The secrets of financial asymmetry...

Elon Musk's other 'green energy' farce…

In yesterday's Digest Premium, we described what makes SolarCity a good short candidate. The company was launched by PayPal co-founder, Elon Musk. In today's issue, we investigate another short candidate Musk created…

To continue reading, scroll down or click here.

Elon Musk's other 'green energy' farce…

In today's Friday Digest... I'm going to discuss "financial asymmetry." Yes, really. And yes, I can hear the groans through the ether. I imagine everyone clicking out of this e-mail and wondering why they subscribed in the first place. Surely our phones will be ringing off the hook with cancellation demands on Monday.

But remember... I write these Digests personally. I continue to work hard at writing my newsletter every month because I'm driven to share with you the information I'd want, if our roles were reversed. That's truly my passion in life. I don't work this hard anymore because I need the money. It's simply what I love to do.

And I think, if you'll just give me a chance today, I can show you something that's truly amazing... something that will absolutely change your life as an investor. It's not hard to understand. It's not complicated. But it violates almost everything you've ever been taught about the way the markets work... about the way life works.

But... as I'm reminded all too frequently... there is no such thing as teaching. I can't make you read this. And I surely can't do much to help you understand it. You've got to be willing to open your mind a bit... to take five or 10 minutes... and really think about the things I'm about to tell you. I sincerely hope you will. But it's totally up to you.

What the heck is "financial asymmetry"... and why should anyone care about it? Most of the time, people use the word "symmetrical" to describe physical things that are balanced. Interestingly, people prefer symmetry. Behavioral studies prove this: People with nearly symmetrical faces are consistently rated as being "more attractive." The same is true for architectural designs, like bridges and buildings. And although I can't prove it, I believe humans innately believe in philosophical symmetry. Most people believe you get what you deserve. They believe in some kind of cosmic balance.

But... nature doesn't agree. Asymmetries are found in almost every part of the natural world. Take your body, for example. Your left lung is smaller than your right lung – it's missing one whole lobe. Your lungs are built this way because your heart is asymmetrical, too. The left side is larger than the right. Interestingly, almost all biological organisms are asymmetric in at least one dimension. The imbalance develops because of the way cells divide.

In chemistry, certain molecules are "chiral" – they are asymmetric. They cannot be superimposed upon their mirror image. Fundamental physical asymmetries exist in particle physics, too (known as "parity violation"). I'm not going to get into particle physics, don't worry. But the example is important to remember. The world frequently doesn't work exactly like the models suggest it should. Asymmetry is actually the norm, despite the human preference for symmetry.

In finance, the critical symmetry we're taught is between risk and reward. This makes sense to us intuitively. And we want to believe it. It seems fair. If you want to succeed, surely you have to take big risks. But that's complete nonsense. Let me give you several simple examples.

In our studies of highly capital-efficient businesses, we've found that investors who simply reinvest their dividends can consistently earn returns of around 15% a year. (We've doubled our money in Hershey since January 2008, for example, which is just a tad faster than we expected.) That's simply investing in high-quality, low-risk, brand-name stocks like McDonald's, Hershey, Heinz, and McDonald's.

We delve into the topic of capital efficiency in greater detail in the latest issue of my Investment Advisory, which will be published today... But the key thing to understand is that buying into businesses like McDonald's, Hershey, etc., at reasonable prices is just about the safest thing you could ever do with your capital. And 15% annual returns are far in excess of average returns. Pairing this extremely safe approach to investing with the capital-raising power of insurance made Warren Buffett one of the world's richest men. There's simply no way that would have happened if risk truly equaled reward in finance.

Here's another real-life example. Most of the people I know personally who have made a lot of money investing have done so by financing companies directly on terms that were absurdly unfair. The more unfair, the better. Typically, companies that need a lot of capital (say, to drill a new oil well or find a new gold mine) will sell stock directly to individuals at a price that's well below the market price of the stock.

So if the shares are trading at $10, the financing might close at $8. Right off the bat, these private financiers are taking far, far less risk than they would buying the shares in the market. But that's not the only advantage. They also demand (and usually get) "warrants" in the stock. Warrants are call options that never expire. As you may know, the price of an option is determined by duration (time) and the volatility of the stock in question. An option that never expires on a highly volatile stock is worth a lot. But my friends get them for free, as part of the deal. These guys are taking on a lot less risk than regular investors.

In these deals, there's tremendous financial asymmetry. They're buying stock at less than the market price. They're getting a call option for free. If the stock simply stays where it is, they'll make a small gain. If the stock goes up a lot, they'll make a bloody fortune. You don't need many deals like these to pan out well to earn a significant fortune in the market. I happen to know a few guys who've done it... several times.

And that got me to thinking... there's got to be a way for regular, individual investors to do the same kind of thing. I've been working on this problem for a long time – several years. I would much rather you get terms like these when you buy into my recommendations than simply paying the market price. I would much rather give you the advantage of this asymmetry – less risk, more return.

