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June 24, 2008

Mining Mergers and Three Wealth Creation Tools
by Daniel Amerman

Overview

The hottest area for mergers and acquisitions has moved from financial firms to acquiring metals mines. Using the illustration of a $100 billion mega-acquisition, we will show how this strategy can dovetail with the destruction of the dollar to create a new class of mega-wealthy investors, with a $5 billion equity investment reaping a $1.5 TRILLION profit in the example shown. We will then clearly and succinctly demonstrate that the biggest source of these potential profits in real terms does NOT come from where the press articles would have you believe, but is the result of three distinct wealth creation tools. Tools that can also be used by smaller investors to create their own personal inflation-arbitrage strategies.

Mining Mergers & The Great Game

In March of 2007, I published an article entitled "The Great Game, Gold Arbitrage & The Three Little Pigs." This article explained how the powerful global financial players who risked the destruction of the dollar with their investment games, would turn the destruction of the dollar into an exit strategy that would vault them to all new levels of wealth, even as the dollar was destroyed. The exit strategy that was predicted in that 2007 article is today's headlines in June of 2008, as shown in quotes from a Bloomberg article that appeared on June 12, 2008:

"Metals are the new green on Wall Street, as mining has displaced financial services to become the biggest source of mergers and acquisitions.

'We have moved into the age of commodities... You clearly have a large number of mining companies just generating cash and profit like there is no tomorrow' (Carl Hughes, Deloitte & Touche)

'There is a global desire to grab whatever resources are available because they are in short supply. There are good times ahead.' (Tim Goldsmith, PriceWaterhouseCooper)"

Bloomberg, June 12, 2008

The Bloomberg article by Choudhury and Foley is interesting and well worth reading, but let me suggest that the reporters who wrote that article are only seeing a small part of the picture. They believe that the story is the asset play - but there is far more to acquiring mines with other people's money in these times of rapidly accelerating inflation than a mere asset play. The heart of the game is to arbitrage the collapse of the dollar. As I wrote last year:

"The Great Game has two halves: going long the real, and short the symbol. That is, going long real assets by owning them, and going short the dollar and the financial system by selective and advantageous borrowing. That way if you are a hedge fund manager, CEO or "private equity" investor who has essentially gambled the world monetary system on your speculations, and you collapse the financial markets and the value of the dollar when you guess wrong - you don't jump out the office window. Instead, you enjoy an extraordinarily lucrative early retirement. Because you still own the real - and by destroying the value of the dollar, this just means that you no longer have to pay back most of what you borrowed to buy the real (in inflation-adjusted terms)."

A Simple Example

To explain what the media coverage is missing - which is the heart of an extraordinary wealth creation opportunity - let's start with the relatively simple example below:

We start with an assumption of a $100 billion acquisition of a mining conglomerate by a private equity company - a size range that is being discussed. Next we assume that the acquirer is a major private equity group using the time-honored source of funding for such deals: OPM, or Other People's Money. In this case we assume that $95 billion of the $100 billion comes from banks, insurance companies, pension funds and the like, and that $5 billion is contributed by the actual equity owners (there are complexities, but we are keeping it simple here.)

Then major inflation... happens. It could be a refusal by oil producing nations to accept dollars, it could be an oil and commodities supply shock that spirals out of control, or it could be that the world's investors eventually accept that the only defense for a fiat currency is a vigorous defense by the nation and central bank - and a Federal Reserve that has pushed interest rates to levels below that of inflation to bail out Wall Street interests isn't even bothering with going through the motions of defending the value of a symbolic currency. Or all of the above, and more.

Whatever the source, for this illustration we assume that there is a quick 1000% burst of inflation, which destroys 91% of the value of a dollar over the next few years. This means that a dollar would only have 9 cents in purchasing power.

We then assume that metals and other commodities deliver their traditional inflation fighting performance, not only keeping up with inflation - but growing in value at a rate that exceeds the rate of inflation. And that as investors see the destruction of their paper wealth, they will flee to tangible assets as a refuge, and this will push up the values of metals and other commodities, by an average of 25% in inflation-adjusted terms.

