The S&A Digest: Would Buffett Buy Countrywide? We asked him.

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(Top 10 highest-returning open positions across all S&A portfolios)

As of 06/27/2013

Warren Buffett in his own words: "Why I'm buying lenders"... Foreclosures on the rise... Natural gas selloff... Big change for the Chinese market... More angry letters... Buy gold?

Was my villa destroyed? As you may remember, our Alliance conference is scheduled for the week after Thanksgiving at the Fairmont Mayakoba, which is just north of Playa del Carmen, Mexico. We picked the hotel because I had a wonderful vacation there in February and... truth be told... because the hotel agreed to let me stay in one of its exclusive beachfront bungalows.

Each villa sits directly on the beach, comes with its own butler, has its own private infinity pool... and carries a nightly price tag that makes private jet travel seem cheap by comparison. It was going to be quite a nice perk... Alas, a Category 5 hurricane slammed into the region last night – there goes my bungalow. No word yet from the Fairmont if it will even re-open by the date of our conference. We'll keep you posted.

Buffett on the move... According to unnamed investors, Warren Buffett may be interested in buying Countrywide Financial (CFC). The company's stock price took a beating in the subprime debacle, and now the largest mortgage lender in the U.S. is trading at four-year lows. Buffett has recently taken an interest in financial companies with mortgage exposure, buying a piece of Bank of America and increasing his position in Wells Fargo, the country's second-largest lender. But rather than merely speculate on whether or not Buffett is buying Countrywide, we asked him. And he told us. See our discussion below.

Foreclosure filings surged 93% nationwide since last year. "While 43 states experienced year-over-year increases in foreclosure activity, just five states – California, Florida, Michigan, Ohio, and Georgia – accounted for more than half of the nation's total foreclosure filings," said RealtyTrac Chief Executive James J. Saccacio. Our dream of buying a beachfront condo in Miami might finally come true. I'm waiting for a seller so desperate he's crying on the phone...

Not over yet... German state-owned Landesbank Sachsen Girozentrale owns $4 billion in investments linked to U.S. subprime mortgages and may lose as much as $672 million. Last week, the German government pumped $23 billion into Landesbank, the second of Germany's banks to receive state funding.

But... Credit Suisse is bullish again. The investment bank upgraded global stocks to "overweight," as prices have fallen in recent weeks. The Morgan Stanley Capital International's World Index fell 11% between July 20 and August 16. Credit Suisse also slapped an "overweight" on the steel industry. The bank's favorite stock in the sector is International Strategist pick Arcelor Mittal (MT). Note: International Strategist is currently available only to Alliance members.

Natural gas prices plunged more than 10% yesterday, the biggest one-day drop in four years. Today, prices have fallen another 3.2%, and September contracts are going for $5.85.

Mexican state-owned Pemex will close 400 oil wells, 2.65 million barrels per day of production, as hurricane Dean passes overhead. Despite the production cut, crude prices fell $0.86, as traders guessed U.S. operations would remain intact.

Beijing will now allow individuals to buy offshore securities for the first time. Investors can open accounts at Bank of China branches across the country to trade Hong Kong-listed securities, whose markets (unlike the mainland's) are globally integrated. The investments will be exempt from a $50,000 limit on the amount of foreign currency Chinese citizens can buy or sell every year. The government hopes these actions will relieve upward pressure on the renminbi. Americans hope the Chinese will buy their mortgages...

New high: Berkshire-Hathaway (BRK-A), an all-time high for any stock, ever.

In the mailbag... No matter what we do, it's sure to offend or enrage someone. In the old 'bag today, we're taken to task for sharing our best ideas with you last Friday... Well, like it or not, we're going to continue to do our best to help all of our subscribers during this tough market. In fact, we've gotten a few good suggestions for our next Correction Opportunity Report, which will be published on Friday. Send us your best idea: feedback@stansberryresearch.com.

"Listened to a fund manager on CNBC on Friday. His investment style and premise of this style is based on his assertion that the big players or 'smart money' comprises 80% of the market and therefore control the direction it takes. His philosophy is to exit the market when they do and re-enter when they do. Please comment on this approach and maybe see what Ian makes of it to back check what the results would be following this technique."

