The S&A Digest: The Attraction of Risk

We're back... Highlights from the S&A Alliance Conference... "The cheapest stock I've ever seen"... Poor Niederhoffer...

We're back... sorta. Following our S&A Alliance Conference in Mexico, some of our staff flew directly to New York to participate in the ongoing Value Investing Congress, hosted by one of our subscribers, Whitney Tilson. With only a skeleton crew back in the office, we'll be brief today.

Yes, we know, that's OK with you...

The best idea from the S&A Alliance Conference last week? "Little, baby pine trees." 12% Letter editor Tom Dyson has figured out how to make a killing on the Mountain Pine Beetle. British Columbia's forest will be wiped out over the next several years. As timber companies try to harvest all the trees before they die, they'll have to plant millions more pine trees than normal. Tom's favorite investment grows "little, baby pine trees."

The best idea from the ongoing Value Investing Congress? Too soon to say for sure, but certainly Rich Pzena's buy recommendation of Freddie Mac is gutsy. Pzena says Freddie Mac is the cheapest stock he's ever seen in his career. He says the mortgage lender's losses are absorbable and that adjustable-rate mortgage (ARM) resets won't cause as much damage as we all fear because people won't want to give up the equity in their homes. Looking at the same situation, we concluded last week that Freddie would go bankrupt. As far as we can tell, only a 1.5% loss on its mortgage book would wipe out its shareholders' equity. But perhaps Pzena is right. Maybe Freddie can raise more capital and keep going.

Dan Ferris isn't so sure. In a note to me about Pzena's Freddie idea, he asked: "If borrowers have ARM loans, how much equity could they have by now? 2006 was the biggest year for ARMs. The most popular products were 2/28s and 3/27s. I have to wonder how much equity anyone will build up, if any at all, from 2006 through 2009. Many of those borrowers will experience negative amortization [when principal rises because borrowers can't cover interest]. Just look at the last few Countrywide 10-Qs and 10-Ks. Countrywide's negative amortization is growing like a field of four-leaf clovers next to a leaky nuclear power plant. Not only that, but I initially heard that $50 billion per month was the maximum reset over the next two years. Now I've heard that it's more like $85 billion of resetting mortgages in a single month. Will this number get higher? Lower? Does anyone know? Heroic market calls sell conferences, magazines, TV shows, newsletters, newspapers, etc. But they're not necessary if your only goal is to make a good return and keep your principal safe."

Poor Victor Niederhoffer. Last summer, when this famed speculator's portfolio suffered a huge drawdown, we thought he might be on the verge of another complete wipeout (see a copy of our earlier essay, below). Back in 1997, Niederhoffer had to sell the family silver (literally) and mortgage his enormous Connecticut mansion to avoid bankruptcy. We predicted that Niederhoffer would soon "blow-up" again, because his trading strategy is based purely on the notion that risk equals reward. Niederhoffer actively seeks to take huge risks, buying plummeting assets using large amounts of leverage. He's like a knife-wielding juggler: If his timing is off at all, he'll lose an arm. And if he makes a real mistake, he's dead.

According to The New Yorker magazine, Niederhoffer has once again wiped out the investors in his funds. Has Niederhoffer learned anything from his repeated spectacular failures? Nope. "My basic ideas about the creative power of the market, buying in panics, buying on weakness – I don't think what has happened has anything to do with that stuff... I am going to keep going, for better or worse."

There's a big difference between buying value and buying on weakness. I hope, for his sake, Niederhoffer eventually figures that out.

In today's brief mailbag... apparently you missed us, dear reader. The mailbag was full to overflowing when we returned from Mexico. We'll have much more mail to show you Monday. Today, we only had time for one small sample. Several of you, it seems, wondered where we had gone. And most of you were happy we'd left... Send your comments to us, please. We read every single note: feedback@stansberryresearch.com.

"What happened to the daily S&A Digest? The last one I received was on Nov. 19." – Paid-up subscriber R. Scott

Porter comment: As we said in the last edition, we were taking a few days off to host a conference in Mexico for our S&A Alliance subscribers. We'll be back at full strength on Monday.

Editor's note: This essay was first published in August 2006.

The Attraction of Risk

"Manchester Trading LLC took a beating in May, when stock prices swooned. That month alone, the fund lost about $100 million, or almost 30% of its assets..."

