Theories of Power




–“What will we do when the Murray River runs dry?”

–“Pray for rain.”

–“Won’t it be too late by then?”

–“Dunno. ”

–We buy our coffee every morning from Adam at Café Presse down the street. He helps us out when we’re learning new Australian words and from time to time we ask him what’s on our mind, just to see what someone else is thinking. Adam may be praying for rain, but he’s also recycling all the unused drinking water patrons leave behind. He’s not recycling it for other patrons, mind you. It goes to water the plants out back. We bring it up only because it doesn’t seem to be getting any wetter outside today.

–In the markets, liquidity is still abundant and merger and acquisition activity flows freely. Yesterday we reported on AGL’s (ASX:AGK) interest in merging with Origin Energy (ASX: ORG). It turns out becoming the largest energy company on Australia’s east coast doesn’t have everyone excited, especially the Australian Competition and Consumer Commission.

–“An industry source suggested AGL was positioning itself for the development of an overdue national gas market, expected to be up and running in the next two years,” reports Geoffrey Newman in today’s Australian. Overdue is the right word. The Council of Australian Government’s Ministerial Council on Energy (we’re serious) has been hemming and hawing on national energy market reforms for years. An Australian Energy Regulator (AER) has been established in order to standardize and harmonize different state energy regulations which have prevented the emergence of a national energy market, delivering reliable electricity and gas at lower costs to Australian consumers.

–Frankly, the whole regulatory environment baffles us. It seems well-intended. It also seems necessary to harmonize various state regulations in order to encourage the kind of infrastructure investment and competition that will lead to better services for customers. But the national regulator does not yet appear to have full regulatory power over the various state agencies its supposed to succeed. This puts establishment of a true national electricity transmission grid that much further into the future.

–In the meantime, though, we sure do like AGL, as we wrote in the January issue of Outstanding Investments. There are other opportunities too, for Australian firms. They just may have to go off-shore to find them. “Local gas explorers will increasingly need to look offshore for new reserves as the Australian landscape is well-picked over, the head of Italian-focused miner Po Valley Energy Ltd says,” reports an article in today’s Sydney Morning Herald.

–“Po Valley chief executive Michael Masterman says Australia’s two biggest natural gas reserves, the North West Shelf and the Cooper Basin, are overcrowded with exploration companies. ‘Australia has a mature, well-picked-over gas exploration arena,’ Mr. Masterman said. Mr. Masterman said investment support for offshore-based resources companies was expected to be robust. ‘There’s more specialist small-cap funds now, and a large amount of funds in superannuation are looking for investments.’”

–Before we get to the web-based drama surrounding Goldsearch (ASX:GSE), a note about gold. The yellow metal took a kick to it’s gold-covered teeth this morning, driving the futures price down to a two week low. We thought it was a good time to take a big-picture look at the gold price, both in Australian and U.S. dollars, and see how far we could look ahead into the future. Not very far, it turns out. But you can read the full report at

–“Five trading days ago someone who goes by the nickname of Jayne delivered a spectacular tip to one of the internet forums dedicated to Australian stocks and their fast-moving day traders,” reports Hedley Thomas in today’ Australian. According to Thomas, on December 28th, Jayne wrote, “I did some research last night on Goldsearch Ltd. And feel that it’s worth a look at. It’s up over 8 per cent this morning and is currently drilling for uranium 6km away from the old Marty Kathleen uranium mine,” (see our post on uranium at

–“Anyone else getting on board,” Jayne asked traders. “The [drilling] program is targeting uranium mineralization at the historic Elaine Dorothy prospect and the recently identified Macgregor target.” And that, dear reader, is all it takes. “I hope your information is good Jayne because I just followed you,” wrote a trader named Crazy Jim Smith.

–Shouldn’t you check to see if the information is good before you follow someone? Hmm. This is how crowds work, though. Some hothead runs off in one direction and everyone else, having no idea why but afraid to miss out, chases in a panic. Don’t be a chaser, be a foot-dragger, at least when it comes to crowds.

–That, by the way, leads us to a quick review of one of the essential tenets of the Daily Reckoning, Bill Bonner’s Law of Perverse Outcomes. This is especially relevant given our, er, heated debate over global warming the last few days. Bill’s Law of Perverse Outcomes states that, “People get what they deserve, not what they expect.”