– Paid-up subscriber Ron Ceurvels

Porter comment: I think you'll make a lot more money doing exactly the opposite of what the "smart money" does. And... by the way... did it ever occur to you to think about why a money manager would take the time to appear on CNBC? How about why anyone would share their real investment strategy with millions of viewers, for free? Do you think it's possible that what you see on CNBC might not always be the whole story?

"Why are you giving away info for free half an hour after I receive it in a paid subscription? In Friday's Digest you gave away two recommendations from True Wealth, which I had just gotten. They were both released after market close, so this morning before I have a chance to get in on them, they have jumped +7% each. Don't get me wrong, I don't mind you giving out the names after a few weeks, once I've had a chance to buy, but come on! I feel like everybody got a free lunch but me, and I'd pre-paid for my lunch."

– Paid-up subscriber Jim F.

Porter comment: We got dozens of these e-mails... Calm down, folks. Yes, it's true that often when we recommend something, the market for that security will move. But that's true whether or not we also write about it in the Digest. Besides, the Digest only goes out to paid-up subscribers. We're not giving anything away. (We can't recall a time ever before in which we were accused of being too generous... We're most often lambasted for being "greedy" because we sell some subscriptions at what are perceived to be high prices. Damned if you do... damned if you don't.)

"Porter... I don't understand your bias toward VVR... looking at longer-term charts, I don't see that VVR's NAV is much more stable than that of NSL... but, historically, NSL provides a better yield, less price volatility, and currently a 37% leverage as opposed to VVR's 45% leverage."

– Paid-up subscriber John Langston

Porter comment: We explained why we liked VVR on Friday. But there are several good funds out there, and you're certainly free to choose your own.

"One [fund] that deserves consideration is CHI – Calamos Convertible & Opportunities ETF. Until July, it enjoyed a premium of about 20% to its NAV and has been higher than that. Since it holds a lot of junk bonds it got knocked down, as they were hard to value. It is managed by Calamos Investments, which is the premier convertible manager in the world. It initially sold at $15 when it was issued in 2002 and has pretty much traded between $18 and over $21 for the past 4 years. It currently returns 10.9% in dividends paid monthly. The stock closed today at $16.53, down roughly $3 from where it was in mid-July. Once the credit concerns get resolved, and assuming that CHI doesn't have any truly bad stuff in their portfolio, it could easily rally back $2, providing a 23% return including dividends. I have owned it but sold it off on the way down and am waiting for the financial markets to put in a sustainable bottom, which they have yet to do." – Paid-up subscriber Bob Tanner

Porter comment: We prefer to buy junk bonds when they're paying us a much higher spread over Treasuries. To read about the best conditions for buying junk bonds, read the December 2002 issue of True Wealth.

"Porter and Co., you guys bring authenticity, frankness, humor, an ability to poke fun at yourselves, and real material to the investing world. There is no other that offers the complete package when it comes to the factors affecting the investing markets. Thanks." – Paid-up subscriber Jerry

Porter comment: That's a tremendous compliment... Thank you. We can't know that our advice will prove to be right... but we can deserve to have it turn out right with lots of hard work.

"O'Neil has it all wrong. While diversification is a surrogate for knowledge, it makes good sense. Diversification protects us against that which we do not know, which is far more than we do know... Clearly, concentration investing can make big money; but it also courts ruin. To win over the long-term, you have to be able to stay in the game. Investing is a marathon, not a sprint." – Paid-up subscriber Geoffrey

Porter comment: I certainly agree.

"My portfolio of stocks is quite substantial, both dollars and numbers... With the exception of one company, each individual stock I own represents no more than 4% of the total portfolio, so I am very diversified. Now I'm worried that maybe I hold way too many individual stocks. I'm an Alliance member and have and will buy companies recommended by any and all of your writers if I like a particular recommendation. I also do lots of options trading – covered calls and naked puts. If I were to reduce the diversity of the portfolio to fewer stocks, like maybe 30-40 and/or a 60% max exposure, where would you suggest I look to next?" – Paid-up subscriber Ron Martin

Porter comment: Ron... I can't answer your question. Even if I were allowed to answer, I don't have nearly enough information to say anything intelligent about your portfolio. It sounds like you're a man of some means. You could certainly afford to pay for an independent personal advisor to look over what you've got and make a few suggestions. I'd recommend sitting down with someone once a year or so. Assuming you can pay a flat fee (instead of a percentage of your assets), it's worth every penny.

