By Simon Grey, on May 9th, 2011
The U.S. plant will employ 100 people, and more than a year ago the company bought a former liquor warehouse outside of Baltimore, thinking they would be open in nine months. But it’s 13 months and counting. Xu and Wang have already spent $1 million more than planned and they don’t yet have an occupancy permit.
The storage room Wang and Xu budgeted to cost $25,000, would have cost $250,000 to comply with the city’s requirements, so the company will not store as many fragrance oils on site, making it more difficult to meet orders.
The building has to be equipped with fire sprinklers and handicapped restrooms. In total, code compliance is estimated to be 30% of the $3.5 million the company has spent on the plant.
One oft-overlooked tax is that of compliance costs. Quite simply, compliance costs refer to the costs of meeting regulations set forth by the government. As this story indicates, compliance costs can be quite expensive, and in many cases prohibitively so. I suspect the main reason why compliance costs are overlooked when discussing tax policy is because compliance costs are largely invisible.
In the first place, the government does not directly receive money from compliance costs. In fact, ensuring that businesses and individuals have complied with government regulations usually costs the government a decent amount of money. Plus, the only ones who profit from regulatory compliance are those who sell products that ensure compliance. It is probable that there is a significant amount of corruption associated with this, but it does not necessarily follow that the government profits from this, either directly or indirectly. (Certain government officials may profit from regulatory corruption, but it seems highly unlikely that said officials use their illicit gains to, say, reinvest in the government. It seems more likely that they simply pocket the money for themselves.)
In the second place, compliance costs aren’t always recorded by businesses and individuals because there are times when it is impossible to tell how large a role regulatory compliance plays in a purchasing decision. For example, a fast food restaurant may decide to replace its ice machine. The restaurant will pay for the ice machine, and will thus bear some of the cost of the machine. However, since it is impossible to tell what sort of machine, specifically, the restaurant would have purchased were there no regulations with which to comply, we cannot be certain how much regulations cost the restaurant, if at all.
Finally, compliance costs remain invisible because they are hard to measure, in total. The sale of gasoline provides a perfect example of this, for it is impossible to say how oil refinement regulation compliance impacts the final cost of gas, how pump safety standard compliance impacts the price of gas, and so on. Compliance with these different regulations and standards occur at different points in the supply chain and, as such, the costs are assessed at different points in the supply chain. They have a cumulative effect, to be sure, but determining the extent of these costs is a fool’s errand, particularly if one tries to do so on a per-unit basis.
At any rate, the lesson to take away from this is that the cost of regulatory compliance should be part of the debate on taxation. That the costs are hard to see and difficult to measure doesn’t mean that the costs don’t exist. Nor does it mean that the costs should be ignored. Thus, when it comes to tax policy, regulations should be fair game.
By Winton Bates, on May 9th, 2011
‘Again, trade is a social act. Whoever undertakes to sell any description of goods to the public, does what affects the interests of other persons, and of society in general; and thus his conduct, in principle, comes within the jurisdiction of society’ … . The ‘so-called doctrine of Free Trade … rests on grounds different from, though equally solid with, the principle of liberty … . Restrictions on trade, or on production for purposes of trade, are indeed restraints; and all restraints qua restraint, is an evil: but the restraints in question affect only that part of conduct which society is competent to restrain, and are wrong solely because they do not really produce the results which it is desired to produce by them.’ J S Mill, ‘On Liberty’, 1859, Ch. 5
  This passage has puzzled me since I was a young man. It seems to me that individual liberty is obviously violated when governments intervene in trade. If a government imposes a tax on a good for the purposes of assisting the producers of a close substitute, this must be just as much an infringement of the liberty of consumers as when it imposes a sin tax on a good to discourage consumers from purchasing that good. However, it is now clearer to me what Mill was trying to say. The first key to the puzzle is that Mill refers to ‘the principle of individual liberty’ rather than just ‘individual liberty’. What Mill means by the principle of individual liberty is explained a couple of paragraphs earlier as the maxim ‘that the individual is not accountable to society for his actions, in so far as these concern the interests of no person but himself’. According to that view, the individual should be accountable to society for ‘actions that are prejudicial to the interests of others’.
  Friedrich Hayek and others have noted that the distinction that Mill sought to make between actions that affect the acting person and actions that affect others is not very useful because there is hardly any action that may not conceivably affect others in some way. According to Hayek the relevant issue is whether it is reasonable for the affected persons to expect legal protection from the action concerned (‘Constitution of Liberty’, 1960, p 145).
Now, in the paragraph immediately prior to his discussion of international trade, Mill acknowledges that damage to the interests of others does not necessarily justify the interference of society. In this context he discussed the views of society toward various forms of contest in which people who succeed benefit ‘from the loss of others’. He notes: ‘society admits no right, either legal or moral, in the disappointed competitors to immunity from this kind of suffering’.
The second key to the puzzle is that in the passage quoted above Mill suggests that all restraints are evil. If Mill is referring to coercion, as seems likely, then it seems to me that at this point he is close to recognizing the merits of the definition of liberty that Hayek later adopted. Hayek defined liberty as ‘a state in which coercion of some by others is reduced as much as possible in society’ (‘Constitution of Liberty’, p 11). This definition meets Mill’s desire to acknowledge that restraints are necessary to protect citizens from force and fraud, and may be appropriate under some other circumstances where individual conduct adversely affects the interests of others.
Mill seems to have been attempting to establish that the attitude of society toward individual conduct should depend on where it lies on a spectrum. At one end of the spectrum, where conduct affects only the individual actor, other people have no right to intervene. At the other end, force and fraud should obviously be illegal. At other points on the spectrum the effects of individual conduct on the welfare of society are ‘open to discussion’. (Mill uses these words are used in the introductory paragraphs of Ch. IV.)
In asserting that the ‘doctrine’ of free trade rests on equally solid ground to ‘the principle of liberty’ Mill is clearly implying that in our discussion of trade there should be a strong presumption that free trade enhances the general welfare of society. It follows that he must believe that government intervention in trade is generally an unwarranted form of coercion. That seems to me to be just another way of saying that such intervention is generally an unwarranted interference with individual liberty.
By The Gold Report, on May 9th, 2011
 As Adrian Day, of Adrian Day Asset Management, plays the current gold market “for all it’s worth,” he isn’t happy about the political decisions fueling it. Read in this exclusive Gold Report interview how he would fix the federal deficit, what he looks for in gold stocks and why his gut tells him the gold price is headed for a fall.
The Gold Report: Adrian, in your 2011 first quarter edition of Portfolio Review, you wrote that President Obama’s budget “shows he doesn’t understand the problem or is not serious about it.” How would you solve the problem?
