Nef Value Research Inc

Nef Value Research Inc.

November 23, 2006

Happy Thanksgiving! As we approach the holidays, I begin to think about next year and what hidden pitfalls or opportunities could develop over the next 12 months. Before I get into this year’s ideas, I’d like to review last year’s themes and whether or not they came to fruition.

Score Card For The Ideas Of 2006

Idea #1: Russia, Iran, Venezuela or OPEC begin to accept payment for oil in Euros or gold.

Although not really talked about, I count this prediction as a winner. On March 20, Kommersant, a Russian business daily, reported that Iran had begun selling its oil entirely for euros instead of dollars. This is Iran's second move in this direction. Back in the summer of 2003, Iran began selling oil to its European Union customers for euros. Iran has switched for economic reasons since the EU imports more oil from OPEC countries than the U.S. does, and the EU also accounts for well over half of the Middle East's imports. Iran is also trying to develop an oil exchange, based in Tehran that would conduct business in euros only, establishing a euro-denominated oil pricing standard.

I would not be surprised to see Russia or Venezuela follow suit. In fact, both countries have talked about doing just that. Indeed, earlier this year, a small bourse in Russia began trading option contracts on oil and gas in euros. Note only options are being traded for now and delivery cannot be taken in oil. Still, it gives the bourse experience in trading in Euros. As I said last Thanksgiving, at this juncture I don’t expect the limited trading in oil for euros to have much impact on dollar hegemony since there are currently not enough euros to accommodate a 100% change over to oil for euros. I do think that over time the U.S. will lose dollar hegemony and that the dollar will weaken further. I believe this process will take years, however, not weeks.

Idea #2: After a one-year reprieve, the U.S. dollar once again begins to weaken versus the Euro and a basket of Asian currencies.

I was right on this one also. The dollar did weaken against both the yen and the euro. Although the dollar has rallied back versus the yen, it still remains below where it started the year. The economy has been much more resilient than I would have expected, however, so I can’t count this as a full dead-on correct prediction. I got the dollar direction right, and some of the sector movements correct, but I didn’t get the economic slowing I was expecting other than in housing and in autos.

Idea #3: Gold continues to hit new highs, and the bull run in gold and gold equities continues.

This one I hit right on the head! Gold was at $507 an ounce when I wrote my Thanksgiving Thought piece last year and I said that it was going to climb at least 10%. As I write this report, gold is now sitting at $628 an ounce. Not a bad one-year return! Given that I gave specific stock ideas under this heading rather than just sector-specific calls I have tabled my stock picks and their returns below. The table shows the returns from the date of the report, to the high and until today. I have also added a column showing the return for a sale 7% below the high since I always expect my clients to use a 7% trailing stop on all my longer-term calls once they are up at a double-digit rate. It is always better to pocket some gain than to give it all back is my motto.

12/5/2005 Price / Price @ High / 7% Stop From High / 11/21/2006 Price
ABX / $26.55 / $36.03 (+35.7%) / $33.51 (+26.2%) / $29.09(+9.6%)
AUY / $5.09 / $12.42 (+144.0%) / $11.55 (+126.9%) / $11.14(+118.9%)
BGO / $2.90 / $6.33 (+118.3%) / $5.89 (+103.1%) / $5.09(+75.5%)
CDE / $4.22 / $7.37 (+74.6%) / $6.85 (+62.3%) / $5.15(+22.0%)
EGO / $4.21 / $5.80 (+37.8%) / $5.39 (+28.0%) / $5.08(+20.7%)
GG / $20.27 / $41.66 (+105.5%) / $38.74 (+91.1%) / $27.48(+35.6%)
GLG / $22.73 / $48.07 (+111.5%) / $44.71 (+96.7%) / $45.07(+98.3%)
KGC / $7.73 / $15.39(+99.1%) / $14.31(+85.1%) / $11.64(+50.6%)
NEM / $46.75 / $62.60(+33.9%) / $58.22(+24.5%) / $45.11(-3.5%)

Altogether, not too bad a job of predicting if I do say so myself…And I do! Below are my thoughts about potential surprises for 2007. Read through them and feel free to contact me with any questions. Also, if any of you want my Thanksgiving Thought pieces for the last two years, don’t hesitate to contact me. I will be glad to forward them to you.

Potential Surprises For 2007:

1. Water infrastructure stocks will come to the forefront as an investment theme. Although the recent elections brought water issues to the forefronts due to a number of infrastructure bonds that were voted on across the nation, longer term trends are what are driving me to be bullish on the industry. Indeed, even though 70% of the earth is covered in water, only about 3% of that water is potable; and about 68% of that 3% is locked up in icecaps and glaciers. Although common in the U.S., only 20% of the world’s population currently has running water. In many third-world countries industrial and human waste contaminate the water supply for whole regions. In Latin America and the Caribbean, one-third of childhood deaths are the result of diarrhea. The problem could be resolved with clean water and appropriate sanitation systems.

