Revisiting One of Porter's Legendary Digests

Another wild swing in the markets... Forget about the coronavirus for a few minutes... A far more dangerous problem for investors today... Revisiting one of Porter's legendary Digests... Eight stocks you can't afford to own right now... You don't have to be a victim...

Another day, another wild reaction to the latest twists and turns of the 'coronavirus crisis'...

The significant swings up and down in the equity markets continue... After all three major U.S. stock indexes gained roughly 4% yesterday, they all fell at least 3% today.

The "unknown" is weighing on investors' minds. As the Wall Street Journal noted today...

Some investors said they expected the stock gyrations to continue, with much uncertain about how far the coronavirus will spread.

"We are all dealing with an unknown," said Stephen Lee, founding principal at Logan Capital Management. "It's testing a lot of businesses."

The number of canceled conferences and travel has continued to rise as the virus has spread, crimping business activity and spending while roiling the outlook for global growth this year. Investors and analysts have slashed their outlooks for corporate profits this year. Many have been worried that the virus will harm consumer sentiment and business investment, though the true ramifications of the sickness remain unclear.

The virus – which originated in central China and has now spread to every continent except Antarctica – isn't slowing down. As we go to press, the number of people infected worldwide is approaching 98,000. And the death toll keeps rising, too... It just passed 3,300.

It's a major story. And we'll continue to cover it in the coming days, weeks, and months.

But I (Mike DiBiase) want you to forget about the coronavirus for a few minutes. Instead, in this Digest, I want to focus on a bigger danger facing investors today. We'll eventually find a way to slow down the virus. But no vaccine can prevent the damage from this problem...

I'll update a warning that Stansberry Research founder Porter Stansberry first issued in one of his legendary Friday Digests in September 2015. And as you'll see, Porter recognized many of the current dangers I'll talk about in this essay... more than four years ago.

Of course, as regular Digest readers know, Porter often sees things long before anyone else...

And he's willing to say things that folks in the mainstream financial media won't say.

For example, back in 2007, Porter warned again and again that "blue chip" carmaker General Motors (GM) would go bankrupt. (If you missed his detailed letters from the "Chairman of General Motors" explaining why this was inevitable, you can read them here.)

Then, in June 2008, Porter predicted that the world's two largest mortgage bankers – Fannie Mae and Freddie Mac – would also go out of business within a year. As he concluded in that month's issue of our flagship newsletter, Stansberry's Investment Advisory...

Fannie Mae and Freddie Mac, the two largest and most leveraged owners of U.S. mortgages are sure to go bankrupt in the next 12 months. Congress may decide to assume their liabilities, to prevent an unprecedented global financial calamity, but Congress won't bail out the firms' shareholders.

Fannie Mae and Freddie Mac are going to zero.

Many subscribers thought he was crazy. These two giants of American capitalism could never go bankrupt. But in both cases... that's exactly what happened.

Fannie Mae and Freddie Mac fell into bankruptcy in 2008. General Motors went belly-up a year later... And the U.S. Treasury bailed them all out with massive capital infusions.

I've learned a lot from following Porter's work over the years, but one thing stands out above it all... While you might not always like his predictions, when he's passionate about something – like he was with GM and the mortgage bankers – he's usually right.

It's wise to listen to Porter. That's why I want to revisit one of his old Digests today.

Porter made several big predictions in that 2015 essay. As you'll see, he once again got a lot of things right. But not everything... at least not yet. In addition, using what we've learned since Porter penned that Digest, I'll share eight stocks you can't afford to own right now.

But before we get to that, I must explain why it's critical to look back at Porter's message...

While the coronavirus grabs all the headlines today, something else is still far more dangerous...

Debt.

Fears about the coronavirus are wreaking havoc. But ultimately, I believe excessive debt will be responsible for bringing down the U.S. economy and ending this record bull market.

As the editor of our bond newsletter, Stansberry's Credit Opportunities, I spend a lot of time studying debt. And I get it... As long as most folks can continue squeezing the last nickels out of this bull market, it's easy to stick their heads in the sand and not think about debt.

But that's a big mistake...

Debt is the source of many dangers lurking beneath the surface of this bull market.

They are hidden from the views of most investors. And ignoring them is far more dangerous to your financial health than a virus. That's why my colleague Bill McGilton and I devoted our January issue of Stansberry's Credit Opportunities – "Seven Credit-Market 'Bombs' Waiting to Explode Right Now" – to exposing these dangers for our subscribers.

And Porter saw these dangers long before anyone else. So now, let's examine his predictions and see if they came true...

In that Digest, Porter predicted a wave of corporate credit defaults in the coming years...

We haven't yet seen a broad wave of corporate defaults. But soon after his Digest, we did experience a wave of defaults in one corner of the market... the oil and gas industry.

In fact, Porter specifically predicted the pain for this industry in that Digest. As he wrote...