As an example, if we say that our metal in the illustration is gold, we start with an assumed gold price of $900 an ounce, and in real terms it rises 25%, then it goes to $1,125 an ounce before inflation. When we then adjust for inflation of 1000% - we are saying that gold has risen to $12,375 per ounce. Rephrased, for the illustration we are assuming a 13.75X increase in the price of the metal, for a nominal return on investment of 1,275%. (Genuinely impressive performance under circumstances that would annihilate the value of most conventional investments, but remember a dollar is only worth 9 cents.)

For a variety of reasons we would expect mining stocks for the metal to grow by an even greater margin, with the core reason being that the value of the mine is not the metals, but the margin by which the value of the metal exceeds the price of extraction, and this should rise at a rate in excess of the rate of inflation. In this illustration, we assume that if the metal rises 25% in real terms, then there is a 50% increase in inflation-adjusted terms for a mine for that metal. So a stock that starts at $100 a share rises to $150 in real terms, then we adjust for inflation of 1000% - and the price of the stock rises to $1,650 a share. Rephrased, for the illustration we are assuming a 16.5X increase in the price of the metal mining stock, for a nominal return on investment of 1,550%.

(Using a price of $12,375 per ounce for gold, or assuming that a share price goes from $100 to $1,650 may seem aggressive, but for a 1000% rate of inflation - these assumptions are very much on the conservative side. If metals were to rise 50% or 100% in real terms, and metal mining stocks were to rise 100% or 200% in real terms (assumptions which are quite justifiable), then the bottom line results shown would be much stronger.)

Turning $5 Billion Into $1.5 Trillion

Let's go to the "Ending Situation, Post Dollar Destruction" section of the illustration. Because the value of the metals mines has risen by 1,550%, the nominal value has gone from $100 billion, to $1.65 trillion. The private equity company still owes $95 billion to outside investors, so after subtracting these outstanding debts, the company has an equity value of $1.5 trillion.

$5 billion + 1,000% inflation = $1.5 trillion

What the "equation" above shows is that if the dollar is destroyed, then a $100 billion metal mining acquisition could work out to be one of the most profitable investments in the history of mankind. Even as the savings of the average person are devastated, we would see the emergence of a new class of mega-wealthy, with wealth that dwarfs anything previously seen in history.

On an individual level, while it might be tough to come up with the initial $5 billion to turn into $1.5 trillion, using different applications of the same methods does open some entirely new horizons. Yes, achieving spectacular returns through simply leveraging investments in metals and metal mines is the obvious (quite risky) surface possibility. But there are also ways for individual investors to dramatically boost their personal after-inflation and after-tax returns, while taking only a small fraction of the risk involved in the illustration above. With sufficient education and understanding, unfair inflation tax treatments can be reversed into inflation driven tax-advantages. Retirees can use some of the tools involved not to leverage up risks - but to strip out risks, and build powerful defenses against the number one threat to retiree finances, that of inflation.

But to achieve any of these goals, we first have to understand what really happened. That requires improving our vision. Which means setting aside (for now) the illusion of nominal dollars, and focusing on the right hand column, when we re-examine each step in inflation-adjusted dollars.

When we look at this column, and we adjust for a future dollar only having 9 cents of purchasing power, then our mining company becomes worth not $1.65 trillion, but $150 billion. Exactly what we would expect for a 50% increase in value, after-inflation. Our equity doesn't go up by 50%, however. In real terms, after adjusting for 1000% inflation, we go from $5 billion to $141 billion. Meaning at the bottom of our bottom line on the illustration chart, we turned a true $136 billion dollar profit on a $5 billion dollar investment in purchasing power terms. Not $1.5 trillion - but a spectacular, historically extraordinary result nonetheless.

To understand where this spectacular wealth gain came from requires understanding that there was not one, and not two, but three distinct wealth creation tools involved.

Wealth Creation Tool #1: The Asset Play

For the average individual investor, the asset play may seem to be the heart of what happens here. The financier controls $100 billion in mines, and they become worth $1.65 trillion, for a gain of $1.5 trillion! As discussed above, the problem is that when you discount for a dollar only being worth 9.1 cents, then the value of the mines drop from $1.65 trillion down to $150 billion, meaning a 50% return on investment.