–That doesn’t mean nature is inherently just. There is just no way for humans to cheat it, at least not forever. Someday, either the global warmists will be exposed as well-intentioned but alarmist frauds, or obstinate hold outs like your editor will have only the cold comfort of having proudly and fatally stuck to the principle of skepticism, as the ice caps melt around us and we drown in our regret, like a polar bear adrift at sea.

–Sometimes things just don’t work out the way you expect. Take our last point for the week, private equity. We’ve taken to call it pirate equity because its reliance on debt loads up otherwise sound companies with a dangerous liability that could prove fatal to the business. Sounds like a bad plan.

–Not so! At least, not so!, according to Henry Kravis and George Roberts in a recent Wall Street Journal story by Henry Sender. Kravis and Roberts are one of “Ks” and all of the “Rs” in KKR, or Kohlberg, Kravis, and Roberts, a private equity buy out firm. They say that managers of publicly traded firms actual welcome private equity. Why?

— “Managements want to take the long-term view, but they know they get clobbered in the short term,” says Mr. Roberts. “A lot of companies want to start new projects but they can’t because they are afraid of the hit to quarterly earnings, even though it may be right in three to five years. When we say our average hold [before selling the company or taking it public] is seven years, they sit up.”

–The enemy of management, apparently, is the shareholder, whose demands of double-digit returns is both unrealistic and destructive of management practices, and thus, ironically, long-term shareholder value. “There is a constant churn in the share ownership of public companies,” adds Mr. Kravis. “Activist shareholders beat up the company because the stock isn’t going up. [Private equity’s] size and indifference to quarterly results may make chief executive officers and boards take us more seriously.”

— Hmm. Does this make private equity the dark knight of capitalism? By rescuing management from the self-destructive task of meeting completely irrational quarterly earnings goals (by hook or by crook), can private equity restore our most valuable and important corporate institutions to a more sane, reasonable path of growth? Wouldn’t this be better for employees, management, and customers? And wouldn’t that be better for shareholders? Maybe it depends on how soon the shareholders want to sell. And today, most shareholders are not buy-and-hold Buffett-style investors but traders, with looming retirements and large cash-flow needs from investment income.

–We’ll give nearly the last word to Jeff Vale, who has some thoughts on the matter in an interesting book called, “Theories of Power.” In chapter seven, Vale writes that, “The publicly owned corporation serves as an example of a pervasive pattern that cannot accept stability; if it does not provide a regular, growth-based return to its investors, it will find itself quickly dissolved. The press, politicians and the general public often rush to express surprise at the corporate decision making process. Why won’t corporations act as more responsible citizens, help protect the environment, or take better care of their employees? Doing so may provide long-term benefits, not only for society, but also for the corporation’s bottom line.

–“Ultimately, however, the very structure of the corporation constrains it in its decision making process: it must respond to the short-term demand to increase shareholder value, resulting in the ubiquitous, shortsighted decision making of corporate America. Like the corporation, economists see serious trouble for a country’s economy as a whole if it temporarily stops growing, as the debt and inflation based finance structure cannot handle mere stability. Any entity, whether a small business or a national economy, that finances its operation by borrowing money at interest must continually grow in order to remain solvent due to the demands of repaying the time-value of money.”

–Ayy, there’s the rub. Taking on debt creates the urgent necessity of growth. The Government Sponsored Enterprises (GSEs) in the United States found this out the hard way. Gearing allows you to ramp up earnings quickly…but you must continually expand the balance sheet in order to stay solvent, using new cash flow to pay off old loans. Even the captains of pirate equity at KKR know that debt poses a risk.
–Derivatives, which are a form of debt-based capital, threaten the expansion of private equity. Kravis says “There are staggering amounts of derivatives…If there are difficulties and counterparties start to default, that could pose problems.”

–Problems indeed. But not if you sell before the liquidity crisis. “Any fool can buy a company,” says Mr. Kravis. “You should be congratulated when you sell.”

Dan Denning
Dan Denning examines the geopolitical and economic events that can affect your investments domestically. He raises the questions you need to answer, in order to survive financially in these turbulent times.

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