June 16, 2007

8 Private Equity Validates Our Strategy
         Peter Schiff, President and Chief Global Strategist

8 Stock Recommendations: Global Food Business

8 Trade War with China? You can profit without buying a single Yuan!
         Michael Checkan, Guest Columnist

8 Euro Pacific In The News

8 Upcoming Appearances

8 Previous Editions of Our Newsletter

The recent wave of private equity buy-outs has resulted in two of our largest Australian positions being bought out for cash. Last month it was Gloucester Coal, one of the three stock recommendations made in the first issue of this newsletter. More recently it was Investa Property Group, a commercial real estate investment trust.

What these two companies have in common, other than Euro Pacific clients being among the largest share holders, is that they own real assets which provide substantial free cash flows. Such assets are attractive to private equity buyers for two reasons. First, inflation erodes the value of the debt used to acquire them, and second, the rising income streams they produce provide the carry to cover the interest costs until the companies are ultimately resold.

This is precisely what our strategy has been for over eight years, except without the leverage. As private investors, we take the cash flow as dividends, and either use them to meet current expenses, or re-invest them to compound returns.

At the root of all this private equity buying is inflation, commonly referred to on Wall Street by its euphemism "liquidity." Stock prices are simply rising to reflect the diminished value of the currencies in which they are traded. Wealth is not being created, merely re-priced. Understanding the distinction is vital to your client's financial survival.

The source of all this inflation (liquidity) is here in the United States, where inflation has now become our greatest export. As we consume so much yet produce so little, we export the money we print to "pay" for the products the rest of the world produces. However, when our "trading partners" receive these dollars there are few American made products for them to buy. As a result, they merely sell their earnings in the foreign exchange markets. To prevent the dollar from collapsing, foreign central banks act as buyers of last resort. However, in order to do so they must first print their own currencies and use the newly created cash to settle the trades. This simultaneously increases their local money supply and their foreign exchange reserves, much of which is now looking for a home in financial assets.

Were it not for foreign central banks the dollar would have already collapsed. The results would have been substantial increases in the prices Americans pay for foreign imports and big reductions in the prices foreigners pay for American exports. The net effects would be a large reduction in the standard of living of Americans and an elimination of our huge trade deficit.

However, through their intervention foreign central banks are preventing the global rebalancing that a free market would have already caused to occur. Not only do these foolish efforts compound the problem and the pain associated with their ultimate resolution, but they create inflation and asset bubbles worldwide.

Much of the newly created money enters the economy through financial markets, pushing up asset prices before consumer prices. But do not be fooled; higher asset prices without corresponding increases in goods production lead to higher consumer prices. Of course this is less evident, as government indexes, such as the CPI, have been re-engineered not to reflect it. However, if you pay attention to what you actually pay for things, rather than what the government claims you are paying, it becomes more apparent.

Just because stock price increases result from inflation does not mean that investors should refrain from buying. On the contrary, failure to convert cash into real things will result in a loss of wealth, as paper savings continue to lose value. This is especially true for dollars, as foreign central banks, such a Syria and Kuwait, continue to abandon their currency pegs.

However, it is important to limit your investments to those stocks best able to retain their true purchasing power. The key is to buy them before the private equity guys do. This is especially true given the current weakness in global stock markets and the bounce in the dollar which followed the recent rise in long-term interest rates. As usual currency traders have failed to connect the dots when it comes to how higher rates will ultimately play out. While in the short-run they may appear to be dollar bullish, their ultimate effect on the over-leveraged U.S. economy will be decisively dollar bearish.

Warren Buffet reported he invested in Gillette because 1 billion men wake up every morning in the world and need to shave. He saw a built-in demand for shaving products. Everyday the Earth's 6 billion humans wake up and need to eat. Those businesses providing food have a built-in demand for their products.

The food business is an established industry like banking, which allows us to find safe, predicable investments in foreign countries. Clients who desire low risk investments, paying high dividends denominated in foreign currencies should consider the companies profiled below. We believe they can be excellent additions to your core portfolio.

