Back from New York...

Back from New York... What to expect from the April issue of Extreme Value... A lesson in cyclical businesses... What makes alcohol and tobacco companies such great investments...
 

 I (Dan Ferris) just got back from New York last night.
 

I was there attending the Grant's Interest Rate Observer conference at the Plaza Hotel. We've agreed not to publish detailed analysis until Jim Grant has a chance to publish his own conference recap, but I can say this: There were more equity ideas this year than I would have guessed, even from investors holding massive – even record-high – levels of cash. I told Porter about that in an e-mail with the subject line "Uh oh." He noted the irony of a roomful of bullish contrarians.
 

They weren't overtly bullish. They were stealthily bullish... giving warnings about the Fed's egregious misconduct followed by long equity ideas. One admitted to me at the end-of-day cocktail party, "What else is there but equities right now?"
 

 Sometimes, when I fly to New York, I feel I should keep going, land in Switzerland, and never come back. There's a great article in the Financial Times today (behind a paywall) that says increasing numbers of Americans are renouncing their citizenship due to the enormous burden and complexity of U.S. tax laws.
 

I moved from Oregon to Washington in 2013 to escape Oregon's onerous state income taxes (11%, no thanks!). In Washington, I pay double the property tax I paid in Oregon, 8.4% sales tax (Oregon has no sales tax), and a 20.5% tax on hard liquor... and yet Washington is still a better deal for me.
 

I still pay about one-third of my income to the federal government each year. And unlike any other country (except the African state of Eritrea, according to the Financial Times), the U.S. claims the right to tax you no matter where you live. In effect, the U.S. says it owns you. If it didn't own you, you would only have to pay tax based on your physical location.
 

So I can't just relocate... I would have to renounce my citizenship. And according to the Financial Times, if you say you're doing that for tax reasons, it's unlikely the U.S. will let you back in the country. I hate paying taxes, but I'd hate not being able to visit my home and family even more. I'm sure many people share the same feeling... and pay even more than I do.
 

 I've been running around Portland, Oregon recently, talking to local businesspeople, doing research for the April issue of Extreme Value, which comes out tomorrow. I've found a company that's No. 1 in a $23 billion global market. This firm is led by excellent allocators of capital. It gushes free cash flow, has much more cash than debt, and operates in a highly fragmented industry in need of consolidation.
 

Perhaps most important, it's one of those rare companies that makes rewarding shareholders a high priority. It generated $1.9 billion in free cash flow in a recent 12-year period and paid out $1.3 billion in dividends and share repurchases. Management openly states that cash-generation is a top priority. Obviously, getting that cash into shareholders' pockets is a high priority, too.
 

In this month's issue, I will share an example of a company many view as a great dividend-payer... but as I'll show, it has underperformed because it hoards too much cash.
 

Extreme Value subscribers will learn why the new stock isn't a buy just yet... and I'll explain exactly when the time will be right to buy it. It's a cyclical company, so it seems cheaper when earnings are higher, near cyclical tops... and expensive when earnings are lower, near cyclical bottoms. It's a real lesson in how complex investing in cyclical stocks is.
 

I'll also mention the two most attractive Extreme Value buys today... which I would bet the overwhelming majority of longtime Digest readers have never heard of before. (You can learn more about Extreme Value and receive the April issue as soon as it hits e-mail inboxes by clicking here.)
 

 The new stock we're covering will be added to our growing Extreme Value watch list. This is a list of great businesses we plan to buy when they get cheap enough... or as in the case of the new one, when the cycle turns down. The list is working out well so far.
 

Since we added our first watch list stock on January 9, shares are down 12%. If it falls another 15% or so, we'll grow interested. It's also in a cyclical industry, so when to buy it is as important as deciding how much to pay for it.
 

