How We Analyze the 'Big Picture'

How we analyze the 'big picture'... What's the 'runway' for Western Union?... A reader with a PhD bashes our brains in and calls us sexists to boot... Looking for a reason to fail?...

In today's Friday Digest...

One of the things I (Porter) believe we do best at Stansberry Research is identify early and thoroughly explain important changes to the "big picture."

Sometimes that means pointing out important changes in countries (like Sjug's work on the coming changes to China's A-shares market). Other times it means figuring out important cycles in different asset classes (like our recent work in the oil patch). And sometimes it means understanding changes to the drivers behind various industries, like our work since 2014 on the auto sector.

More often than not, I believe the "big picture" will create most of your profits (or cause most of your losses) as an investor. It's rare to find a company that can completely buck a dominant industry trend. Instead, the relative performances of most companies are far more likely to be closely correlated to the industry's average return.

So... how much thinking do you typically do about the big picture?

In this week's Friday Digest, I thought I'd explain our approach to this kind of "big picture" analysis and give you the three things you should always understand before buying into any asset class, industry, or sector.

Let's start with autos...

Today, investment bank Merrill Lynch announced it sees a "swift and material" decline in U.S. auto sales developing this year, with new-car sales falling to 13 million, down 25% from the peak of around 17.5 million in 2016. Among the many problems the sector faces is a "tsunami" of off-lease inventory, which will drive down used-car prices.

Where have you heard this before? I point out Merrill's comments not because they're new or particularly valuable – the research note doesn't contain anything you haven't heard a dozen times from us. Merrill's comments are important because Merrill is the "thundering herd." By the time Merrill has figured out a trend, you can be sure it's well in motion.

When we began our "big picture" work on the auto sector in March 2014, sentiment was very bullish. A dozen of the world's most successful hedge funds were investing in the new General Motors (GM) – including Warren Buffett, Kyle Bass, and David Einhorn's Greenlight Capital. But when we looked at the fundamentals of the industry, we saw three glaring problems.

First, the global automotive sector was (and still is) suffering from a huge amount of overcapacity. That's because governments are loath to allow any major automaker to fail. The resulting declines in associated industries and employment aren't politically acceptable. We saw this political reality play out yet again when GM went bankrupt. The government invested $50 billion (and lost $10 billion) to save a single private company and violated all of the major principles of bankruptcy proceedings rather than allow GM to be liquidated.

As a result, even though two out of the three main U.S. auto companies went bankrupt, zero capacity actually came offline. And last year, during a record year for the U.S. auto industry, GM's returns on assets were only 3%. You could make almost as much owning long-term government bonds.

But my favorite proof of the enormous amount of overcapacity in the global automotive sector is the fact that in 2000, Malaysia became the 11th country with its own domestic auto industry capable of engineering and building its own cars. Called Proton, the Malaysian auto "champion" has never earned a profit, but did receive enough government support to buy the famed British sports-car company Lotus. Just think about that for a while... Let that sink in. We can't run our own car business successfully... so let's go buy another one!

Here's the first part of understanding the "big picture" in any industry...

It's simply having a good understanding of whether the industry as a whole is likely to have growing or declining sales and profits.

It was obvious to us that despite the bankruptcies of GM and Chrysler, nothing had been done to address the industry's core problem (overcapacity). In our view, that made it more likely than not that one or both of those firms were likely to go bankrupt again when the sales cycle turned.

Here's a good mental model to use, when trying to figure out if an industry in general is a good place to invest, ask yourself, "If the company I'm about to invest in didn't exist today, how eager would a young, successful entrepreneur be to start a brand-new company in this business?"

Where are the 20- and 30-year-old geniuses starting successful new car companies? There aren't any. There hasn't been a successful new global automobile business launched in more than 50 years. (By the way, I'm excluding Tesla [TSLA] because it has never made any money, and as the fans of its stock will tell you again and again, it's a battery company, not a car company.)

The second obvious problem we saw when we started our work on the auto sector was a big deterioration in underwriting standards and loan quality. The auto industry, like many industries, depends heavily on financing. More than 80% of the people who buy a new car borrow the money to do so, either via a loan or a lease. Lending standards had evaporated by 2014.

