The S&A Digest: How to manage risk

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

As of 06/24/2013

How to manage risk... Gold in the mainstream... More troubles at Goldman?... No foreclosures... Introducing – True Income...

In today's mailbag, I take on the question of risk management, which is probably the single most important part of stock investing. Unfortunately, our mailbag shows it's a topic that some of our subscribers don't even vaguely understand. So, if you only have time to read one thing today, skim down and look at my answer to the first item in the mailbag.

To follow up on my Wednesday observation that gold is slowly creeping into the mainstream... Goldsmith tells me the History Channel last night ran a documentary on numismatists. It featured footage of a gold coin convention... which is hard to believe. When we started our Gold Conferences in conjunction with the Long Beach coin show back in 2003, no one in the building was younger than 50. But times change... This morning, Bloomberg ran a piece about the cost of a gold-plated Oscar hitting a record high of $500...

Rumors coming out of Goldman Sachs suggest there's more damage to be revealed – something we've been betting on all year. News came out last month that the Wall Street powerhouse was cutting 1,000 employees. But now layoffs are expected to increase to 1,500. While Goldman considers itself an 'investment bank,' only 16% of its $46 billion in revenue came from investment banking. Goldman is an investment bank in the same way Enron was a gas pipeline company. What both firms really did was trade. At Goldman last year, two-thirds of its revenue ($31 billion) came from trading. And – as we've seen time after time – lots of trading revenue is a sure sign of an impending disaster.

The ultimate security for an investor in mortgages was supposed to be the underlying property. If you don't pay your mortgage, you're supposed to lose your house. I always wondered what would happen politically if a large number of people were actually in jeopardy of foreclosure. And now we're starting to find out...

Hillary has been campaigning with a foreclosure moratorium pledge. And our legal system seems to be setting up a big impediment, too. In November, we reported on an Ohio Federal District judge ruling that Deutsche Bank could not foreclose on 14 properties because the bank couldn't prove ownership of the mortgages. And now the problem is getting worse for the big banks that split up mortgages and sold them as CDOs to anyone willing to pay. Judges in at least five states have stopped foreclosure proceedings for the same reason. More than $2.1 trillion, or 19% of all mortgages, were bundled and sold this way.

Professional help companies will keep you sane. As long as you hold on to them, they'll do the right things with capital... the things most investors can't seem to do... like be patient and avoid hyperactive trading. Disciplined investors with long-term track records of successfully outperforming the market run these companies. These investors buy assets at bargain prices and hold them for the long term - or they don't buy at all.- Extreme Value, January 2008

Dan Ferris is talking about the holding companies of investment legends, like Buffett's Berkshire Hathaway. These companies are the perfect way to profit in a shaky market. It's like investing in the world's greatest hedge funds without the exorbitant fees. Dan has recommended several of these plays in Extreme Value. The most profitable, Icahn Enterprises, is up close to 500%. We should be seeing more gains shortly...

Icahn Enterprises sold the Stratosphere and three other Nevada casinos this week to Whitehall Street Real Estate Fund for $1.2 billion. Icahn made a pretax profit of more than $700 million. Dan recommended another professional help stock last month that is run by one of the truly great investing families in America. This stock has returned 16% a year since 1970 - a 13,200% cumulative return. And it's trading at a 30% discount to intrinsic value. This stock is set to explode. To learn more about Extreme Value and access Dan's research on professional help stocks, click here.

New highs: Chunghwa Telecom (CHT), PowerShares DB Agriculture (DBA).

In the mailbag... When several dozen subscribers didn't get my pretty obvious joke about when not to use trailing stops, it occurred to me that lots of you probably don't understand the underlying principles of risk management and why they're so important. So... a more genuine and more complete answer is in today's mailbag. Let us know when we let you down: feedback@stansberryresearch.com.

"I can't imagine a more stupid, condescending answer to Subscriber Todd's question as to when to ignore a 25% trailing stop than the one you gave. You said: 'Porter comment: You shouldn't follow the trailing stop loss rule in those cases when the shares bounce back strongly and immediately go on to post higher and higher prices. We thought everyone knew this....'

"Of course he wouldn't sell at a 25% loss if he knew the stock was about to go back up. I, too, have sold stocks at a 25% loss and then watched them go back up. And I too would like some professional advice. But 'Don't sell it if it's about to go back up' doesn't cut it." – Paid-up subscriber Jim

Porter comment: We got several dozen letters like Jim's, all furious at me for making light of what they considered a serious question. My response was, of course, written 'tongue in cheek' for the simple reason: There is no reliable way to know when you should ignore trailing stop losses because no one can know, for certain, what will happen in the future. This uncertainty is why you use preset stop losses or trailing stop losses in the first place.

It is easy to get frustrated when you stop out of a stock only to see it continue to move higher and higher and higher. But, what you must remember is that stop losses cannot optimize your return in any given investment. They won't help you pick bottoms or sell at tops. What they will do is prevent you from experiencing a catastrophic loss. And for most investors, avoiding a catastrophic loss is the first step to becoming a successful investor.

