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Published on April 13, 2008

Author: Roxie

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Slide1:  Barry B. Bannister, CFA Managing Director Stifel, Nicolaus & Co. Visit to University of Maryland Business School Finance and Investment Society February 1, 2006 “Who am I? Why am I here?” :  “Who am I? Why am I here?”  Stifel Nicolaus (SF- NYSE) - Founded in St. Louis over a century ago. Modernized via acquisitions including the recent purchase of the Equity Capital Markets operation of Legg Mason. Securities-related financial services. Three segments: Equity Capital Markets  40% of revenues, Private Client retail brokers  40%, and Fixed Income  40% . Revenues  $500 million if the two firms are combined. Me - Prior to joining Legg Mason Capital markets in 1998, which became Stifel Nicolaus in Dec-05, Barry B. Bannister, CFA held the positions of U.S. Capital Goods analyst and co-head of U.S. Equity Research in the New York offices of S.G. Warburg/Warburg Dillon Read, the London-based investment-banking unit of the Swiss Bank Corporation of Zurich (1992-98). Also was a senior analyst covering various consumer, financial, and industrial sectors for the buy-side firms FTIM/Highland Capital and AmSouth Bank (1987-92). Analyst/strategist for 19 years. BA (1984) with dual majors in Accounting & Finance and a minor in Philosophy from Emory University in Atlanta, GA. After working to gain experience before graduate school, returned to Emory for accelerated MBA (1987). Received CFA (1991). Wall Street Journal All-Star Analyst in 1993, 1995, 2001, and 2003. Interviewing for 2nd Associate from the Bachelor’s Degree pool in the Business School – I’ll be conducting an on-campus interview at UMD on Monday Feb-13. Candidates should submit both a cover letter stating interest and “fit” and a resume in preparation for March 2005 interviews. Stifel Nicolaus is an equal opportunity employer. If you are interested after this, please send that to the Office of Career Management pronto so I can set the list up for that full day of interviews. What is the equity capital markets business? Ever been to a Friday’s restaurant? Ever walked into the back?:  What is the equity capital markets business? Ever been to a Friday’s restaurant? Ever walked into the back? Large institutional clients come in and look at the “menu” - (Clients are large Mutual Funds, Hedge Funds, Endowments, etc.) and retail brokerage go-betweens (not brokers individually). Equity Research - Cooks up good ideas so that the Salesmen/Waiters will have something to say, and look good. Traders – Less visible but key. They buy & sell customer’s orders and are key to a favorable customer experience and repeat business. Investment Bankers – Like the Maitre D, they welcome the corporate clients and put an esteemed face on the work. Institutional Sales – Assigned to “Cover” and wait on specific accounts and territories and the large institutional clients therein. Syndicate – Lead Managers and their co-managers allocate new equity offerings to institutional clients. Slide4:  Our clients, whom we love. The types, and what we can do to help them make money in their portfolios. (A) We try to help them predict the outcome of the intersection of sometimes unrelated events leads to collisions, which produce changes to which investors adapt. All known information is reflected in the price of a stock. (B) Some investors, which we associate with true “Value Investors,” assume “anticipatory risk” and try to forecast collisions, the reward for which is capturing the largest price change from the lowest level. Ex., oil moving from $10 (1999) to $70 (2005) was +600%. (C) Other investors, which we associate with “Growth Investors,” attempt to adapt quickly, assuming lower “adaptive risk” in exchange for lower mathematical returns after changes are under way. Ex., oil moving from $35 (2003) to $70 (2005) was +100%. (D) Some investors adapt too late, such as when many money managers “caught up” to major technology market indices in 1Q00, “capitulating in” and leading to wreckage. (E) Some investors never adapt, and melt away like ice cubes in the summer sun. Usually, those who received the accolades during the prior regime are the slowest to adapt. (F) As for me personally, I employ an aphoristic style in an attempt to illustrate and understand anticipatory risk, which is my preferred style of investing. Slide5:  What makes a good investment professional. Some traits are more sell-side, others more buy-side. All are key: (Not in any particular order) SKEPTIC - Never nods "yes" or "no" if hearing new information. Questions & analyzes. WRITER - Writes concise but lucid prose that flows beautifully; words that convey ideas. IMPARTIAL - Buries personal beliefs; completely neutral at work; only goal is correctly predicting the future - any future. Investigator, not an advocate. QUICK - Not a slowpoke. Ability to get it right - fast. Operating in one sense like a combination of an officer in battle and a reporter on a tight deadline. ORGANIZED - The ability to juggle people, assignments, travel work and ideas. PERSUASIVE - Convincing reasoning and non-intrusive persistence that sells ideas. PROMOTIONAL - Able to make the mundane exciting, and capture the attention of a busy audience. SHARP - Having a HIGH GPA, and just being naturally bright. Ready to sharpen the business tools you have acquired. Not a drone. CURIOUS - Inquisitive and knowing the correct questions to ask. Driving for answers, but not arousing ire or suspicion in the