The S&A Digest: What's Different About Extreme Value

Signs of a market bottom?..."Smart money" at a record level... More on Jeff's track record... Another Ferris coup... Introducing the "Stock of the Year"... Feeling like Lucy... Meet Joe, the tape reader...

Signs of a market... bottom? Hedge funds are shorting S&P 500 futures at the highest rate in three years. Analysts estimate that it will require $45 billion to cover the shorts.

Here's another very bullish sign, from one of the world's truly astute market watchers, Jason Goepfert of SentimenTrader:

In the latest Commitments of Traders report, released this afternoon, we saw a surprise... "Smart money" commercial hedgers, who over the past seven years have typically held net short positions in the major equity index futures contracts, have swung to their largest net long position in history. More than any other time in 20 years, these traders have amassed a long-side bet that the rally will continue. With a nominal dollar value of $14 billion, their current position has become close to being matched only twice before – late May 1994 and mid-October 1999. Both periods pretty much marked the low for the S&P when looking out over the next several months, and equities enjoyed gains somewhere between modest and outstanding. The fact that these traders are net long at a time when the indices are flirting with new highs is extremely unusual, and now the fact that they've established a new record long is all the more shocking.

Why is it so difficult to reach a consensus on how to keep a newsletter track record? Says Jeff Clark, our in-house options trading specialist, "There's something seriously wrong with the way you're calculating The S&A Short Report track record."

Yesterday, a prospective subscriber asked how Jeff's trading was going. I told him what I thought was the truth: On average this year, Jeff has made about 15% per trade... which is a fantastic result, given the short holding periods and the difficulty of timing options trades correctly.

But... as Jeff points out... our method of comparing all results to long-term equity investments (which are typically held for at least one year) "significantly penalizes the results of short-term trades." I hadn't thought about that. I've always thought it was more important to have a simple and consistent way to represent our track records... and to have one that slightly understates results, so that subscribers will appreciate our modesty. But... looking at Jeff's results... I think he's got a point.

In The S&A Short Report, I've made 31 recommendations this year (not counting Monday's trade). But we've never had more than 10 trades open at any one time. So, if you assume $5,000 invested in every trade, then the highest dollar amount we've ever had at risk is $50,000... We've closed out 23 trades so far this year. We profited 19 times and lost money four times. Of the eight open positions, three are profitable, three are unchanged, and two are losers (so far). So if we close everything out today, we have 22 winners, six losers, and three ties... and unrealized profit on the portfolio is $35,822. That's a gain of more than 70% on the maximum amount invested for just the first six months of the year.

True Wealth pick BHP Billiton (BHP) is in talks with private-equity groups to team up on a $40 billion bid for aluminum producer Alcoa (AA). (BHP is said to favor Blackstone Group.) Shares of BHP – long one of Steve's favorite ways to invest in China – are up more than 24% since June. True Wealth readers have made a total of 90% on the recommendation.

Carl Icahn's American Real Estate Partners (ACP) – an Extreme Value pick – raised its bid for Lear to $37.25 per share from $36. The board "strongly encourages" shareholders to accept the offer and will vote on the offer at the annual meeting on July 16. The bid still faces opposition from Lear's second-largest shareholder, Richard Pzena. Pzena appreciates the higher bid, but does not believe the increase will shake out the long-term investors. We wrote about the Lear ordeal in these pages last month.

Another Ferris coup... S&A Penny Letter recommendation Winthrop Realty Trust (FUR) will replace Highland Hospitality (HIH) in the S&P REIT index.

There's a whole bunch of new highs across our recommended portfolios... so update your trailing stops! Anglo American (AAUK), BHP Billiton (BHP), BG Group (BRG), ConocoPhillips (COP), Chevron (CVX), Eni (E), Winthrop Realty (FUR), Intel (INTC), KLA-Tencor (KLAC), Arcelor Mittal (MT), Occidental Petroleum (OXY), Petrobras (PBR), Southern Copper (PCU), Petro-Canada (PCZ), Posco (PKX), PetroChina (PTR), Royal Dutch Shell (RDS-A), Seabridge Gold (SA), ExxonMobil (XOM), Taiwan Fund (TWN).

As I'm sure you've noticed... we have "opened" our most elite subscriber level – the S&A Alliance. Why would you want a lifetime subscription to our newsletters? There are only two reasons. First, if you've come to trust and respect our work, there's no better or cheaper way to continue to read what we publish. It won't surprise you to learn that we save some of our best ideas for our top subscribers.

