Warren Buffett's annual letter to shareholders came out last week..

 by Stansberry & Associates Investment Research

Warren Buffett's annual letter to shareholders came out last week… And the first thing I noticed was that Berkshire Hathaway's per-share book value (Buffett's favorite method of valuing the company) grew 4.6% compared with last year… one of the three worst years in the company's 47-year history. Still, Buffett said he's happy with the results. He outperformed the S&P 500 (which returned 2.1% pre-tax, nearly all in dividends). He wrote…

Our major businesses did well last year. In fact, each of our five largest non-insurance companies – BNSF, Iscar, Lubrizol, Marmon Group, and MidAmerican Energy – delivered record operating earnings. In aggregate these businesses earned more than $9 billion pre-tax in 2011. Contrast that to seven years ago, when we owned only one of the five, MidAmerican, whose pre-tax earnings were $393 million. Unless the economy weakens in 2012, each of our fabulous five should again set a record, with aggregate earnings comfortably topping $10 billion.

Buffett also said he thinks book value is a "considerably understated" proxy for intrinsic value.

Hedge-fund manager Whitney Tilson, a foremost expert on all things Buffett-related, said in an e-mail today that he thinks "over time, as Berkshire's value has shifted from its stock portfolio, which is valued at market (i.e., book value), to operating businesses like GEICO and [BNSF Railway], that Berkshire's intrinsic value is a greater percentage premium to book value – yet the stock is currently trading near the lowest premium to book in its history."

Also in the letter, Buffett reaffirmed his intent to repurchase Berkshire shares at 1.1 times book value (or $110,000 a share). Shares currently trade at $120,300. And they're trading near their lowest premium to book value in history. According to the Wall Street Journal…

After dropping 4.7% in 2011 and rising only half as much as the S&P 500 index so far this year, Berkshire shares are trading near their lowest valuation in decades: close to 1.1 times book value, versus its average valuation of about 1.6 times book value over the past two decades.

What struck me most about this year's letter was Buffett's discussion of languishing stocks… and how he likes flat markets (perhaps another reason he was so happy with Berkshire's 2011 performance).

When you buy high-quality companies, as Buffett does, you should only concern yourself with the company's earnings and shareholder payouts… Ignore the market noise. Buffett uses his recent IBM purchase as an example. (Berkshire owns 63.9 million shares, or 5.5% of the company.) As a long-term shareholder of IBM, what should Berkshire wish for over the next five years? Buffett says he wants the stock to "languish." Below is a long excerpt, but his reasoning important…

Let's do the math. If IBM's stock price averages, say, $200 during the period, the company will acquire 250 million shares for its $50 billion. There would consequently be 910 million shares outstanding, and we would own about 7% of the company. If the stock conversely sells for an average of $300 during the five-year period, IBM will acquire only 167 million shares. That would leave about 990 million shares outstanding after five years, of which we would own 6.5%.

If IBM were to earn, say, $20 billion in the fifth year, our share of those earnings would be a full $100 million greater under the "disappointing" scenario of a lower stock price than they would have been at the higher price. At some later point, our shares would be worth perhaps $11.2 billion more than if the "high-price" repurchase scenario had taken place.

The logic is simple: If you are going to be a net buyer of stocks in the future, either directly with your own money or indirectly (through your ownership of a company that is repurchasing shares), you are hurt when stocks rise. You benefit when stocks swoon. Emotions, however, too often complicate the matter: Most people, including those who will be net buyers in the future, take comfort in seeing stock prices advance. These shareholders resemble a commuter who rejoices after the price of gas increases, simply because his tank contains a day's supply.

So the next time someone complains about Microsoft "going nowhere" over the past 10 years, enjoy a private chuckle. And enjoy the increasing earnings power and growing dividends. It's the beauty of buying a capital-efficient business… These businesses earn large returns on tangible assets without large capital expenditures. And they can increase their returns without big increases to capital spending.

