An obvious sign of trouble most investors have overlooked... Check your investment portfolio for this semi-fraudulent management practice... Why Exxon will lose its triple-A rating... A bear market strategy you should follow soon... And a note from PJ O'Rourke...
Editor's note: The market will be closed Monday for Labor Day, as will the Stansberry Research offices. So we won't publish the Digest that day. We'll resume our regular publishing schedule on Tuesday.
In today's Friday Digest... a secret about America's best management teams I think you'll have a hard time believing.
Now, if you're new to our business you might find the information below a bit mean-spirited. You might even think I'm some kind of a crank – always looking at the downside of everything.
No, no. I write the Friday Digest personally and my goal is always the same: To give you the information I'd want right now, if our roles were reversed.
And today, I want to share another signal I've been watching. It's a quirky signal. Not many people follow it, and few really understand it. But this signal is giving me a powerful reason to believe we may be approaching a bear market, not just a short correction in stock prices.
This signal is particularly important right now because of changes I expect will happen soon in the U.S. credit markets. You need to understand this signal and what it means.
I doubt anyone else will explain this to you. So... get a glass of wine (or bourbon), put your feet up, and read carefully.
(If you can make it through to the end of today's Digest, your reward is a funny bit by legendary satirist PJ O'Rourke. Our readers – PJ included – were recently besmirched by a local newspaper columnist. We're used to being insulted. But PJ took offense. Not so much to what the man said... but who said it. His response is pretty funny...)
In the first quarter of 2015, the 500 largest publicly-owned companies in the U.S. paid out more capital to shareholders (through dividends and share buybacks) than they earned from their business operations. (Credit to Bloomberg's David Wilson for bringing this to my attention back in June.)
It should be obvious to everyone that companies can't spend more buying back shares and paying out dividends than they earn – at least not for long.
This heavy corporate buying has been a major "leg" supporting the bull market. Goldman Sachs predicted earlier this year that U.S. companies would buy $1 trillion worth of shares in 2015. That represents a large percentage of the total capital flowing into the stock market. And it's not only the direct buying power of U.S. corporations that supports the market. By reducing the number of shares outstanding, U.S. corporate investing reduces the supply of stock, making the remaining shares more valuable.
Here's the secret: Corporate managers, as a group, are terrible investors. The last time the S&P 500 managers collectively spent more than they were earning on shares and dividends was the second quarter of 2007. Just a few months before the market's last peak. The managers' spending reached 156% of their free cash flow in the fourth quarter of 2007. You may recall the last big stock market peak was in November of 2007.
This phenomenon is one of those delicious paradoxes of finance: The more bullish the best management teams in America become, the more likely we are to enter a bear market.
How can that be? Surely these super-smart managers – with fancy degrees from Harvard, Northwestern, Chicago, University of Virginia, etc. – know when to buy their own company's stock. I mean, who knows more about their company's prospects? They're privy to every possible operating detail.
That's all true, of course. But the more important thing to understand is that, when they are spending more collectively than they're earning, their buying power is immense – enough to move the market higher by itself. When they stop buying, it's almost certain the market will fall. And they can't keep spending more than they're earning, not for long.
Over the last 20 years or so, stock buybacks (as opposed to simple dividend increases) have become far too popular with management teams. There's a good reason why: Stock buybacks allow managers to convert additional debt into higher earnings per share. By reducing share counts, the same amount of earnings will look bigger on a per-share basis.
Warren Buffett has commented frequently about the poor ethics of management teams who use their balance sheet to inflate their earnings per share, all to the long-term detriment of their shareholders. He wrote in his 1999 letter to Berkshire Hathaway shareholders:
If a company's stock is selling well below intrinsic value, repurchases usually make the most sense. In the mid-1970s, the wisdom of making these was virtually screaming at managements, but few responded... That day is past. Now, repurchases are all the rage, but are all too often made for an unstated and, in our view, ignoble reason: to pump or support the stock price... it appears to us that many companies now making repurchases are overpaying.
I hope you'll take the time to review your own portfolios for companies that have been engaging in aggressive share repurchases at the expense of their balance sheets. Companies that have been adding significantly to their debt loads in an effort to buy back stock are going to be badly hurt during the next few years.
When you see corporate managers spending far too much on shares, that's a good market-timing tool. It suggests that a bear market may emerge over the next few quarters.
But there's a deeper reason I think you should pay attention to this problem now. Over the past 20 years the balance sheet of the average American business has become a lot more encumbered. We've gone through a long period of low interest rates. That has encouraged managers to add debt, to "lever-up" their businesses, and earn bigger profits. A lot of the managers who have done so don't care about the long-term ramifications of these decisions.
