The S&A Digest: Enron Sachs

Enron Sachs... Cheap real estate in Miami and Detroit... Foreigners keep buying... Exelon: Compound returns... More about taxes...

Goldsmith took advantage of my absence to mock my bearish view on Goldman Sachs. He's very clever. But Goldsmith is about to learn an important lesson...

Here's what Goldsmith doesn't know: $800 million of Goldman's record $3.2 billion in "earnings" came from selling a long-held investment, Cogentrix electricity plants. Those aren't bonds, securities, or re-occurring trades: They're power plants. And they made up 25% of Goldman's profits in the quarter. Goldman has huge cash-flow losses every year ($47 billion in 2006), but continues to claim record earnings based on mark-to-market accounting of illiquid securities, and is now selling power plants to make its quarterly numbers. If that doesn't remind you of Enron, what would?

I'd rather be right than clever.

Two things you might be interested in: high-end Detroit real estate and beach condos in Miami. The first big auction in Miami took place last Saturday and revealed market-clearing prices have fallen to below $250 per square foot on the mainland neighborhood of Brickell. Meanwhile, high-quality, new condos are selling for less than $400 per square foot in Miami Beach for the first time in years. Prices had gone as high as $1,000 per square foot. I bet you'll see non-oceanfront prices fall to around $250 for high-quality units in Miami Beach before the end of next year.

In Detroit, extremely high-end residential real estate is selling for absurdly low prices. Example: 110 Cloverly Road. It's an 11,000-square-foot, three-story, all-brick Tudor in Gross Pointe. Built in 1926, it boasts 10 bedrooms, 10 baths, a huge yard, and an in-ground pool. It features wood paneling throughout and a separate guesthouse. Almost every room has a fireplace. The kitchen and master suite are new. Asking price: $2.4 million, or about $200 per square foot. It would cost at least twice as much to build this house.

Or look at 211 Vendome Road – another 10-bedroom, 10-bath, all-brick estate. Designed by the city's most famous architect, Robert O. Derrick, this 18,000-square-foot mansion has 10 fireplaces and sits on a large, private lot in Gross Pointe. It has a separate catering kitchen and two independent guest apartments in the carriage house. Asking price: $3.4 million – only $189 per square foot.

There are more than 30 $2 million+ residential homes for sale in Detroit, which means even an absurd low-ball offer will get consideration. Spend a week in Detroit, get to know all of the properties for sale, and bid on them, one at a time. Offer 50% of asking price the first time around. Sooner or later, someone will take it...

At this rate, we'll all soon be working for foreigners... Investment bank Morgan Stanley announced a $9.4 billion mortgage hit today. To raise capital, the bank sold part of itself to China Investment Corp. for $5 billion. China Investment will receive equity units that convert into as much as 9.9% of the bank's common stock. The shares carry a fixed payment of 9% before converting to common August 17, 2010. Morgan Stanley joins the ranks of Bear Stearns, Citigroup, and Blackstone as companies that have sold out to foreign funds.

We've long held out our fall 2002 PSIA recommendation of America's leading nuclear power generator, Exelon, as a case study of compound returns. We've "owned" Exelon five years now, for a total return of 332%. This is a great result... but future gains are likely to be even larger, simply because Exelon has the ability to raise prices, which have more than kept pace with inflation, and because it steadily increases its dividend.

Yesterday, Exelon announced a 14% increase to its quarterly dividend, to $0.50 per share, and a buyback program of $500 million. Based on our split-adjusted buy price of $21.50, we should earn 9.3% next year on cash dividend payments alone, not including any impact from the company's share repurchase. We're only at year five... imagine what our annual dividend-only returns are likely to become in another five years. I'd bet by year 10, we'll be earning close to 20% a year on our original capital in dividends alone. That's why holding high-quality businesses for the long term is so hard to beat.

Signs of more trouble to come... Moody's predicts companies will default on 4.7% of their bonds in 2008, up from 1% this year.

A new way to save fuel... Startup company SkySails is installing $725,000 kites to pull freighters. The company says it can reduce fuel costs by 30% to 50% and reduce CO2 emissions. The first outfitted ship sets sail next month. If things go well, SkySails plans on equipping four to eight ships next year.

In the mailbag... readers celebrate my absence. Wonderful. What witty criticism do you have for us, dear reader? We wait with bated breath: feedback@stansberryresearch.com.

"Hi Goldsmith. Way to give it to old Porter on Goldman Sachs. I wish I had of known it was Porter's birthday so I could have sent him a bag of shit to go with the stocking full of coal that is already on the way for his Christmas present." – Paid-up subscriber Dave Charles

"Well Sean and Porter, it is amazing that both of you are right about Goldman Sachs. Whichever of you are more right, I don't care. I shorted (GS) on Porter's negative review several weeks back and am up over $20K as of the close today. I am glad Lehman's employees are about half as productive as Goldman. I am glad profits are up at Goldman by 2%. I am glad you both are correct; so long as my short keeps chugging along. With fundamental and technical ratings as strong as they are, this has not been an easy short and I am sure it will continue to fluctuate." – Paid-up subscriber Jonathan Mossberg

"Like I said, no offence, the alternative was to give Porter a compliment." – Paid-up subscriber Ignorant Dupe

"Enough already with the chit chat with idiots. Please just write about stocks and the market." – Paid-up subscriber G Oram

"It amazes me almost every day to read in the Digest the letters you get. You'd think that over the course of time a certain amount of 'selection' would occur and there would be fewer subscribers to your publications who can't or won't think for themselves or accept personal responsibility for their decisions, since you continually challenge us, educate us or even ridicule us into doing just that." – Alliance member Edward J. Parker

"If all the recent talk about Beavers and pimping transsexual prostitutes is leading up to a new sales pitch for another letter, please keep going as I may be interested in subscribing." – Paid-up subscriber Roger Johnson.

Porter comment: If there's one thing you can be sure of, it's that we'll keep coming up with ideas for new newsletters. Each one better sounding than the last...

"I think your advertising is wonderful, entertaining, hilarious, and every so often anyone that can think can find what you are advertising. Think how BORING everything you do would be without some personal insight... Porter, like Howard Cosell, they either love you or hate you. However, the bottom line is that they all read what you publish." – Paid-up subscriber Carl

"As a fortunate citizen who is in the highest tax bracket, I certainly have mixed feelings about the tax structure. To some extent, the rich must pay more because they are the ones who have it. The perpetual battle is about what is the 'right' level of progressives in the tax code, something which will be argued about forever. However, to play devil's advocate with your figures, you conveniently leave out FICA taxes, which constitute a big portion of total receipts and are tilted heavily toward low-wage earners as a percentage of their total income." – Paid-up subscriber Brian Avery

Porter comment: This is a nonsense criticism for two reasons. First, nothing is "right" about a system where 10% of the population ends up paying virtually the entire government tab, with no corresponding amount of political power. Second, even if the system weren't "progressive" at all, the rich would still pay the lion's share. But that's not the point. The top 10% are still paying vastly more in taxes as a percentage of their income than the average taxpayer – about twice as much. If you believe in equality under the law... which if I recall correctly is mentioned in the Constitution... you cannot support a system that's so heavily biased against the rich. Secondly, and this is the much more important point, income taxes aren't hitting the rich in any case, because truly wealthy people do not generate income. Folks who own their companies or live off trusts, or other property, earn dividends and capital gains – which are both taxed lightly and at fixed rates. The real penalty of the income tax is on high-wage earners. This greatly reduces social mobility, making it nearly impossible to become rich by simply working and saving.

Regards,

Porter Stansberry

Baltimore, Maryland

December 19, 2007

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