Buffett also dedicated part of his letter to discussing his distaste for gold and gold stocks. He still prefers farmland, operating companies, and cash. But according to executives at the world's largest gold mining companies, their stocks are poised to rally.

"At some point, we become so inexpensive on a cash flow per share multiple that it makes no sense for buyers not to acquire the stock," Goldcorp CEO Chuck Jeannes said in a February 15 interview with Bloomberg. Gold-mining shares have fallen out of favor as investors moved capital into gold-backed exchange-traded funds (ETFs) and other proxies for physical gold. Over the past five years, the NYSE Arca Gold BUGS Index (the HUI), which includes the world's biggest mining stocks, has advanced 53%. Spot gold prices have more than doubled over the same time frame. Aaron Regent, CEO of the world's largest gold miner, Barrick Gold, said gold-mining stocks are heading for an "inflection point" and will soon rally.

You should consider buying gold stocks right now…

The opportunity is just too good to pass up. The last time these particular conditions came together, gold stocks rallied 121% in 12 months.

Let me explain the opportunity…

Typically, if gold goes up, gold stocks move even higher. And if gold goes down, gold stocks fall even more.

But during 2011, that relationship broke down. Take a look…

The chart shows the price of gold in blue and gold stocks in black. You can see that in 2009 and 2010, gold stocks performed as expected… They tracked the price of gold, but with more volatility.

But as you can see, that relationship fell apart in 2011… Last year, gold moved higher for the 11th straight year, gaining 10%. But gold stocks actually fell 16%.

Matt Badiali, our resident gold expert, sent me the following note about China's huge appetite for gold…

Imagine going to your favorite Macy's department store to pick up a couple of quarter-ounce bars of gold. In China, you can. Beijing's Caishikou Department Store carries gold jewelry, but it also sells gold bars. The Chinese people are so gold-focused that they are lining up at the gold-bar counter of the department store.

China will likely become the world's largest consumer of gold this year. The average person in China views gold as safety… and so do the country's leaders. China is quietly building up its gold reserves. That could become a major problem for you and me.

Matt has recently released a report describing China's quiet initiative to amass an immense gold reserve… and ultimately back its currency with gold. Given the trillion-plus dollars we owe them and the huge volume of dollars we're creating to cover our debts… this plan represents a danger to our standard of living.

Quotes of the Day

“Twenty years from now you will be more disappointed by the things that you didn't do than by the ones you did do. So throw off the bowlines. Sail away from the safe harbor. Catch the trade winds in your sails. Explore. Dream. Discover.”
― Mark Twain

“It is better to remain silent and be thought a fool than to open one's mouth and remove all doubt.”
― Abraham Lincoln

“I am enough of an artist to draw freely upon my imagination. Imagination is more important than knowledge. Knowledge is limited. Imagination encircles the world.”
― Albert Einstein

Relax your Mind

The Largest Gold-Accumulation Plan of All Time By Porter Stansberry

For more than 30 years, since the start of the country's "Reform Era" in 1978, China has been selling (exporting) more goods than it has imported.  

That's allowed the nation to stockpile trillions of dollars – more money than our entire monetary base totaled before the recent financial crisis.



The way it works is simple to understand. When a Chinese business earns dollars by selling overseas, the law requires the company to hand those dollars over to the country's central bank, the People's Bank of China (PBOC). In return, the business gets Chinese currency (called either the "yuan" or the "renminbi") at a fixed rate.  

There's nothing fair about this. The Chinese people do all the work, and the Chinese government keeps all of the money. But that's the way it goes.

At first, the dollar inflow was small because trade between the two countries was tiny. In 1980, for example, China's foreign currency reserves stood at approximately $2.5 billion. But since then, the amount of foreign currency reserves held by the Chinese government has gone up nearly every year… and now stands at $3.2 TRILLION. That's a 127,900% increase. It's simply astonishing to look at the chart of the increase in currency reserves…  

 
As I mentioned yesterday, the group in China that manages these foreign reserves is called the State Administration of Foreign Exchange (SAFE). This group is engaged in a full-fledged currency war with the United States. The ultimate goal – as the Chinese have publicly stated – is to create a new dominant world currency and dislodge the U.S. dollar from its current reserve role.

