Mining Mergers & Three Wealth Creation Tools
Part 2
Daniel R. Amerman, CFA
Overview
The hottest area for mergers and acquisitions has moved from financial firms to acquiring metals mines. In Part 1 of this article, we used the illustration of a $100 billion mega-acquisition to 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. In Part II of the article below, we will 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.
A Simple Example
(The chart above and the growth in nominal dollars from $5 billion to $1.5 trillion are more fully explained in Part I of the article.)
Wealth Creation Tool #1: The Asset Play
For the average individual investor, the asset play may seem to be the heart of what happens here. The financier controls $100 billion in mines, and they become worth $1.65 trillion, for a gain of $1.5 trillion! As discussed above, the problem is that when you discount for a dollar only being worth 9.1 cents, then the value of the mines drop from $1.65 trillion down to $150 billion, meaning a 50% return on investment.
So, let’s take out the debt, and see how much of the profit is from the assets alone. If you start with $5 billion in metals mining stock with no debt – then you end up with $82.5 billion in metal mining stock. Spectacular! Until you adjust for a dollar only being worth 9 cents. Meaning your $82.5 billion in stock is worth $7.5 billion in today’s dollars. A highly worthwhile real (pre-tax) profit of $2.5 billion – which is $133.5 billion short of the $136 billion in inflation-adjusted profits shown in the illustration. To find where the extra $133.5 billion in real wealth comes from, we need to look to our 2nd and 3rd wealth creation tools.
Wealth Creation Tool #2: The Leverage Play
Well-read individual investors and financial professionals likely looked at the illustration and thought one word: “leverage”. Leverage is of course the heart of many types of financial strategies, and the principal here is simple. You borrow money from someone else to buy an investment, you buy an investment that makes a fat profit, you pay back what your borrowed, and you keep the excess profits. Because the use of OPM (Other People’s Money) allows you to control more of an asset that does well, for less investment on your part, your return on investment is much higher than it would otherwise be.
What is illustrated above does have a powerful leverage component – but that is not necessarily the most important part. Let’s look at what leverage does, in this case. It means for a $5 billion investment, you control $100 billion in mining stock instead of $5 billion. So when the value of your stock in inflation-adjusted terms rises by 50%, you capture that 50% rise on $100 billion instead of $5 billion. That is $50 billion in profits instead of $2.5 billion, and this means that by leveraging yourself by 20X ($5 in equity for every $100 in assets), you multiply your profits by 20X.
This is classic leverage, increasing your risks to increase your profits, and – as long as it works – then large amounts of wealth can be created quite quickly (when it doesn’t work, wealth can be destroyed even more quickly). Yet, leverage by itself “only” multiplied our profits by 20X, an increase of $47.5 billion from our asset-only play. Combined, our total profits from the asset play and the leverage play are $50 billion, after adjusting for inflation. Which is great – but it’s $86 billion short of the $136 billion in profits shown, for our $5 billion investment. Where does the remaining $86 billion in inflation-adjusted profits come from?
Wealth Creation Tool #3: The Dollar Destruction Play
At first glance, it may seem difficult to distinguish from leverage, but the heart of the contrarian arbitrage illustrated above is not the asset, nor the leverage, but the destruction of the value of the liability. What really makes this work is not the 50% increase in the value of the asset, but the 91% decrease in the value of the liability.
Look at the Beginning and Ending Situation sections for the chart, and compare the inflation-adjusted value of the borrowing. On a nominal basis we start and begin with the same number: $95 billion in debt. Except, thanks to a 1000% rate of inflation, what was a dollar when we began is only worth nine cents when we end. Our financier borrowed $95 billion – but only paid back $9 billion in purchasing power terms.
The difference in real value between what the private equity group borrowed and what they paid back is $86 billion dollars. Eighty-six billion dollars of value that used to belong to the lenders has now been redistributed to the borrowers. As shown below, it is the inclusion of the difference of the value between what we borrowed and what we paid back that makes all the (inflation-adjusted) numbers add up, and explains the source of 63% of the total profits from the strategy.
What distinguishes this Wealth Creation Tool from leverage, is that leverage is about using other people’s money to buy assets, making a bigger profit through controlling more assets when the price rises, paying your lenders back, and keeping the excess profits. Wealth Creation Tool #3 is about using other people’s money to buy assets – and then not paying them back, while keeping the assets you bought with their money.
When we say “not paying them back”, we mean that in real terms (as defined by economists). Legally, contractually, ethically, in every way that almost the entire world would look at the situation –you did indeed pay your lenders back in full, with every dollar that is due to them. The key is however, that nearly our entire contractual and legal structure is based upon the principle that a dollar is a dollar.
The whole point behind inflation however, is that a dollar is not a dollar. The higher the rate of inflation, the greater the error that comes from viewing a dollar as being worth a dollar. For most investments and most investors – this increase in error is potentially catastrophic.
(Do keep in mind as well, that while the metals mine value produces “only” $2.5 billion of the profits in real terms, without it or other tangible assets, then the strategy doesn’t work. Having the value of your debt collapse in real terms doesn’t do any good unless the proceeds are invested in an asset that isn’t collapsing in inflation-adjusted value. As I cover in my three day immersion workshops, a multi-asset inflation-arbitrage strategy can generate both higher returns and lower risk, on a tax-advantaged basis, when compared to a single asset strategy such as metals only.)
A Redistribution, Not A Creation
This is where the “adding insult to injury” part comes in.