process. REASONING - Projecting the outcome of complex data points under fluid circumstances. ELOQUENT - Reducing complex concepts to clear, short, interesting verbal descriptions. READER - Reads widely, especially finance, accounting, history, philosophy, statistics. OUTSIDER - Judge a situation as an outsider looking in; not an easily impressed or easily swayed trend follower or fashion plate. UNEMOTIONAL - But not dull. Able to anticipate, interpret, and act in a cool, collected and ultimately correct way. ANALYTICAL REALIST - Understanding human nature & economics in approach to problems. Thinks of what the future will be, not what should be. TOP-DOWN - The ability to see the forest for the trees and incorporate it into your research. BOTTOM-UP - The patience to look behind the trees if poor accounting is lurking there… CEREBRAL - 3-dimensional thinking combined with reason and logic. Though emotion can test your limits, it rarely prevails. CHAMELEON - The ability to adapt one's personality or pitch to that of the audience, to facilitate smooth interaction. ENTERTAINING - The ability to develop a relationship with your customers that is not just business-as-usual. Slide6:  Why investments? “The men who can manage men manage the men who can manage only things, and the men who manage money manage all.” – Historian Will Durant Slide7:  What you can do to keep your life from ending in tears. Find out what you do well AND enjoy, and do it. Most people fail because they are unable to identify their niche, or understand their limits as well as strengths. The box of happiness Tests available in most testing centers: Myers Briggs: Your personality. You aren’t going to change it. You have to adapt your career to your personality. Strong Campbell Interest Inventory: Your aptitude based more so on interests, but a very good gauge nonetheless of what you will do well and enjoy. Investment Banker or Social Worker. Accountant or Stunt Man? It is more subtle than that, and helpful. Some good investment books:  Some good investment books The Story of Philosophy by Will Durant The Prize: The Epic Quest for Oil, Money & Power by Daniel Yergin The Great Wave: Price Revolutions and the Rhythm of History by David Hackett Fischer 100 Decisive Battles: From Ancient Times to the Present by Paul K. Davis Monetary History of the United States, 1867-1960 by Milton Friedman, Anna Schwartz A History of Money: From Ancient Times to the Present by Glyn Davies The Federal Reserve System: A History by: Donald R. Wells Devil Take the Hindmost: A History of Financial Speculation by Edward Chancellor The Middle East by Bernard Lewis Wall Street: A History : From Its Beginnings to the Fall of Enron by Charles R. Geisst A History of Interest Rates by Sidney Homer, Richard Eugene Sylla Manias, Panics, and Crashes: A History of Financial Crises by Charles P. Kindleberger Once in Golconda : A True Drama of Wall Street 1920-1938 by John Brooks Slide9:  The top-down side of investments, in action. (The bottom up side is that report I am handing out on paper). Examples of potentially washed out or just blossoming investment opportunities for the Value Investor. Slide10:  Some investment ideas: Airlines, based on expectations for reduced capacity, rising pricing power, a near-term peak in energy costs, and low equity prices. Source: Bloomberg, Economy.com inflation data for the SPI Airline Far (SA) and CPI Urban (SA). Source: Economy.com, Factset prices. Shock Acceptance Slide11:  Source: Bloomberg, Economy.com inflation data for the SPI Airline Far (SA) and CPI Urban (SA). Source: U.S. Census, Economy.com. The pricing power of electricity generators may be recovering, a potential driver of utility profits. Source: U.S. Census, Economy.com. The pricing power of electricity generators relative to the PPI for Fuel may also be bottoming, finally. Some investment ideas: Electric IPPs, based on reduced capacity, rising pricing power, a near-term peak in energy costs, and low equity prices. Latest data point Dec-05. Latest data point Dec-05. Slide12:  Some investment ideas: E&Cs, based on reduced capacity, rising pricing power, lagging capex needs in energy supply, and high EPS potential. Source: The PPI for All Commodities from 1936 to 1956, and from 1957 to 2005 the CRB Futures Index. The E&C revenues are FLR’s E&C operations (only, we exclude non-E&C) post-1945, FWLT post-1935, CBI post-1955, and JEC post-1970. Slide13:  Some investment ideas: Farm Machinery, based on reduced capacity, potential pricing power, a near-term peak in energy costs, a “new” market driven by ethanol, and low equity prices. Source: Bloomberg, Economy.com inflation data for the SPI Airline Far (SA) and CPI Urban (SA). Source: “Historical Statistics of the United States, Colonial Times to 1970,” a U.S. Census Bureau publication for Commodities, as well as other agencies. Ethanol figures are from PRX ProExporter and Stifel Nicolaus 2010 estimate. As an analyst, look for things that are “out of whack.” Either corn & sugar (both used to make fuel) are too cheap, or gasoline is too expensive. Arbitrage is occurring as a result. I don’t see $2.50 gasoline rationing demand, so I must conclude that corn is too cheap via poor Government policies that may change with the 2007 Farm Bill. Slide14:  Agriculture (part 2) Source: Bloomberg, Economy.com inflation data for the SPI Airline Far (SA) and CPI Urban (SA). Slide15:  Agriculture (part 3) The preceding chart examined only the past 25 years. This chart captures 200 years of farm commodity cycles. Note the red and green trace