And for the past few years, SAFE has had one big problem: What to do with so much money? 

SAFE decided to use most of these reserves to buy U.S. government securities. As a result, the Chinese have now accumulated a massive pile of U.S. government debt. In fact, about two-thirds of China's reserves remain invested in U.S. Treasury bills, notes, and bonds. The next biggest chunk is in euro. Of course, all this money is basically earning nothing to speak of in terms of interest… because interest rates around the world are close to zero.

And while the Chinese would love to diversify and ditch a significant portion of their U.S. dollar holdings, they are essentially stuck. You see, if the Chinese start selling large amounts of their U.S. government bonds, it would push the value of those bonds (and their remaining holdings) way down. It would be like owning 10 houses on the same block in your neighborhood… and deciding to put five of them up for sale at the same time. Imagine how much that would depress the value of all the properties with so much for sale at one time.

One thing China tried to do in recent years was speculate in the U.S. stock market. But that did not go well… The Chinese government bought large amounts of U.S. equities just before the market began to crash in late 2007. It purchased a nearly 10% stake in the Blackstone Group (an investment firm)… and a similar stake in Morgan Stanley. Blackstone's shares are down about 46% since the middle of 2007, and Morgan Stanley is down about 70% since the Chinese purchase.

The Chinese got burned big time by the U.S. equities markets and received a lot of heat back home. They are not eager to return to the U.S. stock market in a meaningful way. So China's U.S. dollar reserves just keep piling up in various forms of fixed income – U.S. Treasury bonds, Fannie and Freddie mortgage bonds, and other forms of debt backed by the U.S. government. These investments are considered totally safe – except that they're subject to the risk of inflation.  

According to a statement by the government: "SAFE will never be a speculator. It mainly seeks to protect the safety of China's foreign exchange reserves and ensure a stable investment return." 

If the Chinese won't buy stocks and the only real risk to their existing portfolio is inflation, what do you think they will do to hedge that risk?  

They will buy gold… lots and lots of gold.

It was no surprise to us when, in 2011, China became the No. 1 importer of gold. For many people in the gold market, this was a big shock – India has always been the world's leading gold buyer. In India, people traditionally save and display their wealth in gold. Their entire financial culture is based on gold. Historically, silver has played the same role in China… but not anymore.

In fact, not only has China become the world's leading importer of gold, it was already the world's leading producer… by far. According to the most recent figures from the World Gold Council, China produces nearly 50% more gold (about 300 tons per year) than the second-place country… Australia. And guess what? Every single ounce produced in China – whether it's dug out of the ground by the government or a foreign company – must, by law, be sold directly back to the government.  

The Chinese are now clearly on a path to accumulate so much gold that one day soon, they will be able to restore the convertibility of their currency into a precious metal… just as they were able to do a century ago when the country was on the silver standard.  

The West wasn't kind to China back then. The country was repeatedly looted and humiliated by Russia, Japan, Britain, and the United States. But today, it is a different story…  

Now, China is the fastest-growing country on Earth, with the largest cash reserves on the planet. And as befits a first-rate power, China's currency is on the path to being backed by gold.  

China desperately wants to return to its status as one of the world's great powers… with one of the world's great currencies. And China knows that in this day and age – when nearly all governments around the globe are printing massive amounts of currency backed by nothing but an empty promise – it can gain a huge advantage by backing its currency with a precious metal.  

As the great financial historian Richard Russell wrote recently: "China wants the renminbi to be backed with a huge percentage of gold, thereby making the renminbi the world's best and most trusted currency."  

I know this will all sound crazy to most folks. But most folks don't understand gold, or why it represents real, timeless wealth. The Chinese do. And in tomorrow's essay, I'll provide more evidence of how they are carrying out the largest gold accumulation plan of all time.

