A bold call pays off...

A bold call pays off... Two lessons I learned from a loser... Three questions from Porter... The stocks I'd buy and hold today...
 

Editor's note: The Digest team is attending the Value Investing Congress in New York City this week, where we'll hear from some of the best investors in the business – like hedge-fund manager Leon Cooperman and short-seller Carson Block.

 

In lieu of our regular Digest, today we're featuring a special piece from Extreme Value editor Dan Ferris, who wrote this original material in response to a recent e-mail from Porter. We hope you enjoy.

 

 

 In the December 2006 issue of Extreme Value, I (Dan Ferris) did something I don't usually do: I made a bold call.

 

I told readers they could put their entire portfolio into just four stocks. I didn't specify a time frame for the investment, but it was implied that I meant you could leave your money in these four stocks indefinitely.

 

I had forgotten about this until last week, when Porter sent me an e-mail wondering what happened to those four stocks. He also asked three interesting questions, which we'll answer below – after we look at those four stocks and how you would have performed if you had taken my advice.

 

 The four stocks I said my subscribers could put all their money into at that time were...

 

•	Wal-Mart (WMT)
•	Home Depot (HD)
•	St. Joe Company (JOE)
•	Microsoft (MSFT)

 

So, how did investors who took my advice fare with those four stocks?

 

If you had put an equal amount into each stock and left it there until today, you would have turned every $10,000 invested into roughly $16,450 (as of Friday's close)...

 

	Price on 12/6/06	Dividends	Price on 9/5/14	Return
Microsoft	$28.99	$5.26	$45.91	76.5%
Home Depot	$39.92	$8.81	$91.61	151.6%
St. Joe Company	$56.95	$0.64	$22.43	-59.5%
Wal-Mart	$46.54	$10.68	$77.51	89.5%
Four stocks' average return:				64.5%

So my bold call turned out pretty well – though I have long since exited the business of making bold calls. I made one huge mistake, recommending Florida land developer St. Joe, which lost 60% of its value during the period. The obvious question is, "What mistakes did you make and what did you learn from it?"

 

 I made two basic mistakes with St. Joe. First, I placed too high a value on its land. The first time I recommended the stock back in January 2003, I said its land was worth at least $10,000 per acre, a little more than four times the carrying value of $2,400 per acre. I landed on $10,000 per acre because that was the average price of so-called "transitional land" in Florida at that time, according to a report by an agricultural economist at the University of Florida.

 

Valuing a little bit of St. Joe's land at that price would have made sense. Valuing it all at that level ended up being way too optimistic. At that moment, most of St. Joe's property was timberland and worth just $1,000 per acre or so. Lesson one: don't be optimistic about future asset prices.

 

The second mistake I made was that I didn't understand how much money St. Joe was spending to develop its land... right at (or near) the peak of the biggest real estate bubble in history. It spent hundreds of millions of dollars in 2006 and 2007, right as the bubble was peaking. I should have recognized there was no way it would get that investment back. Lesson two: respect market cycles and learn to be skeptical of big capital projects of any kind.

 

 As I mentioned earlier in today's Digest, Porter asked me three questions in his e-mail. The first was, "What have you learned since then?" Anybody who has read Extreme Value since then knows the answer. Mostly, I've learned to avoid businesses that require huge amounts of capital investment before they can even earn a penny of revenue (like St. Joe with its land-development plans). I've learned to love businesses that require little capital to maintain and grow their businesses. That description covers 24 of the 29 stocks currently in the Extreme Value model portfolio. The other five are energy and commodity businesses.

 

One good example of this is over-the-counter health-product seller Prestige Brands Holdings (PBH). Extreme Value subscribers are up 465% on the recommendation. It's the top-performing open position across all S&A portfolios today.

 

The company owns familiar household brands like Clear Eyes, Dramamine, and Comet. It was gushing free cash flow when I found it in May 2009, and it's gushing even more today. It will continue to add new brands and generate more profits. It recently closed on another acquisition, which will immediately add to its bottom line. Prestige is a fantastic business, because it doesn't do manufacturing or distribution. It owns the brands and markets them, which requires almost no capital investment.

 

 Next, Porter wanted to know, "What would you do differently?"

 

I'm doing things differently today... Back when I originally recommended St. Joe in January 2003, my analysis focused on finding companies that owned large amounts of cash, land, or other assets that were trading at big discounts in the stock market. My focus today is on finding great businesses run by great management teams.

 

I doubt I'll ever recommend a stock like St. Joe in Extreme Value again. I only want great businesses that produce real cash profits. Cash flow gives equity its value. Asset values don't. Assets cost money to own, develop, and maintain. Only a substantial amount of excess cash flow – far more than operation costs – can justify the ownership of assets.

