  Some stocks are cheap and the market is about to expand in two ways.

Privatization

We have learned from experience that when a country undergoes a large-scale privatization of state owned industries it creates speculative opportunities.  Sometimes the opportunity is to buy the newly privatized companies and sometimes the opportunity is to buy what everyone else is selling because they want a piece of the hyped up new offering.

Peru plans to double the number of state companies listed on the Bolsa this year to raise financing for investment projects.   The minister of economy indicated it would likely list all 33 state companies including state mining company Activos Mineros SAC, and the state owned oil company Peroperu at a time when other regional governments are strengthening their control over national assets.   When these big boys come to market they will cause distortions as they wreak havoc on the indexes.  The iShares MSCI Peru ETF (NYSE:EPU) and other products designed to track the index will be forced to sell shares in other companies to match the index.  This selling will likely drive down the prices of some of the shares we like that are already trading at low multiples with attractive dividends.  This is an exciting opportunity.

The Regional Stock Exchange

The second reason we opened an account to buy on the local market is because of the recent announcement that Colombia, Peru and Chile will soon integrate their stock markets so that brokerages in all three countries can buy shares on any of the markets.  Chile and Colombia both have larger markets, a more developed financial sector, and a larger retail and institutional investor base, which will find the Peruvian Bolsa undervalued.

It is our hypothesis that we may find ourselves in a position to first buy attractive shares at a discount as the wave of privatization sucks up capital and the rebalancing of indexes and institutional portfolios forces the sale of strong companies.  Then we suspect the integration of the regional stock markets over the next two years will drive those share prices higher.  It may not work out that way but we suspect it is worth the effort to open an account in Lima.  If you are interested in doing the same we recommend you contact Kallpa Securities.  The CEO Alberto Balzan graduated from the Stern School at NYU and is a former managing director of the Lima Stock Exchange.  His brokerage is a relatively new venture with an entrepreneurial attitude focused on customer service.  We were impressed.  He also welcomes US clients.

Summary

We like Peru as a place to invest, speculate and start a business.  This month we highlighted the economy, politics and capital markets.  Next month we will focus on the entrepreneurial opportunities, Real Estate and living conditions including what it is like to eat a roasted guinea pig.  It is our considered opinion that Peru should be on your short list.

Actionable Intelligence

Minas Buenaventure (NYSE:BVN)

I first discovered Minas Buenaventura while talking with Carlos Andres of the Frontier Research Report.  When I mentioned I was heading back to Peru he started spouting off with facts and figures about ounces in the ground and major deposits and geological formations and kilometers to the port and all those other things he has focused on in his research.  Carlos focuses on early stage junior resource stocks that have a high likelihood of doubling or tripling in price if the deposits they are hunting for are economic.  He found one in Peru that he recommended a few months ago that is already 30% higher than when he recommended it.  He knows the Peruvian mining world far better than I do because as he hunts for the little known stocks flying under the radar he follows the old adage, ¨The best place to build a mine is next to another mine.¨, so he was familiar with Beunaventura and its operations.

At Without Borders we tend to focus on more developed companies that have cash flow and profits.  You know we are bullish on gold and we like the leverage to the gold price that mining companies offer so we were excited when we found Buenaventura and discovered that market forces as well as economic forces were presenting us with a rare opportunity.

Peru’s Place in Gold Mining

Despite being known as a mining jurisdiction, few may be aware that Peru is the 5th largest gold producer in the world.  In a decade where global gold production has fallen annually from roughly 84Moz in 2001 to 72Moz today, annual production in Peru has risen steadily to 5.8Moz today.  Two gold mines alone account for over half of that total.  One is Barrick’s Laguna Norte mine weighing in at 1Moz of production per year.  The other is partially owned by this month’s pick and holds the title as the largest gold producer in Latin America by a wide margin.  Buenaventura´s Yanacocha needs little introduction.  It is a world class open pit mine that produced 2.1Moz of gold in 2009.  This is one of the largest gold mine operations in the world and has produced over 26Moz since it opened in 1993.