Adrian Day: Low taxes didn’t cause the problem and high taxes won’t solve it. High spending caused the problem, therefore we have to tackle it by spending less. If you want to cut the deficit, you have to cut spending. If you want to cut spending, you have to go where the money is. You could eliminate every single discretionary item in the budget and hardly make a budge in the deficit. You need to cut entitlement spending—Social Security, Medicare and Medicaid—and defense.
TGR: How is the deficit problem affecting the gold price?
AD: It’s affecting the gold price significantly. The U.S. is borrowing tremendous amounts of money to meet its deficit. Over the last four to six years, China and Japan have been the largest buyers of U.S. debt. For the last six months, China has been a seller. Japan is likely to be a seller when the latest numbers come out.
The Federal Reserve has boosted the adjusted monetary base by over 27% from January to March 2011. It’s printing money to help the economy and to monetize the debt. It is buying Treasuries from the government because nobody else will. The Federal Reserve is buying over 80% of the new Treasuries being issued.
I think the situation is almost hopeless. About 10% of the federal budget is servicing debt. Since the credit crisis in 2008, the government has been doing more funding at the short end. The average yield on 30-year bonds is 2.2%. That’s extraordinarily low. On the new bonds, the average is even lower; I would venture to say well under 1%.
TGR: Standard & Poor’s warned that the U.S. would lose its credit rating should the White House and GOP lawmakers fail to reach a long-term solution to America’s mounting debt load. Is there a way out of this that isn’t good for gold?
AD: I don’t think so. They can’t immediately cut spending enough without putting the country into an enormous depression because so many people are dependent on government paychecks. They can’t raise taxes enough. They can’t raise interest rates.
The only answer is to print money and let the dollar go. The Fed can inflate or default. I don’t think they want to default. So, the Fed will continue deflating and printing money. The more that happens, the less attractive U.S. bonds become to foreigners.
TGR: Where do you see gold stocks and the gold price headed?
AD: I think we’re going to get meaningfully lower prices between now and the end of September. It’s partly a gut feeling, partly the fact that markets don’t go in straight lines for two years without corrections. We’re overdue for a correction in both the dollar and gold. I don’t think a correction in gold will be long and deep. I think gold stocks are going to correct much more than gold itself.
We’ve had some enormous runs in gold stocks in the last year or two. When people see gold start to correct, they will be ruthless in locking in their profits. I think some of the thinly traded juniors could come up significantly. Some of them have come off dramatically—20%, 25%—just in the last month.
In addition, May is often a seasonal peak for gold. So, weakness in July and August would be more typical than not. We just need to be a little bit patient and cautious in adding to positions. But there are some good buys.
TGR: Your firm specializes in gold plays, which appreciated more than 60% last year. Isn’t this a boom for you?
AD: Oh, absolutely. We’re going to play it for all it’s worth.
TGR: What’s the typical asset mix in your gold accounts?
AD: We have gold accounts and resource accounts. In the gold accounts, we have around 25% in the seniors. We have 10% to 12% in non-gold resources, which would include silver and more diversified companies. Then we have about 35% to 40% in exploration. We have about 10% in emerging producers, second-tier companies, like Allied Nevada Gold Corp. (TSX:ANV; NYSE.A:ANV). The rest are companies affiliated with the gold business like investment banks.
The major mining companies have a problem in that gold is a depleting asset. When Newmont Mining Corp. (NYSE:NEM) produces an ounce of gold, it has to go out and find another ounce of gold. When you’re producing 5 to 7 million ounces (Moz.) annually like Newmont or Barrick Gold Corp. (TSX:ABX; NYSE:ABX), it’s not that easy to find another 7 Moz. every year. That forces these companies to make acquisitions just to stay in place.
For the juniors and the exploration companies, the problem is that the odds are so long against them. The often-quoted statistic is that only 1 in 3,000 anomalies ever becomes a mine. Those are extraordinarily long odds.
TGR: But if the speculative interest in junior mining stocks were only to get to the point where the deposits were actually mined, there wouldn’t be any speculative interest, right? You can still make money on stocks that never get into production.
AD: Oh, absolutely. But a company raising millions of dollars from the market, pouring the money into holes in the ground, and not coming up with anything has to have a speculative move at some point.
It is the triumph of hope over experience that we keep giving money to companies when the odds are so long. We try to overcome that by looking at companies where the business risk is minimized or mitigated to the extent that it can be.
With seniors, for example, we’re very big on royalty companies like Franco-Nevada Corp. (TSX:FNV) and Royal Gold, Inc. (TSX:RGL; NASDAQ:RGLD). These companies have business plans that mitigate mining risk. They have plenty of upside, but they don’t have the same downside as producers who have the heavy curse of replacing ounces.
We very much favor the prospect-generator model where a company generates prospects and joint ventures production so other people spend the money. In return for giving away the majority of a particular property, the prospect generator retains its balance sheet. A good prospect generator can do this 5, 10, or 15 times.
TGR: What are some of the prospect generators that have been successful for you?
AD: One of the first was Virginia Mines Inc. (TSX:VGQ), which started out as a pure prospect generator. The model is that as you build a company, build a balance sheet, build the number of prospects where other people are spending money, and build the number of joint ventures, then you are in a position to afford a little more risk with a given property without destroying your balance sheet. Virginia did that with a discovery up in James Bay called the Eleonore Project. Eventually, Virginia sold the Eleonore Project to Goldcorp Inc. (TSX:G; NYSE:GG), which is putting it into production in 2014. It’s going to be one of Canada’s largest mines, with a mine life of 17 or 18 years. It has about 9.5 Moz. of reserves at the moment and is still growing.
TGR: Virginia also gets a royalty in advance of production.
AD: Yes, a very attractive advance royalty of about US$100,000/month. It’s also a variable royalty that goes up along with the price of gold as the cumulative number of ounces produced increases, with a 3.5% cap. Virginia will receive the cap in the second full year of production. Starting in 2015, Virginia, a US$280M market cap company, will receive about US$40M a year of free cash flow for 17 years. That is just remarkable.
TGR: If Goldcorp is going to pay Virginia US$40 M for 17 years, wouldn’t Goldcorp be better off just buying it?
AD: Goldcorp is the obvious buyer since it is probably worth more to Goldcorp, the company paying the royalty, than it would be to a third-party. Virginia also has a lot of land in the Eleonore area. Some of it has already had some attractive early stage exploration. Goldcorp is likely to want that as well.
TGR: Any other names?
AD: I like Vista Gold Corp. (NYSE.A:VGZ; TSX:VGZ) as an asset play. The current stock price is US$3. The company has 15 or 16 Moz. of gold at projects around the world. The company just did a joint venture on a property in Idaho. My guess is that after doing more exploration and building up reserves, Vista will spin that off into a separate public company.
