The chart my editors didn't want you to see...
The chart my editors didn't want you to see... A threat to my career... Why I think regression analysis is so important... Kindergarten investing: which of these does not belong... A full discussion of my personal asset allocation strategy...
Last week, the copy editors here at Stansberry Research took a critical chart out of the monthly newsletter I'd written, Stansberry's Investment Advisory. You might think that having my name on the door means that people don't mess with my copy. But you'd be wrong. It happens all the time...
The same thing happened to me early in my career, too, back in 1996. I'd used the same kind of chart, called a regression analysis, to show how overvalued one of the markets in Latin America (Peru) had become. My publisher at the time told me, "If you ever try to publish a regression analysis again, you're fired."
I suspect both our copy editors and my publisher 16 years ago don't think you – our dear subscriber – can understand what a regression analysis is or why it's important. I'm sure they'd both argue that it was my writing about it that didn't hold water and that they were merely trying to save me from myself.
Well, here I go, diving off the deep end...
As you know from reading these pages, I spend my Friday mornings writing to you about the things I'd want you to tell me if our roles were reversed. Today, I'm going to tell you about regression analysis.
Doing so is as close to career suicide as I'm likely to get – I'm basically begging thousands of you to cancel and ask for a refund. Nobody in his right mind would write to a subscriber file made up mostly of individual investors about regression analysis. Nothing could be more boring, more confusing... more off-putting.
But I'm doing it anyway... because regression analysis is among the very best tools we have as analysts.
I guarantee if you're willing to spend 10 minutes with me on this topic, you'll leave this essay having a tremendously richer and deeper understanding of how to find and pick good stocks.
Now... as always... a disclaimer. I am fully aware that 97.8% of our subscribers have no desire to learn about regression analysis... or anything else, for that matter. Most of you rightly consider this "hard stuff" to be my job. It is my job. And as you can probably tell, I love doing it. The thing is... if you're willing to turn on your brain for just 10 minutes, I know you could have an entirely new and much broader understanding of the market. I'm hoping you will... but I'm also conceding to the reality that there's no such thing as teaching; there's only learning.
If you'd like to learn about regression, please keep reading. I'll show you something immensely valuable that could change the way you look at almost everything in life, not just stocks. I can't give you the understanding though... You'll have to open your mind and think. (Or you can simply skip ahead to the conclusions below...)
Before I show you the chart in question, let me just tell you, in basic terms, what a regression analysis does and why it's very important in securities analysis.
A regression analysis measures the relationship between two variables. It determines whether or not two things are correlated – that is, is there a relationship between the two variables, and, if so, how tight is that relationship? This is important in the stock market because understanding how different variables affect a stock's price helps us find stocks that are mispriced.
Here's a very simple example. There's a strong correlation between height and weight in adult males. This relationship is obvious: The taller someone is, the heavier they're likely to be. You don't need to do a regression analysis to determine that there is, in fact, a relationship. But if you plotted both data points on a chart, you'd end up with a very linear scatter plot. The line of the data points would be tightly grouped, with a few outliers.
While you don't need to do a regression to understand the relationship between height and weight... regressions are very useful for finding stocks whose prices are out of whack with other, similar companies.
For all of these stock-focused regressions, we're measuring the relationship between quality (return on equity, for example) and price (a premium or a discount to asset value or net asset value).
I want you to remember this... It's extremely important. We do regressions using a large number of sample companies to determine which stocks offer us the most quality in exchange for the lowest price. To make sense of any stock-focused regression analysis, all you really have to do is figure out which variable represents quality and which variable represents price. Got it? It's that simple... It's just quality versus price.
One of the most basic measures of the quality of a corporation is return on equity (ROE). That's simply a measure of a firm's annual profits versus the total equity that's been invested in the business. It shouldn't surprise you to learn that companies with extremely high ROEs also typically trade at a very high price – a multiple to the accounting value of their assets.
Take shares of Hershey, for example. According to Yahoo Finance, the company produced a 74% return on equity over the most recent 12-month period. My Investment Advisory subscribers remember I recommended the stock back in 2008 because, back then, it was trading at a very low price per share ($40) relative to the earnings power of the business. Today, at $71, the stock seems much more fairly valued. Thus, it isn't currently a buy. It's merely a hold in my recommended portfolio.
Hershey's price today ($16 billion) is roughly four times more than the total value of all its assets ($4.4 billion). That's because the quality of those assets is so high, as measured by ROE.
In the regression analysis I did for my last issue, the question I was seeking to answer was: Are there any trophy-asset companies, like Hershey, that have very high annual ROEs, but that are trading for a wide discount to their asset value?
You'll find the answer in the scatter plot below, which shows the result of the regression study I did. This is the chart that was pulled from my issue by my editors.
One likely criticism from the smart guys in the back of the room is... why did I describe price as merely a premium or discount to asset value? Why didn't I use net asset value? I'm deliberately not including any debt in the analysis. That's because for trophy properties like these, financing is always available.
This isn't a study of every company in the stock market. It is only a study of firms whose assets are one-of-a-kind – companies, like Freeport-McMoRan (FCX), which owns by far the world's largest copper and gold mine, Grasberg in Papua. We believe investors who buy these stocks, companies that own world-class "trophy assets" when they're trading at prices well below their asset values, will have a very good opportunity to make huge gains.
Part of our reasoning is obvious: trophy assets ought to be worth at least their stated, asset value. (In the real world, if these assets were auctioned or sold, they would actually fetch far higher prices than their accounting value.)
Part of our reasoning is more complicated. The extremely high quality of these assets allows more debt to be used safely in the capital structure (in lieu of equity), which produces very high annual returns on equity (ROE). Using debt this way can greatly increase investment performance, as private equity funds have proven over the last 30 years.
