The 12 Days of Xmas: Equity Steak

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

As of 06/24/2013

Editor's note: In the September 18 edition of DailyWealth, we published an adapted version of Dan's Ferris' September Extreme Value advisory. By showing how far down the ladder the common stock owner is in event of a company liquidation, Dan illustrated why focusing on stocks with high-quality assets, low-debt balance sheets, and great business franchises is essential when it comes to common stock investments.

Equity Steak

Originally published in the September 18 edition of DailyWealth

I like you.

You and I are birds of a feather... I feel privileged to be able to write to you. I'm grateful for the attention you give to my ideas and advice. And given the smallish size of the flock, I hope we'll continue to stick together.

So, please don't take the following personally. I'm only making a point...

But let's face it... As an investor, you just aren't that important.

For starters, you're an outsider. Sure, the stock you buy means you own a piece of the company. But let's be realistic. You have no idea what's going on in its hallways, meeting rooms, and corner offices minute by minute, day by day. Management could be swinging from the chandeliers. (How do you know there aren't any chandeliers?)

Not only are you an outsider, you're passive, too. You get to vote your shares, but otherwise, management doesn't want to know and certainly doesn't really care what you think. In management's view, you, the shareholder, are best neither seen nor heard.

And while you may have the potential to vote with the majority, wielding whatever power you possess, you are the tiniest minority of all: the individual shareholder. You are a gnat on the windshield of the companies in your portfolio.

Putting a more technical face on it, the publicly traded common equity we typically discuss (and discuss and discuss...) represents a residual claim on earnings and assets.

Note the word residual, as in residue. You know what residue is. It's the stuff you have a bear of a time cleaning off the bottom of the pan. After you take the meat out and use the drippings and scrapings to make the sauce, there's a little bit of stuff stuck to the bottom.

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That's the residue.

In other words, that's the equity. Not the meat, or the drippings, or the scrapings. The residue. The stuff nobody wants.

Well, if the equity is the residue, then what are the steak and the sauce? What comes before equity? The answer, it turns out, is "just about everything and everyone." The following list shows you the order of claims on a corporation's assets in the event of liquidation. Note the position of the common-equity holder. Now that's what I call residue.

1) Secured creditors paid when pledged property is sold or refinanced, then

2) Unpaid wages, then

3) Taxes, then

4) Trade creditors, then

5) Unsecured debt holders, then

6) Subordinated unsecured debt holders, then

7) Preferred stockholders, and finally, after all these other claims are met,

8) Common stockholders get whatever is left.

You are eighth in a line of eight. Every common-equity holder should see this list, study it, and remember it forever. This list of priorities is why I've often been attracted to stocks with little or no debt and way too much cash or other high-quality liquid assets.

And claims on earnings are an even wispier notion than claims on assets. Before a corporation can pay common dividends – if it even wants to – it has to pay all of its interest payments and other expenses.

Makes you appreciate a world-class dividend payer like ExxonMobil that much more.

Once you start thinking about yourself as a subordinated unsecured creditor, you're really just making sure you'll get paid.

That's why we recommended Alexander & Baldwin a few years ago in my advisory Extreme Value. Alexander & Baldwin owns 90,000 acres of raw land in Hawaii. At the time we bought, you got the land at a discount, and its business operations for free.

We recommended American Real Estate Partners for similar reasons. It was selling for 75% of book value a few years ago. It was easily worth much more than book value. It was around $20 a share then. It's more than $110 a share now, and selling for about three times book value. Today, it owns even more undervalued assets. And it still has more cash than debt. It's a very safe stock to hang on to.

We analyzed the position of Borders from the same perspective and realized that its debt is secured in part by its inventory. Borders book inventory can be returned to the publisher at cost, so there's a firm bottom to its value. Not what you'd expect, given that today's $39.95 hardbacks will be in the bargain bin for $5 in a few months. Even if the worst happens at Borders, there'll still be some value for the shareholder. We made sure we'd get paid.

That's how a creditor thinks. We're not predicting earnings. We're not figuring out the next hot technology. We're not even worried about the business having some great competitive advantage. We're just looking at the business through the eyes of a subordinated unsecured creditor. That's how we get safety, and staying safe is how you keep yourself in a position to take advantage of the big gains that come from stocks like Alexander & Baldwin and American Real Estate Partners

If this were what you got every time you scraped the bottom of the pan, you'd be happy to let others eat the steak.

Good investing,

Dan Ferris

P.S. Dan Ferris is the editor of Extreme Value, a monthly advisory focused on the safest, highest returning stocks in the market. To learn more about the "Extreme Retirement Plan," click here.