 We're compiling a watch list because highly compelling long-term bets are hard to find today. If we were running a fund instead of a newsletter, we would likely hold plenty of cash right now. At the Grant's conference, I spoke with two well-known professional investors, one of whom is holding 30% cash right now, the other 68%... his highest level since right before Lehman Brothers declared bankruptcy during the meltdown of 2008.
 

 A great place to learn about the importance of buying at the right point in the cycle is Oaktree Capital co-chairman and billionaire investor Howard Marks' excellent book, The Most Important Thing. Chapter 8 is a great little essay on cycles.

Marks offers two rules about cycles you can hang onto with confidence:

The trouble with cyclical bets is that you can never predict where the bottom is. So you have a couple choices. You can avoid them altogether. I've heard lots of value investors – perhaps believing they were imitating investing legend Warren Buffett – say they avoid businesses whose revenues depend on metals or other commodity prices.
 

I understand this viewpoint... but I'm a little too greedy to share in it. In fact, avoiding cyclicals (including mining stocks) seems to defeat the point of getting involved in picking your own stocks to begin with. If you can't find ways to take advantage of big cyclical moves... maybe you would be better off buying index funds instead.
 

If you decide to buy mining stocks or other beaten-down cyclical stocks, you should use a trailing stop on each position. This helps you remember that when you buy mining stocks, you're speculating, not investing. Trailing stops ensure you limit potential losses on each position.
 

 That said, there are one or two mining-related businesses that I consider true investments. I've definitely found one of them and have been begging my subscribers to buy it lately. (Extreme Value subscribers know exactly which company I'm talking about. I ran into a subscriber at the Grant's conference and the company's name was the first thing he said to me.)
 

But I'll be darned if I can find another one like it. If you're in mining stocks, you're exposed to commodity prices. If you're in exploration-mining stocks, you're exposed to businesses with no revenues that can react violently to commodity prices (in both directions). Trailing stops will leave you with more capital and more sanity.
 

There is one other possibility if you're convinced we're near the bottom in mining stocks. If you have the discipline, you can try to build a portfolio of the highest-quality mining stocks in a slow, disciplined manner when you think the bottom is near. If you buy on the way down, at the bottom, and as the market starts to tick upwards, it would average your cost over the bottom of the market. This would expose you to further price drops a little at a time.
 

Of course, that takes more discipline than most people have. It's hard to buy even small positions in companies as the market is dropping. That's why trailing stops make it so much easier.
 

 Mining cycles occur because it takes a long time to find new deposits, get them developed, permitted, and built into mines. It can take decades for a deposit to get into production after initial discovery. It's hard for the industry to know how much new metal to mine.
 

So it winds up doing what humans always do: It responds to the commodity prices in the here and now. When prices are way up (like in 2007-2008 and again in 2011), they mine more, explore more, and spend a lot more money bringing a ton of new supply online. That drives the price down... and one day, the world realizes that there's far more supply than there is demand (like it has the last three years). Prices fall and the whole thing starts over again.
 

 Sometimes, a stock in a non-cyclical business will have a recurring problem that makes it seem cyclical, which creates opportunities to buy a great business at a cheap price.
 

Tobacco is an interesting example. Selling brand-name cigarettes and other tobacco products is a great business. Intense brand loyalty (addiction) has helped a few big companies generate thick profit margins and steady cash flows over many years, even during recessions. A few big brand names – like Marlboro and Newport – have dominated the industry for decades. The companies that own them have tended to be good all-weather investments that pay out large and growing dividends.
 

Tobacco has proven to be more resilient than anyone would have guessed. Big Tobacco was sued by 46 U.S. states in the 1990s for health problems caused by smoking. (Who ever would have thought inhaling smoke was bad for you?) The resulting agreement is set to extract more than $200 billion from tobacco companies through 2025 after making upfront payments of $13 billion prior to 2000.
 

And yet last year, Altria, Philip Morris International, Reynolds American, Lorillard, and British American (companies named in the original agreement) generated roughly $17.4 billion in free cash flow on $136 billion in sales. It's as if there were five Microsofts in the software industry... but run by better allocators of capital. These companies pay out most of their cash to shareholders through dividends. Reynolds and Lorillard yield around 3.7%. Altria yields 4.1%. Philip Morris and British American yield more than 5%.
 