Almaden Minerals Ltd. (TSX:AMM; NYSE:AAU) is very strong, with good management and a good balance sheet. They have a couple of exploration projects in Mexico that are returning strong results. Almaden is at US$4. At that price I’d probably not chase it, but it’s one we like a lot.
Eurasian Minerals Inc. (TSX.V:EMX) is selling at US$2.90. This is a prospect generator, so in return for low risk you have to be patient. Eurasian is a very strong company with a good balance sheet, good management, and a lot of projects around the world, including a joint venture with Newmont in Haiti. The whole company is selling for only US$150 M, a very low price.
Kiska Metals Corp. (TSX.V:KSK) used to be Rimfire, a pure prospect generator. Then it merged with Geoinformatics and obtained a project called Whistler. That’s when they started changing their strategy to focus on exploring. It’s a huge project with lots of upside.
TGR: Kiska has a lot of money on the balance sheet . . .
AD: Yes, but Kiska is spending money. I think they’re going to have a very good resource. I’m suggesting the project is too big for them to develop and bring into production on their own. There’s just enormous upside there before bringing in a partner.
TGR: Didn’t Kiska just find some copper/gold targets?
AD: Just last night (May 2, 2011). The results look very attractive. Assuming the results continue strong, the real key will be financing. Success depends on how quickly the company goes through money and how soon and how often it has to refinance before bringing in a partner.
TGR: The company just did a US$17M financing, so they should be cashed up and good for a while.
AD: They should be fine for a while. But it’s an expensive project. It’s at US$0.83 and there are 100 M shares out. So, you’re paying US$86 M for a lot of upside.
TGR: Another prospect generator that you have said you like is Midland Exploration Inc. (TSX.V:MD).
AD: Yes, we hold 5% in Midland, one of my favorite companies. It’s a smaller company with a market cap. The CEO, Gino Roger, runs the company in a very methodical manner without spending a lot of money. The company has about US$5 M on the balance sheet. It has two gold ventures with Agnico-Eagle Mines Ltd. (TSX:AEM; NYSE:AEM). Agnico just re-upped in one of those ventures for the third time. The other one is a regional joint venture in the James Bay area, where Goldcorp’s Eleonore project is. Midland also has a JV with Copper One Inc. (TSX:CUO) and an attractive JV with a Japanese national oil company on a rare earth project in the northern part of Québec called JOGMEC.
I think Midland is going to be the next Virginia. I would definitely buy it, but it doesn’t trade very much. So, this is not one that you buy at your discount broker. This is an astonishing buy. You’re getting an awful lot of value.
TGR: Any other companies you want to talk about?
AD: Miranda Gold Corp. (TSX.V:MAD) is another prospect generator in Nevada and Colombia. The market got a little bit tired of Miranda because it doesn’t seem to have much success. I don’t know when Miranda will succeed, but I would bet that it will have a discovery. In the meantime, you’re paying less than US$25 M for 12 joint ventures. I think the company is very cheap.
TGR: You have a long-term investment philosophy.
AD: Absolutely. We buy parts of companies, not pieces of paper. I am a ruthless seller. If I change my mind on a company or the company deviates from its business plan, I look at it very carefully. But I’m also very patient in holding throughout stock price volatility.
TGR: You will be at the New York Hard Assets Investment Conference on May 9 and 10 to talk about your new book, Investing in Resources: How to Profit from the Outsized Potential and Avoid the Risks. Can you give us a preview?
AD: I’m going to talk about four long-term trends in the world. First is the shift in economic power from the U.S. and the industrialized nations over to China and the emerging East. Second is the helpless financial situation of the U.S. Third is the ongoing decline of the dollar. The last is the growing shortage in resources across the board.
All four are interconnected. That’s where I want to be positioned. Even in my global managed accounts, we have 40% of our assets in resources. There will be growing shortages of platinum, copper and uranium; those prices are just going higher. That is where you want to be for the next several years.
TGR: Adrian, thank you for your time and insights.
Adrian Day is a British-born writer and money manager, a graduate of the London School of Economics, who has made a name for himself searching out unusual opportunities around the world. At his money management firm, Adrian Day Asset Management, he specializes in global diversification and gold equities for individual and institutional clients. Adrian is a frequent speaker at international seminars, a frequent guest on CNBC and The Wall Street Journal Radio network and has been interviewed by Money, Straits Times, Good Morning America and others.
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By Simon Grey, on May 6th, 2011
That is a big part of the problem. It is not politically possible for either the Federal Reserve or the Obama administration to leave the economy alone and let it recover on its own.
Both are under pressure to “do something.” If one thing doesn’t work, then they have to try something else. And if that doesn’t work, they have to come up with yet another gimmick.
All this constant experimentation by the government makes it more risky for investors to invest or employers to employ, when neither of them knows when the government’s rules of the game are going to change again. Whatever the merits or demerits of particular government policies, the uncertainty that such ever-changing policies generate can paralyze an economy today, just as it did back in the days of FDR.
There are two ways in which government tinkering promotes systemic uncertainty: by discouraging investment or by encouraging malinvestment.
The government discourages investment when it increases taxes and/or the cost of regulatory compliance. The state also discourages investment when it constantly reverses its own policies or is erratic in the enforcement of already existing policies. A continual state of flux discourages long-term investment because no one is able to feel certain about forecasting. One of the main reasons why ObamaCare and its counterpart RyanCare is so damaging is imply due to the fact that businesses aren’t able to feel certain about the future. The vociferousness with which RyanCare was debated helped to fuel systemic uncertainty, to a limited extent, because economic actors weren’t able to tell if any (or all) of the proposal would become law, and were thus unable to also determine what sort of long- and short-term plans would be viable.
But beyond that, the constant flux of change that is government tinkering also has a tendency to encourage malinvestment and market timing. Virtually every subsidy speaks as evidence for the former; Cash for Clunkers speaks as evidence for the latter.
Subsidies encourage malinvestment because they eliminate what economists refer to as moral hazard. Moral hazard is simply a fancy way of saying that people are more careful when investing their own money. When the government, for example, subsidizes corn-based ethanol, farmers have an incentive to grow more corn and venture capitalists have an incentive to invest in companies that will turn corn into ethanol-based fuel. This is generally unsustainable by market means because corn-based ethanol is energy negative, which simply means that producing ethanol burns more energy than it creates. Malinvestment can also be encouraged by indirect subsidies, like tax breaks or regulatory exemptions. This lowers the cost of doing business and increases profits, encouraging companies to pursue certain ventures.
