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After a year-long hiatus, Above Average Odds Investing is back. Our reasons are multifold (I missed you guys!), but for now just know that we’ve got some amazing bells and whistles coming down the pipe. Within the next 1-2 months the site will experience a dramatic overhaul that should usher in a new era for the site/service. To say we’re excited to roll out these changes is an understatement. So stay tuned!

To kick things off right, I’ve included long-time friend of the blog Adam Patinkin’s latest letter to partners. Adam is a CFA Charterholder and is the Founder and Managing Member of David Capital Partners, LLC (“David Capital”), based in Chicago, IL.  Prior to founding David Capital in late-2011, Adam was a member of the investment team at Sheffield Asset Management, L.L.C., a $500M long/short equity hedge fund. At Sheffield, he was responsible for sourcing and evaluating investment opportunities in public securities and commodities markets on a global basis.  Adam specializes in cyclical industries and businesses undergoing substantial structural or competitive change. His equity investment experience covers a wide range of sectors and is augmented by significant work involving commodities, credit, derivatives, and special situations.

I’ve had the pleasure of knowing Adam for a few years now, and in my opinion he is about as brilliant and incisive an investor as there is.  Adam launched his fund with $2M in assets in late-2011, and in about 2.5 years he’s grown it to more than $20M – which speaks to his talent, top notch analytical abilities, and a fund almost certain to have a very bright future.  At 29 years-old, we think he’s a “rising star” in the value world/hedge fund community.

Adam’s quarterly letters usually provide an in-depth write-up on a single investment idea, but in his latest missive he switches gears to share his thoughts on the broader markets.  Adam has generously allowed us to republish his commentary on AAOI (we unfortunately are unable to publish the rest of the letter, including performance metrics, for compliance reasons).

I think it’s a great read and a wonderful way to re-launch the site.  At any rate, we look forward to sharing Adam’s thoughts again in the future (you can count on it) – David Capital is without a doubt a fund to keep an eye on!

Enjoy!

David Capital Partners, LLC – 2013 Q4 Macro Commentary FINAL

 

If your planning to go to the Berkshire Hathaway Annual Meeting the Yellow BRK’ers Meet and Greet is a great event for a first timer and anyone else:

Berkshire Hathaway shareholders from all online communities are welcome to an unofficial gathering on Friday, May 3th, 2013.

You are invited to join as fellow shareholders unofficially gather on Friday, May 3th, 2013 at the DoubleTree Hotel in Omaha to meet and have fun, starting at 4:00 pm and you can linger until 7:00 pm (or longer). There will be a short program at approximately 5:00 or 5:30.

This is a casual atmosphere, with light snacks available. It’s a “happy hour” type of gathering – not a formal dinner or anything of that sort.

The DoubleTree is located on 16th and Dodge. There may be some street parking, otherwise, one can use the parking garage with an entrance from the South at 16th & Dodge street, just east of the First National Bank.

To register for the event: http://yellowbrkers.com/

Before we get into the performance I wanted to quickly discuss a few housekeeping notes. If you’d prefer to skip the background and head straight towards the results just click here.

A couple of quick thoughts though before we delve into the numbers…

First things first, I wanted to quickly thank all of the amazing readers of this blog, especially those who’ve taken the time to write me with their thoughts and ideas, to comment and to generally share there thoughts on all things value investing over the years. To say it’s been not only wildly fun but the learning experience of a lifetime is an understatement. I’m quite certain in fact that I’ve learned more from the contacts and lifelong friends I’ve made over the course of the years writing this blog than I’ve ever given back and so for that, as with so many other things in life, I remain eternally grateful for the support and ongoing dialogue.

In fact, when I started this blog years back the idea that anyone would actually read it struck me as borderline preposterous, but life’s funny that way and what began as a humble project to feed my addiction to all things value investing while journaling my investing ideas – and if I was lucky, harnessing the “wisdom of crowds” in my research efforts here and there – has managed to not only surpass those expectations, but in truth ultimately far exceeded even my wildest imagination. So in short thank you, the reader, for making this endeavor such a rich experience and better yet, for making me a much better, more thoughtful investor over the years.

Secondly, I want to provide some context for the creation of the “new” AAOI blog portfolio of which you’ll see here today for the first time. As the natural follow up to the blogs real money Spoke fund, I think some explanation is in order but the goal is in one critical sense the same, meaning its purpose is to continue on in the tradition of tracking my investment performance in the public square over the life of the blog. In regards to the original AAOI Spoke Fund® and its fate, the short answer is that my transition to a new firm in early 2011 along with the dissolution of wealth-front as originally envisioned only a couple of months thereafter made the spoke fund’s continuation an unfortunate impossibility. This was a tough break no matter which way you slice it given the Spoke fund’s consistent history of substantial alpha generation, particularly in light of getting so close to that magical three year hurdle all of us emerging managers naturally look forward to surpassing.

Nonetheless, at the end of the day theres no sense in crying over spilt milk and of course, new opportunities called and so I moved on. That said, within a few months I decided another portfolio was needed if I was going to continue on with the blog as originally envisioned, both because on a certain level I think I owe it to readers in order for them to better gauge whether I’m worthy of their continued support, contributions, time, and energy – and because on a personal level, I wanted to continue on with a portfolio managed solely by my own hand.

Third, I wanted to address that with this new portfolio came a key change of heart as it relates to the wisdom of the original spoke fund’s policy of total transparency (read 24/7 real time access) to the fund’s holdings by the public at large as opposed to the fund’s investors specifically. My obligations to the LP’s I serve must always and everywhere come first.

Why that’s relevant specifically here is because it explains the new portfolio’s policy of only updating the results on an annual, and depending on the opportunity set at any given time, a potentially semi-annual basis thereafter.

So with all that said (if your still reading :)), lets get down to the mission at hand…

Since inception on 9/23/2011 until Feb 1, 2013 the AAOI portfolio has generated a total return of approximately ~55% vs. ~33% for the S&P 500, ~23% for the Russell 2k, and ~(-20%) for the S&P/TSX Venture index.

While my goal has always been absolute as opposed to relative performance, I was particularly pleased with the relative outperformance of the AAOI portfolio vs. the S&P/TSX-V index considering the relatively dramatic differential when over 50% of my holdings were listed on the venture exchange, at least over most of the time period in question.

Regardless, I was more than pleased with the portfolio’s results from an absolute standpoint. While difficult to pin down exactly given the Sandstorm Gold and Star Buffet errors, (after adjustments) it appears the annualized return has clocked in at roughly 40% give or take a percent since inception.

If I can manage to somehow continue at this rate going forward I would obviously be ecstatic, but unfortunately something closer to half the current run rate is likely to be closer to what is achievable on a sustainable basis. That said, I should add that even with all the uncertainty in what I continue to believe is a risk-fraught global economic environment I can’t remember ever being so bullish on the prospects of my current holdings, specifically as it relates to my highest conviction pics. Turning back towards the question of future performance though, if I can manage to generate returns approximating even half the present run-rate over the long-run, rest assured your editor will be more than pleased.

Thanks again for everything and here’s too the next five years of low-risk, high-return investing at Above Average Odds Investing being even better than the last – and rest assured the search for opportunity and hence, for those exceedingly rare, one of a kind “epic investments for posterity” rolls on.

Footnotes:

(1) The SSL error is a function of Investopedia’s failure to account for the 5:1 reverse stock split. Regardless, adjusting for the change, the quantity of shares owned should approximate 1700, so the value of my SSL position in the Canadian account is ~$21k, not $93k. Therefore, the Canadian account value should equate to ~148k (220k-72k), not 220k.

(2) Also, in case your wondering why I’m just now publishing these returns given that we are roughly four months past the one-year mark, the answer is twofold. First, originally I had held off in hopes that Investopedia could fix the Sandstorm Gold related error with the goal being to allow me to unveil the portfolio in a cleaner fashion. This seemed entirely reasonable at the time given that all the other journal entries related to the portfolio’s various corporate events had been accounted for, or if temporarily in error, at least promptly fixed by Investopedia’s admin. After about three weeks of trying to get the issue resolved that hope unfortunately turned out to be in vein, and for some reason still inexplicable to me, not possible. Anyhow, given this seemingly non-fixable error I’ve just decided to include an explanation on how I adjust for this above. The other reason was because shortly thereafter I found a handful of ideas (really one in particular) that imo required secrecy and hence necessitated a further delay. For what its worth, with a defined process in place going forward I don’t expect any future delays to be an issue.

(3) The Star Buffet position has recently emerged from bankruptcy and hence has lost the Q in its ticker as it begins trading again as a post bankrupt entity. Unlike with SSL, this change should be be accounted for shortly although, also unlike with SSL, the net effect will be pretty much immaterial in terms of its effect on the portfolio’s performance. I figured I should note it anyway.

(4) As always I also hope readers will point out any errors or discrepancy’s if they come across any, as I’m not entirely certain the Sandstorm Gold issue hasn’t effected the total and annual returns at the margin in a manner that I haven’t considered, but then again I don’t expect it to be material either. To paraphrase Buffett, the goal here was to be approximately correct rather than precisely wrong.

Mark’s latest…

Another fantastic read from Jim Grant

Kyle Bass’s latest…

“The power of value investing flies in the face of anything taught in academics. Value is the way stocks are eventually priced. It requires the perspective of patience because the market will eventually gravitate toward value.”