So, let's take out the debt, and see how much of the profit is from the assets alone. If you start with $5 billion in metals mining stock with no debt - then you end up with $82.5 billion in metal mining stock. Spectacular! Until you adjust for a dollar only being worth 9 cents. Meaning your $82.5 billion in stock is worth $7.5 billion in today's dollars. A highly worthwhile real (pre-tax) profit of $2.5 billion - which is $133.5 billion short of the $136 billion in inflation-adjusted profits shown in the illustration. To find where the extra $133.5 billion in real wealth comes from, we need to look to our 2nd and 3rd wealth creation tools.

Wealth Creation Tool #2: The Leverage Play

Well-read individual investors and financial professionals likely looked at the illustration and thought one word: "leverage". Leverage is of course the heart of many types of financial strategies, and the principal here is simple. You borrow money from someone else to buy an investment, you buy an investment that makes a fat profit, you pay back what your borrowed, and you keep the excess profits. Because the use of OPM (Other People's Money) allows you to control more of an asset that does well, for less investment on your part, your return on investment is much higher than it would otherwise be.

What is illustrated above does have a powerful leverage component - but that is not necessarily the most important part. Let's look at what leverage does, in this case. It means for a $5 billion investment, you control $100 billion in mining stock instead of $5 billion. So when the value of your stock in inflation-adjusted terms rises by 50%, you capture that 50% rise on $100 billion instead of $5 billion. That is $50 billion in profits instead of $2.5 billion, and this means that by leveraging yourself by 20X ($5 in equity for every $100 in assets), you multiply your profits by 20X.

This is classic leverage, increasing your risks to increase your profits, and - as long as it works - then large amounts of wealth can be created quite quickly (when it doesn't work, wealth can be destroyed even more quickly). Yet, leverage by itself "only" multiplied our profits by 20X, an increase of $47.5 billion from our asset-only play. Combined, our total profits from the asset play and the leverage play are $50 billion, after adjusting for inflation. Which is great - but it's $86 billion short of the $136 billion in profits shown, for our $5 billion investment. Where does the remaining $86 billion in inflation-adjusted profits come from?

Wealth Creation Tool #3: The Dollar Destruction Play

At first glance, it may seem difficult to distinguish from leverage, but the heart of the contrarian arbitrage illustrated above is not the asset, nor the leverage, but the destruction of the value of the liability. What really makes this work is not the 50% increase in the value of the asset, but the 91% decrease in the value of the liability.

Look at the Beginning and Ending Situation sections for the chart, and compare the inflation-adjusted value of the borrowing. On a nominal basis we start and begin with the same number: $95 billion in debt. Except, thanks to a 1000% rate of inflation, what was a dollar when we began is only worth nine cents when we end. Our financier borrowed $95 billion - but only paid back $9 billion in purchasing power terms.

The difference in real value between what the private equity group borrowed and what they paid back is $86 billion dollars. Eighty-six billion dollars of value that used to belong to the lenders has now been redistributed to the borrowers. As shown below, it is the inclusion of the difference of the value between what we borrowed and what we paid back that makes all the (inflation-adjusted) numbers add up, and explains the source of 63% of the total profits from the strategy.

What distinguishes this Wealth Creation Tool from leverage, is that leverage is about using other people's money to buy assets, making a bigger profit through controlling more assets when the price rises, paying your lenders back, and keeping the excess profits. Wealth Creation Tool #3 is about using other people's money to buy assets - and then not paying them back, while keeping the assets you bought with their money.

When we say "not paying them back", we mean that in real terms (as defined by economists). Legally, contractually, ethically, in every way that almost the entire world would look at the situation -you did indeed pay your lenders back in full, with every dollar that is due to them. The key is however, that nearly our entire contractual and legal structure is based upon the principle that a dollar is a dollar.

The whole point behind inflation however, is that a dollar is not a dollar. The higher the rate of inflation, the greater the error that comes from viewing a dollar as being worth a dollar. For most investments and most investors - this increase in error is potentially catastrophic.

