Thu, Nov 21, 2013|Porter Stansberry

A private letter from Warren Buffett (no joke)...

What happens when the facts overwhelm the Fed's 'smoke and mirrors'…

In yesterday's Digest Premium, Porter showed how unsustainable our government's debt-fueled policies are.

Today, he looks at what could be a tipping point driving the world away from the dollar…

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

A private letter from Warren Buffett (no joke)... How business owners ought to invest... Why what Wall Street calls 'safe' is actually dangerous... How I manage my own stock investments...

Editor's note: In today's Digest, we return to the investing wisdom of Warren Buffett…

Continuing our look at some of our best writings on investing fundamentals, today we're featuring a piece – originally published in the August 30 Digest – in which Porter reveals what the investing legend wrote in private correspondence about valuing a business…

In today's Digest, we will break confidences in a way... I (Porter) will tell you about a private discussion I had with a very wealthy man, who… perhaps like you… has long struggled with his personal portfolio. He now faces even tougher decisions about how to allocate capital for his business.

Out of all of the things we've talked about over the years in the Digest, I think you'll find this discussion might hold the greatest value... if, that is, you're willing to think carefully about this private discussion. The message at the heart of today's Digest addresses the very foundation of successful investing...

Now... a warning. And not our usual one, either. As you know, we firmly disclaim the ability to teach anyone, anything. Or as we write so frequently, there is no such thing as teaching, there is only learning.

And with today's message... I have found that to be doubly true. In my experience the ability to comprehend and internalize the ideas below will be limited to people who have owned or operated their own business. Very few others have grasped their significance. I hope you will be among the few who do. Nevertheless... I believe that understanding from the beginning that the strategy we're discussing below is most suitable for business owners may, in fact, be the key to understanding it for everyone.

The story starts this way...

Several years ago, a close friend, who is the CEO of a major global business, asked me to help him with his personal portfolio. Normally, I'd never even agree to a meeting where I thought the subject would come up. Most people assume, wrongly, that I know something more about securities or investment opportunities that I don't include in my newsletter. But I don't. I write up all of the best ideas I discover.

And that is exactly what I told my friend. Besides, I knew he really didn't need my newsletter. "There's no secret to investment success," I told him. "As the leader of a big, global business, you've done dozens of very successful acquisitions. You know exactly what creates business success. And you know the appropriate price to pay for private companies. Just apply the exact same care to your personal investment decisions."

I saw my friend yesterday for the first time in a great while. We were talking about investments again. But this time, we were talking about how he manages his company's tremendous cash flows. He explained that he'd hired a "professional" money-management group.

I asked the logical question: "How's that working for you?" But I knew the answer before I asked – terribly. He tried to justify the poor results by explaining, "It's not really their fault. I told them to manage the assets for maximum preservation of capital. I think they could have done better if I was willing to take more risk..."

My friend is making two significant errors. First, he believes that investment professionals – who do not have day-to-day responsibility for operating a business – will prove to have better business judgment than the long-term CEO, who has successfully managed dozens of acquisitions and grown his business from $75 million in market cap to more than $1 billion.

My friend has world-class business judgment. He developed it by making decisions every day about marketing, product development, personnel, policies, branding, real estate, partnerships, lawsuits, and insurance... decisions with millions of dollars at stake. To believe that a money manager, whose chief source of business insight is probably Barron's magazine, is going to prove more successful as an investor is like believing the local putt-putt champion will beat Tiger Woods in a driving contest.

Yes, I know... a select few money managers have outstanding, world-class business judgment – like Carl Icahn, for example. But you can count these money managers on two hands. And investing with them is extremely expensive.

Whether my friend likes it or not... he's likely to be far better off managing his company's excess capital personally than he is entrusting it to a "professional." The same is likely true for you, if you have any significant business experience. That experience is your greatest advantage in the markets. And yet... few business people invest in the stock market as they would in their own industry. It's easier to simply wire the money somewhere else... and make it someone else's problem.

The other mistake my friend is making is even more surprising to me... because I know he knows better. You'll recall when I questioned him about the investment performance of the "professional" firm, he was quick to excuse their marginal results by explaining that he'd instructed them not to take any risk. While I'm not privy to the details of his asset allocation, that normally means the capital is largely tied up in fixed income – assets that professionals deem "safe" because they typically are not very volatile.

We will return to this question of defining risk as moving prices as opposed to actual loss of capital. But for the moment, it's enough for you to know that the majority of professionals pretend that most forms of fixed income – like corporate bonds held to maturity, market accounts, and U.S. Treasury obligations – carry very little risk, primarily because their quoted prices tend to be stable compared to stock prices. They have what's called "low beta" compared with stocks.

