The S&A Digest: It's Time to Lighten Your Load in Emerging Markets

A 33%-a-year trading system... Why emerging markets will crash... Chavez takes CANTV... CECO's in the clear... Playing the "condo squeeze" in Miami... More condemnation in the mailbag...

Don't miss our weekly "quant" research. In today's essay, Ian Davis delivers a simple trading system that earns 33% a year – reliably.

Venezuelan President Hugo Chavez ordered the takeover of telephone company CANTV to take place before any investors are paid. Shares of CANTV have fallen 30% since the nationalization was announced, and are down an additional 13% in early-morning trading. PSIA recommendation Verizon (VZ) owns a 23% stake in the company... which was worth about $600 million before the confiscation. Will Verizon have to write off the asset? Maybe not. The company has a contract to sell its stake to Mexican billionaire Carlos Slim. We don't expect the situation to have a material impact on Verizon, either way.

The U.S. Department of Education lifted a restriction, imposed in June 2005, preventing PSIA pick Career Education (CECO) from acquiring schools and opening new, domestic campuses. Shares are up 9% in early trading today. We're up 17% since November.

Signs of a market top: Investment in commercial real estate hit a new high in 2006 with $643 billion of stock being traded, up 33% from last year. Observers expect the high prices and rents to continue throughout 2007.

For the first time, money-center bank operations in Europe and Asia earned more than their U.S. counterparts. Citigroup saw international revenues from its corporate and investment bank rise 34%, compared with 10% domestic growth.

What a change... When I left Baltimore this morning, it was 25 degrees, windy, and snow was blowing everywhere. When I landed in Miami this afternoon, it was 90 degrees. I rented a convertible.

My subscribers delivered – once again. One of you introduced me to a very knowledgeable realtor in Miami. She specializes in "condo squeeze plays." Apparently, lots of investors put deposits down on pre-construction condos they never intended to actually purchase. They planned to "flip" them before they had to close. When the market collapsed last year, their plans fell apart. And now they're on the hook for the full price of those condos, but they can't pay. If you've got ready cash, you can buy out these distressed owners at a substantial discount.

As appealing as the condo squeeze play seems, I wonder about the prices... Let's say you can buy a $1 million condo for $800,000. Is it worth it? I don't know... but I doubt it. Five years ago, these same condos were selling for $450,000.

I'm leaning towards the bottom end of the market, which seems like a much better value. Like a 1,200-square-foot, historic, Art Deco apartment with high ceilings, hardwood floors, and deeded parking... for $250,000.

While I'm checking out real estate in Miami, Sjug is in Tokyo doing the same thing. The sun won't set on Stansberry Research today...

New highs: AutoZone (AZO), PowerShares Pharma (PJP), Ares Capital (ARCC), Convergys (CVG).

Lots of mail this weekend. Don't miss the last note – a reader describes attending the University of Florida in the 1940s. If you send it to us, we'll read it: feedback@stansberryresearch.com. (Please note: We can't respond individually. For customer service, call us: 888-261-2693.)

"Did I miss something? What is the ticker symbol of the $20 stock that will pay the $10 dividend? To what letter do I have to subscribe to get the answer? Please let me know." – Subscriber B. Berbotto

Porter Comment: We got dozens of notes like yours over the weekend... Apparently, not everyone reads The Digest every day. Tisk, tisk. For more information on our latest "dividend grab" idea, see last Thursday's Digest. By the way, since we started recommending these "dividend grab" situations last November, we've found four worth buying (and recommended them to you). The average gain has been 14%. That's not bad for three months' time. We're considering publishing a newsletter dedicated solely to covering these situations. What do you think?

"I know you have been sick this past week, but reading your 1/18/07 post, since when has this happened? 'Net current assets are total liabilities minus current assets.' Are you still recovering?" – Subscriber Cullen Brueske

Porter Comment: You caught me. I wish I could blame it on my health... but it was my brain that wasn't functioning at peak levels. Tight deadlines and being in a hurry lead to errors like that one. Obviously, I inverted the formula. Luckily, you guys are smart enough to know what I meant.

"I love to receive your letter and usually understand everything you say, however, I'm at a loss to understand how we laymen are to implement the three rules. How do we know about the minimum 3% dividends? How do we know when the stock is priced right? Investing in businesses we understand is the easiest part. I'm sure other readers would be interested in your answers." – Subscriber Russ Berens

Porter Comment: There are many tools you could use to implement my three rules, but the best way would be to find a broker who agrees with the methodology and is willing to help you screen for opportunities. If you're on your own, I'd recommend using Microsoft's Deluxe Screener and Yahoo! Finance. The screener will allow you to quickly find high-yielding, relatively cheap securities. You'll have to download a small "software client" from Microsoft to use it, but it's free. Yahoo! Finance gives you a nice interface to learn more details about each security.

Using my three-part method, the hardest calculation you'll have to perform is the measure-of-safety test. Learn how to do this by reading my newsletter, Porter Stansberry's Investment Advisory or by reading Ben Graham's classic book, The Intelligent Investor. Once you understand the mechanics of finding stocks that meet my criteria, work on your discipline. Remember that while opportunity is infinite, your capital is finite. Keep your standards up.

"Thanks for being so straightforward and honest about the three most important things in stock selection for long-term results. I think you are spot on with that advice. It's nice to see this coming from an investment advice publisher instead of the usual 'secrets' to investing. Dividend payers don't get the respect as excellent investment vehicles that they should. More investment advisers need to recognize that fact. Thanks for your column. I don't always line up with your thinking, but I do enjoy reading the sometimes heated banter between you and your readers and readers between themselves. Have fun on your trip down here to sunny and warm Florida!" – Subscriber James McGovern

"What are your thoughts on Stan Weinstein's method for investing?" – Subscriber Neville Batliwalla

Porter Comment: I don't have any. I've never heard of Stan Weinstein. Who is he?