(Do keep in mind as well, that while the metals mine value produces "only" $2.5 billion of the profits in real terms, without it or other tangible assets, then the strategy doesn't work. Having the value of your debt collapse in real terms doesn't do any good unless the proceeds are invested in an asset that isn't collapsing in inflation-adjusted value. As I cover in my three day immersion workshops, a multi-asset inflation-arbitrage strategy can generate both higher returns and lower risk, on a tax-advantaged basis, when compared to a single asset strategy such as metals only.)

A Redistribution, Not A Creation

This is where the "adding insult to injury" part comes in.

Inflation in and of itself, doesn't destroy wealth, rather, it redistributes wealth. The primary source of profit illustrated above is not the indirect play on metals benefitting from a reduction in the value of a dollar. Instead, the primary source of profit is the much more direct redistribution of wealth through the destruction of the value of the currency leading to the destruction of the value of the liabilities.

There is ample irony here. Wall Street has been playing increasingly aggressive games with the value of all of our money, with fun little experiments like creating $593 trillion in global OTC financial derivatives products. In theory, these are supposed to reduce risk, but in practice, they turn out to look a lot more like a line of dominos. Dominos with total notional values that now exceed ten times the size of the global economy, and just might destroy the value of all of our paper currencies, if they go out of control.

In a just (in other words, theoretical) world, the financiers, who for personal profit created the problems that may lead to financial ruin for the rest of us, would bear the brunt of the consequences. In the real world, the collapse of the currencies can in fact be turned into the ultimate profit opportunity, as the value of the life savings of many millions of hard working people around the world are not destroyed - but redistributed. The financiers didn't create tremendous wealth independent of the profound losses in wealth by most of the population, but rather used a destruction of the dollar to redistribute real wealth from other people and to themselves. (A simple to follow illustration and explanation of this principle can be found in a free resource I offer entitled "Inflation Pickpocket".)

Wealth Creation & Vision

Now, here comes the most important part of this article, the part where you make an important two-part decision about your personal financial future. The first part of the decision comes when you decide what it is you saw illustrated above. The second part comes when you decide whether to do anything about it.

What did you just see? A) The advantages of owning gold and gold mining stocks during inflationary times? B) The power of leverage? C) The ability to turn the destruction of the dollar to your direct personal advantage?

The answer is: D) All of the above. Understanding the full sources of the wealth requires understanding that there are three distinct wealth creation tools being utilized.

Of those three tools, one is much riskier than the other two. Which is Wealth Creation Tool #2, that of Leverage. The difference between Wealth Creation Tools #2 & #3 is particularly important for retirees and those investing for retirement. The dilemma is that the segment of the population most vulnerable to inflation and the destruction of the dollar are the older citizens (and this is true regardless of your nation or unit of currency). If this describes you, then you are in urgent need of protection.

Yet, as I would hope that most financial professionals would agree, advocating a highly leveraged strategy for a retiree exactly like that illustrated for major financiers above, would be quite irresponsible. Leveraging up on margin loans to buy volatile securities that may produce little if any cash flow is a very good way to lose your life savings in a hurry.

However, when our focus is not on leverage, but dollar destruction, then something very interesting emerges. Wealth Creation Tool #3 is fundamentally contra-cyclical when compared to conventional retirement financial risks. As are tangible assets such as metals and metals mines. In other words, the worse things get for pensions and conventional investments, the stronger the results that are delivered by Tools #1 and #3. Right when they are needed the most.

Here is the question: is it possible to build a strategy that essentially "pulls the fangs" from Wealth Creation Tool #2, the leverage component, neutralizing much of the risk, while still maintaining much of the advantages of Wealth Creation Tool #1, the asset play, and Wealth Creation Tool #3, the dollar destruction play?

The answer to the question above is - yes, you can. One of the nice parts about having three wealth creation tools is that you have a vast range of different tool combinations that can be created between the three tools. Depending on the particulars of your situation, you have the ability to find the right risk and return combination, for the asset choices and liability levels that you are personally comfortable with. Where you can not only sleep at night, but sleep better than ever, because you feel better about the reduction in your risk from inflation.

To get there, however, requires taking an essential step - that of learning.