A lot of businesses are going to get hurt as this period of credit excess reverses. One way to spot which companies might be in the most jeopardy is simply to ask: Have the managers been spending more on stock than the company's earnings can support?
Here's an extreme example: ExxonMobil is a triple-A-rated, global corporation. Its management team is considered to be the best in the world. I can't think of another financial writer who would ever question the safety or soundness of Exxon's management team. But... look at the numbers.
Over the last 10 years, Exxon spent $211 billion buying back its own stock, and $88 billion on cash dividends. Over the same period, it earned $242 billion in free cash flow (that's cash from operations, minus capital investments). So in just 10 years, Exxon has added $57 billion in debt, primarily to fund its share repurchases. That's a significant and material increase, representing about 20% of the company's market capitalization today.
Here's a prediction: Over the next 30-40 months, as credit tightens and defaults rise – especially in the oil industry – Exxon will be placed on credit watch. Eventually it will lose its triple-A status. Three primary factors will trigger this...
One, increasing competition and new technology in the oil and gas industry will create a permanent reduction in Exxon's operating profits, reducing Exxon's ability to afford its debt. Two, efforts to repay debts will require a reduction in capital spending. That will lower the company's future earnings potential for at least the next decade. Three, credit stress throughout the oil and gas industry will cause Exxon to pay more for capital, again, resulting in lower margins and higher risks for Exxon's creditors.
"So what?" you might say. "Who really cares if Exxon remains triple-A? Not even Berkshire Hathaway is AAA anymore. What's the point?"
Well, if the most creditworthy corporation in America can screw up its balance sheet during a 10-year credit binge, there's a very high likelihood that at least some of the management teams in your portfolio have done the same – or far worse. I'd check the numbers now.
Oh... just in case you're curious. One of Buffett's recent buys, IBM, has been criticized roundly in the press for spending too much on shares. Given Buffett's expertise and decades-long focus on this particular management issue, I'd assume Buffett probably knows a lot more about how IBM is being managed than the financial press.
But just for fun, we checked the numbers ourselves. Over the last 10 years IBM has earned $139 billion in free cash flow. That's roughly equal to its current market capitalization of $141 billion. Management has spent $29 billion on dividends and $99 billion on buybacks, for a combined total of $128 billion. That means IBM hasn't been spending more than it's making on buybacks – at least, not over this period.
I'd like to close on a high note. I believe we're approaching a period of rising credit defaults, higher lending costs, and falling corporate profits. To follow along at home, just watch a big exchange-traded fund of corporate bonds, like the iShares iBoxx High Yield Corporate Bond Fund (HYG).
As I've been warning you since May 2013, interest rates on corporate borrowing reached completely unsustainable lows. They must reverse. And that's going to cause a lot of temporary financial pain. Maybe even some panic.
No, I don't believe this is the end of the world. It's just a normal cyclical feature of our credit markets. (I detail this cycle in my Investment Advisory newsletter this month, which we will e-mail to subscribers this evening.) However, this particular period of rising credit risks will be a lot worse than normal because the Federal Reserve cut short the last "credit-cleansing" back in 2009 by essentially guaranteeing a trillion in bad debts, which allowed them to be "rolled over" instead of going through default. These actions, and the following manipulation of interest rates to essentially zero, have seen more low-quality borrowers taking out bigger loans, against weaker and weaker terms.
This kind of binge lending, fueled by low interest rates, always ends badly. I'm sure it will end poorly again and soon. Marty Fridson, the world's leading expert on the credit cycle in corporate bonds, predicts something around $1.6 trillion in defaults over the next four years.
That sounds bad. And it will be, for a lot of people.
But it doesn't have to be bad for you. This will be the largest, legal exchange of wealth in U.S. history. Investors who have borrowed too much are going to be wiped out. But for investors with cash, this will be the best buying opportunity of the decade. You need to take action now, so that over the next 30-40 months, you're on the right side of these trades.
How can you do that? I'll be writing about three basic strategies (again and again) in an effort to help you profit during this period.
The first of these is simply to short stocks. That allows you to make a profit as share prices decline. You want to look for companies that have borrowed way too much money or whose business model depends on access to low-cost financing. We're recommending two such short sell trades in my newsletter this month.
If shorting a stock is unfamiliar to you and you're afraid to try, then start small: Just short a single share. You'll discover that it's no different than simply buying a stock. But whatever you do, don't ignore this advice. Learn to short. Make sure you have an arrangement with your broker so that you're allowed to do so. This might be the key to avoid taking big losses on your other investments.
