The S&A Digest: Where to Put Your Money In a Crisis

Ian Davis on the big plunge… "You bastards"… Maryland jumps into subprime… Lampert opens up… What Dreman is buying… The great debate: to stop out or not?

Dan Ferris, quoting Felix Dennis, reminded me of something this morning: "Public companies aren't sane places, and their share prices aren't determined by sane people." That's why "quant" hedge funds, which are based on the idea that the markets are rational, i.e. efficient, seem to blow up once about every 10 years. And that's why, contrary to almost all academic research, contrarian investing works so well. More about this in the mailbag…

Speaking of the insane… reading the local paper I found this:

"Nearly 4,000 homebuyers turned to the state [of Maryland] for their home loans last fiscal year, a record for Maryland's 28-year-old loan program… The state made about $767 million in low-interest loans to buyers." That's about three times more than the previous – 1995 – record of $250 million in loans. Why the huge jump in mortgage issuance by the State of Maryland? They're now offering 40-year, interest-only loans, loans equal to 99% of appraised value and 'down payment assistance,' which nine of our ten borrowers required to close. Stephen Silver, the CFO for Maryland's department of housing, says of last year's 4,000 borrowers: 'I'm sure we are picking up some people that were being steered toward subprime…'"

So… the State of Maryland… in all its infinite wisdom… has decided to use some of the 7.5% of my income it taxes each year to compete in the deadbeat mortgage market. Wonderful.

Have an extra $25 million sitting around? If so, you can hand it over to Eddie Lampert. The famed value investor and chairman of Sears Holdings is opening his hedge fund, ESL Investments, to new investors. What do you get for your money? Lampert runs a high-concentrated portfolio, where his top five holdings make up 70% of the total. In short, you'll spend $500,000 per year (2% of $25 million) to own five large, publicly traded companies. But at least it might be a good time to buy them. Eddie's top holdings – Sears, AutoZone, Citigroup, and AutoNation – are all down considerably this year. (Remember: It's the "smart" money that buys hedge funds…)

The U.S. stock market is "pretty solid" and offers some "great opportunities," says value investor David Dreman. In particular, the manager of $22 billion Dreman Value Management is interested in financials. The S&P 500 Financials Index has lost 10% this year and last week traded for 10.8 times earnings – the lowest valuation since 1995. Dreman mentioned that he's looking at buying shares of Extreme Value pick JPMorgan (JPM), 12% Letter pick Citigroup (C), and Wachovia (WB).

China's stock market refuses to be stopped by the subprime scare. The recent two-week 14% rally is creating some of the largest and most expensive companies in the world. Industrial & Commercial Bank of China (ICBC) is now behind only two U.S. companies – ExxonMobil and General Electric. Its $285.2 billion market cap bests Citigroup's $233.8 billion, although ICBC's $6.1 billion in earnings is less than one-third of Citi's. How much further can it go? Well, ICBC trades for 39 times earnings, close to four times Citi's 11. Shares in China's CSI 300 trade at 50 times earnings, while those in the S&P 500 trade at 17 times.

New highs: None.

In the mailbag, a bit more venom, which, paradoxically perhaps, we like to see. Why do we enjoy the nasty, angry letters that point out our flaws, mistakes, and egregious lapses in good judgment? Because we know "fast money" investors inevitably buy only the riskiest stocks we recommend, refuse to diversify, and never follow any of our risk-management advice. Then, in a correction like this, they panic, take huge losses, and blame the whole mess on us. Once they've taken their beating, gotten out of the market, and canceled their subscriptions, we can go back to making good money in stocks. So… we're waiting. And enjoying the mail. Caterwaul here: feedback@stansberryresearch.com.

"Porter, you are the bastard of all these bastards. When your AHM pick went bad, you right away pointed [to] all the reasons it went bad by saying you already wrote in the month's edition. Why are you pointing out these guys [Sowood Capital]? You bastard. You and your guys are losing steam and guts. I tell you this, if you have the guts/balls, why don't you put a table in every month's edition, showing all the losers of that newsletter."

– Paid up subscriber Ramakrishna B

Porter comment: Is losing 30% on one stock pick that was clearly labeled as speculative – "I'm probably going to regret this... Hold your nose and buy..." – the same thing as losing more than 50% of all the funds you have under management? Is writing a monthly newsletter the same thing as being the fiduciary manager of a hedge fund, who is paid 2% of assets a year to manage funds?

We point out the risks (and the frequent failures) of hedge funds because we think it's foolish to invest your capital in these vehicles. The manager's only real incentive is to go for risky, highly leveraged, speculative bets. Heads, he gets 20% of your profits. Tails, he takes his 2% fee and starts a new fund.