An investor with tremendous business experience, Warren Buffett, addressed the real risk inherent in these kinds of financial instruments – risks that professional money managers tend to be oblivious to – in his 2011 annual shareholder letter.

Investments that are denominated in a given currency include money-market funds, bonds, mortgages, bank deposits, and other instruments. Most of these currency-based investments are thought of as 'safe.' In truth they are among the most dangerous of assets. Their beta [the volatility of their quoted price] may be zero, but their risk is huge. Over the past century these instruments have destroyed the purchasing power of investors in many countries...

Governments determine the ultimate value of money, and systemic forces will sometimes cause them to gravitate to policies that produce inflation. From time to time, such policies spin out of control. Even in the U.S., where the wish for a stable currency is strong, the dollar has fallen a staggering 86% in value since 1965, when I took over management of Berkshire. It takes no less than $7 today to buy what $1 did at that time.

Consequently, a tax-free institution would have needed 4.3% interest annually from bond investments over that period to simply maintain its purchasing power. Its managers would have been kidding themselves if they thought of any portion of that interest as "income."

For tax-paying investors, like you and me, the picture has been far worse. During the same 47-year period, continuous rolling of U.S. Treasury bills produced 5.7% annually. That sounds satisfactory. But if an individual investor paid personal income taxes at a rate averaging 25%, this 5.7% return would have yielded nothing in the way of real income...

'In God We Trust' may be imprinted on our currency, but the hand that activates our government's printing press has been all too human... Today, a wry comment that Wall Streeter Shelby Cullom Davis made long ago seems apt: 'Bonds promoted as offering risk-free returns are now priced to deliver return-free risk.'

In short... if you're an experienced business person, you're not likely to solve your investment challenge by going to "professional" investors because your business judgment will almost surely be more sophisticated than theirs... Nor can you "hide" your company's earnings in fixed income, where recently the average yield on higher-risk corporate debt was less than 5%. At these low rates, it is simply impossible to even pretend that after inflation, taxes, and the risk of default, investors have any chance at a real return on their capital.

What then, should the experienced business person do? Once again... we turn to Warren Buffett. In the mid-1970s, he became the business "coach" and confidant of the Washington Post's Katharine Graham. Graham became chairman and CEO of the newspaper company unexpectedly when her husband committed suicide. She leaned heavily on Buffett's business judgment – especially when it came to the question of how to manage the business fund. Buffett addressed that critical question in a private letter to Graham.

Fortunately... I was sent a copy of that letter last week. Here's what Buffett told one of his closest friends about how to manage her company's pension account…

The directors and officers of the company consider themselves to be quite capable of making business decisions, including decisions regarding the long-term attractiveness of specific business operations purchased at specific prices. We have made decisions to purchase several television businesses, a newspaper business, etc. And in other relationships, we have made such judgments covering a much wider spectrum of business operations.

Negotiated prices for such purchases of entire businesses often are dramatically higher than stock market valuations attributable to well-managed similar operations. Longer term, rewards to owners in both cases will flow from such investments proportional to the economic results of the business. By buying small pieces of businesses through the stock market rather than entire businesses through negotiation, several disadvantages occur: a) the right to manage, or select managers, is forfeited; b) the right to determine dividend policy or direct the areas of internal reinvestment is absent; c) ability to borrow long-term against the business assets (versus against the stock position) is greatly reduced; and d) the opportunity to sell the businesses on a full-value, private-owner basis is forfeited.

[These disadvantages are offset by] the periodic tendency of stock markets to experience excesses, which cause businesses – when changing hands in small pieces through stock transactions – to sell at prices significantly above privately determined negotiated values. At such times, holdings may be liquidated at better prices than if the whole business were owned – and, due to the impersonal nature of securities markets, no moral stigma need be attached to dealing with such unwitting buyers.

Stock market prices may bounce wildly and irrationally, but if decisions regarding internal rates of return of the business are reasonably correct – and a small portion of the business is bought at a fraction of its private-owner value – a good return for the fund should be assured over the time span against which pension fund results should be measured.

[Success] in large part, is a matter of attitude, whereby the results of the business become the standard against which measurements are made rather than quarterly stock prices. It embodies a long time span for judgment confirmation, just as does an investment by a corporation in a major new division, plant, or product. It treats stock ownership as business ownership with corresponding adjustment in mental set. And it demands an excess of value of price paid, not merely a favorable short-term earnings or stock market outlook. General stock market considerations simply don't enter into the purchase decisions.

Finally, [success] rests on a belief, which both seems logical and which has been borne out historically in securities markets, that intrinsic value is the eventual prime determinant of stock prices. In the words of my former boss: 'In the short run the market is a voting machine, but in the long run it is a weighing machine.'"

This approach... to buy individual stocks in the same way you'd buy whole business operations and to ignore whatever sentiment is prevalent in the stock market... turns out to be both the most profitable way to invest (because of the focus on long-term results and appropriate purchase price) and the safest.

