The S&A Digest: The Commodity Bull Market's Next Triple-Digit Gain

Ian Davis on why to go soft... Insiders buying... Don't buy the Picasso, yet... No, we don't endorse O'Neil... Fiduciaries? Not us... Have we been drinking?

With stock prices falling due to subprime mortgages and private-equity deals slowing, companies are finding value... in their own shares. Anglo American, Nestle, and chemicals group DSM, for example, aggressively purchased their own shares in the past couple of weeks.

Billionaire Eli Broad, who recently bailed out Goldman Sachs' failing hedge fund, made an interesting prediction regarding the aftermath of hedge funds going belly-up... "The art market will soften, and an adjustment in values will take place, but it may not happen for six months to a year." His reasoning: Many big-time art collectors are investors in hedge funds and have lost serious capital in recent months.

S&A Oil Report pick Petrobras (PBR) will spend $100 billion to become one of the world's largest integrated oil companies by 2020. The company plans to tap into its cash flow and produce income from new oil and gas reserves to fund the investment. The Brazilian state-owned oil major – the seventh-largest oil company in the world – will have already spent $25 billion by the end of the year. Readers are up more than 15% on the investment.

Closed-end funds are trading at the biggest discount to net asset value in two years. The median discount for the funds was 5.9% in July, more than double the 2.34% median in March. According to mutual-fund analyst Lipper, 82% of closed-end funds trade at a discount now, compared with 64% in March.

New highs: Oakley (OO) and Coca-Cola (KO).

Hidden among the accusations of perfidy, incompetence, and one tiny mention of "thanks," is a good debate about position sizing and the relative value of mutual funds. There's even a link to our report on mutual funds, which features our top three mutual fund picks. Enjoy Monday's "bag." And, if you've never written us a note, shame, shame, shame. We write to you nearly every day of the week. At the very least, you should drop us a note in reply every now and then: feedback@stansberryresearch.com.

"Porter, in yesterday's newsletter you said you couldn't understand why the least experienced investors take the most concentrated positions. Perhaps they are reading and following the advice of William O'Neil in Investor's Business Daily. I love the paper and use it daily but if you read his books and his advice (which many do) he says: Almost everyone in America has been brainwashed into believing in wide diversification... wide diversification, as far as I'm concerned, is nothing but a hedge against lack of knowledge. You're not sure what to own, so you buy lots of different equities you don't know quite as much about. Another key to successful portfolio management is realizing that your objective in the market isn't just to be right, it's to make big money when you're right. The way you do this is by concentration... rather than broad unwieldy diversification. O'Neil says if you have $5,000 to invest, you should own no more than 2 stocks; $10,000, 2 or 3; $25,000, 3 or 4; and $100,000, no more than 5 or 6. Before buying a new position, sell one of those. He states that asset allocation is misallocation and dilutes returns, so making substantial money involves 'concentrating your eggs in fewer baskets, knowing them well, and watching them carefully' and selling when they dip 8% without exception. With many new investors learning from IBD, this may be the reason for not spreading portfolio assets around in different areas."

– Paid-up subscriber T. Taylor

Porter comment: I strongly disagree with Mr. O'Neil. His strategy might be appropriate for traders, but what he suggests doing is certainly not investing... and will lead to disaster for the average, part-time investor. After spending more than a decade working for individual investors, I know that it's simply impractical for most people to follow such tight trailing stops. I also know it's risky to make big, concentrated investments. While it might work for O'Neil, what I have seen is that inevitably people miss these stops (or refuse to sell) and end up taking a big loss. That's why I strongly advocate both small position sizes and more reasonable (wider) trailing stops.

As for the amount of capital you need to invest directly in stocks, I suggest anyone with less than $100,000 to invest remain mostly in low-cost mutual funds. No, that doesn't mean you should never buy a stock. But you'd be foolish to ignore the outstanding value mutual funds offer for small amounts of capital. For around 1% per year in total fees (assuming you invest $100,000, that's only $1,000), you can have a world-class investor do all the work for you. (Note: We recommend very, very few mutual funds, as most aren't worth what they charge. On the other hand, there are some truly excellent funds available if you know which managers to choose. See our mutual fund report here.)

If you simply want to run your own money or if you have more than, say, $250,000 to put to work, I recommend you keep at least 10 different, roughly equally weighed stocks in the equity side of your portfolio. (Most people shouldn't have more than 60% of their liquid assets in stocks.) Following this allocation strategy, your largest initial position size would be 6% (that's one-tenth of your 60% in stocks). Combined with a 25% stop loss, the most you could lose in any new investment would be 1.5% of your portfolio – which is nothing to lose sleep about.

We encourage all investors – but especially new investors – to focus on using strategies that closely limit the downside to any investment. In fact, when we evaluate mutual funds, we don't do it the way Morningstar does. We don't look for managers with large annual gains. We look for managers with very small maximum "drawdowns" (losses). We know the biggest risk our readers face is getting "blown up" – taking a big loss that scares them out of the market and ruins their opportunity to become successful, long-term investors. The next time you consider buying a mutual fund, ask the manager what his biggest quarterly loss has been. (For most funds, the biggest losses came in the third quarter of 2002.) Don't buy a fund whose biggest quarterly loss is big enough to keep you awake at night.