 

 Finally, Porter's most intriguing question: "What stocks would you pick today?"

 

The question is hard for me to answer in the Digest, since I would have to mention stocks I recently recommended in Extreme Value. That's not fair to my subscribers, who paid for that answer and may not have purchased those recently recommended stocks yet. Overall, there aren't many stocks cheap enough to buy today. But I can give you a couple ideas of the type of stocks I like.

 

 I would put Automatic Data Processing (ADP) on the list if it weren't trading at 25 times free cash flow. ADP is the biggest payroll processor in the U.S. It processes more than one-sixth of the country's payroll checks. It pays you and collects your taxes and deductions and makes sure they go to the right place.

 

ADP is like a bank. Most folks open an account and rarely change banks for many years. Customers are "sticky." ADP is basically a service business, requiring very little capital investment. It generated more than $1.8 billion in operating cash flow last year, and capital spending was less than $217 million.

 

In addition to a great cash-gushing business, ADP has something extra... It earns interest on the money it withholds from paychecks. Last year, it made $374 million in interest on client funds. Imagine if interest rates rose 50%. That could add another $185 million to ADP's bottom line... without the company having to lift a finger or invest one extra penny.

 

 Another company I would put on the list if it weren't too expensive today is alcoholic-beverage firm Constellation Brands (STZ). The company is up nearly 310% since we recommended it in June 2011. But it's trading well above our maximum buy price today.

 

There's also a small insurance company I like, and an oil and gas royalty firm, both of which I recently recommended in Extreme Value. Both are far better deals today than Automatic Data Processing or Constellation Brands.

 

Both companies are great businesses with stellar management teams. Their corporate cultures are focused on shareholder value like none I've ever seen before. One is sporting a double-digit dividend yield (13% as of last month when I added it to the portfolio). These two companies also produce lots of cash profits without much capital investment.

 

 Every serious investor should understand how to identify these types of businesses... If you simply buy and hold what I call "World Dominators," the best businesses in the world that gush cash flow, you will outperform the market over the long term. In fact, the average gain for the open World Dominators in my Extreme Value portfolio is 103% as of Friday's market close.

 

There are five financial clues I look out for when locating and evaluating World Dominators... And I recently put together an educational video explaining each one of these clues in detail.

 

Plus, if you decide to try my newsletter after watching this video, I'm offering one free year of Extreme Value... There's also another bonus offer as a special thank you: a book I wrote about these businesses, which is yours to keep free of charge. To watch my new educational video, click here.

 

 

 New 52-week highs (as of 9/5/14): Alcoa (AA), Automatic Data Processing (ADP), Activision Blizzard (ATVI), SPDR S&P BRIC 40 Fund (BIK), Brookfield Property (BPY), Berkshire Hathaway (BRK), CVS Health (CVS), ProShares Ultra MSCI Emerging Markets Fund (EET), Integrated Device Technology (IDTI), KLA-Tencor (KLAC), Leggett & Platt (LEG), Eli Lilly (LLY), Microsoft (MSFT), Nuveen Municipal Opportunity Fund (NIO), ONEOK (OKE), Plains All-American Pipeline (PAA), PowerShares Buyback Achievers Fund (PKW), ProShares Ultra S&P 500 Fund (SSO), Steel Dynamics (STLD), Guggenheim China Real Estate Fund (TAO), Union Pacific (UNP), and ProShares Ultra FTSE China 25 Fund (XPP).

 

 In today's mailbag, one subscriber is offended by another subscriber's comments... and we respond to one of the questions we get asked most frequently about our marketing efforts. What's on your mind? Drop us a line at feedback@stansberryresearch.com.

 

 "I had a good chuckle at Jason R's comments yesterday in the Digest regarding the DG/FDO buyout... not that his business analysis of the situation wasn't accurate... more that he mentioned with a salary of 200k his household is 'really tight' and has to 'scratch' for every advantage in order to make it through these 'hard times' the poor in this country are facing. Dude, WAKE THE EFF UP. On a salary of 200k, if you have trouble making ends meet or putting money into investments or savings, you need a serious reality check. A lifestyle change. Start with ditching the Ivy League preschool and private schools. The fact that his wife looks down on shopping in these places only accentuates what is truly wrong with America. Consumerism, waste, pride, and ignorance are what keeps the poor from getting rich, and what keeps the rich like Jason from truly enjoying a young retirement and enjoying the best things in life, which cannot be bought." – Paid-up subscriber Jeremiah W.