An Imminent Coking Coal Settlement At $195-$210 Per Tonne Had Better Be A Bottom by Peter Epstein

The following report, if confirmed, is moderately negative for coking coal sentiment, therefore coking coal producers such as Walter (WLT), Teck, (TCK), Alpha, (ANR), Arch, (ACI), Peabody, (BTU), Cliffs, (CLF), Patriot, (PCX) and Consol Energy, (CNX).
A few days ago we got the following comment,

It is reported that the Jellinbah group (a privately owned independent Queensland based coal company with operations in Central Queensland's Bowen Basin) has entered into a price settlement with JFE Steel in Japan for the quarter Apr-June. They have set the price for HCC at $205 and PCI at $153/ton.

Yesterday it was reported that coking coal was offered in Asia at $195 per tonne on the spot market. Steve Doyle of Doyle Trading Consultants flagged this news item, but his team is waiting for more definitive news before passing final judgment on 2nd quarter pricing.
First quarter pricing of $235 per tonne is down approximately 29% from the high of $330 per tonne last year. A settlement at $200 per tonne would be a disappointment and may weigh on investor sentiment. However, if $200 per tonne is perceived to be a bottom, which many think that it will, then investors might take comfort.
Last week, Gerard McCloskey stated at coal conference that coking coal prices might bottom around $200 per tonne, McCloskey is quoted as saying,

There will be a correction of prices down towards $200," McCloskey predicted. "It's a great price. Until two years ago we had not had prices above $200 except for one brief period in 2008.

While McCloskey has been dead on in his prediction of where coking coal prices were headed from last summer, I respectfully disagree with his comment that a benchmark coking coal price of $200 is a, "great price." Three or four years ago, a price of $200 per tonne was indeed great. But since then, the marginal cost of production has risen substantially. Some market participants believe the higher end of the cost curve is at $150-$160 per tonne.
There are four main implications here. First, it appears that downside below $200 per tonne should be fairly limited. Second, whereas $200 was a great price 3-4 years ago, it's only a good price today. Third, low-cost producers around the world should be especially attractive going forward. Names that most readily come to mind in this regard are Consol and SouthGobi Resources (SGQRF.PK). Fourth, a price of ~$200 per tonne for the 2nd quarter had better turn out to be a bottom or many coking coal producers will be missing analyst expectations for 2012.
Consensus earnings estimates for coking coal companies appear to incorporate a 2nd half of 2012 up-tick in U.S. economic activity, a rebound / soft landing in China and, to a lesser extent, a slight increase in demand from Europe. Many sell-side research shops have penciled in an average price of $225-$250 per tonne for CY 2012. However, if we average ($235 + $200 = $217.5) in the first half, we will need to achieve 2nd half pricing of between $232.5 to $282.5 to reach a full year average of $225-$250.
This suggests again that 2nd quarter pricing of roughly $200 had better mark the bottom, and that 3rd quarter pricing had better bounce back to $235-$250, or analyst estimates will have to come down. I have repeatedly said that my hurdle rate for investment in the volatile coal sector is 25%. Many investors are excited that coking coal fundamentals are in the process of turning. For me, if a sustainable rally in coal stocks hinges upon a fairly strong rebound in 3rd quarter pricing, I will remain on the sidelines waiting for better visibility.
Disclosure: I am long ACI, CNX, BTU, ANR, PCX.

The U.S. Energy Story No One's Telling By Larsen Kusick

As you know, new technologies have "unlocked" massive amounts of natural gas right here in the U.S. These resources are so enormous, we're now the "Saudi Arabia of natural gas." Within a few short years, we'll be exporting liquefied natural gas (LNG). We'll see thousands of trucks converted to run on natural gas. And hundreds of natural gas-gas stations will pop up all across the U.S.

Companies like Westport Innovations (natural gas engines), Clean Energy Fuels (natural gas fueling stations), and Cheniere Energy (LNG exports) are obvious winners.

