The S&A Digest: What to Do with Your Weakest Stocks

Time to part ways with your weakest stocks... Buffett sells... It's not all bad news… The funniest letter we've ever read… Which way's east?

Be sure to read the essay today… I'm responding to a question I'd bet a lot of investors are asking themselves right now: Which stocks should I sell and which should I hold?

By the way... some of our recommended stocks have done well this week: Carbo Ceramics (CRR) is up 11% since Tuesday; Kodiak Oil & Gas (KOG) is up 6% this week; Gen-Probe (GPRO) is up 6% since Tuesday. Plus, two of our mortgage-company recommendations (Thornburg and Annaly) have held up well, as has Dan's recommendation in the July Penny Letter issue.

Who said Wall Street was crooked? An academic study due to be released today shows that U.S. executives can secure better ratings for their companies from investment banks if they perform favors for Wall Street analysts. Favors range from recommending analysts for jobs to agreeing to speak with analysts' clients.

Kurt Schacht, director of the Center for Financial Market Integrity at the CFA Institute, which represents more than 80,000 analysts and fund managers, noted that these actions were "in clear breach of our code of conducts and standards." Does the obvious unethicality of these actions stop the analysts? According to the study, four out of six analysts admitted to receiving favors from company executives.

The European Union's top antitrust regulator has charged PSIA pick Intel (INTC) with trying to bully its smaller rival Advanced Micro Devices out of the semiconductor business. The charges against Intel include selling chips below cost and making payments to customers in order to secure business. Not mentioned in the EU's legal brief is this mildly pertinent fact: Intel spends $6 billion per year on R&D. Advanced Micro Devices spends about $400 million.

Buffett on the move... On July 12, Berkshire sold 16.9 million shares of True Wealth pick PetroChina (PTR), reducing its stake to 10.96% from 11.05%.

Signs of a market top... The two most anticipated IPOs of the year, Blackstone (BX) and Fortress Investment Group (FIG), are not living up to the hype. Blackstone is currently trading at 17% below its IPO price from June 21 and Fortress is trading at $19.31, 48% below the $37 high hit on the first day of trading. We are not surprised.

Company of the day: VCA Antech (WOOF) is a Los Angeles-based animal health care provider. In addition to operating its own veterinary clinics, VCA provides diagnostic equipment and research services to other veterinarians. VCA is a $3.4 billion company trading for 33 times earnings. The company has $38 million in cash and $383 million in debt. Current revenues are $983 million, up 46% from 2004.

New highs: Covance (CVD), Gen-Probe (GPRO), UltraShort Real Estate (SRS), Access Flex Bear High Yield (AFBIX).

In the mailbag, we start with one of the funniest lines we've ever received: "I have been a long-term investor for about six months..." Oh boy. We read all your letters, even the ones that make our sides hurt. Send yours here: feedback@stansberryresearch.com.

"I have been a long-term investor for about six months... [But] I sold everything out on 7-17-07 except Steve's SRS and [a recent Dan pick]. The reason I sold everything on the 17th was due to Jeff's comments several months ago. He stated that he kept an eye on MER to determine the market direction... I was looking for a reason to sell and that was it."

– Paid-up subscriber Larry Miller

Porter comment: Larry, the next time you decide to become a "long-term" investor, let me know first, okay?

"Don't buy the newer Eldo. Hold out and find a 1971 Eldo or my personal favorite a 1968 Coupe De Ville Convertible red or blue with a white leather interior… I can live vicariously. The 68 is the last of the stacked headlights, offered all options including disc brakes, full power, the new 472 ci engine, and auto leveling ride control, and is actually not that bad on gas. Stock engine with premium gas should get you at least 14 mpg. I was able to get 16 mpg on highway out of my 4 dr sedan De Ville '68. The great thing is these cars in very nice condition will cost less than half of any new full size car. With the difference, you can afford to buy the gas. Also the older cars can be made to run on propane as well. Worse thing now is finding all the parts if something goes wrong. Glad you have the bucks to play."

– Paid-up subscriber Michael Stevinson

Porter comment: I'm still shopping. Look at this beauty.

"Tell Dan I am sorry about buying all his picks. Usually, everything I buy goes down, but this time I am going to hold until he says to sell!"