"Hi. I bought a subscription last year with Jeff Clark, looking for advice on gold... Last month, I used Jeff's advice to play the ABC correction. The accuracy was uncanny. Although I didn't invest much, I did manage a good return. Reading your feedback, which seems to come from people who understand the market better than I do, why the crying? I felt my buy and sells were naive, but sloppy as they were, I more than doubled. If Jeff can predict these ABC corrections this well, where is the problem? And yes, I'll use part of the earnings to continue the subscription... Thanks for a great month." – Paid-up subscriber Anonymous

"Stop cluttering my in-box every day!!! Send bulletins/messages ONLY when you have something REALLY IMPORTANT to say. Turns out this is rather rare for you!" – Paid-up subscriber RHP

Porter comment: One man's trash is another man's treasure. If you don't want to read our e-mails, just follow the instructions at the bottom of each e-mail to unsubscribe from the list.

"Hey gang! Just subscribed to True Wealth, and it has been an eye-opening experience. For so long my fiancée and I have let faceless managers control our money and our retirement future. We are now trying to take control of our own destiny. One question we do have has to do with investment size. A lot of times I read of investors plunking down tens of thousands of dollars and doing great. I'm wondering if you have any different advice for the small-time investor than you have for the heavy hitters, or if the advice is the same and hopefully by following it and common sense we will graduate from small fry to Big Shots over time." – Anonymous

Porter comment: We offer lots of advice on position sizing and risk management... You can read more about it here.

"Having served as the portfolio manager of an investment advisory firm that managed $65 million of OPM (other people's money), I have experienced many of the things that Porter deals with on a regular basis. Inflated egos aside (and most successful investors have them), Porter is providing his readership with an unusually candid view of what goes on behind the scenes in the investment world – pay attention, you will not find this stuff in the WSJ or Forbes. No one is always right in this business, and while good advice is soon forgotten, bad advice lives on in infamy – believe me, I know this from personal experience... What makes the investment game interesting to me, are not the numbers but the emotional and psychological factors – it is truly theater on a large stage, and Porter is one of the better 'actors' I have come across, and I say this in the spirit of Sir John Gielgud. He is not lacking in intelligence, conviction, or passion, but this does not mean he is always right... This is a tough game, and remember that only the minority get rich. If this were not the case, then all of us would be wealthy. Give credit where it is due and be thankful for the things you learn along the way." – Paid-up subscriber Peter von Raits

"I'm relatively new to S&A and am starting, albeit slowly, to get used to your style of non-stop marketing. I've come very close to pulling the plug on a couple of occasions, but then something comes out from Dan Ferris, and I stay put. I like the direct, no-nonsense approach of Dan's letters. It seems incomprehensible to me that such a sensible guy would hook up with such a marketing machine – but perhaps you need each other. I also appreciated the write-up on the sub-prime loan implosion. It was the clearest and most logical explanation of the U.S. mortgage mess that I had read anywhere! Porter, nice to see that you can write well too (when you need to!). I thought of Dan when I saw this quote: 'The stock market is a device for transferring money from the impatient to the patient.' (Mark Twain)" – Paid-up subscriber Wendi

Porter comment: Our "nonstop" marketing is precisely what allows us to recruit, retain, and compensate the talented editorial staff we're very lucky to have. You might be surprised to learn that, inside our industry, our marketing is thought to be among the very best.