For example, as an S&A Alliance member, you're invited to our members-only annual meeting (in Playa del Carmen, Mexico, this year), where we will unveil: The Stock of the Year. Each of our analysts will present on the single security they believe will be the single best investment in 2008. After the presentations, the editors and our advisory board will vote and select one security. Our subscribers will vote separately, selecting one of the nominated securities as the "stock of the year." Then, over the next year, we'll follow those two securities and update all S&A Alliance members each week on their progress.

For those of you who want a deeply focused portfolio, this is a chance to see what your favorite analysts believe is the single best idea for 2008. Of course, it's quite possible that our members and our experts will pick the same "stock of the year," in which case we'll follow both the No. 1 selection and the No. 2 selection. (And yes, even if you can't attend the meeting, we'll send you a report on all of the stocks that were nominated and on the two "winners.")

There's one other reason you should join the S&A Alliance now. From the creation of the S&A Alliance in 2003, we have always promised our members that they will receive all of our publications (except Phase 1) for as long as we're publishing, plus all of the publications we create in the future. However... as we've grown... and our list of products has expanded (we publish more than a dozen separate advisories now), we wonder how long we can afford to continue making this promise to new subscribers. In the future, we may not be able to make the same promise, on an unlimited basis. And, if you don't join now, you will definitely have to pay more – much more. We're planning to launch at least three new products this year, which will allow us to increase the price of the S&A Alliance.

(If you're an S&A Alliance member and feel like you've gotten more than your money's worth, drop us a note and tell us why: feedback@stansberryresearch.com.)

Now... the mailbag. We take on target prices, the use of the word "free" in our advertisements, and yet another question about Seabridge. Send us your complaints, your accusations of fraud... the kitchen sink... whatever you'd like: feedback@stansberryresearch.com.

"I've a bone to pick. Your recommendations do not include a target. Hence we newcomer newbie investors, tightly grasping our hard earned savings, are confounded by anything other than a new reco. Nothing keeps going up forever, or does it? You have many recos years old that say "BUY." Are we to understand that that reco is about as good as the day it was new, else it would say hold, or sell?" – Paid-up subscriber SK

Porter comment: On many of our portfolio pages, we do offer you an update on our recommendations. For example, in my newsletter (PSIA), I advise readers to either buy, sell, or hold. Further, I assign all of my recommended securities a risk rating (1-10). I encourage my readers to always buy the lowest-risk stocks first. Additionally, we almost always offer our readers some estimate of how we value the business and what we think it's worth. In some cases, such as macro-based speculations, this isn't possible... or wise.

Ferris comment: "Target" is a Wall Street analyst's term for a 12-month stock price prediction attached to a research report. I won't speak for anyone else, but if I were doing targets, I'd be extremely frustrated with my own poor performance. And no one has anything but a poor performance at this, since it's impossible to get it right consistently.

But I've been really wrong about the value of a few stocks I've covered... and it's quite alright with me (and the reader, too). As long as we make a good high return on average, and as long as I pick very few losers, there's no need to hit or exceed 12-month price targets. Janus' share price went nowhere for about three years after my initial recommendation. Its average rate of return was mediocre. And all of the sudden, the market chose to recognize what we had total confidence in all along – that it was a superior business at an inferior price. The average rate of compounding return on our Janus recommendation is now about 25% per year. That's very hard to beat.

Even the poor performers can do just fine. I would have sworn all day long that SonicWALL would have doubled easily by now. It's been two and a half years since I recommended it. And yet, at 45% above our initial Extreme Value buy price, it has appreciated at about 16% a year, which is more than adequate.

Chairman Buffett says: Better to be approximately right than precisely wrong. I would say that it's better to be really confident about a business' value than about the direction or predicted level of a stock's price.

"I go fishing quite a bit as I live in Alaska, but the bait I use is natural. Why do you persist in sending me teasers, telling me I am going to get some stock advice because I'm a subscriber, then I find out, after reading a small book, that I have to plunk down $6,000 to the 'FREE' information which I was first informed was free. Bullpuckey! If you are going to give me some information because I'm a subscriber, please do so without the teaser. I feel like Charley Brown and the damn football. Bye, Lucy." – Paid-up subscriber Joe Ryan

Porter comment: Joe... as I'm sure you realize because you're a "paid" subscriber, we don't give away stock tips in our pages without receiving something in return. The word "free" in a few of our headlines highlights the opportunity you have to buy something from us and get something else, in addition, for free. This is a standard promotional practice. It's not a lie or a fraud. Didn't your father tell you that nothing in life is really free? Mine did.

