Tue, Aug 27, 2013|Brian Hunt

A bubble developing in the stock market

What I THINK about Facebook and what I KNOW about Hershey...

The universe of the highest-quality capital-efficient businesses is always changing. So how do you know when a business joins that elite group?

In today's Digest Premium, Porter answers the question by comparing capital-efficient poster child Hershey with Internet darling Facebook...

To continue reading, scroll down or click here.

What I THINK about Facebook and what I KNOW about Hershey...

The universe of the highest-quality capital-efficient businesses is always changing. So how do you know when a business joins that elite group?

In today's Digest Premium, Porter answers the question by comparing capital-efficient poster child Hershey with Internet darling Facebook...

To subscribe to Digest Premium and access today's analysis, click here.

A bubble developing in the stock market... Tesla tramples the shorts... An important, timeless trading idea... As expected, silver stages a huge rally... Ackman gives up the ghost...

Despite the benchmark S&P 500's recent decline, you've had to squint in order to see interesting market action over the past few weeks.

Traders are on summer vacation. Stock market volume is low. The S&P is near the level it sat at one month ago. At 2.72%, the yield on the 10-year Treasury is where it was one month ago. Gold has gained a few bucks over the past week.

But if you look under the hood, you see some amazing things... and the end of a predictable investment tragedy.

First among them is the developing bubble in Tesla Motors (TSLA).

Tesla is America's premier electric-car manufacturer. It was founded by the genius Elon Musk, who also founded online-payment firm PayPal (which was sold to eBay for more than $1 billion).

Driven by rising sales and hype over its new models, Tesla's stock has gone "parabolic" in 2013. Shares are up more than 400% this year. As you can see in the one-year chart below, shares have quadrupled since March. One analyst has called the company "the Apple of automotive."

Although Tesla delivered about 1% of Ford's sales in July, its market cap is $20 billion, compared with Ford's $64 billion market cap and GM's $48 billion market cap.

Tesla isn't turning a profit yet, so conventional price-to-earnings metrics aren't applicable here. However, Tesla is trading at an utterly absurd, dot-com-era valuation of 14 times trailing 12-month sales. Bloomberg reports the stock is trading for 260 times expected 2013 earnings.

Traders who attempt to profit from falling stocks – called short-sellers – have bet big on Tesla returning to a "less absurd" valuation. So far, they've been trampled. When you short a stock at $100 and it runs to $150, you suffer a 50% loss.

We have no doubt the Tesla bubble will suffer a gigantic correction. When it's finally pierced, Tesla will probably fall at least 50%. The problem for short-sellers is the timing.

Our resident trading expert, Jeff Clark, just analyzed the situation in Tesla... and details why a different stock is a better short-sale candidate right now. You can read Jeff's commentary in our free trading e-letter, Growth Stock Wire, right here.

Another impressive performance over the past few weeks comes from silver. Gold's more speculative, more volatile cousin has surged 28% in the past three weeks.

If you read and acted on our August 12 issue of the Growth Stock Wire, you weren't surprised by this move... and you've probably made huge short-term profits. You also probably realize why we urge every reader to become a "connoisseur of extremes"...

Like every investment and trading idea we're passionate about, we've published a short, useful, educational interview on being a "connoisseur of extremes." You can read it for free right here.

By saying you should become a "connoisseur of extremes," I'm saying you should always be on the hunt for situations where market conditions are in a drastically different state than normal.

By spotting these extreme states – and then betting on conditions heading in a normal direction – you can consistently make low-risk profits in any market. You can make a fortune trading extremes in stocks, commodities, currencies... anything.

Extremes can be fundamental in nature. For example, if a stock market's historical price-to-earnings multiple is 15, and a crash sends that market's price-to earnings multiple to just eight, you'd say that's an "extreme" situation... and you'd buy.

Extremes can also be related to price action. Jeff Clark regularly trades these extremes for short-term profits. And extremes can develop in sentiment readings, like surveys that monitor investor pessimism and optimism. You want to be bullish when the investment crowd is extremely bearish, and you want to be cautious when the investment crowd is extremely bullish.

In the August 12 Digest, we highlighted how speculative trading funds held an extreme position in silver... one that would resolve itself in a big short-term rally. As you can see from the chart below, that's exactly what happened. (Subscribers to DailyWealth Trader have made huge gains in our recommended silver trade.)

Finally, we note that fund manager Bill Ackman has liquidated an "extremely" bad investment. The media-darling manager has finally given up the ghost on his failed J.C. Penney venture...

We've detailed Ackman's position in J.C. Penney many times in the Digest (most recently here). Regular readers know we've always been very skeptical of Ackman's attempt to revive the struggling retailer...

In 2010, with J.C. Penney's business steadily declining, Ackman began building a huge position in the retailer. After gaining control of the company, Ackman fired the CEO and replaced him with Ron Johnson – a retail manager who achieved success with Apple.

As Porter and his research team reviewed the story in the August issue of Stansberry's Investment Advisory...

Ackman went on to praise the retail All-Stars assembled by Johnson, including Michael Francis from Target, who Ackman said was "considered the best marketer in the business." Despite mountains of financial evidence suggesting that J.C. Penney could not compete in modern retail, Ackman was convinced the problems could be "managed" away.