But they're not the only ones that will see huge increases in profits.

It's going to take thousands of "intermediate steps" to build out America's natural gas infrastructure… which brings me to the "picks and shovels" plays of the natural gas story.

Whenever you hear about a huge boom in a commodity… look around for the suppliers – the "picks and shovels" plays – that can profit. Because they'll do a steady business through swings in the commodity price, they're often the safe, "sleep at night" way to invest in a resource trend.

And this energy "megatrend" is no exception. You see, natural gas is trickier than liquids like oil and gasoline. A child with a bucket can move a liquid from one end of the house to another. Transporting gas is a different story.

Outside a pipeline, natural gas becomes a headache for anyone trying to move it. To make it manageable for transportation and storage, natural gas needs to be cooled down…. way down, to below -259 degrees Fahrenheit.

That requires a lot of special equipment. You need a machine called a heat exchanger to reach such subzero temperatures. And massive LNG plants have entire systems (known as "trains") that generate millions of tons of LNG each year.

Gas stations that want to sell natural gas will have to buy special equipment and systems. These new businesses will need special storage tanks, piping, safety equipment, and so on.

While the stocks of natural gas producers will boom and bust with small moves in the commodity price, the picks-and-shovels companies will continue to build out America's new natural gas infrastructure.

One likely leader in this new market is Air Products and Chemicals (APD). Air Products is a $19 billion company that has supplied and handled gases for decades.

It's been integral in building LNG plants all over the world since the 1970s. It sells machines such as heat exchangers, as well as a variety of other parts and services needed to operate an LNG plant.

In short, it's one of the few companies in the right place at the right time… just as natural gas use is about to boom in the U.S.

Air Products is already a giant company. The majority of its business comes from selling other industrial gases, like oxygen, nitrogen, and argon. So you won't get as much "bang for the buck" as a company that has more direct exposure. But you're much less likely to see the massive volatility you would with producers.

You can't crack the Wall Street Journal or the Financial Times without reading another story about the natural gas revolution. This is the story no one's telling yet… the picks and shovels story.

With divestitures and rate case successes, American Water's strategy to right its ship is working.

American Water Works is the largest investor-owned water and wastewater utility in the United States. As such, the company enjoys some considerable advantages over its competitors in pursuing the investment opportunities presented by the dismal state of American water infrastructure. Despite its position, we recommend that investors dial back their enthusiasm when considering this investment, as government regulation limits the profits the company can make and creates hurdles to rapid growth.
Much of the U.S. water infrastructure dates back to the Great Depression, and the Environmental Protection Agency estimated in 2007 that it would require about $335 billion to upgrade and repair just community and not-for-profit water systems. With municipalities struggling to finance basic repairs and federal funding unable to bridge the gap, the signs point to massive opportunities for investor-owned businesses.
American Water's size and geographical diversity mean that the firm is better able to capitalize on these opportunities, as it is easier to connect new customers to existing systems and treatment plants than to build new infrastructure. It also helps the company maintain lower rates, as it can balance less profitable operations in one state with more profitable operations in others. This helps with regulatory goodwill but doesn't generally lead to great regulated returns. Continuing economic weakness also weighs on performance, as regulators are more inclined to sacrifice shareholder returns in exchange for political capital.
American Water's regulated businesses occupy local monopoly positions, since it would be prohibitively expensive to reproduce those assets. However, as most of American Water's revenue is dictated by state and local regulators, profits are effectively capped, diminishing the attractiveness of investments the company could make. In our opinion, this is the source of the company's narrow economic moat. Allowed returns are often not achieved, and excess returns are almost never allowed.
An investor must be willing to sacrifice excess returns for stability that is not necessarily guaranteed. In 2003, German conglomerate RWE acquired this company and took it private with dreams of huge growth. It is telling that RWE took only three years to decide to divest its holdings, finding American regulation too onerous. After the initial public offering and three follow-up offerings in 2008 and 2009, RWE no longer holds a stake in the company.
While the company will press ahead with its regulated investments and try to gain some ground with its allowed returns, we think appealing opportunities could lie in nonregulated contract operations. The firm designs, builds, and operates facilities, as well as assuming responsibility for operating and managing existing systems. Given the company's size, expertise, patents, and past successes, we believe this is an area where it could greatly expand its footprint. If it can, this story may get more exciting. The regulated businesses should continue to be a consistent, if unexciting, backbone for profits, and management is committed to paying a steady dividend. The firm has made some sizable divestitures to raise cash, narrowing its focus to a smaller number of states. Still, American Water still has a slog ahead to reach the top tier of regulated investments in our coverage universe.