China also suffers from a potable water shortage. Some 21,000 chemical factories are believed to be located along China's rivers and coastline. More than half of these plants are on the Yellow and Yangtze rivers, which are relied upon by millions of people for their drinking water. Earlier this week a stretch of China's Yellow River turned red because of pollution. This marks the second time in a month that the river was impacted. A year ago, an explosion at a chemical plant in eastern China caused a major toxic spill in the SonghuaRiver. Water supplies to Harbin city were cut off for four days, and rivers in Russia's Far East were affected. As China continues to increase its industrial base, the country’s demand for fresh water will intensify. Three stocks to look at if you want exposure to the Chinese market include: CLWT, MPR, and WTS. Although there are larger companies that can give you exposure to the Chinese markets, water related products typically don’t make up enough of their revenue base to make them “water” plays. GE is a good example of one of these companies.

In the United States,the American Society of Civil Engineers (ASCE) estimates that the U.S. will have to spend about $1 trillion over the next twenty years to upgrade our infrastructure. In California, for example, ASCE found that “many components of the state’s water systems are nearing the endof their design (or useful) life.” In their 2006 Infrastructure Report Card For California ASCE stated that they believe the total identified ten-yearinvestment need required to support the state’s growing population is$40 billion. This represents an annualized cost of approximately $4.0billion. These amounts only take into consideration the costs for drinking water. Urban runoff and waste water collection were also rated and again the state came up with systems that need upgrading. In fact, ASCE recommended a minimum amount of spending of $5.5 billion and $2.6 billion over the next five years to update the current systems. Clearly, companies that supply water infrastructure products in the region stand to benefit from any added spending that the state does to improve its water and wastewater infrastructure.

On Election Day,California voters approved $9 billion in resource management bonds to help address some of these requirements. Although there are many companies that would benefit from the added spending, Ameron International stands out since it is a regional market leader for both water and waste water pipes in California. Currently, the company’s Water Transmission Group is suffering through weak market conditions. Its Fiberglass-Composite Pipe and Infrastructure Products Groups and TAMCO, Ameron's 50%-owned steel mini-mill, are all generating record sales and profits due to strength in the energy markets. At this point in the cycle, I would put AMN on your radar list only. The stock is trading at about 14x earnings, which is its average high multiple over the past 18 years. The stock has been on a bit of a tear since bottoming on October 4th likely due to speculation about the outcome of the bond votes. The stock is very volatile and has traded below 10x earnings in 11 out of the past 12 years. A little patience here should reward you with a good entry price below $67 a share.

Implications:

To finish up on my thoughts on water, infrastructure spending is needed world wide. In the west the infrastructure has gotten old and is beginning to wear out. While in the third world many water systems will be installed for the first time. Demographics point to increased spending on this niche going forward and I believe all portfolios should have some exposure to the group. For those of you who want broad exposure, take a look at PHO, Powershares Water Resource ETF. This fund holds a basket of stocks that are involved in water infrastructure and transmission. For those of you a little more adventuresome, I like MPR, WTR and CWCO. CWCOuses reverse osmosis technology to produce freshwater from seawater and has a lot of Caribbean nations as customers.Meanwhile, WTR is a water utility (1.90% dividend yield) with well diversified U.S. operations. The company recently did a large acquisition in the Northeast that should give revenues and earnings a boost in 2007. Moreover, the company has a number of rate cases coming up that should also have a positive impact on the bottom line. Finally, MPRmanufactures and sells product recovery and pollution control equipment for purification of air and liquids, and fluid handling equipment for corrosive, abrasive and high temperature liquids. The company has been hitting on all cylinders as of late, reporting record revenues and net income during its third quarter. MPR was also recently recognized as one of America's "200 Best Small Companies" by Forbes magazine.All three of these stocks I think will be solid holdings for the year ahead.