The next strategy you'll see me using more often over the coming months is what I call the Alpha Strategy. It's too complex to fully explain here (if you're interested, please consider subscribing to our publication of the same name). The short explanation is simple enough: When investors get scared, they will pay you to agree to buy shares from them. It's like selling other investors insurance. And as the market dives, selling this kind of insurance can be very lucrative.
Back in 2008/2009, I averaged 50% gains on each of these trades, which typically only take six months or so to close, implying 100% annualized gains. I'll explain more about this strategy over time. It's complex. But it's worth it, I promise.
Finally... there's an easy and totally safe way to make a killing during a credit correction. All you've got to do is some basic math to figure out which companies can actually afford to repay their bonds. It's not hard. At all. Why other investors don't do this, I can't understand.
What happens is, when bonds start falling, they can be downgraded by rating agencies. When that happens, banks, insurance companies, pension funds, etc. frequently are forced to sell because they're not allowed to own bonds below a certain rating. Prices for bonds – even fairly high-quality bonds – can plummet.
Now, buying bonds isn't as easy as buying stocks. You have to use the telephone to call your broker's bond desk. It might take two or three minutes to fill a trade, instead of instantly like with stocks. For some people, these challenges are just too much. But if you're willing to endure a phone call, you will probably be able to buy bonds for half of what they'll pay out when they mature.
That means you can collect interest rates of more than 10% while you wait to double your money at maturity, which is typically two or three years away. These are fantastic investments. I promise, if you do a couple of these trades with us you'll never buy stocks again. For more details, go back and read our 2011 Report Card (published in January 2012) and consider the track record of our True Income publication coming out of the last credit cycle. We will be relaunching a distressed debt publication soon.
Here's an example of the kind of credit we're looking for: resource giant Freeport McMoRan. Currently, its bonds are trading as low as $0.72 on the dollar. The company has free cash flow (even with depressed commodity prices) to cover 126% of its interest obligations/principle repayments. It could also cut its capital expenditures further, if necessary, to repay these bondholders.
We're not buying yet, though, as the average yields on Freeport's bonds are still less than 10%. Eventually, there will be plenty of opportunities to buy safe bonds and earn outrageous yields and profits – just like in the last cycle.
Finally, a quick notice to end today's Digest...
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New 52-week highs (as of 9/3/15): Inogen (INGN).
Today's mailbag is a little unusual... In place or our usual subscriber feedback, we're sharing a special letter from our friend and best-selling author PJ O'Rourke. We'll resume our usual mailbag on Tuesday... please send your questions and comments to feedback@stansberryresearch.com. As always, we can't respond to every e-mail, but we read them all.
Regards,
Porter Stansberry
September 4, 2015
Baltimore, Maryland
A Note From PJ O'Rourke
There oughta be a law.
The presence of a trained, professional humorist should be required at all public events and gatherings. In case of emergency.
I mean what if something pretentious and stupid happens in an avant-garde Off-Broadway theater? (I'm not much of a play-goer, but I understand this does occur.) Will the stage manager stop the play, go out on the stage and make a desperate plea, "Is there a humorist in the house?"
No. There is a shortage of trained, professional humorists, especially in New York, especially in the avant-garde.
Fortunately, Porter Stansberry has one on hand, in the form of his friend – me, PJ O'Rourke.
Unfortunately, "public events and gatherings" include the publishing of small-time financial advice columns in obscure venues.
Hence the "humor emergency" e-mail I got from Porter. Porter was irked. Irksome things are funny when they irk other people, but when they irk us, oh-oh, "Red Alert Irk."
Porter sent me a link to a small-time financial advice column by a fellow called Malcolm Berko in an obscure venue, The Columbian newspaper in Vancouver. That would not be Vancouver, Canada. That would be Vancouver, Washington State.
The column was headlined "Berko: Stansberry? More like Scamsberry."
In response to a reader inquiry concerning favorable things the reader had heard about Stansberry Research, the financial advice columnist has a conniption fit.
He claims [Editor's note: falsely] Porter predicted oil would go to $360 a barrel (glad I filled the car!) and that Porter has been forecasting the collapse of the Dow Jones Industrial Average for 12 years (during which the Dow only collapsed nine times). The columnist drags up the decade-old SEC suit against Stansberry. Being sued by the SEC – that's like being Molly Ringwald, Emilio Estevez, Anthony Michael Hall, and Judd Nelson in The Breakfast Club. Or more to the point, it's like being one of those other fly-by-night operations who've been sued by the SEC – such as Citigroup, Deutsche Bank, Goldman Sachs, JPMorgan, Merrill Lynch, Wells Fargo, Bank of America, Credit Suisse, Morgan Stanley, Charles Schwab, Fannie Mae, and Freddie Mac.
