Mining Mergers & Three Wealth Creation Tools
Part 1
Daniel R. Amerman, CFA
Overview
http://the-great-retirement-experiment.com/Products/Mine%20Mergers.htm
The hottest area for mergers and acquisitions has moved from financial firms to acquiring metals mines. Using the illustration of a $100 billion mega-acquisition, we will show how this strategy can dovetail with the destruction of the dollar to create a new class of mega-wealthy investors, with a $5 billion equity investment reaping a $1.5 TRILLION profit in the example shown. We will then clearly and succinctly demonstrate that the biggest source of these potential profits in real terms does NOT come from where the press articles would have you believe, but is the result of three distinct wealth creation tools. Tools that can also be used by smaller investors to create their own personal inflation-arbitrage strategies.
Mining Mergers & The Great Game
In March of 2007, I published an article entitled “The Great Game, Gold Arbitrage & The Three Little Pigs.” This article explained how the powerful global financial players who risked the destruction of the dollar with their investment games, would turn the destruction of the dollar into an exit strategy that would vault them to all new levels of wealth, even as the dollar was destroyed. The exit strategy that was predicted in that 2007 article is today’s headlines in June of 2008, as shown in quotes from a Bloomberg article that appeared on June 12, 2008:
“Metals are the new green on Wall Street, as mining has displaced financial services to become the biggest source of mergers and acquisitions.
‘We have moved into the age of commodities… You clearly have a large number of mining companies just generating cash and profit like there is no tomorrow’ (Carl Hughes, Deloitte & Touche)
‘There is a global desire to grab whatever resources are available because they are in short supply. There are good times ahead.’ (Tim Goldsmith, PriceWaterhouseCooper)”
Bloomberg, June 12, 2008
The Bloomberg article by Choudhury and Foley is interesting and well worth reading, but let me suggest that the reporters who wrote that article are only seeing a small part of the picture. They believe that the story is the asset play – but there is far more to acquiring mines with other people’s money in these times of rapidly accelerating inflation than a mere asset play. The heart of the game is to arbitrage the collapse of the dollar. As I wrote last year:
“The Great Game has two halves: going long the real, and short the symbol. That is, going long real assets by owning them, and going short the dollar and the financial system by selective and advantageous borrowing. That way if you are a hedge fund manager, CEO or “private equity” investor who has essentially gambled the world monetary system on your speculations, and you collapse the financial markets and the value of the dollar when you guess wrong – you don’t jump out the office window. Instead, you enjoy an extraordinarily lucrative early retirement. Because you still own the real – and by destroying the value of the dollar, this just means that you no longer have to pay back most of what you borrowed to buy the real (in inflation-adjusted terms).”
A Simple Example
To explain what the media coverage is missing – which is the heart of an extraordinary wealth creation opportunity – let’s start with the relatively simple example below:
We start with an assumption of a $100 billion acquisition of a mining conglomerate by a private equity company – a size range that is being discussed. Next we assume that the acquirer is a major private equity group using the time-honored source of funding for such deals: OPM, or Other People’s Money. In this case we assume that $95 billion of the $100 billion comes from banks, insurance companies, pension funds and the like, and that $5 billion is contributed by the actual equity owners (there are complexities, but we are keeping it simple here.)
Then major inflation… happens. It could be a refusal by oil producing nations to accept dollars, it could be an oil and commodities supply shock that spirals out of control, or it could be that the world’s investors eventually accept that the only defense for a fiat currency is a vigorous defense by the nation and central bank – and a Federal Reserve that has pushed interest rates to levels below that of inflation to bail out Wall Street interests isn’t even bothering with going through the motions of defending the value of a symbolic currency. Or all of the above, and more.
Whatever the source, for this illustration we assume that there is a quick 1000% burst of inflation, which destroys 91% of the value of a dollar over the next few years. This means that a dollar would only have 9 cents in purchasing power.
We then assume that metals and other commodities deliver their traditional inflation fighting performance, not only keeping up with inflation – but growing in value at a rate that exceeds the rate of inflation. And that as investors see the destruction of their paper wealth, they will flee to tangible assets as a refuge, and this will push up the values of metals and other commodities, by an average of 25% in inflation-adjusted terms.
As an example, if we say that our metal in the illustration is gold, we start with an assumed gold price of $900 an ounce, and in real terms it rises 25%, then it goes to $1,125 an ounce before inflation. When we then adjust for inflation of 1000% - we are saying that gold has risen to $12,375 per ounce. Rephrased, for the illustration we are assuming a 13.75X increase in the price of the metal, for a nominal return on investment of 1,275%. (Genuinely impressive performance under circumstances that would annihilate the value of most conventional investments, but remember a dollar is only worth 9 cents.)
