Value Microcaps Motherboard

[kipp440]

"Basic Points" Must Read for Commodities/Metals

(I copied the text from the report here, a little hard to read and no graphics, but worth the read)


Earth, Air, Fire, Water—and Globalism

October 25, 2006

Produced by Harris Investment Management
Distributed by BMO Capital Markets



Basic Points


An Investment Journal

Donald G. M. Coxe

Global Portfolio Strategist, BMO Financial Group
Global Portfolio Strategist, Harris
Chairman, Harris Investment Management, Inc.
Chairman, Jones Heward Investments Inc.


[phone]
e-mail: [e-mail]
Research/Editing: Angela Trudeau
e-mail: [e-mail]


Production: Sandra Naccarato
e-mail: [e-mail]


Distribution: Anna Goduco (print orders and mailing lists)
e-mail: [e-mail]


Earth, Air, Fire, Water—and Globalism



Overview



Basic Points has been published for 14 years. By its nature and its audience it usually
discusses current markets and current concerns. This month, we step back from the
markets’ current enthusiasms, and try to peer a decade ahead. We do that by first
looking a long, long way back.

In part, this process comes because we are going to take our first sabbatical—a one
month leave of absence. I shall be in India, and my colleague will be in Italy. When we
return, we will be joining BMO Capital Markets on a full-time basis in the Global
Portfolio Strategy function. I have discontinued portfolio strategy responsibilities for
Harris Investment Management. My increased level of commitment to BMO Capital
Markets, together with my extensive traveling, forced a choice. Basic Points will resume
publication in December. There will be no Conference Calls during November.

My time in India will not include the economic and financial hot spots. This is a return
to my roots. Apart from a brief visit to Delhi, I shall be visiting Rajasthan, where my
grandparents and father lived for many years, so long ago.

In preparing for this journey, I have been studying Indian history and culture. India has
only recently begun to emerge from the socialist straitjacket it so eagerly donned in
1947 after Britain’s socialist government hurriedly partitioned it from Pakistan and
then abandoned it in indecent haste, triggering fearsome slaughters, and leaving the
status of Kashmir as a continuing casus belli between the parts of the former colony.

But that story is part of the bigger story—the emergence of the Third World as the
primary engine of world growth, with globalism reshaping the ways humanity lives,
works, and invests.

This month we look at how investors can position themselves for this economic power
shift—the most momentous since the Industrial Revolution enthroned Europe and
North America as the world economic leaders, ending the 18 centuries in which China
and India were the largest economies in the world. We suggest that a good starting
point for portfolio construction for the next decade is by looking back 2500 years to a
time when an Asian-conceived view of the planet became the basis of Western scientific
thought.

October


Recommended Asset Allocations


American Portfolios


U.S. Pension Fund
Allocations Change
Domestic Equities 24 unch
Foreign Equities 21 unch
Domestic Bonds 20 unch
Long-Duration Bonds 15 unch
Foreign and Foreign-Pay-Bonds 15 unch
Cash 5 unch

Foreign Equity Allocations
Allocations Change
European Equities 6 unch
Japanese and Asian Equities 5 unch
Canadian & Australian Equities 6 unch
Emerging Markets 4 unch

Bond Durations
Years Change
Global 4.50 unch
US 5.25 unch
Canada 5.50 unch

October


Basic Points

Earth, Air, Fire, Water—and Globalism

A time of correction and pause in some sectors of the commodity bull
market—notably energy—is a time to reflect on how the next phase will
unfold.

The over-arching trend of our time is the growth of the new middle class in
the Third World, notably in China and India. We define “middle class” as
people living in dwellings with indoor plumbing, electricity and basic
appliances, and with reasonable expectation of owning a car. Future
historians will characterize the first quarter of this century as the greatest
single efflorescence of personal economic liberty in history. That driving
force will, we have argued, set world prices for oil and base metals.

Therefore, since early 2002, we have been strongly recommending shares of
companies producing oil and base metals.

We continued to reiterate and reinforce that enthusiasm during the many
selloffs of commodities and stocks, arguing that each setback was a buying
opportunity. (We always recommended gold shares, but primarily as
portfolio insurance, remaining convinced that deflation was the primary
challenge to the global price system.)

We have built our case to date on three arguments:

1. The Triple Waterfall Crash in commodity stocks ended in late 2001.
Using S&P 500 weightings, that sector peaked at a towering 35% in
December 1980. At bottom, after 9/11, the weight was a pitiful 4.8%.
For the beaten-down commodity stocks, there was nowhere to go but
up, at least in weighting, because tech’s crash had barely begun and tech
companies are inversely correlated to commodity producers: Tech
companies are the economic avatars of abundance and change,
developing and selling the next new things at prodigious rates; oil and
mining companies are the scions of scarcity, inheriting the ancient
reserves of resources in the earth laid down eons ago, which they harvest
and sell at a pace commensurate with global economic growth.
2. From those decades of decline and defeat has come this decade’s
lucrative legacy: “The best investment opportunities come from an asset
class where those who know it best, love it least, because they have been
disappointed most.”
“For the beaten-
down commodity
stocks, there was
nowhere to go
but up...”

October


“The devastation of
the 21 years of
commodity price
collapse was
reflected in the
psyches of the
relatively few
people who still
had jobs...”

The devastation of the 21 years of commodity price collapse was
reflected in the psyches of the relatively few people who still had jobs,
either as executives in the shrunken producing companies, or as analysts
on the Street, where they were assigned the precarious task of
maintaining investor interest in the worst-performing asset class.

This commodity bull market has been characterized primarily by
backwardation—futures prices selling at a discount to spot prices in an
environment associated with low or negative inflation and deep
skepticism about the outlook for raw materials. The inflationary 1970’s
were the era of contango bull markets, when Club of Rome views of
endless scarcities and endless inflation ruled.

3. The publicly-owned mining and oil companies collectively have huge
challenges replacing their production because they have harvested the
low-hanging fruit, their low p/e ratios discourage massive undertakings,
most managements have little faith that high commodity prices will
last, and the fastest growth they see is in political risks in the countries
with the most attractive reserve potential. (We call this the Law of
Political Risk in Commodity-Producing Emerging Nations: the political
risks increase as the square of the price increase of the commodities
produced. For example, Putin and Chavez were eager to make attractive
deals with Big Oil when oil was $20; they began breaking those deals
once oil passed $45.) Conclusion: stocks should be valued based on
unhedged reserves in the ground in politically secure areas of the
world—not on companies’ current earnings.
Notwithstanding this year’s selloffs that began as Japan unleashed the most
dramatic liquidity drain in history, investors who began buying in 2002 and
kept adding to their positions in pullbacks have continued to prosper.

S&P/TSX Capped Metals & Mining Index
January 2002 - October 2006


October


Basic Points


AMEX Oil Index
January 2002 - October 2006


“The financial
power of these
‘poorer’ societies
is also growing
so fast that the
world’s financial
power balance has
also shifted...”

Our emphasis on the oil and base metal stocks continues as our core belief
system for coming years.

But we now conclude that we need to expand our horizons. A once-inhistory shift of the world’s economic power creates investment
opportunities that go beyond mines and oils.

Commodities Cool As Liquidity Dries Up

The baton is being passed: The economic growth of the Emerging Markets
has been so strong that, for the first time since the Industrial Revolution
reshaped Europe and North America, they have a larger GDP than the
OECD. The financial power of these “poorer” societies is also growing so
fast that the world’s financial power balance has also shifted: So high are the
savings rates in these bourgeoning new economies that collectively they are
net capital suppliers to the OECD.

Those twin power shifts have spawned the other major economic shift of
this era: These countries have what is called “high energy and metals
intensity,” meaning that, for each unit of growth in GDP, they consume a far
higher percentage of energy and metals than the mature economies. Result:
investors in oil and base metals own cyclical stocks which are correlated—
at the margin—primarily to the rate of GDP growth in the Emerging
Markets, not the OECD. But old habits die hard. Investors still price these
stocks based on their outlook for the economies of the OECD, particularly
the US: base metal stocks sell at similar multiples to US housing stocks.