So... here's the regression analysis and the scatter plot my editors didn't want you to see. The left axis of this chart shows you the companies' annual return on equity (ROE). That's the measure of the company's quality. The bottom axis gives you a measure of its price – in this case, it's the discount or the premium the shares trade at today in relation to the total accounting value of its assets.
Not every company is labeled (as it would have made the chart unreadable) but the entire data set can be accessed in a new special report I just published exclusively for my Investment Advisory subscribers: How to Own the World's Trophy Assets.
As you can see, the companies generally fall within a narrow range around the center of the chart – the so-called "best fit" line, which lies at the center of the theoretical correlation. We'd expect to see all of the companies grouped around this line, as there is clearly a relationship between the quality of these assets and their prices on the stock market.
Now... this grouping doesn't look as tight as it really is because there is a relatively small number of stocks in this regression and because the two extremely high ROE outliers (MGM and Hershey) have skewed the "best fit" line considerably. But don't worry about these details... Once you realize what the chart is telling you, what's important should jump right out – instantly.
There's clearly one stock whose value (ROE) is extremely high, but whose share price is extremely low. Investing this way is akin to playing the childhood game of "which of these does not belong?" Can you figure out which one...? Let us know: feedback@stansberryresearch.com.
In the July issue of my Investment Advisory, I published the full list of 20 companies that own bona fide trophy properties. If you simply watch this list and buy these stocks when they're trading at big discounts to tangible asset value, I know you'll produce great returns for decades.
Not surprisingly, most of the trophy assets in the world are owned by mining companies... And the bull market in resources for the past 14 years has only made these assets more valuable.
I'm no expert on mining stocks... But my friend John Doody is.
John is one of our most-trusted mining stock analysts... And today, he's super-bullish on a specific type of mining company. In fact, he's prepared a report with his top-five favorite companies in this sector.
John has studied mining stocks for decades. He's made over $10 million investing in them. And he thinks these five stocks are going to make him even richer. To learn more about John – and access the report detailing his five favorite mining stocks today (which he thinks could return several times your initial investment) – click here...
In the mailbag... I reveal my personal asset allocation strategy. Ask your questions here: feedback@stansberryresearch.com.
"Porter often talks about once you understand and start purchasing bonds you won't go back to the stock market. I've come to find that I am a much more conservative investor than I thought and seeing the dividend payments come in like clockwork goes a much longer way with me than watching my stock account bounce up and down like a rubber band. What is Porter's stance on how large a chunk of an investment portfolio can/should be tied up in bonds. Does he recommend some general guidelines or just keep adding bonds as you have the funds?" – Paid up subscriber Scott Reasinger
Porter comment: It's impossible to answer this question for any individual – first, I'm not allowed to do so under SEC rules, but secondly, because I don't know anything about your individual circumstances. So let me just tell you how I think about bonds versus stocks in my own portfolio.
My No. 1 goal as an investor is to never lose money. I always think about risk before I think about return. I have a good income, and I'm relatively young (39). I've got plenty of time to allow my capital to compound. So if I just focus on not losing any of my savings, even if I produce low average returns, I'll still end up having plenty of money for my entire life.
I believe a lot of our subscribers think this approach won't work for them because it doesn't involve chasing big, gaudy returns... or because they think they don't have enough time to allow compounding work. I fear for them... I don't think they've learned enough hard lessons.
Opportunity is infinite. Capital is finite. Unless you preserve your capital, first and always, pretty soon you'll lose it... and you'll be out of the game.
So when it comes to stocks versus bonds, the first thing I ask myself is: Is there great value in stocks? Is there great value in bonds? If the answer isn't clearly "yes!" I'm going to look at other asset classes for the bulk of my additional savings.
For example, since 2010, I've been allocating almost all of my additional savings into real estate. I've been doing small apartment deals that are paying me between 8% and 18%. Just last month, I did my first big commercial real estate deal with some partners from Florida. We bought some raw commercial land. It last sold for something around $6 million. We got it for less than $1 million... and it probably has $500,000 of timber on it, too. These deals are available in many parts of the country to investors, like us, who have plenty of cash and plenty of patience.
On the other hand, during the fall/winter of 2008-2009, I saw the best values in stocks I'd seen in my entire life. I bought stocks more aggressively then than I ever had before (or since). I'm hopeful that I'll get a few more opportunities like that over the next 20 to 30 years of my working life. I always keep at least 20% of my assets in cash or cash-like instruments, just in case there's a sudden crash. I always keep a list of a dozen stocks I'd really like to own, if I ever got the opportunity.
So... in answering your question... when it comes to corporate bonds... I like to see a wide spread between high-yield bonds and U.S. Treasury bonds of similar duration. I want to make sure I get paid a good premium for lending to corporations. In general, I also want to earn at least a 10% annual yield to maturity, as I believe I can usually earn at least that much in either stocks or real estate.
Finally, I want to make sure the price I pay for a bond is fully guaranteed by unencumbered assets owned and controlled by the corporate entity I'm lending to. In short, if anything goes wrong, I want to make sure I get all my money back, no matter what.
To do my allocation, I simply look around and see how many bonds meet my investment criteria, versus how many stocks, versus how many real estate deals. Where's the most value? Where's the least amount of risk? And when nothing looks great, I either buy gold coins (the St. Gaudens look cheap today) or, best of all, I do nothing. Learning to do nothing until there's a truly compelling value is one of the real secrets to great investment returns.
Like Buffett says, "patience bordering on sloth" is a valuable attribute. (I've tried to explain that to my wife... but she says the principle doesn't apply to marriage...)
Regards,
Porter Stansberry
Baltimore, Maryland
July 20, 2012