So began a recent article in The Wall Street Journal by Gregory Zuckerman. I mention it here because the principal of Manchester Trading is Victor Niederhoffer, a famed investor, former U.S. squash champion, author, and leading libertarian party fundraiser. Victor and I have several mutual friends (though we've never met). He allows us to syndicate some of his writing in our daily e-letter DailyWealth. I have followed his work closely for more than 10 years.

When I was younger, Niederhoffer's gutsy trading enchanted me. I loved to read about how he hung onto his positions by the thinnest of margins. He seemed to catch every market right at the bottom, reaping fantastically large profits, often in a single night.

Now, with a bit more experience, I follow Niederhoffer in the same way I imagine NASCAR fans follow Dick Trickle – waiting for something excitingly bad to happen to a proven loser.

The last time Niederhoffer blew up was in 1997. He went long Thailand and other emerging markets as they fell... further and further and further. Then, trying to make up for his losses, he sold puts on the S&P on a Friday in October, counting on the fact that lightning wouldn't strike twice and that "Black Monday" of 1987 – when the Dow fell 508 points in one day in October – wouldn't happen again. He was wrong. By exposing his fund to the nearly unlimited risk of selling put options, he lost $400 million in one day.

Says Niederhoffer: "I don't know how to make money without a lot of risk." His trading team is comprised of a former professional poker player, a kid recently graduated from college, and several mathematics professors. To deal with the emotionally draining nature of their high-risk trading, they don't speak in the office. As Niederhoffer explains, "I've adopted the traditions of the British Navy... at any moment disaster can strike."

Why would anyone invest with this kind of institutional gambler? Greed and ignorance are two reasons that spring to mind. Even Niederhoffer seems firmly in denial about his own track record of failure. Of his recent large drawdown, he says that one sparrow doesn't make a spring and that he gave no thought to closing the fund. (Sure, he hasn't lost all of the money yet...) But what about his other sparrows? What about how he blew up, losing half his assets, when gold plummeted in 1980? Or what about his more recent 1997 debacle?

Investors can be willfully ignorant of risk. It's much more enchanting to imagine the size of your portfolio if Niederhoffer produces another one of his 50% annual gains (which is about average for him) instead of one of his admittedly rare 100% losses.

But here's the rub: It's only a matter of time until he blows up again... so it doesn't really matter how many years of 50% he books. Investors will never see a penny of those gains.

On the other hand, if you expect your money manager to deliver gains you can eat, I'd recommend strongly favoring those managers who can produce double-digit annual returns without suffering any 20% or greater drawdown on a quarterly basis. A quick way to check almost any equity fund is to see how it did in the third quarter of 2002, which was the pit of despair for the equity markets globally. Any long-only manager that survived the third quarter of 2002 with less than a 20% drawdown is a very low-risk manager. If they're also producing double-digit gains annually over the long term (10 years), they're the ones you want to put money with. They're not gambling.

Here are 8 excellent funds that meet that criteria... and they're all a lot cheaper than Niederhoffer's.

American Funds Capital Income Bldr A (CAIBX)

Manager: Joyce E. Gordon

Investment Style: income-producing securities

Fidelity New Markets Income (FNMIX)

Manager: John H. Carlson

Investment Style: debt securities issued by companies and governments in emerging markets

American Century Equity Income Inv (TWEIX)

Manager: Kevin Toney

Investment Style: income-producing securities

Royce Total Return Inv (RYTRX)

Manager: Jay Kaplan

Investment Style: long-term growth (65% of assets in equity securities issued by companies with market capitalization less than $2.5 billion)

FAM Value Inv (FAMVX)

Manager: John C. Fox

Investment Style: common stocks and securities convertible into common stocks

Fidelity Advisor Emerging Markets (FAEMX)

Manager: John H. Carlson

Investment Style: emerging markets (80% of assets in securities of issuers in emerging markets)

FAM Equity-Income Inv (FAMEX)

Manager: Paul Hogan, Thomas O. Putnam

Investment Style: income-producing equity securities

Tamarack Enterprise Small Cap S (TEESX)

Manager: Lance F. James

Investment Style: common stocks of small, faster-growing companies

Regards,

Porter Stansberry

Baltimore, Maryland

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As of 06/25/2013