October


“...due to global
warming, the
North Atlantic
was hotter than ever,
which absolutely
and certainly
guaranteed
another Katrina.”

Overweighting the metals and oils has been the correct weighting for four
years—overweighting the sectors with the fastest earnings growth rates
based on producing products with soaring pricing power derived from
demand from the economies with the strongest economic growth.

It has, however, been the wrong weighting in recent months.

The base metal stocks sold off sharply when the Bank of Japan drained the
Euroyen pool, but they have inched back up. Indeed, the TSX Capped
Metals and Mining Index reached an alltime high last week.

However, oil stocks have delivered poor returns this year, and the market
weight of oils is huge compared to base metals stocks (and the open-market
supply of major mining stocks has been falling faster than Bush’s approval
ratings).

Oil prices got ahead of themselves because:

• Ahmadinejad was on Page One almost every day, spewing extravagant
threats to do mighty deeds that would mean triple-digit oil prices;
• Amateur climatologists became excited about reports that, due to global
warming, the North Atlantic was hotter than ever, which absolutely and
certainly guaranteed another Katrina.
Well, Ahmadinejad has been pushed off Page One by his sometime friend
of the North, and the hurricane season is almost over; it was one of the most
benign in years. Yes, there were tornadoes that killed orange trees and drove
up the price of OJ, but the only shock to hit New Orleans was the
turnaround in performance of its football team: the Saints have emerged
from their tomb.

Crude oil prices gave up their gains based on geopolitical and climatalogical
speculation, and now trade based on the current oversupply of heavy crude,
which has also pushed light crude prices sharply lower.

That oil oversupply comes, in part, from some slowing in demand growth
arising from a downshift in another of our core investment concepts—the
record growth in this decade of what we call “Real, Effective Global
Liquidity”. The combination of (1) the high savings rates in Asia, (2) the
buildup in dollar reserves held by the Bank of China and the Bank of Japan
under the 1998 understanding we call “The Great Symbiosis,” (3) the

October


Basic Points


formation of the euro pool of liquidity on a scale approximating the size of
the global Eurodollar pool, (4) the rapid erosion of controls on the
movement of currencies across national barriers, (5) the explosive growth in
currency and financial derivatives, and (6) remarkably modest growth in
global inflation, meant that the global economy has been awash in Real,
Effective Liquidity.

When the major central banks began reversing their post 9/11 monetary
flooding, one bank held out: the Bank of Japan (BOJ), fighting domestic
deflation and a decline in domestic bank lending that lasted for a seemingly
incredible 94 months, kept expanding its Monetary Base. It became larger
than the Fed’s Base, making the Bank, by that measure, the world’s biggest.

As other central banks kept raising their rates, the liquidity supplies offered
in Eurodollars and Euro-euros and Euro-Sterling moved to Perrier pricing,
while the BOJ’s gushing liquidity stayed on offer at tapwater rates—at the
barely-observable Euroyen borrowing rate of 0.36%. Who came to these
wells? Major financial players, including the trading operations of global
banks, and, of course, large hedge funds with connections to Japanese
banks. Those cheap Euroyen were partly deployed into the carry trade—
buying Treasurys and mortgage-backs, but also into big bets on such assets
as Emerging Markets stocks and bonds, oil, and metals—particularly the
precious metals. The peaceful, passive, quietly deflationary Japanese
financial system had become the money pump for a group of global
speculators whose activities were raising alarums of stagflation. When The
Wall Street Journal, stunned by gold’s leap to $720, called on the Fed to start
raising rates in fifty point hikes to avert a new outbreak of stagflationary
speculation, it was time to take away the NippoH2O. (As we documented in
previous issues of Basic Points, the BOJ’s awareness of this problem came
after a report by BOJ economists edited, with recommendations by Ben
Bernanke, was published in The Journal of International Central Banking.

The BOJ decided at its March meeting that the time had come to (1) close
the spigots, and (2) to drain the Euroyen pool. The BOJ thereupon
vaporized 30 trillion yen (approx. $175 billion) from its Monetary Base in
11 weeks, a cleanup on a scale that recalls Hercules’ cleansing of the Augean
Stables.

“...to avert a new
outbreak of
stagflationary
speculation, it was
time to take away
the NippoH2O.”

October


"Here’s a
howdy-do..."

This major monetary operation was surgically focused—on global
speculators. Liquidity and lending for the slowly-recovering Japanese
economy remained strong. This was the BOJ equivalent of the lovely
“Here’s a howdy-do” trio in The Mikado, when Ko-Ko, Yum-Yum and Nanki-
Poo come to grips with the wider implications of what had seemed like a
brilliant subterfuge.

Sic transit stagflatus:

Gold
June 2005 - June 2006


Copper
June 2005 - June 2006


October


Basic Points


Nasdaq
June 2005 - June 2006


“The Bank of Japan
must keep a wary
eye on the
yen’s value...“

iShares MSCI Emerging Markets
June 2005 - June 2006


Looking forward, it seems reasonable to observe that central banks will not
tighten indefinitely: the Bank of Canada and the Fed are in “Pause” mode
and, if they haven’t resumed tightening by March or so, they may well
resume rate-cutting. The Bank of Japan must keep a wary eye on the yen’s
value, because, under its Great Symbiosis arrangement with China, it must
not let its currency slip deeply below its eight-year trading range with the
renminbi—which has become one of the strongest currencies in the world.

The Big Bang Effect

North Korea’s announcement of a nuclear test hit the yen hard, because
Japan is, as always, North Korea’s prime regional adversary. (The US remains
the adversary North Korea has most feared since MacArthur blocked the
North’s invasion of the South and launched Japan into its twin roles as
Asia’s second-largest democracy and pre-eminent geopolitical castrato.)

October


Yen
October 2005 - October 2006

“...it began to
look that the
shock heard
‘round the world
could be mere
Marxist schlock.”


New Premier Abe, a third-generation product of Japan’s democratic process,
(and a vocal seeker of national recapture of the lost samurai virility of its
defense policies), kicked off his term with visits to Beijing and Seoul—both
off limits to Koizumi, because of his insistence on visiting the Yasukuni
Shrine. That the yen was tumbling toward the fateful level of 122 as this
assertive new leadership caught global headlines obviously meant that
Japan’s regular recycling of its inflow of dollars back into Treasurys and
mortgage-backs had to be put on hold. Treasury yields backed up sharply.

Then the news about this latest triumph from the Dear Leader of the Peoples
Democratic Republic of Korea turned from apocalyptic to cryptic. Indeed, it
began to look that the shock heard ‘round the world could be mere Marxist
schlock. Some commentators suggested the explosion might be nonnuclear, and others dismissed it as barely a burp. North Korea responded by
saying it was planning other test explosions.

If the North Korean situation retreats back to Page 16, the yen should rally
back past 115, leaving the BOJ free to set its lending rates in response to
Japanese inflation and GDP rates. Japan finally has some inflation, but, like
rainfall in Abu Dhabi, it is not at a rate high enough to register anywhere
else in the world.

Arguing against that outcome is the possibility that Japan will choose to
withdraw from the Nuclear Non-Proliferation club. Foreign Minister Taro
Aro raised that issue last week, but Premier Abe swiftly quashed it—with
Condoleezza Rice already in the air for a visit with Japanese leaders. Japan
is letting China know that if it keeps saying that nothing remotely nasty

October


Basic Points


must be done to North Korea, then Japan would have to reconsider its no-
Nuke pacifism. That would threaten The Great Symbiosis and would
unsettle more than the bond markets. We see that development as
unlikely—at least in the near term.

Conclusion:

Some time next year, central banks globally should show signs of easing.
Then the next boom for commodity stocks—coinciding with what we have
called the Third Movement of the Mining Sonata—will be born.