 

 "I have been a subscriber to more than one S&A publications for a number of years now and have experienced some very good clarification and beneficial information about the economics of investing in stock markets. However, I have to inform you that I'm experiencing 'information overload"' in that many of your e-mails I receive are preludes to so many bloviated videos or presentations that take so long to read or navigate that end in a 'you have to subscribe' HERE!, and buy more publications to get the information that you entice and that I want. Have you EVER considered 'concise'? I'm bored with your too long repetitive e-mails soaking up my computer's memory and my time." – Paid-up subscriber Doug Atkins

 

Goldsmith comment: Doug, we get this exact question often. The short answer is that we're able to provide you with world-class investment research because of our marketing efforts. Porter summed it up well in the June 25 Digest. Here's what he said...

 

I always chuckle a bit when folks who like our newsletters complain about our ads, their length, the breathless tone, etc. I remember when I was a child I complained to my father about advertisements on television. "Porter, if it wasn't for the advertisers, there wouldn't be any television."   If it weren't for our advertising – our relentless and endless ads – these newsletters wouldn't be published. And if we didn't use the kind of advertising that works, we'd be out of business in a year.   Instead of sitting here writing a reply to you this morning, I'd be one of the hundreds of great money managers you've never heard of. Those guys certainly don't advertise. You wouldn't have been able to profit from any of the strategies, ideas, or recommendations we've published over the last 15 years.   Fannie Mae and Freddie Mac going broke? That would have made my clients hundreds of millions. GM going bankrupt? Same. The prediction that a flood of oil and gas would see the U.S. become a major energy exporter and make shale drillers billions? I could have kept all of that stuff to myself and done just fine.   So if you really don't care for our business model, no problem. I'm always happy to part as friends. I'm pretty sure I can find something productive to do with my time.   Oh... one more thing... how do you think we got your business in the first place?

 

Regards,

 

Dan Ferris

September 8, 2014

 

Jeff Clark: There are very few markets in the world that look this good right now...

 

One area of the market has caught S&A Short Report editor Jeff Clark's eye.

 

In today's Digest Premium, he reveals which sector has "a tremendous amount of upside"... offers a 4% yield... and can lead to huge gains over the next several months...

 

To subscribe to Digest Premium and receive a free hardback copy of Jim Rogers' latest book, click here.

Jeff Clark: There are very few markets in the world that look this good right now...
 

Editor's note: One area of the market has caught S&A Short Report editor Jeff Clark's eye. In today's Digest Premium, he reveals which sector has "a tremendous amount of upside"... offers a 4% yield... and can lead to huge gains over the next several months...

 

 

 What usually draws my attention to a sector is its technical setup. What's interesting with Chinese stocks is that if you mention them to the average investor, they roll their eyes. They know it has been a horrible place to invest and they don't want to hear anything about it. All they think is fraud and bear market and all the negative stuff.

 

That is typically what happens at the bottom of a bear market, and China has been in a bear market for about seven years. Chinese stocks peaked in 2007 and they have been consistently moving lower ever since – a whole bunch of lower highs and lower lows. But in February and March, Shanghai's stock exchange wasn't making lower lows anymore.

 

I drew subscribers' attention to that, explaining that when it finally does manage to break out, there's some pent-up demand – things could really take off. So we nibbled on a small position in late April on the iShares FTSE China 25 Index Fund (FXI). We timed that well and the trade worked out. In mid-June, we closed the trade for a 124% gain.

 

 We also recently added a couple more positions. Those have worked out because the Shanghai stock exchange broke out. When it did, it was explosive. I think it moved 7% in one week, and we were ahead of that trend. What I like is that few folks are talking about it right now. They either look at China and say it's a one-time blip and it will fall right back down or they ignore it all together. That's typically what happens at the start of a brand-new bull market. When you change from bearish to bullish, sentiment doesn't turn right away. That's where we are right now.

 

 In terms of technical analysis, there are few markets in the world that look as good as China looks right now. There's just a tremendous amount of upside. We haven't seen any good action in China in seven years, so there's a lot of upside potential and relatively little downside risk.

 

A lot of Chinese stocks are trading with single-digit price-to-earnings ratios. Some of them offer healthy dividends north of 4%, and you can find plenty of situations where stocks are trading for the value of the liquid net assets on their balance sheets. A lot of these stocks are trading for cash – or a slight premium to cash. So you're buying the stocks, getting all the cash, and then getting the rest of the business for free.

 

There's a lot of value out there. If you can time it correctly, you can make a ton of money in China over the next several months. We'll figure out whether it will extend several years down the road, but right now as a trader, there are few markets in the world that look as good as China does right now.

 

– Jeff Clark

Jeff Clark: There are very few markets in the world that look this good right now...

 

One area of the market has caught S&A Short Report editor Jeff Clark's eye.

 

In today's Digest Premium, he reveals which sector has "a tremendous amount of upside"... offers a 4% yield... and can lead to huge gains over the next several months...

 

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