For a variety of reasons we would expect mining stocks for the metal to grow by an even greater margin, with the core reason being that the value of the mine is not the metals, but the margin by which the value of the metal exceeds the price of extraction, and this should rise at a rate in excess of the rate of inflation. In this illustration, we assume that if the metal rises 25% in real terms, then there is a 50% increase in inflation-adjusted terms for a mine for that metal. So a stock that starts at $100 a share rises to $150 in real terms, then we adjust for inflation of 1000% - and the price of the stock rises to $1,650 a share. Rephrased, for the illustration we are assuming a 16.5X increase in the price of the metal mining stock, for a nominal return on investment of 1,550%.
(Using a price of $12,375 per ounce for gold, or assuming that a share price goes from $100 to $1,650 may seem aggressive, but for a 1000% rate of inflation – these assumptions are very much on the conservative side. If metals were to rise 50% or 100% in real terms, and metal mining stocks were to rise 100% or 200% in real terms (assumptions which are quite justifiable), then the bottom line results shown would be much stronger.)
Turning $5 Billion Into $1.5 Trillion
Now, let’s go to the “Ending Situation, Post Dollar Destruction” section of the illustration. Because the value of the metals mines has risen by 1,550%, the nominal value has gone from $100 billion, to $1.65 trillion. The private equity company still owes $95 billion to outside investors, so after subtracting these outstanding debts, the company has an equity value of $1.5 trillion.
$5 billion + 1,000% inflation = $1.5 trillion
What the “equation” above shows is that if the dollar is destroyed, then a $100 billion metal mining acquisition could work out to be one of the most profitable investments in the history of mankind. Even as the savings of the average person are devastated, we would see the emergence of a new class of mega-wealthy, with wealth that dwarfs anything previously seen in history.
On an individual level, while it might be tough to come up with the initial $5 billion to turn into $1.5 trillion, using different applications of the same methods does open some entirely new horizons. Yes, achieving spectacular returns through simply leveraging investments in metals and metal mines is the obvious (quite risky) surface possibility. But there are also ways for individual investors to dramatically boost their personal after-inflation and after-tax returns, while taking only a small fraction of the risk involved in the illustration above. With sufficient education and understanding, unfair inflation tax treatments can be reversed into inflation driven tax-advantages. Retirees can use some of the tools involved not to leverage up risks – but to strip out risks, and build powerful defenses against the number one threat to retiree finances, that of inflation.
But to achieve any of these goals, we first have to understand what really happened. That requires improving our vision. Which means setting aside (for now) the illusion of nominal dollars, and focusing on the right hand column, when we re-examine each step in inflation-adjusted dollars.
When we look at this column, and we adjust for a future dollar only having 9 cents of purchasing power, then our mining company becomes worth not $1.65 trillion, but $150 billion. Exactly what we would expect for a 50% increase in value, after-inflation. Our equity doesn’t go up by 50%, however. In real terms, after adjusting for 1000% inflation, we go from $5 billion to $141 billion. Meaning at the bottom of our bottom line on the illustration chart, we turned a true $136 billion dollar profit on a $5 billion dollar investment in purchasing power terms. Not $1.5 trillion – but a spectacular, historically extraordinary result nonetheless.
To understand where this spectacular wealth gain came from requires understanding that there was not one, and not two, but three distinct wealth creation tools involved.
(In Part II of this article, we will delve into exactly where the $136 billion in inflation-adjusted profits comes from, and show that neither the mines themselves nor classic leverage are the largest sources of wealth.)
Do you know how to Turn Inflation Into Wealth? To position yourself so that inflation will redistribute real wealth to you, and the higher the rate of inflation – the more your after-inflation net worth grows? Do you know how to achieve these gains on a long-term and tax-advantaged basis? Do you know how to potentially triple your after-tax and after-inflation returns through Reversing The Inflation Tax? So that instead of paying real taxes on illusionary income, you are paying illusionary taxes on real increases in net worth? These are among the many topics covered in the free “Turning Inflation Into Wealth” Mini-Course. Starting simple, this course delivers a series of 10-15 minute readings, with each reading building on the knowledge and information contained in previous readings. More information on the course is available at InflationIntoWealth.com .
Contact Information:
Daniel R. Amerman, CFA
Website: http://InflationIntoWealth.com/
E-mail: mail@the-great-retirement-experiment.com
This essay and the websites, mini-course, books and audio recordings, contain the ideas and opinions of the author. They are conceptual explorations of general economic principles, and how people may – or may not – interact in the future. As with any discussion of the future, there cannot be any absolute certainty. What this website does not contain is specific investment, legal or any other form of professional advice. If specific advice is needed, it should be sought from an appropriate professional. Any liability, responsibility or warranty for the results of the application of principles contained in the website, pamphlets, recordings, books and other products, either directly or indirectly, are expressly disclaimed by the author.
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