How will it differ from its predecessor?

We think the list of raw materials that will be the objects of unprecedented
ardor will be longer. We also expect more participation from Asian portfolio
investors, and from Asian-based commodity corporations—both private
sector, such as Tata Steel, and the government-controlled entities, such as
CNOOC. At some point, Asian decisionmakers will question a policy of
accumulating American bonds when their own robust growth continues to
raise the value of commodity-producing companies controlled by OECD
investors. Those who are collectively enriching a handful of pipers may
decide that merely calling the tunes is not enough: they should buy the
pipers.

There is a tradition of natural philosophy in Asia that could, perhaps,
influence the way governments and wealthy investors in that region look at
the future, and how they might place their bets—for both capital investment
and portfolio investments.

Like much other wisdom of the Orient, this ancient tradition offers financial
wisdom to investors everywhere. Everything really old is new again.

The Fabled Four

The concept of the Four Elements—Earth, Air, Fire, and Water—originated
with Zarathustra, the founder of what most scholars consider the first
monotheistic faith—Zoroastrianism—which is today considered the oldest
continually-practiced religion in the world.

During its multi-millennial history, Zoroastrianism has influenced all the
major religions that were founded in the Mediterranean and in Western and
Southern Asia. For example, The Three Wise Men, whose journey to
Bethlehem was recounted by St. Matthew, are thought to be Zoroastrians.

“...merely calling
the tunes is not
enough: they
should buy
the pipers.”

October


"...[Zarathustra’s]
most enduring
importance comes
from his
identification of
the four elements
of the natural
world—Earth, Air,
Fire and Water..."

Herodotus wrote of Zoroastrians approvingly, which is notable because he
wrote about the wars between Greeks and Persians, at a time the Greeks
were accustomed to calling Asians “barbarians,” and his countrymen
rejected monotheism until Christian times.

Little is known about Zarathustra, including where or when he was born,
with some scholars claiming prior to 2100 B.C. and a minority saying a mere
600 B.C. There is even disagreement about the meaning of his name: one
tradition is that it means “keeper of old camels,” and another “bringer of the
Golden Dawn.” Most people today who can identify his name associate it
with the dramatic theme music of the movie “2001”—Richard Strauss’s Thus
Spake Zarathustra. Nietszche’s book of that name is probably best-known for
its inclusion of his famous assertion “God is dead.” However, that savagely
irreverent book had no more to do with the founder of Zoroastrianism than
those childish Danish cartoons had to do with the founder of Islam.

Apart from the continued practice of his religion by Parsis, his most
enduring importance comes from his identification of the four elements of
the natural world—Earth, Air, Fire and Water—and then populating it with
three biologic forms—animals, plants, and humans.

Zoroastrianism has exerted an influence on Indian history out of all
proportion to the numbers of Parsis, who currently number less than sixty
thousand. (In the whole world, their number is said to be less than
140,000.) There have recently been some attacks on Parsis by Hindu
extremists, particularly in Mumbai, (as described in Rohinton Mistry’s
noteworthy novel Family Matters). This is due, in part, to the great
commercial success of leading Parsi families, such as the Tatas, but also to
the sect’s practice of handling their corpses: their strict rules against
pollution of the four pure elements forbid them from practicing either
cremation or burial—on land, river, or sea. They leave their deceased at
elevated locations to be eaten by vultures, a practice that the Hindus
tolerated—barely—when Bombay was less populous and much poorer.

Empedocles is credited with introducing Zoroaster’s Four Elements into
Greece in 460, and Plato and Aristotle subsequently embedded them into
Greek science. As with most of the rest of Greek high culture and science, the
Romans adopted the Four Elements, which meant they made their way into
Catholic science and natural philosophy. Buddha’s followers apparently
learned of the Elements from Zoroastrians in India, and took the concept to
East Asia, Japan and China. Islamic scholars, who by 1100 were the world

October


Basic Points


leaders in mathematics and natural philosophy, adopted the principle,
thereby confirming it as the regnant view of reality until the discovery and
adoption of the Periodic Table in the 19th Century.

Why think about such outdated science today? Yes, it continues to have
influence among astrologers. But, more importantly, it has great influence
among environmentalists. The concept of holism—the basis of ecology—is
rooted in the idea of the Four. That these elements, which together make up
the external environment, have worth in themselves and not merely because
of their utility to humans is the basis of thoughts about the natural world
over the millennia—by scientists, moralists, preachers and poets. As an
example, consider Mohammed’s striking statement that when Doomsday
comes, if a man has a palm shoot in his hands, he should plant it. That there
will be no people to enjoy it is irrelevant: God will see it.

How do the Four Elements help in structuring a long-term investment
philosophy?

Because the effects on the planet from the addition of a billion or so Asians
to the ranks of the global middle class will be particularly obvious on the
Four Elements.

The Earth, and the Fullness Thereof

People living at the subsistence level barely enter the global pricing
structure, and rarely influence it. People who move to the middle class have
demands that affect the prices of a wide range of raw materials and show up
in the global balance of trade statistics. Wealthier people, however, spend
most of their money on services and high-end merchandise, not raw
materials.

First there was the Flat Earth. Then came the Round Earth. Now we are in
the process of creating the Whole Earth, which is, in Thomas Friedman’s
phrase, flat for the purposes of global trade in goods and services and
increasingly covered with networks of liquidity flowing across national
borders in the financial equivalent of oceans, lakes, rivers and canals.

The Whole Earth, the creation of the interaction of globalism, geopolitics,
and environmentalism, feeds on resources through its digestive and
circulatory systems, but needs growing intake of water and energy, and is
more and more vulnerable to air pollution. It may also be at risk from

“First there was the
Flat Earth. Then
came the Round
Earth. Now we are
in the process of
creating the
Whole Earth...”

October


“Globalism...doesn’t
exist: Microsoft
Word still puts a red
line underneath it...”

climate change—either the kinds that have occurred over the millennia, or
a modified form caused by over-production of one of the system’s most
basic needs—carbon dioxide.

Globalism, arguably the most controversial and challenging concept of our
time, is a word that has been around for many years. However, by at least
one widely-used test, it doesn’t exist: Microsoft Word still puts a red line
underneath it to signal that it is non-existent. (Dear Bill: Before you retire from
Microsoft to devote yourself to philanthropy, you should call the holdouts among
your programming staff, and make the point that “The Battle for Seattle,” which
was among the first large-scale riots against globalism, occurred a long time ago.
Your programmers should face up to defeat and admit that globalism exists.)

Globalism may have provoked more riots than insults to Mohammad, or
even American policy in Iraq. It is routinely demonized by critics ranging
from Noam Chomsky on the far Left to Pat Buchanan on the far Right to the
AFL-CIO to Jacques Chirac to Vladimir Putin and to Arab and Hindu
leaders, as the intellectual excuse for imposing American capitalism and Big
Business practices on the whole world. This, they scream, is the New
American Imperialism.

Although the word “globalism” is used widely as a term of reference—or
rage—it means different things to different people and different interest
groups. The long-standing definition seems to be “a policy promoting
globalization,” or “promoting world government.” But it is generally used
in connection with international organizations involved in global trade and
economics, such as the IMF, WTO, NAFTA, and the kind of globe-trotters
who schmooze at Davos.

What interests us for this essay is that the trend toward globalism in trading
of goods and services, and in financial liquidity flows, promotes
productivity growth, which means faster economic growth, and stronger
financial markets—worldwide. But growing productivity and faster
economic growth put greater strain on resources and the environment. For
example, it has been estimated that computers, networks, and servers could
account for half of the increase in American electricity demand by 2015.

