How to Dodge the Stampede

On growing a pair... The CEG arb play... Graham's net-nets are back... The Age of Things that Can't Happen... Einhorn vindicated... "The risks to cash in banks"...

Congratulations to the House of Representatives. They grew a pair and said "up yours!" when asked to crown Hank Paulson, "King Henry." I hope the members' newly implanted spines last the week. More banks need to fail if we're going to allow the market to fix this.

Yesterday brought the kind of sheer insanity that creates fantastic, once-an-eon opportunities.

Take Constellation Energy Group (CEG), for example. A friend pointed out the stock to me a couple weeks ago, when it tanked hard, falling more than 70% in the wake of the Lehman/Merrill Lynch/AIG weekend. A few days later, Warren Buffett's MidAmerican Energy subsidiary offered $26.50 per share for the whole company.

Yesterday, Constellation fell below $17/share. Today, it's going for around $24 per share. Lots of stocks cratered yesterday and recovered today. That's not the point. The point is you could have bought it at yesterday's low with the intention to sell it to Warren Buffett very soon for a 58% profit.

Maybe these are tough markets to trade in, but not when you've got Warren Buffett standing in front of you, checkbook in hand, salivating to give you $26.50 a share. A typical arbitrage spread would be about 2%, leaving the stock just under $26. Like I said: sheer insanity.

If you're familiar with the work of Ben Graham (and you should be), you know that as long ago as 1973, Graham was complaining super-cheap stocks were a thing of the past.

That complaint is still valid, but opportunities exist to buy stocks for less than their current assets minus all liabilities, Graham's so-called "net-nets." James Montier of SocGen, the European financial services giant, sent around a research note yesterday that said, "Buying a basket of global net-nets would have generated a return of over 35% [per year] on average from 1985 to 2007. Right now, Japanese small caps are providing half of all the net-nets we can find." Ask yourself how much you want to buy Japan right now, and you'll understand how stocks can get that cheap.

Net-nets are priced to give you all the property, plant, and equipment of a company for free. You can also think of it as a discount to liquidation value, and you're getting the going-concern value of the business for free. Either way, it's the cheapest kind of stock you'll ever find.

The third quarter ends today. I wonder what the bank writedowns, chargeoffs, and loan provisions will look like this time?

We bragged a bit about our prediction Wachovia would fail. While we were essentially right, we didn't tell the whole story. As the American Banker reported today, Wachovia is selling to Citigroup "its retail bank, its corporate and investment bank, and selected wealth management businesses, including its private banking arm."

Various investment-management businesses, including a brokerage, will remain as a public company. Though the remaining pieces are hard to value, Robert Patten of Morgan Keegan says they might be worth $5-$7 per share. The stock is selling for just above $3 as I write this. Its 52-week low, hit yesterday, was $0.75 a share.

I spoke to Porter about the risks to cash held in banks as he prepared to write yesterday's Digest. (Did I just write "risks to cash held in banks"? What country is this?) After I got off the phone with him, I called my online brokerage and had it stop sweeping my cash into a money-market account. I doubt the brokerage will ever freeze the cash, but I feel no need to trust any money-market fund not to break the buck. Also, remember what's in money-market funds: U.S. government securities. No thanks.

As you probably have figured by now, I don't trust our banking system. In a fractional reserve system like ours, virtually every bank is inherently insolvent. When you lend out 90% of every $1 you take in deposits, you're betting no more than 10% of the depositors will show up demanding their money.

At times like these, when the banking system is imploding, you should also know the FDIC's "deposit insurance" is a pure fraud. The banking system is too leveraged to be solvent in the face of a deposit run.

That's why Porter cautioned you yesterday to have a few months worth of cash handy. In our system, when you put your money in a bank, you take some risk that you won't get it back. Don't ever forget that, especially not right now.