lines on this chart, and how they compare to the preceding page. Deere’s stock beat the S&P 500 by over 400% in the 1970s once deflation made the turn and the moving average below crossed over to positive pricing. Source: “Historical Statistics of the United States, Colonial Times to 1970,” a U.S. Census Bureau publication for Commodities, as well as other agencies. Slide16:  Agriculture (part 4) For farmers, the tractor purchase is based on the pricing power for crops. Note the 30-year price cycle peaks, 1920 (See page 4), 1950 and 1980. Perhaps 2010 is the next big peak for the equipment cycle? Most investors appear to have given up on agriculture. Source: U.S. Department of Commerce "Fixed Reproducible Tangible Wealth in the United States, USDA, U.S. Census, U.S. Department of Commerce, U.S. Bureau of Labor Statistics, PPI - Agriculture is the Producer Price Index for Farm Products and predecessor indices for raw agri-products. 1920 1950 1980 Slide17:  An important observation: Commodities have broken out of their secular (1981 to 1999) bear market by every measure we track. There is nothing especially insightful in the view that commodity producers are prospering, so we caution against linear extrapolation of strength. We now prefer commodity serving plays. Slide18:  Commodities inflate & deflate in unison, with energy at the core to preserve order and prevent entropy. Energy is certainly leading this cycle. Commodity producers periodically need pricing to replenish physical & human assets. Source: “Historical Statistics of the United States, Colonial Times to 1970,” a U.S. Census Bureau publication. 1793 to 1890 are the applicable Warren & Pearson U.S. commodity indices and average constructed from: Farm products, foods, hides & leather, textiles, fuel & lighting, metals & metal products, building materials, chemicals & drugs, household furnishing goods, spirits and other commodities. 1891 to 1913 is the Wholesale Commodities Price Index from the BLS and other agencies. 1914 to present is the PPI for All Commodities modern series, about two-thirds of which we feel are classic commodities. Slide19:  Commodities follow something we call the “Rule of Saturation.” As real income grows from about $5,000 to $20,000 per capita (Purchasing power parity rules may apply overseas), commodity usage vastly outstrips real income. Then saturation occurs, and individual income grows faster than commodity use. We believe emerging markets today are following the same trend the U.S. followed in the first half of the 20th Century. Source: U.S. DOE/EIA, BP Statistical Review of World Energy 2005, USDA, U.S. Census. Stifel Nicolaus format and opinions. Slide20:  It would be unusual if commodities did not foreshadow consumer inflation. Commodity price peaks only seem to occur when prices clear (economies weaken), new supply is developed, and reflation devolves to stagflation. In our view, we are a long way from universal acceptance of those items. Source: “Historical Statistics of the United States, Colonial Times to 1970,” a U.S. Census Bureau publication. 1947 to present consumer inflation is the CPI Urban annual average, y/y change. 1800 to 1946 are from the Bureau of Labor Statistics (BLS), including a study published by the BLS in 1919 in Bulletin 357 "Cost of Living in the United States." We link all applicable series. For Commodities, 1793 to 1890 are the Warren & Pearson U.S. commodity average constructed from: Farm products, foods, hides & leather, textiles, fuel & lighting, metals & metal products, building materials, chemicals & drugs, household furnishing goods, spirits and other commodities. 1891 to 1913 is the Wholesale Commodities Price Index from the BLS and other agencies. 1914 to present is the PPI for All Commodities modern series, about two-thirds of which we feel are classic commodities. 1 3 2 6? 4 5 Slide21:  Is this the Industrial Revolution in a nutshell? Every 15-20 years or so farmers, miners, drillers, etc. (and developing countries tied to the land) must receive pricing power to replenish fixed assets and draw a new generation into the business, only to be smashed against the rocks in a deflation for 15-20 years until the workers & assets are “retired.” Source: BEA, U. S. Census “Historical Statistics of the U.S., Colonial Times to 1970,” and other U.S. Government agencies. Equity bull market cycle Equity bull market cycle Equity bull market cycle Equity bull market cycle Equity bear market cycle Equity bear market cycle?? Equity bear market cycle Equity bear market cycle Slide22:  Another observation: Stock market indices, and in particular traditional “growth stocks,” have broken down from their secular (1982 to 2000) bull market by every measure we track. All else being equal, we would “sell the spikes” in traditional growth stocks that are hurt by resurgent pricing power for inputs (To include the cost of credit), since inflating costs leads to both profit margin erosion and P/E multiple compression. Stocks and commodities seem to trade-off price leadership. This is the stock market relative to a commodity index, 1877 to 2005, and the 1982 to 2000 equity bull market certainly looks like it has broken down, in our view.:  Stocks and commodities seem to trade-off price leadership. This is the stock market relative to a commodity index, 1877 to 2005, and the 1982 to 2000 equity bull market certainly looks like it has broken down, in our view. Source: Stock market prices are from the Cowles Commission study ordered by Standard & Poors, combined with the S&P 500 post-1960. For Commodities, 1793 to 1890 are the Warren & Pearson U.S. commodity average. 