"Thanks for your insight regarding William O'Neil's method of trading and using stops. I learned first-hand how this can cost the average investor. Although I had some success with the method, in the end I still lost more than I made... By the way, what really convinced me to drop IBD's trading method was when I paid a few thousand for a seminar of chart reading and all I heard from people was they desperately wanted to get rich NOW – not later. Some were taking outlandish risks with their money." – Paid-up subscriber Alan Kahn

"OK, your comments in The S&A Digest on Monday finally shamed me into writing you a note. As you know, I've been a subscriber of yours since the beginning and an Alliance member since it was first offered. We've shared some good times at conferences as well as in Argentina. I'm happy for your success and only hope that you and your team continue in the growth of your 'empire.' I read just about everything that comes out of your company. I agree with much of it, but there is plenty of room for debate. I was very intrigued by your comments on August 16 regarding your personal portfolio. You indicated that you owned very few stocks and that 25% of your money was in cash, 45% of your money was in short positions, and 30% of your money was in long positions. This raised several questions. First, your newsletters recommend hundreds of stocks at any given time, but there are very few short recommendations. Other than some trading recommendations from Jeff Clark, you could count on one hand the number of short ideas (from Steve and yourself). It seems to me that there should be a better balance between shorts and longs. Without knowing the specifics in your portfolio, I would be really interested in your approach to your portfolio. It is certainly the right call at the moment. Second, you indicated that you often only hold 4-6 stocks. That seems very inconsistent with what you tell your subscribers. Third, I would like more discussion of asset allocation. Although having said that, I really like your quarterly Alliance portfolio as well as some of your recent lists (top recommendation by each editor, or top 4 stocks to own after the correction last week). Keep this up." – Paid-up subscriber Tim L.

Porter comment: Hi, Tim... nice to hear from you. Hope you'll join us again this year in Mexico. (Tim, by the way, was a very successful engineer who struck it rich working for microchip companies in the 1980s and 1990s. Today, he lives quite a life, managing his portfolio and traveling around the world.) To answer your question, I run a focused portfolio because I am a full-time equity analyst who spends all day, every day, looking at securities and reviewing the work of other security analysts. Over 12 years, I've learned to read financial statements thoroughly – something most investors can't do for themselves. Thus, I have both the opportunity and at least some of the ability (I hope) to make more focused investment choices. But, what's appropriate for me isn't appropriate for the typical investor.

Regarding short-sell positions, as you know, making these recommendations during the raging bull market we had (until July) is extraordinarily difficult. You should expect to see more short-side analysis from us going forward... but... it's still very, very hard to make money shorting stocks. The timing is twice as difficult to get right. The best we can really hope to accomplish is to show subscribers which companies (GM, for example) have such huge financial hurdles that they're likely to fail.

"Everything that a gold investor ever wanted is happening. No one wants to touch any commercial paper other than Treasury bills. The largest drop in yield in 60 years in one day. If you are scared of commercial paper that a company issues, why in the world are you lining up to buy the common stock of the same company? In the end, if people and institutions are panicking over the same paper owned by the money market funds, does that not tell you there is going to be a run on the funds?" – Paid-up subscriber Larry

Porter comment: Then why has the price of gold declined during this crisis?

Would Buffett Buy Countrywide? We Asked Him.

"I'm definitely more popular than I was a few months ago," Warren Buffett remarked to The Wall Street Journal yesterday. "But I started from a low base."

Speculation on Wall Street says Buffett is probably buying the best mortgage assets that have been marked down – like the $20 billion of top-ranked mortgages that Thornburg (TMA) sold yesterday.

But the big question is whether or not Buffett will buy a large stake in Countrywide Financial (CFC), the country's largest mortgage originator by volume.

During the last real estate crisis (1990), Buffett bought every share of Wells Fargo (WFC) he was allowed to buy without getting permission from the Federal Reserve. Then, in 1991, he went and got permission to buy more, as the crisis deepened and Wells Fargo's price continued to decline.

Although we can't know how bad the subprime residential mortgage debacle will become, it's hard to believe it will end up being worse than the commercial real estate bust of the early 1990s. By 1993, more than 1,500 federally insured banks had failed. Southern California was the epicenter of the crisis: 22% of Orange County's office space was vacant by 1990. Half of Wells Fargo's real estate loans were in Southern California, leaving it with two and half times the exposure of its nearest competitor, Bank of America. By the end of 1990, Wells Fargo's share price had fallen by 50%.

