The rational way of life...

While we've recently quoted some high-profile investors advising caution about the current market rally... it appears the world's largest hedge funds spent much of the first quarter leaping into stocks.

Research firm FactSet recently published an analysis of first-quarter activity for the 50 hedge funds with the most assets under management. Overall, these funds increased their equity exposure by more than 5% in the first three months of the year.

And the stock that enjoyed the most hedge-fund buying in the quarter was airplane and defense-systems manufacturer Boeing Co. (BA).

The most commonly held stocks (the largest aggregate holdings) among the 50 hedge funds included chemicals manufacturer LyondellBasell Industries, Internet giant Google, real estate brokerage conglomerate Realogy Holdings, and insurance firm American International Group (AIG).

What if there was a secret way of looking at the stock market and individual companies that allowed you to see the real value of everything – regardless of the current price?

If there was such a method, you could invest your hard-earned capital with much more confidence, knowing you were getting a real bargain. You would never have to worry about using a stop-loss because you'd never, ever lose a penny investing again. All you'd really have to do is look around once in a while and pick up the most obvious bargains.

If you had this kind of ability, you'd not only become a more successful investor, you'd become a vastly more patient investor. You'd have real certainty about your choices. You'd know, every single time you bought something that, sooner or later, it would end up becoming massively profitable.

The good news is… There is such a method. There is a real, bona fide, proven, and easy-to-learn method of developing this kind of worldview, this kind of wisdom.

Learning this technique doesn't merely give you an advantage in the markets, either. It gives you a whole new way of looking at the world. You might call it a "value" lens. It's a school of thought... a way of life... a philosophy, if you will. Those who practice it have a few simple things in common. These traits set them apart from other investors even more so than their analytical skills. In short, they see the world in a slightly different way than the rest of us do. It gives them immense power.

Recently, William Thorndike, founder of the private-equity firm Housatonic Partners, wrote a guidebook to this secret world. The book is called The Outsiders: Eight Unconventional CEOs and Their Radically Rational Blueprint for Success.

Before I (Porter) get into the details of this secret way of looking at the world, I'd like to start with a simple example. I'd like to show you three pictures. These are three "snapshots" of a company over the past 15 years. You could derive a few key facts from these charts. What do they tell you?

Most investors have no idea about the real underlying value of individual securities or how to estimate it. And because they know nothing about measuring value, they cannot make wise choices. They're left to gamble. To most investors then, a high-quality business looks exactly like a low-quality business. To most investors, every stock looks something like this one:

The chart above shows the nominal price over the last 15 years of a widely traded equity. Some people looking at this chart will say the stock looks good to buy because it made a "base" and is now trending higher.

And most investors – I'd wager around 90% of active individual investors – only think in terms of nominal prices. They say, "I bought a cheap stock – only $2 per share. If it goes to $4, I'll double my money. If it goes to $1, I'll sell. But I'll only lose half my money. With even odds, over time I will win."

Some people may point out that our stop-loss advice underscores this focus on nominal prices. That's right. It does.

We know that many of our readers will never move beyond their focus on nominal share prices. So giving a clear, conservative exit strategy is crucial for improving their results and protecting them.

But one day, I hope they will "see" the market the way I do… the way they should. Like this…

What the top line in the chart above shows you is the book value per share of the same company whose share price chart was above. What's important is that over the same 15-year period, the book value increased year after year at a substantial rate. Whether the share price went up or down, the actual business grew more valuable every year and continued to produce additional value. That's one of the most important signs of a good business (along with wide profit margins and low capital requirements).

Take a second look at the chart above… The lower line shows us the real price. It shows us how much cash per share the company generated each year. This is how great investors see the situation.

This is what Thorndike wrote his book about... people who see the world in a totally different way. When they look at a company, they ignore share price. Instead, they see values and cash generation. Most of the people in Thorndike's book refused to pay more than eight or 10 times this figure… for any business… ever.

Think about that for a minute. The last time you bought a stock, how much thinking did you give to its price in terms of cash generation? My bet is close to none.

Wall Street prefers to talk about "earnings." Earnings are an accounting fiction. They're derived by taking the income statement and then applying a whole series of tests and guesses. Earnings are easily manipulated by managers, using both legal and illegal means.

The world's best investors ignore both earnings and the timing of earnings. All they care about is the amount of cash a company generates over time.

Simple question... Given what you've seen, should you buy this stock? What price would you pay? Here's one more critical clue. The next chart shows you the company's cash profit margins over the last 15 years. You'll notice: They're almost completely unchanged throughout the entire period, which includes the worst recession America has faced since the 1930s.

These data tell you we're looking at a high-quality business. It has built value at a significant pace. It has steady, cash profit margins.

We started recommending these shares in 2006. A lot of folks said we were nuts at the time. Couldn't we see that the share price was in a downtrend? They didn't get it. They couldn't see the value that was plainly visible to us.

The company we've been looking at is Wal-Mart (WMT) – the World Dominating retailer.

Wal-Mart was my company's No. 1 investing idea in 2006, 2007, and for most of 2008 – when it went up as the rest of the market went down. It survived the 2008-2009 crisis with nary a hiccup. It has produced outstanding returns since. We most recently urged subscribers to buy the stock when a minor scandal erupted over its operations in Mexico. Since Dan Ferris first recommended it in October 2006, Extreme Value subscribers who followed his advice have earned more than 10% annualized profits in this position – with nearly zero volatility.

Most people couldn't recognize the value in Wal-Mart because they didn't understand the numbers. They only understood their own emotions. They saw it as merely a discount retailer with a lot of bad press (largely because of its stand against unions). They wouldn't shop there. They wouldn't buy the stock. Case closed.

