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F I R S T Q U A RT E R 2 0 1 1

THE BROYHILL LETTER


“The general who advances without coveting fame and retreats without fearing disgrace, whose only thought is to protect his country and do
good service for his sovereign, is the jewel of the kingdom.”

– Sun Tzu, “The Art of War”


Executive Summary

Rather than the same old letter warning investors that most equity markets remain dangerously overvalued, that sentiment
on most measures is exceedingly optimistic, or that the cyclical rally in stocks (and the economic recovery for that matter)
is looking more extended at each passing month, we thought we’d try something different this quarter. After spending a
weak in Edinburgh with Board members of local CFA Societies from around the globe, and hearing from another excel-
lent line-up of speakers at CFA Institute’s 64th Annual Conference, it’s satisfying to step back and consider the big picture.
As such, this quarter’s Broyhill Letter will be a summary of what some of the industry’s best and brightest had to say in
Scotland.

At every conference, no matter how enlightening the speakers, there is always at least one “sleeper” in the schedule. For
those that haven’t experienced a full week immersed deep into an investment conference, the “sleeper” in the schedule
provides you with the desperately needed opportunity to run back to your room for a quick powernap, ensuring that you
are well rested and capable of absorbing all of the information shared by the true headline speaker. This is considerably
important in Scotland where every evening reception consists of unlimited whisky “tastings.” But this year’s sleeper was
anything but. In fact, he was saluted by a standing ovation from the 1300 or 1400 members of the audience as he walked
off the stage. I, for one, am very glad I skipped that powernap.

The Sleeper

CFA Institute’s agenda for the last day of the conference kicked off with Raghuram G. Rajan, author of Fault Lines and
concluded with Jim Rogers before lunch, with Sanusi Lamido Sanusi, Governor and Chairman of the Central Bank of
Nigeria sandwiched between. I imagined it was the perfect opportunity to rest up before soaking in all one could learn
from the investor that best called the long term commodity cycle and author of one of my favorite books of all time,
Investment Biker. Skipping that nap was easily the best decision I made in Edinburgh.

Sanusi Lamido Sanusi is the best thing to happen to central banking since Paul Volcker. There, I said it. I have never heard a
public official speak so openly about the fundamental truths behind the financial industry, let alone an official with former
ties to the banks themselves. Sanusi is recognized in the banking industry for his contribution towards developing a risk
management culture in the Nigerian banking sector. He was appointed Governor of the Central Bank of Nigeria in June
2009, in the middle of the financial crisis. In August 2009 Sanusi bailed out Afribank, Intercontinental Bank, Union Bank,
Oceanic Bank and Finbank and dismissed their chief executives. He said, “We had to move in to send a strong signal that
such recklessness on the part of bank executives will no longer be tolerated.” Many senior bank officials face charges that
include fraud, lending to fake companies, giving loans to companies they had a personal interest in and conspiring with
stockbrokers to boost share prices.

Go back and read that last paragraph again and contrast it with our own experience. How is it that not a single person
from the banking industry is in jail for their crimes? These were in fact crimes. Crimes against the public, yet many of the
same management teams which got us into this mess are either still running the banks, or worse, running our government!
Sanusi believes you need strong institutions and you need strong individuals to run these institutions. We have neither. He
believes the relationships between the banks and the government is just too cozy. He sees that Goldman Sachs alumni have
always been at the Treasury and The Fed, which arguably explains their behavior around the crisis in his view and my own.
Nigeria is not waiting around for regulators to tell them what to do. While Dodd Frank is watered down to a slap on the
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hand by bank lobbyists, Sanusi is moving forward today by separating commercial and investment banking and forcing the
banks to pay for the bailouts.

“At the end of the day it is about values. It’s about looking at character,” said Sanusi. “The banks are holding the money
of the general public. And they’re taking risks with the people’s money. It is my job to protect their money.” This does
not sound like any central banker I have ever known! It’s unfortunate that in the land of the free, we prefer to protect
our banks rather than our people. The Nigerian people are lucky to have such an admirable leader, watching over their
economy. His closing remarks included a quote from Sun Tzu – “If you’re going to battle, make sure the ground you stand
on is strong.” Sanusi’s take - “If they can’t bribe you and you’re not afraid of them, they don’t know how to deal with you.”
Seems to me that the ground is getting stronger in Nigeria, and if Sanusi is able to accomplish even half of what he aims
to do, the Nigerian economy, already rich in resources, might just have quite a tailwind behind it.

