How I Doubled Rick Rule's Money With The Rebound Report

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

As of 07/08/2013

* * * Fun riddle: Why are manhole covers round? Answer at the end of today’s bullets…

* * * Technological irony: On the same day Google announces its YouTube acquisition, the judge overseeing the Tower Records bankruptcy orders the company to be liquidated. Anyone want to invest in Blockbuster?

There were lots of comments in the office today about the YouTube deal. One thing most didn’t notice: It’s an all-stock deal. According to Yahoo! Finance, in the last six months, Google’s employees have sold 4.7 million shares of stock, valued at close to $1.8 billion. The agreement to purchase YouTube is a $1.6 billion deal – it’s actually worth less than shareholders have been paying Google’s employees.

What’s this mean? Why doesn’t Google’s board think its shares are worth more than its cash? Why would the board of directors of Google – a company that proudly says it’s changing the world and does "no evil" – like cash more than its own equity? Can you imagine offering equity in your home instead of paying your power bill? Why would you do that? Maybe you’d do it if you thought your house was worth far less than its market price…

In any case, it seems like a good deal for Google. According to my web guys, people spend more time searching on YouTube than they do on Google. Is that possible? Sure… you go to Google for something quick and then you leave. I’ve spent hours searching for surfing videos on YouTube. It’s a much "stickier" website than Google.

* * * Barron’s noticed us! Good news for my colleague Dan Ferris. Barron’s wrote up his recent recommendation of Canadian oil and gas giant EnCana (NYSE: ENC, $45.66). In my humble opinion, Ferris is the best equity analyst on our staff. Why is he buying EnCana? Not because of the company’s oil and gas production – believe it or not. There’s a more compelling, less well-known reason to buy it, something that Wall Street has totally ignored.

* * * Manhole covers? They’re round because the diameter of a circle is uniform. There’s no way to slide it through the hole on its side, as you can do with any kind of straight-edged polygon. Geometry nerds would point out that the same is true for a reuleaux triangle (a sort of puffy equilateral triangle). I’ve argued that manhole covers are round because it’s easier to dig a circular hole and because cylinders are the most efficient shape for underground tubes. But the right answer is that manhole covers are round so they can’t fall into the sewer.

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These are the kind of e-mails you like to get…

About two years ago, at a conference, I explained from a podium why PriceSmart (Nasdaq: PSMT, $16.19) was recently recommended in The Rebound Report. I was surprised to see Rick Rule sitting in the second row. Rick is the founder and principal of Global Resource Investments. He’s the world’s leading resource investment banker. He’s also made more money than anyone else I know with his personal investments. He’s got an entire staff of people who do nothing by vet investments for him… yet there he sat, listening to me talk about PriceSmart.

After I’d finished my presentation, Rick approached me and told me, "I’m going to buy that stock. A lot of it. That’s the best story I’ve heard in a long time."

Yesterday, he e-mailed me to tell me that he’d kept his shares… and more than doubled his money. As he told me, "The only risk in that investment was boredom."

The Rebound Report focuses on investments that no one else wants. Stocks that are in trouble, that have been forgotten. You might call it your "left for dead" portfolio. Not surprisingly, this is one of those newsletters that we can’t seem to interest anyone in reading – the ideas are simply too contrarian for mainstream investors. And that’s exactly why so many of them are so profitable.

You’ve heard of PriceSmart before… but you probably don’t recognize it.

The Price Company pioneered the idea of using warehouse clubs to sell retail items in bulk. From 1976 until its merger with Costco in October 1993, the Price Company’s warehouse stores were the most innovative and profitable enterprises in retail. Robert Price was the CEO of Price Company and his father, Sol Price, was the chairman of the board. After the Costco merger, as so often happens, the founding family left the day-to-day operations of the company and sold their shares.

That’s where the Wall Street history would end. But that’s only the beginning of our tale.

The family didn’t get out of the retail game. Instead, as the family left PriceCostco (which was soon renamed Costco) the Prices bought back two of the company’s warehouse stores in Panama. Costco, at the time, didn’t want to operate stores outside the U.S. The Price family knew that its warehouse idea was extremely popular in Panama and could expand to many other countries in Central America and the Caribbean. Although the Price family wasn’t allowed to compete with Costco in the United States, the noncompete agreement didn’t apply abroad. Today, there are 23 PriceSmart locations in 11 countries.