1891 to 1913 is the WPI from the BLS and other agencies. 1914 to present is the PPI for All Commodities modern series, about two-thirds of which we feel are classic commodities. Separately, note that Prof. Gary Gorton of the Wharton School and Prof. K. Geert Rouwenhorst of Yale University demonstrated that rolling commodity futures have out-performed stocks for the post-1959 period, improving investor returns on the efficient frontier, as we interpret it, in “Facts and Fantasies About Commodity Futures,” Yale, 2005. Slide24:  Is this a commodity “mania”? Owners of commodities call it a bull market, those who don’t call it a mania. History shows that “this” can last many years and outstrip most expectations, as may the busts for the formerly in-favor asset class (i.e., NASDAQ 1990 – 2005 shown here). Source: Respective price series, format Stifel Nicolaus. Note the implication that NASDAQ (pink line) may be in for at least five more years of flat-type returns. Slide25:  Productivity has been the greatest factor suppressing the consumer price index in recent years (capacity built during the non-inflationary credit boom, Asian imports, technology are additional factors). We wonder if adverse labor demographics 2000-2015 will raise U.S. production costs and the CPI. Source: U.S. Census and Bureau of Labor Statistics, format Stifel Nicolaus. Slide26:  We have found that the ratio of this productive demographic (35-49 relative to the younger 20-34 group) is positively correlated with the real U.S. and Japan (and others, not shown below) stock markets for a half century. That is because high productivity and low inflation, and thus profit margin & P/E multiple expansion, are associated with 35-49 year olds in the ascent. Source: U.S. Census Bureau, International Data Base; Bank of Japan for Nikkei data, Ministry of Public Mgt., Home Affairs, Posts & Telecommunications CPI Excluding Imputed Rents. THE LAST DATA POINTS ARE Dec-5, 2005. Slide27:  We’ve discussed margin pressure from costs. Another reason stock market returns rise and fall is that equity valuation moves inversely to inflation. P/E’s are past their peak in our view, typically oscillating from about 8x to 20x. Guess the level off of which we just bounced… Source: Cowles Commission U.S. stock market composite data from Standard & Poor's Corporation are joined with the more recent S&P 500 12-month annual average prices. “Historical Statistics of the United States, Colonial Times to 1970,” a U.S. Census Bureau publication. 1947 to present consumer inflation is the CPI Urban annual average, y/y change. 1800 to 1946 are from the Bureau of Labor Statistics (BLS), including a study published by the BLS in 1919 in Bulletin 357 "Cost of Living in the United States." We link all applicable series. “Fair value” is something we pass on the way to +/- one standard deviation. If we drop to a 3%-4% real 10-year compound total return (incl. dividends) by 2013-2015, the S&P 500 price, adjusted for inflation, achieves the old high of about $1,500 by that time. :  “Fair value” is something we pass on the way to +/- one standard deviation. If we drop to a 3%-4% real 10-year compound total return (incl. dividends) by 2013-2015, the S&P 500 price, adjusted for inflation, achieves the old high of about $1,500 by that time. Source: Stock market total returns are from NBER working paper #2985 “Indexes of United States Stock Prices [Note: Including dividends] From 1802 to 1987,” May 1989, G. William Schwert. Later dates are the S&P 500 total return data. The Consumer price inflation series is from “Historical Statistics of the United States, Colonial Times to 1970,” a U.S. Census Bureau publication and subsequent U.S. BLS data. Slide29:  In the charts below (1895 to 2005) and to the right we show the only three “secular bear” (flat nominal, declining real) U.S. stock markets of the 20th Century. At all other times, stocks generally rose nicely. Source: For all charts, Standard & Poor’s, Cowles Commission, NBER Macro-History Database, U.S. CPI deflator. Slide30:  Note how the current market (current to 12/6/05) has tracked history for seven years. On the left we show the nominal market versus historical bear cycles, on the right the inflation-adjusted market versus the same. We expect a 4Q05 or 1Q06 rally if the Fed stops hiking or changes its language in response to a slower economy or a desire to shift the burden of raising longer term rates to the bond market. But then, perhaps, caution is in order. Source: For all charts, Standard & Poor’s, Cowles Commission, NBER Macro-History Database, U.S. CPI deflator. Prices are updated to Dec-6, 2005. Slide31:  Another observation: Monetary policy tends to be reactive and lags during inflation cycles. In contrast, during declining inflation cycles (which usually follow war victories, including the Cold War) the opposite seems to be true. Inflation always starts low and builds, and is often foreshadowed by rising commodities and real estate, as well as by the compression of real consumer income and manufacturer’s margins. Conflict over scarce resources and resource nationalism seems inevitable to us, as does resulting U.S. monetary and fiscal laxity to “deal with” the problem. Historically, having the world’s reserve currency has been a tool/weapon, and it may soon be used if, indeed, the process has not already begun. Slide32:  The divergent interests of land, labor, capital and government have been with us for a long time. “Everywhere there are three sorts of men and four sorts of coinage (monetary policy)...the first sort of men are those who have rents (financial interests)...this sort of men...clearly wish money of a strong alloy (a strong currency, low inflation)...the second sort of men are those who engage in commerce...who wish for a middle sort of money...Trade is always poor except when money is a middle state...the third sort of men are those who live from the work of their bodies (farmers, miners, drillers, et al.)