The Big Reset

The articulate Jim Grant reminded us that up until 1935,


the US financial system did stand on firmer ground as the
stockholders of an individual bank got a capital call when
banks were under pressure. I suppose the only difference
today is that the capital call flows through Washington
before we ultimately foot the bill. Since the suspension
of dollar convertibility, according to Grant, the dollar has
been a derivative without an underlier. That said, there
may be upside surprises ahead for the dollar as it is not in
nearly as bad shape as the Euro. But neither one is a store
of value. We would agree with Grant on this call and are
positioned accordingly. We also find ourselves agreeing
with Grant on China, who claims that The Peoples Bank
is leveraged 1500 to 1. While we haven’t checked his math
on this one, it is obvious to us that there is significantly
more debt in the system than the low levels often quoted
by “the street.” Per Grant, “In China, the party forces
the banks to lend to the SCEs but it can’t seem to tell the
SCEs to pay the loans back.”

Sharing our “emerging” concerns, CLSA’s Russell Napier


gave an eye-opening presentation reviewing the unin-
tended consequences of US monetary policy. Accord-
ingly, the only thing Bernanke has accomplished with QE
is successfully scaring people out of the dollar. Most in-
vestors assume, hope, or pray that emerging markets will
sit back and accept this global rebalancing through infla-
tion. Instead, Napier believes we are building up to “The
Great Reset” as high inflation in emerging markets forces
independent monetary policy, causing an accelerated rate
of emerging market currency appreciation. China is fol-
lowing the Nixon playbook step by step on controlling

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inflation, but one day when China loses control of one of their economic variables - currency, capital controls, etc. - they
will go bankrupt. It’s the biggest capital misallocation on the planet, according to Napier. Amen.

Napier was the rare strategist at CFA Institutes 2009 Annual Conference who was uber-bullish on equities. Today, he
warns that the target for the developed world is to deleverage in a slow and deliberate measure, which means credit growth
must be below GDP growth for the foreseeable future, which means “fewer idiots getting rich.” Additionally, overheating
emerging economies are bad for equity markets as it feeds through to inflation in the developed world. Inflation becomes
a big problem for equities north of four percent, according to Russell. He suggests it may be important because this
is when the Fed thinks it’s important.
Either way, we have created an insti-
tutional bias to hold capital in certain
asset classes despite the opportunities
(or lack thereof) that are present. The
Cyclically Adjusted Price to Earnings
ratio (CAPE) predicts poor long term
returns, as we have written at length,
but very few people have a holding
period greater than three years. Napier
explains that historic peaks in CAPE
have been driven by “new” economies
but are always unsustainable. In fact, up
until 1995, a CAPE above 23 was not
sustainable. We stand at 24 today.

Where We Stand

Napier attributes the past two decades of


overvaluation to massive distortions in
the treasury market as money and credit
targeting changed the outlook for asset
prices. He believes that “The Great Reset”
will structurally alter the demand for trea-
suries at the same time that the retirement
of baby boomers creates issues of over-
supply. While we agree on most points,
I think he is early on the Treasury call,
like so many others as 95% of investors
surveyed are bond bearish today. Even
Napier admits that with everyone’s port-
folios aligned for inflation, we are likely to
see a massive deflationary shock first And by his own measures, QE has failed in generating money or credit growth.

James Grant advised that “Deflation is too little income chasing too much debt. A symptom of this disorder is falling
prices.” This is precisely where we stand today. On this point, we found ourselves agreeing with David Blanchflower, Pro-
fessor of Economics at Dartmouth and former member of the Bank of England’s Monetary Policy Committee. As he

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explained, deflation is the thing that kept us up at night. Inflation was “the fix.” Well, we certainly got what we asked for!
But those focused on rising commodity prices fail to see the lack of similarities between today and the price shocks of the
70s. There is no evidence of second round effects. Wage growth is benign around the world.

Unlike certain members of our Federal Reserve who are “100% certain” that they can control inflation, Blanchflower
openly admits that one of the problems with economic forecasting is you don’t know where you’re going. But it’s worse
than that. He also informs us that, “You don’t know where you are and you don’t know where you’ve been!” With that
comforting thought in mind, we can see that tightening too soon will have severe implications and as such, Blanchflower
thinks the ECB has made another fundamental mistake. The scary part is that even though authorities around the world
continue to make very optimistic growth assumptions, the real worry is that inflation is expected to remain well below nor-
mal (even under rosy growth forecasts) and deflation is likely to accelerate when growth disappoints. Blanchflower admits
that QE is a blunt instrument, but it’s the only game in town. “We really didn’t understand how it would work. The point
was to raise asset prices and depreciate the currency.” We need a strategy for growth, rather than one for lack of growth.
Perhaps we could learn a thing or two from our friends in Nigeria.

Popular Delusions

We’ve been fans of Dylan Grice’s Popular Delusions for years. The free-thinking SoGen strategist regularly provides the
French bank’s clients with provocative ideas for protecting portfolios from the proverbial “black swans” and the more fre-
quent, and slightly more predictable “grey swans.” Per Grice, he works with investors to help them understand things that
“might happen,” rather than making absolute predictions of what will happen, so he fully understands the shortcomings
of economic forecasting highlighted by Blanchflower. From an investment perspective, the key in leveraging these “grey
swans” is finding cheap ways to hedge against them – in other words, those few scenarios where the market has mispriced
the odds of a certain event occurring and where intense, independent research can tilt the odds away from the house.