I already know that the vast majority of you – probably about 90% – will never believe me when I tell you what I've recently figured out. You'll continue to believe that risk is always balanced with reward. That's what makes sense. That's what your broker told you. That's what the finance professors teach. Well... I know for a fact that it's not true.

I know from my studies of the markets. I know from my friends' investing results. And I know because I personally found an anomaly in the options markets. It's an anomaly that allows almost any investor, at almost any time, on almost any stock they want to own, the opportunity to invest with lower risk and earn profits that are far greater than what's possible by just owning the stock outright.

Like I said, I don't expect you to simply take my word for it. So I've put together a three-part e-mail series about this anomaly and how to trade using it. I call the strategy "Alpha."

In finance, "alpha" is the excess return you earn, above the market's return, per unit of risk. This anomaly I discovered, quite simply, will allow you to invest in the markets with less risk, while potentially earning bigger returns. Yes, you've still got to pick the right stocks. This strategy can't turn a bad track record into a winner. But... it can take a fairly safe portfolio... and turn it into a world-beater. Look for these e-mails over the next couple days. You should have already received the first one. The next two will arrive this weekend. If you're interested in learning more... read them. If not, no problem. Like I said, there's no such thing as teaching. There's only learning. It's up to you.

One more thing about financial asymmetry. We look for asymmetry in terms of risk and return. We want investing opportunities where the risks are very limited, but our returns have the potential to be very large. The same ideas power the management teams at Fortune 500 companies. But... the way some of them go about developing this financial asymmetry can be very detrimental to your wealth. Let me give you an example...

When Meg Whitman was CEO of eBay, she paid $3 billion for Skype – a company whose software allows customers to speak over the Internet for free. The company had no material revenue, nor a viable business model. It didn't appear to fit with eBay's business in any way. Two years later, Whitman was forced by her auditors to recognize a $1.4 billion loss on the investment.

Later, after she had joined Hewlett-Packard (HP), Whitman approved or orchestrated the acquisitions of IT giant EDS (as a board member), smartphone maker Palm (as CEO), and software company Autonomy (as CEO). HP paid around $26 billion for these companies.

HP accountants have determined that HP overpaid by at least $19 billion for these three companies alone. That's right… $19 billion of investment losses on Whitman's watch. Today, the entire company is only worth $28 billion.

Some of the deals were so bad that, even at the time, they were laughable and widely mocked. For example, of the Autonomy deal, Oracle Chairman Larry Ellison said, "Autonomy tried to convince us to buy their company... we thought $6 billion was way too much... and HP just paid twice that!" Just to prove its point, Oracle even set up a website called "Please Buy Autonomy."

Corporate investment losses are one of Wall Street's dirty secrets. You'll hear very little about them from mainstream financial analysts. Why? Putting these deals together generates hundreds of millions worth of profits every year for Wall Street. These are the deals that make investment banking such a lucrative trade. Nobody on Wall Street wants companies to become more capital-efficient or to return more money to shareholders. They want more deals. They want more fees. And so, nothing negative is ever said about the number and magnitude of very poor investments made by public corporations.

The even bigger problem for shareholders is the compensation structure for top CEOs. There's tremendous asymmetry between the risks they take with the shareholders' money and the risks they face personally. The compensation structure of most of the S&P 500 CEOs allows them free access to the retained earnings of their companies. That means, if they make good investments and earnings increase, they can make huge, windfall gains from their stock options. On the other hand, if they make horrible investments with the company's capital, they're likely to be fired... and receive a huge, windfall exit package.

The scale of this problem is not widely appreciated because Wall Street downplays it and very few investors really understand the damage big corporate investment losses will have on their returns. How big are these losses? So far in 2012, S&P 500 companies have written off $40 billion in investment losses.

Here's the good news. You can completely avoid this enormous risk by simply focusing on companies that are capital-efficient. These companies generally don't do big deals, mostly because they get a much higher return on capital by simply reinvesting in their own shares.

We think focusing on capital efficiency is particularly important right now. Corporate America is sitting on a ton of cash. Deloitte, the international accounting and consulting firm, recently released a study about the cash balances of the S&P 500 and large investment groups. They found…

• S&P 500 cash balances are currently at record highs – and represent nearly 10% of total assets. This is more than double the average for the preceding 14 years... and more than triple 1998 when cash made up around 3% of total assets.
• Private-equity funds are looking to deploy around $500 billion in capital. That's compared with 2008, when private-equity activity was negligible.
• Leveraged buyout loan volume exceeded $52 billion in 2011... compared with $5 billion in 2009.

Buffett once noted that management with money to burn on acquisitions "behave like teenage boys who just discovered girls." Corporate America certainly has money to burn right now.

In an environment like this, you want to be very wary of which companies (and managements) you partner with. All kinds of cash sloshing around can create bidding wars, so it's especially important to steer clear of companies with histories of impairment charges. Instead, gravitate toward level-headed managers who have shown a history of demonstrating capital efficiency.

New 52-week highs (as of 12/13/2012): iShares Singapore Fund (EWS) and Hershey (HSY).