– Joel Greenblatt

Thesis:

Mongolian Growth Group (“MGG”) is an obscure, underappreciated micro cap franchise with an attractive highly skewed risk/reward equation and substantial downside protection.

Investment Highlights:

An investment in Mongolian Growth Group around the current price possesses nearly all the qualities we look for in a great long-term investment.  These include: (1) a low valuation (2) a good, incentivized management team backed by a savvy board, (3) near to medium-term operating momentum and (4) multiple internal and external high-probability catalysts which we expect will drive substantial upside.

Other attractive attributes of MGG include:

  • A simple business model with an unlevered balance sheet and tangible assets
  • A strong competitive position in a rapidly appreciating niche market
  • Improving economics on an attractive and fast growing asset base
  • A high likelihood of experiencing meaningful improvements in profitability and cash flow
  • Leverage to strong expected growth in the Mongolian Economy
  • Relatively low correlation to the general market
  • Opportunity to deploy capital at high ROIC’s for an extended period of time

MGG owns city-center real estate assets in Ulaanbaatar, Mongolia (“UB”).  Due to the development of the country’s mining sector and certain capital market related factors, we expect per capita income in the country to substantially increase over the next 5-10 years.

This growth in the real earnings power of Mongolian citizens will be a function of a multitude of factors, but primarily driven by:

(1) The continued development, and commencement of production at two world-class “mega” mines within the next 1-2 years. Mines expected to garner over $10B in development capital over the next five years, as well as create tens of thousands of new high paying jobs (salary’s that pay ~10x the present average), not to mention generate $5-7B billion in recurring export revenue on a tiny economy whose current run rate GDP is only ~$8.6B. Additional capital devoted to further discovery, defining, developing, and bringing into production, dozens of other mines within the near to medium-term should augment per capita incomes further.

(2) Various capital market developments, such as the creation of liquid, fully functioning mortgage, bond, and stock markets should be an additional positive aiding the growth in average incomes, by helping further facilitate foreign direct investment and in turn to grow the economy. There is also the upcoming IPO of TT, where the equity of one of the world’s largest, low-cost coal mines will be distributed amongst the citizenry -allowing Mongolians to participate directly in the success and growth of the asset or if they choose and/or sell it back to the government for cash.

Basically, as mines turn on and progress on the capital market front continues, we expect a dynamic, (positive) feedback loop to develop and reverberate throughout the Mongolian economy as a whole, triggering the development of all kinds of different businesses that will benefit from a higher level of economic activity. As the Mongolian “snowball” starts to roll down hill, it should give way to a virtuous cycle that drives down interest rates/funding costs, which frees up capital to fund more businesses, which in turn provides government with higher tax revenues to invest in critical infrastructure/related projects, which will drive down manufacturing and transport costs, increasing productivity and so on, all of which will cause GDP to grow rapidly and per capita incomes to grow even faster.

With that in mind and considering the direct correlation between per capita income growth and Mongolian real estate values, we expect MFG’s diversified portfolio of high quality retail, office, and redevelopment property in downtown UB to compound at 30-50% per year going forward undergirded by a combination of rapidly rising rental yields and compressing cap rates. By purchasing the stock today at ~1.25x our estimate of “true” book value, MGG offers investors a direct way to get outsized leverage to Mongolian per capita income growth, a highly attractive theme and durable, multi-year tailwind.

Viewed from a different angle Mongolian real estate, as the largest direct beneficiary of growth in GDP and average incomes, typically appreciates at ~3x the growth rate of the underlying economy. With Mongolian GDP set to more than double over the next 5 years irrespective of either macro or micro factors – so pretty much regardless of the health of global financial markets or political developments at home – an investment in Mongolian real estate offers low-risk growth in a no growth world, basically a stable shelter from any oncoming economic storm. Evidence of this can be gleamed from the fact that even in a contracting economy that lacked the tremendous embedded growth tailwinds of the next 5 years, Mongolian real estate was flat (read held up like a champ) amidst the great recession.

Given that, we view MGG conceptually as a LEAP or long-term call option on near certain growth within the Mongolian economy with a high probability of expiring deep in the money  - a rare vantage point offering investors a chance to dance in the rain in a risk-fraught global economic environment.

Why the Opportunity Exists

We believe there are three key reasons why MGG is mispriced.

1.  Macro Concerns Regarding Economic Sensitivity

Given various recent data points from the first couple of quarters this year, fear surrounding Mongolia’s vulnerability to commodity prices and a Chinese hard landing seem overblown, especially given the imminent ramp of Oyi Tolgoi, the primary driver of Mongolia’s near to medium-term economic growth. To be clear, OT is a game changer, 100% financed and given its abundant level of gold byproduct, actually has negative cash costs on its copper production.

Notably, OT, as well as most of the other larger tier 1 projects set to come online within the near to medium-term, are all low cost producers with dominant competitive positions driven by a structural cost advantage relative to traditional sources of Chinese supply. This reality should all but ensure that they continue to take a larger and larger share of Chinese demand over time. Given its coming off such a low base, we don’t think its a stretch to say that the Mongolia’s prospects and embedded economic growth will be by and large relatively immune to 1) the state of global capital markets 2) near to medium-term cyclical swings in commodity pricing and/or 3) a Chinese hard landing. These are important points.

2. Understated Book Value

With a stated BV of ~$1.63/share the company doesn’t appear statistically cheap upon first glance, certainly not cheap enough to look particularly interesting in the world we live in and/or without digging a bit deeper. Yet for various reasons we believe that true economic BV by YE ’12 is easily north of ~3/share and set to appreciate rapidly. In other words, what appears to be trading at something closer to 2x BV is in reality trading at a depressed multiple approximating 1.25x.

A small premium to BV (all things considered) is simply way too cheap in our opinion, making MGG one of the more remarkably mis-priced investments we’ve come across in some time. Especially though given the company has been compounding BV at a run rate approaching 50% and the fact that a basket of less attractive emerging market RE focused comps trade anywhere between 4-5x.

So IFRS numbers vastly understate reality here. Confidence in this assessment is derived through IFRS numbers being naturally backward looking and calculated based on yields and subjective cap rates. Notably, MGG’s assets have extremely depressed yields (they were booked at below market rates) and because the most valuable piece of the property portfolio is the land making up MGG’s redevelopment parcels – and hence naturally doesn’t generate current income. That said, over half of their property contracts are set to rollover at rates on average 50% higher over the next 12 months which obviously distorts the calculation even further but again, because more than half of value here lies with a redevelopment portfolio that doesn’t generate income such a method makes very little sense.

We’ve also had talks with a multiple independent sources that have spent significant amounts of time with boots on the ground and who have each crosschecked MGG’s listings with present valuations of comparable assets and built estimates through a property-by-property build-out from the bottom up.

3. CNSX Listing

MGG currently trades on the Canadian National Stock Exchange, basically the worst exchange in Canada, which makes MGG’s equity by and large un-investable for most institutions due to mandate restrictions and liquidity related issues. This is about to change with an imminent up-list to the TSX-V. The dynamics here are actually very similar to the underlying dynamics of the real estate portfolio. Because the stock is un-investable at this point for the vast majority of institutional investors, the idea is to purchase these assets before that changes. So by “front-running” this liquidity unlocking event (the day it becomes investable) current shareholders should be able to sit back and enjoy themselves as the price is subject to a sharp, upward revaluation due to a massive pool of newly investable capital getting put to work in what is a small, very illiquid float with finite supply of sellers.

In addition, all Canadian equity markets have recently been crushed due to justifiable fear surrounding a slow down in Asia. This liquidity vacuum has pummeled non-resource based Canadian domiciled investments right alongside their resource based peers (particularly the more one goes down the exchange quality spectrum).

Long story short, we are comfortable that the business is both significantly mis-priced and (like the country it operates within) misunderstood.

Mongolia: A Unique Set Up

The Situation

Rich in untapped mineral wealth and on the cusp of an epic boom, Mongolia is only ~2-3 years into what we believe will be a 10-20 year secular bull market sustained by positive structural change and a diversified set of stable, competitively advantaged mineral based “exponential growth engines.”

Critically, these growth engines are poised to benefit from a multitude of durable multi year tailwinds and an uncommon stability derived through a combination of diversity (gold, oil, copper, uranium, coal, natural gas, rare earth’s, etc.), natural counter-cyclicality (base commodities vs. precious metals), long lives and the spoils of a structural cost advantage, a function of its geographic proximity to China. Together they provide the Mongolian economy with the capability to drive sustained periods of exponential growth in GDP and per capita incomes.

Why Mongolia?

  • Tiny population rich in mineral wealth
  • Construction of world class mines (on the cusp of commercial production)
  • Proximity to China results in a structural cost advantage
  • Experiencing a high teens annual GDP growth rate
  • Anticipate near-term growth to accelerate
  • Hard Working and ambitious pro western culture

Other interesting data points on the question of “why Mongolia” include Mongolia’s Doing Business Ranking: http://www.doingbusiness.org/rankings. Mongolia is #29 in the world in “protecting investors” (ahead of, for example, Australia or France) and #33 in the world in “enforcing contracts” (between Denmark and Japan).