"As a subscriber to True Wealth, I try to follow Steve's recommendations as closely as possible. When he re-emphasized Seabridge in June after it was already up 700%, I decided to give it a try. I bought it at $18.17 and have watched in amazement as it has climbed to $26.42 in three weeks – a 46.5% return. However, in looking at its chart, it has gone up in absolute value as much in the past 45 days as it did in the prior year and a half. Is there some reason for the sudden upward surge since gold itself has moved very little in this period of time?" – Paid-up subscriber Bob Tanner

Porter comment: Bob... I got a chuckle out of your note. Congratulations on Seabridge. And congratulations on trusting Steve Sjuggerud – he won't let you down. What made me chuckle? Well, you apparently read enough of Steve's issue to follow his advice... but did you only read the last page? The entire eight-page letter was nothing but new facts about Seabridge that explain why the stock has moved so quickly... They're the same facts that explain why Steve re-recommended it.

Regards,

Porter Stansberry

What's Different About Extreme Value

By Dan Ferris

I had to take the car in to get it looked at recently. My wife couldn't get away from work, so I had to take the dealer's shuttle van back and forth while they worked on my car.

I got to talking with the shuttle driver. Let's call him Joe. Joe's been working at the car dealer for about eight years. He says he thought he'd be retired by now, but the stock market let him down. Joe the shuttle driver told me what he does with real money.

Simply put, Joe is hypnotized by the tape. He reads the paper and various websites, watches a lot of CNBC, and makes lists of stocks that are mentioned. "I've got eight or 10 lists of stocks, with 50 stocks each."

I couldn't help asking Joe, "What do you do with these lists?"

JOE: "I watch 'em."

ME: "What do you watch for, Joe?" I had an idea where we were headed, but I wanted to draw him out.

JOE: "I just wait to see how they do."

ME: "You mean, you wait to see if the stock price goes up or not?"

JOE: "Yeah. I've got some stocks on my lists that have gone up 500% in just a few weeks. Some have fallen in half, though, too."

ME: "Which ones do you buy?"

JOE: "Well, I buy the ones that go up... 'Course, you gotta be careful cuz sometimes they don't go up anymore... I got one that's down 70% but I'm just gonna hold on to it and wait for it to come back now... I like to read my lists at night before I got to bed, just to see if anything jumps out at me..."

Before we parted, Joe handed me a slip of paper with a stock symbol on it, a pink-sheet stock that's building social networking websites. Super speculative. No profits. Destined for the scrap heap as far as I can tell. All of a sudden, I was J.P. Morgan, getting stock tips from shoeshine boys and wondering if the market was going to crash soon.

Throughout the conversation, I barely got a word in edgewise. Joe was excited and eager to share his secrets about making lists of stocks to watch. And he knew our conversation would end when we arrived back at the dealership, so he was talking like an auctioneer selling ice sculptures in Arizona.

Either way, he had so little to say and so many ways to say it that I was only able to tell him once that his "strategy" was never going to work because he didn't know what he was buying and didn't hold anything long enough to make any money. Joe would do much better if he simply bought every name on his lists, forgot about them for 10 years, and got a hobby.

Joe did one bit of work that might actually justify his aimless list making. He has a list of every stock that's ever been touted to him by regular mail and e-mail. He says almost every single one of them falls precipitously after it goes on his list. I thought he was going to tell me he'd made a fortune shorting them, but no. He doesn't short them. Just another list to... er... watch.

Unfortunately, I have a feeling Joe's story is a typical example of how people treat real money. They sit mesmerized by the tape and the news and the news and the tape. It's all price quotes and sound bites and a completely passive orientation toward what to do with real money. Who knows how they actually decide what to buy? I figure intestinal gas is taken as a buy signal much of the time.

Joe is like a deepsea diver who has mistaken water skis for scuba tanks and now he's trying to find sunken treasure while riding on the crests of waves. He doesn't notice his enormous mistake, because it feels good to be skipping along on top. There are people hauling up treasure all around him, so he knows he's in the right place.

Bad news for Joe and his ilk is good news for me.

The fact that anyone with $2,000 can open an online account means that more people than ever are managing their own money. And that virtually guarantees that I'll always be able to get an advantage in the market by doing deeper research, holding a more focused portfolio, and always, always, always holding for the long term.

I used to feel sorry for Joe. Now I think feeling sorry for folks like him is a mistake. They're adults. Adults have an obligation to be rational. If you're not rational, you run the risk of becoming road kill. Call it evolution, then. Joe is a dodo bird, and Extreme Value investors are cockroaches. He's doomed, and we're indestructible.

Good investing,

Dan Ferris

July 10, 2007

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