The S&A Digest: Back from vacation

Back from vacation... What happened to privacy?... One solution to the mortgage crisis: Borrow more... Jeff Clark's prediction... Bullion vs. rare gold coins... The real reason behind our employee stock-buying rules...

After a week's vacation in Captiva, Florida, I've returned to my post. As much as I enjoyed the beach house, the chef, the bike rides, the fishing... I'm secretly thrilled to be back at work. Don't tell my wife.

Below you'll find a special, extended version of our mailbag. While I was away, readers raised some pointed and critical questions about sensitive topics, like the rules regarding staff buying stocks and the ongoing debate over bullion vs. rare coins. You'll find my answers in the mailbag.

Left unanswered in the Eliot Spitzer saga... Why isn't there any privacy left in banking? Spitzer's bankers turned him over to the federales because he was wiring $5,000, from time to time, in his own name. Keep in mind Spitzer is independently wealthy. Tax documents show he made $1.9 million in 2006. Why would a millionaire spending $5,000 from time to time trigger a federal investigation? And why would that level of spending convince a judge to issue a warrant for a federal wiretap? Hmmmm...

As you know, financial stocks rallied yesterday, with several well-known mortgage bankers' shares gaining 15% or more. The Federal Reserve has begun to accept private mortgages as collateral for 28-day loans, furthering its policy of expanding allowable collateral that began last August.

Here's what I want to know: How can borrowing more money against dodgy collateral help these businesses, which are on the verge of bankruptcy precisely because they've borrowed heavily already against these mortgage assets? If anyone can explain to me how allowing Freddie Mac and Fannie Mae to borrow still more money (they're already leveraged 28 times and 18 times, respectively) is likely to help their shareholders, please take the time to jot me a note.

Jeff Clark wrote it. Did you buy it?

The S&P 500 rarely strays more than 30 points above or below the magnetic pull of the 20-day EMA. When the average drifts too far away, then traders can bet on a reversal. Right now, the S&P 500 is almost 55 points below the 20-day EMA. So it needs to close that gap, and the odds are it will do it by rallying sharply over the next week or two.At least, that's how I'm going to play it.

– Jeff Clark, March 11 GrowthStockWire

Yesterday, the S&P 500 gained 3.71% – the biggest rally since October 2002 – on the Fed's $200 billion injection. Jeff Clark was in for the rally. Were you?

Steve Sjuggerud has said it a million times... Wait for an uptrend to buy. The same applies to going short. Betting against trends is a costly game. Boone Pickens learned that the hard way when he shorted oil and natural gas last month. Pickens' hedge fund is down 14% so far on the trade.

The blog Marginal Revolution reports: "Over here in the Netherlands, court proceedings are starting this week on the biggest speculation fraud ever..." Investors have lost tens of millions of euros in what turned out to be a big pyramid scheme. Any idea what these people were investing in? Tulip bulbs. No kidding.

Al Gore's hedge fund, Generation Investment Management, will soon close to new investors. The fund, which only invests in socially responsible companies, is approaching its $5 billion benchmark. Gore won't give performance details for the fund that was started in 2004...

New highs: Stone Energy (SGY), Westshore Terminals (WTE-UN.TO), NGP Capital Resources (NGPC).

I leave the office for a week... and the mailbag goes to hell. We blew critical answers to important questions like "why don't editors buy the stocks they recommend" and "how can I sell gold coins"? I try to repair the damage and set the record straight, below. Also... a subscriber takes me to task for offering more advice than he paid for... Send your e-mails to: feedback@stansberryresearch.com.

"I too agree with many of my fellow subscribers about how unfair and perplexing your policy to ban the editor from owning securities he/she recommends. It's not good enough to just say our policy is to... blah, blah, blah. Would we not be better served if you explained WHY..." – Paid-up subscriber Joseph Bonamarte

Porter comment: Yes... All of our subscribers should know and understand the rules we impose on our employees as they relate to buying and selling the stocks we cover in our pages. I apologize for how badly we've botched the answers to this question over the last week. (This question comes up about every six months or so... and we usually do a much better job of answering it.)

First of all, we can own the stocks that our fellow editors recommend, but an editor cannot own a stock he is covering. Who said we didn't? I believe all of the editors in our group buy the stocks recommended in our letters. (We require all employees and editors, however, to wait a suitable length of time following a recommendation to buy. So you get in first.). Furthermore, I know our friends and our family members invest in our recommended stocks from time to time - my mother only buys Sjuggerud stocks, for example. We most certainly have skin in the game. However, as mentioned, we do not allow the analyst who is recommending a stock to our readers to buy the stock in question during the period of his coverage. Why?

Before the SEC sued us in 2003, we did allow our editors to buy the stocks they recommended, provided they waited a suitable amount of time before making their purchase. We changed our policy to try and avoid being under direct SEC regulation.

The 1934 Securities and Exchange Act contains a critical rule, known as SEC 10b-5, which prohibits certain acts done "in connection with the purchase or sale of any security." We are concerned that if an editor of ours were to buy the stocks he recommends, the SEC could argue that writing and publishing newsletters is being done "in connection" with buying stocks, thus making the newsletter part of the SEC's jurisdiction.