The men and woman in Thorndike's book are the most successful CEOs in the history of modern capitalism. They include Tom Murphy (Capital Cities), Henry Singleton (Teledyne), Bill Anders (General Dynamics), John Malone (TCI), and Dick Smith (General Cinema).

These guys make the CEOs who are routinely celebrated in the media (like GE's Jack Welch) look like wannabes and posers. Thorndike's CEOs all made 20%-30% a year for investors... for decades. That kind of performance made everyone who invested with them – even folks who put in as little as $10,000 – extremely rich.

And they all did it the same way. They all managed their companies (and their lives) in a very similar fashion. They all looked at investing in the same way… the way I've outlined here… and the way I write about it constantly in my newsletter.

Why should that matter to you? All of these CEOs followed the same pattern. They spent their time allocating capital – investing. They delegated the operational responsibilities to junior executives. They spent all of their time deciding whether to invest in their existing businesses, whether to buy back their own shares, or whether to buy other businesses.

Like you, they were investors, not just CEOs. They made these key investment decisions – and all of the other decisions in their lives – by the same standards of value. They quantified everything.

If you learn to do the same with your investing, you will become vastly more successful. I'd urge you to read Thorndike's book... or at least to ask yourself these three questions before you buy another stock:

• Is this a great business? Does it have the ability to grow its sales and to maintain its profit margins? Is the management team dedicated to rational decision making and rewarding shareholders?
• Am I paying a reasonable price for these shares? Are the shares trading around book value or at less than 10 times cash earnings?
• If the stock were to fall by 50%, would I be confident enough to buy more?

All of the CEOs Thorndike wrote about ended up making a few large and crucial investment decisions. They bought other companies (or their own stock) at a size that made up 25%-40% of their company's enterprise value. That would be like you putting 40% of your net worth into a single stock. The only way you will ever have the confidence and the knowledge to make that big of an investment safely is by learning to look at the real numbers – not just the share price.

I firmly believe that to be extremely successful as an investor, sooner or later you have to make the big, the very big, investment. Great ideas and great opportunities just don't come along that often in your sphere of competence. When you see a great opportunity that you fully understand... be prepared to swing for the fences. But make sure... make absolutely sure... you've done all of your homework. That starts with only buying great businesses and understanding what they're really worth.

Oh... one more point about these world-beating CEOs. You've probably never heard of any of them before. Part of their way of life was to avoid Wall Street and the media. They figured out that the closer they got to the Wall Street circus, the more cloudy their thinking would become.

They didn't want to be influenced by anything but their own rational thinking. So they established their offices and went about their lives as far away as possible from Wall Street and the mainstream business press.

That's why, if you're looking for a great investment, I'd recommend staying away from feel-good front-page stories. The press tends to all think with the herd... which is the opposite of what you ought to do as an investor. (Of course, negative stories are often great buy signals since the press always exaggerates the consequences of bad news… like Wal-Mart's Mexico problem.)

New 52-week highs (as of 5/16/13): Advent Claymore Convertible Securities & Income Fund (AVK), Constellation Brands (STZ), Coca-Cola (KO), Blackstone Group (BX), Chart Industries (GTLS), Washington Real Estate Investment Trust (WRE), Integrated Device Technology (IDTI), Microsoft (MSFT), and Qlik Technologies (QLIK).

In the mailbag today... signs of a top. It happens during every bull market. Subscribers start making a lot of money. They inevitably mistake a bull market, driven by incredibly stupid monetary policy, for genius (us). I'm all for everyone enjoying the ride. But when people with zero investment experience start making huge profits by merely reading a newsletter... I know the top can't be far away.

The good news is, a real jackass also wrote in. So... we're not at the top yet. Send your unjustified praise and ludicrously mean-spirited criticism to feedback@stansberryresearch.com. I promise to read it.

"I have been a subscriber for a few months and I'm earning 19% on my IRA, with my dividend stocks. I am 80 years old and it's never too late to learn some new tricks. Thanks so much for Dr. Eifrig's insight. My IRA is up $21,000 this year." – Paid up subscriber Maxine Wagner

Porter comment: Maxine... Nobody is happier for you than I am. But I just want to make sure you understand... that rate of return isn't sustainable. Doc is a genius. And he'll continue to keep you as safe as possible. But just remember... when he says it's time to sell, he's not kidding.

"I am a very small investor (only $10,000). I am a subscriber to S&A Digest, and followed your company's advice on two stocks, LNG and CCJ. In just over one month, I have gained over $1500. I am still reading and trying to understand all of the information that you provide. I have no background in finance. So it is taking me a long time to understand what the different terms mean and how that item might be of interest to me. I hope to continue learning, and hopefully your information will assist me in the future. Thank you again." – Paid up subscriber Mike O'Donnell

Porter comment: Mike... just as I responded to Maxine… We promise to try our best to keep picking winners. But make sure you realize that we're in the midst of a roaring bull market that's being manufactured by the Federal Reserve. At some point... maybe soon... we will have to sell. Don't lose sight of what's really causing these gains – a massive inflation.

"You guys must be hard up for copy for your feedback print space. You gave way too much room for gay-sounding Winston Goodfellow to windbag about Ferraris. How many of your subscribers do you actually think would be able to purchase any of these cars? In the future, please reserve such minimally useful information for your subscribers to the $3000 per year subscription publications you produce." – Paid-up subscriber Joseph Paysse

Porter comment: I love Ferraris. I'll probably never own one, but I believe they are some of the most beautiful cars ever made. I understand why people would want to collect them. And I appreciated the update on their soaring prices. It's confirmation of our inflation thesis. And that's valuable to everyone. Even jerks like you.

Regards,

Porter Stansberry
Baltimore, Maryland
May 17, 2013