The Most Important Tool Of All: Education

New times mean new strategies. New times mean that the strategies that have worked over the last 20 years quite likely won't work the same way in the years to come, and the strategies that worked best in 1995, and 2000 and 2005 - may be among the worst performers of 2010 and 2015. To prepare for a different future requires first and foremost - learning new strategies for new markets.

John Paulson saw the crisis that was coming in subprime mortgages, researched and educated himself on this area (which had not been his field of expertise), and he turned the crisis into a $3-$4 billion personal payday in 2007. If you're not a hedge fund manager like Paulson, you may not have the tools that he used to turn a market crisis into personal billions. That's OK, because Paulson didn't start with the tools either. He started with educating himself, learning about a new area, until he came up with a novel way to profit from disaster. A method that wasn't in the financial textbooks, and that he didn't find by reading a financial columnist in the paper.

You have more tools than most people think. Tools which can give you the opportunity to turn financial disaster into personal net worth. There are ways you can use those tools to turn the destruction of the currency into perhaps the greatest real wealth-building opportunity of your life, on a long-term and tax-advantaged basis. But, you are going to have to educate yourself, and work to not just understand, but to master some of the financial forces and methods in play here. You will have to learn how to turn the destruction of paper wealth into real wealth. With Turning Inflation Into Wealth being the first key step. My best wishes to you for turning this challenge into an extraordinary personal opportunity.

Do you know how to Turn Inflation Into Wealth? To position yourself so that inflation will redistribute real wealth to you, and the higher the rate of inflation - the more your after-inflation net worth grows? Do you know how to achieve these gains on a long-term and tax-advantaged basis? Do you know how to potentially triple your after-tax and after-inflation returns through Reversing The Inflation Tax? So that instead of paying real taxes on illusionary income, you are paying illusionary taxes on real increases in net worth? These are among the many topics covered in the free "Turning Inflation Into Wealth" Mini-Course. Starting simple, this course delivers a series of 10-15 minute readings, with each reading building on the knowledge and information contained in previous readings. More information on the course is available at InflationIntoWealth.com.

Daniel R. Amerman, CFA
The-Great-Retirement-Experiment.com

Daniel R. Amerman is a financial futurist, author, speaker, and consultant with over 20 years of financial industry experience. He is a Chartered Financial Analyst (CFA), and holds MBA and BSBA degrees in Finance from the University of Missouri. He has spent seven years developing a large, unique and intertwined body of work, that is devoted to using the foundation principles of economics and finance to try to understand the retirement of the Baby Boom from the perspective of the people who will be paying for it.

Since 1990, Mr. Amerman has provided specialized quantitative consulting services to financial institutions, with a particular emphasis on structured finance. Previously, Mr. Amerman was vice president of an institutional investment bank, with responsibilities including research, synthetic securities, and capital market originations.

Two of Mr. Amerman's previous books on finance were published by major business publishers. "COLLATERALIZED MORTGAGE OBLIGATIONS, Unlock The Secrets Of Mortgage Derivatives", was published by McGraw-Hill in 1995. Mr. Amerman is also the author of "MORTGAGE SECURITIES: The High-Yield Alternative To CDs, The Low-Risk Alternative To Stocks", which was published by Probus Publishing (now a McGraw-Hill subsidiary) in 1993. Advertised by the publisher as a professional "bestseller" for four quarters, an Asian edition was sold as well.

Mr. Amerman has spoken at numerous professional seminars and conferences nationwide, for a variety of sponsors including New York University, the Institute for International Research, and many others. After the publication of his prior books, he acted as keynote speaker at a number of banking related conferences over the next several years.

This article contains the ideas and opinions of the author. It is a conceptual exploration of general economic principles, and how people may - or may not - interact in the future. As with any discussion of the future, there cannot be any absolute certainty. What this article does not contain is specific investment, legal or any other form of professional advice. If specific advice is needed, it should be sought from an appropriate professional. Any liability, responsibility or warranty for the results of the application of principles contained in the website, pamphlets, videos, books and other products, either directly or indirectly, are expressly disclaimed by the author.

Copyright © 2006-2008 Daniel R. Amerman, CFA

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