Somewhere, Warren Buffett must have rolled his eyes. Buffett has famously quipped that when a manager with a great reputation takes on a business with terrible economics, the business always emerges with its reputation intact.

... Regardless of Ackman's involvement (or lack thereof) J.C. Penney is doomed. The dying retailer has passed the point of no return... no matter who sits in the corner office or boardroom.

Despite Ackman's best attempts, J.C. Penney lost more than $500 million in the fourth quarter of 2012 alone. It's still burning through mountains of cash every quarter. Shares have fallen from the $30 range to $13.75...

Yesterday, news that Ackman must finally agree with Porter's assessment hit the wires: Ackman just sold his entire J.C. Penney stake. Bloomberg estimates Ackman's loss is over $500 million.

New 52-week highs (as of 8/26/13): Chesapeake Energy (CHK) and Laredo Petroleum (LPI).

In today's mailbag, we take a break from piling on Robert Gifford. Send your notes to feedback@stansberryresearch.com.

"'Better to remain silent and be thought a fool than to speak out and remove all doubt.' (Abraham Lincoln)'...

"For decades, whenever I heard or read this, it was attributed to Winston Churchill (except Winston just said speak not speak out). Then a few years ago someone attributed it to Mark Twain. Now I can add Abraham Lincoln. I'm wondering who will be next on the list. Perhaps Al Gore? After all he did invent the Internet." – Paid-up subscriber H. E. Erbes

"Even though I never really believed that a real economic recovery was taking place I held out hope that it was true. This past weekend I learned the truth at Bristol. You see the August Bristol, TN NASCAR race week is the most popular and well attended in all of NASCAR and during good years all the campgrounds and yards of close by homes are filled with campers and people needing parking spaces.

"This last week was even worse than last year which was worse than the previous 10 years. No camping area filled up and those campers that did show up came for a shorter amount of time and spent less than ever before. The parking areas did not even fill up. So no recovery yet. Maybe next year." – Paid-up subscriber M. Morin

Regards,

Brian Hunt
Delray Beach, Florida
August 27, 2013

What I THINK about Facebook and what I KNOW about Hershey...

In yesterday's Digest Premium, we said there are probably only about 100 great, capital-efficient businesses in the world. Again, these are the best businesses in the world with the best brands. Coca-Cola (KO) and Hershey (HSY) are quintessential examples.

However, the specific companies that make up that universe of 100 are always changing... Sometimes outstanding businesses stop making relevant products. And new businesses are constantly being created... Inevitably, over time, a few thrive and outmuscle declining giants.

The question is, how do you know when one's joined the elite ranks?

Let's take a look at one of the most talked-about new companies in the market today – social-networking giant Facebook.

Facebook owns a tremendously powerful franchise. And it will likely be in business for a long time. But there's a big caveat here...

While I THINK that's true of Facebook, I KNOW it's true about Hershey. People are going to enjoy chocolate for the foreseeable future. And we know that as a branded purveyor of chocolate, Hershey has been one of the most successful in history. You can be confident that 20, 30, or even 40 years from now, Hershey will still be selling a ton of chocolate. It's very, very likely.

On the flip side, who can really say with confidence what Facebook will be in 10 or 20 years... or how the Internet and social networking will change over that period? You can only know it's going to change a lot.

I'm willing to say that Facebook will indeed remain dominant. But there's a lot that could go wrong with that prediction...

Facebook has something in common with eBay... Out of all the different online businesses, eBay had a huge franchise that was most likely to continue in the long term.

That's because of the "network effect." It's hard to compete with eBay simply because it's already the largest. The sellers and the buyers all go to eBay because that's where they find the most sellers and buyers. Its reputation becomes self-fulfilling. It's very difficult to unseat that because both sellers and buyers want lots of transactions.

The same thing will likely end up being true about Facebook. Over the long term, it'll be harder to compete with Facebook because everyone is already using it... That becomes a powerful competitive advantage because of the nature of social networks.

If you look at Facebook's performance, there's a lot that can be improved. But the funny thing is, it's not nearly as profitable as it ought to be. And that should give investors pause. It's not clear yet that Facebook can ever really make a profit.

The company is spending huge amounts of capital to build out its service. In the last year, Facebook invested more than $5 billion in its own business. It only made $1.6 billion in cash from operations. So it had to raise a ton of money to fund the growth of the business... It sold $6.7 billion worth of stock in an initial public offering.

The owners of Facebook so far have displayed no willingness or interest in treating their shareholders very well. Instead of being a company that's producing capital and distributing it to investors, Facebook has taken the opposite approach... It's gathering capital from investors and then essentially distributing it to its users by building a huge network and offering it to people for free.

Ideally, this will switch over the long term. Once Facebook has built its network, it should be able to generate lots of profits for a very long time. But that's yet to be proven. And since it's difficult to say what will happen with this particular social network... it doesn't fit the model we have for capital-efficient companies for three reasons.

One, it's not currently highly profitable. Two, the owners of the company have not taken shareholder-friendly stances in regards to lots of issues. Most particularly, the company is issuing lots of stock options as compensation. That's almost never good for existing shareholders.

And three, Facebook is in an industry where the future is very difficult to get right. It's difficult to judge what the whims and fancies of online social network users will be going forward.

– Porter Stansberry with Sean Goldsmith