Bottom line, we think the combination of low population density, trillions in “in ground” resource wealth, proximity to China/the Asia Pacific, and the fact that tens of billions are being spent on capital projects in planning, development, and production phases over the next five years – all in a tiny economy with run rate GDP a mere fraction of that size – has created a situation where all the stars are aligning to generate a potentially staggering level of wealth. As mines turn on and the capital that follows tries to squeeze itself into Mongolia’s tiny economy, a doubling if not tripling of GDP over the next 3-5 years is all but certain.

Mongolian Growth Group: Well Positioned on the Eve of the a Historic Boom

Enter Mongolian Growth Group (MNGGF.PK), a Mongolia based diversified investment company run by fellow VIC’ster, adventure capitalist, founder of Praetorian Capital, and CEO, Harris Kupperman. As we mentioned, MGG’s focus is on real estate and financial services or put a bit differently, the two sectors most leveraged to the growth of the economy and GDP.

We think an investment in MGG is a strategy tailor made to optimize the above dynamic, and at approximately 1.25x “true” BV (where that BV is poised to compound at approximately 3x a rapidly growing GDP) investors are getting a highly asymmetric investment opportunity with fairly predictable upside of 5-10x in 5 years and minimal probability of permanent loss. We think paying a small premium to “depressed” TBV or the market clearing (private market) value of its assets today, without any monetization of the redevelopment portfolio – immediately prior to multiple high probability “hard” catalysts offers not only an 1) attractive entry point but 2) a hard floor intrinsic value wise and 3) significant near-term appreciation potential uncorrelated to the movements of the market as a whole.

Clearly we like that risk/reward.

Opportunity Overview

Keenly aware of the short window available to them given 1) poorly functioning capital markets temporarily holding back institutional capital flows and 2) the historic tendency for downtown real estate located in the capital city of countries undergoing historic booms to accrue value to its owners in parabolic fashion, Harris (and co-pilot Jordan Calonego) wisely set about gobbling up as much prime real estate in downtown Ulaanbaatar’s (UB) as possible in anticipation of it closing.

Realizing that 1) an expanding and rapidly growing real estate market causes step change rises in property prices and rents, which acts as a multiplier on valuations – typically to the tune of 3x the growth experienced within the general economy and 2) real estate in a rapidly expanding economy offers arguably the best leveraged risk/reward set up to take advantage of that growth, the two set out building an enviable market position in the heart of downtown and succeeded.

Luckily, MGG managed to get in early enough to compile what is an utterly amazing property and land package that includes an extensive list of city-center real estate located directly on, or immediately adjacent to, Peace Avenue, Mongolia’s main (and only) street. MGG’s property and land package consists of a diversified collection of prime class A/B office property, residential apartments, and retail space. Notably, prime locations are now long gone or very expensive so the timing on this was a thing of beauty.

So why now?

  • Recent government election and foreign direct investment related political reforms aimed at welcoming the worlds capital with open arms have removed a material overhang/associated political uncertainty for at least the next 4 years
  • Billions in new government related infrastructure spending coming down the pipe
  • The receipt of full financing for a game changing, world class mineral asset Oyi Tolgoi (OT) currently on the cusp of commercial production – essentially investors are investing in Mongolia at a major inflection point that will drive rapid growth in GDP and exponential increase in per capita incomes
  • Recent announcement of QE to infinity – western central bank money printing and presence of negative real rates across the global financial markets should support hard asset prices and hence ongoing development of Mongolia’s vast natural resource base.

Ultimately we think a better, more unique set of circumstances to get exposure to Mongolian economy than on the eve of the turn is unlikely, given the above factors, rapidly improving fundamentals and the presence of external near-term catalysts set to kick start the second wave of what may very well turn out to be one of the greatest economic growth miracles in history.

As far as MGG specifically, well, basically we have premier real estate assets with massive gearing on the eve of this historic multi-year growth phase in general economic activity, which again provides an ideal set up where investors have a predictable outcome, a hugely asymmetric risk/reward equation, and the chance to front run a tsunami of incoming liquidity. I’m sure all of us can appreciate that getting leverage to an specific outcome at the right time, in the right market, through the right vehicle can be incredibly rewarding. That’s exactly what we have here.

That said, let’s talk about Mongolia. Sparsely populated with only 3m people, Mongolia is a former soviet satellite that is 1) geographically well positioned to benefit from free trade and 2) endowed with bountiful natural resources to the tune of trillions. In fact, Mongolia has enough below ground mineral wealth to make every Mongolian man, women, and child a theoretical millionaire, a data point that in and of itself helps paint a pretty clear picture that Mongolia isn’t your average commodity driven emerging market or secular growth story – but something unique with extraordinary potential over the fullness of time.

To highlight this point, we are talking about a people that could go from half nomad to the wealthiest in the world on a per capita basis within the span of a roughly a decade. I mean holy sh%t!! Perhaps there is a historical precedent, but I’ve certainly never come across a country that has the potential in ~10 years time to go from one of the poorest to the richest simply by unlocking the embedded value beneath their feet through changing a few laws and signing a few JV’s. Clearly that’s an oversimplification but with avg GDP per capita of only ~$3,000 and a present run rate of ~$8.6B in GDP in a country sitting on a trillion + in embedded asset value and the potential to generate GDP of 40B+ over the next 5 years, clearly the runway is massive and the countries present run-rate represents a mere fraction of its ultimate potential.

So we think the seeds are currently being sown for an epic wave of wealth creation unlike any other nation on earth that I’m aware of – a story that’s still in the very early innings and likely to accelerate substantially in the years ahead that should (in all probability) continue pretty much irrespective of global economic conditions or turmoil within the western world. I’m not talking about GDP + type of growth, which while respectable enough in the current environment isn’t it. I’m talking about, is an economy that’s capable of creating EXPONENTIAL increases in the average real earnings power (standard of living) of its people on a sustained, multi-year basis.

For those taking score, exponential is super compounding and if most estimates are to be believed Mongolia is poised to compound GDP by a factor of four over the next 5-10 years – and if things go smoothly near-term, nominal GDP could actually double in just over two.

A Quick Word on OT & TT

With two of the largest development projects in the world in Oyi Tolgoi (OT) and Tavan Tolgoi (TT) commencing production over the next couple of years (TT won’t really get started until next year) its easy to imagine how things could get downright silly on the growth front given the amount of latent, embedded growth in export capacity held within these two assets. It’s nuts, but these two projects alone looking out over the next five years have combined (committed) levels of Cap-ex approximating ~$12B, so close to 2x run rate GDP.

To give a better idea of the scope of these near, medium and long-term growth drivers, these two mines presently sit on ~81 B pounds of copper, ~46M ounces of gold, and ~6B tons of coal (big boys clearly). Initial production capacity is looking at annual production rates of ~1.2B pounds of copper worth an estimated $4.6B, 650,000 ounces of gold worth an estimated $1.1B, and ~3m tons of coal worth an estimated $100m or taken together, ~ $5.7B – and remember this $ amount consists of ongoing (recurring) export capacity and hence stands to be a gift that will keep on giving for an estimated 60-70 years.

Of course none of that discusses any of what I’m sure is a very real, near certain pathway to expand the resource and in turn, to grow OT or TT’s ultimate steady state production levels materially above initial estimates.

So things could get a bit nutty in the blue sky scenario and again, were talking about only two mines, so none of the above includes any additional growth potential that will be driven by the 25 or so additional projects in the pipe, each of which is expected to represent ~5% GDP on average. Nor does it speak to the ripple effects and positive feedback loops that all of this investment will spur throughout the various other facets of the economy.

Real Estate Portfolio (Portfolio Composition, Valuation, & Strategy):

Property Strategy

  • Buy top quality properties along Peace Avenue
  • Focus on leasable retail and office property
  • Focus on redevelopment opportunities with sizable value uplift through redevelopment

Property Portfolio

  • 28 Residential Units
  • 6,081 meters of Retail Space
  • 5,361 meters of Office Space
  • 13,800 meters of Redevelopment Opportunities

Portfolio Composition and Valuation

Note: I apologize for the tiny font, it was the only way I could make it format properly…

Brief Primer on Downtown Ulaanbaatar:

MGG currently owns 28 residential units, 6081 meters of retail space, 5,312 meters of office space and the crown jewel, 13,800 meters of redevelopment property all strategically positioned within a prime 3 kilometer stretch in downtown. That said, one of the most important aspects of this thesis is to understand the geography of Ulaanbaatar and the nature of downtown.

UB is landlocked and runs east west as its constrained to the north and south given its wedged directly between two mountains – so its much more comparable to a place like Hong Kong than it is to your average city. Also, and this is equally as critical, there is only 1 main street in downtown UB, the aforementioned Peace Avenue. So when thinking about MGG’s property and land package its important to grasp that there is really only 1 area with a distinct financial and residential presence downtown where everyone wants to be located and its extremely small – which is a function of the fact that UB was originally constructed for only 300k people by the soviets. This is an obvious problem for a city housing 40% of the population of Mongolia or about 1.2m people.

Considering this reality then, its probably no surprise to anyone that downtown UB is currently facing a drastic supply shortage of Class A&B office, residential and retailing frontage and this shortage is getting more acute day be day as more and more of the worlds corporations and various expats are arriving in UB to set up operations. The shortage of residential apartments is particularly large, which are highly desirable to wealthy locals not only for status reasons but because of basic logistics given that traffic getting in and out of downtown is notoriously bad. Commutes on average take about and hour and a half to two hours back and forth.