"I've gotten quite a lesson in the operation of a closed-end fund (CEF) like VVR in the last week. As long as you're touting such an investment, don't you think you have a fiduciary duty to warn your readers that such leveraged investments can swing violently to the negative in a bear rout such as last week's? I got the same enthusiasm foisted on me to buy Pioneer Floating Rate (PHD) two years ago, only to watch a $12K capital gain evaporate before my eyes. I'm a bit incensed to be told in the aftermath of a panic sale such investments are 'riskless' when there was virtually no information on CEF volatility to be found on the web last week or any evidence linking ultra short senior bank loans to the subprime mortgage fiasco. Had I remained calm (or been vacationing in Timbuktu), I would have never seen my principal dip into the red before bouncing back in less than 48 hours. Now you tell me I should jump into a similar investment (VVR) that features almost twice the management fee, trades at a similar discount, but proffers almost a point less in yield according to Morningstar. If you're going to make a recommendation, don't you think you owe your subscribers a detailed comparison why VVR is better than its competition? As I've come to understand it, your return in a CEF is virtually determined by your discount and fee. What am I not seeing here?" – Paid-up subscriber Tom Anderson

Porter comment: First and foremost, we don't have any fiduciary obligations at all – to anyone. In fact, we spend a good deal of time reminding our readers that we are only publishers: We don't offer any personalized advice, and we don't manage anyone's money. We have been wrong in the past, and we will surely be wrong again in the future. If you have questions about our recommendations, you should consult with your own personal advisors.

Now... about your comments. These funds are "riskless" in the sense that there's very little chance of a widespread default in the loans they own. These funds hold only the most senior notes, which have specific collateral attached. The NAV of these funds can and does vary, depending on the loans they make and changes to interest rates. However, we selected VVR (the Van Kampen senior income trust) rather than the other dozen or so choices because its NAV is the most stable (historically). It was also offering matching discounts and yields at the time we did our analysis, though as the price has moved up, both the discount and yield have shrunk. Given that you seem to understand a lot about these funds, I wonder why you're so "incensed" that we'd recommend them... and I wonder why it bothered you so much to see the price bounce around? You seemed to know what you were buying... and what it was worth.

"How am I handling the fall in stock prices? I am not – went to Treasuries last November – too early as usual! Now I am looking for 'that cash in the corner' and contemplating what 2008 will bring us. Keep the ideas coming!" – Paid-up subscriber MSF

"I've been investing for more than 40 years – one of the best investments was the purchase of three shares (with paper-route savings) of a small Texas oil company at my aunt's urging and then leaving the dividends to compound, which they've done handsomely since the little company merged into Texaco (briefly Chevron-Texaco, now Chevron). We also owned Dell back in the late '80s and would be quite wealthy if we hadn't sold it once the stock tripled to pay for a couple of college educations, certainly the best investment decision we ever made. Now the market is down. It has been down before, but overall it is a lot higher than it was 40 years ago. The Alliance subscription helps to bolster the investments we and our advisers have made. By and large, you and your team are doing quite well. I particularly like the idea of providing some tips on how we might profit from the current downturn." – Paid-up subscriber Mike Maus

Porter comment: Once you've experienced long-term, compounding gains, you find it very hard to spend your time trading or doing anything but searching for another super-safe investment that you can hold for 20 or 30 years.

"Shame on you for causing us to lose our money... HA HA HA! Okay, jokes aside. Since at least December, you have been suggesting signs of a market top, over and over and over. At the same time, you and your guys have continued to research and recommend, (recommend also means suggest) both value investments and higher-risk plays. That's your job; it's what we pay you for. Not once have you ceased your warnings, though. I won't list all the charts, patterns and such you've shown us to help us not to buy into the bull market hype of the talking heads. You did that for free. Now, I know it may confuse some people, because it seems almost contradictory. But that is where my responsibility to make my own judgments and decisions comes into play. My money is my responsibility. I own my decisions and whatever soundness of mind I determine to maintain. Whatever money I have lost, I am the one who lost it. And, it hasn't been much since being with you guys. You've taught me to be wary and shrewd, more than I was before when I was losing like a kid in Pro Sports. For instance, my position in Annaly Capital is as boringly profitable as you say value investments usually are. Anyone who didn't hear the wind whipping up from the first of the year must never have been in a storm. I listened to your guys' recommendations, but heeded the warnings as well. Most importantly, I heard the wind myself and thunder in the distance. And, when I saw the trees starting to throw off their weak leaves, I headed for shelter. I 'felt' the inevitability in January, when many others were popping Champagne corks. It wasn't easy watching the charts go higher. But, I didn't go into Short-Mania either. I'm a novice investor, but I didn't lose my ass, as others are crying about. Why? Because I MADE MY OWN DECISIONS. Had I not had you folks, (especially Porter-the-Hated) my decisions would not have been so wise. So, thanks. By the way, I wonder why Countrywide is still sending me junk emails for refinancing? They stopped only on Thursday and Friday, and now they're back. The end is near, which means... so is the beginning! I'll wait, like Death itself. How's that for contradictory metaphorisms?"