In the mailbag... a great question about investing in high-quality, capital-efficient companies. Although we can't reply directly, we do read all of your e-mails. Please send your praise, your blame, your rants... and your sincere questions here: feedback@stansberryresearch.com.

"Porter, thanks for the Hershey recommendation. I bought it for my wife's IRA because it is a very faithful dividend payer/raiser, and because one or more of your newsletters was recommending it. (I think PSIA recommended it in December 2009, when I bought it for $35.30.) Because of your lessons in capital efficiency, it seemed like a great stock for her to have in another 15 or 20 years. It's been my favorite investment, because it has been the ultimate sleep-at-night investment.

"My question is about exit strategies with such a stock. It just reached another all-time high. (It's well over a double for me, even without the lucrative dividends.) But I am having qualms in this case about the trailing stop strategy you taught me. It would seem foolish to sell such a fantastic company if it were ever to drop 25%; my preference would be to celebrate a 50% sell-off, rather than honoring my trailing stop. If I continued to hold it, I would continue to receive a dividend that has risen now to 5% of my purchase price, paid very faithfully. It seems irrational to let the market force me out of a stock I want in our portfolio 20 years from now. When by that time my yield will probably be over 20% of my cost basis! What are your thoughts on this? I'm open to your changing my reasoning." – Paid-up subscriber Timothy Schroeder

Porter comment: That's a great question, Tim. I applaud you for having the foresight and the discipline to invest during the fall of 2008, when most other investors were running for the hills. You've set yourself up to enjoy massive, compounding gains over time.

And yes, you're certainly right... you don't want to sell shares of Hershey bought at an attractive price. You know that dividend will continue to increase and you know your results will accelerate through time, thanks to the magic of compounding. Here's what we recommend in regards to long-term investments that pay good dividends.

First, keep using a trailing stop loss. But the key is to adjust the stop point lower as dividends are paid. Your stop becomes 25% plus all of the dividends that have been paid. We first recommended Hershey in January 2008 at $40.55. We have a total of $6.18 in dividend income. The stock's most recent new closing high price is $73.70. A 25% trailing stop would tell you to sell the shares if they closed below $55.27. But... the dividend you've received gives you a further $6.18 cushion. You should adjust your stop, therefore, to $49.09.

Two more thoughts about this...

We recommended Hershey just before the worst stock market collapse since the Great Depression. Even so, we didn't stop out of the shares. My point is, if we didn't stop out in 2008, I believe you're unlikely to ever be faced with this decision, especially given the substantial dividend that will surely continue to grow.

But if something does go seriously wrong... I believe you should be prepared to sell. I don't think it will happen... but if it does, you've got to remember the first and only iron law of investing: Don't lose money. Trailing stops will prevent you from any possibility of a capital loss in a situation like this where you're up, quite a bit, on a good stock. Follow the rules and you'll do well. Break them and you'll pay – sooner or later.

Regards,

Porter Stansberry

Baltimore, Maryland

December 14, 2012

The secrets of financial asymmetry... And the risks of financial asymmetry in the boardroom... How to find less risk and higher returns in the options market... In the mailbag: A great problem to have... How to handle a stock you've doubled your money with...

Yesterday, we talked about the latest solar power initial public offering (IPO), SolarCity (SCTY). The company was launched by PayPal's billionaire co-founder Elon Musk.

We think solar power is a sham… And we think SolarCity, which jumped nearly 50% on its first day of trading (and is up another 1% today) will eventually make a great short.

Musk has another publicly traded company, Tesla Motors (TSLA), which is an equally attractive short candidate.

In his October issue of Extreme Value, Dan Ferris discussed Tesla's shortcomings… He had just seen a presentation on the company at the Value Investing Congress in New York City. As Dan outlined in the issue, the company has three strikes against it…

Let's dig a little deeper into the numbers… In 2009, Obama extended Tesla a $460 million line of credit. As of June 30, the company has already borrowed $432 million of that money. (It's probably gone today.)

And the company recently reported it expects between $400 million and $440 million in sales of its Model S sedan this year (that's down from $560 million to $600 million in projected sales earlier this year).

Sales have grown 82% the last two years, which is great. But expenses have grown more than 400%. And losses have grown 357%. The company lost $254 million last year on $204 million in sales.

In the first three quarters of this year, the company lost $306.3 million on $106.9 million in sales. As the company sells more cars, its losses accelerate.

Because the company is losing money, it's having trouble paying its loan to the government. It filed a Securities and Exchange Commission document modifying the loan covenant and payment schedule.

The company is far from the scale it needs to make money. And given today's economic environment, you have to wonder if there's enough demand for expensive electric cars (Tesla's cars cost between $50,000 and $98,000… And that's after government tax credits).

Today, 58.9% of the company's float is sold short. Despite the heavy short pressure, the stock has marched toward new highs. Today, it's expensive to sell the stock short (because the short demand is so high). In October, it cost 32% annually to borrow shares of Tesla to short. So, if you short $100,000 worth of shares, it will cost you $2,667 a month to remain short.

Keep this stock on your radar. It's too expensive to short today (and we don't see a catalyst for the downturn). But we'll keep you updated on the position.