A Digest to save...

A Digest to save... My core strategy... Capitalism is about capital... Why Xerox is going broke... Plus, in the mailbag: the clients we can't serve…

In today's Friday Digest... I want to start by asking, "What's the single most important variable in the stocks you buy?" This is an important question. Perhaps the most important of all...

Here's a quick warning... If you don't know what your core investment strategy is, right now, right off the top of your head… you may not have one. And if you don't... you're in trouble. Serious trouble.

Lots of strategies will work. None will work in every kind of market. But "no strategy" doesn't work in any market. So... today... let's take a closer look at my core strategy. Let's find out how it compares to several other popular approaches and how it compares to yours.

Every investor has his "toolkit" – the metrics and analysis he'll use to determine if a particular stock is right for him. Successful folks with long careers end up being known for their toolkits as much as for their track records.

For example… David Dreman, who spoke in October at our last Alliance meeting, is known for seeking out stocks with low price-to-earnings (P/E) ratios.

Those are stocks whose market capitalization – the total value of all of their shares outstanding – is relatively low compared to their annual earnings. Low-P/E stocks typically trade for less than 10 years of earnings…. sometimes, much less. Dreman's approach works, as he's proven over several decades. (See the latest version of his classic book, Contrarian Investment Strategies: The Psychological Edge for all of the proof you'd ever need.)

My colleague Dr. Steve Sjuggerud has become rightly famous for his mantra of "cheap, hated, and in an uptrend." Sjug, as we call him, (pronounced like the first syllable of "sugar") uses these simple words to describe a pretty complex mix of value, sentiment, and trend – factors that are well-known to influence stock prices.

I've watched over the last 15 years as he's perfected this approach. It definitely works, as thousands of our subscribers could tell you. And it works in all kinds of markets (commodities, currencies, real estate, etc.), not just with stocks. That allows Sjug to show people lots of alternatives to investing in stocks, something that's made his newsletter True Wealth one of the safest available.

Another colleague, Extreme Value editor Dan Ferris, has amassed a truly incredible track record (double-digit annual gains over the last decade, when stocks, on average, did essentially nothing) without using trailing stop losses. Dan focuses on buying super-high-quality businesses – what he calls "World Dominators" – when they trade at low multiples of cash flow or at a discount to book value.

His strategy features an almost child-like simplicity... just buy the best businesses and wait. But of course, if it were really that easy, we'd all be rich. Dan excels by being able to distinguish which kind of "warts" are truly a detriment to the company's intrinsic value and which are not. Wal-Mart's Mexican bribery scandal this year is a perfect example…

Despite the hit Wal-Mart's shares took, Dan argued that the case (though embarrassing) posed no long-term threat to the global retailer. It afforded investors a great chance to buy the stock at a hefty discount.

My core approach is something altogether different... I believe in capital efficiency, which is based on an analysis of a company's cash flows. How much cash does the company generate per unit of sales? How much of that cash is required to grow the business? How much is returned to the company's real owners?

I believe capitalism is about capital – how much you earn and how much you keep. I believe that investors ought to be capitalists. At the end of the day, I believe capital efficiency, or the lack of it, is what drives all the other metrics – the technicals, the sentiment, the trends, etc.

Let me show you what I mean, with a real-life example. On lots of different metrics, Xerox would seem like an attractive business for investors. It is a brand-name business with a long and steady operating history. It has paid cash dividends for decades and decades. And it's increased its dividends repeatedly. Its stock is super-cheap by almost any metric. The shares have a P/E of only six, based on next year's forecasted earnings (or 7.5 times trailing earnings).

Comparing its cash flow with its enterprise value, it looks even cheaper – only 5.5 times. The stock price isn't even large enough to cover the company's existing book value. That's right... this stock trades at nearly a 30% discount to book. It is, according to every measure, dirt-cheap.