– Paid-up subscriber John Bull

"Well, it's probably not the most important subject covered in the Digest… but we oughta clarify our definitions, if we want to argue specifics. The easternmost point in the U.S. is not in Maine or NC, but on St. Croix in the U.S. Virgin Islands, about five miles from my house. We have the U.S. flag over the post office; we have ZIP codes, etc.; and to paraphrase Archie Bunker, feel like "real Americans." – Paid-up subscriber Karl Bauknight

"The Easternmost point of the United States as a national political entity is actually the island of Guam. Guam is interesting economically because the decision to relocate the Marine Corps bases from Okinawa to Guam will approximately double the size of the island's economy for the next five years. There will be many investment opportunities for those companies involved in the relocation and associated infrastructure build out."

– Paid-up subscriber John Parkinson

"Actually, the most easterly point in the USA (and the most westerly) is in the Aleutian islands of Alaska (because they cross the international date line)." – Paid-up subscriber Bob Brown

"While the chart of U.S. employed in the mining industry since 1970 looks impressive to the commodities bull, at least some of the drop in employment in natural resources is due to the promulgation of environmental regulation. It's simply more difficult to start or expand a mine in 2007 than it was in 1980. Doesn't mean that you're wrong about the bull market in commodities, just that the employment issue is more complex." – Paid-up subscriber C Benediktsson

Porter comment: Actually, the regulation will make the bull market last longer and rise farther, as it restricts the ability of new market participants to increase supply. There's a reason companies encourage regulation: It restricts competition.

"The market dropped a lot and I watched my investments drop, but I'm happy. You see, most of my money is in Seabridge, and other prospect generators I read about in the Gold Report as well as in gold and silver bullion and some rare coins; so the money I lost was just a small portion from profits gained since I began investing, and that means I have lost nothing yet. I'm sitting here reading other news reports on how people are dumping their stocks and buying into bonds and foreign currencies. I'm also reading how it is highly likely those currencies will experience the same problem our dollar is experiencing. When most people realize this, they may run to gold and other precious metals as their safe haven, and if that happens, I may very well make even more profit..." – Paid-up subscriber Daniel Duke

"My brother just pre-paid for his 4-yr-old's college education. Is that wise or do you think he's better off investing that money in the market?" – Paid-up subscriber Jeff Shaw

Porter comment: I don't know... but I think a better question is why anyone would let the government educate their kids any longer than they have to. It took me years to unlearn the crap they taught me in college – especially about finance. Except for the football games, the beer, and the lovely ladies of Sorority Row, college was a gigantic waste of time.

I'll encourage my children not to go to college, but to audit the classes they need for their careers instead. If I'd spent the five years I wasted in Gainesville, Florida, doing anything related to the markets, I would have been much better off. Even if I were only running errands for a closet-indexing mutual fund manager, I still would have learned a lot more than I did in school.

"I am a new subscriber to Steve S. newsletter. I am not a big trader, but I easily made the newsletter subscription cost in a week or two. I was pleasantly surprised to see PCU, which I bought at $60, on the list. I really enjoy the different philosophy and insights that your group brings to the investment forum. I bought SA shortly after joining and easily made the money for five years of the newsletter. I am just excited about this, and wanted to thank you for making this available. By the way, I put a stop at 89 on ExxonMobil as I was in at sixty." – Paid-up subscriber Kim Horchner

"If I understand Dan Ferris correctly, he says a value investor buys the stock and is in it for the long run. You pretty much don't look at the stock every day and fret about it. He doesn't seem to stress stop loss orders. In light of what I've heard about limiting your losses, where do you think he stands in this quirky market?" – Paid-up subscriber Bill Eickhoff

Porter comment: Dan would ask, "Has the intrinsic value of this business been materially weakened? Assuming the answer is 'no, probably not,' why would you expect my opinion to change?"

"On 7/24 I bought 100 shares of Anglo American (AAUK) at $31.75 the next day my on line broker (Zecco) informed me there was a reverse split and I now owned 91 shares at $34.89. The new symbol is (AAUKD). Come to find out the new symbol is an ADR. I'm not quite sure what this is, or why. Might you explain this to the readers? And, did I get hosed as I believe I did?"

– Paid-up subscriber Markis

Porter comment: You really need a better broker. It's his job to keep you up to date on what's happening with situations like this one. But... we answered this question a few days ago, here.