– Paid-up subscriber Mike Rollins

"Very interesting... What you wrote in Thursday's Digest was:

However, we are allowed to buy the stocks other editors recommend, and I believe all of the editors in our group (and many of our other employees) frequently buy the stocks covered in our various newsletters.

"This begs a couple more questions: 1) When are you allowed to buy these recommendations of the other letter writers? 2) Are you allowed to purchase these 'other writer's recommendations' during the same trading day that the reco letters are scheduled to hit the e-mail boxes of the letter subscription owners (usually in our e-mail inbox after the closing bell)? In other words, are you allowed to purchase a reco a day prior to when I get my first chance to get into a new reco? I hope the answer to No. 2 is not 'YES.'"

– Paid-up subscriber Dennis

Porter comment: It always amazes me to see that folks who have decided to pay for our letters routinely assume that we're cheating them by buying stocks ahead of our own recommendations. Everyone, it seems, assumes we're scoundrels... We absolutely DO NOT buy any of the stocks we recommend until after you have had a fair chance to act on our advice first. We advertise this policy in our disclaimer (next to our copyright) on everything we publish. It says clearly: "...all Stansberry & Associates Investment Research (and affiliated companies) employees and agents must wait 24 hours after an initial trade recommendation is published on the Internet, or 72 hours after a direct mail publication is sent, before acting on that recommendation."

In addition, as I mentioned before, we do not allow any of our analysts to buy – at any time – the stocks they personally recommend. We put this rule in place for legal reasons, but we also simply prefer to offer our analysis from a genuinely independent perspective. Right or wrong, you should know our analysis was honest and wasn't swayed by any other interest.

"I am a nubie investor when it comes to doing my own investing. I am a subscriber to True Wealth, and 12% Letter in an attempt to educate myself in this area. I take it as serendipity that I have 30% of my liquid assets in cash right now. The rest is in 401k accounts. The recent volatility seems to be a good opportunity to get in on some bargains, or to lose my ass. Nothing ventured, nothing gained and all of that. I am amazed at the number of subscribers who feel you can control the market. I would compare that to the people who blame the weatherman for bad weather. I read the complaints, and see that Global Whining really does exist." – Paid-up subscriber Ed Schuetzle

"Can't begin to express our appreciation for the kind thought, for the little guy, behind your Correction Opportunity Report. Sincere thanks."

– Paid-up subscriber Ken Crawley

"Do we have a drunk writing the comments and issuing advice?? It may sound funny but it communicates a personal weakness." – Paid-up subscriber Jack

Porter comment: What have you been reading? If there are drunks here... and I wasn't invited to join them... I'm going to be very upset.

Regards,

Porter Stansberry

August 20, 2007

Baltimore, Maryland

The Commodity Bull Market's Next Triple-Digit Gain

by Ian Davis

Sugar, cotton, and other "soft" commodities may be poised to rise by hundreds of percent...

Since 2002, the DJ AIG Precious Metals, Industrial Metals, and Energy Indexes have all soared by staggering amounts... precious metals are up 101.7%, industrial metals 249.2%, and energy 83.6%.

We are clearly in the midst of a commodity bull market. Yet one category is noticeably being left behind...

The DJ AIG Softs Index (equally weighted in coffee, sugar, and cotton) has fallen by 18% over this same time period.

The following chart shows the relative performance of these four categories of commodities – energy, precious metals, industrial metals, and "softs."

The "Softs" Have Been Left Behind

But it looks as though the doldrums may be behind us...

"Goldman Sachs Group Inc., the world's biggest securities firm, is recommending corn after correctly predicting a rally earlier this year. Former hedge fund manager Jim Rogers and Marc Faber, who told investors to sell U.S. stocks a week before the 1987 crash, also say agricultural commodities are the ones to buy. Wheat, coffee and corn this month outperformed almost all commodities in the UBS Bloomberg CMCI index." – Bloomberg

Sugar at an All-Time Discount to Crude Oil

Sugar, like corn, can be used to produce ethanol biofuel. Therefore, its price – in some ways – acts more like a fuel than a food source. When sugar becomes extremely cheap relative to crude oil, it's a fair bet that a rally in sugar is just around the corner.

Sugar is down 20% on the year. Now, it's as cheap relative to oil as it has been in 20 years, according to Bloomberg.

Conclusion

Commodities are in a roaring bull market, and soft commodities could be the next to take off. They are cheap relative to other commodities, and there is an increasing demand for crops that can be turned into biofuel.

Soft commodities are also a good defensive play in this recently volatile market. In a recession, people can do without new cars or homes, but they still need to eat.

A good way to play the softs is through the PowerShares DB Agriculture Fund (NYSE: DBA). This ETF is equally weighted in soybean, wheat, corn, and sugar futures.

Good investing,

Ian Davis

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