The S&A Digest: How to Avoid a Catastrophic Loss When You Get Started in the Market

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

As of 07/02/2013

Margin debt reaches a new high… Two angry doctors… A bottom in newspaper stocks?… Ferris says the market's not overvalued… Billiton prepares a $10 billion buyback…

Signs of a market top: Margin debt hit a record high last week. The combined margin balance of the NYSE and the Nasdaq exceeded $300 billion, topping the previous high of $299 billion. The date of the previous high? March 2000.

Dan Ferris thinks all of our talk about a potential market correction is dead wrong. "All this market-top talk is wrong. Let me ask all you market prognosticators a question. Say you have enough cash to acquire every company in the S&P 500 at today's prices, around 20 times earnings, according to Reuters. Would you rather buy U.S. Treasuries or every company in the S&P 500? Which one do you think will get you more buying power in 20, 30, or 50 years? If you said you'd rather have the cash, you're obviously interested in something other than the present value of 496 of the biggest, and many of the best, businesses in the world, at just 20 times earnings. If that's not a bargain, there's no such thing."

I don't agree with Dan. After all, wouldn't his argument be just as valid at 25 times earnings on the S&P 500? The earnings yield would be "only" 4%... but that's probably more, in real terms, than T-bills. What about 30 times earnings? A 3.3% earnings yield? It's still probably a better value than T-Bills.

But what does history tell us to expect, in terms of future returns, when you buy stocks at 20 times earnings? Or 25 times? Or 30? It's not good. I've never believed in the Treasuries comparison as a measure of value... such a comparison requires you to forecast interest rates over the lifetime of an investment. If interest rates rise at all, stock prices could decline dramatically. While I'm not saying that's going to happen, what I do know is that, at these prices, there's no margin of safety in buying the S&P 500. And that's why I've written that it's time to be very cautious in stocks. A correction in prices (a decline of more than 10%) will probably occur soon.

Third Avenue Value, the mutual fund family launched by investment great Marty Whitman, has taken a 38% stake in a Canadian newsprint manufacturer, Catalyst Paper (CTL.TO). The size of its investment essentially gives it control of the business – something I've never seen Third Avenue Value do before. I've been watching the newspaper sector closely for several years, as it has steadily declined in price. (As usual, I was way too early, buying a local newspaper publisher, Journal Register, on the way down.) I don't believe the Internet will wipe out local newspapers or that Generation X doesn't read newspapers. Advertising rates have fallen simply because of increased competition for ad dollars from the Internet. Sooner or later, ad rates will stabilize, and these stocks will soar. The two recent deals in newsprint stocks (Catalyst's peer Abitibi was bought out at a premium) suggest that a bottom is approaching.

It is rare when a congressman asks an intelligent question, but we have to tip our hats to Rep. Henry Waxman (D-Calif.), who yesterday asked: "Who in their right minds would send 360 tons of cash into a war zone?" The answer, it seems, is Paul Bremer, President Bush's former Iraq consul. Bremer explained he didn't have time to set up a "modern financial system." Thus, 360 tons of US$100 bills (US$20 billion) were shipped into Iraq on wooden pallets between March 2003 and June 2004, and then disbursed in the backs of pick-up trucks and in duffel bags. No one really knows where all the money went. Stuart Bowen, the inspector general for Iraq reconstruction, says much of the cash was stored in unguarded sacks in Iraqi ministry offices.

We have two researchers in Switzerland right now – Graham Summers and Ryan Markish. I'll have to ask them if there's been a sudden influx of Iraqi deposits.

Inside Strategist and True Wealth pick BHP Billiton (BHP), the largest miner in the world, announced record profits of $6.3 billion for the six months ended in December, up from $4.36 billion in the year-ago period. The company will add $10 billion in share buybacks to the previously announced $3 billion buyback. The repurchases will take place in the next 18 months. These results are the seventh straight record-breaking half-year for BHP. Readers of both publications have made more than 20% in the last year.