Buenaventura is a jewel in the crown of Peruvian precious metals mining and as such is somewhat of a national treasure and for good reason.  The company is a multi-mine major gold producer.  BVN generated over US2.1B in revenue on production of 1.3Moz of gold, 16.8Moz of silver, 154Mlbs of copper, 90Mlbs of zinc, and 46Mlbs of lead.
The company is a large scale diversified producer, mine developer and explorer, with a vast majority of its operations in Peru, where they own and operate 7 underground mines and 1 open pit mine, in addition to Yanacocha.  They also own a 19.26% interest in the Cerro Verde copper / molybdenum mine with copper and gold powerhouse Freeport McMoran (54%) and Sumitomo (21%).  Gold represents roughly 63% of Buenaventura’s output, with silver at 11%, copper at 18% with zinc and lead bringing up the rear at 8% combined.

The mineral reserves and resources of this behemoth are so mind boggling we had to take our glasses off, rub our eyes and bang our forehead on the desk a few times.  After a while carrying the one becomes heavy lifting.  After checking, and rechecking, we present the eye watering numbers.  Buenaventura reports that it has 20M ounces of gold, 250Moz of Silver, 4.1Mlbs of Zinc, and 1.4Mlbs of Lead.  If that were not enough, and of course it is…the company has a mind-boggling 8.6Mlbs of copper.  If we translate all of this into gold equivalent ounces for ease of comparison, this equates to 70M gold equivalent ounces.  The copper component alone represents 39M gold equivalent ounces.  Let that number sink in.  In simple terms, the copper deposits represent twice as much value as the gold deposits at today’s prices.  With these numbers, Buenaventura may be a major copper miner masquerading as a major gold miner.  The reality is that it is both.  As shown in the table below, the company’s mineral treasure chest is currently valued at roughly US$140 per gold equivalent ounce.  This is a major producer being valued like a junior explorer.

A full 31.2Moz of this total, or over 40%, are in the confidence inspiring Proven and Probable reserve category.  They will not be running out of resources to mine any time soon.  In addition, Buenaventura benefits from favorable geology and relatively shallow deposits, which translates into low cost accessibility to its minerals.  They operate at average mine operating costs between US$341 (Yanacocha) and US$375 (other mines) per oz of gold.  Cash operating costs for silver averaged US$9.17 for 2009.  The Cerro Verde copper mine also has substantial copper reserves and resources in the neighborhood of 28Blbs of copper of which Buenaventura owns a 19.26% interest.

Net income is up 13.4% for the 1st half of 2010 at US$266M versus US$235M in the 1st half of 2009.  Most of this increase can be explained by contributions from Yanacocha and Cerro Verde.  At the current share price, that’s a PE ratio of roughly 15.6.  The current PE ratio range for the Buenaventura’s large cap peers is between 14 and 48.  Thus BV is at the low end of the P/E range.  The company is realizing average sales prices in excess of US$1,100 for gold and US$17 for silver.  In a bold and forward thinking move in 2007 and 2008, the company committed to settling all outstanding forward sales contracts that committed them to sell a significant amount of future gold production at prices significantly below spot.  These toxic hedges have now been removed and the company’s production currently has full exposure to a rising gold price as reflected in the 1st Half 2010 financials net income mentioned above.

For a major gold producer the company has a modest share structure of roughly 254M shares outstanding trading recently at US$38.61 and a market cap of US$9.8B.  In terms of market cap size this puts the company at the smaller end of the major producer spectrum in excellent company with all-stars such as Agnico-Eagle, Kinross, AngloGold Ashanti, Goldfields and Randgold.  Based on the current share price and annualizing the first half of this year through June 30, the company will pay US$165.4M this year or a 1.68% dividend.

Compared to other mega miners we consider Buenaventura the lesser known cousin as the company reflects a similar value proposition in terms of existing operations as well as development and exploration projects in the pipeline.  The lower valuation may be a reflection of the lack of geographic diversification with respect to the concentration of the company’s operations in Peru but as we mentioned above we are bullish on Peru and comfortable with the political risk.