Use your hard-won business judgment. Don't buy a single share of stock in any company you wouldn't want to own forever. Don't judge the investment's success or failure by its share price, but instead by its business results. Don't allow popular sentiment to sway you from your course. Instead, use the wild, irrational swings in average share prices to give you both opportunities to buy at great discounts and opportunities to sell at unwarranted premiums. As Buffett himself says, thanks to the impersonal nature of the market you can take advantage of "unwitting buyers" without any stigma.

This approach, by the way, is the strategy that I have adopted for my own personal savings. My goal is to acquire a portion of one great business each year (via common stock) at an unreasonably cheap price, so that my wealth will compound at an unreasonably high rate (15%). Given a very depressed stock market, I will try to acquire more than just one such company... but in any given year, you can always find sectors of the stock market where companies are trading well below the private-market value of the whole businesses.

This year, I have focused my personal efforts on the for-profit education sector, which has been (in my view) far oversold due to unreasonable fears about the long-term outlook. Throughout human history, paying for an education has been a great investment. Education is the key to advancement for most people. And while I disclaim the ability for anyone to teach anything, I know very well how important institutions that promote real learning can be to advancement.

Some of those institutions are even schools... and the schools I believe have the most incentive to promote real learning are the for-profit education colleges. Therefore, I believe for-profit education is overwhelmingly likely to continue and that the well-managed companies in this space will find a business model that works, regardless of new restrictions on the government's backing of student loans.

To me, these conclusions seem obvious. To the market, my view is currently heresy. We'll see who is right over the long term. My background as a business owner gives me confidence in my judgment.

Also, because I operate in a similar business (much of what we sell is education), I can evaluate these companies' business results. I'm not left with merely share price to determine whether or not they are making progress. My income, my other assets, and my strategy of investing over time (one great business each year) gives me the fortitude to withstand the volatility in the share price. This is how business owners and managers ought to invest. This is how everyone should try to invest.

I hope my friend reads today's Digest ... and thinks carefully about his reliance on "professional" investors, fixed income, broad diversification, and other "low-beta" (aka low-knowledge) approaches to investing. I know he's capable of far better and safer results. Many of you, I bet, are in the same boat.

New 52-week highs (as of 11/20/2013): Energy Transfer Equity (ETE), Gladstone Capital (GLAD), Johnson & Johnson (JNJ), Navigators (NAVG), Penn Virginia (PVA), Sturm, Ruger (RGR), and ProShares Ultra Health Care Fund (RXL).

In today's mailbag… A subscriber shares his perspective on inflation and dollar devaluation. Send your comments to feedback@stansberryresearch.com.

"I have been [an institutional bond trader] a long time. I've seen what happens when inflation erodes the value of fixed income investments, and know that it is only a matter of time before the bond market implodes. My guess is that it will take a long while to play out (the seeds of the inflation of the late 70s began in the mid-60s and Nixon's departure from the gold standard in 1971).

"It will happen. Maybe faster this time, because we did not have the massive government intervention in both the bond markets and the refinancing process (save people's interest expense, and they will spend more in the economy) we have today. We did not have the massive government expansion of entitlements that we have today. We did not have the covert manipulation of the inflation and unemployment rates that we have today. The only way out of this mess is through significant devaluation of the dollar, which is underway as we speak. And even that might not work, as other governments are doing the same thing, just to keep up.

"Once the government started buying all of these bonds and creating a totally artificial interest rate environment, along the entire yield curve, I put on a similar trade. I bought the TBT and the DGLD (same trade, just 2X leveraged on both sides, so you can do half as much). I've unwound it a few times at a nice profit (and some losses, too!) and jumped out of it for a while as the price of gold started falling. Recently, I've agreed with Steve Sjuggerud and Jeff Clark and put the trade back on. However, the trade is down (recent fall in the price of gold without a similar downside move in bonds), but I am confident it will be a moneymaker in the future. I will add to it as what you've so properly predicted begins to come true." – Anonymous

Regards,

Porter Stansberry and Sean Goldsmith
Singapore
November 21, 2013

Stansberry & Associates Hall of Fame
(Top 10 all-time, highest-returning closed positions across all S&A portfolios)

Investment

Sym

Holding Period

Gain

Publication

Editor

Seabridge Gold	SA	4 years, 73 days	995%	Sjug Conf.	Sjuggerud
ATAC Resources	ATC	313 days	597%	Phase 1	Badiali
JDS Uniphase	JDSU	1 year, 266 days	592%	SIA	Stansberry
Silver Wheaton	SLW	1 year, 185 days	345%	Resource Rpt	Badiali
Jinshan Gold Mines	JIN	290 days	339%	Resource Rpt	Badiali
Medis Tech	MDTL	4 years, 110 days	333%	Diligence	Ferris
ID Biomedical	IDBE	5 years, 38 days	331%	Diligence	Lashmet
Northern Dynasty	NAK	1 year, 343 days	322%	Resource Rpt	Badiali
Texas Instr.	TXN	270 days	301%	SIA	Stansberry
MS63 Saint-Gaudens		5 years, 242 days	273%	True Wealth	Sjuggerud