 I continue to recommend Philip Morris in Extreme Value. Part of the reason it's down 18% from its all-time high of around $95 per share in 2013 is that governments around the world never stop talking about restricting smoking.
 

The U.K. recently passed "plain packaging" laws for cigarettes. Cigarette makers will now have to use standard fonts for product names and won't be allowed to using graphics that identify their brands. This is silly. Smokers who bought Marlboro when it was in a red pack will simply ask for Marlboro in the new, plain pack.
 

The law was passed last month. Philip Morris' stock fell from $91 to $77 over the past several months, perhaps in anticipation the law would pass. But now that it has passed, the stock is doing fine. It's the flip side of the old adage, "Buy the rumor, sell the news."
 

I hate to admit it, but betting on vices is generally a good idea. Heck, the best-performing open position across all of Stansberry Research right now is alcohol producer Constellation Brands in my Extreme Value portfolio, up 461%. My subscribers are also sitting on big gains in booze giant Anheuser Busch-InBev (172%) and cigarette companies Altria (172%) and Philip Morris (96%). If only I had recommended even more tobacco and liquor stocks, my subscribers might be even richer!
 

You should always keep an eye out for bargains among tobacco and liquor stocks. I continue to bet that "shopping trumps politics." I also expect to see plenty of continued demand for tobacco, liquor, and other products that people moralize about publicly and indulge in privately.
 

And again, if you're interested in a trial subscription to Extreme Value – where you can access my list of the greatest bargains in the market today – click here to learn more.
 

 New 52-week highs (as of 4/8/15): Aflac (AFL), Deutsche X-trackers Harvest China A-Shares Fund (ASHR), Brookfield Asset Management (BAM), Blackstone Group (BX), Global X China Financials Fund (CHIX), WisdomTree Japan Small-Cap Dividend Fund (DFJ), Dollar General (DG), Energy Transfer Equity (ETE), iShares China Large-Cap Fund (FXI), SPDR International Health Care Sector Fund (IRY), Prestige Brands Holdings (PBH), Guggenheim China Real Estate Fund (TAO), and ProShares Ultra FTSE China 50 Fund (XPP).
 

 One subscriber shot us a thoughtful note complimenting Editor in Chief Brian Hunt's answer about conflicting advice between analysts. Send your notes to feedback@stansberryresearch.com.
 

 "I want to compliment Brian for his excellent response to Amanda Odlin's mailbag letter asking why Microsoft was recommended by Doc as a buy and yet Dan recommends against Microsoft in his portfolio. There are many different strategies depending on your own situation. Are you looking for solid performers with good dividends, or are you looking for the bigger winners and willing to take more risk? We are all at different stages of our investing lives and we are all in much different financial situations. There is never going to be only one way of thinking. I enjoy all points of view from your experts and in the end I will decide what I want to invest in. I believe all readers should make their own decisions after educating themselves with excellent publications like yours. Keep giving me different opinions and explain why! Thank you." – Paid-up subscriber Gordon S.
 

Ferris comment: Thanks for the kind note, Gordon. I agree... Brian handled yesterday's inquiry especially well.
 

My compliment goes to you, because you truly understand that our publications and those of our parent, Agora, Inc., are intended for those who want to take charge of their own destiny, not hand it over to a newsletter writer. (I'm not suggesting Ms. Odlin wanted to relinquish responsibility.)
 

You've also correctly pointed out that all our readers are at different stages of their investing careers, so the contradictory advice really isn't contradictory after all. It's simply aimed at two different audiences, and you must decide which group you're in after reading both arguments. My sincere hope for all our subscribers is that they learn to sift through our advice while keeping their own goals in mind.
 

Regards,
 

Dan Ferris

April 9, 2015