There are dozens of stories in major publications about people who could clearly not afford to buy a car being given high-cost subprime loans. By 2014, subprime lending had grown to almost 30% of total new-car loans (a new high) and more than 60% of used-car loans.

Worse, the structure of these loans was of a much lower quality: smaller monthly payments, larger amounts borrowed, and longer duration (up to 84 months). It was obvious to us (and should have been obvious to all investors) that a big decline in lending standards would inevitably lead to higher defaults and bigger losses than in previous credit cycles.

That's the second factor that you have to understand fully...

It's knowing how closely tied to the credit cycle (and the corresponding capital investment cycle) is the business you're going to invest in.

What are the dynamics in that area of lending? Have lending standards recently been weakened? Is it likely that loan losses will soon hurt the industry?

Think about the mortgage boom of 2005-2007. Trillions of dollars in mortgages were written for people who had no ability to service the loans, never mind repay them. The collapse in lending standards was common knowledge. Just about everyone knew someone who bought a house (or multiple houses) he couldn't afford.

Anyone buying a homebuilder or any commercial real estate during that time period probably lost a lot of money or at the very least could have gotten a far better price by waiting for the inevitable credit bust. For most industries, the big picture of finance – credit standards, lending, and the resulting capital investments – is the best predictor of investment success or failure. You don't want to buy after a long period of massive lending and investments.

Here's the last question you'll need to answer to understand the big picture of your investing...

What's the "runway" for this investment? How much growth is really possible where you're about to put your money? You shouldn't ever buy stocks where growth is likely to be nonexistent or stagnant. You shouldn't want to buy Kodak after digital cameras were everywhere because the business had no future. I don't care how cheap the stock looked, it wasn't cheap enough.

For a current example, look at money-wire firm Western Union (WU). The company has a great brand and the stock is super-cheap. It's worth about $8 billion today and spends almost 10% of that amount each year returning capital to shareholders in the form of dividends and stock buybacks. It's a very good business, and it's extremely capital-efficient. But what's the future of transferring money around the world? There's an extreme proliferation of fully digital means of sending money with just a cell phone. So... where's the runway leading in Western Union's business?

Understanding the runway can also help you figure out how risky owning an individual business might be. If a company's runway is littered with competition or technological changes, a lot can go wrong. But what about when its runway is well-protected... like in the growth of a beloved, branded and franchised business? Well, that's likely to be a lot safer.

When you put all of these ideas together, you can find great investment ideas, both long and short...

In the auto sector, we figured out that the rental-car companies were the most vulnerable. They own the most used cars (about $30 billion worth). Their business has razor-thin profit margins. They borrow enormous amounts of money and are extremely vulnerable to higher lending costs. And finally... what's the runway for this industry? With ride-sharing services like Uber and car-sharing services like Zipcar (ZIP), it's possible that the rental-car business will simply disappear. It's certainly not going to grow.

Understanding the big picture in autos and identifying the companies most vulnerable to the current credit cycle and ongoing technological change led us to recommend shorting Hertz Global (HTZ) and Avis Budget (CAR). We recently closed those positions for a combined 53% gain.

We've recently put all of these concepts into practice again...

We're using it to help us understand the likely path of the current oil cycle. We were among the first analysts anywhere to figure out that shale oil production would lead to U.S. energy exports and we made big gains on energy exporters as a result (Targa Resources, Energy Transfer Equity, and Cheniere Energy).

Then, as we predicted would occur, crude exports were legalized in the U.S. just as U.S. energy production climbed to record highs (outpacing even Saudi Arabia). This huge increase to U.S. production is helping to offset the OPEC production cuts... And it's setting the stage for an epic oil-industry bust. It's obvious to us that it will be almost impossible for any company in the industry to grow its profits because of the size of the record oil glut in the U.S. and around the world.

This shake out will see hundreds more oil industry bankruptcies (in addition to the 200-plus we've already seen). But it will also set the stage for the next big run higher in oil prices – $500-a-barrel oil by 2028.

Oil is the world's biggest commodity business...

