Corporate Neros

Stansberry & Associates Top 10 Open Recommendations
(Top 10 highest-returning open positions across all S&A portfolios)

As of 07/08/2013

* * * Fall’s here. We got our first big frost last night. Made a big fire, pulled the couch up close, and let the dog sit in our lap. Fall ain’t bad.

* * * Oil is on the rise again today, says Mr. Dennis Gartman, who looks upon the world’s financial markets like an old sea captain standing atop a lighthouse. Apparently, there’s going to be another OPEC meeting this Thursday. Made wealthy by an accident of geography, the Arabs seek to add to their fortune by strong-arming the market. Perhaps they should consult the Hunt brothers… or read more history. Never in recorded time has any cartel, such as OPEC, been able to control the price of any commodity for long. The higher they put it up, the more incentive there is for the market to bring it down. Oil will keep falling. And that’s why the region’s stock markets keep tanking.

* * * About three years ago, when local newspapers were writing worried articles about deflation, S.D., a very wealthy man and a major fund-raiser for the Republican Party told me, "What we need is a little inflation." I knew what would happen next. Inflation is good for rich people. Rich people don’t keep their money in savings bonds or in the local bank. S&A editor Christopher Hancock tells me there are about 3 million people in North America alone with a financial net worth, minus primary residence, greater than $1 million… That’s up 20% over the last three years. They should thank S.D.

* * * I’ve always been skeptical of trading strategies. Over the years, I’ve met dozens of guys who claimed they could make a fortune with lightning-fast trades. One guy I know even boasted to colleagues that he made 100 trades per day. Strangely, none of these guys wore nice clothes, had nice cars, or lived in nice houses. In fact, most of them lived in shoddy apartments… If they were making money, it sure didn’t show. But then I met Jeff Clark… Clark built an entire brokerage firm with successful short-term (a week to a couple of months) trading. He made his clients a lot of money – I know because they wrote to us. But the clincher was when Clark told me how much he loved driving his new Mercedes SL-500. This guy really was making a ton of money trading. The first time we met for lunch, he brought a copy of his latest trading report – he was shorting XM Satellite Radio. I’d written the exact same report, independently, a few days earlier. This was a trader… who did good stock research… whose thinking was a mirror image of my own. We made a deal. I decided to publish Jeff’s recommendations. And he decided to retire from managing money. If you had put $5,000 into each of his recommendations since we started in May 2005, your account would have earned more than $244,000 by today (our lawyers vetted the figure; it’s accurate). Jeff Clark has become our second most popular editor (after Steve Sjuggerud), and it’s easy to see why: He’s brilliant, he’s honest, and he consistently makes his subscribers a lot of money.

* * * One more thing: Clark says his next trade is on an oil stock, but it’s not your typical trade. Called a spread trade, it’s designed to profit from volatility, not direction. You can make money whether oil goes up or down. Clark says he expects a 150% return from this trade, calling it one of the best setups he’s ever seen.

* * * Help! There’s a debate raging in our editorial office. The issue is: What’s the best practice for publishing the track records of our newsletters? It’s not feasible to publish a newsletter’s complete track record in each issue, because years and years of recommendations simply won’t fit on the back page… or back several pages. Our practice has been to print all open positions, which are certainly the most pertinent, along with the average return of all open positions. (In my newsletter, I take the additional step of reviewing all picks at the end of the year. So you can easily see all of the picks I’ve made through the years, simply by reading the review issues.) I argue that it’s useful to know how, on average, how an editor’s picks perform. Some on my staff argue that the average of all open recommendations is a misleading figure. They argue that accounting for only open positions masks all the closed positions – winners and losers. I think they don’t know enough about statistics… You see, when you include all the picks over the year, you find the average return barely changes. It may go up or down a little bit, but when you’re dealing with a large sample (20-30 picks), the average of the open positions is going to be representative of the average return of the entire population of recommendations. If it were your newsletter, how would you handle the track-record issue? Let us know: feedback@stansberryresearch.com.

* * * The answer to Thursday’s riddle. I asked, "Why do mirrors reverse right and left, instead of up and down?" Mirrors don’t reverse anything, actually. If you hold up an arrow in front of a mirror and point it to the left, you’ll see the arrow in the mirror pointing to your left, too. Wait a minute, though, if mirrors don’t reverse, then why can’t you read a newspaper with a mirror? Mirrors reflect directly all of the light that comes at them. We read newspapers from left to right. But the mirror reflects directly, making us read right to left, which most people can’t do. Look for a new riddle tomorrow.

* * * * * * * * * * * * * * *

There’s one more aspect to the options-accounting scandal that hasn’t been made public – yet.

This year, for the first time ever, all public companies in the United States are required to charge the value of the options they grant against the net income they earn. Many folks, myself included, believed this would help to reduce the kinds of abuses I’ve seen. Simply put, it’s much harder to rob the bank if everyone can see you’re doing it.

The new accounting rule – FASB 123 – requires companies to use the Black-Scholes formula to account for options grants. The formula uses a few bits of information to determine the value of an option. The key number in the formula is "implied volatility." To know the value of the option, you have to make a guess as to how volatile the share price is likely to be in the future.

Yes… that’s right… I said "guess."

In the past, companies tended to guess on the high side, making the grants appear more expensive. The expense of granting options was used to offset income taxes.

But now?

Well, now that options are being charged against earnings (not just against taxes), you’d be surprised how much implied volatility has fallen…

At Yahoo!, the value of all its options outstanding fell by $698 million in the last year, because of a reduction in the rate of implied volatility. At eBay, playing with the numbers reduced the value of the options outstanding by $414 million. At Hewlett-Packard, playing with the numbers reduced the value of all its outstanding options by $351 million.

All of these savings occurred in only the last year. But rates of implied volatility have fallen sharply since 2004, when the changes to the accounting rules were passed. By playing with the numbers over the last three years, tech companies have magically reduced the expense of granting options by billions.

At first, these companies claimed options didn’t hurt shareholders and weren’t truly an expense for the company – thus they shouldn’t be accounted for. Then, these companies told us that it was impossible to provide an accurate accounting for their options grants. Now after being forced to account for options expenses… the companies are simply cooking the books.

The 10 technology companies we examined for this research reduced the accounting value of their outstanding options expense by a quarter of a billion dollars, in one year, by "adjusting" implied volatility.

The game goes on. In a few years’ time, these companies will undoubtedly take a charge against earnings, claiming they’d mistakenly set the implied volatility of their options charges too low. This, they’ll say, is evidence that it’s too hard to account for options expenses…

Regards,

Porter Stansberry

Cockeysville, Maryland

P.S. New feature for our Digest – the Stansberry Top 10. It’s a list of our 10 best current "open" positions. As I’ve been telling you, our Extreme Value product is by far our best performer. I’ll comment on the list from time to time, when we add a new position.

Stansberry & Associates Top 10 Open Recommendations