Thanks, Porter... Red flag: Relatives buying gold stocks... Another big payday for Paulson... How to make money in distressed debt... Bill Gross doubles down... Cash up the wazoo... Jeff Clark's new bond trade...
I agree with everything you said on Friday.
Your pal,
Dan
P.S. Thanks for saying I did a good job. I love applause. But I was only right once in a row, and I wouldn't hold my breath for twice.
Another sign of the top... A relative called me up yesterday. He said he wasn't making enough in his 401(k). It's up about 10% over the past few years. He said he wants to take more risk. He wants to buy gold stocks.
When you write about investments for a living and relatives who don't know a stock from a bond call you up wanting to buy gold stocks, you know you're closer to a top in gold stocks than a bottom… at least in the short term.
I skipped the discussion of how more return does not necessarily come from taking more risk. I asked him point blank, "What do you know about the gold mining business?" He said, "Nothing." We got off that topic in a hurry.
By the end of the conversation, I'd learned he's a good saver and has a chunk of cash he was thinking about using to pick up a small rental property on the cheap. He'd been paying attention to local real estate trends. I told him that sounded a lot better than buying gold stocks, as long as he could keep the property rented. He's handy, too. So he could easily maintain the property.
I also told him being in a hurry is why nobody ever does well in the stock market. Most people don't want to hear that building wealth takes time. They want it all, right now. And right now, everybody thinks you can speculate on silver and gold prices and make a fortune (or at least they did until last week). It's just like in 1999 when all you had to do was buy Amazon because the Internet made it "different this time."
The financial markets don't cough up huge sums of money easily. When the money comes easy, look out below. It's been really easy to buy silver, rinse, and repeat (until last week, of course). Since Fed Chairman "Helicopter Ben" Bernanke went on his second big money-printing spree last November, it's been easy to be long just about anything.
John Paulson – the hedge-fund manager who made $4 billion shorting subprime mortgages and billions more dollars betting on gold and a rebound in financial stocks – has another huge payday approaching... this time in corporate bonds.
The day investment bank Lehman Brothers filed for bankruptcy protection, September 15, 2008, Paulson bought more than $251 million of the bank's bonds at about $0.35 on the dollar. (They were trading around $0.80 on the dollar in the days before bankruptcy.)
Over the next two and a half years, Paulson bought more than $7 billion worth of Lehman bonds in about 1,800 transactions. The average cost of those trades was $0.13 on the dollar. Paulson paid as little as $0.08 on the dollar on December 1, 2008, just after AIG was bailed out.
Now Paulson is in court, battling for his fund to be repaid $0.25 on the dollar for its bond holdings. The California Public Employees' Retirement System and San Mateo County both bought the same bonds Paulson owns at face value years before the Lehman collapse. They're supporting Paulson's plan for recovery (even though both pension funds will lose money under the scenario). If the court accepts Paulson's $0.25 proposal, the hedge found will make around $726 million – a 78% return.
We don't publish a distressed debt newsletter (True Income comes the closest, recommending high-yield bonds) because small bond investors don't have a say in bankruptcy proceedings. They don't have a big enough stake. The judge decides who will be on the creditors' committee, so it's an insider's game. But that doesn't mean you can't still make a fortune in the space...
Porter personally bought GM bonds in bankruptcy. But he had an expert understanding of what the liquidation value would be. If you buy these bonds with a large enough margin of safety, it's difficult to lose money buying bonds out of bankruptcy. However there's not much liquidity, so you must be patient. In the GM scenario, Porter deemed the bonds were worth something between $0.35 and $0.40 on the dollar in recovery. He bought at an average price between $0.16 and $0.17 on the dollar.
But you can always encounter hiccups... In GM's case, the union ended up getting 40% of the company out of bankruptcy. It was unprecedented. And that took bondholders' recovery down from $0.40 to around $0.30.
If you're going to buy distressed debt, you need to follow two rules:
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No. 1: Know the real liquidation value of the asset (factoring costs associated with the bankruptcy). In Paulson's case, he spent years studying the company because he was shorting its mortgage bonds. And Porter spent years studying GM's balance sheet. |
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No. 2: Buy bonds for less than the price they'll return in liquidation – that's your return. And you've got to be willing to buy all the way down (as Paulson did). |
If you know the liquidation value of the bonds and you buy below that value, you can be certain to make a profit.
If you want to read about an investor who spent virtually his entire career doing liquidation analysis, read There's Always Something To Do: The Peter Cundill Investment Approach, by Christopher Risso-Gill. Cundill was a successful Canadian investment manager with a solid track record spanning four decades. He died earlier this year. He practiced Graham-and-Dodd style value investing… which is essentially the same basic discipline legendary investor Warren Buffett – a friend of Cundhill – uses.
One of Cundill's specialties was sovereign debt defaults. That's a risky area, unless you know exactly what you're doing. Most sovereign defaults result in adequate recoveries. But some of them result in zero recoveries. Cundill once described his strategy as, "We do liquidation analysis and liquidation analysis only." In other words, he maintained a strict research discipline. If he couldn't buy below liquidation value, he didn't buy.
On April 11, Bill Gross, manager of the world's largest bond fund, went short U.S. Treasurys with 3% of his $240 billion PIMCO Total Return Fund. Then, Treasurys had their best month in eight years. We thought his Treasury short might scare investors away. We were wrong... Assets under management increased $4.2 billion last month.