1. Despite the recent rally in Homebuilding stocks, the housing market is likely to get worse in 2007 and start to have an impact on the economy.In my opinion, housing has been building into a bubble since about 1998. Declining interest rates and a 1997 tax law change that allowed married homeowners to deduct up to $500,000 ($250,000 for singles) of capital gains from the sale of a house owned for at least two years combined with easy lending practices to drive housing demand to heights not seen since the 1920’s. The increased use of mortgage-backed securities also allowed the banks to increase the level of risk they were willing to take when giving a loan since they would quickly securitize the loans and offload them to investors with higher risk tolerances. All said, the loans are on the banks’ books for less than sixty days in many cases. The trends noted above combined to drive median house prices well above their usual relationship with the CPI. Indeed, it would take a 35% drop from current levels just to get housing prices back in line with the CPI. My reasons for believing that lower housing prices are on the horizon are threefold.
2. Surveys done by the National Association Of Realtors in 2005 showed that 28% of all homes sold were bought for investment and another 12% were bought as vacation homes. This implies that a large number of homes are out in the market place that are not owner occupied. If real estate sales keep lagging and prices keep dropping these “investors” could decide to sell now to avoid the risk that prices could drop further. Moreover, I would suspect that there are many small homebuilders who built spec houses since prices last year were running up so strongly on a weekly basis. All of these houses could potentially come on the market at drastically reduced prices to “move” them quickly. In my county in NJ, my realtor has told me that listings are up 60% and that sales are down 10% year over year. In New Hampshire, (where I just bought a house) I can tell you from experience that house prices are falling.

Overall, what I am trying to point to is that inventories of unsold homes are rising (and have the potential to rise more) while sales are declining. As with any industry, rising inventories and lower sales is an early sign of earnings trouble. All of the homebuilders have been adding incentives to try and stimulate sales, yet sales are still declining. EPS estimates have been falling and given the levels of incentives they are bound to fall further. Look for lower earnings estimates ahead for the homebuilders as we enter 2007. All said, the U.S. currently has a 7.1 months supply of houses for sale compared to a low of below 4 months supply in early 2005. The big risk to the housing market is that speculators panic due to the falling prices and lower their prices to make a quick sale causing others to follow suit. Lower prices will lead to further lower prices causing a spiral downward. Using the past as a prelude, it usually takes about two years from the first sign of a slowing in sales to when price discounting begins. Because of the large amount of speculation in the housing market right now, that point could come sooner.

• Mean reversion. Housing sales have been falling since July of 2005. From the peak in June 2005 existing home sales have fallen 14% and new homes are down 22%. Still as I noted above we would need to see a 35% drop from current levels just to get housing prices back in line with the CPI, which it has typically run pretty close to. Unfortunately, when markets overshoot to the upside they often over correct as well so a decline could be even larger.

Although it is easy just to point to mean reversion and leave it at that, it is more beneficial to point out what will cause the reversion. One trigger that can help lead to higher inventories and lower prices is the current make up of the mortgage pool in the United States. As I have already noted above, mortgage lenders have increased the amount of risky loans they have made while offloading much of the risk they have taken to the mortgage-backed securities market. On the flip side of this statement is the fact that many borrowers have gotten themselves into loans with adjustable rates. Typically, borrowers who use these loans are using them to buy a house that they otherwise could not afford. The loans start with a lower payment rate and then adjust later as interest rates rise or fall. Over the past year, interest rates have been rising and there are about $1 trillion in loans out there that are ready to reset this year. Although many of the borrowers will opt to refinance their loans and thus keep similar payments, many won’t be able to due to lower housing prices and higher interest rates. These buyers could also put their houses on the market leading to more inventory and lower home prices.

• My final reason for a potential bust is that real estate has a very large impact on the economy in general. Indeed, Some reports say that 2/3 of the jobs created over the past five years are directly tied to real estate. If the real estate markets declines precipitously, it is likely that the economy will suffer also further dampening housing sales.

Implications:

All said, what I have painted above is a worst case scenario. More likely is that we do see a decline in housing prices and sales, but more in the order of 10% - 15% in 2007. A drop off in real estate prices would be deflationary and would likely cause the Fed to lower rates. This in turn would be inflationary since it would likely weaken the dollar even further. Under this scenario I believe stagflation would exist…a stalled economy with rising consumer prices coupled with declining financial asset prices. It took about 10 years for the Japanese real estate bubble to decline close to 50%. I see nothing that would lead me to believe that a similar situation can’t happen here. One point that confuses me, however is that if the Fed cuts interest rates it would likely weaken the dollar. In my opinion, the U.S. needs high rates to continue to attract foreign buyers of our debt so that the government can continue to over spend their budgets. At some point, rate cuts will become untenable and the dollar will weaken substantially. At this point I have to admit that I am not a smart enough guy to figure out what the Fed or the government can do in this situation. If the above scenario plays out the U.S. will be caught between a rock and a hard place.

Under the above scenario where real estate prices are eroding, interest rates are falling and the dollar is weakening I believe the precious metals stocks would likely be a safe haven. Moreover, given that we are already on the ground in the Middle East, I believe the stocks of defense companies that provide goods and arms that are needed now for the missions in Iraq and Afghanistanare likely better investments than the defense stocks that supply non-essential R&D-type programs to the government.