...These would wish to have weak money. The fourth sort of money is desired by lords when they are at war, and he [sic] can thus strike coin as feeble as he likes to have the means to pay his troops.” This statement was made in or close to the year 1340, almost seven hundred years ago, by Guillaume de Soterel, the Treasurer of the Kingdom of Navarre (what is now northeastern Spain). Soterel was explaining monetary policy to his King, Philippe of Évreux (Philip III of Navarre), in the early years of the Hundred Years’ War. “This currency, as we manage it, is a wonderful machine. It performs its Office when we issue it; it pays and clothes Troops, and provides victuals and ammunition; and when we are obliged to issue a Quantity excessive, it pays itself off by Depreciation.” This was a tongue-in-cheek comment by Benjamin Franklin delivered in April 1779 during the U.S. Revolutionary War, perhaps addressing the trustworthiness of money management by governments during conflicts. Source: "A Free Nation Deep in Debt - The Financial Roots of Democracy" by James MacDonald. Slide33:  Camp Anti-Inflation: (1) Commodity inflation is an isolated event, and is demand-pull rather than supply-constricted. (2) There is an abundance of inexpensive South and East Asian labor with rising productivity. (3) There is increased independence among central banks as guardians of a flexible albeit fiat money system. (4) U.S. military primacy supports the U.S.$ via “Bretton Woods II,” recycling world savings back to the U.S. (5) Strong productivity growth is underwritten by ageing work force demographics and high technology. (6) The U.S. victory in the Cold War between 1981 and 1991 ensured a deflationary, supply-side Pax Americana. Camp Pro-Inflation: (1) Excessive liquidity lowers rates & boosts assets, but the government-guaranteed moral hazard will implode. (2) Early warning indicators of inflation are rising (i.e., less elastic real estate, gold & commodities). (3) As world living standards rise & money velocity (GDP/Money) accelerates, inflation usually ensues. (4) We’ve spent a century fighting anti-individualists at the high cost of inflation, and that war isn’t over yet. (5) Twin deficits are the spoils of empire, but raise the exposure to capital dependency or asset collapse risk. (6) Adversity breeds the politics of protectionism, entitlement, & full-employment (GenX jobs support Boomers). What is different – i.e., history doesn’t repeat, it only rhymes. Though tight money raises real interest rates, defending the U.S. dollar and prolonging access to foreign savings, tight money will lead to insolvency and unemployment. The Fed may then be forced to choose between managing for growth and targeting for acceptable inflation. So, only when the Fed stops raising rates (i.e., fighting), implicitly accepting low or negative real rates, will longer rates really start to rise, and asset values fall after a brief equity market sucker’s rally. As a result, inflated asset values and the U.S. dollar may now be the weak links. The equal balance between inflation & deflation risks reminds us of the equal balance between water and a dam… Slide34:  An upturn in M2 leads rising consumer price inflation by about 6 years. M2 turned up in 1997, but has recently slowed. Equity bull markets correspond to eras of falling inflation (A,C,E), and some of the largest equity price blow-off peaks occur when liquidity surges, inflation is low with residual deflation pressures, and bond prices haven’t yet peaked (B,D,F). Source: National Bureau of Economic Research macroeconomic database, U.S. Federal Reserve for M2 (seasonally adjusted) 1959 to present, for M2 prior to 1959 We add M1 + time deposits in banks + bank vault cash + monetary gold stock + mutual savings bank deposits + S&L deposits as provided in the U.S. Census publication "Historical Statistics of the United States, Colonial Times to 1970." Stifel Nicolaus format. A B C E D F Slide35:  The fastest growing part of the world (S. & E. Asia) are the most natural resource poor parts of the world. This causes history to repeat the 1965-80 experience when Western demand drove oil up. Now, it is Asia. Source: 1965 to 2004 data: 2005 BP Statistical Review of World Energy. 2005 and later projections are from Stifel Nicolaus, with data from EIA’s Annual Reports. Our oil consumption projections are "reference cases" from EIA's projection, and the "high economic growth" case oil consumption projections were used for China, the former Soviet Union, Australia, and the Middle East. We used EIA's reference case projection for regional oil production, with any excess consumption assumed to be covered by OPEC discoveries, allocated by country according to available capacity per EIA's projection. Source: 1965 to 2004 data: 2005 BP Statistical Review of World Energy. 