Buying it all the way down earned Buffett a 24% compound annual gain over the next 16 years (pretax). If you had put $100,000 into Wells Fargo alongside Buffett in 1990 and 1991, you'd be sitting on $3.1 million today.

Given these facts, it seems worthwhile to examine the circumstances that led Buffett to buy Wells Fargo and compare those factors to today's situation and Countrywide Financial. All of the Buffett quotes (below) were taken from Berkshire Hathaway's 1990 letter to shareholders.

My conclusion? Things at Countrywide are likely to get worse. And I wouldn't be surprised to see the share price fall even more over the next 12 to 18 months. But... my bet is the company will survive. I wouldn't be surprised to learn that Buffett is, in fact, buying...

Buffett: Lethargy bordering on sloth remains the cornerstone of our investment style: This year [1990] we neither bought nor sold a share of five of our six major holdings. The exception was Wells Fargo, a superbly managed, high-return banking operation in which we increased our ownership to just under 10%, the most we can own without the approval of the Federal Reserve Board. About one-sixth of our position was bought in 1989, the rest in 1990.

Porter comment: Countrywide's chairman, Angelo Mozilo, built Countrywide from scratch. He's widely regarded as the most accomplished mortgage banker in America. Countrywide is well managed, earning annual returns on equity in excess of 30% in good years and 19% last year, despite very tight mortgage spreads. (Wells Fargo earned 20% on equity last year.)

Buffett: The banking business is no favorite of ours. When assets are twenty times equity – a common ratio in this industry – mistakes that involve only a small portion of assets can destroy a major portion of equity. And mistakes have been the rule rather than the exception at many major banks. Most have resulted from a managerial failing that we described last year when discussing the "institutional imperative:" the tendency of executives to mindlessly imitate the behavior of their peers, no matter how foolish it may be to do so. In their lending, many bankers played follow-the-leader with lemming-like zeal; now they are experiencing a lemming-like fate.

Porter comment: Currently, Wells Fargo employs a 9.6 to 1 equity-to-debt ratio. Countrywide Financial is significantly more leveraged. As of its last quarterly statement, the company was leveraged 13 to 1. Of greater concern are the assets into which the company has leveraged itself. Countrywide (as of the end of 2006) held $78 billion worth of mortgages as investments on its balance sheet. That's up from only $6 billion in 2002. Rather than following the lemmings, Countrywide has been leading the charge – much like Wells Fargo did in the late 1980s in commercial real estate.

Buffett: Our purchases of Wells Fargo in 1990 were helped by a chaotic market in bank stocks. The disarray was appropriate: Month by month the foolish loan decisions of once well-regarded banks were put on public display. As one huge loss after another was unveiled - often on the heels of managerial assurances that all was well - investors understandably concluded that no bank's numbers were to be trusted. Aided by their flight from bank stocks, we purchased our 10% interest in Wells Fargo for $290 million, less than five times after-tax earnings, and less than three times pre-tax earnings. Wells Fargo is big – it has $56 billion in assets – and has been earning more than 20% on equity and 1.25% on assets.

Porter comment: Over the last year, one mortgage broker after another assured the market that the loans it retained on its books were sound and that its dividend would be maintained. Then, one after another, they promptly went broke. But, like Wells Fargo, Countrywide is big and profitable. It has $200 billion in assets and, last year, earned 19% on its equity and 1.3% on its assets.

Buffett: Our purchase of one-tenth of the bank may be thought of as roughly equivalent to our buying 100% of a $5 billion bank with identical financial characteristics. But were we to make such a purchase, we would have to pay about twice the $290 million we paid for Wells Fargo.

Porter comment: At the bottom in 1990, Wells Fargo was trading for 0.86 times book value and five times earnings. Countrywide is currently trading at 0.79 times book value and six times after-tax earnings. Its market cap is $12 billion. SunTrust (STI), a bank of similar size ($182 billion in assets), would cost more than twice as much. SunTrust's market cap is $28 billion; it's trading at nearly three times book value and for more than 12 times earnings.