October


Basic Points


What may be useful in defusing the kind of wrath, fear and prejudice that
animate discussion of globalism is to cast it into a series of challenges:

1. How can we extract enough oil and gas from the Earth so that, with
reasonable conservation measures in the US and OECD, there is enough
economically available energy so that Third World countries who adopt
modern economic, financial, agricultural and governance practices can
realistically expect that their children and grandchildren will be able to
lead lives approximating those of inhabitants of the First World?
2. How can we produce enough vegetable protein to provide for the
biofuels we shall need as oil and gas resources dwindle, while also
generating enough protein to enable the hundreds of millions of new
middle class people in Third World countries to enjoy diets comparable
to OECD residents today?
3. How can we smelt enough metals, run all the factories and refineries the
world will need, and operate all those cars and trucks and still have air
pure enough to promote health and growth—for humans and animals?
If global warming is indeed a major threat to our future, how do we cut
emissions of greenhouse gases in the First World without a serious and
permanent decline in our standard of living? How can the Third World
attain our living standards without inflicting irreparable damage on the
global environment?
Globalism & the Four Elements

Globalism is a dynamic, yet reasonably coherent structure for continuous
expansion of ownership, production and distribution of goods and services
worldwide. Therefore, international trade will grow far more rapidly than
global GDP. Its intellectual roots are in the ideals of free trade, as outlined
by the great liberal political economists, such as Adam Smith and
David Ricardo.

It is instructive, then, to look back at why the world order that evolved in
response to their ideals broke down under the weight of protectionism and
autarky, a collapse that led to World War I and to the Great Depression.

The 19th Century was Britain’s Century. What made Britain the richest nation
was its pre-eminence in innovation, manufacturing and trade. Britain
became the first country to make free trade the cornerstone of its economic
system. Not only did the Industrial Revolution begin there, but Britain

“The 19th Century
was Britain’s
Century.”

October


“...trade followed
the flag, and the
flag kept finding
new places to fly.”

remained the world leader in science and technology for most of the 19th
Century. The British Navy (that continued to style itself “Nelson’s Navy”)
ruled the waves, which meant that piracy, government-sponsored or
otherwise, was rarely at a level that hampered global shipping unduly. That
navy also implemented Britain’s policy of ending the slave trade, by
interdicting slave ships at sea. The concept of free trade was reified, in part,
because of the superiority and ubiquity of British shipping—military and
merchant.

Backing this progress was the British Empire, which was not conceived as a
coherent Grand Design for imperialism, but arose as a result of series of
oversights, accidents, adventurers, and opportunities, often in morals-driven
campaigns against odious regimes. Still, there is no doubt that most of these
political ventures were sold to doubting Prime Ministers with the argument
that British commerce would benefit. The loss of the American colonies
gave empire-building a bad name with liberals, but “trade followed the
flag,” and the flag kept finding new places to fly.

In particular, the flag found places that produced the raw materials British
industry and commerce needed. When France later industrialized, its
leaders also saw the value in establishing ownership of sources of essential
materials. Even Belgium got into the act. By the time Bismarck and friends
had unified Germany, and German manufacturers were building worldwide
reputations, most of the world’s landmass was off limits to new imperialists.

British industrialists’ growing dependence on raw materials produced
within the Empire meant that pressure from Germany to create its own
empire had to be resisted. When the Dutch in South Africa threatened to
take that nation’s vast mineral wealth away from Britain, then a “virtuous”
war against dastardly Boers was inevitable.

World War I was about far more than Germany’s insistence on gaining
commodity-producing colonies for its fast-growing industries, but the three
decades of growing competition between Germany on the one hand and
France and Britain on the other for overseas raw materials production—and
overseas markets for its industrial output—was an important factor.

What evolved as the ideological challenge to free trade was the concept of
autarky: a Great Power needed to be self-sufficient in what it needed, so it
would not rely on foreign suppliers. Not only would an autarkic nation be
economically stronger than a nation of traders (or, to use Napoleon’s
epithet, “shopkeepers”), but it would be stronger in war. Hitler was, of
course, a strong proponent of autarky.

October


Basic Points


It is with this historical backdrop that we contemplate a world that, after the
end of the Cold War and the advent of WTO, was evolving along 19th
Century lines of free trade and low inflation.

Then began the rise in commodity prices.

Then began China’s rush to acquire commodity production abroad, with
special emphasis on pariah states such as Sudan, Burma, and Iran.

Then began India’s rush to follow the Chinese model of overseas
dealings.

This neo-autarkism of the newly-industrializing powers is a disturbing
reminder of Germany’s rush to make up for lost time in terms of control of
important raw materials.

It lends special urgency to the question of longer-term commodity
investing. Will the supply of politically secure commodity-producing
countries shrink even faster than it has in the past eight years? Will the rush
to industrialization in those two heavily-populated nations mean a growing
assault on the global reservoir of clean air?

For investors, this new kind of large-scale competition for control of
strategic raw materials supplies means that owning shares in leading
commodity-producing companies should be the basis of an investment
policy for coming decades. During times when commodity stocks sell off,
such as in May-June of this year for metals, and this autumn for oil, takeover
and buyout bids appear (e.g. Inco, Falconbridge, Shell Canada). In effect,
major commodity-producing companies and foreign government-
controlled companies substitute for private equity in terms of bidding for
companies whose shares become bargains the market will not recognize.

The Four Elements and Long-Term Investing

Earth

Although the world’s population growth is slowing, and most OECD
countries face population declines within the near future, the global
demand for resources from the Earth will climb as hundreds of millions of
people who now live subsistence existences move onto the list of
measurable consumers. This trend will last for at least two decades.

“...neo-autarkism
of the newly-
industrializing
powers is a
disturbing
reminder...”

October


“...forecasters are
now beginning to
grasp...that...future
generations will
not overrun the
planet like the rats
in Hamelin...”

(a) Food
For two centuries, people have been arguing whether Malthus, a
conspicuously gloomy Hobbesian, was right that the world’s population
would always and inevitably exceed its food supply. The Club of Rome,
composed of some of the trendiest intellectuals of its time (including Pierre
Trudeau) adopted Malthus with the ardor some of Hollywood’s trendiest
types would later lavish on Scientology.

Perhaps the most significant intellectual shift of our time is away from that
modern Malthusianism. What forecasters are now beginning to grasp is
that, while future generations will not overrun the planet like the rats in
Hamelin, the rapid growth in numbers of those whose consumption
patterns put strains on the Earth’s resources signals a significant shift in
income patterns away from secondary producers and suppliers of services to
primary producers—farmers, fishers, miners, and oil producers. This is a
reversal of the pattern that has applied for most years since the arrival of the
Industrial Revolution. For two centuries, raw material prices trended
downward relative to finished goods and services. The share of the global
pie allocated to primary producers shrank except during brief periods
characterized by massive crop failures or economic booms, or
geopolitically-driven shortages.

When those Club of Rome glitterati gathered to discuss the inevitability of
global starvation over six-course dinners washed down with fine wines, the
OECD countries’ birth rates had already begun their collapse, and the
Rockefeller Institute scientists were already demonstrating how the Green
Revolution would expand global food production to undreamt-of heights.
Three decades later, we hear that the Saudis have begun to ponder publicly
the implications of a global population implosion that will begin by mid-
century, which will put a cap on Saudi revenues, but will extend the life of
the Kingdom’s oil reserves well into the next century.

The belief that humanity’s biggest problem is babies is becoming less
fashionable. Warren Buffett, for example, had long promised that his vast
fortune would be heavily allocated to population control, but he has
decided to give it to the Bill and Melinda Gates Foundation, which is
primarily devoted to keeping babies and other people alive.

The huge growth in the middle class in China and India has already begun
to show its power through the pricing of oil and metals. As that expansion

October


Basic Points


of the bourgeoisie continues, the pressure on mineral resources can only
intensify.

What is now becoming clear is that if China and India continue to grow at
the rates they have achieved over the past dozen years, then the second stage
of middle class lifestyle will become the norm for an extra billion or so
people over the next twenty years. That second stage, which comes after
people move into a dwelling with indoor plumbing, electricity and basic
appliances, is the upgrading of diets—most specifically, a sustained increase
in animal protein consumption compared with the diets found among the
rice bowl rural population and lower-class urban dwellers.