When people think that the government may subsidize them, directly or by tax breaks, they have a tendency to wait until they qualify for the terms of the subsidy. This is true especially of temporary programs, like Cash for Clunkers, as mentioned before, or special tax breaks, like the first-time homeowners tax credit. These programs were ultimately failures because all the accomplished was pulling demand forward by a couple of months. They did not jump start the economy or increase long-term demand. Temporary subsidies, then, contribute to systemic uncertainty because economic actors try to time the market in order to get the most favorable deal. Businesses hold inventories to take advantage of greater demand later on. Consumers delay spending money in order to purchase things later on. Instead of allowing the market to function as it ought and smooth demand over time, government interference causes people to time the market and upset long-term plans.
Incidentally, the reason why temporary government programs generally become permanent is because there are some people who find temporary programs to be personally beneficial. When you have programs that offer lower prices to consumers and larger profit margins to businesses, most of the parties involved want to continue taking advantage of that system. Because of this, politicians vote to make temporary programs permanent because it is politically popular with their constituents, and because the political costs are widely dispersed and indirect.
Of course, the possibility of a temporary program becoming permanent also encourages systemic uncertainty because economic actors are unsure which specific programs will become permanent and if the terms of those programs will be altered in the process of attaining permanence.
In sum, it is simply best to let the market correct itself. Tinkering is futile at best and counterproductive at worst. Therefore, simply letting the market be is the best strategy, even if it is somewhat painful from time to time.
By Christopher Briem, on May 6th, 2011
It may be hard to appreciate the story in the news of Chevron leasing 228 thousand acres of land for Marcellus Shale development in the state. How much is that? By my calculation it looks like the area in red in the graphic below, compared to the footprint of the entire city of Pittsburgh.
Someone really ought to go and do a study to figure out how much Pennsylvania landowners got for leasing their land and compare it to how much those rights are going for in this mega secondary market.
By Simon Grey, on May 6th, 2011
Federal Reserve Chairman Ben Bernanke said Thursday the central bank was already moving forward with its new mandate to promote broad financial stability in the wake of financial oversight reform legislation that instructed it to do so.
The Fed “has restructured its internal operations to facilitate” a regulatory approach that looks beyond the health of individual financial institutions, to one that looks at the interlinkages between firms and the overall state of the banking system, the official said. [Emphasis added.]
Notice what the FRB has to say on its “About” page: The Federal Reserve System is the central bank of the United States. It was founded by Congress in 1913 to provide the nation with a safer, more flexible, and more stable monetary and financial system. Over the years, its role in banking and the economy has expanded. [Emphasis added.]
I’m not sure how Bernanke managed to overlook this, what with him being the head of The Fed and all, but the whole purpose of having a central bank was, from day one, to promote financial stability. That has always been The Fed’s mandate. It’s like a default setting for the system, which is why it’s so surprising that Bernanke is just now catching on to this.
Bernanke’s reaction thus speaks to the general problem of bureaucrats. Namely, bureaucrats have a nasty tendency to shirk their duties, which always requires renewing their efforts at doing their job, accompanied with more power and money than before. The reason why bureaucrats fail at their job (micromanaging the economy) is not because they don’t possess enough knowledge and information, it’s because they don’t have enough resources at their disposal.
Thus, no bureaucrat ever admits that he is less than omniscient. He merely pledges to renew his effort, promising that he’ll get the job done right this time. Provided, of course, that he is given more money and power with which to do his job.
By The Energy Report, on May 6th, 2011
 With rising global demand for food comes escalating cash flows that enable farmers to purchase additional fertilizers to further boost yields. Dundee Securities Senior Analyst Richard Kelertas follows junior potash explorers that have been red hot for much of the past six months. In this exclusive interview with The Energy Report, Richard shares some names that he believes could develop into bumper-crop multiples for investors.
Companies Mentioned: Agrium Inc. Aguia Resources Ltd. Allana Potash Intrepid Potash, Inc. Karnalyte Resources Inc. Passport Potash Inc. PotashCorp The Mosaic Company
The Energy Report: Are we at the beginning of a global bull market in food, Richard?
Richard Kelertas: Yes. We believe the upward price pressure started after the economic crisis in 2009, and it could remain a substantial bull market until stocks:use ratios (carryover:total use) in most major food stocks—grains, corn, soy beans—can be brought back up to 10-year averages. Currently, the ratios are well below those averages. There doesn’t seem to be any reprieve in sight, unless we have two to three years of bumper harvests in all grains around the world.
TER: Rising food prices usually mean increased demand for fertilizer, but that hasn’t necessarily been the case this time around. Do you believe the share prices of potash equities have exceeded potential growth rates?
RK: No, not at all. In retrospect, 2009 was a tough year for a lot of fertilizer producers. Farmers had to delay applications, even though they started to see crop shortages followed by slowly rising crop prices. We didn’t really see fertilizer-price recovery until 2010. Around March/April, or mid 2010, we started to see a pickup in fertilizer stock prices. It was slow at first and, in some cases, it has been muted; but at the beginning of 2011, it started to surge dramatically. Now it’s come off again on the expectation that all commodity prices, including that of oil, will come off as the global economy slows down (especially in China). But our view is that this is just temporary, and that these stock prices don’t really reflect anywhere near the fertilizer prices we are looking at in 18–24 months. So, these current stock prices are only reflecting mid-cycle, but nothing near peak, prices.
TER: What is the real driver for fertilizer stocks? China, India?
RK: It’s global, definitely global. China kick-started the demand increase by buying corn on a large scale, but it suffered a significant drought in the southern part of the country. That was followed by several crop failures, droughts, weather—you name it—throughout the world in different locations. However, the main driver, going 5–10 years out, is population growth and the increase of the middle class’ diet requirements. That’s the big driver.
TER: What about phosphates versus potash? Will phosphates catch up in the foreseeable future?
RK: Yes, eventually. Not much phosphate supply is coming out over the next 18 months, so it’s going to catch up. There’s no doubt about it.
TER: What about global potash and phosphates prices? They are not consistent across the world. Do you see them evening out in time?
RK: Well, it all depends. You could look at history and assume that they will, but governments’ export/import restrictions can have a dramatic effect on regional prices. So, it all depends. I suspect that small regional differences will start to coincide at some point. Prices are lower in China, India, Indonesia and the United States. In another six to nine months, we could see increases in all regions.
TER: Is there an arbitrage opportunity for investors there?
RK: Oh, yes, but not really in stock prices. You’d have to play the futures markets and the actual commodity.
TER: Do you have a price forecast for potash? And, will we ever see $1,000/ton again?