As I'm sure Steve would agree… the company is definitely hated. Its stock price has a recent peak in 2007 at $20 a share. Today, it trades for far less than 35% of that price – below $7 a share. But… Steve would also tell you, the shares aren't yet in an uptrend, so he wouldn't buy.

What I can tell you might be worth a bit more than that good advice... You see, I don't believe Xerox will ever see an uptrend. I believe the company will go bankrupt. Capital efficiency is why…

The company is like a black hole of capital. Money pours in... and disappears forever.

The business, which was once based on its eponymous copying machines, has grown and developed into a full-service IT company. This is a tough business because technology changes rapidly. To stay current and competitive, Xerox must continually invest in new products and services. Frequently, it buys smaller companies to acquire new lines of business.

This looks good on paper because it helps drive sales and earnings growth. Sales are up from $15 billion in 2009 to $22 billion today. Free cash flow in 2011 was nearly $2 billion. Almost half of this cash was returned to shareholders in the form of buybacks ($687 million) and cash dividends ($287 million).

On paper, the company looks reasonably profitable. It seems to have a fair payout ratio. It would pass almost all the tests of value investors. It would pass almost all the tests of price-to-earnings investors. But it fails the most important test of all...

Since 2007, Xerox has spent $9.1 billion to acquire 41 other companies, including $6.5 billion in 2010 on Affiliated Computer Services. More than $5 billion of this purchase was allocated to "goodwill" on Xerox's balance sheet. All told, Xerox's goodwill now totals $9 billion – an amount that's substantially more than its market value. Not surprisingly, the company also carries just over $9 billion in debt, giving it a huge debt-to-equity ratio of 73... and leaving it with net tangible assets of just $31 million.

A slew of famous value investment firms have piled into the stock, including Dodge and Cox, Greenlight Capital, and Franklin Resources. Normally, when successful investors like these buy into a stock, the management teams will feel pressure to "do something" about the low stock price. We believe that's why you've seen a big increase in the size of Xerox's share buybacks.

I believe its efforts are far too late to save the company for two simple reasons. First, too much money was borrowed to buy too many low-quality assets. You will see Xerox write off more than half of its entire goodwill amount – a loss of at least $4.5 billion. But the $9 billion in debt cannot be written off... Xerox must repay it.

Secondly, I believe these value investors seriously misjudged the nature of this business. The managers of Xerox made these investments because they believed they were necessary to grow the business.

Yes, they paid too much. And yes, it will end up being a disaster for shareholders. But they were right about the general direction. If Xerox doesn't make similar investments for the future, it will lose the ability to compete. That's already beginning to happen... sales are starting to fall.

The managers believed they could grow through acquisition. The value investors believe they can survive without those expenditures. They're both wrong. The simple fact is, IT service is an extremely tough business with several vastly better competitors (like IBM). The normal business metrics that most investors use don't reveal these facts. The proof is in the capital efficiency... which I'd judge to be negative.

What's happened at computer maker Hewlett-Packard – overpriced acquisitions that have left the company's balance sheet deeply impaired – isn't unique. It has happened all over corporate America. Overly aggressive management teams have used cheap debt in an attempt to grow through acquisition, rather than by simply producing new and better products. Inevitably, as our national gross domestic product (GDP) growth stalls and these debts soar, most of these deals will go bad.

Remember... in capitalism, what matters is capital. How much capital does a company earn? How much must it continue to invest in its growth? And what happens with those investments?

These questions set up the most crucial one of all… How much money is left over to return to the rightful owner – you, the shareholder?

I hope you'll read our upcoming issue of Stansberry's Investment Advisory carefully. We have been working on several capital-efficiency screens that will help point us in the right directions, in addition to keeping us out of value traps like Xerox. If you're not already a subscriber… you can learn more about my latest work and how to subscribe here.

Also, if you're not already reading Dan's Extreme Value, you should start... His World Dominator stocks should be the core of every investor's portfolio. By simply buying these stocks and doing nothing, you will compound your wealth and vastly outperform the market over the long term... Plus, you'll collect dividend checks every quarter.