What happened to African-Americans as their diets improved over the past
century is illustrative, (as evidenced by US military and sporting records).
They grew taller and heavier when they graduated from cornpone to meat
and fish. Comparisons of recruits for WWI and WWII showed the
improvement in black physical conditions. The Korean War and Vietnam
War statistics showed that this had become a sustained trend.

The mostly-black rosters of the NBA and NFL testify to the remarkable
physiques these athletes have attained—mainly because of the meat.

Admittedly, vegetarianism of various kinds is more common in India than
even in Beverly Hills, (let alone the rest of the US). India’s Jains are pure
vegetarians—they even try to keep their mouths closed when insects are
flying around, lest they swallow one by accident. Many Hindus also are.
Nevertheless, it is reasonable to assume that demand for meat and fish will
grow faster than the world’s population will increase.

Poultry is the most efficient farm-bred converter of vegetable protein into
animal protein—2.5 grams of vegetable protein to produce one gram of
animal protein compared, with 3.5/1 for pork or beef. What the history of
North American diets shows is that, except where religious or other taboos
apply, middle and upper class people who try to avoid red meat in their
diets have trouble stickin’ with chicken. What is known in the fast food
trade as “Chicken saturation” doesn’t mean that chickens overrun the land:
it means that a steady diet of industrial-style broiler chickens eventually
palls. Eventually, a craving for bacon, or lamb and/or steak emerges.

The kinds of red meat chosen may depend primarily on religious taboos. A
spectacular example of the potency of those taboos occurred in India.

“...the second stage
of middle class
lifestyle will
become the norm
for an extra billion
or so people...”

October


“...the EU’s fishing
fleet wiped out
Newfoundland’s
cod fishery, which
had survived four
centuries of heavy
harvesting.”

Next year is the 150th Anniversary of the Indian Mutiny, which was caused
by a bureaucratic blunder in the British War Office. London sent out a new
style of greased cartridges for use in the Enfield Rifles. The soldiers had to
bite off the end of this new bullet before sliding it into the gun.

From whence the grease? Opponents of the Raj had long tried—with little
or no success—to convince Indian troops serving in the Army, (known as
sepoys) to rebel and drive out the imperialists. They saw their opportunity
and began spreading rumors that the grease came from processing meat.
They told Muslim troops that it was pork fat, but assured the Hindus it was
cattle fat. Despite denials, the two native religious groups who together
made up the overwhelming majority of the population of sepoys in the
Indian Army were so alarmed that their souls would be at risk from eating
forbidden substances that, for the first and only time during the two
centuries of British rule, they united in a widespread rebellion against
Britain that left thousands dead.

The point of that story is that food taboos can be important. When Tyson
Foods bought IBP (the former Iowa Beef Processors), the world’s biggest
feedlot operator, it knew that its long-term growth in export markets would
include China, and the Muslim world, but the majority of the people in
India would reject beef in their diets no matter how rich they became.

If another half-billion people become used to animal protein in their diets,
how will it be produced?

If they all want fish, and those fish have to be caught at sea, then the fish
population of the oceans will vanish within a decade, like the buffalo and
passenger pigeon. In only a few years of uncontrolled, taxpayer-subsidized
use of advanced technology, the EU’s fishing fleet wiped out
Newfoundland’s cod fishery, which had survived four centuries of heavy
harvesting. The Chilean sea bass already faces a similar fate. Aquaculture,
despite its environmental risks is, in the long run, the only technique for
meeting soaring fish demand.

That means increasing the supply of corn, soybean meal and other high-
protein fish feed.

But soaring demand for feed grains from poultry, beef, pork and lamb
producers will provide stiff competition for the aquaculturists.

October


Basic Points


We believe that the long-term outlook for demand for soybeans, sorghum,
corn and other feed grains is excellent. Given the sharply-rising demand for
these crops as biofuels (see discussion below), the challenge will then be to
produce enough for animal feeding.

The most obvious route to meeting this expected increase in demand is to
boost yields per acre. Attendees at the BMO Capital Markets Conference
“Food For Thought” last month learned that Monsanto is continuing to
develop hybrids that will boost yields—dramatically. They already have
developed some hybrid corns that could mean production of 300 bushels
or more per acre—nearly double current production rates.

Monsanto (MON)
October 2000 - October 2006



That kind of growth in output means a proportional growth in inputs.
Although organic farming products continue to gain market share in the
Neiman Marcus of foodstores—Whole Foods and their ilk—we suspect that
few of those hundreds of millions of new Asian consumers of meat and fish
will reject meat or fish fed on grains produced with chemical fertilizers, and
protected with chemical herbicides and pesticides.

“...organic farming
products continue
to gain market
share in the
Neiman Marcus
of foodstores—
Whole Foods...”

October


Potash Corp. (POT)
January 2000 - October 2006


“...we cannot
take...wheat...for
granted.”


Deere (DE)
January 2000 - October 2006



Meanwhile, we cannot take the world’s supply of the most basic food
commodity—wheat—for granted.

Wheat
January 2000 - October 2006


October


Basic Points


To the casual observer, wheat is always in oversupply, and governments are
always falling all over themselves to sell—or give away—their farmers’
excess wheat. Wheat production is subsidized in many of the OECD
countries, and some of the most bitter battles within the WTO are about
wheat export subsidies.

But behind the blather, global wheat demand has outrun supply for most of
the time in recent years, a condition that has begun to sound eerily similar
to oil. According to the Financial Times, global yearend crop carryover this
year will be 119 million bushels, down from 146 million last year and 208.9
million at the depths of the commodity Triple Waterfall crash.

Unlike the mining industry’s response to high prices, when wheat prices
soar, farmers respond by producing more wheat. Wheat prices have risen
dramatically because of a severe drought in Australia, which ordinarily
accounts for roughly one-seventh of the global wheat trade, at a time of
restrained production in many major wheat-producing regions worldwide.

That leap in wheat reveals an essential fragility: to the extent that farmers
have been shifting production from wheat to the more profitable feed grains
as ethanol and biodiesel provide new markets for those grains and oilseeds,
then the basic supply/demand of wheat may have been altered.

The runaway inflation of the early 1970s is generally (and erroneously)
blamed on the trebling of oil prices after the Arabs attacked Israel on Yom
Kippur. (That unfair allegation would become the basis of many anti-Arab
and anti-Muslim libels.) But a closer look reveals that wheat’s leap from
$1.65 a bushel to $5 had at least as big an impact on global inflation,
because it stimulated hoarding and speculation in foodstuffs, and food
processors used the cover of the inflation mania to boost prices of their
products far above the increased cost of their inputs. A typical loaf of bread
in which the cost of wheat was a nickel might double in price, and the
bakers would blame farmers and speculators.

The world’s supply of arable land is barely adequate to meet global grain
demand for food for people and livestock, under existing production
conditions.

If governments and NGOs stop their campaigns against genetically
modified crops that can resist pests, weeds, and reduced rainfall, there’ll be
plenty of grain for all uses—and abuses.

“...behind the
blather, global
wheat demand has
outrun supply for
most of the time in
recent years...”

October


“...nobody ever
went broke
overestimating
bureaucracies’ and
NGOs’ abilities to
impede food
production, or, for
that matter, to
protect flying
insects carrying
such diseases as
malaria, yellow
fever, and
encephalitis.”

But prejudice, irrationality and defense of vested interests are the staff of life
to many bureaucracies and NGOs.

So wheat may yet go to $6 a bushel. H. L. Mencken observed that nobody
ever went broke underestimating Americans’ good taste. Similarly, nobody
ever went broke overestimating bureaucracies’ and NGOs’ abilities to
impede food production, or, for that matter, to protect flying insects
carrying such diseases as malaria, yellow fever, and encephalitis.

(b) Oil and Gas
As we have long been documenting, the world’s capacity to produce
conventional light oil is under severe strain. Many major fields have peaked,
others are peaking, and the big new fields coming on stream mostly
produce heavy crude—or ultra-heavy unconventional crude.