A large 27% of the company is owned by the Benavides family who founded the company some 58 years ago.  Roque Benavides is the current CEO and he followed his father Alberto into the family business and has run Buenaventura since 2001.  From 1985 to 2001, he was the company’s CFO.  Another 11% is owned by Peruvian pension funds and 50% by institutional investors.  Institutional investors include the likes of BlacRock Group (14%), Fidelity (4%),Van Eck (3%), Market Vectors (3%), and iShares Emerging Markets ETF (1.8%).  The company is traded on both the New York and Peruvian stock exchanges.  As previously noted we suspect the funds mentioned above will have to sell some of their BVN shares to rebalance their portfolios when the next wave of privatization hits.

The company had a sizeable US$444M in cash at the end of June and reported net cash flows from operating activities of US$90M for the 1st half of 2010 alone.  This is a healthy amount of cash on hand and cash from operations from which to fund an aggressive 2010 capex program.  The program entails production expansion and infrastructure projects, new mine development as well as continued exploration to expand reserves and resources.

In addition to existing operations, Buenaventura has an impressive array of projects and prospects in the pipeline. They include but are not limited to the following:

Yanacocha ‘s Conga Project – Yanacocha is the gift that keeps on giving.  Conga is an advancing exploration project with reserves of 11.8Moz of gold and 3.2Blbs of copper.  If a positive development decision is made (expected within 18 months) the production profile of this mine will be on the order of 700koz of gold and 180Mlbs of copper annually.  This would be a large scale mine by any measure.  They are fast tracking the Environmental Impact Study to reach a development decision as soon as possible.

La Zanja Project – This is an almost completed, low-cost (US$400/ oz), open-pit, gold and silver mine that is owned 53% by Buenaventura and 47% by Newmont.  The mine currently has proven and probable reserves of 726koz and resources of 131koz.  It will produce 100koz annually and is due to begin production in August (2010).

Tantahuatay Project – This project is similar and located in close proximity to La Zanja.  Construction began a couple of months ago and when completed in the middle of next year, it will be yet another low-cost (US$400/oz), open-pit, gold and silver mine that is owned 40% by Buenaventura, 44% by Southern Copper, and 16% by others.  The mine currently has proven and probable reserves of 660koz and resources of 3.6Moz.  It will produce 100koz annually and is due to begin production by the middle of next year.

El Brocal Production Expansion – This is a US$200M plant capacity expansion project to increase processing from 6,000 tonnes per day to 18,000 tonnes per day.  El Brocal is a producing mine (46% owned by Buenaventura) that primarily produces zinc with lead, silver and copper credits.   The mine currently produces 75,000 tons of zinc annually with reserves and resources of 7M tons.  Once again, this is just a very large deposit of zinc.

Huanza Hydroelectrical Plant – Buenaventura is spending US$145M to build a 90 Megawatt hydroelectric power plant to assure energy security for all of its direct operations.  Construction began in November of 2009 and completion is expected by June of 2012.  The company has a long history of developing electrical infrastructure both for its mines and local communities.
Exploration – The Company has at least another 6 promising gold, silver, and molybdenum exploration projects or prospects, two of which are owned in partnership with Newmont and Goldfields respectively.  The company is also looking to expand its portfolio throughout Latin American.

Recommendation: BUY UNDER US$ 30

After that lengthy build-up, we are not recommending that you buy these shares at the moment. As we mentioned in the dispatch we suspect the privatization wave will force a significant amount of BVN shares to hit the market as index funds and ETFs rebalance their portfolios and other investors free up cash to buy new offerings.  BVN is a good company with great leverage to the price of gold.  We suspect if we are patient we can get in below US $30 a share.

Over the Horizon: Brazil Turning Left?

Long time subscribers know we are Brazil bulls.  We love the growth prospects of the internal Brazilian economy as well as their exporting power.  But each time we go to Brazil or talk to our contacts there, we pick up on more and more disturbing news.  Here is the latest.

We had lunch the other day with two very rich, very successful entrepreneurs who made their fortunes in Brazil.  One is a native Brazilian the other is an Argentine who lived in Sao Paulo for almost thirty years.  Both still have the bulk of their business activities in Brazil.  When we expressed our concern that Brazilian policy was set to make a hard turn to the left they both quietly nodded and said, “Yes. That could be.”