A few weeks ago, we wondered how interest rates could remain so low in the midst of an enormous credit crunch. The market is beginning to get it, as interest rates went through the roof yesterday. The London interbank offered rate (LIBOR), which banks charge one another for overnight loans, soared to an all-time high yesterday, from 2.57% to 6.88%, up 431 basis points.

Imagine mortgage rates rising that much in one day. Bankrate.com puts a 30-year mortgage at around 5.9%. Multiply that by yesterday's rise in LIBOR (2.68x), and suddenly, you're paying 15.8% for a mortgage. Maybe you think it can't happen. But we live in the Age of Things that Can't Happen.

Find a way to profit from a rise in interest rates, and you might not need another investing idea for years.

As the saying goes, when the U.S. sneezes, the world catches a cold – or in this case, bailout fever. Today, the Irish government guaranteed $575 billion of liabilities for six lenders including Anglo Irish Bank Corp. The government will guarantee all deposits, covered bonds, senior debt, and dated subordinated debt. And Belgium had its second bailout today as the Belgian and French governments paid $9.2 billion to save Dexia, the world's biggest lender to local governments. This comes two days after European governments injected $16.4 billion to save Belgian bank Fortis.

South Korea, Taiwan, and Indonesia stole another page from our government's playbook when they banned short selling following the rejection of the $700 billion bailout. South Korea will temporarily ban short selling in all stocks. Indonesia banned short selling for the month of October, and Taiwan banned short selling of 150 stocks until October 3. "There is no reason why our market has to be in a panic because of the U.S. situation," said Lim Seung Tae, secretary general of South Korea's Financial Services Commission.

I wonder if shorts had been around to cover yesterday, would the financials have been killed as badly as they were? What do I know? I'm no bureaucrat.

After years of work and regulatory harassment, Greenlight Capital founder David Einhorn is vindicated. This morning Allied Capital reported that its Ciena Capital subsidiary filed for Chapter 11 bankruptcy. The stock was down 53% by around 11 a.m. Einhorn's book, Fooling Some of the People All of the Time, details his work on Allied, as well as the rough treatment Einhorn received at the hands of regulatory authorities.

Lehman Brothers found a buyer for its crown jewel, asset-management firm Neuberger Berman. Or perhaps we should say Lehman found a thief... Private-equity firms Bain Capital and Hellman & Friedman will pay $2.15 billion for Neuberger, which has more than $230 billion in assets. Neuberger earns around 1.5% of its assets under management every year as a management fee (probably more for its wealth-management division). On $230 billion, that's $3.45 billion a year. Bain and Hellman bought a world-class asset manager for less than a year of management fees. Under normal conditions, the ballpark for this deal should have been between $7 billion and $9 billion. Keep your powder dry and wait for blood in the streets, and stocks can make you very rich.

Fund managers are pouring into corporate bonds. The credit crisis makes it more expensive for companies to borrow, so investors get higher yields as long as companies remain solvent. Lower-range investment-grade bonds currently yield more than 7%. Junk bonds are yielding nearly 10% over comparable Treasuries. When the credit crisis turns, companies will still have a hard time making earnings and stocks will likely languish.

At the same time, default risk will decrease, and corporate bondholders will be holding debt collecting huge yields. As one manager put it, you're getting "paid to wait." If you want to know which high-yield bonds we think are the best, sign up for True Income. You can read more about our high-yield bond advisory here...

New highs: none.

Lots of folks digging financial bomb shelters in today's mailbag. Send your survivalist tips here: feedback@stansberryresearch.com.

