Thursday, February 19, 2009 0 comments ++[ CLICK TO COMMENT ]++

Donald Coxe Unplugged

“I haven’t lost my enthusiasm for the belief that if there’s a world tomorrow, it’s going to be a world that needs more commodities, and that this still is the overarching theme of our time...the opportunities for investors are going to be really marvellous.”
-- Donald Coxe

The latest Globe Investor magazine, The Globe & Mail's investing magazine insert, has a detailed interview with Donald Coxe. For those not familiar, Donald Coxe is a former BMO portfolio strategist who was one of the top commodity superbulls from Canada. He is famous for having off-the-wall theories and not towing the consensus view. For liberals like me, reading him, at times, is equivalent to the pain felt by conservatives reading George Soros ;)

It is a well written article by Derek DeCloet and it asks the tough questions, including how Coxe could have been so wrong with not seeing the commodities sell-off. One often encounters many investor profiles that praise an individual's correct calls and completely ignores the mistakes, but this is no such article. I have excerpted some important points below and added my thoughts.

Changing times and, in India, changing governments had not budged either nation’s commitment to joining the modern economic world. “This,” says Coxe with typical flourish, “will be the greatest simultaneous efflorescence of personal economic liberty in human history.”

What on earth does that mean? “I define that as people who move into dwellings with indoor plumbing, electricity, basic appliances, and [who] acquire personal motorized transportation. If you’ve got those things, you’ve got more personal freedom than 99% of the people who’ve ever lived.” In other words, Coxe foresaw that the urbanization and accelerating industrialization of China and India would lift tens of millions to a better standard of living, which would increase their consumption on a massive scale.

Donald Coxe was one of the first strategists to see the incremental commodity demand from the growth of China and India, among others. This is one of the key pillars for macro commodity investors. To use this strategy properly you probably need to be really early and/or a good macro investor. What I saw in the last two years was investors who clearly didn't fit into either of these cases (for example, commodity investors purporting to use value investing) bet heavily on commodities. This makes no sense to me because it's difficult to ascertain the value of anything when your whole case is based on a macro view.

Cox is known for having off-the-wall theories and his view of Global Warming certainly fits into that camp:

Coxe believes that theories of man-made global warming are, to be polite about it, a crock. The climate’s natural swings are much greater than we think, and on this point, the man can cite trivia almost endlessly. (Coxe, a long-time friend says, has an eternal fascination with weather patterns.) “At the time of the Norman conquest in Britain [around 1066], the Vikings were growing grapes in Greenland,” he says. Later, the Earth went through an extended cool period, so that by the late 1700s, “it’s recorded that people went from Manhattan to Staten Island on horse and carriage” across the winter ice. Coxe believes the data show sunspot activity is responsible for these changes. And since sunspot activity has recently been lower than expected, Coxe thinks it’s possible we’ll soon be fretting about global cooling. Buy Monsanto. Buy other agriculture stocks. If you have the stomach to play the futures market, buy grain futures. “We’re going to have probably the worst food crisis on record,” Coxe says.

The verdict on Global Warming is still uncertain and Cox, taking a contrarian position, is not only dismissing that view but also thinks it is possible that we'll get some sort of global cooling.

As for his suggestion of Monsanto and other agricultural stocks, it's a difficult call if you we are limiting ourself to the global warming or global cooling case (it's a different story if we consider emerging market demand--discussed below.) I'm in the neutral camp when it comes to Global Warming or global cooling and don't feel comfortable making investment decisions based on that. The results are unpredictable and it is a risky macro game to play. If Global Warming materializes--Coxe doesn't believe this--then, believe it or not, crop yields may actually go up. I remember watching a documentary once that said one of the benefits of Global Warming--yes, there are upsides to even negative things--is that Global Warming improves photosynthesis. Now, it is also possible that huge swaths of earth's arable land is also wiped out so who knows what the net effect will be? Similarly, if global cooling were to occur, who knows what the net effec will be.

Coxe claims that the collapse in commodity prices were engineered by the FedRes--a proposition I find hard to believe.

“What you had was the sharpest sustained drop in commodities in history, and we didn’t have a global depression,” says Coxe. Coxe says he underestimated the role of the hedge funds. He knew that many of them had gone long on commodities and short on financial stocks—that was rather obvious, and amplified the sharp rise in commodity prices in 2007 and the first half of 2008. What he didn’t realize, or fully appreciate, was how many billions of dollars of those bets were made on borrowed money. Since commodities futures themselves are a leveraged investment, the result was a series of bets in which leverage was piled on top of leverage. The whole edifice came tumbling down during the summer, as hedge fund losses began to pile up and the margin calls came pouring in.