It drives trade flows and currency values. It drives politics and wars. The global oil industry is one of the world's biggest businesses and consumes immense amounts of capital – tens of trillions of dollars. At the top of the cycle, it's normal for oil companies to be the largest in the world. Today, only one oil company, ExxonMobil (XOM), is in the top 20 of the world's biggest companies.

What's the runway for oil demand? Have you been to China or India? Do you think people all around the world would like to use American oil for cars, planes... or even dependable home heating? My bet is they will.

That's why I'd urge everyone to check out our revamped oil and commodity research publication. It's called Commodity Supercycles. It's written by Flavious Smith, who spent nearly 40 years in the U.S. oil and gas business. He has worked in practically every major U.S. basin and for big companies like EOG Resources (EOG) and smaller firms like Forestar Group (FOR), where he served as chief oil and gas officer and executive vice president.

I hope you were paying attention when we began warning about the coming problems for the auto industry. And I hope you profited from our work early in the U.S. oil boom. But either way, don't sleep on our work about the coming oil bust.

We're about to see once-in-a-lifetime opportunities to make major investments in the world's best oil assets. Getting just one or two of these bets right could set up your portfolio for several decades. Learn more about a charter subscription to Commodity Supercycles – and how to get a free year – right here.

New 52-week highs (as of 6/15/17): AbbVie (ABBV), American Financial (AFG), Boeing (BA), iShares Select Dividend Fund (DVY), Global X MSCI Greece Fund (GREK), Johnson & Johnson (JNJ), Mid-America Apartment Communities (MAA), 3M (MMM), Annaly Capital Management (NLY), Travelers (TRV), Weight Watchers (WTW), short position in Canadian Natural Resources (CNQ), and short position in Brinker International (EAT).

Please... do me a favor. If we've helped you understand the big picture in autos, oil, or China... please send us a note. We're driven by a desire to give our subscribers the information we'd want if our roles were reversed. Has the auto slowdown given you more confidence in following our recommendations? What about our work in oil? Have we changed your views? Let us know at feedback@stansberryresearch.com. And in the mailbag... one of the top three all-time most bizarre pieces of feedback we've ever received. Hope you enjoy.

"I really appreciated reading your article on the Escher Economy. I can't believe I'm saying this, but maybe this time is different. The stock market cannot and will not be allowed to go down! The powers that be have created a perpetual money machine. For every share that is sold, some central bank will just print money to buy it up. What happens when the central banks and corporations have bought back the entire stock market and own almost all shares...? What would ever cause them to sell when they own everything? Something else has to give!

"Did this not happen 100 years ago in Weimar Germany; the stock market soared and never came down. Would it even matter if all currencies went worthless around the world? They would just issue another global currency; such as SDR's, and re-price all the assets they own in the new currency. No one will be allowed to sell the stock market if trouble arises. My question is how does this all end; when you can't make proper investment decisions based on mispricing of assets? What happens to all currencies, bonds, etc.? Nothing makes sense anymore." Paid-up subscriber Matt W.

Porter comment: The perpetual money machine has two potential problems, both of which are fatal.

As the Mississippi Company/South Sea Company bubble from the 1700s taught us, when central banks start inflating securities, they eventually trigger inflation and a panic out of fiat money and into gold, real estate, and other hard assets. That could happen here at any time. So far, technology and the vast amounts of surplus labor in developing economies have controlled inflation. It's incredible how large the gains in productivity have been over the past 20 years.

If those continue or accelerate – which isn't impossible – then eventually the unlimited amount of capital that's being created will cause profit margins to collapse across the entire economy. Just look at the oil industry for an example. Most of the capital investments made during the first three rounds of quantitative easing (2010-2014) went into the oil industry. The resulting boom in production has made it impossible for the industry as a whole to earn a profit, which had caused hundreds of bankruptcies (with hundreds more still to come).

Sooner or later, the paper chase will unravel, either from an inflationary panic... or from a massive credit default cycle. The thing central bankers forget (or never understood) is that money isn't merely a medium of exchange and a store of value. It's also a form of communication, via prices. Prices inform both consumers and producers across the entire global economy. When the central bankers play games with the money, they corrupt the price signals. And sooner or later, it causes a big accident.