And why is being under the SEC's regime so problematic for publishers? Because what's prohibited under rule 10b-5 is a matter of tremendous legal debate – and it has been for years. In short, a 10b-5 violation is pretty much whatever the SEC says it is... which puts people like us in grave legal jeopardy because we can't know, for certain, if what we write will bring a lawsuit against us.

For example, we're currently being sued over a report we wrote back in 2002. The SEC alleges our report was fraudulent. I'm not allowed to discuss the case in any detail, since the matter is still being litigated. I can tell you the 'fraud' in question boils down to one of our sources claiming we misquoted him (even though we sent him a copy of our report, and he never asked us to change a word until the SEC knocked on his door).

We can't afford to get sued by the SEC every time we publish something someone doesn't like. Also, small mistakes and omissions are a regrettable, but normal fact of life for publishers – these are newsletters, not securities filings or prospectuses. While we go to great lengths to ensure our work is accurate, it is impossible to avoid making mistakes from time to time.

If we have to worry about being sued every time we make an error, no matter how slight, we couldn't stay in business. Likewise, when we publish something that's controversial, we're sure to be accused of 'misquoting' people from time to time. That's the nature of publishing, and it shouldn't lead to a federal lawsuit.

By separating our published analysis completely from any securities transaction (like the writer buying the stock after the newsletter has been published), we can better safeguard our business from lawsuits. That's the real reason for our rule. But there are other considerations, too.

While some subscribers like the idea of their editors having "skin" in the game, I know from personal experience editors who buy the stocks they write about inevitably come under suspicion if the stock goes south. For example, before we changed our editorial policy on buying stocks, I owned shares of VaxGen, which was a high-risk biotech company attempting to build a vaccine for HIV. The vaccine failed. The stock crashed. For years people accused me – falsely – of recommending the stock simply to pump up the value of my own shares (which I bought in the market following my written recommendation). I lost as much money as anyone in the affair, but "having skin in the game" only led to more criticisms and accusations. By stating no editor may buy the stocks he recommends, we squelch these very harmful accusations before they get started.

Once you understand that we, as a community, are deeply invested in the quality of our work, both as publishers and investors, you may begin to appreciate our rule against an analyst buying the stocks he has under coverage. It allows him to be totally objective and eliminates any of the emotional hurdles other investors face. I appreciate that when I'm holding a stock.

"What's the best way to take advantage of the VISA IPO? Visa said this week that it's IPO is slated to raise as much as $19 billion and thus become the largest IPO ever. It's common knowledge that U.S. credit card defaults have jumped recently, Visa isn't directly at risk because like MasterCard, it is a credit card processor, not a lender. All factors considered, this should make this IPO a great opportunity for buying VISA shares and then selling them for a profit soon after it reaches its peak in the market. Do you agree – what are your thoughts? Should I be drinking scotch on rocks in order for this to be published? ;-)" – Paid up subscriber Rob McIntosh

Porter comment: Few things are as reliably bad as investing in IPOs. In short, if you can get shares, you shouldn't buy them because they're sure to be hugely overpriced. While I don't know anything about this particular IPO, I've learned to avoid the entire IPO market.

"Sean Goldsmith's response to the gentleman who purchased the St Gaudens MS 65 gold coins was ludicrous. First, if he thinks that anyone can sell these coins for $2,050.00, tell him I'll sell mine right now for 10% less. Moreover, using the retail price as a measure of the increase in value is obviously misguided. A dealer will give you nowhere near that. This also highlights the misleading nature of the stated increase in price over the recommended price set forth in investment letters... The fact is that these St Gaudens (which are 'generic gold' for all intents and purposes) have been a terrible investment compared to bullion. The premium has not increased commensurately with the spot price. Let's be honest about this..." – Paid up subscriber RB.

"Subscriber Jim relates his experience with $20 Saints vs. Bullion. Investors need to realize that coins are a collectible, whose value is no more tied to gold than the price of a fine painting is a function of the price of paint. Having said that, at some point the coin market will take off and history shows the gains will be much more spectacular than bullion – if for no other reason than limited supply. While it is sad that he panicked into a loss for himself, he is correct that investors need to do their homework. They also need reputable dealers. This is paramount. While David Hall Rare Coins is often mentioned (they are the cream of the crop so to speak on PGCS only coins), they are also more expensive. Two dealers that I have experience with as a collector and can wholeheartedly recommend are David Lawrence Rare Coins in Virginia Beach, VA and John Hamrick Coins in Alpharetta, GA." – Paid up subscriber Ross Reynolds

Porter comment: Buying collectible coins or collectibles of any kind is a specialist's game (Steve Sjuggerud is our specialist). If you're not a specialist, or if you're not working with a specialist you can trust, you're very likely to get burned – meaning you'll pay far too much for the coins you buy, and you'll end up selling your coins at a dumb price.

In regard to the coin prices we use in our newsletters, we get our quotes by calling large volume dealers and taking a price that's in the middle of the bid/ask spread. We believe this is the price a patient seller could get in today's markets.