As effective and useful as trailing stop losses are, they are not the only way to limit risk and avoid big losses. In my newsletter (Porter Stansberry's Investment Advisory), we take on the challenge of effective risk management in three different ways.

First, when we're recommending speculative growth stocks or when we're short-selling stocks, we always use trailing stop losses. We use this simple, mechanical system to reduce our risks because in these situations we have very little confidence in our estimates of intrinsic value. We recognize that using trailing stop losses will reduce our total returns over time because you inevitably sell some positions that would have gone on to post profits. Even so, you have no other way to speculate without risking a catastrophic loss.

Second, when we're recommending very high-quality companies (like Microsoft, Intel, and Duke Energy) where we have a high degree of confidence in our estimate of intrinsic value and when our entry price in these stocks is within our "no risk" range (which means the company could afford to buy back all of its stock), we use a 25% stop loss. In these situations, we want to be very long-term holders of the companies, so we're able to fully capture the discount to intrinsic value over the long term. We're not speculating in these stocks, we're investing. Our desired holding period is forever. We keep a 25% stop loss (not a trailing stop loss) so that we're protected if our estimate of intrinsic value turns out to be wildly wrong. As I recall, since I began recommending stocks in this category in 2002, we've stopped out of less than five of these recommendations. And all but one of these losses were triggered by some kind of fraud. It's important to use stop losses because you can't know what you don't know about a business.

Third, a very few number of stocks feature products, brands, and operations so iconic we would never choose to sell the shares. Even if the price were to decline by 25% or more, we would only buy more. These are companies whose products are timeless – like Budweiser – and whose position in their markets is utterly dominant, like Moody's. For the "forever" stocks, I do not recommend any fixed stop loss. Instead, I advise subscribers to mitigate the risk of owning these stocks by using an appropriate initial position size – no more than 2% of your investable assets.

The key principle to understand about risk management is that you should never put more than 2% of your capital at risk. If you've got a 4% position and you're using a 25% stop loss, you're risking 1% of your portfolio. That's a loss anyone can live with.

The single biggest difference between professional investors and amateurs is that amateurs are far, far more likely to "blow up" and suffer a catastrophic loss. The cause of the loss is always the same: Far too big of a position, and no risk management discipline.

It normally takes two or three big losses before investors wake up and realize risk management – whether done via position size limits, trailing stop losses, or both – is every bit as important as the stocks you buy or the strategy you're following. Poor risk management will make a loser out of any investment strategy – I guarantee it.

Please – if you have learned the importance of risk management in your investing and if trailing stop losses or small positions sizes (or both) have helped you become a far more successful investor, let us know your story. Your experience might save someone else from having to learn these lessons the hard way. Send us your story: feedback@stansberryresearch.com.

"I want to let you know how pleased I am that you are starting a report on bonds. We are both retired, in our 80s and welcome income from our investments. I would urge you to include municipal bonds as well and corporate bonds, so we don't have to give a percentage of the income back to the government." – Paid-up subscriber Caryl Edgar

Porter comment: For subscribers that haven't heard, we launched a new product this week, True Income. Currently it's only in "beta" stage, which means we're working out the kinks of producing the letter and seeing how our ideas perform in the market. (S&A Alliance members have access to beta issues.) And to answer Caryl's question, no, we won't include muni bonds. The strategy in True Income is to identify attractive "junk" bonds that are trading at absurdly discounted prices. These are bonds that have been downgraded to below investment grade by the rating agencies. Since most institutional bond investors are not allowed to own noninvestment-grade debt, the market for these bonds is extremely inefficient. That allows us to find lots of diamonds in the rough. We're picking short maturity obligations (that will mature in less than five years) where we can see the cash flow required to pay the coupon and the company has enough assets to cover the principal. Thus... we're making very safe bets on bonds other investors consider risky.

The great thing about distressed bond investing is the issuer has a legal obligation to pay you the full price of the bond at maturity. Thus, you can know exactly what your capital gain will be and when you'll be paid. For example, our first recommended bond is trading at $650 today. When it matures, less than three years from now, the company must pay you back $1,000. This capital gain, along with the nice coupon it pays, should double your money in three years – with far less risk than owning the stock.

"To all the carping subscribers. About the writing I'll not hear another disparaging word to me! Not everybody writes so well, but if there was not some poorer writers then how would we know about the really swell ones, I ask you? So, leave Dan and the other goldbricking guy alone for Pete's sake, whoever Pete is, ha ha. I likes 'em all and reading each is a far, far better thing than anything I've ever done before. Gulp.

"But leaving off the kidding, let me tell you that JC, no not that biblical one (but close), but Jeff Clark is the way to be one of those who find it difficult to pass through the eye of the needle. What a call on PAL! Made $7,400 on 2,000 shares when I sold at $8. But wait, there's more. If uranium is rebounding as JC observed, maybe it was time to get back into DNN? I did and that one is my longer-term play and it's going up, too. Nice. This week I also made $600 on JC's call on USU. I've been able to make money on numerous other calls by him. Some losses, too, of course, but on balance really great returns. The guy walks on water." – Paid-up subscriber Michael Meek

Regards,

Porter Stansberry

Baltimore, Maryland

February 22, 2008

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