The "N" word

The "N" word... Longleaf says know your stuff... Worst year in market history... "Lose a billion, get a check"... Dick Fuld punched – literally... Chanos still short Macquarie...

Greetings, my illustrious komrade. The administration of the great George W. Bush believes, in its infinite wisdom, that the time may soon come for the Great Regime to save the proletariat from the incompetence of the capitalist lackeys of foreign governments.

This morning, Komrade Bush said he is considering whether the Great Regime of the People will take ownership stakes in some of our largest financial institutions to restore the confidence of the Great Proletarians throughout the illustrious People's Republic of the United States.

No kidding. The Treasury Department wants to nationalize some of the big banks, just like England and Iceland have done recently. "It is the policy of the federal government to use all resources at its disposal to make our financial system stronger. We will use all of the tools we've been given to maximum effectiveness, including strengthening the capitalization of financial institutions of every size," Treasury Secretary Hank Paulson said yesterday.

The Treasury isn't using the "N" word. But what else is it but nationalization when a government takes an equity stake in a business?

A glimpse of things to come if the government starts injecting capital directly into businesses... The Federal Reserve Board announced yesterday it will give AIG another $37.8 billion to shore up its cash supply. This, of course, is in addition to the previous $85 billion the Fed gave AIG. According to an AIG spokesman, the additional cash is to keep the company from having to use the first loan so quickly.

This reminds me of the old Chrysler slogan of the 1980s K Car campaign. "Buy a car, get a check." The government bailed Chrysler out soon after, and everyone joked, "Lose a billion, get a check."

In an otherwise upbeat letter to clients, Longleaf Partners Fund managers Mason Hawkins and Staley Cates indicated Longleaf has endured seven bear markets over 33 years and its best performances come when they end. Longleaf says, "Knowing what our businesses are worth and the potential risks to those appraisals is critical. When the seas are roughest, a conservative appraisal is our anchor against fear."

I agree. That's why I've been writing in Extreme Value about the intrinsic value of the world's dominant franchises for months now. It's also why I've examined the intrinsic values of two world dominators a couple months ago and decided they weren't quite cheap enough to buy...

... But that's going to change this month. Tomorrow's issue of Extreme Value will feature one new world-dominating franchise. It is one of a handful of the most financially sound companies on Earth. (Hint: It's not Berkshire Hathaway, UPS, Johnson & Johnson, or ExxonMobil.) It makes all its money when people pay their taxes. (But it's not H&R Block.) It's got substantial earnings derived from float. (Yet, it's not an insurance company.) Like other world dominators selling on the cheap today, this one is easily worth more than twice its current price of just a little more than 10 times free cash flow.

I spoke with investment manager and author Vitaliy Katsenelson at the Value Investing Congress earlier this week in New York. He agreed with me that, for most companies, intrinsic value estimates have been too optimistic and will need to come down going forward.

Personally, I don't think the bottom will feel this good. But I'm not in the bottom-calling business. I'm in the business of buying the best companies in the world for less than half what they're worth. You almost never get the chance to do that... and here it is.

I can't seem to establish the truthfulness of the rumor that Lehman CEO Dick Fuld was punched in the face at Lehman Brothers' gym the day Lehman announced it was going under. If it's true, did Fuld deserve it? You decide...

Lehman published documents on Monday, including an e-mail exchange that suggests Fuld wanted to use $2 billion of the potential $5 billion Korea Development Bank infusion (which never came) to buy back Lehman common shares, thereby "hurting Einhorn bad!!"

"Einhorn" is David Einhorn, the short seller who figured out Lehman was dramatically undercapitalized last year.

The government-imposed shorting ban, which was supposed to keep our markets from plummeting, ended last night. Like most government interventions, the shorting ban failed to stop the bleeding – between its introduction on September 19 and Wednesday, the Dow Jones fell almost 19%.

The short ban very likely had the effect of causing investors to liquidate unhedged long positions in beaten-down financial stocks. Perhaps the ability to hedge will help investors regain their appetite for risk, which seems to have dwindled to a starvation diet.

Year-to-date, this is the biggest decline in U.S. stock market history. The S&P 500 is down about 38%. The next worst start was in 1974, when the S&P lost 33.4%.

One year ago today, the Dow Jones Industrials Average hit its all-time record high. It's now 35% below that high, having fallen 15% over the past six trading days.

Jim Chanos, president of short-only hedge fund Kynikos, spoke on CNBC this morning about current short-selling opportunities. Chanos said he's the least short financials he's been in years. At market bottom, the stocks that have gone down the most tend to lead the rally upward, and Chanos doesn't want to be short when that happens.

Instead, he's looking abroad for opportunities. He sees more pain for infrastructure, including cement, steel, construction, contractors, and overhead-crane companies. He's still short Macquarie Infrastructure, an Australian holding company. Macquarie bought state and local infrastructure assets (like airports and toll roads) for 40 and 50 times cash flow. Every year, it marked up the value of the assets – and counted that as earnings – to continue paying its large dividend. Chanos thinks the company will have a hard time marking up its assets again come year end.

In yesterday's Digest, we covered the strategy of selling puts on high-quality companies you'd like to own at lower prices. If shares never fall to the strike price, you keep the premium. If they do, you buy shares of a company you want to own.