PriceSmart’s new business plan focused on "sender countries," countries that have a large expatriate population living in the United States. These "senders" repatriate approximately $20 billion each year to their home economies.

I know, from spending time in Managua, that many Nicaraguans live in the U.S. until they can acquire enough wealth to start a business at home. When they return to Nicaragua, they want to buy the American goods they’ve become accustomed to. It’s this population, as well as the aspiring locals, that PriceSmart appeals to. From my experience, it is a growth market. In fact, I would say that PriceSmart has the most attractive retail business in all of Managua.

So… what went wrong? How did it all fall apart? Well, the Prices made two mistakes. First, they hired a CEO (Gil Partida) without any retail experience. He was actually the president of San Diego’s chamber of commerce and a "blue ribbon" executive: He was great at showing up for store openings, but not much else. Second, instead of expanding organically, opening one store at a time using cash flow from the business, the family decided in 1998 to take several hundred million dollars from Wall Street and open a bunch of stores at once. Wall Street loves to pile cash into a company because then it has a "growth stock" story it can sell to retail investors.

As you might expect, it all went to hell. The merchandising was right. But the inventory software couldn’t handle the additional locations. The company didn’t have the logistical capacity to manage different customs regulations. And most importantly, basic accounting control broke down. It was an unmitigated disaster.

In 2003, PriceSmart’s auditor, Ernst & Young, warned that the company’s internal controls had material weaknesses. In particular, revenue had been inflated by $16 million in 2002 and by $12.7 million in 2003 through various schemes at individual stores. At the same time, inventory was being stolen from stores in the Philippines and Guam.

But Partida didn’t warn the company’s board or Wall Street. As late as the end of 2001, he was predicting revenues would hit $1 billion by 2005. Home Depot cofounder Arthur Blank even flew down to Panama to see the company’s stores. A small detail some investors missed: The week after wooing Wall Street in August 2001, Partida sold $700,000 worth of stock.

As soon as the truth came out, the stock crashed. And investors have never trusted it since. It was left for dead.

Meanwhile, in 2003, Robert Price himself took back day-to-day control of PriceSmart. He injected an additional $5 million of equity into the company, paying $10 per share – far above the market price at the time. The Price family had its reputation to save. The Prices had gotten their friends and family into this stock deal and they were going to make it right for everyone, even if that took several years and many millions. Plus, they knew the secret to the business…

Every customer of PriceSmart is also a member of a club. And each club member must pay annual dues each year. Costco’s U.S. stores have more than 40 million customers, who each pay $44 a year, on average, just for the privilege of shopping there. Those fees add up: That’s $1.7 billion. As a result, even though membership fees only make up 2% of Costco’s revenue each year, they contribute 56% of the firm’s net income.

You can see the same effects working in PriceSmart’s emerging-markets warehouse stores. The company brings in about $8.4 million in membership fees each year, which is about 1.5% of total revenue. But these fees made up 62% of the company’s operating profit in 2002. In other words, the model works in a remarkably similar way.

All the Price family had to do was stabilize the business. In time, the membership dues would create all the profits the business needed.

Soon, Price hired a new management team, including CEO Jose Luis Laparte, who was formerly the vice president of Wal-Mart Mexico. That was our signal to buy the stock. It was no surprise to us that just after Laparte came on board, the company began reporting much improved operating results. For example, through September of this year, same-store sales are up 15% over last year. During his first year, cash from operations increased to $13.9 million from only $2.5 million in 2003. The turnaround wasn’t painless – the company had to sell its operations in the Philippines and Guam. It had to settle lawsuits. And the Price family, along with other shareholders, had to invest another $50 million.

How did we know it would succeed? Simple. There was plenty of money behind the efforts to turn around the company, and the basic business concept was very sound. Additionally, at each step along the way, extremely qualified people kept joining the effort and the insiders kept buying stock.

The stock has gone from $6.51 to more than $16.00 in a little over two years. As Rick Rule said, the only risk here was boredom.

Good investing,

Porter Stansberry

P.S. Last week, we made another Rebound Report recommendation that has all the hallmarks of a "no-brainer." It’s an easy way to make three to four times your money in six months. How? We’re buying an energy company for approximately 1/77th of its current reserves. It’s almost a guaranteed buy-out target, and I expect we’ll see a deal in days’ or weeks’ time, not months. The only risk? Boredom.