"I have been most thoroughly enjoying your publications, UNTIL TODAY. As a highly-educated individual with a Ph.D., I have been reading your analyses, and especially enjoying the comments and webinars, especially those by DR. Sjuggerud, DR. David Eifrig, and most recently DR. Richard Smith. BUT... today (June 15, 2017) I received a truly DISGUSTING issue of 'The Stansberry Digest, containing an article by P.J. O'Rourke, titled 'Six Lessons From A Man on Horseback.' That article is TOTALLY IRRELEVANT to the focus on Financial Matters, it is totally personal and written by an obvious sociopath with very limited education, and MUCH WORSE, this person has NO knowledge of history, the accomplishments of the people he DEGRADES, and. MOST ESPECIALLY, he tramples upon the accomplishments of 'our previous chief executive,' who was awarded a Nobel Prize for Peace, and who NEVER behaved as outrageously as our 'current chief executive.'

"In fact, he wrote a book about the 'current chief executive': How the Hell Did This Happen? The Election of 2016 (2017) ISBN 978-0802126191. If you people at Stansberry Research think that insulting innocent people for financial gain is 'funny,' and want every one of your readers to believe this, too, then I want nothing to do with your company. IF YOU, MR. PORTER STANSBERRY, AND YOUR TEAM ARE IN AGREEMENT WIITH THE OPINIONS STATED BY THIS 'P.J. O'ROURKE,' THEN CANCEL ALL EMAILS TO ME, AND ALL OF MY SUBSCRIPTIONS TO YOUR PUBLICATIONS IMMEDIATELY. There is no room in the scientific research focus of your company for ridiculous AD HOMINEM ATTACKS against individuals, by persons who are undereducated in the financial field, and who only want to write articles about themselves. This guy only has a Bachelor's Degree from Miami University, and an M.A, in English from Johns Hopkins University.

"I shall continue to pay attention to only those who are highly educated, not those who live a life of hate, creating discord, and causing disruptions for their own personal and financial gain. Once again, IF you and your colleagues 'love' this person so much that you add his disturbing articles to your newsletters, then i hereby state that I do not want to be involved with your company. I am attaching my Curriculum Vitae to this message, as proof that, although I was born 'female,' I actually do have more education and experience than 'P.J. O'Rourke.' Final Note: i have noticed that your company does not have any female analysts, which should be corrected. Best regards." – Paid-up subscriber Paulette R. Caswell, PhD

Porter comment: Dr. Caswell was true to her word. She attached her C.V., noting her academic accomplishments starting with Audubon Junior High School in L.A., continuing through her course work in high school (Fairfax High School, L.A.) and then her studies at nine different universities. Her C.V. was almost 10,000 words long – that's 22 pages of her educational and professional accomplishments.

Apparently, though, a sense of humor can't be taught. Neither can humility.

Oh... and in regard to hiring female analysts, we're constantly in the market for talent. We're constantly hiring. And we don't care at all if you have a penis or a vagina. We care if you have a brain. We care that you're crazy passionate about finance. And we'd greatly prefer that you have at least a decade of professional experience. If that's you, let us know.

Finally... if I didn't already think Dr. Caswell was a complete loon, I'd take the time to explain that we have several senior female editorial employees and women in leadership roles across our company. We also have promoted women to the most senior positions in our company, including our financial controller and one of our senior partners. Dr. Caswell believes that not having a newsletter written solely by a woman is a problem that I should "correct." I disagree.

As a business owner, I see two big problems between men and women in the workplace. The first, and more common problem, are men who discriminate against women and disparage them with a variety of inappropriate remarks and behaviors. We don't tolerate that crap at my company. Forget zero tolerance – if anyone tried that kind of crap around us, there would be immediate physical consequences. We're no-nonsense folks. Our mothers raised us the right way. Getting fired would be the least of that jackass's problems.

The second problem is less common, but more problematic for me. There are women in the workplace who use their gender as an excuse for their own lack of professional accomplishments or their inability to get along with their peers. It's awfully hard to deal with this problem because if you look for a reason not to succeed, you'll find it every time.

Seems like Dr. Caswell found her excuse in P.J.'s essay.

Regards,

Porter Stansberry
Baltimore, Maryland
June 16, 2017