For a while now we have been concerned that Brazil is trending left.  It wasn’t that long ago that financial markets were predicting the worst for Brazil.  When Lula was elected investors feared the worst.  He was a socialist.  He believed in wealth distribution.  He wanted to raise taxes.  Then he took power and proved to be a pragmatic centrist fortunate enough to inherit a bull market in the stuff Brazil has in abundance.  Now everyone is sure that Brazil is on a smooth glide path to prosperity.

Our contrarian tendencies start to rise to the surface when everyone else seems to form an unassailable consensus.  The government of Brazil is starting to roll out more and more social benefits and spending more on feel good projects.  They will soon be the majority share holder in Petrobras (NYSE:PBR) and they recently formed another state owned company which will hold offshore oil licenses.  Lula and his hand-picked successor Dilma Rouseff have both stated publicly that the oil finds off of the coast should be used to eliminate social inequality.  That didn’t work so well for Mexico´s.

Rouseff is far more radical than Lula when it comes to economic and social policies.  She believes state owned enterprises should dominate strategic industries and has been a vocal critic of privatization.  She favors capital controls and higher taxes on income and imports.  Didn’t know this?  Most people don’t because the entire investing populace has been trained to think that she will be just like Lula and she has been tempering her rhetoric to fend off the more conservative pro business candidate Jose Serra.

But the plot thickens.  Now a Green Party candidate is gaining momentum by criticizing Rouseff´s lack of radical credentials.  Marina Silva is Lula´s former Environmental Minister who resigned after losing high profile battles with business interests.  A couple of months ago she had less than 1% in the polls and now she has just over 10%.  Will she take votes away from Rouseff and thereby allow Serra to win in a first round ballot?  Not likely.  More likely she will force a run off and in the process force Rouseff to move left and make more promises to the more radical sections of her party.

We worry for Brazil because time and again when Latin American (or North American for that matter) democracies are faced with managing the fruits of prosperity they have a tendency towards wasteful populist programs.  Could the economic juggernaught that is modern day Brazil suffer the fate of the post guano boom Peruvians?  Yes indeed they could.  We worry that Brazil is trending towards policies that could erase all of the progress made since Lula took power in 2003.  We are not recommending you head for the exits but we want to alert you to the fact that all is not as it seems.

At the end of lunch we asked our Brazilian friend if he would invest in the Bovespa now.  His response?  “With your money maybe.  Not with mine.”

Global Speculations

Starting this week every Without Borders subscriber will start to receive a free daily missive entitled Global Speculations. It will be short, pithy and we hope insightful.  Carlos Andres, Mark Wallace and I will be regular contributors and we have invited some learned friends to share their thoughts on the passing parade of geopolitics, economics and finance.  We will also hold court on issues ranging from living abroad to finding true freedom in an increasingly less free world.  We will frequently answer questions from subscribers and there will be a comments section where questions, comments and snide remarks are both welcome and encouraged.

My increased travel and chronic lack of organization have made end of the month deadlines painful to the point of having to cut out much of the commentary on many of the interesting tidbits that pops onto the radar throughout the month.  I hope that Global Speculations fills that void.  You don’t have to do anything to start receiving Global Speculations and if you don’t want to receive it there will be an unsubscribe link at the bottom of each issue.  We hope you find it worthy of five minutes of your time on most days and we welcome your feedback and suggestions on topics that interest you.

End Quote:

Next month we will be discussing the entrepreneurial adventures that await the intrepid in Peru.  I recently exchanged emails with a young subscriber trapped in a cubicle who wants nothing more than to pack a bag and head for adventure.  So for those unfortunate souls still waiting for a reason to act I leave you this month with Mark Twain´s words of wisdom.

“Twenty years from now you will be more disappointed by the things you didn’t do than by the ones you did do.  So throw off the bowlines, sail away from the safe harbor. Catch the trade winds in your sails. Explore. Dream. Discover.”

So close that spreadsheet, log off the computer and quit your day job.  It is time to be an intellectual adventurer and dare to fail greatly.