Standard & Poor's has agreed to buy the Goldman Sachs Commodity Index from Goldman Sachs Group. Financial terms were not disclosed. The GSCI is one of the largest commodity indexes, with $60 billion in institutional funds tracking it. The index will be renamed the S&P GSCI.

We wrote it, did you buy it?

China absolutely needs wood for growth... Today, China has to import three-quarters of its wood pulp. Sino Forest owns 850,000 acres of timberland across China. If the company can grow its business at even just a fraction of the rate it has since it started trading in 1995… I think you could make triple-digit returns here within three years' time… – Steve Sjuggerud, June 2006 issue of Sjuggerud Confidential.

Steve was way, way off. It only took about seven months to break into triple-digit returns. Sino-Forest is up more than 100% since Steve recommended it.

New highs: Cumberland Resources (CLG), Healthcare Realty Trust (HR), Posco (PKX), Silver Standard Resources (SSRI), Xcel Energy (XEL).

In the mailbag today, we found a few angry doctors… and one drunken (i.e. happy) customer. Enjoy. And send your own venom, via e-mail, here: feedback@stansberryresearch.com.

"Not only did Ford kill the Taurus, do not forget that they also discontinued the Escort, which was at one time the highest-selling car in the world. And it was one of the longest-lasting. I kept my 1988 Escort for 10 years. And I still have my ‘98. My mechanic called the ‘88 Escort the cockroach of automobiles. If an atomic bomb hit, it would still start!!" – Paid-up subscriber Dianna Mitchell

"I resent the implication that most doctors are in debt most of their lives. Complete falsehood and irresponsible." – Paid-up subscriber Dr. Vukcevich

Porter Comment: No, it's actually the truth. In fact, a whole sub-sector of the finance business focuses on providing credit to doctors. Check out: www.loansfordoctors.com.

"I am a practicing physician, so I take whatever Dr. Effrig [sic] says with a large grain of salt… He clearly should not be giving medical advice. I suspect he understands the medical literature well enough to discuss it in some corners of the financial world, but his arguments and opinions on medical issues belie what I suspect is a lack of rigorous training in clinical medicine and a total lack of training in or understanding of biomedical research… Dr. Effrig's [sic] writings on various medical topics have left me with the clear impression that he is not a credible source and that the labeling of him as some sort of medical expert is misleading… Feel free to forward his c.v. – he's welcome to check out mine!"

– Paid-up subscriber Eric Swagel, MD

Porter Comment: There's nothing quite so humble as a doctor with an opinion.

[Ed. Note: Yesterday, Mr. Joe Kaplan sent us a letter asking if we would consider selling him a "2fer" – a second newsletter at a heavily discounted price.] "Maybe, if Joe Kaplan would act on the information contained in True Wealth, rather than just subscribing to it, he would be able to take part of his 3-month, 21.37% gain in D.R. Horton and buy a subscription to another of your publications as opposed to having to ask for charity. I fail to understand why anyone would object to paying for such profitable advice as that available through PSIA, True Wealth, and Extreme Value." – Paid-up subscriber Ken McGaha

Porter Comment: Value, like beauty, lies in the eye of the beholder.

How to Avoid a Catastrophic Loss When You Get Started in the Market

The most frequently asked investment question we get goes something like this:

I'm a (45-or 55-) year-old man who's worked hard to scrabble together a nest egg. I've got ($250k-$500k) saved and I can't afford to lose it. I want to be ready to retire in a few years (as soon as possible) and I don't think I'll get there in mutual funds, or with my broker – who charges a lot and delivers results that compare unfavorably with simply investing in bonds. I've bought your newsletter(s) and I'm impressed with your ideas and your track record… but I don't know how to begin. Where should I start?

If our roles were reversed, here's what we'd want you to tell us:

Most people have to learn the hard way how important it is to manage risk. No matter how good we are at picking stocks, each year we recommend several stocks that "blow up" – decline more than 50%. It happens to everyone in our business, sooner or later. Even our best analysts' most conservative recommendations can still "blow up." We do everything we can to prevent situations like this, but they can still occur because of rare events (like two years of terrible hurricanes, corrupt government actions, or corporate fraud). If you're not careful, one of these rare supernovas can wipe you out.