Inflation in and of itself, doesn’t destroy wealth, rather, it redistributes wealth. The primary source of profit illustrated above is not the indirect play on metals benefitting from a reduction in the value of a dollar. Instead, the primary source of profit is the much more direct redistribution of wealth through the destruction of the value of the currency leading to the destruction of the value of the liabilities.
There is ample irony here. Wall Street has been playing increasingly aggressive games with the value of all of our money, with fun little experiments like creating $593 trillion in global OTC financial derivatives products. In theory, these are supposed to reduce risk, but in practice, they turn out to look a lot more like a line of dominos. Dominos with total notional values that now exceed ten times the size of the global economy, and just might destroy the value of all of our paper currencies, if they go out of control.
In a just (in other words, theoretical) world, the financiers ,who for personal profit created the problems that may lead to financial ruin for the rest of us, would bear the brunt of the consequences. In the real world, the collapse of the currencies can in fact be turned into the ultimate profit opportunity, as the value of the life savings of many millions of hard working people around the world are not destroyed – but redistributed. The financiers didn’t create tremendous wealth independent of the profound losses in wealth by most of the population, but rather used a destruction of the dollar to redistribute real wealth from other people and to themselves. (A simple to follow illustration and explanation of this principle can be found in a free resource I offer entitled “Inflation Pickpocket”.)
Wealth Creation & Vision
Now, here comes the most important part of this article, the part where you make an important two-part decision about your personal financial future. The first part of the decision comes when you decide what it is you saw illustrated above. The second part comes when you decide whether to do anything about it.
What did you just see? A) The advantages of owning gold and gold mining stocks during inflationary times? B) The power of leverage? C) The ability to turn the destruction of the dollar to your direct personal advantage?
The answer is: D) All of the above. Understanding the full sources of the wealth requires understanding that there are three distinct wealth creation tools being utilized.
Of those three tools, one is much riskier than the other two. Which is Wealth Creation Tool #2, that of Leverage. The difference between Wealth Creation Tools #2 & #3 is particularly important for retirees and those investing for retirement. The dilemma is that the segment of the population most vulnerable to inflation and the destruction of the dollar are the older citizens (and this is true regardless of your nation or unit of currency). If this describes you, then you are in urgent need of protection.
Yet, as I would hope that most financial professionals would agree, advocating a highly leveraged strategy for a retiree exactly like that illustrated for major financiers above, would be quite irresponsible. Leveraging up on margin loans to buy volatile securities that may produce little if any cash flow is a very good way to lose your life savings in a hurry.
However, when our focus is not on leverage, but dollar destruction, then something very interesting emerges. Wealth Creation Tool #3 is fundamentally contra-cyclical when compared to conventional retirement financial risks. As are tangible assets such as metals and metals mines. In other words, the worse things get for pensions and conventional investments, the stronger the results that are delivered by Tools #1 and #3. Right when they are needed the most.
Here is the question: is it possible to build a strategy that essentially “pulls the fangs” from Wealth Creation Tool #2, the leverage component, neutralizing much of the risk, while still maintaining much of the advantages of Wealth Creation Tool #1, the asset play, and Wealth Creation Tool #3, the dollar destruction play?
The answer to the question above is – yes, you can. One of the nice parts about having three wealth creation tools is that you have a vast range of different tool combinations that can be created between the three tools. Depending on the particulars of your situation, you have the ability to find the right risk and return combination, for the asset choices and liability levels that you are personally comfortable with. Where you can not only sleep at night, but sleep better than ever, because you feel better about the reduction in your risk from inflation.
To get there, however, requires taking an essential step – that of learning.
The Most Important Tool Of All: Education
New times mean new strategies. New times mean that the strategies that have worked over the last 20 years quite likely won’t work the same way in the years to come, and the strategies that worked best in 1995, and 2000 and 2005 – may be among the worst performers of 2010 and 2015. To prepare for a different future requires first and foremost – learning new strategies for new markets.
John Paulson saw the crisis that was coming in subprime mortgages, researched and educated himself on this area (which had not been his field of expertise), and he turned the crisis into a $3-$4 billion personal payday in 2007. If you're not a hedge fund manager like Paulson, you may not have the tools that he used to turn a market crisis into personal billions. That’s OK, because Paulson didn’t start with the tools either. He started with educating himself, learning about a new area, until he came up with a novel way to profit from disaster. A method that wasn’t in the financial textbooks, and that he didn’t find by reading a financial columnist in the paper.
You have more tools than most people think. Tools which can give you the opportunity to turn financial disaster into personal net worth. There are ways you can use those tools to turn the destruction of the currency into perhaps the greatest real wealth-building opportunity of your life, on a long-term and tax-advantaged basis. But, you are going to have to educate yourself, and work to not just understand, but to master some of the financial forces and methods in play here. You will have to learn how to turn the destruction of paper wealth into real wealth. With Turning Inflation Into Wealth being the first key step. My best wishes to you for turning this challenge into an extraordinary personal opportunity.
Do you know how to Turn Inflation Into Wealth? To position yourself so that inflation will redistribute real wealth to you, and the higher the rate of inflation – the more your after-inflation net worth grows? Do you know how to achieve these gains on a long-term and tax-advantaged basis? Do you know how to potentially triple your after-tax and after-inflation returns through Reversing The Inflation Tax? So that instead of paying real taxes on illusionary income, you are paying illusionary taxes on real increases in net worth? These are among the many topics covered in the free “Turning Inflation Into Wealth” Mini-Course. Starting simple, this course delivers a series of 10-15 minute readings, with each reading building on the knowledge and information contained in previous readings. More information on the course is available at InflationIntoWealth.com .
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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