2005 and later projections are from Stifel Nicolaus, partly based on EIA’s Annual Reports. Consumption projections are the EIA "reference cases“ for the U.S. and Japan, and the "high growth" cases for China, South Korea and India. The EIA China + Hong Kong forecast (red line) reaches only 9.55 mb/d in 2015 versus 7.0 mb/d in 2004, the latter more than double the 3.33 mb/d used in 1994, for comparison. Our alternate scenario, shown by a pink line for China + Hong Kong, assumes 12.0 mb/d of demand by 2015, 59% imported versus 48% imported in 2005. - about 2/3 of which is China. Slide36:  Political stability makes the oil-rich countries wealthier and ensures supply via increased output. Accountable government spreads and sustains that wealth, hence U.S. foreign policy. But, as the producers first become wealthy, and with no U.S./Soviet camps to hold sway in a Nash Equilibrium, these newly enriched countries may hold a severe grudge against “the West.” As always, however, economic desires reign supreme, and oil will always find a market. Source: BP Statistical Review of World Energy 2004. All countries with more than 5 billion barrels of proven reserves are shown below, sorted by reserves/production; note how high reserve/production ratios (in years) are key to U.S. foreign policy. Natural gas is also a priority. The dollar value of world oil production, from 1965 to the 12 months ended May 2005: Note the renewed up-cycle. The bulk of that wealth is going to the producers, but whether it helps the producer’s populations is another matter. Source: BP Statistical Review of World Energy 2004. OIL RICH OIL NEEDY Algeria n/a The belle of the ball in the 21st Century, in our view. Some investors like to look at the asset side of Western economic balance sheets. If that is the desired method, then our retort is to apply today’s oil prices to developing country proved reserve balance sheets, since ¾ of the world’s known oil is in the hands of state-owned enterprises in the developing world. The amounts are staggering, as is the shift in power. Slide37:  Source: U.S. Department of Energy EIA. The U.S. oil & gas productivity vs. cost per well problem of the 1970s is reoccurring (A, B). The U.S. is vulnerable to resource nationalists and thus seeks trade + pacification. Costly gas has positive (LNG, GTL) and negative (fuel cost) investment implications. A B Slide38:  Disinflation seems to be proactive, and reflation appears reactive, with examples of the latter being war & social programs. “Hard assets” like land & commodities hold value vs. paper and rise early as precursors of reflation. At first the Fed resists, as in 2005 vs. 1970 (green circles, right). WW1 WWII & New Deal Cold War & LBJ’s Great Society WW1 WWII, then socialism Source: British Historical Statistics, B.R. Mitchell (data), DOE/EIA, U.S. Federal Reserve, U.S. Census, EIA, Stifel Nicolaus format. Perhaps the surplus of world savings today reflects the impending end of the West’s ability to generate incremental growth by consuming, as well as emerging markets about to discover the joys of consumption, the latter thus far delayed by slack labor markets and command economies that depressed living standards.:  Perhaps the surplus of world savings today reflects the impending end of the West’s ability to generate incremental growth by consuming, as well as emerging markets about to discover the joys of consumption, the latter thus far delayed by slack labor markets and command economies that depressed living standards. Source: U.S. dollar data is from the U.S. Federal Reserve 1971 to present, for 1970 and prior we use R.L. Bidwell - “Currency Conversion Tables - 100 Years of Change,” Rex Collings, London, 1970, B.R. Mitchell - British Historical Statistics - Cambridge Press, pp. 700-703. The hand-off from the UK to the U.S. of the position of leadership within an Anglo-American Economic Empire In our view, the positive characteristics of what we term the Anglo-American Economic “Empire” are (1) a John Lockean parliamentary republic with a strong executive; (2) a multi-national, business-oriented base that encourages the same in order to promote growth, peace and price stability; (3) The historically isolationist U.S. nature, and adequate domestic land, labor and capital endowment that has caused the U.S. to eschew occupations, a past criticism of Empires. In our view, the negative characteristics are (1) the desire to cheapen raw materials and labor,which devalues the output of commodity producers and labor-rich nations; (2) the U.S. appetite for foreign savings to fund consumption, which also underscores the lack of overseas consumption; (3) rising debt that has led to capital dependency, potentially adding an element of desperation to foreign (and military) policy; (4) a lack of appreciation of the need to periodically allocate more resources to holders of “labor” and “land/commodities” in order to create new markets or replenish the fixed assets of producers. No empire can survive without creating new, external markets, nor may they by milking raw material and capital suppliers dry. Slide40:  Another observation: The inflation of assets that has rolled through bonds, stocks and now real estate since the mid-1980s, rewarding ever larger swaths of the investing public. We speculate that those rewards may soon shift to debtors, i.e., from the left to the right side of the balance sheet, the outcome of which would be to inflate away “asset-backed” debts. The central bank/treasury “put” may mean that it is now better to owe money than to own creditors. If there is a pause in the hard asset (Land, commodity) rally, that “put” may underpin the next leg up in hard assets, circa 2006-2010. Slide41:  Rolling asset bubbles in the Greenspan era (since 1987): It started with bonds (owned by few), then stocks (owned by more), and now real estate (owned by most). By the time asset bubbles trickle down to the little guy (homeowners), the central banker is a deity, but is that a sign of the end? Source: Respective price series, format Stifel Nicolaus. THOUGHT OF THE DAY: After inflating assets (the left side of balance sheet), perhaps the next group to be rewarded is debtors (the right side of balance sheet) by allowing them to pay back loans with devalued paper (i.e., inflation)? Either way, by inflating assets or inflating away debt, equity is the residual, so perhaps this is just a balance sheet shift. Slide42:  “I.O., I.O., its off in debt we go”...