Valuation
We are increasing our fair value estimate to $27 per share from $26 as American Water has managed O&M and rate activity better than we had forecast. We also incorporate a time-value adjustment. We expect the company to grow at a modest clip, increasing gross margins at an average rate of roughly 5% per year through 2015. We project capital expenditures totaling $4.4 billion during the same period to drive growth, with contributions from minor acquisitions and tuck-ins, given the highly fragmented nature of the industry. Rate cases after years of stay-outs will provide some operating margin improvement. We project operating margins to average nearly 29% through 2015. Returns on equity will be unimpressive but should remain in the 8%-9% range.
One of our key assumptions is high-single-digit average growth in the firm's nonregulated wastewater and contract services segments during the five-year period. We agree with management's assessment that nonregulated design, build, and operate projects as well as operating and maintenance partnerships provide an attractive avenue for growth for which American Water is poised to take advantage. Our fair value estimate is sensitive to our 7.3% assumed weighted average cost of capital, based on a 10% cost of equity. If we decreased our estimated cost of equity by 50 basis points, our fair value estimate would rise to $31 per share. If we increased it by 50 basis points, our fair value estimate would fall to $24 per share.

Risk
American Water Works derives most of its profits from regulated operations. Consequently, the greatest risk it faces is regulation that does not permit the company to earn its allowed return and does not protect it from regulatory lag, which is the time between the incurring and the recovery of costs. A prolonged freeze in the credit markets could force the company to scale back growth expenditures. As acquisitions are a major source of growth for this company, competition with rival regulated utilities is a threat to American Water Works' growth prospects. Municipalities may also resist its overtures, as they did in Trenton in 2010. Its nonregulated businesses are also subject to competition.

Management & Stewardship
American Water Works' senior management has a wealth of experience in dealing with regulation and in the water services industry in particular. Former president and CEO Donald Correll had more than 30 years of experience at water utilities, including 25 years with United Water Resources, and managed to keep the company's house in line despite a difficult period with the RWE debacle. New president and CEO Jeffry Sterba also has a wealth of experience with regulation, having served more than 30 years with PNM Resources PNM, in both power and water. Judging by the regulatory successes in 2010, Sterba has done a fine job at the tiller so far. We like that the average tenure of board members is less than 10 years. The absence of long-term incentives creates a potential conflict of interest between shareholders and management. Current annual incentives are based on short-term financial and operational goals. Furthermore, the firm's newly developed compensation plan should draw skepticism. The plan appears to protect current executive pay by allowing immediate vesting--upon committee approval--in the event that control changes hands. While the use of return metrics is praiseworthy, immediate vesting of options for the executives could dilute future shareholder value.

Overview

Financial Health: American Water carries a significant amount of debt, with a 58% debt/capital ratio at the end of the third quarter of 2011. Coverage ratios should continue to improve with rate increases, and we expect EBIT/interest coverage will average just below 3 times through 2015. Asset sales should help the firm deleverage in the near term, with a large divestiture slated to go through in early 2012.

Profile: 
Founded in 1886, American Water Works is the largest investor-owned U.S. water and wastewater utility. It provides water and wastewater services to residential, commercial, and industrial customers, and operates predominantly in regulated markets, which account for nearly 90% of its total revenue. Its nonregulated businesses include wastewater management operations and public/private partnerships.