After the Treasury rally, the market speculated Gross was second-guessing his short. They were wrong... PIMCO today announced it added to the short-Treasury trade. The fund now has 4% of its assets in the trade.
Gross also says he's now holding an all-time high of 37% of his fund in cash ($89.1 billion). Gross is practicing what I've been saying – to the vociferous chagrin of many – for weeks now: If you're not holding a big slug of cash, you're making a mistake right now.
In the May 2011 issue of Extreme Value, my readers learned things about cash I bet they never expected to learn. For example, starting at today's valuations and assuming modest inflation and dividend growth, returns from cash and stocks are highly likely to be similar over the next 10 years – right around zero percent per year, give or take a little in either direction. If that's the case, how on Earth can you justify the risk you take buying most stocks today?
Extreme Value readers also learned about a no-cost option that never expires and how to preserve the purchasing power of cash while maintaining the flexibility to quickly snap up assets when they get cheap.
If you want to shatter your expectations on a topic you thought you knew everything about, get access to Extreme Value and read the May 2011 issue. I promise you've never read anything quite like it. If you don't like it, you can always get a refund.
This is a message I am passionate about. I believe it's something everyone – and I mean everyone – needs to hear right now. Click here to get access.
Obviously, not all stocks will perform poorly. Yet another voice has been added to the chorus I've been singing for a couple years now... Morgan Stanley says mega-cap stocks are the cheapest they've been in 25 years. Morgan Stanley analysts say the 30 largest U.S. stocks normally trade in line with the overall market. But that hasn't been the case lately, as the great herd has stampeded into riskier small-cap and commodity-oriented names, pushing valuations higher.
The 30 largest stocks are selling for around 12 times earnings, with the overall market around 16 times earnings, according to Morgan Stanley analysts. That's why, in addition to holding cash, you're better off buying World Dominator stocks – big-cap companies with enormous competitive advantages that keep them gushing free cash flow, growing relentlessly, and raising dividends annually. They're some of the only stocks cheap enough to buy today.
If you're worried about Treasurys and other bonds falling, you have to ask yourself, when will the falling begin? If you're my colleague Jeff Clark, the answer is, "Right about now."
Jeff has shorted bonds three times in S&A Short Report... And he's made money every time. And his latest "rising interest rate" trade focuses on the end of the current round of quantitative easing on June 30. After that date, the U.S. government, which is buying around 70% of all new Treasurys issued, exits the market.
The question many of us have posed is, "Who will buy these bonds when the Treasury doesn't?" The artificial demand will disappear, and we'll see a spike in interest rates. Jeff says he expects his trade to double "at a minimum." But if the market wakes up to the Fed's manipulation of the Treasury market, he says it could soar even higher... up to 190%.
To access Jeff's short Treasury trade, which he recommended this morning, click here...
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In today's mailbag... some readers take on the "con man" allegation. Send your comments to feedback@stansberryresearch.com.
New 52-week highs (as of 5/9/11): BlackRock Corporate High Yield Fund (HYV), NFJ Dividend, Interest, & Premium Strategy Fund (NFJ), PowerShares Dynamic Biotech (PBE), DirecTV (DTV), Eli Lilly (LLY), Altria (MO).
"Is Porter a con-man? No. The various complaints concerning Porter I have encountered hither & yon on the 'net seem to have a couple of things in common: [1] the additional advertising we find in our mailboxes (which is a lot) and [2] the stock dropped and they lost a lot of money.
"As for the first, well, that's how the company stays in business. I know how to use the 'delete' button, so that's not a problem for me. Sometimes, they're amusing and entertaining, though, so I don't always delete them immediately.
"As for the second, all I can say is that they apparently have failed to understand [1] the market moves up AND down and no man can say exactly when either will happen and [2] the concept of trailing stops, which Porter has explained thoroughly and which information I have found to be most useful.
"I'm also willing to bet the complainers lack the required investment discipline, which has also been explained by the good Mr. Stansberry. Ya gotta know when to hold 'em and when to fold 'em and when to sit out the game. I'm still developing that myself, to be honest. The number of folk who can't seem to fathom either the existence or the use of the website is interesting as well.
"I'm a paid-up subscriber to SIA, and very happy with it. Can't always pick up a recommended stock, but the information provided is most useful in many ways. I'm a minuscule investor with very little capital to play with and had to initially learn the hard way. I've had my losses over the few years I've been investing, but have stuck it out and have managed to eke out a 38.4% overall gain over three years. The concept of stop losses helped a lot. Nothing to shout about, that gain, but it's a start. I am still learning and SIA remains one of my most useful texts." – Paid-up subscriber Richard
"I take issue with the notion that Stansberry Research is just for rich people with lots of money to invest. My wife and I have gained new confidence and a more specific approach to reallocating our small IRAs, and we've found a way to get ahead of our mortgages on our home and our one commercial building. My teenage daughter and I have saved enough cash to buy a few dozen ounces of silver, and we are looking forward to buying during a correction sometime this summer.
"Even people who have little or nothing to invest can benefit from the insights of Stansberry Research, which, at the very least, confirms what is likely to happen, and encourages preparedness. When it's all over, and America begins anew, we expect to have nearly three quarters of a million dollars worth of real estate and World Dominator stocks. Best of all, my daughter will understand how to start small and invest for the rest of her life." – Paid-up subscriber MacEntyre
Regards,
Dan Ferris and Sean Goldsmith
Medford, Oregon and Baltimore, Maryland
May 10, 2011