Company Number 1

The first company is located in Asia and sells soymilk as its flagship product. Soy is the cow that feeds Asia. This company manufactures and sells other food and beverages too. Reuters reports the company maintains production facilities in Shenzhen and Shanghai on mainland China. Their plant in Australia carries production lines for refrigerated soymilk and ultra heat treated (UHT) soy drink for consumers in Australia and New Zealand. 64% of their sales are in Hong Kong, 8% to Australia, and 7% to mainland China. The USA accounts for 17% of their sales. They are Pacific Rim oriented.

Sales have been steadily climbing at about a 4% annual clip, the net margin is regularly 6%, and return on equity has been about 10%. Price to earnings ratio is 20 and their dividend yield is around 7%. Their share price is up about 120% in five years. Market cap is about US $448 million.

Company Number 2

The second food company we selected services the Scandinavian area of Europe. The company is engaged in the operation of grocery stores through the development of wholly owned subsidiaries and a franchise chain. Its retail operations are conducted through 224 stores. In addition, it collaborates with more than 500 supermarkets, grocery stores, warehouses and depots.

Sales have been flat for the last 5 years, but their net margin has risen from 2% to 3% during that period. They are making more money today on the same level of revenue. This is a solid, steady, mature business that has great management. They have an approximate 15.4% market share in Sweden. The industry is completive and the company chooses to grow organically through existing units, instead of through merger and acquisition activity.

Their market research has shown that many customers want to be able to spend more on priority products, luxury goods and specialty items. More than half of the Swedish population belongs to this category.

Return on equity has been about 30% and rising. Price to earnings ratio is 20 and their dividend yield is around 8%. Their share price is up about 65% in five years.

Their market cap is US $1.9 billion.

Investing in foreign securities involves risks specific to international investing, such as currency and political risks. There can be no guarantees of success in pursuing any of the strategies we recommend, or that any of the specific companies will gain in value. Risks include an economic slowdown, or worse, which would adversely impact economic growth, profits, and investment flows; a financial accident resulting from the veritable explosion of global liquidity, increasingly risk-taking and its attendant volatility; a terrorist attack; any developments impeding globalization (protectionism); and currency volatility/weakness.

My story has been NOT to invest in China directly…a country without rule of law. Instead, invest in Asian countries that are benefiting from Chinese growth, such as Korea, Japan, etc. In addition, there is another way to take profit on China's growth…indirectly.

Take over 1.3 billion people. Begin to spoon feed them capitalism. Ever so slowly, crack open the doors to free trade (on a controlled basis). And keep your currency at artificially low levels. What you end up with is an economic explosion.

Welcome to China in the year 2007.

For the past four years, China has experienced double-digit growth. There are several reasons for this. The first is obvious…over 1.3 billion people. The world's most populace country has a massive pool from which to draw a workforce. As a result, wages remain extremely low compared to western standards.

The second reason is equally obvious…over 1.3 billion people. That's over 1.3 billion potential consumers. The result is a stampede by corporations all across the globe to gain a foothold in this massive and potentially lucrative new market.

The final reason that I will touch on here is the artificially low exchange rate for the Chinese yuan relative to all of the world's major currencies. This is a source of concern for all of China's major trading partners, but it is a source of immense concern for one trading partner in particular…the United States.

For years, China had its currency pegged to the U.S. dollar. Simply put, the yuan would fluctuate at a fixed basis from the U.S. dollar. Therefore, during the early part of China's explosive growth, they had the benefit of some of the lowest production costs worldwide with the added enticement to the world's consumers of an extremely favorable exchange rate. Even as the Chinese economy grew by leaps and bounds, the yuan's value, as measured by other currencies, did not increase to reflect the growth.

This resulted in huge profit margins and enormous demand for Chinese goods. The largest demand has been from the United States. Why? The United States is the world's biggest consumer nation. Americans as a whole like to accumulate stuff. Cheap stuff with adequate or good quality is even better.

So, as the U.S. consumer takes advantage of the bargains coming out of China, dollars flow to China. This is important, but I will get back to that in a minute.

Something else flows to China as well. Jobs.

As corporations in the mature U.S. market look for ways to get an edge in a very competitive environment, they look to China. After all, the low production costs and the largely untapped labor pool allow them to produce and ship at a cost significantly less than that incurred by domestic production. Yet, they can still sell their products at or near the "acceptable" pricing points. The profit margins are much better.

So, even though it seems to be a deathblow to U.S. manufacturing, the lure of profits has proven an irresistible temptation for corporate America. Eventually, this will serve to weaken the U.S. economy and the U.S. dollar along with it.