So, the most important piece of the structural shortage puzzle is it’s a certainty that their is only one way to go downtown to help alleviate these bottlenecks – and that’s up – meaning the construction of office, retail and residential towers. Understanding this inevitable reality is a big part of connecting the dots in our mind as well as the sheer genius of how Kuppy went about acquiring MGG’s existing property (the specifics will become readily apparent shortly), not to mention where a big part of MGG’s ultimate upside will come – and to be clear by upside I mean big time, many many multiples of the current stock price type of upside.

Also, with 40% of Mongolian citizens living in a city built for a population a mere fraction of that, its not surprising that the infrastructure of the city is in dire shape and in critical need of repair and expansion. Why this is relevant to property prices is because any land outside of the city is essentially worthless because it has no infrastructure (so their is no water, sewers, electricity, etc.). This in turn drives up the price of the land within city limits because it’s the only land attached to infrastructure. This dynamic naturally provides a huge tailwind to property investments within the city center.

A Roadmap for the Future: Thinking about Valuation & the Kazakhstan Boom (2002-2008)

In order to better frame the opportunity and the second order effects of what we believe is in store for the Mongolian economy in the years ahead, we wanted to note investors have multiple historical comps where the transition to an open economy results in a large multi-year period marked by vast wealth creation – so there are various road maps but for our purposes here, Kazakhstan seems the most relevant.

While by no means a perfect comparison, in fact we would argue on a variety of levels that the unique nature of the Mongolian situation makes it substantially more attractive, the Kazakhstan example is a useful case study in a multitude of meaningful ways and it makes sense on a high level to use it as a blueprint for thinking about how an investment in MGG will unfold over the next 5 years or so.

As far as the specifics that make Mongolia materially more attractive, the quick and dirty outline includes 1) Almaty isn’t land locked and therefore suffers from no shortage of land with ~200 sq. kilometers (big difference) 2) UB has only one premier shopping street (Peace Avenue) where Almaty has 5, all substantially developed (another huge difference) and 3) while technically a democracy, its been ruled by the same leader for ~20 years and our read is that its generally understood that its a pretty good idea to keep ones business small enough to keep it out of sight from the authority’s. In other words, capital apparently flows out of Kazakhstan like bees to honey when it can (big big difference). After all, in Mongolia and UB, free enterprise is a big part of their national character and property rights are well respected, a point of pride amongst the vast majority of the population, so its very likely that the wealth of the country will stay within its borders and reinvested back in the economy. At the margin all of the above should intuitively make any investor more bullish on Mongolia relative to Almaty.

That being said, there are many critical similarities that make the comparison apt and at the end of the day, a solid roadmap to use for thinking about how all this plays out. Both countries are resource based economies, both came across massive resource discovery’s and grew rapidly due to large step change increases in production derived from those discoveries, both are former soviet satellites, both share similar cultures, architecture, initial infrastructure etc. – and so the primary difference (outside of those already noted), is that Kazakhstan is 10 years farther along in its boom than Mongolia so we think comparing the two helps MGG investors see around the corner of the oncoming mining boom.

As a side note, studying comparable situations of formerly centrally planned economies that have set about making the transition to a free, market based system is instructive. Historically, these booms tend to last approximately 15-20 years before prices normalize within the ballpark of developed nations and the evolution of these situations is broadly predictable as far as the general effects on the economy. These are key insights. What we have here then is textbook Soviet market reform, and the effects on the underlying economy in terms of these reforms are indeed predictable, and because Mongolia’s in the very early innings of this long-term transition, studying Kazakhstan (which is about halfway through) gives us a reasonable template to build of off.

Kazakhstan’s statistics over its 2002-2008 boom can be seen in the chart below (per MGG’s presentation)

Not bad by any means, but its much more interesting to compare present Prices in Ulaanbaatar today to get an idea where they may end up tomorrow. Odds are Mongolians have seen anything yet…

What the above comparison makes clear is that on an apples to apples basis prices per meter in Almaty are about 3-5x those in UB, which for reasons already noted we think is the absolute low end of where they will end up at in UB 5-10 years from today.

That said, if one is willing to factor in cap rate compression over time, a fair assumption we think, then MGG’s existing property will be worth something approximating 5-10x its present value within 5-10 years. Not bad for a small premium to BV today no?

Special Situations

Now for some insight into Kuppy’s value creation strategy, and again, this is just one of many special situations within the larger property portfolio that illustrate the value of a mind set focused on the right things. Of course this is just 1 example but its illustrative we think of the type of value that is accruing to MGG shareholders above and beyond the pricing and rent tailwinds but I digress, back to the point. Another colleague put it like this…

“MGG recently purchased a ground floor retail space that’s tenant was an ethnic restaurant on a side street of Peace Avenue. MGG purchased this property for $1.6m at a mid-teens cap rate from a forced seller. MGG is now beginning construction on an extension to the property that will increase the property’s rentable area by 60% at a cost of about $300k, effectively creating a low 20′s cap rate at today’s yields. In a few years we expect 10 caps or less to be the norm in central UB, and rents to be 2-3x higher than today’s on this property – effectively 5-7x upside on the purchase, not counting the interim yield.”

In a nutshell MGG’s investors are getting paid 20% a year with downside protection and a high probability of making 5x our money in 3-5 years, and all for owning prime downtown real estate in the capital city of one of the most promising economies on the planet looking out the next 10 years. Hard not to like that type of asymmetry all things considered. In fact, Steve over at the excellent Capitalist Exploits had an apt analogy, describing buying into select, high quality Mongolian real estate as akin to buying high dividend paying equities that are set to double every couple of years for a number of years going forward. I think that sums it up rather nicely.

And again, this is only one deal out of many similarly attractive “special situations” within the present property portfolio, and not an instance of “one off” cherry picking. Anyone interested in learning more about other deals should check out the company’s letter to shareholders for a few additional examples.

Resource Conversion – Monetizing the Redevelopment Portfolio

The biggest opportunity for shareholders at this point lies in the redevelopment portfolio. To understand why we think this, lets take a step back a bit and remember the underlying reality in downtown UB and how alleviating the bottleneck as far as supply/demand is concerned is a function of building out office, retail and residential apartment towers. This is the future, that I am all but certain. Remember UB is landlocked (sandwiched) in a valley between two mountains, so think of it like Hong Kong. There is nowhere to build but up. Having a downtown that is nestle between mountains makes is easy to identify the “money zone” and helps mitigate the risk that the city could “grow away from you” as an owner.

Also, the savvy I referred to earlier requires a bit of explanation in that as a former Soviet satellite, most property ownership was a function of the government privatizing its (real estate) assets, and it did it in a way so that all of its citizens participated in said land monetization and hence ended up resulting in lots of tiny land parcels (one for each man, women and child presumably). Well, to put it mildly having ~3m people each own some tiny parcel of land doesn’t do much for property values or for businesses looking to redevelop downtown by adding a new high quality office tower. Therein lies the problem and as always, the opportunity – and that’s exactly the opportunity has MGG capitalized on by exploiting its first mover advantage and quickly aggregating multiple small, adjacent land parcels along Peace Avenue into a handful of large blocks. All in, MGG owns ~7-8% of downtown’s “sweet spot,” which is amazing when you think about it. Anyhow, given the unique history here, we shouldn’t be the least bit surprised that the value uplift through the creation of large land packages in landlocked, deeply spaced constrained downtown UB along its main street is quite substantial.

So, given that and keeping in mind that high rents in downtown UB result in property values that are several times there replacement costs, owners of existing land and property have an attractive opportunity to convert land and existing structures towards their “highest and best use.” As an example, assuming current building costs of 1,200 to 1,500 meters property owners are looking at paybacks on investment of between 2 to 5 years. So ROIC are very attractive. Thanks to MGG’s ownership of multiple large land parcels in prime locations, which again is exceedingly rare given the time, money, and negotiations it took to roll-up multiple parcels into large development ready blocks, to say these assets are valuable or that MGG is in a position to create tremendous value for its shareholders over time is an understatement.

Lets take a look and see just how tremendous by reviewing just 1 of these land packages, which possesses a total size of ~2200 meters. 2200 meters translates into (roughly) 1500 meters of sellable land space per floor if we assume the remainder is used as space for general utility (think recreational area for businesses and residents). If we then assume the tower in question being built has 20 floors (entirely reasonable if not conservative) and use current costs and values for class a residential located in the heart of downtown according to local broker BDSec’s latest report, this development would create an incremental $75m (or ~2.20/share) in value! That’s 2.20/share in value vs. a current stock price of $3.90 and that’s just 1 of MGG’s 6 land parcels. Disclaimer: I had to lay down the first time I realized this.

So the math looks like this: $4000 in sales per square foot * 30, 000 square feet of residential sellable space (1500 square meters per floor * 20 floors) equals $120m less cost of $45m ($1500 meters in cost per square foot * 30,000 square feet) which equals ~$75m in total profit ($120m – $45m = $75m).

Granted, the example above assumes MGG were to do the redeveloping themselves, which isn’t going to happen given the companies preferred strategy of entering into a JV with experienced developers and contributing the land and retaining some % of the building while taking the property management rights, so that $75m in profit wouldn’t accrue solely to MGG but that’s not the point. The point is to illustrate the incredible value creation that MGG can deliver to shareholders over time by entering into select deals on land packages with the right partners – of course its also to illustrate that MGG is dramatically undervalued at today’s quote or said differently, relative to its existing asset base assuming no additional accretion of value through rising rents and property values.