In regard to your comment about our "guts" and testicles, perhaps you haven't seen any of our "bastard" newsletters. Information on all of our open positions is on the back page of each issue. This includes the recent losses. And each year, we publish a "report card," which discusses in detail how all of our recommendations have performed.

"In an irrational, contrived, panic-type market (like the one we have now), stop losses CAN and DO kill one's long-term portfolio. Thousands of dollars are left on the table unnecessarily. Assuming that we – you, they, or whomever – have picked… fundamentally sound investments, that are not related in any way to the crisis de jure,… why would we not want to hold on until the idiots get out of the way? Sure they (the good companies) are getting the hell pounded out of them because of the overall malaise in the market. However, anyone with a brain knows that when the music stops, these are the companies that have the potential and where-with-all to recover rapidly. Good companies, with excellent balance sheets, no debt, good cash flow, dividend paying (or not), good management, superb competitive advantage, etc. WILL EVENTUALLY SURVIVE and flourish. So, why in goodness name, do we want to get stopped out when the lunatics are running around with completely irrational behavior?" – Alliance subscriber RLS, for the long term!

"I disagree with Dan Ferris' strategy of holding on to a stock no matter how far the share price drops. I believe the use of trailing stops is a better strategy. Dan believes that, unless the fundamentals of a company have changed, a drop in the share price is of little or no significance. The problem with this viewpoint is that it assumes you have all the pertinent information about a company and that you are analyzing it properly and drawing the correct conclusions. It does not even consider the possibility that other investors know something you don't. Even if you are correct in your analysis about the intrinsic value of a company, the fact is that, by definition, a stock is only worth the price that other investors are willing to pay for it. If investor sentiment has turned against a stock, whether you are right or wrong about the fundamentals really doesn't make much difference."

– Paid-up subscriber David Edwards

Porter comment: The two letters above present the two sides of the trailing stop loss debate. I think both letters present incomplete arguments, however. Neither letter addresses the principle behind stop losses – which is to prevent catastrophic loss.

We endorse trailing stop losses because we know, in almost every situation, they will prevent our readers from taking a catastrophic loss. There are exceptions – like biotech stocks that open down 40% when the FDA rules against them, etc. But these situations are very, very rare. In almost every case, using trailing stops will eliminate the risk of any loss greater than 25% (or wherever you set the stop).

That said, trailing stops are not the only way to limit risk in your portfolio. For instance, you can use options to protect against the possibility of a loss. Diversification and position sizing also mitigate risk. If you're taking a 2% or even a 4% position in a stock, you've certainly got a lot more leeway on what type of risk-management approach to take. Most people can suffer a total wipeout of a 4% position, and it won't ruin their year. On the other hand (as I'll discuss below), for some reason, most individual investors refuse to diversify at all, which is a huge mistake. If you're holding a 50% position in one stock, not even a 25% stop loss is going to save you from a major loss that will wipe out all of your other gains for the year.

There is one significant problem with stop losses: They can take you out of a great, long-term investment unnecessarily. Therefore, I do not apply trailing stop losses to the stocks in the "no risk" portfolio of my newsletter. To qualify for inclusion in that part of my portfolio, a company's balance sheet has to be strong enough to afford additional debt equal to its entire market capitalization. In other words, before I forgo a trailing stop, I make sure the company I'm buying could easily afford to buy back all of its stock at the current price. I limit my "no risk" portfolio to GREAT companies with long-lived businesses that I can easily understand – Verizon, Intel, Nokia, Duke Energy, Exelon, etc. And, finally, I only buy if the company is trading for around half of the most relevant measures of intrinsic value. These rules make it nearly impossible for me to lose money. In fact, my strategy is built with worst-case scenarios in mind, because, if you hold a stock long enough, eventually the worst case will occur. Any estimate of intrinsic value is likely to turn out to be wrong – but more than 50% wrong? Many investors will have more information than I do… but could that information be any more valuable than knowing the company can afford to buy back all of its stock? Sooner or later, every business will run into a tough market, where margins fall and profits suffer. But… if you've bought the right stocks at a great price… you've got nothing to worry about, you can hold on through the down cycle.

As for why you'd want to hold a stock for years, even through hard times, long-term investors reap the benefits of compounding returns. Take our 2002 recommendation of Exelon, for example. If you bought when I recommended it (at the bottom of the market in 2002), you're now earning around 10% a year in dividends alone. Learning how to identify businesses that will be around in five, 10, and 20 years and learning how to buy them so that when times get tough you're not tempted to sell is the key to long-term, compounding returns. And, I believe it's the only sure path to wealth as an investor.