"I believe there is a huge misapprehension about what the FICO scores mean. They only quantify what the borrower has already done in managing his finances. For any prospective loan, all you can really say is that somebody with a higher FICO score is less likely to default than somebody with a lower score – on the same loan and collateral! But if some ordinary schlump borrows $10 million to gamble on horses, the loan is obviously likely to default even if he went in with a perfect FICO score. It's like looking at a sports car's perfect maintenance history (a testament to owner diligence) and then imagining that means it's a-OK to drive it down Baja California through the sand dunes. FICO ain't underwriting. Real estate was promoted so heavily as an investment no matter the home price (and not as wasteful consumption) that many otherwise prudent people with high credit scores made egregiously poor decisions – with an army of eager, greedy, co-conspirators." – Paid-up subscriber Matt Kennel

What to Do with Your Weakest Stocks

From paid-up subscriber Mr. Barnatan: First of all, every day I like the S&A Digest better and better. I currently don't subscribe to Porter's letter, but I'm starting to like your sharpness... although you ARE a LITTLE, as they say, arrogant...

Now for the investment education question... I would like to know what you call the "weakest positions" in which to cut loses, and which are the strongest as a long-term investor to keep and wait?

Are all the ones you recommend in True Wealth and Penny Letter, for example, speculative or long-term solid businesses? Seabridge could be looked at as a solid business as explained in Sjuggerud Confidential... but it could also be looked at as a mere speculative play on a company without even any earnings as of yet! Or USG a great business... but flying down like a falling knife! Or Annaly the great "safe" investment, which I bought at $15.80 when I subscribed to True Wealth and is now substantially down...

It simply depends on the company in question. Only one of our publications, Extreme Value, only recommends long-term investments. In all of our other letters, we publish a mix of super-safe stuff... and more risky speculations. That's why, in every recommendation we make, we give you our risk- management strategy upfront. It's important that you follow our advice in this regard.

Specifically, as you know, True Wealth recommends a 25% trailing stop loss in most cases. If you're in doubt about which stocks to sell and which to hold, just go back and read the recommendation. More often than not, subscribers put words in our mouths. For example, we knew USG wasn't a great business, which is the opposite of what you remember. Here's part of what I wrote last December about USG, a speculation I recommended on the housing market…

USG is the market leader in interior walls and ceilings with approximately 30% market share for such building materials in the United States, Canada, and Mexico... Its vertical integration and dominant brand reminds me of Budweiser. You can say that USG is the king of dry wall.

Having said that, you should also know that dry wall is not a great business. As I documented in my original August 2005 recommendation (which we closed out of with a 49% profit), USG is a low-margin business, with average gross margins below 20% and average operating margins below 10%.

As the stock market knows well, USG will, at some point, be hurt by the collapse in residential construction…

As cheap as USG was when I recommended it last December, the company is still at the mercy of the housing industry. I didn't think housing was going to get much worse. But now it appears that housing starts could continue to decline through 2010.

We bought USG expecting to make a substantial profit in a short amount of time, because we thought too much bad news was already "priced in." I was wrong in this speculation. Thus, we recommend you follow our advice (given at the time of the recommendation) to cut your losses, using a 25% trailing stop loss.

Some subscribers will undoubtedly argue that this strategy ends up selling us out at the low or that it makes sense to wait and see what happens. After all, sooner or later, people will buy a lot of wallboard and USG is the market leader. The company is in good shape financially, with very strong backers (including Warren Buffett). Why not just hold?

In my mind, it's foolish to hold on to this stock. When I was analyzing the situation rationally (before I was looking at a loss), I decided this wasn't a great business to own forever. USG doesn't have great margins, it has a relatively low return on assets (7%), it has a history of bankruptcy, it doesn't pay a dividend, and it doesn't buy back stock. We bought it specifically because we thought the worst was over in the housing sector.

Investors that allow speculations to become long-term investments merely because the share price declines will wind up with a portfolio full of mediocre businesses. We made 49% the first time we speculated in USG. We've lost 25% the second time. That's the nature of speculation. And that's why we focus most of our time and energy on finding long-term investments that are worth keeping.

Regards,

Porter Stansberry

Baltimore, Maryland

July 27, 2007

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