Nearly all the growth in the U.S. high-yield bond market over the last decade is related to oil and gas exploration and production... These debts cannot be repaid with oil prices at less than $60. And yet they're all coming due between 2016 and 2020.

As these debts go bad, even major oil companies will see their bonds downgraded and their dividends cut... for the banks, insurance companies, private-equity funds, and pension funds that provided this initial capital, there's a tremendous amount of pain ahead.

From 2011 to 2014, many energy companies levered up when a barrel of oil cost more than $100. They were greedy... betting that oil prices would never get cheaper again.

But by September 2015, oil prices were in a freefall...

As the U.S. shale industry flooded the market with cheap supply, oil prices quickly plunged from their peak. And in the past four-plus years, prices have averaged about $53 per barrel.

In the following chart, you can see what happened. Oil and gas bankruptcies in the U.S. skyrocketed, peaking in the second quarter of 2016 – just months after Porter's warning...

I'd say Porter nailed that part of his first prediction.

Porter also warned about auto loans going bad – and the pain that would cause for investors...

He predicted "massive losses" for companies that owned these loans – like Ford Motor (F), General Motors' financing arm (GM Financial), and Santander Consumer USA (SC).

Ford's stock is down 25% since Porter's warning, even after factoring in the dividends you would have received. GM and Santander are up in that span... but they've significantly underperformed the broad market.

Altogether, these three stocks have returned a paltry 9%, on average, since then. That's eight times less than the benchmark S&P 500 Index's 73% return in that stretch...

Last October, credit-ratings agency Moody's noted that some of subprime lender Santander's auto loans were going bad at the fastest rate since 2008. And the two giant carmakers that depend on a steady influx of subprime buyers are feeling the pain, too...

GM's sales dropped 6% last year, while Ford's revenue fell 3%. At the same time, their combined debt has soared from $63 billion in 2015 to more than $250 billion today.

Plus, these two companies' massive pension liabilities total $150 billion. The combined debt and pension liabilities of these two automakers is five times more than their market value.

I'd say Porter nailed that prediction, too. And as he said in his original essay... "This problem is going to get a lot worse." I don't think this part of the story is over yet.

However, as I said earlier, Porter didn't get everything right in that Digest...

Porter also identified five companies in cyclical industries that had been borrowing huge sums of money to finance large stock buybacks – already more than six years into the current bull market. He called them "leaders in value destruction." As Porter wrote...

Even investors who aren't directly hit by any of these ticking debt time bombs are going to be severely hurt by the coming wave of debt defaults. That's because corporate America can rarely resist taking a good idea (buying back stock) and making [it] into a farce.

But as you can see in the table below, this group of stocks fared much better than expected. On average, this group outperformed the S&P 500 as the bull market continued...

These five stocks have returned 119%, on average, since Porter's Digest... better than the S&P 500's 73% return in that span. Mall owner Simon Property Group (SPG) was the only stock that didn't beat the market... It declined about 14%.

When I shared these results with Porter recently, he wanted to know what we learned...

No one is perfect... not even Porter. And as an investor, it's crazy to think that you'll be right 100% of the time. Instead, it's important that you learn from your mistakes so you don't make them again.

After studying these five businesses more closely, I realized none were in poor financial condition at the time of Porter's original Digest. They all had good fundamentals... growing revenue, solid "free cash flow" ("FCF"), and easily affordable debt. (Remember, FCF is what's left over after factoring in all of a company's operating expenses and capital expenditures.)

Because of that, taking on a ton of debt to fund expensive stock buybacks didn't disrupt these businesses. And it didn't cause investors any heartburn as the good times continued.

After all, stock buybacks do boost earnings per share without a company actually needing to increase its earnings. By reducing the number of shares outstanding, management can perform this accounting magic. These benefits outweighed the negatives of the added debt.

But what if Porter had instead focused on companies with weak fundamentals?

More specifically, I'm talking about companies with declining sales and shrinking FCF.

With that in mind, I put together a revised list of six companies with weak businesses that were buying back excessive shares at the time of Porter's Digest in 2015. Take a look...

As you can see, these companies are the real value destroyers... This group of stocks lost an average of 9% since September 2015. And of course, Sears went bankrupt.

Here's what we learned...

When capital is super cheap – as it was in September 2015 and still is today – levering up a good business is a sure-fire way to increase return on equity... and therefore, the stock price over time. However, the important point is, no matter how cheap capital becomes...

Levering up a weak business and buying back shares won't save it...

You can identify a weak business in several ways...

It could have declining sales, margins, and cash flows. It could have large ongoing capital needs that are greater than the cash its business produces. Or it could have debt that has grown so large that it can barely afford to pay the interest.

The eight companies below have weak businesses. And they're spending far too much money buying back stock and paying dividends than they can afford. Take a look...