According to Grice, there are a few


characteristics which are common place
among inflations historically - public fi-
nances under pressure; a government
which has committed to a level of
spending they cannot afford; and cen-
tral banks which have relinquished in-
dependence. We may be looking at one
such occasion today, as the mere size of
Japanese government debt makes Eu-
rope’s fiscal problems look more similar
to a college freshman struggling to pay
down his first MBNA credit card. Japa-
nese tax revenues no longer cover the
bare necessities, social security spend-
ing now represents more than half of
tax revenues and interest expense as a
share of tax revenues is roughly 30%.
Grice calculates that a rise in interest
rates toward a level more consistent with its developed world peers – call it three percent - would eat up half of Japanese
Government revenues. Japan must ultimately see a transfer of wealth from the private sector to the public sector and the
easiest way to accomplish this is through inflation. For a politician, it’s the best way to pass on blame, mainly because
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there is no “bad guy.” For investors, the best protec-


tion against a Japanese hyperinflation may be long-term,
out-of-the-money call options on the Nikkei as all nomi-
nal assets are revalued higher with spiking interest rates.
The folks at Soc Gen suggest that ten year call options
on Nikkei at 40,000 cost roughly 4% so hedging 10%
of your portfolio’s notional value would cost roughly 4
bps annually. Not too shabby, considering the outlook
for the island nation (and the upside during previous hy-
perinflations – i.e. Israel). Napier seems to agree saying,
“The Japanese Government will go bankrupt one day.
But it will be on page two of the FT.”

Wall Street Revalued

Global stock markets are overvalued by Grice’s pre-


ferred measures. But interesting enough, he finds Japa-
nese equities looking cheap, as the Shiller PE for the
Topix now stands at 16x. More qualitatively, it feels as
though the international investment community has
given up on Japan and the market is severely under-
owned. Andrew Smithers, the brilliant British econo-
mist would tend to agree on both counts. By his count
(and our own), there have been 4 times in history the
US market has been this overpriced, although we are
not nearly as overpriced as ‘29 and ‘00. Investors would
be well served to remember that when markets finally
do come down to fair value (and they always do) they
come down fast, but don’t always stop at fair value -
they often overshoot. Conversely, he sees a great deal
of virtues in Japan and finds it “absurdly impossible
that Japan is not the cheapest market in the world” selling around book value. Accordingly, Japan is very likely to be the
best performing market over the next decade, with little in the way of downside risk according to the London-based
market observer – “If a market trading at book, falls 20% it would look very cheap. If the US fell 50% no one should be
surprised.”

In addition to his work on stock market valuations, Smithers is one of few that fully understands the impact that excessive
debt has on an economy. He, like us, believes that private sector debt is the fundamental problem of the US economy as
it has increased eight-fold since 1945 as economic policies encouraged debt accumulation rather than discouraged it. Ac-
cordingly, “The stupidest thing we do in the world today is subsidize interest on debt. The second is to rely on people who
got you into the mess to get you out of it.” Rather than relying on the “bubble squad” to repeatedly bail us out, Smithers
stresses the importance of leaning against bubbles before they get too dangerous, as the cost of clean-up is very high.
Instead, we should be trying to make asset prices go down slowly rather than pushing them higher. Sort of like hedgehogs
making love - very slowly and very carefully.

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Economic forecasts that cannot predict asset prices are not going to tell you anything about the economy. Falling asset
prices have a dramatic effect on the economy and are amplified by debt. Making matters worse, the current methods of
clean-up are unrepeatable. The private sector can’t pay down debt simultaneously. It must be transferred to the public sec-
tor as cash flow sums to zero - private sector cash flow must equal public sector deficits. And since public deficits must
come down, private sector cash flow must see a very, very serious deterioration. Given the level of profit margins today,
this is extremely worrying. Smithers asks, “Do you really think we can do this again, if we have another crisis with deficits
as large as they are and debt loads already so great?” I’m assuming this is a rhetorical question.

