September 20, 2004

September 20, 2004


As reported in the world media in recent days, Putin has taken control of the Russian governmental apparatus to place the levers of Russian control firmly in his hands. First, it was the move earlier this year to take over large oil company, Yukos. Last week, in what was not the only anti-democracy action taken, Putin set his sights on the eighty-nine elected regional governors, who will, henceforth, be appointed by him. To quote the New York Times, “a headline in Isvestia called it the ‘September Revolution’, equating Mr. Putin’s consolidation of power to Russia’s most famous October almost eighty-seven years ago.” As a wise friend of mine explains it, the Russian experiment with democracy is ending.

Does this mean that Russia will return to central control and top down management of the economy? Perhaps, to a degree, but Russia was not a successful experiment in capitalism. Russia was poor at democracy and even worse at capitalism. I attribute this to the thinking of the Russian populace. They lived a long time under strict governmental, commercial and economic control, and only a few seem to be quickly adapting to capitalistic thinking or entrepreneurial behaviors. Much of their economic activity has been based upon political contacts, payments to officials and corruption of other types. In short, old habits are slow to disappear.

The opposite is true of China where communism was a shorter experiment and where the family dominates the society. Further, the Chinese entrepreneurial moxie and love of money is legendary and appears to have been very little impeded by communism.


During the Yukos /oil supply fear wave that gripped the energy markets this summer, any informed observer surmised that the attack on Yukos was about government control of energy assets and a reprimand to business people who were engaged in politics. It was not about oil production, exports, or capitalism.

Russia wants to encourage investment in its capital markets while maintaining majority control of all energy assets in the country at the same time. They want to give the impression that they are investor friendly and try to attract foreign money to the Russian equity market.

In the coming years, we expect that all of the major energy assets of Russia will again come under governmental control and the government will pay little or nothing for them. This includes the oil production rights of foreign oil companies. The Kremlin will accuse those that control these assets of tax evasion or other trumped up charges and confiscate their assets in a quasi-legal way that they believe the investment markets will tolerate. They will allow investors to control minority interests in the assets, but only so the government can tap the capital markets for money to expand production.

They will continue to pump oil just as fast as they can in order to acquire cash for their government programs. They will continue to use the services of foreign oil service companies to improve the productivity of their fields. We expect plenty of oil production from Russia. It is their most important resource and they will milk it, expand it and use it as a weapon to achieve their economic and their political goals.

Russia’s oil minister has now warned BP, and all other foreign oil companies operating in Russia, that their permits to operate may be terminated. This will not happen.

If it did, foreign investment money would not find its way into Russia, and whatever money is in Russia, both foreign and domestic, would find its way out of the country. We can assume all of Russia’s economic growth will be in raw materials and manufactured goods of the basic industry type. I do not expect good development of financial infrastructure or service industries as long as the government continues to control the economic outcome. But I do expect a more controlled economy with less democracy and more production of raw materials.


The Indonesian, Australian and Korean stock markets have been doing better lately. Indonesia is a big exporter of energy and other raw materials. Australia is a big exporter of coal and many other minerals, and is located near China, who continues to be in major demand of raw materials.

Korea is a beneficiary of an increase in demand for technology products, including semiconductors flat screen TV’s and many other technology products as well as the end of a credit card bust in 2003.

The U.S. market has been very volatile and has stayed within a trading range this year. European markets have been mixed. In general, markets where raw materials are the heart of the market, have done better than those whose future depends upon manufacturing, especially technology manufacturing.

The sectors that were hurt most earlier in the year (i.e. semiconductors) have recently been rallying. I think that the U.S. market may enjoy a rally as we approach the election, but I remain skeptical that the U.S. economy will be strong next year.


From February to August, to put it in a nutshell, the U.S. market was no fun at all. It was volatile, and traded in a generally declining trend. Since mid August, the market has been a bit better, reacting favorably to positive news. Market sectors, which had been battered for months, finally became reasonably priced and began to attract investor interest.

In our opinion, between February and August the market was in the process of discounting slower rates of growth for both the economy and for corporate profits in 2005. We believe that this period of discounting is drawing to a close.

We are of the opinion that U.S. economic growth will be about 2 or 2 1/2 % in 2005 with a recession possible, but not probable in the second half. In this type of slowing economic environment, what groups are most attractive for investment?

1. Income generating stocks that can increase their income payouts over time.

This is an old theme of ours and we continue to like natural gas pipeline companies that can increase their income as natural gas prices rise slowly or stay the same. Oil royalty trusts where they do not deplete, but will continue to enjoy a lengthening life of distributions. Thirdly, mortgage real estate investment trusts (REIT’S), which can continue to grow profits even if interest rates rise.
While not all pipeline companies, oil royalty trusts and REITS fit this description. We have to do research to select those that can perform up to these standards.

2. Energy companies that can add reserves in a cost effective manor.

We have found that most of the attractively priced energy companies which are adding reserves at a low cost with a high degree of success to be European domiciled. Most of their drilling is in the North Sea, South Asia, India, Bangladesh and Pakistan or in one of several West African countries where major oil discoveries have been found.

3. Low P/E growth companies that can grow through an economic slowdown.

We see these companies in the manufacturing and raw materials sectors, and some technology companies may be entering this undervalued sphere.

4. For clients that sell short, we think the average consumer, financial or manufacturing company with a low growth rate and a low yield is vulnerable to market depreciation.


The reasons for the dollar to decline versus other currencies have continued to be strong and highly visible to the investing public. Yet the dollar has remained in a trading range for several months. We remain confident that the dollar must decline in order to balance the effects of the large budget, current account and balance of payments deficits. We continue to monitor the situation and will repurchase the currencies when they once again start to attract investor attention.


Inflation is not currently a major problem and the dollar is not moving aggressively one way or the other. Accordingly, precious metals have been lackluster. When the dollar decline reasserts itself, we can expect precious metals and precious metal stocks to move up again. Longer term, it cannot be doubted that Russia’s confiscation of energy assets and consolidation of power in the Kremlin are bullish for gold. Capitalistic money in Russia may find its way into gold. The impending military confrontation with Iran is another wildcard and one that could lead gold higher if it develops into a fighting war. In our opinion, just because currencies and gold have gone sideways for 6 months does not mean that the underlying causes of the impending rise in currencies or gold have been eradicated. Quite the contrary, as time has passed the fire boiling below the pot has only gotten hotter. Eventually the pot will boil over and currencies and gold will rise substantially.


It is a turbulent political world with Russia retaking over its oil industry, limiting democracy within the political process, not to mention the threat of terrorism arising everywhere. I believe that Russia’s recent activities are bad for global democracy and will prove to be a very difficult challenge for the U.S. All of this is unsettling to the world financial markets, and they wait expectantly to see how far and how fast Russia will push things.

The markets are doing better as a result of the fact that investors have discounted the slowing down of U.S. and European economic growth. We still expect there will be clashes with Iran in the not too distant future, and thus we do not want to be unabashedly bullish on stocks for the long term. Short term, however, stocks in the U.S. and Asia especially may be in for better performance. We outlined above the sectors that appeal to our sense of value.