…the rise of consumer debt, the falling GDP efficiency of new debt, and the de-leveraged U.S. government that backs most of the securitized paper. Moral hazard and a future bail-out? We speculate…Yes! Source: Federal Reserve Flow of Funds, Series D.3 Debt outstanding by sector, U.S. Bureau of Economic Analysis, format Stifel Nicolaus. De-levered guarantor? Future problem? Slide43:  The dispersion of risk via currency and interest rate shock absorbers has been an enabler of debt. But our view is that markets go to extremes, not to moderation. So, debt won’t be a problem…until it is too late. Source: Federal Reserve Flow of Funds, U.S. Treasury, Federal reserve currency series, Department of the Census and Commerce. (1) Volatility has been transferred into currency... (3) …creating a “shock absorber” for real GDP… (2) …and into interest rates... (4)…that has enabled more debt leverage. Slide44:  Source: U.S. Bureau of Economic Analysis NIPA tables, U.S. Government CPI data, U.S. Federal Reserve Flow of Funds, Stifel Nicolaus format and conclusions. The post-1980 Fed used lower short rates to jump-start growth but reached a 2004 floor for rates and is “out of ammo” for that weapon. Also, high real rates have led to periodic blow-ups, producing moral hazard. Perhaps the Fed’s best move now is to stop hiking, allowing the 10-year to rise, shifting the load to the bond market. Slide45:  Source: New York Fed Rediscount Rate 1947 to 1954, U.S. Fed Funds 1955 to present. The average annual CPI-Urban inflation rate is subtracted from the rates. U.S. dollar data is from the U.S. Fed 1971 to present, for 1970 and prior we use R.L. Bidwell - “Currency Conversion Tables - 100 Years of Change,” Rex Collings, London, 1970, and B.R. Mitchell - British Historical Statistics - Cambridge Press, pp. 700-703. For trade weightings pre-1971 we use “Historical Statistics of the United States, Colonial Times to 1970,” a U.S. Census publication. The dollar may bounce due to the recent rise in real rates and foreign rate differentials. After that bounce, private capital may press hard in 2006 for continued high real interest rates, more than foreign central banks ever did from 2002-2005. Since “guns & butter” plus debt based on “asset values” make a strong dollar policy as infeasible today as it was in 1971, “Bretton Woods II” may unwind. Perhaps that is the 2006 epiphany for currency markets. Slide46:  China may be using a weak currency to gain advantage, just as the weak U.S. dollar was juxtaposed to UK sterling before WW 1 (Page 25). As shown below, having tried and failed to achieve dominance in their day, the defeated Axis Powers turned to economic strength by inhibiting domestic consumption and becoming exporters. So, it would appear that even though a strong currency is either the spoils of victory (U.S. post-WW II), or the penalty for defeat (UK, Japan), everyone tries a weak currency once! Source:U.S. Federal Reserve, R.L. Bidwell - “Currency Conversion Tables - 100 Years of Change,” Rex Collings, London, 1970, and B.R. Mitchell - British Historical Statistics - Cambridge Press, pp. 700-703. Slide47:  Another observation: We think the next leg up in hard asset plays will be powerful for the firms that serve commodity producers (i.e., the capex plays). Slide48:  A long period of underinvestment by commodity producers, “A” & “C,” was in response to poor pricing. Note the duration of capex and pricing cycles over time, alternating with disinflation/deflation. The 1970s were over-done, and the 1990s under-done, in our view. This may indicate a longer recovery from depressed lows (B, D), and though it won’t be linear, it may be long. Source: Company annual reports, pre-1980 annual reports contained in the Angelo Bruno Business Library Historical Annual Reports collection, “Historical Statistics of the United States, Colonial Times to 1970,” a U.S. Census Bureau publication for Commodities, 1793 to 1890 the Warren & Pearson U.S. commodity average constructed from: Farm products, foods, hides & leather, textiles, fuel & lighting, metals & metal products, building materials, chemicals & drugs, household furnishing goods, spirits and other commodities. 1891 to 1913 is the Wholesale Commodities Price Index from the BLS and other agencies. 