“None of us, or nobody I talked to, thought that much of it was hedge funds that were leveraged 30 or 40 or 50 to 1,” says Coxe. Does he wish he’d figured it out? “You bet. But I don’t know how I could have gotten that information.” As for how the slide began, Coxe has become something of a conspiracy theorist. He believes that the Fed, with some help, engineered the commodity correction to try to bring hedge funds to their knees, forcing them to cover their short positions in financial shares and thus driving those shares up to the point where banks could raise new capital that they desperately needed. “Although it wiped out 40% of my net worth temporarily, I believe they did the right thing. In order to save the banking system, they had to kill the commodities.”

I don't share Cox's views of what caused the commodity correction. I agree with the first part: hedge funds, institutional investors, and even some retail investors through ETFs and ETNs, caused a massive rise in commodity prices. However, I don't think he is correct in saying that the FedRes caused commodities to collapse in order to save banking. Yes the hedge funds were using the famous--we know it's famous because even a non-professional like me has seen it discussed in mainstream newspapers--pair trade of shorting financials and going long commodities, but I think commodities would have collapsed even if the FedRes did nothing. Recall how the financial shares collapsed even without additional short-selling so I doubt the FedRes had much impact. Furthermore, my impression from the articles I have read was that many hedge funds put on the trade way back in 2007 or early 2008. So these funds would have been sitting on massive gains on both the financial short and commodity longs and wouldn't have had as much reason to sell into a panic.

I had been of the opinion that commodities would collapse when these funds sell out (I held this view because fundamentals didn't seem to support the bullishness.) What I never factored in--and Coxe alludes to this--is the fact that futures contracts were inherently highly leveraged. I thought hedge funds were using real money collected from investors to invest in these commodity futures and stocks. Instead, it seems that most of it was with money they never had. If I had known that hedge funds had extremely high leverage then I wouldn't have sold my TSX inverse ETF (which was a quasi-bearish-commodity bet) that I had.

So does this mean commodities overshot? Jim Rogers and others argue that the commodity correction is panic selling--the implication being that commodity prices would be higher in a natural state. I don't buy that. What if commodities went up so much due, not necessarily to fundamentals, but due to leverage and speculation? If this is correct then all we are seeing is a speculative rise and then a collapse. The real price may not as high as it was. Maybe oil oil hit $147, not because of fundamentals, but because of all this distortion. If so, then one cannot assume that oil will go back to $147 once the panic selling subsides.

I think the following question can be asked of anyone bullish on commodities (it's something that I never understood either):

“I don’t know how you could miss that,” says Paul Gardner, a portfolio manager at Avenue Investment Management in Toronto. He’s a long-time Coxe fan, but is nonetheless perplexed by what he sees as a gap in logic exhibited by Coxe and such others as Eric Sprott: If you’re bearish on the economy, how could you think that commodities will just keep going up? “You have to lose some of your shine because of that,” says Gardner. “You’re putting all your chips on China and India, and do you really trust the numbers there?”

The questions being asked by Paul Gardner is similar to some concern I had in the past. If you are calling for the economy to be weak, how likely is it for commodity prices to go up? The commodity bulls tend to rely on supply side more than the demand side, but at some point wouldn't the demand matter? A good example of the discrepancy in views is with the Peak Oil theorists, who tend to almost soley look at oil supply and ignore demand. Interestingly many Peak Oil theorists, how have lost massive fortunes in the last year, are still maintaining the view.

He is as convinced as ever that China and India will be the world’s great economic powers by the middle of this century, that the standard of living of their people will grow, and that the next great investment is food. “I haven’t lost my enthusiasm for the belief that if there’s a world tomorrow, it’s going to be a world that needs more commodities, and that this still is the overarching theme of our time...the opportunities for investors are going to be really marvellous.”

I think what Donald Coxe says of agricultural commodities may come true. People's diets are certainly improving and it is likely to be bullish in the long run. Although agricultural commodities have been one of the worst commodities in the last hundread years, with them almost continuously deflating over time, they may finally stabilize and start rising permanently. The question though is whether the potential increase in agricultural production--there are huge swaths of land in poor countries with almost unlimited poor agricultural workers willing to work them if prices go up--will be less bearish than the bullish case.

If you are a bullish on agriculturals and not a fan of owning commodities, perhaps one can find companies that supply fertilizers, equipment, and the like. Commodity companies like Potash seem too cyclical for my liking (it looks overvalued anyway); but one may be able to find processors, seed companies, and others with moats and good ROE arising from intellectual property like Monsanto or Syngenta.

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