You should avoid these companies. They're destroying shareholder value by buying back stock using debt. Levering up a weak business never ends well. If you're holding them today, I'd advise you to sell. They'll likely underperform the market in the coming years.

And the thing is, the recent market turbulence from the coronavirus fears will be nothing compared with what we can expect once the real storm arrives. Pressure is building for a catastrophic event.

Porter's warning about a coming wave of corporate defaults is more important today than ever before...

And in the end, I believe Porter will be proven correct once again.

U.S. companies have never been more indebted in history. Corporate debt keeps hitting all-time highs, both nominally and as a percentage of gross domestic product ("GDP")...

And not only is the debt pile much larger, its quality is far worse, too...

In a November report, the Federal Reserve noted that the debt-to-asset ratio of publicly traded U.S. companies is at its highest level in two decades. And according to the Fed's report, the ratio for debt-heavy firms is near a historic high.

The credit ratings of U.S. companies are worse than ever...

In the 1990s, more than 60 U.S. companies operated with the highest credit rating – "AAA." But today, just two U.S. companies – consumer-products behemoth Johnson & Johnson (JNJ) and technology giant Microsoft (MSFT) – maintain a perfect AAA rating.

According to Bloomberg, the largest portion of U.S. corporate bonds outstanding today is rated "BBB" – the lowest tier of "investment grade" debt. It totals $3 trillion... or 40% of all corporate-bond debt. It's the largest percentage ever... four times higher than in 2008.

The chart below shows the growth of U.S. corporate debt by credit rating since 2001...

This could soon become a major problem...

You see, many institutional investors can only invest in investment-grade debt (BBB or higher). So if the debt is downgraded to noninvestment-grade – also known as "junk" status (BB or lower) – these investors will be forced to sell... no questions asked.

And the junk-bond market is much smaller than the investment-grade market. So when that happens, there won't be enough buyers. As a result, bond prices will collapse.

And here's the thing...

Credit downgrades are on the rise again. Last year, credit-ratings agency Standard & Poor's (S&P) downgraded the credit of 1,053 companies in North America – the most since 2009...

In 2016, many of the downgrades occurred in the oil and gas space. But the trouble isn't centered on one industry this time... It's spread across different parts of Corporate America.

Many companies' balance sheets are stretched to the limit and bloated with debt. They're completely dependent on banks and the junk-bond market to keep rolling over (refinancing) their debt.

It's a game of "kick the can down the road"... But the game can't go on forever.

You always see a spike in downgrades before defaults rise.

Except for the oil and gas industry, we haven't seen a period of vast credit default – yet...

Many companies today can barely afford to pay for the interest on their debt. The Fed's artificially low interest rates have kept these "zombie" companies alive for much longer than in the past. The central bank is simply delaying the inevitable...

Allowing bad businesses to go bankrupt is a natural part of capitalism. It frees up resources that can be invested in better ideas.

But the credit markets aren't as liquid as the equity markets. They can dry up quickly.

We're not there yet... But it will end in a sudden, massive crisis. The past sins of the corporate-debt binge will finally catch up... and bankruptcies will soar.

The good news is, you don't have to be a victim...

As the editor of our distressed-bond service, I'm looking forward to the next crisis. And as an investor who follows our work, you should start preparing for what's coming, too...

You see, coronavirus or not, the euphoria we've seen in the markets for more than a decade won't last forever. Fear will eventually take over... punishing even the best companies.

When the time comes, we'll be ready to pounce in Stansberry's Credit Opportunities. But you should know something else... You can make big, safe returns with bonds today, too.

Sure, the best opportunities will develop after the real trouble starts. However, we've already helped our subscribers earn impressive returns since Porter's initial predictions...

Since we launched Stansberry's Credit Opportunities in late 2015, we've closed 26 bond positions (81% win rate) with an average annualized return of 17%.

That's more than double the 7% annualized return of the overall high-yield bond market – as measured by the iShares iBoxx High Yield Corporate Bond Fund (HYG). And we've even beaten the 15% annualized return of the S&P 500 over that span... while taking on far less risk.

In fact, as regular Digest readers know, one subscriber wrote to us last summer to explain that our strategy helped him retire at age 52. We reached an agreement with him, offering access to new subscribers of Stansberry's Credit Opportunities at an all-time low price.

And right now, you can still take advantage of that special offer... If you're worried at all about the markets today, I encourage you to at least check it out. Get started right here.

New 52-week highs (as of 3/4/20): Quest Diagnostics (DGX), Invesco Value Municipal Income Trust (IIM), iRhythm Technologies (IRTC), JD.com (JD), Lonza (LZAGY), Novo Nordisk (NVO), Service Corporation International (SCI), Sea Limited (SE), and iShares 1-3 Year Treasury Bond Fund (SHY).

A quiet mailbag today. What's on your mind? As always, you can drop us a line at feedback@stansberryresearch.com.

Regards,

Mike DiBiase
Atlanta, Georgia
March 5, 2020