The columnist took a gratuitous swipe at Ron Paul: "Porter prepared a book called 'America 2020,' a 238-page 'survival blueprint' with a foreword by former Rep. Ron 'Bonehead' Paul." And – what made Porter even angrier than that – the columnist jacked his leg and blew his nose on you, the reader.
"Porter markets a newsletter primarily to morons, dummies, and frantic get-rich-quick fools who believe in the tooth fairy and the goodness of mankind, and think Moses is the real man on the moon."
This made me angry too – or it would have if I hadn't been laughing so hard. The financial advice column is accompanied by a photograph of the financial advice columnist. He is wearing the largest, ugliest bowtie I have ever seen. It looks like an endangered species of tropical bird. No, it looks like a species of tropical bird that everybody wishes were endangered, lest it show up on the rail of our Caribbean cruise ship and cause the crew to jump overboard in alarm. There are colors on this bowtie that Lily Pulitzer wouldn't have touched with a polo mallet.
Porter, in his e-mail to me, said, "I don't think this is the first time this guy has written about me."
It isn't. Last year, he wrote a column in something called The Daily Journal (ah, the mysterious Internet – lets you find anything) possibly published in Kankakee, Illinois (ah, the mysterious Internet – gives you no idea what you've found). And in this column, he said, "Stansberry's newsletter is a perfect fit if you are intellectually vacant, have a good fourth-grade education, are bereft of common sense, speak only pig Latin, have an IQ of 67, or were born on Pluto. This over-chubby fraudster... "
Porter wrote me back, "I prefer 'husky.'"
Here's my reply: Porter – "Of sturdy build" is how I'd put it.
Yeah, you could sue the guy or something...
But really, if you had a fly on the wall in your living room, would you bring in an elephant to crush it? You'd get a big elephant smudge on your wallpaper and probably wreck your carpet.
"The Dogs Bark, the Caravan Moves On…"
Think about a fellow who had to endure being a "Malcolm" in Junior High, not to mention having a last name that rhymes with... Bet you a grand his 8th grade nickname was "Jerk-O."
I have no idea why he's got it in for you. Did you sell him that bowtie?
Anyway, here's a non-prominent, non-celebrated, non-successful (and not very good) financial columnist at an obscure newspaper with a circulation of less than 46,000. He would be pleased beyond telling and convinced that the sun shone out his fundament if he were attacked by you. Or me. Or Ron Paul's cousin's girlfriend's dog.
And confronting or correcting him would cause what he has written to be – for the first time in his career – read by someone other than his wife.
Plus, potential Stansberry subscribers around the world would think of you as "over-chubby."
The Columbian is the local daily for Vancouver, population 162,000, and the neighboring town of Washougal, population 14,750. The paper prints high school sports scores, traffic accident reports, and appeals to the public for help finding lost pets. Today's front page headline (cleverly printed above a photograph of a fallen tree): "Gusty Storm Knocks Over Hot, Dry Spell."
The Wikipedia entry for The Columbian – which barely exceeds what I believe is known as a "stub" – says, "It is the newspaper of record for both Vancouver and Washougal." Eat your heart out, Arthur Ochs Sulzberger, Jr.
Vancouver, Washington, is directly across the Columbia River from Portland, Oregon. It is a part of "Portlandia." Need I say more? I will. I looked at a couple of these "financial advice" columns (which don't seem to provide much of same) while holding my hand over the computer screen so as not to be distracted by fits of bowtie giggles, and Berko loves, loves, loves Elizabeth Warren.
The Columbian went into Chapter 11 in 2009, emerged, and is (if I'm correctly reading the runes – and after 45 years in print journalism, I am) heading back to Chapter 11 with a sureness that would do an aboriginal Australian master of the boomerang proud.
Also, the Portland Metropolitan Area has another daily newspaper, with seven Pulitzer prizes and actual readers, the Portland Oregonian.
Yes, the column is out on the Internet. But so is everything. Including the 1965 snapshot of me with my Senior Prom date. She was "of sturdy build."
– PJ
P.S. If you'd like to blow your nose back at Berko... I think this webpage accepts comments:
http://www.columbian.com/news/2015/aug/29/stansberry-more-like-scamsberry/
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