RK: No, we won’t see $1,000/ton. I don’t expect the type of hoarding experienced back in 2007 and 2008 will happen again to the same degree. We certainly will get speculation; but, typically, the amount of cash that’s available, the lending requirements and margin calls are more stringent than they were three years ago. You will probably see one-half of the speculative run-up in potash that we saw back in 2007. This time it is coming from actual supply/demand dynamics, not speculative investors gobbling up contracts. So, $1,000/ton?—I’ll never say never, but I think the next peak we’ll see is probably more in the $700–$750/ton range.
TER: Do you have a timeframe for that?
RK: Yes, about 24 months.
TER: How do you start your due-diligence process on something like a potash stock?
RK: Well, there are two different types of companies—the junior exploration plays, which are predevelopment, and the established producers. The established producers are companies like Agrium Inc. (NYSE:AGU), PotashCorp (TSX:POT; NYSE:POT), The Mosaic Company (NYSE:MOS) and Intrepid Potash, Inc. (NYSE:IPI). The due diligence you have to do on those is pretty basic, and a lot of information is available from published sources on the Internet. So, the amount of research is directly related to the amount of information available—and there’s really not much you can’t find. We sit down with management to go through the numbers, and then tour one or two of the operations. We consider the overall picture on different types of fertilizers to determine if this stock is positioned well and rank it next to its peers.
For junior developers, which are either in pre-exploration or exploration phase, it’s more difficult. We spend a lot of time with the management team, going onsite, talking to the geologist and making sure the resource is there. We also ensure that there are no outside risks—no native land claims or land lease difficulties. We want to make sure a company can secure land and exploration leases over a contiguous area, so it will be smooth sailing when drilling starts.
After that, it depends on how well the company is financed, the quality of its management team and the level of its compliance and its experience in the field. Finally, you have to ask: “What are the barriers to entry for these particular players?” It could be country, infrastructure or any of a whole list of risks. The amount of due diligence you do on the smaller companies is a lot more than you would do on the larger ones.
TER: Do you like to see smaller companies being managed, especially in the field, by people who have come from larger companies?
RK: No, not necessarily. It depends on their experience level. They may have worked and been successful at smaller companies in the past. A lot of the guys who work for larger companies haven’t had to go through the exploration phase—they’ve just gone through the production phase. So, the smaller companies don’t really need an expert in production quite yet—they need exploration experts. That’s where the difference lies.
TER: Do you consider these junior exploration companies you’re following value stories or growth stories?
RK: Well, it’s a combination; but sometimes you don’t have the value yet. Some might be growth stories only because they haven’t yet established the resource. Even if a company hasn’t started drilling yet, we look at the historical holes done 15–20 years ago. And if it shows some good concentrations of potassium chloride (KCL) or phosphorus, we’re happy to follow it along and look at the company as a growth story even though the value hasn’t been established.
TER: How long do you typically follow a company before you initiate coverage?
RK: Well, I spend a lot of time with management and going through the numbers. So, we probably spend two to three months with a company before we initiate coverage.
TER: Where are you finding your desired characteristics now?
RK: Right now, the ones that we spend a lot of time on are Allana Potash (TSX.V:AAA) and Karnalyte Resources Inc. (TSX:KRN). These two companies have tremendous potential for resource expansion, as they’ve done drilling on only a fraction of their properties. Allana is in Ethiopia, and Karnalyte is in Saskatchewan.
Another one that we’re looking at is Passport Potash Inc. (TSX.V:PPI, OTCQX:PPRTF) in Arizona near Holbrook. It has a lot of potential based on exploration work conducted there about 25 years ago. Passport’s management team has done a lot of advance work, and drilling is just starting now. But the history indicates, to us, that there will be some fairly large deposits.
We’re looking at another one called Aguia Resources Ltd. (ASX:AGR), which is a Brazilian phosphorus and potash play—a combination play which is fairly unique. We’re doing more work on it, but we think it’s going to an interesting value-and-growth story there also.
TER: The first two you mentioned, Allana and Karnalyte, seem to have a tremendous sense of urgency. Drilling is faster than expected.
RK: Right.
TER: Allana has 105 million tons (Mt.) potassium chloride in the inferred category. Ultimately, how large could this resource be?
RK: The company is looking at the first 11 drill holes and some of the 3-D seismic data, but it has not made anything public yet. The NI 43-101 will be out in mid May. From our experience, we believe that we could be looking at 500 million to 1 billion tons of potash—mineable potash.
TER: Let’s just take the low end of that, 500 Mt. of mineable potash. You’ve got a target price of $2.50 here, which represents 50% upside from where Allana is right now. But, at 1 billion tons of mineable potash, where could that take this stock?
RK: Well, if you put the sensitivity on the mineable potash, it could take AAA’s price well over $10–$12/share quite easily. It depends on the grade; so, there are a lot of ‘ifs.’ That’s why we make a sensitivity table, just to get an idea. If the grade is about 35%, which seems to be the case with the last four or five drill holes, it could be a 25% average grade. That would take us north of $10/share.
TER: Well, grades seem to be high, so far, from what I’ve seen.
RK: Very, very high—and Allana can do open-pit mining.
TER: There are some near-term catalysts; do you believe these catalysts are priced in or discounted to the stock?
RK: No, not at all. But I would say that many unanswered questions remain. There are still some risks and issues having to do with the country, location, infrastructure and things of that nature. There’s also a continuing view that commodity prices, potentially, have topped off here for the short term. We’ll probably see other commodities pull back; but, essentially, the farmer is sitting with lots of money in his pocket and is starting to apply more fertilizer.
TER: Karnalyte was the second company you mentioned, I noted that it was up just 2% over the last three months while Allana was up 79%. Does that give an investor something of a relative-value play here in Karnalyte?
RK: Yes; but, you also have to remember that Karnalyte surged from $8–$13 very quickly after its IPO. So, it put on a lot of its capital appreciation early in the process. Right now, the resource is based on just 7% of its total land holdings. The CEO thinks that the potash deposit is extremely contiguous, very deep and very large. So, if you extrapolate to 100% of Karnalyte’s property and add its newly added exploration rights, you’ll start to see the stock catch up.
TER: Ok, you have a $20 target price on Karnalyte. That’s an implied 60% upside from where KRN is now.
RK: Correct.
TER: And, the next catalyst could move it to there?
RK: Well, I don’t know if it’ll move it to there. It may take a couple more catalysts to get it there. But that’s my 12-month target, and I have no doubt that KRN will blow through that number.
TER: What is your target on Passport Potash?
RK: I don’t have a target yet. The company hasn’t made any resource information public, at least not to the extent that we can infer a net asset value (NAV); but that information will be out shortly. Passport is working on its NI 43-101 now, which will be ready by June. The company’s drilling as we speak and will release its first drill results in the next couple of weeks. Then, after two or three holes, we’ll be able to come out with a valuation.
TER: You mentioned Aguia. Is it formally under your coverage?