More importantly, publicly-traded oil companies are running out of
politically-secure places to find and produce any kind of oil. Meanwhile,
public resistance in the OECD nations to opening new refineries remains
formidable.

OPEC is once again in the headlines, because oil prices are weak and the
cartel is being brought back from the margins of the global economy to do
the exact opposite of what it was being begged to do for three years—drive
down oil prices.

OPEC is scrambling to cut production to prop up prices. It may succeed, but
it is now manifestly a one-way cartel: it can cut production during short
periods of modest oversupply, but it cannot bring on enough new
production to meet rising demand and keep prices within a narrow range.

If Hugo Chavez hadn’t booted out so many engineers at PDVSA and if the
Iranians were reinvesting in oil wells instead of deploying their oil profits
into nuclear weaponry and Hezbollah, OPEC could be producing as much
as three million barrels daily above current global demand. To that extent,
those who have been predicting oil oversupply have sound reasons: if OPEC
were run by wise governments, we could see adequate oil supplies, because
the oil is there. But we skeptics recognize that Chavez and his allies, the
Mullahs, have more important goals than maximizing oil production.

Apart from mismanagement among oil producers, there will probably also
be a continuation of the declines in production of light oil from Ghawar,

October


Basic Points


Cantarell, the North Sea, and other key fields. Oil fields are like the rest of
the natural world: their production isn’t infinite and it is subject to the aging
process. Yes, there is lots of oil to be found and developed, but most of it
won’t come anywhere near as cheaply as the oil from existing fields that are
already in decline.

That nature has limits was understood as far back as Zarathustra.

How strange that some people still try to allege that this law applies to
everything in nature except oil.

c) Minerals

Until Classic Times, human eras were classified according to the minerals
they used for tools and weapons. By Zarathustra’s time, Egyptians and
Sumerians had been making copper alloys and smelting gold and silver for
a millennium.

Although the mining industry is today small in relation to global GDP, and
the capitalization of mining stocks is small in relation to global stock
indices, investors have been rediscovering the attractions of the group.

Yet the stocks are, arguably, the cheapest they have ever been, in relation to
earnings and proven reserves. That scanty valuation is rooted in three well-
known features of modern mining history.

1. Over the centuries, the industry had a terrible record for looking after
the earth and air—and the local inhabitants and animals—around its
operations. “The evil that men do lives after them.” Long-bankrupt
mining companies left scars on the land, and diseases in the lungs of
former employees. That historical insensitivity and brutality feed today’s
litigators and radical politicians in the Third World—where most of the
untapped reserves remain.
2. Everyone knows that the industry is a world leader in self-inflicted
wounding. It has a long record of bringing on major new production
late in the economic cycle—and/or after the next recession has begun.
3. That ill-timed capex program has always meant that the industry’s
balance sheets are most burdened with debts—and its inventories most
burdened by excess production—once the next recession is under way.
Metal prices that were sliding because of a recession would collapse as
hapless, debt-laden producers unloaded their output for whatever they
could get.
“Everyone knows
that the industry is
a world leader in
self-inflicted
wounding.”

October


“...latte liberal
vegetarians like
Jeremy Rifkin, who
inveighed against
bovine flatulence.”

It is true that investors who do not learn from history are destined to repeat
it. But this time, the executives of the mining companies, who managed to
survive the Triple Waterfall Crash have learned the lesson that the industry’s
history is a series of horror stories, and they are unwilling to write any new
chapters. Their balance sheets are pristine; and inventories are at near-record
lows. Nor is the temptation to bring on new production irresistible: most of
their most attractive untapped orebodies are located where the political
risks are the greatest. Result: companies are happier buying each other and
buying back stock than putting money back into the earth.

Air

The followers of Zarathustra didn’t have to worry about air pollution for a
few thousand years. Now, the 20 large cities with the worst air pollution are
in China and India.

Cars, trucks, trains, electrical generation, smelting base metals and steel,
refining oil, and manufacturing petroleum or natural-gas-based plastics are
major sources of urban air pollution. (On the other hand, ask Iowans or
Carolinians who live within a few miles of one of the major modern
piggeries whether country air is any better than Beijing’s and you can expect
an expletive-strewn reply.)

One potential advantage of the discussions about what is alleged to be the
greatest threat to humanity since DDT—global warming—is that it could
focus attention on the damage inflicted on people, animals and the
environment by large-scale air pollution. Until recently, it often seemed that
most of the articulate polemics about bad air came from anti-smoking
crusaders, and latte liberal vegetarians like Jeremy Rifkin, who inveighed
against bovine flatulence.

For those of us who remember the 1970s, when scientists were as united in
warning of a new ice age as they now are in warning of warming, our main
hope in the global warning debate was that it would intensify the demands
to clean up the air. However, those whose goal is solely to combat global
warming candidly admit that the coal-burning plants in China and India
help fight global warming by filling the sky with gases and particulates that
make the air as dark as Dickensian London.

October


Basic Points


Fire

It is a natural progression from discussion of preserving clean air to
discussing the challenge to the environment from fire.

Open flame fire evokes atavistic urges because it is associated with the
Promethean liberation of primitive man from the twin dominations—of
the gods and of the Hobbesian natural order.

Perhaps the most dramatic form of fire is the forest fire. We were raised to
believe forest fires were caused by bad people—careless smokers and
drunken campers. Watching films of fires engulfing vast areas, with trees
many decades old going up like matchsticks, was a powerful message to
protect the environment. Remember Smokey the Bear? He’s now outdated,
because governments now have learned to set forest fires as part of the
process of “resource management.” (They still have a way to go in their
learning, as shown by the disastrous Los Alamos fire, set while the birds
were on their nests.)

Fire is important as an investment theme: combustion, (for power
generation and transportation), will continue to drive the engine of global
economic growth. As the competition for available oil and gas (and biofuel) intensifies, energy generated by atomic fission or fusion will rise in
importance. Few governments will have the mettle or might to supplant
human development of lands for a Three Gorges-scale of hydro-electric
project.

An example of how manmade fires can create new kinds of environmental
challenges has been acid rain caused by large-scale burning of high-sulfur
coal. It has been decades since Canadians living in Central and Eastern
Canada first began to demand that the US control the smokestack emission
producing “acid rain”—precipitation with highly acidic concentrations of
H2SO3, H2SO4 and NO that were particularly devastating to hardwood
forests. The prime sources of these pollutants were coal-burning electrical
generating plants. The two nations reached agreements on controlling such
pollutants, but the research for those programs has gained new relevance in
Asia, as the booming economies of India and Asia fatten on coal-fired
electricity.

According to the World Coal Institute, China produced 2.226 billion tonnes
of coal last year, double its production in 2000. That coal is mostly used to
produce electricity and smelt metals. Although India also has enormous

“...the booming
economies of India
and Asia fatten
on coal-fired
electricity.”

October


“The anti-nuclear
forces have carried
the day almost
everywhere
outside France.”

reserves of coal, it only produced 398 million tonnes, which means its
contribution to global air pollution is still a small fraction of China’s. But
it’s growing.

Assuming that oil prices remain high, it is crucial that technology be
implemented to burn coal cleanly or to turn it into gas—as does Sasol,
(which uses the technology that helped Hitler survive the loss of much of
his oil production, and South Africa to survive the global boycott.)
Otherwise, even the Pacific won’t be big enough to protect the Americas
from Asian-generated acid rain.

Sasol (SSL)
January 2000 - October 2006



Those hundreds of millions of new middle class Asians need heat and
electricity and transportation. If North America and non-French Europe
continue to reject construction of new nuclear electrical plants, then the
implications for global warming and air are obvious: greenhouse gas levels
will continue to increase, and cities will continue to have problems with
particulates and ozone.