Stansberry & Associates Top 10 Open Recommendations
(Top 10 highest-returning open positions across all S&A portfolios)

As of 11/20/2013

Stock	Symbol	Buy Date	Return	Publication	Editor
Rite Aid 8.5%	767754BU7	02/06/09	683.6%	True Income	Williams
Prestige Brands	PBH	05/13/09	436.4%	Extreme Value	Ferris
Enterprise	EPD	10/15/08	236.2%	The 12% Letter	Dyson
Constellation Brands	STZ	06/02/11	225.0%	Extreme Value	Ferris
Ultra Health Care	RXL	03/17/11	190.9%	True Wealth	Sjuggerud
Altria	MO	11/19/08	182.1%	The 12% Letter	Dyson
McDonald's	MCD	11/28/06	172.2%	The 12% Letter	Dyson
GenMark Diagnostics	GNMK	08/04/11	159.0%	Phase 1	Curzio
Hershey	HSY	12/06/07	155.0%	SIA	Stansberry
Ultra Health Care	RXL	01/04/12	154.0%	True Wealth Sys	Sjuggerud

Please note: Securities appearing in the Top 10 are not necessarily recommended buys at current prices. The list reflects the best-performing positions currently in the model portfolio of any S&A publication. The buy date reflects when the editor recommended the investment in the listed publication, and the return shows its performance since that date. To learn if a security is still a recommended buy today, you must be a subscriber to that publication and refer to the most recent portfolio.

Top 10 Totals

1	True Income	Williams
2	Extreme Value	Ferris
3	The 12% Letter	Dyson
1	True Wealth	Sjuggerud
1	Phase 1	Curzio
1	SIA	Stansberry
1	True Wealth Sys	Sjuggerud

What happens when the facts overwhelm the Fed's 'smoke and mirrors'…

Editor's note: In today's Digest, we return to the investing wisdom of Warren Buffett…

The story starts this way...

Fortunately... I was sent a copy of that letter last week. Here's what Buffett told one of his closest friends about how to manage her company's pension account…

To me, these conclusions seem obvious. To the market, my view is currently heresy. We'll see who is right over the long term. My background as a business owner gives me confidence in my judgment.

In today's mailbag… A subscriber shares his perspective on inflation and dollar devaluation. Send your comments to feedback@stansberryresearch.com.

Regards,

Porter Stansberry and Sean Goldsmith
Singapore
November 21, 2013

In yesterday's Digest Premium, I (Porter) shared the simple numbers that make it clear… Our government's current debt-fueled policies are unsustainable and creating a huge crisis. The simple fact is, if our government were required to pay a fair market rate of interest on its debt… the interest payments alone would swallow up all of our tax revenue (and then some).

Sooner or later, that fact will overwhelm the smoke and mirrors and the chicanery of quantitative easing. Sooner or later, that fact will overwhelm the passions of the world's banks that keep 60% of their reserves in U.S. dollars. Sooner or later, that fact will overwhelm the popularity of the U.S. dollar as the basis of international trade.

And make no mistake… China has had good reason to negotiate bilateral trade and currency agreements over the last 18 months with every single major trading counterparty in the world. At some point, the Chinese will unveil a complete convertibility of its currency, the yuan. And when that happens, what do you think will happen to the value of the U.S. dollar? What do you think will happen to the actual rate of interest on U.S. Treasury bonds, especially long-dated bonds?

All of those things will change because, as I said yesterday, the markets over time are weighing machines. And I guarantee you the passions of the crowd change over time. So the current pricing for equities in the United States is based on 18 years of earnings.

Facebook is trading at a valuation of around 100 years of earnings. But what is the value of all those future earnings if the value of the dollar crashes? What is the value of all those future earnings, 15 years', 17 years' worth of earnings, if instead of the long bond being 3%, it was 8%?

If you do the math, if you do the dividend discount models, and you compare it with the risk-free rate, you can see for yourself that evaluations of U.S. stocks could easily fall in half.

– Porter Stansberry with Sean Goldsmith

What happens when the facts overwhelm the Fed's 'smoke and mirrors'…

In yesterday's Digest Premium, Porter showed how unsustainable our government's debt-fueled policies are.

Today, he looks at what could be a tipping point driving the world away from the dollar…

To continue reading, scroll down or click here.