Also, with each monetization MGG would retain a high margin recurring revenue stream approximating ~100k a year. Not game changing by any means but its an asset worth at least a million bucks (i.e. 10x) so a nice little kicker for playing.

We think finding the right JV partners should be a relatively simple and painless process given the extremely high quality of the asset. As far as financing, we’re looking at 50% down payments on construction that is pre-funded – with the JV partner obviously fronting that bill.

In sum, MGG has the ability to unlock value worth several times its present price within the existing asset base and again, this is assuming no additional price increases on property values/rents.

One last recap of the redevelopment strategy before we move on, per the company presentation…

  • Partner with experienced developers
  • Contribute Land and local experience to a prospective JV
  • Manage the property afterwards which leads to high margin, recurring revenues
  • Avoid outsized financial commitments
  • Avoid completion risk
  • Avoid budgeting risk
  • Retain high returns on capital with reduced risk

Management Quality:

As I mentioned last time with my write-up on SND and reference to its CEO Nolan Watson, we think Harris also possesses that “…passion, the magic if you will, that is the hallmark of all truly great business leaders and entrepeneurs – “what he does mixes with who he is, which is cooked and propelled by what he believes.” I put it like that not to be promotional but in order to accurately portray that I think we are dealing with something special in terms of managerial quality, particularly in terms of incentive alignment, strategic vision, capital allocation, and sheer dedication to exploiting a very unique opportunity.

Not only has he put the vast majority of his net worth on the line, but unlike the vast majority of the executives I know (or people in general for that matter) Harris was willing to pack up his life and move halfway across the world from the sunny beaches of Miami to a developing, non English speaking country where he knew practically no one, with long -40 degree winters and most of the day to day luxuries all of us have come to rely on, all pursuit of fulfilling his dream. Maybe it just part of my personality, but frankly that’s the type of thing that fires me up. Attempting such a feat takes courage, conviction, and a bold, pioneering spirit – exactly the type of combination necessary to succeed in a frontier environment, and exactly what I would want in the CEO attempting to lay down his mark by building a great, truly enduring business in an emerging market on the far side of the world.

Nonetheless, readers should judge for themselves so in that vein I’ve linked the following profiles and interviews – each of which should help paint the picture as far as sizing up the caliber of the individual leading MGG’s charge.

Lets start with one on compensation and incentive alignment….

“Chris: Mongolia Growth Group is a bit different from most other public companies in terms of compensation. Can you explain?

Harris: the Company started with me asking friends to invest alongside me in Mongolia. I wanted a diversified company that would have adequate exposure to the Mongolian economy. I simply didn’t have the resources to do that myself.  I felt funny asking my friends to invest in my company and then tell them that I was going to take a salary and dilute them through stock options or any other scheme like that. Instead, I have decided to take no salary, stock options, performance allocation, bonus or anything else. I’m here in Mongolia because I’ve invested my own money in the company. My Co-Pilot in this venture, Jordan Calonego feels the same way.  Besides, we’ve been investors for over a decade now and have been disgusted to learn that the CEO always seems to do better than the shareholders. Now that our roles are reversed and we are management, it would be wrong of us to do what we have always criticized. Investors need to think of this company as a business created by a bunch of very successful hedge fund guys who want to invest their own money in Mongolia. Minority shareholders can come along for the ride if they want without any of the onerous fees normally associated with hedge funds. It is the only company that I know of like this. I hope we can use this as a template for the next time that I complain that some Management team is overpaid, but that’s a different story!”

Shareholder Letters – http://mongoliagrowthgroup.com/?cat=12

Interviews:

http://capitalistexploits.at/2011/06/a-mongolian-capitalist-part-i/

http://capitalistexploits.at/2011/06/a-mongolian-capitalist-part-ii/

http://www.distressed-debt-investing.com/2010/11/hedge-fund-manager-interview-series.html

http://www.distressed-debt-investing.com/2010/11/hedge-fund-manager-interview-series_21.html

http://seekingalpha.com/article/488591-conversation-about-mongolia-with-hedge-fund-manager-harris-kupperman

http://thedailygold.com/interview-with-harris-kupperman-ceo-of-mongolia-growth-group/

Thoughts on Mongolian Economic Sensitivity: The Rock of the Asian Pacific

For the non-believers out there, evidence of Mongolia’s decoupling from the rest of the world can already be gleamed from its 30% nominal (17% real) growth rate over the first half of this year, and this growth rate (I would add) looking out 6 months to two years will accelerate. That, and with 90% of Mongolia export capacity being Chinese driven one would think that any serious slowdown in its neighbors economic activity would result in a similarly lock-step downward adjustment to Mongolia’s economy, yet this hasn’t happened and given the dynamics at play we don’t expect it will. That’s not to say that its entirely immune, not at all, just that even if near-term weakness eventually shows itself, such weakness will ultimately be overwhelmed (and then some) in the near-term by much stronger countervailing forces.

We should also point out that such growth is unheard off pretty much anywhere else in the world today, which is telling in and of itself but especially remarkable in light of the slow down in emerging markets and China in particular, not to mention the significant recessionary fears in developed markets the world over…and again, this is PRIOR to the substantial acceleration in economic growth that will take place as OT starts to produce over the next 12 months, the $10B IPO of TT takes place, or the government starts putting to work billions towards infrastructure improvements. Candidly, if such durability doesn’t intrigue you it should, as within it are the clues to what lies ahead in my estimation, namely a Mongolia that dances happily through the rain and comes out the other side significantly stronger.

Nonetheless it appears a decoupling has already started and is likely to continue given the commencement of steady state production at OT. Basically, once OT ramps the divergence highlighted in the chart should blow out, as it will single handedly grow the real economy in the high teens and average incomes by even more – not to mention diversify the economy from one that’s primarily coal based, to a dramatically more stable one driven by a diversified, countercyclical mix of coal, copper, and gold pretty much overnight.

Given this reality, it seems pretty certain that the Mongolian economy will be shielded from 1) a reasonable level of economic turmoil within the developed world and 2) a Chinese hard landing. At the very least the implication seems to be that economic conditions (i.e. stability and growth) should hold up substantially better than other more developed economies, both east and west.

The somewhat paradoxical conclusion above is a function of a couple of things…

Mongolia’s proximity and hence sizable cost advantage (transportation costs, labor, etc.) to traditional sources of Chinese supply removes a considerable amount of uncertainty in terms of the big picture. Unlike most resource driven economies, commodity pricing plays second fiddle to the ultimate outcome given Mongolian low cost production is able to feed more and more of China’s existing demand at the expense of higher cost competitors – and we would note that even under a draconian 20-30% drop, its hard to see how that would come close to being of sufficient magnitude to materially effect the baseline demand number that China would require even if it started shrinking. Therefore, as crazy as it sounds, the health of the Chinese economy would seem unlikely to effect Mongolian economic growth prospects materially at this early stage in it’s development.

Put a little differently, the level of demand destruction required for Mongolian production to feel a GDP growth negating hit would need to be staggering – we think one that would imply a depression like scenario globally, so the simple answer is that Chinese coal demand may drop, but not to a level that would destroy demand for its lowest cost producer. Same with copper, gold etc. So we expect Mongolia to hold up as China rationally shifts their needs towards the lowest cost producer and because at the end of the day, Mongolia’s production capacity isn’t big enough (even at maturity, say 10 years down the line) to take the entire share of the commodity needs of the worlds 3rd biggest economy.

After one takes into account the gold byproduct, Oyi Tolgoi actually has NEGATIVE cash costs for its copper production. Hard to believe, but this tier 1 mega mine/multi billion dollar copper producer with a mine life of ~60-70 years literally can’t become uneconomic under most reasonable future scenarios given practically every other copper mine in the world would need to go bankrupt before OT would face material stress. I say that because as a low cost producer of gold and copper with massive scale, high grades, natural counter-cyclicality (gold should do well when copper does poorly and regardless of whether we have inflation or deflation), and a structural cost advantage large enough to drive a truck through makes it extremely unlikely. So a scorched earth scenario where this happens is REALLY difficult to envision barring some type of Yellowstone type event (such as a Chinese or Russian invasion).

Basically given the Mongolian economy’s low base and OT’s contribution, not to mention its scale as the third largest copper mine in the world, or its negative costs on copper production (due to its unusually high level of gold byproduct) etc. it remains difficult to come up with a scenario in our mind where OT’s impact as a growth driver could be negated. We just can’t figure out how to remove any legs from the foundational stool under any scenario worth worrying about given OT’s economics are bulletproof relative to competition. The mine should generate cash regardless of where we are in either commodity’s cycle, so the odds that it would ever get idled over the life of the mine is pretty much nil.