"Tim's plan sounds great until you notice that he inflated the payoff per person by three decimal places. Everyone gets only $3500, which won't go too far toward 'poofing' all of our financial problems." – Paid-up subscriber David

"I have been taking cash out of my bank, $1000 at a time from the ATM, which is the daily limit, for 5 days now with a goal of taking out ¼ of my savings slowly and under the radar. I don't know if a run on the bank in the U.S. would cause fear to spread to Canada but just in case, the bank is paying me only 1% on my savings so there is no incentive to keep it with them anyway. I was going to put 20% of my savings into gold and silver bullion split evenly but have not found an effective place to buy it, does your suggested dealers send gold out of the country? Also is there an ETF or stock I can buy that would track gold in Canadian dollars. What to do with the other 55% of my cash I don't know? I thought about paying down the mortgage at 5.89% but maybe my mortgage will yield less then some other forms of investment to come, nice to have money in the bank just in case. Maybe some of Dans world dominating businesses or a once in a life time investment opportunity is around the corner so I will sit with cash and be patient. I have taken too hard of a beating these last couple years to jump into anything (down 70%)." – Paid-up subscriber The Canadian

"'New highs: Are you kidding?' That started me roaring... I love your sense of humor...!!! Also, I would say you missed out on the easy profits in gold by recommending it only recently. I have been buying it back when it was hated, or at least disliked allot (2000ish). Now I am doing ETF's like GLD and SLV. What is the S&A take on them as a cyclic short play in the long term?" – Paid-up subscriber Mike

Ferris comment: My take is you better be careful with ETFs of any kind. Who would have thought you could lose a ton on the short financials ETF? Then, wham, the SEC steps in and the thing falls apart.

The gold ETF strikes me as an adequate vehicle for speculating on the gold price. But in a really bad, 1929-style liquidation, I bet it would fall apart just like everything else. Of course, at that point, it'd be a great buy... If you want to own gold to protect purchasing power, I think you should hold gold and silver coins (which, by the way, Steve has been recommending for years).

"The WaMu demise was a no-brainer. I predicted it 3-4 years ago. Similarly for Countrywide. They both would make 80% neg am firsts with very high true rates that were hidden by the 1% teaser. Incredibly they then made 20% 2d mortgages behind those firsts. That was insane, even in a rising market, to say nothing of the fact that the effective marginal interest rate on the deferred interest could exceed 200%! World/Wachovia is a different situation. First, World never went over 70-80% without mortgage insurance. Second, World let WaMu do the foolish 2ds behind the neg am 1sts. Finally, World had generally lower margins and more stable, conservative indices; so their negative amortization tends to be much less than WaMu and CW. Yes, they have problems, but their loss severity should be nowhere near that of WaMu. Still, in this market any perception of weakness is enough to be fatal." – Paid-up subscriber Bill Matz

Regards,

Dan Ferris

Medford, Oregon

September 30, 2008

How to Dodge the Stampede

By Ian Davis

The herd is stampeding...

Two weeks ago, on September 15, the Dow fell 504 points, its largest point drop since the 9/11 terrorist attacks. Yesterday, the Dow had its biggest point loss in history, falling 778 points.

In the intervening days, the Dow experienced multiple snapback rallies, gaining as much as 400 points.

If you're tired of the stomach-lurching ride, I've found a few sectors that will let you sleep easy. And I've highlighted some sectors to avoid if you're on a stress-free diet.

With the failure of Washington Mutual, it's no surprise banking tops the list of "heart-attack" sectors. Same for financial services. This sector contained some big-name failures, like Lehman Brothers and Bear Stearns. Rounding off the list are the gambling stocks.

Now let's look at the other side of the spectrum.

The least volatile sectors are all related to nondiscretionary products: i.e. "the basics."

Leading the list is nondurable household goods – companies that make toothpaste, deodorant, and batteries. Procter & Gamble is a big name in this sector. Food products – which covers companies like Kraft, General Mills, and Kellogg – has also been remarkably stable. Same goes for the brewers.

Besides their relatively sedate share prices, all of these sectors have one other thing in common...

They all have strong cash flows. The tight liquidity market isn't hurting these stocks.

So what should you buy for a restful night's sleep?

Your best bet is the Vanguard Consumer Staples ETF (VDC). This fund holds a laundry list of high cash-flow companies that make products consumers will buy throughout a recession: Altria Group, Anheuser Busch, Coca-Cola, and Colgate-Palmolive.

Good investing,

Ian Davis

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