According to a recent filing, Warren Buffett is using the same strategy. As of October 6, Buffett sold put options on 1.3 million shares of railroad BNSF at $7.02 an option, exercisable before December 8, 2008, with a strike price of $80 a share (around where Buffett started building his initial position in 2007). As of June 30, 2008, Buffett owned 67 million shares of BNSF.

Jeff Clark recently recommended selling puts on certain gold stocks in the S&A Short Report. If you follow his trade, you will collect huge, cash premiums up front. If gold stays steady or rises, you simply keep the cash. If it falls, you buy the stock and own a great hedge against inflation. This is one of the best trades in the market today. To learn more about the Short Report, click here.

New highs: none. (New buys? Lots.)

Are you buying or selling? Are you panicked or looking for bargains? Write in and tell us: feedback@stansberryresearch.com.

"I think you all need to apply your outstanding analytical skills to a newsletter which is specific to the short side. One need look at the long vs short positions offered up this year to see where the big gains have been and most likely will continue. What say ye? Maybe each of the guys could offer up a short of the week. Also, if you are going to inundate us with solicitations from various get rich publications, it would be nice to have one of you offer up a personal recommendation as to which ones are worthwhile. I went with Jack Crooks, despite his name, based on Steve's recommendation and have been smiling ever since. He is earnest and forthcoming and has introduced me to a whole different venue for investing which I think is fascinating, not to mention that I paid for my subscription in the first trade. Maybe you could get reader member/feedback about these various services? See you in Hong Kong." – Paid-up subscriber BB Gregory

Ferris comment: Funny you mention that, BB. Crooks' service is one of the most talked-about products in the entire financial publishing industry this year. We've received a lot of positive feedback about it. If other readers are interested in checking it out, you can click here.

As for me, shorting is the last thing on my mind right now. I'm trying to pick from among about 10 different high-quality stocks trading for less than 50% of intrinsic value. I was starving a few months ago, telling readers about a new company but advising them not to buy it unless it fell. Now I almost don't know what to buy first. I say "almost" because I'm going to start with the highest-quality companies with the cleanest credit profiles. As indicated above, the first new buy will be in the next issue of Extreme Value, out after market close tomorrow. If you'd like to receive it, click here.

"Dan, I subscribe to Ext. Value... thanks for all your great work. It's a great time to be a value investor as it's the only way to stay in the game. If you could give an update on what price you would find Posco, Kepco, Encana, Icahn, KHD, and Comstock attractive for first time positions I would appreciate it. They are listed as 'Hold.' I'm curious at what point they would hit a new buy price based on your metrics and some of your other subscribers might find the same information to be of value for future positioning." – Paid-up subscriber Joe Hartzell

Ferris comment: I can't give too much away here because my specific advice is for Extreme Value subscribers only. One of the companies you mention may be the cheapest stock I've ever found in 10 years of doing this. It's a screaming buy, as I'll make clear in tomorrow's issue. Also, a couple others you don't mention are fantastic bargains now. You're going to like the October issue a lot. Look for it tomorrow.

"I've heard at different times from various sources that gold does well during inflation or deflation. The inflation scenario is often talked about and easy to understand, however, the deflation scenario is not commonly described. Could you offer an explanation of why gold would do well in deflationary times?" – Paid-up subscriber Gary S.

Ferris comment: Somebody once said if you string the world's economists together, end to end, they wouldn't reach a conclusion. Same goes for the age old question you're asking. I don't know the answer, either.

It's interesting that, right now, I'm reading articles and hearing talking heads crow about deflation or "disinflation," even though gold is clearly discounting a weaker dollar. Also, the gold price is a bit of a sham right now, as the bottom end of the spread on gold bullion coins is above the spot price of gold. In other words, it'll cost you more to buy physical gold than the current spot market quote. Like I told a reporter for MarketWatch recently, it's normal to have this tight condition in the physical markets when all hell is breaking loose.

As for inflation or deflation, I don't know what's coming, though I do know that, when you have a fiat money system, inflation is the only logical expectation. The Federal Reserve has no incentive whatsoever to do anything but weaken the currency. Also, all the banks in a fractional reserve banking system are inherently leveraged... and inherently insolvent. I don't trust that all the cash I think I own will be delivered to me on demand, so I take cash out of the system by using a debit card to buy gold coins.

"I am an alliance member and have stopped out of every one of my positions except Walmart and First Cash Financial (and my 200 ounces of gold). I am guessing that all of your publications will have a tremendous amount of housecleaning for their next issue. I now see Dr. Steve was correct when he did that last month. So my question is – you recommend staying away from a stock for 6 months, but I am seriously considering going into several canroys heavily. These stocks have been mercifully beaten down beyond all logic – ERF, PWE, PGH, HTE, PVX – are all sporting yields in excess of 25% as I write this! Consider HTE is paying out 42% based on their current price! So why should I stay away from these for 6 months? By then the market will have realized what a fire sale they are at now." – Paid-up subscriber Jim M.

Ferris comment: The six-month rule is one Steve and other editors follow to keep him from getting emotionally attached to any particular stock.

But in my view, no matter what's going on in the world, any time you see something really compelling, you have to act on it. Ben Graham implored investors in his classic work, The Intelligent Investor, to have the courage of their convictions. If you think the Canadian royalty trusts are selling way below what they're really worth to an informed buyer, there's only one thing to do and it isn't wait.

Regards,

Dan Ferris

Medford, Oregon

October 9, 2008

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