Ten other tidbits from Smithers that I felt compelled to include if for no other reason than to refute current consensus
thinking are: 1) GDP growth does not equal stock market appreciation. So many investors assume faster growth equals
higher returns. This is simply not backed by the data. 2) His personal impression is that Australian home prices are a bubble
and the banks should be worried. In full disclosure, we prompted him with a question of our own here, so I look forward
to sharing our work with his office. 3) The most stupid idea in finance is valuing equities against bonds. Amen. 4) Valuation
metrics are useless for short term
predictive purposes. Sad but true. 5)
If you want to forecast economies,
try to forecast markets. Don’t do it
backwards. In other words, markets
are leading indicators of economies.
6) One of the most ridiculous claims
from investment banks is that the
corporate sector is in good shape
and under-leveraged. The Flow of
Funds data shows the truth clearly
for all to see. This is not disputable.
7) Corporate pay-outs are essentially
options with no downside and im-
mense upside. If you pay people
with options, you get volatility be-
cause this is what increases the value
of options. Seems simple enough to
me, and likely explains much of the
recent volatility in markets as stock options have increased in popularity during the past two decades. 8) The UK economy
may not be as exposed to housing falls as the US, because they didn’t build as many homes, but the risk of higher rates is
greater. 9) Return on capital is a function of efficiency and profit margins, which are extremely mean reverting. This is one
of our greatest worries about US markets. And last, but certainly not least, 10) The European banking system has no equity
whatsoever. Vast amounts of equity must be raised to firm up the system. Why are so many willing to overlook this?

The Bull in the China Shop

The 19th century belonged to the UK. The 20th, the US. The 21st will belong to China. “China’s gonna be the next great
country in the world,” says Jim Rogers. “The best advice I can give you is to teach your children Mandarin.” Rogers has
been singing this song since the last innings of the tech bubble. He’s been early, he’s been right, and he’s stuck with his
call. It’s tough to argue anything but. While we certainly have our share of concerns, topped by China’s incredible thirst
for credit, the Investment Biker’s views are worth hearing.

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Long bull markets in commodities are normal in history. Most have lasted 15 or 20 years. This one doesn’t have to. Rogers
believes this one will likely run longer and will ultimately end in a bubble. He points out that we’ve had no major oil fields
discovered since the 60s. And since politicians now know they can be reelected by printing money, you should still own
real assets rather than paper assets because money printing will debase currencies even if the economy doesn’t get better.
Consequently, one of the reasons he’s long cotton is because that’s what money is made of!! “Ben is not an economist.
He’s a money printer.” Today’s commodity bull market is simply supply and demand, according to Rogers. The market was
underinvested during the 80s and 90s. The predictable result - all major oil supplies are in decline. We should be expanding
capacity a decade into this cycle, but in 2008-2009 capacity additions were shelved so this cycle may last longer than normal.
Rogers pointed to the forced liquidation in commodities due to AIG and Lehman bankruptcies, where commodities only
went down for five months. He viewed this as artificial selling leading the bull to quickly resume. Historically, we’ve had
long periods where “finance types” captained the world, followed by periods led by “real” producers of goods. In 1958 we
graduated 5000 MBAs. Now we graduate over 200,000. Roger’s advice, “Think about becoming a farmer.” I’m pretty sure
he was serious. Interestingly, the average farmer in the states is 58 years old. In 10 years they will be 68. This is a problem.
Rising prices will create crisis in the next decade. He asked the audience if we knew anyone that has gone into farming.
Surrounded by farms in Western North Carolina, I resisted the embarrassment of raising my hand.

Bottom Line

When questioned about risk, Rogers responded, “The biggest long term risk to China is their water supply. If China
doesn’t solve this, there is no China.” We were pleased to hear this long-standing bull at least admit that risks do exist
around the China-driven commodity demand theme. Yet, we are still left wondering just how large a part rampant credit
growth has played in this storyline (this is a good time to revisit our first two charts). Throughout history, fear of “short-
ages” have resulted in excess orders and further buying in anticipation of price increases and restrained supply, confirming
expectations and promoting even more buying . . . a vicious self-feeding cycle.

Today, this dynamic is complicated by the context of a long term deleveraging process, where falling prices may well reveal
falling demand. In the past, massive inventory buying has given way to production cuts and inventory liquidation. Only
time will tell, but we were certainly happy to learn that at least near term, Rogers’ positioning is in line with our own think-
ing. He is short emerging market equities today as the region has been overexploited by MBAs for years. He is long dollars
given the extreme bearish sentiment. He is not short bonds right now because 95% of investors are bearish and he’s been
investing long enough to know that when 95% of investors are bearish on anything, it’s not a good idea to follow the herd.
We would go one step further and make the wild suggestion that bonds (even at these levels) offer investors an attractive
hedge against renewed deflationary pressures in light of the sentiment above and today’s obsession with long term infla-
tion risks.

- Christopher R. Pavese, CFA

The views expressed here are the current opinions of the author but not necessarily those of Broyhill Asset Management. The author’s opinions
are subject to change without notice. This letter is distributed for informational purposes only and should not be considered as investment advice
or a recommendation of any particular security, strategy or investment product. This is not an offer or solicitation for the purchase or sale of
any security and should not be construed as such. Information contained herein has been obtained from sources believed to be reliable, but not
guaranteed.
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