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Agcapita May 2012 - Risk, Return and Value in Western Canada


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The challenge current investors face is that sovereign debt default via inflation/currency debasement obviously doesn’t create any new wealth but it certainly reallocates it amongst economic participants, and it is a process that takes place largely unnoticed until it is too late for most.

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Agcapita May 2012 - Risk, Return and Value in Western Canada

  1. 1. Agcapita UpdateMay 23, 2012
  2. 2. Agcapita UpdateINVESTMENT THEMES - RISK, RETURN AND VALUE INWESTERN CANADAThe challenge current investors face is that sovereign debtdefault via inflation/currency debasement obviously doesn’tcreate any new wealth but it certainly reallocates it amongsteconomic participants, and it is a process that takes placelargely unnoticed until it is too late for most.Sadly, that is the entire point of the ongoing zero-interest ratepolicies - to quietly expropriate as much scarce capital aspossible for the benefit of bankrupt but politically influentialsectors of the economy - particularly in finance and realestate.Where do you invest in such a world - a world of negativereal interest rates, bloated central bank balance sheets andsolvency challenged governments? I do not intend this letterto be a definitive answer to that question by any means,rather a quick overview of some ideas which we believe areworth consideration.There are still pockets of good risk-adjusted returns to befound in the developed world despite the relentless overalldeterioration in western growth fundamentals - or perhapsdue to the dogmatically Keynesian mindset of our monetaryand fiscal authorities, because of them. I hope it does notcome as a surprise that for the diligent researcher there areways outside of gold to go long monetary malfeasance whileobtaining some growth exposure and perhaps a margin ofsafety as well.Consider the value of commodity-linked returns in apolitically stable part of the world - western Canada.Commodity production assets, or more generally commoditylinked cash flows, have interesting inflation hedging 1
  3. 3. Agcapita Update (continued)characteristics, can be useful tail risk hedging tools never be ignored, as I believe it is a key differentiator(farmland) and when located in Canada provide of returns. Just ask investors in Sino-Forest or YPF tolinkage to emerging market growth and tight supply name just two recent demonstrations of this principle.dynamics without emerging market risk. In addition,agriculture and energy have another useful quality in Private Equity (“PE”): Canada has some of the bestvolatile times - highly inelastic demand curves. PE returns globally (particularly smaller transactions):For those unfamiliar with western Canada’s 10 years 5 years 3 yearscommodity endowment, it is a region with less than Canadian PE 14.2% 16.8% 7.2%10 million inhabitants but is the epicenter of one ofthe world’s most impressive concentrations of real US PE <250mm 3.4% 4.2% 0.1%assets. Its approximate global reserve rankings (or TSX 3.9% 4.1% -2.5%production rankings in the case of beef, timber andwheat) are as follows: At the most basic level western Canadian PE returns are linked to commodity prices and the consistently Potash - 1 higher and more stable rates of growth that have Oil - 2 been occurring in this market. However, there are Uranium - 3 some additional factors driving returns as well: Timber - 5 Firstly, there is a strong supply of small & medium Wheat -6 enterprise deal-flow in western Canada due to Gold - 7 high levels of entrepreneurship (roughly speaking a Beef - 10 “SME” is a business with less than 100 employees Natural Gas - 20 or an enterprise value of less than $10 million). SME penetration in the west is almost 30% higher than theThe advantage of producing the commodities that Canadian per capita average.the emerging economies need and importing themanufactured goods they make is significant - per 1,000 popwestern Canadian growth rates have averaged twicethose of central Canada over the last decade. So for Canada 70investors looking for commodity linked returns with Saskatchewan 91political safety - western Canada is a good choice. Alberta 92 BC 81Why the reference to political risk? When seeking togenerate commodity linked returns political risk can Ontario 68 2
  4. 4. Agcapita Update (continued)Secondly, the number of Canadian baby boomer subject to two discounts: 1) the discount of heavyretirees has been increasing rapidly and is projected to WTI prices and 2) the discount of WTI to globalreach more than 40% of the working age population prices. Conventional heavy oil represents a relativelyby the late 2010s. It is no secret that baby-boomers inexpensive oil BTU and we believe spreads willcontinue to be an influential cohort and in retirement compress over time, enhancing returns to heavy oilwill have a significant effect on the pricing of assets, production assets. In addition, we are experiencingjust as they did during their key investment years, historically low natural gas (“NG”) prices. Theexcept now they are entering liquidation mode. The perverse effect of low NG prices is to force operatorseffect on the private equity market is simple - retiring with high levels of NG in their production mix to sell oilbaby boomer entrepreneurs must sell their numerous production assets to raise capital. This in turn tendsSME businesses which should create both deal flow to creates oil production deal flow - even though oiland downward pressure on cash multiples. Phrased cash flows are robust.another way, PE returns should improve. Natural Gas: For the extreme value orientedSaskatchewan Farmland: Since the beginning investor with a long-term horizon, NG assets withof 2007 Saskatchewan farmland has appreciated large reserves and low production levels necessaryat a rate of over 12% per year due to increasing to maintain leases represent a low cost-of-carryagricultural commodity prices but much more long position. Our analysis leads us to believe thatbecause of a large price discount to fundamentally for this purpose such a position has distinct cost,identical land in the neighboring province of volatility and return advantages over traditional longAlberta. In fact, the differential between the rate NG futures exposures or investments into operatingof appreciation of similar land in Alberta and companies. Assuming that the market will find a waySaskatchewan is over 50% with Saskatchewan to exploit one of the most inexpensive BTUs in worldfarmland generating substantial “margin of safety” (North American NG) then we should expect prices toreturns as the long-term price parity with its recover over the medium to long term as these BTUsneighbour is restored. On a fundamental price per are eventually pulled into other markets - perhapsbushel of yield basis Saskatchewan stills trades at a in the form of feed stocks (ethylene & propylene),material discount to global averages, a diminishing finished goods (fertilizers) or LNG. Obviously this islegacy of regulatory barriers to capital that have not an investment with a view to an immediate returndisappeared for domestic investors. but for value investors who believe in the long-term strength of the energy markets surely somethingConventional Heavy Oil: When investing in worth considering.conventional heavy oil in western Canada, you are 3
  5. 5. DISCLAIMER: The information, opinions, estimates, projections and other materials contained herein are provided as of the date hereof and are subject to change without notice. Some of the information, opinions, estimates, projections and other materials contained herein have been obtained from numerous sources and Agcapita Partners LP (“AGCAPITA”) and its affiliates make every effort to ensure that the contents hereof have been compiled or derived from sources believed to be reliable and to contain information and opinions which are accurate and complete. However, neither AGCAPITA nor its affiliates have independently verified or make any representation or warranty, express or implied, in respect thereof, take no responsibility for any errors and omissions which maybe contained herein or accept any liability whatsoever for any loss arising from any use of or reliance on the information, opinions, estimates, projections and other materials contained herein whether relied upon by the recipient or user or any other third party (including, without limitation, any customer of the recipient or user). Information may be available to AGCAPITA and/or its affiliates that is not reflected herein. The information, opinions, estimates, projections and other materials contained herein are not to be construed as an offer to sell, a solicitation for or an offer to buy, any products or services referenced herein (including, without limitation, any commodities, securities or other financial instruments), nor shall such information, opinions, estimates, projections and other materials be considered as investment advice or as a recommendation to enter into any transaction. Additional information is available by contacting AGCAPITA or its relevant affiliate directly.#205, 120 Country Hills Landing NW Tel: +1.403.608.1256 www.agcapita.comCalgary, AB T3K 5P3 Fax: +1.403.648.2776Canada