The bigger issue for subscribers though, is the question of buying plain, gold bullion or buying collectible coins.

I collect wine, not gold coins. And I can tell you the price of the wine I collect has absolutely nothing to do with the price of grape juice. Prices for fine, collectible wines have soared in the last eight years, simply because drinking wine has become very popular recently. In the past, the same thing has happened in the rare coin market – most recently in the late 1980s. Coin manias can be extraordinary... The prices for certain coins can become completely unhinged.

If you want to invest in a very liquid, easy to buy, and easy to sell monetary commodity, you should buy bullion. When I buy gold, I buy bullion because I want to protect my savings against inflation and I have no interest in becoming a coin collector. On the other hand, coin collectors can make money whether the price of gold goes up or down. Gold coin collecting is a good hedge against inflation. It's a noncorrelated asset (meaning it doesn't follow the value of the stock market). From time to time, rare gold coins will make you a tremendous amount of money – and they've done pretty well since 2003 when we began recommending them. But rare coin investing is a completely different art than simply buying gold.

"Please cut it out with the 'buy this stock but hedge your bet with covered calls' recommendations. This is not the type of advice you have historically given and it's not the kind of investment I'm looking for from you. I find this extra twist adds unnecessary complication that I don't want, so if the stock is not worth buying on its own I have wasted my money on the PSIA subscription for that month. Now this wasted value has happened twice. I don't want to cancel, I'm requesting that you resume making the kinds of recommendations that you have made historically. If a recommendation is so risky that we have to cover our asses with a covered call then I suggest it's not appropriate for the PSIA publication." – Ken Mosher

Porter comment: From time to time (though rarely), I will recommend a stock whose share price I think isn't going to go up immediately, but which I think is a terrific investment over any reasonable investment timeframe (like one year). In these situations, I will recommend that subscribers buy the stock and then sell an out-of-the-money call option against their shares. This generates income up front in the position, providing a hedge against an immediate price decline.

For example, last year the share price of Moody's fell more than it had ever fallen before in its history as a public company. It fell because of the fallout over the subprime debacle. Meanwhile, Moody's doesn't own any subprime debt, it isn't a leveraged business, and it had more than $1 billion in cash. It also has one of the truly great businesses in the world, selling extremely high-priced information to financial service providers and generating an absurdly high return on assets for shareholders.

It was a great long-term investment where I first recommended it in the mid-$40s. But... I also knew the share price was likely to continue to fall in the short term, so I recommended selling a call to hedge our position, and I warned subscribers not to buy the stock if they weren't going to sell a call. Since then, we've sold a second call against the stock, generating about $6 in call income. And the stock price has fallen about $10. So, even though we're down $4 on paper, we have $6 in hand and we've got a stock that we're happy to own for a long, long time. I also advised my subscribers to buy the stock without selling a call option, if the share price fell to below $32.

Ken... I can't understand why giving this extra advice for free bothers you so much. But, here's my suggestion: Just ignore the one or two stocks a year I cover with selling calls. It shouldn't ruin your subscription or your investing returns.

"When inserting a penny behind a fuse the fuse is eliminated thus eliminating the safety device (overcurrent device) designed to protect the circuit it serves. The reason some people do this is they are having some sort of problem that blows the fuse. Fortunately fuses, plug fuses in this case, are no longer used in favor of circuit breakers in residential applications. This practice has cause disastrous results (house burns down) when the circuit is overloaded. The analogy is not clear to me how this applies the financial markets. The house has already burned down." – Paid-up subscriber Norris

"With no personal disrespect to subscriber J. Douglas Holmes, please do NOT change your practice of presenting stock performance charts in logarithmic form. Log scales are far more informative than linear scales when presenting price movements. Mr. Holmes is quite correct stating the mid-November move for Freddie Mac from about $44.50 to about $24.50 (a 45% drop) was more precipitous than the end of Feb/beginning of March move from 25 to about 17.25 (a 31% drop). However, it is the very use of a log scale chart that makes the point for him and in no way did you misinform your readers." – Paid-up subscriber Brian Clark

Ian Davis comment: In science, you use a logarithmic scale when you are measuring a wide range of values and you are not interested in the absolute size of a change, but on the size of a change in proportion to the value itself.

That is why we use logarithmic scales when looking at movements of stock prices. The dollar change is not what we're interested in... The dollar change in relation to the beginning stock price is what we're after.

Let's take a look at your example and see why a logarithmic scale makes sense:

1) The stock falls from $25 to $20 (this constitutes a $5 change, or a 20% fall).

2) The stock falls from $65 to $55 (this constitutes a $10 change, or a 15.4% fall).

On a linear scale, the fall from $65 to $55 would look twice as large as the fall from $25 to $20, even though the stock fell by 5% less on the $10 fall.

On a logarithmic scale, however, the two falls look roughly the same. This is because they both reflect roughly the same percent drop in stock price.

Regards,

Porter Stansberry

Baltimore, Maryland

March 12, 2008

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