My understanding of the last few years is that much of the of torrid growth has been driven primarily through exporting coal from smaller mines, pretty much by selling it at half market to the Chinese for what is presumably their local power needs. That would seem to imply that all of the rapid growth from foreign investment from these tiny mines over the last few years is very stable and in all probability sustainable indefinitely – after all, presumably these pretty much non-discretionary foreign inflows are a function of necessity, i.e. of ensuring the lowest cost sources of coal possible can be used to keep the lights on in local Chinese cities located close to the Mongolian border (so again, sustainable because its clearly the lowest cost source of power they could possibly utilize). Either way in the long-run, unless China stops powering their cities, homes, etc. the demand for this low cost coal should be more than sufficient to support Mongolia’s present run rate GDP – sure, volatility in volumes and pricing will always be there but production increases from existing mines and/or additional coal derived from new mines should easily overwhelm that cyclicality as export capacity grows.

As an aside, planned infrastructure investments/logistical improvements should buoy run rate coal exports and hence GDP since most of today’s low cost coal is transported by truck ~250 miles to the Chinese border (so not exactly the most efficient method to put it lightly), so its worth highlighting that when the rail currently in planning is built the economics of this portion of the economy (i.e. its core driver at present) will get materially better, further augmenting Mongolia’s already steep cost advantage. Hard to tell if the entirety of the additional margin will accrue to Mongolian producers, but regardless I view any progress on this front is icing on the cake and figured I should mention it, as the positive effects on general economic activity aren’t trivial.

Summing it all up then, all signs point to the Mongolian commodity juggernaut possessing “inevitable” status in Buffett parlance given a high probability of near certain growth looking out 2-3 years from the economy’s present $8.6B base.

Catalysts:

Mining

As Mongolian mines turn on, GDP and per capita incomes will grow and hence the value of MGG’s RE assets will appreciate even faster. As far as specifics, the big near-term catalysts are the commencement of production at OT as well as the upcoming IPO of TT – both of which should result in substantial growth and large windfalls in terms of wealth to Mongolia’s citizenry, catalyzing a substantial re-rate in the value of MGG’s properties. That’s just what happens in an ~8B dollar economy where one mine is set to bring in ~$5B in recurring export revenue within 6 months to a year and another that’s expected to raise ~10B in an IPO – an amount that in and off itself is larger than the entire GDP of the country presently.

Fwiw, these developments are practical certainties in our opinion (OT especially), and as we’ve already mentioned, should come to fruition in the near-term irrespective of cyclical swings in commodity demand/pricing, turmoil within the capital markets, or political grand standing by a small minority of Mongolian politicians dead set on killing the golden goose.

Remember, OT is fully funded and TT is arguably one of the best low cost coal assets in the world in terms of size/scale and proximity to the hungriest coal consuming economy on the planet. Remember, Mongolia’s is starting from a very low basek and its status as a low cost producer with a structural cost advantage relative to other high cost producers such as Australia, Indonesia, etc. practically ensures Mongolian production continues to displace foreign resource demand unabated.

Capital Markets

Mongolia’s capital markets do not function and any improvement on this front will be a major positive for economic growth and per capita incomes given it would unleash an additional source of upside leverage to GDP entirely independent of the mining boom, and would unlock an enormous amount of latent consumer spending power providing an economic growth/average income/real estate pricing tailwind for literally decades.

There is still much to be done but the good news is the wheels are turning. While progress is naturally slow, the positive changes on the horizon are multi-fold, including 1) the continued arrival of foreign banks 2) the passage of legislation related to various capital market related issues next month (such as the creation of laws to regulate credit and create securities markets), 3) the London Stock exchanges successful modernization of the Mongolian Stock Exchange (MSE) and 4) the successful IPO of TT (hopefully on the MSE) etc., all of which will help (at the margin) facilitate the structural changes necessary to create the foundation needed to allow fully functioning capital markets to take hold. So all of the pieces of the puzzle are in motion and coming together but this will take time.

Also, as of today most Mongolian banks generate NIM’s of 8-9%, and are still woefully undercapitalized, which naturally makes credit very expensive and access to long-term debt financing of any kind extremely rare. Something like 80% of loans are turned down, a statistic that in my mind pretty much says it all. I mean it’s an obvious problem when even the best businesses and entrepreneurs (entirely) worthy of capital can’t get. But again, luckily things are changing and when they do, a virtuous feedback loop will start to gain traction and in the process naturally drive down NIM’s, the cost of financing, etc. which will naturally broaden access to capital and help make long-term financing available, etc. and in turn facilitate the creation of a mortgage market and a liquid, fully functioning modern stock and bond market. So all of this is critical to keep in mind in context of the longer-term story here, as today’s headwinds will eventually become very powerful tailwinds.

Lastly, as long-term investors with an eye towards the inevitable, we want to get in before this happens and in truth, hope the window stays open a bit longer given the extreme inefficiencies it creates for a company like MGG run by a pair of opportunistic investors with the willingness, ability, and capital to exploit it on shareholders behalf. Obviously any time interest rates are excessively punitive and loans are short-term in nature, this dynamic will lead to a fairly large amount of financial turmoil and a pretty much continuous flow of forced selling like the situation described in the special situation segment earlier. So to tweak St. Augustine’s famous line on chastity, Lord please give Mongolia functioning capital markets, just not yet.

Exchange Up list(s)

We expect MGG to up list to the TSX-V within the next few months, the Mongolian Stock Exchange in the near-term and eventually the TSX longer term. The up-list to the TSX-V is by far the most consequential in terms of a hard, near-term catalyst and we expect it will drive a material revaluation in the company’s shares. Keep in mind that MGG is currently listed on the Canadian National Stock Exchange (huh?) or the “CNSX” – a tiny exchange for emerging companies. Basically the worst exchange in Canada. This is critical as this listing has heretofore prevented large amounts of capital (read a long list of institutions) from investing in MGG despite their willingness given internal mandate/liquidity restrictions, a barrier that critically will no longer apply once the TSX-V makes those issues mute.

Given all of the pent up demand and assuming an up-list along with a modest increase in MGG’s IFRS book value as those numbers are changed to reflect the substantial increase in Mongolian property prices and rents over the latest twelve months (which again is still substantially below “true” book value), perhaps something approximating $2.25. If we then assume a multiple on those revamped IFRS numbers at or below the lowest end of the comp range, so say 3-4x, both reasonable assumptions given the substantial uplift in Mongolian RE and the relative superiority vs. comps – MGG’s equity would end up somewhere between $6.75 and $9 in the relatively near-term, so upside approximating 2-3x the present quote at some point within the next year. Not bad.

As far as the MSE up listing, it may take a bit longer than the TSX-V up list, but eventually we think this will be a substantial catalyst as MGG is the best positioned and really the only company that will be listed that provides institutions with a conservative vehicle to play the multi year growth wave in Premier downtown UB RE. Fwiw, can’t imagine Asian sovereign wealth funds not wanting exposure once it’s available.

Point being, we see these events, particularly the imminent TSX-V up-list as having a high probability of driving a material re-rate, and in the process pushing MGG’s valuation more in line with intrinsic value and/or that of its global peers.

Risks:

Resource Nationalism/Government Related Issues

Figured we’ll start off with the elephant in the room by noting that additional government regulation/bureaucracy could affect the cost and pace of development in Mongolia going forward. For reasons outlined below it’s a negligible risk in the thesis killing sense. Also, we should probably mention that if the current political grandstanding and melodramatic/western press seeking antics of a small minority of politicians continues, its reasonable to assume some impossible to quantify amount of damage (in terms of lost FDI) will walk away. While powerless to affect change in any real sense, the mere perception of political risk could become self-fulfilling to an extent, but again it would be an immaterial amount and is nothing to lose sleep over in context of the long-term thesis but definitely something to monitor.

That said, lets remember the ambitious, pro western nature of its people and the fact that both major political parties are pro-business and better yet, that the more classically liberal of the two was just elected in the countries quadrennial elections. This is evidenced in the new governments DP plan (and others) that highlights their policies, as well as in their actions, most recently by voting down calls to renegotiate terms of the OT contract twice within the last couple of months. I emphasize it given all of the recent events/press of late that paints a very different picture, so I wanted to reiterate that right out of the gate to highlight that while its true Mongolia has its fair share of myopic, pandering politicians intent on enacting self defeating policies, so do we all, and the “kooks” in the headlines are a small minority with zero power to do anything of material consequence – just like the kooks in our own, or any representative democratic government for that matter.

So while no discussion of this topic would be complete without the above, neither would a discussion that didn’t provide a good idea of the character of the Mongolian people as a whole, particularly in terms of standing up for property rights and the democratic form of government. I mean this is a country that went on a hunger strike (for God sakes) in order to achieve democracy, so the belief in the rightness of a democratic system of government isn’t just a phase, its actually deeply ingrained in who they are as a people. At the risk of sounding hyperbolic, I actually think its fair to say that democracy is in their blood. Evidence of this can be gleamed from a variety of angles, most notably by Mongolia’s multi-decade history of stable democratic governance, a period marked by peaceful, seamless transitions of power. This type of thing is practically unheard of in the prototypical frontier market and really speaks for itself.