The anti-nuclear forces have carried the day almost everywhere outside
France. It is ironic that the European nation whose foreign and trade
policies are among the most emotional and irrational is—by far—the most
rational on energy policy.

We are regularly asked why we have not included uranium stocks in our list
of base metal companies that benefit from the growth of China and India.
The answer is that when we are out on the road visiting institutional
investors, we have had a hard enough time getting people who’ve never
owned an oil or mining stock to consider our case for a commodity boom
without raising the emotive issue of nuclear power. Speaking to groups of

October


Basic Points


mostly youthful investors in the Northeast and California who came into
the business in the tech era is a real challenge. Clients who have graduated
from elite universities with a natural affinity for tech stocks have trouble
investing in the “polluting sunset industries” such as mining and oil.
Mentioning the investment merits of uranium to liberal arts graduates of
leading universities, many of whom demonstrated against building nuclear
power plants, is rather like promoting Jane Fonda films to Vietnam veterans.
The Storm King nuclear plant in upstate New York suffered from three
problems that were not of its own making—Three Mile Island, Chernobyl,
and its proximity to so many non-engineering institutes of higher learning.

We can hardly discuss the Four Elements without discussing nuclear power,
so we are breaking our silence on the subject. We suggest that clients review
the merits of nuclear power in the light of recent studies that show that
America faces an electricity crisis in the next decade unless it rapidly
expands its electrical generating facilities. Nuclear power, like hydro power,
emits no air pollution—either of the toxic or greenhouse gas variety. As for
hydro, there aren’t many big new hydro sites outside of Northern Canada,
and those Pacific Northwest plants already built have devastated the salmon
industry.

The vehicles for investing in uranium are limited. Cameco is the biggest
uranium pure play, but its aggressive hedging strategies make it problematic
for those who accept our criterion: “unhedged reserves in the ground in
politically secure areas of the world.” Its recent calamity at its key Cigar Lake
mine illustrate the perils that even the biggest mining companies can face.
BHP Billiton, whose Olympic Dam mine will likely become the world’s
largest single uranium-producing orebody, is the world’s largest mining
company, so uranium will never be more than a small share of its total
profitability.

Cameco (CCJ)
January 2000 - October 2006


“The Storm
King...suffered
from three
problems that
were not of
its own making—
Three Mile Island,
Chernobyl,
and its proximity
to so many
non-engineering
institutes of
higher learning.”


October


“...the dread that in
the past was felt
about a moonlit
graveyard infested
with werewolves
and vampires...”

BHP Billiton (BHP)
January 2000 - October 2006



There are, however, quite a few junior pure plays. Our compliance rules
prevent us from making specific recommendations, but we suggest that you
contact your BMO Capital Markets representative for details.

We believe that nuclear power is about to enter its second growth phase, and
recommend that clients include uranium producers in their portfolios…

Even if they demonstrated against nuclear plants when they were young.

After all, when ecology guru James Lovelock, who invented the concept of
Earth as Gaia, a superorganism, can come around to comparing fear of
nuclear power plants to “the dread that in the past was felt about a moonlit
graveyard infested with werewolves and vampires” there has to be hope for
the nuclear solution.

The biggest argument for nuclear power is the biggest argument of our
time—global warming. Believers in global warming will be forced,
ineluctably, to endorsing nuclear power.

On the other hand, skeptics on global warming can keep right on shouting,
“No More Nukes!”

Water

Until now, we have not included water in our commodity discussions. That
is not because clients have never asked us about investing in water, it has
been a matter of investment focus.

October


Basic Points


We have concentrated our efforts on investing in largely unregulated
commodities and industries. The water industry, until recently, had been
heavily regulated, with comparatively few investment opportunities.

But, in trying to construct a theoretical basis for an investment policy that
stretches deep into the next decade, water needs to be included.

We were reminded of that importance as we were working our way through
Indian philosophy and history. My three weeks in India will be spent mostly
in Rajasthan, where my family lived and worked. Although Rajasthan is
home to a major desert, it has historically gloried in its abundant water
supplies. We read of those beauty spots in the books that had been in the
family for years. Its lakes were the sites of some of the most spectacular
architecture in India. Now, we learn, the growth in population and in the
agricultural and industrial use of water has imperiled some of these historic
places.

Water is also an important factor in a long-term appraisal of our most
frequently-discussed commodity story—the Alberta oil sands—and more
recently, in trying to appraise the scale of Saudi oil production over the next
decade. As we have noted frequently, Saudi Aramco says it will need oil
priced at least $32.50 to bring on the next five million barrels a day of
production, mostly because of the costs of waterflooding the heavy crude
fields that will be the backbone of the Kingdom’s production in the future.

(Perhaps if oil prices go to $100 a barrel, the Saudis will revisit a scheme
they were considering in the 1980s to detach gigantic icebergs from
Antarctica and tow them to Arabia as sources of fresh water.)

By coincidence, water investments have rather suddenly become major
financial stories this month. The Canada Pension Plan Investment Board
announced it was committing $C1.05 billion to join a consortium bidding
for a British water company. When the German utility RWE announced it
would sell its interest in Thames Water, deep-pocketed bidders from around
the world materialized. Macquarie, the Australian bank that has figured in
so many mining and infrastructure deals in recent years led the consortium
that won the bitterly-contested competition, bidding $14.9 billion. Among
the other contestants was a team of Qatar Investment Authority and UBS.
Barron’s published an interesting summary of the investment case for water
stocks this week, which coincided with an alltime high for the Bloomberg
World Water Index—which is up by more than 50% since 2004.

“...detach gigantic
icebergs from
Antarctica and
tow them to
Arabia as sources
of fresh water.”

October


“...the idea
of profiting
from water
seemed bizarre.”

Large-scale ownership of drinking water is a comparatively new economic
concept. We recall an article datelined Arizona published in The Economist
nearly forty years ago in which that magazine’s longtime US correspondent
took a trip across the US prior to moving back to Britain. The writer
confessed amazement at the growth of American conservatism. Admitting
that she had spent nearly all her time in New York and Washington, with
occasional trips to Florida and San Francisco, she recounted interviews with
the management and some customers of a privately-owned water company
in Phoenix. To the writer, the idea of profiting from water seemed bizarre.
But she was struck by how comfortable Arizonans were with that
arrangement, and how their views on water derived from an overall view of
the proper limitation on government power. Her conclusion was that she
now understood Barry Goldwater’s popularity, and even ventured the view
that conservatism could someday become a real national force. This was a
sobering thought, because the prevailing wisdom was that Barry
Goldwater’s landslide loss to Lyndon Johnson had buried the Right
forever—and a good thing, too.

If private ownership of water utilities was bizarre back then, it is an everyday
reality now. Perhaps the most obvious advantage of private ownership is the
access to capital for infrastructure expansion and upgrading that is
independent of the constraints of state and municipal budgets. India’s
infamous infrastructure problems are due, in large measure, to that
country’s socialist traditions and the inevitable wrangling, delays, and
corruption that come from a democratic federal structure where private
ownership is widely deemed an unacceptable alternative, and budgets’
primary priorities are giving pay increases to government employees—not
building water projects or highways.

Discussion of long-range water requirements should not be based on static
models. For example, modern plant genetic research about reducing crops’
water requirements has made remarkable progress. Corn production in
Illinois and Iowa this year was robust, exceeding forecasts based on
suboptimal crop moisture conditions due to several years of below-average
precipitation.

Based on our reading of several estimates of needed capital investment for
water transmission and purification over the next decade, there is little
doubt that water is going to be a growing component of basic-materialsoriented portfolios. Within that component will be (1) mature companies

October


Basic Points


who sell water to consumers within a defined geographical area, and they
will be dividend-paying analogs to mature electric and natural gas utilities;

(2) companies engaged in water transmission, and they will be analogs to
natural gas and/or oil pipelines; (3) companies engaged in bringing on new
sources of water, from drilling, or from accessing large sources of fresh
water; (4) companies engaged in desalination; (5) companies engaged in
manufacturing and distribution of water-treatment equipment.
In other words, a diversified portfolio of water investment alternatives will
resemble a portfolio of oil and gas investment alternatives, except there’s no
OWEC to act as a form of global price-setter.