Buffett: Of course, ownership of a bank – or about any other business – is far from riskless... The market's major fear of the moment is that West Coast real estate values will tumble because of overbuilding and deliver huge losses to banks that have financed the expansion. Because it is a leading real estate lender, Wells Fargo is thought to be particularly vulnerable. None of these eventualities can be ruled out... [But] even a meaningful drop in real estate values is unlikely to cause major problems for well-managed institutions. Consider some mathematics: Wells Fargo currently earns well over $1 billion pre-tax annually after expensing more than $300 million for loan losses. If 10% of all $48 billion of the bank's loans – not just its real estate loans – were hit by problems in 1991, and these produced losses (including foregone interest) averaging 30% of principal, the company would roughly break even. A year like that – which we consider only a low-level possibility, not a likelihood – would not distress us. In fact, at Berkshire we would love to acquire businesses or invest in capital projects that produced no return for a year, but that could then be expected to earn 20% on growing equity. Nevertheless, fears of a California real estate disaster similar to that experienced in New England caused the price of Wells Fargo stock to fall almost 50% within a few months during 1990. Even though we had bought some shares at the prices prevailing before the fall, we welcomed the decline because it allowed us to pick up many more shares at the new, panic prices.

Porter comment: Last year, Countrywide earned $2.6 billion, after a $261 million allowance for loan losses. If 10% of Countrywide's mortgage loans held for investment were hit by problems in 2008 and these problem loans produced losses averaging 30% of principal, Countrywide would lose $2.3 billion on its loan portfolio in 2008. Ergo, like Buffett and Wells Fargo, we'd expect Countrywide to roughly break even, despite a huge increase in its loan losses.

However, we also recognize that Countrywide has engaged in truly irresponsible lending practices. The riskiest portion of Countrywide's portfolio is its big holdings of "pay option" adjustable-rate mortgages, which allow homeowners to forgo making payments until the size of the loan is equal to 115% of the original loan amount. Countrywide holds a total of $32 billion of these "you've gotta be kidding me" loans. Nearly all of the loans ($28 billion in total principal) have some accumulated negative amortization. In total, Countrywide is holding $653 million in total negative amortization.

I expect that many of these loans (and all of the negative amortization) will eventually become problematic. If we assume 20% of these loans will default, the negative amortization will never be repaid, and Countrywide will only be able to recover 50% of the principal owed, the company would sustain $8.6 billion in losses, representing about four years' worth of earnings. Assuming the worst in its pay option portfolio and a bad result in its other loans, we see the company's total eventual provision for bad loans made between 2002 and 2006 will total between $10 billion and $15 billion. Admittedly, this is a wide estimate. Nevertheless, whether the loss turns out to be $10 billion or $15 billion doesn't really trouble us all that much: Countrywide has $40 billion in cash on its books.

Buffett: Investors who expect to be ongoing buyers of investments throughout their lifetimes should [welcome declines in share prices]; instead many illogically become euphoric when stock prices rise and unhappy when they fall. They show no such confusion in their reaction to food prices: Knowing they are forever going to be buyers of food, they welcome falling prices and deplore price increases. (It's the seller of food who doesn't like declining prices.) Identical reasoning guides our thinking about Berkshire's investments. We will be buying businesses – or small parts of businesses, called stocks – year in, year out as long as I live (and longer, if Berkshire's directors attend the seances I have scheduled). Given these intentions, declining prices for businesses benefit us, and rising prices hurt us. The most common cause of low prices is pessimism – some times pervasive, some times specific to a company or industry. We want to do business in such an environment, not because we like pessimism but because we like the prices it produces. It's optimism that is the enemy of the rational buyer. None of this means, however, that a business or stock is an intelligent purchase simply because it is unpopular; a contrarian approach is just as foolish as a follow-the-crowd strategy. What's required is thinking rather than polling. Unfortunately, Bertrand Russell's observation about life in general applies with unusual force in the financial world: "Most men would rather die than think. Many do."

Porter comment: Very few investors have the brains, the fortitude, or the patience to be successful long-term investors. That's why there's always plenty of opportunity for those who do have these traits.

Regards,

Porter Stansberry

August 21, 2007

Baltimore, Maryland

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