Also numerous sources who’ve spent a material amount of time on the ground have told us that the average Mongolian will tell you that property rights are considered sacred and that the government will simply never just take an asset from anyone. The only exception to this rule is when the Chinese are involved as Mongolians harbor a severe mistrust of their larger, more powerful neighbors, and reflexively fear Chinese control of Mongolian assets – but even here, the two countries are for the most part able to work around these differences and somehow manage to make it work. As further evidence of the larger point consider that Mongolia is #29 in the world in “protecting investors” (ahead of both Australia & France) and #33 in the world in terms of “enforcing contracts” (between Denmark and Japan). Interestingly then, as nuts as it seems, capital appears to be relatively safer in Mongolia than in a wide variety of developed western nations – and yet people that wouldn’t think twice about investing in Japan, Australia or France wouldn’t invest in Mongolia with a ten-foot pole. As fact and data driven investors, all in all this makes no sense to us given the empirical and anecdotal evidence points to a large disconnect between perception and reality in terms of the perceived vs. actual risks of investing in Mongolia in terms of the stability of government, property rights and respect for the rule of law. These are critical points for potential investors to internalize.

I should probably also note that as unusual as it may be in terms of the average frontier market, I don’t think it’s at all abnormal for country that underwent decades of oppression and the “cog in a wheel” reality of Soviet rule to have deep-seated preferences for democratic forms of government and a profound respect for property rights amongst the majority of its people (Poland comes to mind). In fact I think its intuitive if anything. So again, my read is that respect for both democracy and the rule of law is deeply ingrained, and both are enduring characteristics that are highly unlikely to change anytime soon.

Again, these are key points and while I fully realize this isn’t orthodox opinion, all things considered I just don’t see Mongolia as particularly risky on an absolute basis or relative to other western developed nations. That’s not to say that Mongolia doesn’t have its owns very real risks and issues, just that the range of outcomes here is relatively predictable and many of the typical pitfalls associated with investing in frontier markets don’t really apply in the traditional sense. As I hope is clear by now, the more you peel back the Mongolian onion the more all of this becomes obvious.

With that foundation established lets get to the point as far as why we don’t feel that governmental/political risk is all that material to the endgame here – at least not significant enough to be amongst the thesis killing variety.

The backbone of this conclusion is derived from…

The fact that Mongolia is a democracy where all existing legislation requires a quorum (or 2/3rds majority) of votes to overturn. In a very real way then handicapping this risk is a basic math problem and an easy one to solve at that.

For example, as far as we can tell the golden goose killing, resource nationalists in the Mongolian parliament (i.e. the ones whose antics get plastered all over the western press) only number in the mid twenties at best – in a government that keep in mind requires a bare minimum of 39 votes in order to affect real change of any consequence. So again, investors need to understand that that this is a small minority in a democratically elected government that frankly doesn’t appear close to having the requisite political muscle to jeopardize the country’s progress (at least for the next 4 years). So the headline risk, while not particularly helpful and a tad unnerving is at the end of the day just that (so pretty much nothing but noise). At minimum I think one can confidently say that because of this structural reality, the political risk is reasonably contained for the near to medium-term future.

Even if we assume by some extraordinary measure the “kooks” in the government managed to garner the requisite 39 votes to do something staggeringly retarded (which again is unlikely for reasons already stated), I would argue we still have an ace up our sleeve in the form of veto by the PM. What the media fails to mention 9x out of 10 is that the PM is on record stating he would veto any such legislation immediately. I mean the guys not dumb given the stakes.

If we want to go one step farther and assume he’s lying (just for the fun of it I suppose), remember that the law is still clearly on Rio’s side and the company is on record stating it wouldn’t stand for it and would fight it if necessary in court. So Rio has made clear that any change in current terms won’t fly and hence under that scenario the case would end up in arbitration within the international court system and hence, any ruling would almost certainly come down in Rio’s favor given what are very clear, mutually beneficial terms that were obviously understood to be legally binding at the time of signing by both parties involved. I’m no lawyer, but this just seems self-evident. So worst, worst, worst-case production gets temporarily delayed 6-12 months as the issue gets settled in court and the economy takes a near-term hit in the meantime.

Lastly, the embedded growth derived from OT & TT “turning on” is a lock regardless of what the future brings on all of the above fronts. I bring it up again because remember that as they “turn on,” these mega mines will in and of themselves fuel substantial gains in GDP and average incomes relative to present run rates – and hence in the value of MGG’s RE portfolio irrespective of the macro. No matter what happens, Oyi Tolgoi ramps up and that is really all that matters in terms of this thesis working. Strictly speaking, the idiocy of politicians is not an impediment to investment success.

Think about it like this, even if we assume the worst-case scenario where the government goes nuts (highly unlikely imo) and rips up OT’s existing agreement and somehow gets away with reinstituting a new contract where Rio is essentially nothing more than a contract miner earning a 10% IRR after it recoups its initial investment (with the rest of the economics going to the government) – and that nonsense stands in court – even then, Mongolian GDP will still roughly double when all is said and done. Meaning OT & TT still get built and hence run rate GDP of $8B becomes “steady state” GDP approximating ~$16B+.

The takeaway is that GDP should approximately double in ~3 years regardless and that this doubling is highly predictable. Put another way, if OT & TT turn on GDP will double and given that our downtown UB RE should appreciate at a rate of 3x that, the value of MGG’s portfolio could easily triple in value even under the most draconian – not to mention improbable – scenarios we can imagine. Again, the above assumes the government does something stupid and most of today’s projects in the works ultimately get nixed as FDI throttles back due to fear surrounding political risk.

Other critical points to internalize is that most of the politicians in power today are amongst the countries wealthiest citizens and therefore they have the most to lose by spooking the international investment community with the specter of sovereign risk. I say that with confidence because in Mongolia the political and business elite are one and the same, and because most of them actually own either 1) large interests in the mines that FDI has been – and will be – developed or 2) if not the mines, certainly any multitude of supply chain related businesses that stand to benefit royally as the country continues to develop/modernize over time. So rest assured the politicians are cognizant of what’s at stake here and any acts of staggering idiocy along these fronts would hit them directly where it hurts (i.e. in their pocketbook).

Also critical is that as Harris has mentioned, the Mongolian people have already “stubbed their toes badly” in this respect with the 2006 excess profits tax, an 85% tax that was partially repealed (almost instantaneously) in 2006 and fully repealed by 2009. From everything we’ve read and/or heard from those in a position to know, the folly of this act was apparent to everyone, everywhere, and pretty much immediately. I mean with the switch of a button, Mongolian FDI and most of the countries mining related jobs/projects ground to a halt and the country was for all intents and purposes plunged into a severe bout of economic distress in the blink of an eye – and again, it took almost 3 years for the damage of that one act to be undone. Maybe it’s just me, but people don’t forget things like that very easily. So its no small point that the memory of what awaits such short sighted decision making is still fresh and/or that the political class stands to lose considerably from a financial standpoint should the minority of the countries politicians somehow succeed in tarnishing the countries reputation as an ideal/safe destination for investment capital. Again, I just don’t see it happening.

Last but not least, consider that the government absolutely needs foreign investors (read the associated tax revenues that these investments will generate) in order for to be able to come up with the billions in requisite funding needed to 1) repair the countries crumbling infrastructure and 2) support economic development in the countries others sectors. For anyone familiar with the situation this is a very big deal as without continued FDI, the Mongolian government would be likely be sh%t out of luck as far as alleviating so many of the infrastructure related issues currently plaguing the country. The cold hard reality is that politicians need this to happen to deliver on their existing promises to their constituents – let alone to deliver on promises relating to a brighter future. In other words, they need it to keep their jobs. That’s the beauty, as unlike most frontier markets and their dictatorial strong men that run the country uncontested (usually with an iron fist) – Mongolian politicians live in fear of losing their jobs just like the politicians in our own or any truly democratic society for that matter, after all, they have two decades of experience watching peers get kicked to the curb which tends to make an impression. Also, none of the political parties or individual politicians have enough power to not fear the reaper, as witnessed by the recent jailing of one of, if not the most, powerful politicians in the country. Because of this, again just like our own politicians, they tend to do what they need to do to ensure they keep their jobs, and not to be a cynic but if there is one thing politicians as a group can be counted on to do, it’s cover their ass and act on an opportunity that ensures their job/advances their own interests. We’re covered on both fronts.

Add it all up and our conclusion is that the majority of Mongolians and the politicians in power are both incentivized and eminently aware that capitalizing on the countries resource wealth is the ONLY way forward. Meaning, they understand that jeopardizing the investments that they depend on by enacting myopic legislation is akin to playing Russian roulette and for what, an extra 15% or whatever of OT’s equity? To say that would be self-defeating, and all around shockingly dumb isn’t the half of it. It’s not like it takes a genius to realize that chasing away the precious capital and investment at this stage in the game would level any hope the government has of achieving its plans, as without the profits from its natural resources, those plans are dead in the water. Everyone loses. Big time. So not only would all Mongolians suffer, the current politicians (read the business elite) would bear the brunt of it, as it’s likely they would not only be out of a job, but vastly poorer.

Now all of the above doesn’t stop western journalists from pasting every scary word they hear from opposition minded Mongolian parliament members every chance they get (and the political circus like press conferences they seem to hold on a bi-weekly basis). We reiterate this point not to beat a dead horse, but to crystalize how this type of thing out of context tends to unnecessarily exacerbate fear/dampen sentiment, and hence leads to overblown concerns regarding political risk when a close examination of the facts and underlying situational dynamics at play strongly suggests it’s just noise. All of this is not to say that that government related risks aren’t real to certain degrees, just that whatever happens we don’t think it will kill the golden goose and that the headlines plastered in the western press typically don’t come close to telling the whole story. Again, perception isn’t necessarily reality, especially in this case, where the members of the MP party are a small minority that happens to be unusually hysterical in their quest to strap what amounts to a stick of nuclear dynamite in the engine of Mongolian progress and economic growth. They will fail miserably, just as they have at every point so far.