His track record speaks for itself... I can't recommend Extreme Value highly enough. You can lean more here...

New 52-week highs (as of 11/29/2012): Guggenheim China Real Estate Fund (TAO); Prestige Brands Holdings (PBH), Monsanto (MON), and Alico (ALCO).

In the mailbag... yesterday, a subscriber complained about our "plugs" in the Digest, where we offer a bit of advice from our paid services and then give you a chance to subscribe.

We like to think this is a two-way street. We give a little. And we ask that you pay a little. That's how free markets work. Without you paying, we'd quickly go broke and out of business. And without us constantly giving a little (and improving our services over time), you'll stop buying.

If we get the mix wrong, let us know. As you'll see below, several subscribers already have... Send your notes here: feedback@stansberryresearch.com.

"I absolutely AGREE with 'paid up subscriber Scott Hunter.' I am SICK AND TIRED of all the publications that I subscribe to about EVERY MONTH teasing just like you did, trying to entice me to pay MORE money for yet ANOTHER service! How about improving the publications that we ALREADY subscribe to!" – Paid up subscriber Jonathon Rigg

Porter comment: I don't know what you've been reading, Mr. Rigg... but I'd point out that the Digest, where we do offer additional products for sale (as well as lots of insightful research each day), is a FREE publication. You don't pay a penny for it. (Although, we wish you would, which is why we will also soon publish a "Premium" version of it, like we do with DailyWealth). You won't find these kinds of "plugs" in our subscription newsletters.

In regards to improving our products... I'll let the subscribers of my newsletter speak to that point. In the last year, I've hired three additional analysts. I've broadened our coverage tremendously and expanded the monthly issues from eight pages to 12 or 16. I've also offered my readers a whole suite of new services – including Stansberry Data – for no additional charge. And I've launched Stansberry Radio this year... which is absolutely free.

Like I wrote above, I know there's a balance between giving and taking in this relationship. My strategy in building this business has always been to give about 10 times more than I take... But if I've got the mix wrong, let me know.

"I get a little miffed at the complaints of some of your Digest readers who complain about your marketing of other products, like the person who complained yesterday about you 'teasing' them about housing recommendations and then asking them to try out a service.

"Get real! That's why Stansberry is in the business – to help us investors get good info and to market their products. I have several of your investment newsletters and I'm no wealthy person. I mine the 'gold nuggets' you offer to advance and increase my IRAs investments. I even chose the recent Advanced option for S&A Digest.

"Great work guys! Keep up the good work. I may not be able to run in the same circles you guys do but thanks for taking the approach, Porter, that if you were in our shoes you'd provide the same information to help us out. Thanks!" – Paid up subscriber Terry Kissell

"After Mr. Hunter complained about S&A's marketing in a comment in yesterday's Digest, you politely explained what you do and why you do it. At the end of your comment, you then again shamelessly plugged Steve Sjuggerud (which I think you should do more often as Steve is fantastic) and his True Wealth letter. The intentional irony brought a belly laugh to this subscriber and started this day off right. Thanks much and keep up the good work." – Paid up Subscriber Phil Dinsmore

"Ha! I enjoyed reading Mr. Hunter's attack on you for not printing the names of your recommendations. 'Disgusting and Unethical' as I recall. I'm in the M&A world, putting buyers and sellers together of companies in the $5MM to $500MM range. If I were to disclose the names of either party to the other before securing a fee agreement, including a confidentiality agreement, I would be out of business and I would be doing a disservice to my clients. Maybe in Mr. Hunter's world we all share our hard work with those who don't work to 'spread the wealth around a little.' Sound familiar?" – Paid-up subscriber Jonathan Mossberg

Porter comment: I've always found that there are some clients... maybe not many, but some... who simply can't be served. No matter what we do... no matter how generous our terms (or our refund policies), they can't be satisfied. For these folks, I am prepared to part as friends... the sooner, the better...

Regards,

Porter Stansberry

Baltimore, Maryland

November 30, 2012