The S&A Digest: Read This Book Before You Buy Another Stock

Read Dhando Investor... H&R Block dumps subprime... New dividend grab?... We can only tell you what to do... Check Amazon...

PSIA pick Career Education (CECO) announced today that the U.S. Department of Justice is closing its grand jury investigation of the company. Justice alleged in 2004 that Career Education submitted false claims to the Department of Education. Readers are up 28% since October.

Extreme Value pick H&R Block (HRB) will sell its subprime mortgage business (Option One Mortgage Corp.) to hedge fund Cerberus Capital. Exact numbers for the deal have not been released, but H&R Block expects to receive close to $1 billion when the deal closes in October. Shares of the tax-preparer are up 5% in today's trading.

Oil services company and S&A Oil Report pick Schlumberger (SLB) saw profits spike 63% to $1.18 billion in the first quarter. The company saw increased international revenues and continuing high demand for its seismic activities. Shares are up 2% in today's trading.

12% Letter pick and fast-food giant McDonald's (MCD) announced net income for the first quarter rose 22% to $762.4 million. Additionally, Mickie D's will sell 1,600 existing restaurants in Latin America and the Caribbean to entrepreneur Woods Staton, the former president of McDonald's in Argentina. The restaurants will be franchised, and McDonald's will continue to earn a royalty. Proceeds from the sale (more than $5 billion) will be returned to shareholders in 2007 and 2008.

To grab or not to grab… Avici Systems (AVCI) will pay a $2 dividend on June 22 to shareholders of record on June 11. Shares of the networking company currently trade for less than $10. S&A Dividend Grabber subscribers will receive our recommendation on this situation next week.

New highs: KHD Humboldt Wedag (KHDH), Nokia (NOK), St. Jude Medical (STJ).

In the mailbag... the return of the disgruntled. Finally. Nothing gets us ready for the weekend like being called "intellectually dishonest." Feeling angry? Unappreciated? Ill-served? Let us hear about it here: feedback@stansberryresearch.com.

"OMI Corp., I ran out and bought the Jan 30 calls, now worthless... you know inevitably some readers will run out and buy options on a recommendation like this, how about a few words of wisdom or a warning label with the recommendation. It would [have] saved me a substantial sum!!" – Paid-up subscriber Prince

Porter comment: Maybe we should publish an all-encompassing list of actions we don't recommend for our subscribers: Don't buy out-of-the-money call options… Don't drink and drive. Don't swallow poison. Don't buy those phony tax shelters in Vanuatu. Don't hitchhike…

We can't share the blame on this one. We warned you specifically that Teekay Shipping was VERY likely to buy OMI and, if the deal happened, it wouldn't go off at much of a premium. That was the main risk to this recommendation – that we wouldn't make much money. I was OK with that because, if a deal materialized, it would happen quickly. Making 5%-10% in a few weeks is still a good trade, as long as you don't screw it up with out-of-the-money call options…

Here's exactly what I wrote:

I also think there's a 75% chance that we'll see a very quick gain in this stock. The company has hired an investment bank (Perella Weinberg) to pursue "strategic options," which normally means the company is up for sale.… Potential industry buyers include Teekay Shipping and Frontline, but these firms will probably be unwilling to pay much of a premium, as historically shipping firms have traded at a small multiple of net asset value.

"I read the Quant Trader's Max Value strategy a few days ago, and found it very interesting. Can you provide more details on the annual returns, or if we wanted to follow this strategy, how we can find the information on the indexes evaluated?" – Paid-up subscriber Dean Bergman

Porter comment: Ian used a universe of 51 different national stock markets, all of which were "investable." He used a very simple (but proprietary) value metric. His testing measured the number of countries that should be bought and the number of years they should be held.

The highest average annual return was buying the single cheapest country (which you could do through an ETF) and holding for four years. This strategy produced a nearly 34% annual return over the last 37 years. Other variations included buying more than one country and holding for less time. The other variations all produced exceptional returns (in excess of 20% annualized) and several did so with remarkably little volatility. We'll be following up on this strategy for subscribers to Quant Trader – showing you which indexes to buy right now. To become a subscriber, call our sales team at 410-864-1709.

"Where can one purchase the Dhando Investor book?" – Paid-up subscriber Rich

Porter comment: According to Amazon.com, The Dhandho Investor: The Low – Risk Value Method to High Returns is in stock and available at a 34% discount from the price on its dust jacket. That's where I'd recommend you buy it. And I would recommend that everyone who plans to buy a stock read this book first. It's one of the top 10 books that have ever been written about stock investing.

"Porter, I see you are choosing not to publish my feedback… because it makes you look really dumb… come on be a man and admit you are wrong, no one is perfect. I'm amazed how you continue to miss the basic economics, first with the dividend grabber [and] now in your newsletter PSIA you state that you lost [money] on buying a house… Where did you learn to do your math?