We want to close by quickly mentioning that we think this article posted below on the second order effects of rising taxes at OT and other emerging Mongolian copper producers (published a couple weeks back) obviously overstates the risks of the new proposal set to come before Parliament, lacking the balance and context in terms of the larger picture which we’ve tried to synopsize in brief.

http://dealbook.nytimes.com/2012/10/15/tax-proposal-in-mongolia-threatens-rio-tinto-project/

For clarity’s sake, the new proposal set to go before parliament detailed in the article above isn’t OT specific – again, those OT specific proposals have already been voted down twice in the last couple of months – but an entirely new law aimed at the copper industry itself. The proposal, if passed, would add an additional ~300m USD in tax liability (by revoking income tax allowances), not to mention introduce a sliding mine royalty that scales up to 20% depending on the copper price at the time in question, which is considerably higher than the fixed 5% rate guaranteed under OT’s existing agreement.

Bottom line is that (as always) anything can happen, but as we hoped we’ve made clear, 1) passage of this bill wouldn’t kill the thesis and 2) a large amount of caution against reading too much into recent press is more than warranted.

At the end of the day we continue to think all signs point towards a bright road ahead for Mongolia. We’re of the opinion that Mongolia’s history says a lot about its future much like the operational track record of a 20 year old corporation does about its own. Sure the world could be upside down tomorrow we just don’t think its likely for much the same reason. The momentum of the last twenty years of history are on its side. That, and they appear to have take the cheap tuition to of the last decade to heart, and possess all the key ingredients necessary for sustained, long-term success (an exceedingly rare combination we might add) – such as an educated, hard working, entrepreneurial culture, a young population – 60% of the population is under 26, can you say baby boom? Wonder what that will do for property prices given a relatively fixed supply due to structural reasons but I digress. They also have a multi-decade history of stable democracy marked by peaceful transitions, a fully functioning legal system with a long history of respecting property rights and the rule of law, relatively low levels of corruption etc. etc. and so ultimately, we think Mongolia has a very high probability of harnessing its vast potential and becoming the wealth creating juggernaut of a country it was destined to be. We’ve positioned ourselves accordingly and look forward to a long, hugely profitable ride as this transition takes place in the months and years ahead.

Development/Production Delays at OT/TT

Closely related to the above, there is a chance that the final piece of the OT production puzzle, namely the ability of Rio Tinto to hook the mine up to nearby Chinese power lines gets scuffled somehow. Given what’s at stake, various tea leaves, etc. we doubt a mutually acceptable agreement won’t be reached near-term but even in the worst case scenario, all this would do is delay the commencement of commercial production by ~6 months or so as Rio would need to build the power capacity themselves. Like with the specter of an arbitration hearing, this would amount to a slight kick in the balls (i.e. a near-term pullback in the economy) but nothing game changing as it would push production back 6 months to a year max.

Commodity Risk

As with any country where the economy is commodity driven, Mongolia is to a certain degree affected by commodity prices and a sustained collapse in pricing obviously wouldn’t be a great thing. Given the countries structural cost advantage though, prices don’t need to improve or even stay at current levels for the thesis to work.

Also, the macro shock risk is real and while I think MGG weathers the storm much better than most, a systematic financial crisis wouldn’t be a good thing as far as FDI/capital flows are concerned. Capital flight would temporarily delay the day Mongolia realizes its full potential.

Geopolitical Tensions with China and/or Russia (Sovereign Risks)

To paraphrase Harris, there’s always a chance China and/or Russia decide to “bring the tanks in,” and while a highly remote possibility it should be noted as a risk.

Corporate Governance

With 1) a sole mandate to create shareholder value 2) a 33% ownership stake 3) full transparency, accountability to investors and an impressive BOD 4) independent verification that all MGG’s property titles are clean 5) Price Waterhouse Coopers doing the books and 6) Cushman Wakefield taking care of the property appraisals etc. etc., we think we are in good hands. As such a small company, it’s telling in my mind they didn’t skimp on fees (and they usually do, though in the good way) and hired world class auditors and appraisers because it was the right thing to do all things considered.

Let me preempt the equity raise question by noting that the up-raises were accretive to per share value as they were done at a premium to NAV and that capital was deployed at very high rates of return. The second they do a raise that’s dilutive rest assured I’ll be the first one in their ear. Don’t see it happening though given Harris and COO Jordan Calonego are both excellent capital allocators, so rest assured they have a firm understanding of what is and what is not, dilutive – and given inside ownership of 33% and the fact that they have put up millions in capital of their own money. I’m pretty sure they aren’t interested in diluting themselves to go empire building given they don’t even pay themselves a salary (there’s no upside, only downside to doing so). So between that and various other data points, MGG might be one of, if not the most shareholder-friendly I’ve ever invested in and it shows (in so many different ways). For example, as noted above, they hired world class auditors and appraisers in order to give maximum comfort to their shareholders yet they’ve raised ~$51m in capital so far, and every time they did a non-brokered deal because they didn’t want to pay the fees. Notice the pattern of spending money like they would if it was their own (which a large part of it is).

Couple more points. The raises were also done because they were approached by the right type of long-term shareholder that wanted to get in, and MGG wanted to have them, and because increasing the liquidity of the stock adds value. Additionally, in order to up-list the company had to meet minimum # of shareholder requirements. The raises helped out on all those fronts.

All that said, I tend to like the idea of additional capital raises going forward as long as they are done above “true” book value because I believe they would be significantly accretive to an already largely fixed cost base and because the window to deploy capital at these super attractive rates is closing. Operating leverage to having a larger property portfolio spread out over a fixed cost base is significant. Equally as importantly, in real estate having a bigger property portfolio is better, not only because of the substantial fixed cost leverage involved, but because having a broader portfolio gives them more negotiating leverage with tenants, and allows them to more easily gain large prospective clients like a YUM brands, where by having a wider selection of property locations to showcase they are able to meet a wider, more varied set of needs.

In terms of the initial policy on no options, and the seeming flip-flopping in that regard, rest assured it isn’t what it seems. First, its not like they are issuing additional stock to themselves (these guys don’t even pay themselves a salary) and second, the options they’ve issued so far were done solely to attract/retain local talent. Really high quality (smart), enterprising locals are naturally hard to find and so when you hire them you want them to stay and giving them an ownership stake in the company is the best way to do that. Historically, some of their best people were getting poached by large multinationals and so MGG decided it was the right way to go in order to make churn less of an issue. They can be cheap skates with quarterly turnover and have their best in brightest stolen from them or they can issue some options judiciously and try and strike the right balance. I think they are doing the right thing.

Last but not least, just take a quick look at MGG’s board, which consists of Ross Beauty’s right hand man in terms of corporate governance or notable short-seller Bill Fleckenstein (who’s also one of the largest shareholders of the company) to name a few. This is an impressive BOD for such a small, off the radar company. I think that’s telling.

Dutch Disease

In terms of the risks of Mongolia catching a case of “dutch disease,” check out the BDSec overview on the new coalition government’s latest DP plan for some good color. The DP plan is basically the government’s framework for policy decisions going forward and I think its pretty clear that they are going about things in an intelligent way designed to minimize these risks. I believe they are using Chile as a template for how to do things right.

Also important in terms of thinking about Mongolia’s ability to successfully navigate the resource curse, the mongols are/will be getting granted stock in these IPO’s like with TT. So if the mines flourish, so will the average mongolian in terms of wealth. They will certainly be much richer than they are now. That should keep a lid on a lot of the envy. Instead of a “he’s getting rich” and “I’m still poor” it’s more “where did all this free money come and its nice that we are all getting wealthier – I want more of this” if you follow me. Embracing free market capitalist principles will make everyone far far richer in the end…and again, I think they realize that and not just on some superficial level. That said, MGG’s portfolio is actually set up in a way to benefit from “dutch disease” in the near to medium term so keep that in mind as well.

Helpful Documents:

Thesis PDF (just in case the formatting doesn’t come through)

MGG Corporate & Property Presentations

BDSec Report: The Heavy Hand of Government Lightens Up

http://www.scribd.com/doc/110231053/MGG-the-Heavy-Hand-of-Government-Lightens-Up

BDSec Report: New Securities/Market Law Draft A Potential Game Changer for Mongolian Capital Markets

http://www.scribd.com/doc/110231132/MGG-New-Securities-Market-Law-Draft-A-Potential-Game-Changer-for-Mongolian-Capital-Markets

BDSec Report: Mongolian Portfolio Strategy

http://www.scribd.com/doc/110231162/MGG-Mongolia-Portfolio-Strategy

Mongolia Overview:

http://www.scribd.com/doc/110231012/Mongolia-Report

Capitalist Exploits (Mongolia related posts & Kupperman interview)

http://www.capitalistexploits.at/tag/mongolia/

Adventures in Capitalism Mongolia Related Blog Posts:

http://adventuresincapitalism.com/search.aspx?q=Mongolia

Business Week Article

http://www.businessweek.com/magazine/foreign-money-invades-mongolia-0721201

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Simply awesome!

Q3 2006

Q1 2008

Another must read

Ned Goodman’s latest…

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