RK: Not yet. Like Passport, it’s an item of interest. We will be getting drill results from the company over the next couple of months.
TER: Richard, thank you and best wishes.
RK: Best wishes. Thank you very much.
Richard Kelertas has 25 years experience as a research analyst covering the forest products sector. He has been one of the top-ranked analysts in the sector over the years consistently, and was most recently ranked No. 1 by Brendan Woods. Richard has worked for a number of well-known brokerage firms, including Scotia McLeod, Deutsche Morgan Grenfell, UBS Warburg, and Desjardins Securities. He has a bachelor’s degree in forestry and a master’s degree in forestry and economics from the University of Toronto. Richard is also a Registered Professional Forester.
By B.P.T., on May 6th, 2011
At 8:30 AM EDT, the Employment Situation report for April will be announced, and the consensus for non-farm payrolls is an increase of 165 ,000 jobs compared to a gain of 216,000 in the previous month, the consensus for the unemployment rate is that it will remain at 8.8%, the consensus average hourly earnings rate is expected to increase 0.2%, and the consensus for the average workweek is 34.3 hours.
At 3:00 PM EDT, the Consumer Credit report for March will be released. The consensus estimate is that there will be an increase of $5.0 billion in the consumer credit available from February to March, after an increase of $7.6 billion last month.
By The Gold Report, on May 5th, 2011
  Party politics in America are pushing up the gold price, according to Encompass Fund Comanagers Malcolm Gissen and Marshall Berol. And that’s playing right into their hands as commodities and other hard-assets plays in the Encompass Fund continue to outperform the broad market. In this exclusive interview with The Gold Report, Gissen and Berol discuss their long-term investment philosophies and several of their fund’s most promising positions.
The Gold Report: Malcolm and Marshall, the GOP and the Obama administration are at a stalemate over how to tackle America’s $1.4 trillion deficit. The problem has rating agency Standard & Poor’s threatening to lower America’s top-notch credit rating unless a solution is reached soon. A similar stalemate could happen again in a few weeks when Congress votes on whether or not to raise America’s debt ceiling above $14.3 trillion to avoid defaulting on existing loans. Is partisan politics in America threatening America’s long-term financial security and, ultimately, driving up the gold price?
Malcolm Gissen: Absolutely. We are concerned that such hostile environments in state capitals and in Washington D.C. have made it very difficult for Democrats and Republicans to work together for solutions that benefit all of us. It seems everything is about getting elected and re-elected instead of doing what’s best for the country. We believe this factor will continue to drive up the price of gold and silver. The stalemate over the budget, both in various state houses, and in Washington, has so polarized our country that we believe it’s having a detrimental impact on markets. All of this plays well into hard assets because when people are worried about their economies, inflation and their own lifestyles, they tend to invest in hard assets. And this is something we’ve taken advantage of with the Encompass Fund and our client accounts.
Marshall Berol: While Malcolm and I often agree on investment philosophies and style, we have somewhat differing views on political issues. But I certainly agree with him that party politics are negatively affecting the people and country and that it’s one of a number of aspects driving up the gold price.
TGR: Gold recently climbed past $1,500/oz. Do you believe further upward momentum could be curtailed by the inevitable “sell in May and go away” sentiment?
MB: It could be, but the emphasis would be on “could.” If so, it would be a short-term effect. We remain very positive about the upward trends for gold and silver on a longer-term basis and that’s 6 months, 12 months and further out. There could be some correction over the next few months and it could be related to sell in May and go away, or it could be the summer doldrums. More likely there would be some profit taking due to the fact that gold is now over $1,500/oz.—a new all-time high and silver is roughly $48/oz. and also approaching a new all-time high.
Our experience in managing the Encompass Fund and individual client accounts over many, many years is that, when a concept or theory becomes well known, it often doesn’t continue to work. Sell in May and go away is certainly in the forefront of people’s thinking this year and probably the last couple of years. It very well could be that, because it is foremost in people’s consciousness, it’s not going to happen.
MG: We invest in a number of junior mining companies, including precious metals juniors. The companies the Encompass Fund invests in tend to be those making lots of progress. They’re exploring, drilling, moving toward production and enhancing their value. There’s a stream of good news that’s coming out of these companies and that moves the stock price regardless, almost, of what’s going on in the markets. As these companies make terrific progress, the Encompass Fund believes they will be rewarded in the marketplace. We don’t invest more or less in gold companies based on the time of the year; the Encompass Fund invests in outstanding companies that we believe are making progress.
TGR: How much is your fund up so far this year?
MG: The fund is up about 3% this year. Morningstar puts the Encompass Fund in the World Stock Fund category and for one year, the category was up 14.17%. As of March 31, 2011, the fund was up 51.5%. It’s very unusual for a fund to outperform its category by more than 1, 2 or 3 percentage points. So, to outperform by 36% is very unusual. Over three years (to March 31), the Encompass Fund has gained a 19.6%-per-year average annual return, compared to about 1% for the World Stock Fund category.
TGR: And to what do you attribute that?
MB: The fund is set up as a no-load mutual fund on a go-anywhere basis. We can invest in companies of any size. We can invest domestically or internationally, and we do; we can also invest in any industry or sector. While we’ve focused on gold and resource companies since we launched the fund in June 2006, we’re not solely a resource or gold fund. We have holdings in other categories. We’re stock investors—we don’t use futures. It’s the focus on the resource companies that has enabled the Encompass Fund to perform so well because the gold and silver stocks and rare earth elements (REE), copper, uranium, coal, gas and other commodities are doing very well.
MG: We have four people here who are involved in sourcing ideas, doing research and monitoring the positions in the fund. All of us have a minimum of 15 years’ experience and a few of us have 25 years’ experience. Over the last 10 years, we’ve formed relationships with brokerage firms doing business around the world. Those relationships not only provide us access to outstanding analysts and their best ideas, but it also brings us opportunities for private placements in companies on very attractive terms. These are companies that have very high growth potential; thus, we provide exposure to sectors and companies that very few, if any, other American mutual funds provide.
TGR: Indeed. As Marshall said, your fund is heavily weighted toward resource companies and particularly junior explorers seeking economic concentrations of hard assets like gold, silver, oil and gas or uranium. These small segments of the market are currently outperforming the broader market, but how long do you think that’s going to continue?
MG: We live in unusual economic times, and we believe the explosive growth we’re seeing in developing economies will likely continue for the next 10–20 years. This growth requires enormous amounts of resources whether they be energy, precious or other metals; and as a result, we believe that resource companies should perform very well over the longer term.