"First off the down payment is not count as an expense!!!! The opportunity cost of the $80K should be included as an expense, i.e. if invested in the market or safe munis the expected return is deducted… Then you forget to deduct the tax benefit that you received for interest and taxes you paid… The net amount is your true cost… My guess is your tax bracket is at least 35% if not higher... rough estimate is you spent $83K on the house opportunity cost muni 5% yield on 80K 3.5 years = $14K ; 35% tax bracket interest & taxes $91K * .65 = $59K = 10K improvements... So you did make [money] on the house… I have not even factored in that you would had to pay rent, if you did not own. So the monthly cost of rent should be deducted from your expenses because it would be incurred regardless of owning or renting…

"It makes me wonder how you are able to analyze a balance sheet and income statement... Apparently you can't get the basic economics right on a simple home purchase calculation… for you own reputation please have someone review your analysis because you are usually wrong when it comes to basic economics… see college is worth something, although this is so basic that you should have learned this in HS." – Paid-up subscriber Robert Montesione

Porter comment: If you want to count the $80,000 down payment only by its opportunity cost, that's fine… but then you'll have to subtract $80,000 from what I got back at the settlement as return of capital. So… my gross "profit" on the house drops to $55,000. From that, if you subtract $25,000 in property taxes and $64,000 in mortgage interest, you still end up underwater. Never mind charging me for the "opportunity cost" on the down payment. And sure, if you want to add back the tax benefits of the mortgage deduction, go ahead. It was about $6,000 per year. But that won't get me into the black – I'm still down $16,000 after three and half years.

Besides, the point I was making is that investing in houses, at these prices and with these taxes, doesn't make sense. Investors don't receive any mortgage tax benefit.

Read This Book Before You Buy Another Stock

I first learned about Mohnish Pabrai from a Forbes article on money managers who mimicked Warren Buffett's low-risk investment style. I think the year was 2004.

I read the article carefully. Since early 2002, I had been doing my own deep value investing and research through a "no risk" portfolio in my newsletter and in the pages of Extreme Value, a newsletter I launched with Dan Ferris. What we discovered about this kind of investing was shocking: We could deliver higher average annual gains through deep value investing, while experiencing much less risk. Unless we'd done it ourselves, I would have never believed it. The first lessons that hammered into you in college finance classes are that risk is inherently related to reward and markets are so efficient that you cannot find a way around this iron law.

But all of my professors were wrong.

The track records of my "no risk" portfolio and Dan's Extreme Value newsletter prove this. We average something close to 28% annual compounded returns with less than one stock in 10 experiencing a loss.

The Forbes article on Mohnish Pabrai touched on every single important point I'd learned on my own journey into deep value, the most important of which was that the market puts far too much value on the predictability of earnings and far too little value on a company's asset base. The way to beat the market was to find companies with good businesses and great assets that had highly unpredictable earnings.

Or, as Mohnish Pabrai explains it in his book The Dhandho Investor: The Low-Risk Value Method to High Returns: "Low-risk situations, by definition, have low downsides. The high uncertainty can be dealt with by conservatively handicapping the range of possible outcomes. You end with the classic Dhandho tagline: Heads, I win; tails, I don't lose much!"

I highly recommend this book to anyone who wants to be an active investor, buying individual stocks. It covers all of the basics of sound investing, but goes about it in a whole new way. It's a very enjoyable read, too… with outstanding stories of so-called "Dhandho" entrepreneurs who put the strategies of sound investing to work inside their businesses.

Additionally, the book taught me about Mohnish Pabrai's approach to the "advanced" questions of investing, including position sizing, loss management, and investment exits. He includes several excellent and novel ideas that I hadn't encountered in any other investment book.

I remember having dinner with Jim Rogers one night, in New Orleans about 10 years ago. Rogers was George Soros' partner in the Quantum Fund for 12 years and is one of the most successful speculators of the last 40 years. I asked Jim how he handled a losing position – what happened when he was wrong. His reply: "I'm never wrong."

Most good investors are very protective over the ways that calculate intrinsic value. They won't share the details of how much capital they decide to put into an individual decision. And they don't talk about when (or how) they manage losing positions. They won't talk about these factors because these are things that tend to differentiate great investors from average investors.

Mohnish Pabrai has averaged 29% compounded annual returns since he began managing money in 1999. He has never had a down year. His fee structure is very unusual: He charges 25% of all gains over 6%, but has no flat fee. And to assure his investors that their interests remain aligned, he invests essentially every penny he makes as a manager back into the fund. Today, he manages close to $1 billion and has a net worth near $50 million.

Someone this successful doesn't usually write a book. There's nothing in it for Mohnish Pabrai. Someone this successful doesn't usually tell you any of his real secrets.

But if you read The Dhandho Investor: The Low-Risk Value Method to High Returns, you'll learn exactly how Mohnish Pabrai calculates intrinsic value, where he looks for stocks, how he does his positions sizing, and how he manages losing positions.

This is the best investment book I've read in five years. And it's certainly one of the top 10 books about buying stocks that's ever been written. If you don't read it before you buy your next stock, you're a fool.

Best,

Porter Stansberry

Baltimore, Maryland

April 20, 2007

Stansberry & Associates Top 10 Open Recommendations

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As of 06/28/2013