Thus, it's critical for beginners to keep their position sizes small. Unless you've been successful as an investor for five to 10 years and unless you can read financial statements easily, never put more than 4% of your savings into any single position. Imagine a metaphoric gun – a revolver with a 50-round chamber. Even if there were only one bullet in the cylinder, would you consider playing Russian roulette? Of course not.

You've got to think about this each time you make a new investment. Murphy's Law dictates that the one time you put on a position that's too big to handle will be the one time that stock blows up. That's just the way it seems to work.

Hand-in-hand with this rule: Be ready to exercise a sell discipline.

You never want to take a loss bigger than 25%. Using a mental stop loss at 25% down from your entry price will prevent you from taking a catastrophic loss. Also useful: trailing stop losses, which help you to lock in gains. (Trailing stop losses, as the name implies, are based on the highest price a stock reaches, not your entry price.) Our analysts vary on which kind of stop they recommend based on their investment goals. And, in certain situations, they don't use any stops. I would strongly recommend that you always use stops until you've got more than half a dozen years of successful investing under your belt.

Note: A 25% loss on a 4% position would equal a 1% loss of your total savings. You can survive many losses of this magnitude, easily. As an investor, it is inevitable that you will take losses. If you make sure to take them when they're small, it will never bother you nor hinder your overall success. The biggest and most common rookie mistake is to invest way too much and then refuse to sell at a small loss. It seems nearly impossible for beginners to avoid this mistake. Write it down somewhere and tape it to your bathroom mirror. Don't let yourself forget it.

Never, ever "bet it all" on one stock or even one investment theme.

Once you've made up your mind to limit your position sizes and use stop losses, you're ready to buy a few stocks. Here's what Michael Marcus, a legendary trader, says about which positions to take:

"The best trades are the ones in which you have all three things going for you: fundamentals, technicals, and market tone. First, the fundamentals should suggest [it's an excellent value], which could result in a major move. Second, the chart must show that the market is moving in the direction that the fundamentals suggest. Third, when news comes out, the market should act in a way that reflects the right psychological tone…. [For example], a bull market should shrug off bearish news. If you can restrict your activity to only those types of trades, you have to make money, in any market, under any circumstance."

This sounds remarkably similar to what Steve Sjuggerud, whose track record features both high returns and a high "winning percentage," would tell you about investing. Steve says he's looking for great fundamentals, where sentiment is terrible, and where an uptrend is in place.

It also sounds remarkably similar to what Jeff Clark says he looks for in short trades (which make money if a security falls in price). Jeff says he's looking for remarkably overvalued securities (terrible fundamentals), where sentiment is at a fever pitch, and where there's a downtrend in place.

If you're like most of our readers, you read several – even a dozen – investment newsletters and you like to make frequent trades. But the best investors we know only take on one or two new positions every few years. They wait until a truly special situation occurs. They buy in at the beginning of an uptrend, and they stay with the trade as long as they can.

While it's not advisable to invest this way without a lot of experience, we still think it's a mistake to be fully invested all the time. And it's almost always a mistake to invest more than 25% of your capital in any given year. (There are exceptions… like the bottom of the market in 2002.) Any individual simply can't discover, research, and track more than three or four truly great opportunities in a year.

Be patient. Even if it takes you four or five years to get fully invested, it will be worth it. Look to invest in certain themes, where you see a great opportunity, one that fits the three criteria: Great fundamentals, a positive trend, and the right "market psychology."

Finally, we'd remind new investors not to underestimate the importance of yield. Keep your capital in a place where it's treated well, while you're waiting for great long-term opportunities to develop. Sjuggerud's municipal bond mutual fund (VKQ), for example, is up about 17% in the last year, with nearly half of the return coming in the form of a tax-free coupon.

You can spend a lot of time waiting for great opportunities when you're collecting yields like that.

To summarize: You probably won't get rich trading. Your returns will most likely be determined by how selective you become and by how carefully you are able to manage risk (i.e., avoid big losses).

Regards,

Porter Stansberry

Baltimore, Maryland

February 7, 2007

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