INVESTMENT CONCLUSION

There was once an asterisk to the list of the Four Elements: Pythagoras
added one Element to the Fabled Four, which he called Idea. He thought
that Knowledge was an Element that we all tried, with greater or lesser
success, to access. Socrates and Plato advanced this concept—innate
knowledge—and it is from their work that we have the term “education,”
which means drawing out the knowledge that is already there somewhere—
not putting something in. Although the Empirical philosophers managed to
get rid of the idea of innate knowledge, the question of intellectual property
as an Element—or quasi-commodity—is with us today.

The cyclical bookends for today’s stock market are comprised in those five
ingredients: the raw materials producers on the one hand, and the tech
stocks on the other.

We believe that new ideas come faster than new oilfields and new mines—
and, like anything else that competes vigorously and is readily available—
should be priced accordingly. Moreover, we have learned that the idea-
generating companies devoted a disproportionate share of top executives’
times to crafting stock option plans based on bad ideas about ethics,
honesty, and legality. Of course, we don’t think that all commodity
companies’ managements are ethical and honest and all tech companies’
managements are slimy and dishonest, but finding a completely honest tech
company (in terms of its accounting policies) has become rather like the
challenge confronting the angels who were looking for some good people
in Sodom and Gomorrah. That story has relevance for our themes: it ended
in Fire, and with the fastest formation of a new source of sodium chloride
on record.

“...there’s no OWEC
to act as a form
of global
price-setter.”

October


“Each decade has
its own excesses,
and produces its
own punishments.”

We believe that the sheer scale of the growth of China and India means
that a long-term investment program should be overweighted toward the
goods they will need to buy, and will be underweighted in what they
will produce.

That argues for a far heavier weighting in commodity stocks than tech
stocks. China and India each year graduate thousands of engineers who
want to be involved in creating the Next New Thing that will take market
share from the established tech companies. Information technology is,
among the major industries, the closest to achieving perfect competition.
That is comforting for consumers, but suspenseful or even tragic for
investors.

What is the appropriate weighting for cyclicals in today’s environment?

We remain of the view that the sustained shrinkage of global liquidity
argues for some sort of slowdown from the record global growth rates of
recent years. The US housing bubble has been discussed for so long that it
is unlikely to die by pricking, but it is surely a drag on an economic cycle
that is already mature.

Each decade has its own excesses, and produces its own punishments. The
70s were inflationary and commodity-fixated; the 80s were characterized by
majestic levels of commercial real estate speculation—primarily in Japan,
but also in London and the US; the 90s were the special boom of the
Boomers, which meant a period of joy, self-indulgence, and stock market
excess.

Will this decade be the one that endures the first sustained house price
plunge since the Depression?

We don’t think so, but recognize that not all risks discussed on Page One
should be ignored.

We therefore recommend that clients maintaining strong exposure to high-
quality commodity-producing stocks in the categories we have outlined
should have exposure to the most nearly perfect hedge for those stocks—
long zero-coupon bonds.

October


Basic Points


INVESTMENT RECOMMENDATIONS

1. After four years of focusing on oils and base metals, it is time to add new
commodity-producing sectors to a long-term portfolio.
2. Within the oil group, our favorites are, in order, oil sands, refiners,
natural gas producers, and offshore drillers.
3. Within the base metals group, our favorites are copper, nickel and zinc.
Each time we get enthusiastic about the aluminums, they announce
major new expansions.
4. Uranium should be a core holding for those who can live with the
problem of political incorrectness.
5. Precious metals stocks have corrected from their highs and some are
now attractive. We continue to believe that gold is the clearest value in
the group, although platinum’s attractions are becoming more obvious
as the automobile industry’s catalytic converter decisions become more
platinum-friendly. Silver is a tweener—it isn’t a truly precious metal,
because it tarnishes, but it still has attractions for Indian brides, and
there will be more of them who can afford baubles and bangles. Its
industrial demand has shifted from film production to electronics, but
has remained strong.
6. Financial stocks have performed well, despite the inversion of the yield
curves. We recommend that investors concentrate on those with the best
dividend records. We share the concerns of those who question the asset
quality of some aggressive American regional banks, particularly in real
estate lending.
7. The forest products stocks are a subset of the earth group. Our esteemed
colleague Stephen Atkinson has been telling us that investors are wisest
to focus on the Brazilian producers, and should eschew the Eastern
Canadian loggers.
8. As for agribusiness, there are numerous opportunities. Although the
ethanol boom is at risk if oil prices fall below $50, we are confident that
Congress will continue to cosset ADM and other alternative energy
players. Always have, always will. We believe that the opposition to
genetically-modified seeds will continue to crumble, which means that
Monsanto, DuPont and their competitors are worthy of consideration as
core investments.
October


9. Our case for long zeros is as hedges against economic problems that hit
the commodity stocks. The US economy continues to give mixed
signals, while economies abroad look stronger. Winter should tell the
tale. If, because of continued strong economic growth, you don’t make
money on long zeros, you will profit hugely on your basic materials
stocks.
October


Harris Investment Management Disclosure:

Basic Points is a publication prepared by Donald Coxe of Harris Investment Management, Inc.
("HIM") and BMO Harris Investment Management, Inc. ("BMO HIMI") for the exclusive use of
clients of BMO Nesbitt Burns Inc., BMO Capital Markets Corp., HIM, Harris N.A., BMO HIMI and
Jones Heward Investment Counsel Inc. (collectively referred to as the "Global Asset Managers").

All rights reserved.

The opinions, estimates and projections contained herein are those of Donald Coxe and do not
necessarily represent the opinions of HIM and BMO HIMI as of the date hereof, and are subject
to change without notice. HIM, BMO HIMI and the other Global Asset Managers believe that the
contents hereof have been prepared by, compiled or derived from sources believed to be reliable
and contain information and opinions which are accurate and complete. However, the Global
Asset Managers make no representation or warranty, express or implied, in respect hereof, take no
responsibility for any errors and omissions which may be contained herein and accept no liability
whatsoever for any loss arising from any use or reliance on this report or its contents. Information
may be available to the Global Asset Managers which is not reflected herein. This report is not to
be construed as an offer to sell or solicitation for or an offer to buy any securities. The Global
Asset Managers and their affiliates and respective officers, directors or employees may from time
to time acquire, hold or sell securities mentioned herein as principal or agent. Any of the Global
Asset Managers may act as financial advisor and/or underwriter for certain of the corporations
mentioned herein and may receive remuneration for same. Each of the Global Asset Managers is
a direct or indirect subsidiary of Bank of Montreal. Bank of Montreal or its affiliates may act as
lender or provide certain other services to certain of the corporations mentioned herein and may
receive remuneration from the same.


Company Name Stock Ticker Disclosures

Archer Daniels Midland ADM
BHP Billiton BHP 4
Cameco CCJ 1,2
CNOOC CEO
Deere DE
Dow Jones DJ
DuPont DD
Falconbridge Limited FAL
Inco N 1,2
Microsoft MSFT 2
Monsanto MON
Potash POT 1
Sasol SSL
Shell Canada SHC.TO 1
Tyson Foods TSN
UBS UBS
Whole Foods Market WFMI

(1) BMO Capital Markets or its affiliates owns 1% or more of any class of common equity securities of the company.
(2) BMO Capital Markets or its affiliates makes a market in the security.
(3) BMO Capital Markets or its affiliates managed or co-managed a public offering of securities of the company in the past twelve
months.
(4) BMO Capital Markets or its affiliates received compensation for investment banking services from the company in the past twelve
months.
(5) BMO Capital Markets or its affiliates expects to receive or intends to seek compensation for investment banking services from the
company in the next three months.
(6) BMO Capital Markets has an actual, material conflict of interest with the company.