Having said all of this about long-term investing, I certainly wouldn't recommend putting more than 5% of your portfolio into any one of my no risk picks or into any investment without a predetermined stop-loss point. Being diversified will make it much easier on you, emotionally, to hold on for the long term… because it will dampen the volatility of your account balance.

"Porter – I find it moderately interesting (depressing?) that Collins Richey is complaining about your ideas because you pick stocks that grow consistently over fairly long periods of time. The oldest pick on your top 10 open recs is Exelon, which you've held for approximately five years and nearly tripled your money. The longest hold time on your hall of fame (ID Biomedical) is also about five years and gained more than 300%. Either one of those sounds pretty good to me. I will gladly keep most of my money away from hit-or-miss (mostly miss) quick gains in exchange for a few solid stocks that continue to grow and compound. Keep up the good work. And if Richey wants to make 300% in a week, I got a couple e-mails in my spam box that he might be interested in."

– Paid-up subscriber Justin

"I'm sorry, I need some help with this question. I don't have a large amount of capital to allocate, so I've gone with my gut after reading your recommendations. Seems like a perfect way to get 'stuck.' So far, NLY, PPH, DBV, and SA are treating me right, as I whistle past this correction. Maybe they will grow enough that I can plow some profits into some other recommendations. Nobody is perfect in the investment world, but track records matter and a certain amount of perspective goes a long way. What am I supposed to complain about again??" – Paid-up subscriber Roger Erickson

Porter comment: Please understand that my comment about your question is not meant to apply to you directly, but to my audience at large. I think it's wonderful that you've done an outstanding job of "cherry picking" our stock recommendations. I'm very happy for you. However, I also know that the single most common (and catastrophic) mistake most individual investors make is putting too much money in too few stocks.

Think about it this way: Only the world's best, most experienced, and most elite investors run concentrated portfolios. I'm talking about guys like Mohnish Pabrai and Warren Buffett. Even in those cases, they've got at least 10 different major positions. The world's best mutual fund managers, guys like David Dreman and Mason Hawkins, always carry at least 20 major positions.

But… time and time again… I see letters from subscribers who have been investing, at most, for five years on a part-time basis, and they've got… four stocks. Or five. And they all say the same thing: I don't have enough capital to allocate. Well, I can tell you one thing for sure: If you're holding most of your investable assets in only four or five stocks, you're never going to have "enough" capital. Ever. I can also tell you that with brokers charging $10 or less on most transactions, you have no excuse for not owning at least a dozen stocks. (If you only want to own four, that's fine too… just don't put more than 4%-5% of your capital into any one stock. So… the vast majority of your capital will be in cash.) Sooner or later, something really bad will happen to one of your positions. When it happens, if you only have four positions, you'll lose 15%-25% of your savings. That's devastating. It will take years to recover.

I've never understood this phenomenon. It seems exactly the opposite of what it should be: The least experienced investors, who can't afford to suffer any major losses, always seem to take the most concentrated positions, and therefore have a far greater likelihood of a catastrophic loss. But I guess, when it happens, they can blame me. Warren Buffett can't.

"Guns, Water, Food, Fuel... Gold. There's your Armageddon priority chain. Gold is a distant fifth. A good supply of the four (or just the first) will get you all the gold you want when times [are] hard. But seriously, why would I want to hold physical ounces of metal in my safe, local bank, federal bank, or buried in my yard, if I still need a bank or broker to cash it back? And how the hell should I feel safer with an offshore deposit on some island I've never heard of? Hey, you started this. I was doin' jus fine watchin' the four, but my wife says we should know more." – Paid-up subscriber Kris

Porter comment: I think you've made my argument for me. When the dollar collapses, gold will get me all the things I want. But it's awfully hard to pay for a haircut with a gun. Besides, I don't believe the bankruptcy of our government will cause Armageddon. It's funny to me that so many people seem to think that without the government, nobody would be able to get out of bed in the morning or have enough sense to come in out of the rain… Americans can take care of themselves just fine. Instead of thinking about the collapse of the currency as a bad thing, I think of it as a kind of nirvana. Finally, sovereignty will return to its rightful place – with the individual.

"Are you really sure Sjuggerud pioneered stop losses, or is this just more self promotion? Either way, I've always had a problem with your stops. I've never been able to adhere to them or even acknowledge them. If I was to buy an investment and acknowledge a 25% loss straight off, I would never be able to buy anything." – Paid-up subscriber Ken Long

Porter comment: Steve was the first person I saw in the newsletter business who made trailing stops a fundamental, consistent, and central part of his strategy. He took the idea with him to several different publishers, spreading the "religion." I also have seen him pass the idea to several other major newsletter writers, including Chris Weber and dozens of Agora's writers. I believe if you asked people in our industry, they would all say Steve popularized the idea.