America's thirst for Chinese products resulted in a 30% increase in the trade deficit with China from 2004 to 2005. That 2005 surplus reached $162 billion. One year later, after another almost 25% increase, the 2006 surplus rose to $201.6 billion.

The loss of jobs, its deleterious effect on our manufacturing sector, and the behemoth known as the trade deficit combine to peg the worry meter for Treasury Secretary Paulson. In fact, he is not alone, and the meter has been pegged for some time.

Hence, there has been a significant increase in protectionist rhetoric with regards to our Chinese trading partner. Most of the dialogue centers around the unfair trade practice of maintaining a significantly undervalued currency. Most experts believe that the yuan is 30% to 40% undervalued.

According to many of China's trading partners, a significant revaluation of the yuan is in order. But China has been reluctant. After all, they have the upper hand. Rather than let the yuan float freely, they choose to manage the revaluation.

The first step was to reset the peg on the yuan to the U.S. dollar. This was done last July when the yuan was allowed to appreciate 2.1%. This was the first change in the value of the yuan relative to the dollar since 1995. At the same time, China allowed for future controlled adjustments, not to exceed 0.3% in either direction per day.

Since then, the yuan has risen a mere 0.6% versus the dollar. According to the United States, this is nowhere near enough.

So, trade restrictions have been imposed, and threats are flowing regarding future, more stringent trade barriers. The war of words goes on. China's trading partners are proceeding cautiously but incessantly.

Chinese officials maintain that the market is determining the value of their beloved yuan. In an interview in Shanghai in mid-January, central bank Assistant Governor Ma Delun stated, "We're not manipulating the yuan. The small appreciation is decided by the market." When probed as to what percentage increase he foresaw for the yuan over the next twelve months, his reply was simply, "You need to ask the market."

Many people believe that harsher sanctions against China are not in the best interest of the U.S. economy. Further, many also believe that, in the end, the Chinese will steadily allow the yuan to appreciate against the dollar and all major currencies.

As a result, investors are scrambling for yuan in an attempt to own the currency directly before it takes off to the moon. However, this is not that simple. Few people have access to yuan, and there is no interest being paid on yuan deposits. So, this is a fairly unattractive play for most investors. No interest…and, thus far, the yuan has taken off to the moon at a pace that would cause it to be lapped by a turtle.

So, where's the opportunity in China for the average investor?

I believe the opportunity for the average investor is not so much in China or in Chinese yuan. Rather, I think the opportunity lies elsewhere because of China.

Remember earlier when I said I would come back to all those U.S. dollars flowing into China.

What has China done with all those dollars to date?

Well, clearly, they have not pumped them back into the Chinese economy. To do so would be counter to the economic scenario that has yielded those double-digit growth numbers. With a basically fixed currency value, if the Chinese allowed those dollars to flow into the Chinese economy by increasing the money supply, you would have over 1.3 billion domestic consumers, flush with yuan, buying Chinese goods. The result would be skyrocketing prices and massive inflation. With price inflation would come the evaporation of foreign demand…the fuel in their economic fire.

To date, they have kept the dollars out of their economy by buying U.S. debt. The problem is that they have enough U.S. debt. The U.S. dollar has fallen in value to date and will continue to fall in value in the longer term. This, coupled with flat yields and the prospect of severe overweighting to a single currency, makes U.S. Treasuries a less than attractive option.

What will China do with all those dollars in the future?

They will put them to use in alternatives to the U.S. dollar. The result will be a better diversification of their reserve assets. The best part, from a Chinese perspective, is that they can continue to keep from swelling their money supply, and they can continue to inch the appreciation of the yuan higher on their own terms.

The Chinese have already announced their intentions, on several occasions, to add euro and other currencies as well as gold and oil to their reserves.

For investors, the best part is that they can benefit indirectly. They don't have to invest in unproven companies in a state-controlled, pseudo-capitalist economy. They don't have to settle for the slow appreciation with no interest that comes with direct ownership of yuan.

Simply buy foreign currencies, precious metals, and/or commodities in general. You get the benefit of China's surplus by owning what they purchase with that surplus. The result…you can make money on China without buying a single Chinese stock and without owning a single Chinese yuan.

This Newsletter is a service of Euro Pacific Capital Inc.