1914 to present is the PPI for All Commodities modern series, about two-thirds of which we feel are classic commodities. PPI for All Commodities Slide49:  Integrated oil companies (XOM, left) tend to be slow to change capex, and E&Ps (UCL, right) somewhat faster, but all eventually respond to energy prices. Reserve-rich E&Ps may be M&A targets for Integrated Oil. Source: Company annual reports, pre-1980 annual reports contained in the Angelo Bruno Business Library Historical Annual Reports collection, energy prices are “Historical Statistics of the United States, Colonial Times to 1970,” a U.S. Census Bureau publication for Commodities, as well as other agencies. Slide50:  Integrated oil companies (XOM, left) and E&Ps (UCL, right) are enjoying resurging ROICs and will probably soon capital spend a great deal more, if they can find investment opportunities. For the majors, buying up reserve-rich, exploration-cultured E&Ps may be the next best step. Source: Company annual reports, pre-1980 annual reports contained in the Angelo Bruno Business Library Historical Annual Reports collection. Slide51:  Mining capex or investments should rise (again, if they can find projects). In the right chart, note how gold, as the “devaluation beneficiary,” is just now turning up, whereas copper as a “growing economy” metal is up sharply. Gold mining stocks may follow copper. Source: Company annual reports, pre-1980 annual reports contained in the Angelo Bruno Business Library Historical Annual Reports collection, copper prices are from U.S. Geological Survey. Stifel Nicolaus estimates for 2005 and 2006. Slide52:  Source: Company reports. Stifel Nicolaus formats. Chart updated to prices as of Jan-9, 2005. Second wave firms that serve commodity producers have more amplitude in their ROIC, and are on the rise. Here are the E&C firms. Slide53:  So where could we be wrong in this thesis? In the short term: If China enters a recession, and “Asia Crisis - Part Two” spreads to Asia’s commodity producer suppliers, the result would probably be a “Golden Avalanche” into the U.S. $, in our view. Such an event may lead to global instability, however, and as a result would only increase U.S. military costs and inhibit trade, in our view. In that sense, we believe the impending commodity price dip may be a buying opportunity in much the same way the Crash of 1987 (the Dow fell about 45% 3Q87-4Q87) became a buying opportunity within the 1982-2000 bull market. The Dow marched almost 800% higher from 4Q87 to 4Q99! In the long term: We could be wrong if the U.S. succeeds in establishing at a minimal additional cost a self-sustaining capitalist, democratic global metamorphosis that is inherently deflationary and features a high level of real global GDP growth without a meaningful price component, an environment we would term Pax Americana not so much because it represents the U.S., but because it represents a democratic capitalist, individualist ideal of efficiency and living standards enhancement. While we do see that as a credible long-term view, recent events remind us that the Pax probably cannot be accomplished in tandem with restrictive monetary and fiscal policies in the next decade, and may require a tolerance of commodity reflation to ensure supplies and enrich/free the populace of the producers from their more radicalized elements who prey on poverty. Slide54:  Note the cycle: (1) Inflation, (2) Crisis, (3) “Renaissance.” We see generally benign average 21st century inflation as global population, the prime driver of price waves, slows, and if a capitalist Pax Americana is achieved that promotes real growth in living standards. The dislocation we see lasts only to about 2015. Source: Wilhelm Abel study of the grams of pure silver per 100 kilograms of grain for major European countries, 1216-1960 titled “Agrarkrisen und Agrarkonjunktur: Eine Geschichte der Land und Ernahrungswirtchaft Mitteleuropas seit dem honen Mittelalter” (1935, 1966), the post-1877 price is wheat per bushel in U.S. dollars, a multi-city average compiled by the U.S.D.A. Slide55:  Important Disclosures and Certifications I, Barry Bannister, certify that the views expressed in this research report accurately reflect my personal views about the subject securities or issuers; and I, Barry Bannister, certify that no part of my compensation was, is, or will be directly or indirectly related to the specific recommendation or views contained in this research report. The information contained herein has been prepared from sources believed to be reliable but is not guaranteed by us and is not a complete summary or statement of all available data, nor is it considered an offer to buy or sell any securities referred to herein. Opinions expressed are subject to change without notice and do not take into account the particular investment objectives, financial situation or needs of individual investors. Employees of Stifel, Nicolaus & Company, Inc. or its affiliates may, at times, release written or oral commentary, technical analysis or trading strategies that differ from the opinions expressed within. Stifel Nicolaus & Company Inc. is a multi-disciplined financial services firm that regularly seeks investment banking assignments and compensation from issuers for services including, but not limited to, acting as an underwriter in an offering or financial advisor in a merger or acquisition, or serving as a placement agent in private transactions. Moreover, Stifel Nicolaus, its shareholders, directors, officers and/or employees, may from time to time have long or short positions in such securities or in options or other derivative instruments based thereon. This investment research report is classified as objective for the purposes of the FSA requirements relating to Conflicts of Interest management. No investments or services mentioned are available in the European Economic Area to private customers or to anyone in Canada other than a Designated Institution. Additional information is available upon request. Please contact a Stifel Nicolaus entity in you jurisdiction. Additional information is available upon request © 2005 Stifel Nicolaus & Company, Incorporated 100 Light Street Baltimore, MD 21202

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