However, trailing stop losses have long been a standard technique for trend-following traders. Several books about trading, particularly Dr. Van Tharp's books, contain a lot of information about using trailing stops.

"I am a very new subscriber to the S&A Oil Report. In the last report, Matt recommended a stock with a 25% trailing stop loss. I understand stop losses, but was unfamiliar with the term trailing stop loss. In yesterday's newsletter, you said this was pioneered by Steve Sjuggerud. Because I am not yet a subscriber to Steve's newsletter, can you explain trailing stop losses to me?"

– Paid-up subscriber Amy H.

Porter comment: It's simple: Never allow any stock in your portfolio to decline more than 25% (from its high price in your portfolio). How do you avoid any drawdown larger than 25%? Simple, you sell.

"Americans piss me off [to] no end. They complain and whine about tax rates and then turn around and vote for every tax-hike-loving politician they can because they believe the government can take [care] of any and all problems if it has enough money and passes enough laws. They rear their kids by TV and complain when they turn into promiscuous heathens who are either addicts or drunks. They bitch about inflation and then want the government to keep on borrowing money to provide services that are not the government's proper business. Now, here we have folks griping at YOU because they lost some money. Hellfire, I know I may lose money when I follow your recommendations, but at least you have a REASON, some RATIONALE for why you are putting your money and your reputation behind what you say to buy. I work 50 hours a week… every week in order to pay bills and save for my retirement (BTW, I know where I am retiring to and what I need to retire there plus account for 5% inflation for 40 years. When I get that number, I am done.) There is no way I can do the research you do in the timeframe I need to do it in. Anyways, I appreciate the work you do. Perhaps after I retire to my bit of sandy beach populated by long-haired, almond-eyed, gold skin, pur-dee baby dolls I will take another job locally and invest THAT money just to see if I can do it again. Right now, though, I have no idea how to research companies the way you do. Still, if more Americans spent more time trying to figure out how to DO something, how to MAKE something instead of using OPM or beating the system in no-money-down, no-credit-needed real estate bullshit, America would be truly growing and great again. BTW, can you recommend a book, a primer, that explains options? Sounds a little like Vegas to me, so I must be misunderstanding what I am reading/being told. Do I know what I am talking about? Not a clue. I could be wrong. I do know that I am tired of people attacking others who clearly try to do a good job. In summary, tell your critics to go piss up a rope. I hope you make out on your legal issues."

– Paid-up subscriber Tim Singleton

Where to Put Your Money In a Crisis

by Ian Davis

"This is all noise, you have a bunch of lemmings that run left and right and up and down," said Roland Manarin, a portfolio manager who runs Manarin Investment Counsel. "It is when an absolute panic is going on that investors should get a second mortgage and diversify among stock investments. You just can't follow along with everyone else." – Forbes Magazine, August 3, 2007

While I certainly don't recommend taking out a second mortgage to speculate in stocks, "lemmings" is a good way to describe how U.S. investors behaved in the latter half of July.

Between July 19 and August 3, the S&P 500 index plunged by 7.7%, leaving almost no stocks unhurt.

On July 26, 90.5% of all stocks on the NYSE fell… prompting me to comment on the oversold state of the market in my July 30 Digest article. The S&P 500 is down only 1.4% since July 30.

I believe that the short-term panic is behind us and the coming month will show a rally in stock prices.

But before we move on with our investing lives, let's take a look at which sectors came away from the panic unharmed… and which were pummeled the most brutally.

The Best and Worst Performers

The following table shows the returns between July 19 and August 3 of the five best-performing DataStream sectors… and the five worst.

As you can see, basic-resource stocks took the brunt of the decline… with forestry stocks leading the way.

At the other end of the spectrum, defense stocks were the only ones to come away with a gain, returning 0.5% during the otherwise painful period.

Best & Worst Performing Sectors (7/19/07-8/3/07)

Conclusion

If you are looking to diversify your portfolio into some defensive stocks, a good place to start would be the U.S. Aerospace and Defense sectors. Other good choices include electronic equipment and gold miners.

On the other hand, if you are brave and think the market is going to rebound, you may want to dabble in some of the hardest-hit sectors.

Basic resource companies like forestry and aluminum fell the most… these sectors may be in store for a bounce as the mass panic subsides.

Good investing,

Ian Davis

August 15, 2007

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