MB: Historically, the small caps have outperformed the large caps. We’re investing for the long term and our experience has been that the smaller companies—the mid-cap, small-cap or micro-cap companies—are more likely to have that long-term growth than are large companies. A large company is more stable but it’s less likely to have the kind of growth that we think can be obtained with smaller companies. Some examples would be Barrick Gold Corp. (TSX:ABX; NYSE:ABX) and Newmont Mining Corp. (NYSE:NEM). Those are fine companies but they’re not going to grow their companies and, hence, the stock prices as quickly as many of the companies we have in the Encompass Fund portfolio. Having said that, we do have positions in some larger companies, such as Freeport-McMoRan Copper & Gold Inc. (NYSE:FCX), which we think is just an excellent copper and gold company. It’s the world’s largest publicly owned copper producer and also a large gold producer; very well managed. But we tend to lean toward the small-cap and micro-cap companies.
TGR: Could you tell us about a few of those companies? Let’s start with some names in the gold and silver space.
MG: A gold company that we have invested in for about three years is Avion Gold Corp. (TSX:AVR; OTCQX:AVGCF). Initially, we invested at roughly $0.10 about three years ago. Avion has since become a gold producer in West Africa and is now trading at around $1.65.
TGR: Was that initial position part of a private placement?
MG: Yes it was, and then we bought more in the open market and got stock in warrants. In fact, we’re exercising the warrants now because they expire in a couple of weeks. The warrants were at $0.65; so, we’ve had a very big gain. Avion’s production was about 51,000 ounces (Koz.) in 2009 and around 87 Koz. in 2010. This year, it anticipates producing about 100 Koz. With gold at $1,500/oz., that’s $150M in cash flow. Avion has very good grade in its mines in Mali. The company’s doing further exploration and getting very good results. In addition, it has and is exploring properties in Burkina Faso, also in West Africa. The results look promising and the company expects to complete an NI 43-101-compliant resource estimate during the second quarter of this year.
TGR: Avion owns 80% of the Segala, Tabakoto and Dioulafoundou gold deposits in Mali. Those are currently open-pit operations, but Avion is going to head underground at some point, correct?
MG: That’s correct. And we believe, with the grade it’s getting and the exploration results, Avion should be expanding its resource. The 43-101 will be important because it will provide verification for what the company’s doing. Many larger gold companies wait for junior miners to produce a 43-101 report before they start getting interested in the junior, in terms of a possible acquisition.
TGR: One thing raising some eyebrows with Avion is its cash costs per ounce. What are your thoughts on that?
MG: Avion’s cash costs have been a bit high. The company has focused on reducing cash costs and expects that it will reduce them.
MB: It’s also a function of increased production. Avion has increased production steadily and feels that it will continue increasing production, which should bring down the cash costs. Cash costs are certainly an important factor to look at; but regardless of whether you’re looking at $450–$500, or even $550/oz. cash costs, with gold at $1,400–$1,500/oz., that’s still a healthy margin for any company.
TGR: Have you met with Avion management?
MG: Yes. We should point out that we meet with the managers of almost all the companies in which we invest. We try to get very close to these companies, so we can call and talk to them on a regular basis and get updated on any developments. A good number of the CEOs of the companies in which Encompass invests call us regularly. I should point out this is not insider information, but we do like to keep abreast of the companies in which Encompass is invested.
MB: With a smaller company, we find that it’s more valuable to have met and sized up management.
TGR: It’s also a matter of reducing the risk because, if you meet and get a good sense of management, you go into that investment with a greater feeling of security.
MB: That’s very true, and each of the four of us involved in portfolio decisions has a good amount of experience in meeting with companies. We feel it’s very helpful in determining whether or not to invest in a company, or whether to sell some or an entire position in a company after we’ve invested. We also believe in doing site visits to the projects of the various companies in which we’re invested or interested.. We find it’s very helpful to meet not just top management, but also the people involved in exploring the project or running the mine.
TGR: What about some other silver and gold names that you like?
MG: Another company that we like is Extorre Gold Mines Ltd. (TSX:XG; NYSE.A:XG; Fkft:E1R;), which is a Canadian company that has some excellent projects in Argentina. It was spun off from Exeter Resource Corp. (TSX:XRC; NYSE.A:XRA; Fkft:EXB). What we like about Extorre is that its projects are near a lot of infrastructure—and those projects are extremely high-grade. The company recently announced some additional drill results from its flagship project, Cerro Morro, and the grade was very impressive. Also, the project should be easy to get into production—maybe even by the end of 2012. Of course, we like the management. Extorre’s a very aggressive driller, which we also like and the drilling results have been incredibly attractive. Extorre has a lot going for it.
TGR: Cerro Morro is not far from Goldcorp Inc.’s (TSX:G; NYSE:GG) Cerro Negro gold-silver project in Argentina, which it bought from Andean Resources for $3.5B last year. Does that increase the odds of Extorre being a takeover target?
MG: Extorre certainly could be a takeover target and its management pointed that out when Andean was taken over by Goldcorp, including what it paid. However, Extorre Cochairman Yale Simpson recently said: “We are not selling; we have a lot further to go. We have a great resource and want to continue drilling, and we are not going to sell the company.”
MB: Most companies have managements that portend to continue exploration—drilling, then on to an NI 43-101 report, then prefeasibility and feasibility studies, developing a mine and getting it into production. That happens, sometimes. But more often, another company comes along with an offer that’s too good to refuse and the company either winds up selling the project or the company. That was the case with Andean. Depending on whose numbers you use, Andean was bought for $900–$1,100/oz. gold in the ground—but Goldcorp recently reported a doubling of the amount of reserves at that project.
We don’t buy a company because we think it will be bought or because its project is going to be bought. That’s the icing on the cake. The Encompass Fund isn’t buying based on takeout rumors—it’s buying based on good, solid projects and good, solid companies. If a buyout comes, and the Encompass Fund has had several buyouts over the course of its life, that’s great and we’re happy to get the additional premium that comes with the deal.
TGR: Extorre is trading in the $9–$10 range. How much did you pay for it?
MB: Several years ago, we bought Exeter; as a matter of fact, when we started Encompass Fund in June 2006, we bought Exeter and added to it over the succeeding years. Then in early 2009, Extorre was spun out of Exeter on a 1-for-1 stock basis. On the suggested tax-basis split of 80% of the original cost to Exeter and 20% of cost to Extorre, Encompass’ cost was roughly $0.40 per XG share. Subsequently, we sold some Extorre when the Fund had a very substantial gain—and sold more when it continued to go up. After that, we bought additional shares because of the company’s continued excellent drilling results. Extorre is making excellent progress. We continue to like it and buy it.
TGR: In addition to your success with gold and silver juniors, you’ve also had success with rare earth plays. What are some REE plays that you’re excited about?
MB: Encompass Fund initially invested in Avalon Rare Metals Inc. (TSX:AVL; NYSE.A:AVL; OTCQX:AVARF) in September 2007 at $1.81 and has added to it since then. Avalon’s current price is about $9/share. Another company that is involved with REEs, but with a very different business model, is Dacha Strategic Metals Inc. (TSX.V:DSM; OTCQX:DCHAF). Dacha is an investment company that is focused on the acquisition, storage and trading of strategic metals, primarily REEs. We think Dacha is very attractive and underappreciated in the marketplace.
As your readers are aware, 95% of the current REE supply comes from China, which has been enforcing export quotas. And the prices of the metals are rising due to industrial countries’ increasing difficulty to source them. Dacha was set up a couple of years ago with the proper licenses to buy REEs in China, store them (primarily outside of China), and then sell and trade them to various customers. It’s been doing this successfully for a couple of years now. Dacha’s a low-priced stock—it currently has a net asset value (NAV) around CAD$0.68/share—but it’s trading at about CAD$0.46/share. There are some concerns about whether the company can source the material coming out of China, warehouse it and sell it. But Dacha’s been able to do that so far, and we think it will continue doing so, which is why the Fund owns it.
TGR: Could one of the other reasons that Dacha’s share price is lagging its NAV be that its biggest customer base is in Japan? As we all know, Japan suffered a major earthquake and tsunami and a lot of its manufacturing has been affected.
MB: It’s possible. I can’t comment on if it’s selling as robustly as it would like to, but it is selling. Some sales have been reported over the last several months. The situation in Japan is tragic and it’s extremely unfortunate, but it’s not going to affect Japanese manufacturing on a long-term basis; it’s a shorter-term situation. Another aspect of Japan’s earthquake and tsunami is the aftereffect on uranium stocks. We have since added to Encompass’ positions in uranium stocks we already own and initiated some positions in other uranium producers because those stocks effectively went on sale.
TGR: Can you provide a few uranium names that you were able to get at lower prices given the onset of the nuclear problems in Japan?
MB: Yes, one of the larger holdings in the Encompass Fund portfolio is Uranium Energy Corp (NYSE.A:UEC). Before the Japanese disaster, it was selling at over $5/share and very briefly dipped down to $3/share. We added to our position at around $3.25–$3.40 per share. Another company that we liked and wanted to have a position in but at a better price is Ur-Energy Inc. (NYSE.A:URG; TSX:URE), which also went down 40%–45% in price. We initiated a position in URG and have since added to it. Another company I will mention quickly is Tournigan Energy Ltd. (TSX.V:TVC, FSE:TGP), which has a uranium project in Slovakia.
TGR: What do you think is the next milestone for gold? And will we reach it in 2011?
MB: The next milestone is further all-time highs. At the Encompass Fund, we’ve invested in certain gold companies and added various others for the last several years while people were saying things like, “It’s a bubble,” “It’s a top” or “It’s not going higher.” We didn’t believe that was the case, and we still don’t think that’s the case regardless of whether pundits gave it a $1,500/oz. price target. We’re there and now they’re talking about $1,600, $1,800 or $2,000/oz gold. We’ll likely get to those amounts, we just don’t know when. It is very difficult to put any specific price on it. So, at this point, we’ll continue to stay tuned and invested. We’re holding a larger amount of cash now than we often do—around 30%. And we’re looking for opportunities to put that cash to work.
TGR: Thank you for talking with us today, gentlemen.
Malcolm Gissen founded Malcolm H. Gissen & Associates Inc., an investment advisory services firm, in 1985. He has been an investment advisor since 1985 and has managed separate accounts since 1999. Mr. Gissen’s management experience has focused primarily on investments in publicly traded companies. Mr. Gissen has a BS degree from Case Western Reserve University and a JD from the University of Wisconsin.
Marshall Berol has been engaged as an investment manager in San Francisco, CA since 1982. Since 2000, he has been the chief investment officer of Malcolm H. Gissen & Associates, Inc. In addition, Mr. Berol has owned his own investment firm, BL/SH Financial for more than 20 years. His investment management experience has focused primarily on investments in publicly traded companies. Mr. Berol did his undergraduate work at the University of California (Berkeley) and received a JD from the University of San Francisco School of Law.
Mr. Gissen and Mr. Berol cofounded Encompass Fund, a no-load mutual fund, in June 2006 and are the Fund’s coportfolio managers.
By Ajay Shah, on May 5th, 2011
Manmohan Singh as finance minister killed off smuggling, by eliminating customs duties. Black money in the real estate sector recently attracted his attention. He suggested lowering of stamp duties to check the flow of black money in this sector. But will this solve the problem of black money? And how will the State compensate for the loss of revenue collected from stamp duty?
Stamp duty is a transaction tax; it is charged as a percentage of the transaction value of the property. Public economics teaches us
that all transaction taxes are bad taxes, that the right level for the stamp duty is zero (as it is for all taxation of transactions).
The stamp duty distorts the behaviour of parties to the transaction. Stamp duty on property is usually paid by the buyer. Hence, the buyer tries to coax the seller to agree to undervalue the property on paper (the transaction value declared to the government) and accept the rest in black money. On the other hand, sellers have an incentive in accepting black money from the buyer in order to evade the taxation of capital gains. As long as real estate capital gains are taxed, eliminating the stamp duty will influence the
behaviour of the buyer but not that of the seller.
Hence, modest changes in the stamp duty rate will not solve the problem of black money in real estate. When stamp duty is eliminated, the buyer will be comfortable with zero evasion, but the seller will still urge him to take some black money.
Bad taxes should be eliminated because they are bad taxes. There should be no attempt at finding a direct replacement. As an example, India largely phased out customs duties, because the economists said these are bad taxes, without specifically trying to find a replacement. The elimination of customs duties enabled high GDP growth, and the main pillars of taxation (income tax and the VAT) generated bountiful revenues. A similar story will hold for stamp duty.
The economists teach us that all taxation of transactions is wrong. The property tax suffers from no such problems. Much work is needed in India in building a sound property tax system. In some countries, property tax revenues can be as large as 1% of GDP, which is a very big number compared with the financing of local government in India. The key issue is that the average value of property in each micro neighbourhood (e.g. a 200 metre stretch of road) needs to be assessed correctly and revised every year. This should then be used as a preumptive property tax rate, per square foot, for that micro neighbourhood. Once this is done, property tax collections will be a powerful source of revenue for local government.
There is a link between these two issues. As long as there is a stamp duty and high taxation of real estate capital gains, the reported data will understate property values. This will hamper the revenues obtained through the property tax. To the extent that we solve the twin problems of stamp duty and capital gains taxation, the data in the hands of government about real estate prices will improve, and this will bring property tax to life as a significant revenue source.
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