"I particularly like that you are reading and responding to your readers' comments in a timely manner. Thanks. As to the stellar performance of your stock picks, I think the more important number is not the Total Gain, but the Annualized Returns. [As the] Hall of Fame shows, you have been able to pick some stocks that return over 30% a year for several years. Bravo and Congratulations." – Subscriber Earl Wycoff

Porter Comment: Earl sent us a re-sorted Hall of Fame, with the numbers all annualized. At the top of the list was my 2000 recommendation of Cree, which produced an annualized return of 921%. The nominal return was "only" 271%. Personally, I don't care about annualized returns, and we don't publish them because I think they're very misleading. Annualized returns only matter if you can continue to reliably compound your capital at those incredible rates. And, of course, no one can do that. What I care about are the total returns produced – the money in the bank. Think about it this way... If you knew, going into an investment, that you were going to make a 200% profit, would it matter to you if it took six months or two years to book it? No, of course not. Earning 200% in two years' time is an exceptional result. The "annualizers" will argue that you'll make a lot more money over time with short holding periods. But that's only true if you can reliably flip your investment from one marketing-beating security to another. And you can't. What I care about as an analyst is a safe security that's definitely going to produce a large return. I don't care whether it takes a year... or three. Neither should you.

"I am an Alliance member and tired of hearing Jeff's great prediction 'Huge Sell Off Coming Soon.' How can you guys all put out buys every month and one of your guys keeps saying 'SELL'? The only one worth anything is you and Dan Ferris." – Alliance member Walter Bushie

Porter Comment: Oh, Walter. Don't say that about me. You'll put the hex on me. Remember: We're all only as good as our last recommendation. I've been on the money for about 18 months now. But the bull market in "Porter" is getting long in the tooth. I'm due for a correction. And, in regard to Jeff's prediction... why would I hire someone as smart as Jeff and then tell him what to write? We publish different letters so that you can get different opinions. Why shouldn't they sometimes (if not always) be contradictory?

"Your information is wrong regarding BMW X3. It is built in Graz, Austria..."

– Subscriber Ron Manuel

Porter Comment: I stand corrected... Magna International (via its subsidiary Magna Steyr) builds the X3 for BMW, all Mercedes E-Class vehicles, and the Mercedes G-class SUV in Austria, not Canada, as I reported earlier.

"I count myself among the most tolerant of people, but the repeated allusions to your personal wealth, at least part of which must come from subscribers, is, at least, tasteless. It is not inspiring if that is your intent. Please find something else to introduce your newsletters with. Or do not bother. Better yet, take a poll of all subscribers asking the question: 'Are you interested in my personal life and how good it is?' If the majority is interested, I will stand corrected. I may even apologize." – Subscriber Joe Mitchell

Porter Comment: Would you buy investment research from a poor person? Seriously, writing every day inevitably requires that I share some details of my life with you. And I should... subscribers have given me most of what I have. I am very grateful. That's why I'm committed to writing every day and to continuing to improve the scope and quality of the research we provide. I hope the relationship is mutually beneficial – it should be.

"After working diligently to scrape together a modest savings, I lost most of it under the direction of a major investment house. At 70+ I took the reins into my own hand recognizing I couldn't do worse. Thanks to your team I have recouped my nest egg and am forging ahead. Best of all, I am receiving a great education and find it stimulating. Thanks for all the fun! You've made an old man very happy." – Subscriber 'Bobalock'

"[Since] you enjoyed the victory of the University of Florida over Ohio State, I thought you might be interested in knowing what Florida football was like when I was there between 1938-1942... The first game that I saw at the University of Florida was the standard warm-up game against Stetson. [Prior to] this game, Stetson had never even scored against Florida. But in my freshman year, Stetson beat the University of Florida! The highlight of Florida football when I was there occurred in 1939, when I was a sophomore. Florida went up to Boston to play Boston College, which was, at that time, a football powerhouse. Florida was thought to have a very poor chance against Boston College, but actually managed to win the game! By a remarkable coincidence, Mary Chamberlain, the woman I met and married in 1944, was at that game as the date of a Boston College student. She told me how her date was in great dismay over Boston's loss. While I was there, the student body at the University numbered around 3,500 men. Women went to the Florida State College for Women at Tallahassee, which is now Florida State University. There were a few women at the University taking courses that were not offered at Tallahassee, such as pharmacy, architecture law. At that time, the University of Florida required no tuition, but there was a student activity fee of about $35. Florida law required that the University admit every graduate of a Florida high school that applied for admission. There was a series of entrance exams, and if a prospect scored too low he would receive a letter from the admissions office suggesting that he save his time and money and not attend college. Actually, selection was by the cruel process of passing or failing. My beginning class contained 900 students, but by the end of the semester only 600 were left. By the end of 4 years, only 300 were left. During my senior year, I was studying for an accounting exam with a friend of mine when the news came that the Japanese had attacked Pearl Harbor. The University responded by requiring all male students to report for calisthenics at 7:00 AM." – Subscriber Robert G. Smith, Jr., Ph.D.

Good investing,

Porter Stansberry

Miami Beach, Florida

January 22, 2007

It's Time to Lighten Your Load in Emerging Markets

By Ian Davis

July 1997 marked the beginning of the East Asian financial crisis.

The International Monetary Fund was required to come forward with rescue packages worth tens of billions and the Malaysian prime minister spent the aftermath of the crisis ranting at George Soros and other foreign speculators, claiming they conspired to cause the crash.

The debacle spread around the globe. Emerging markets (as measured by the DataStream Emerging Market Index) fell 56% in a little more than a year.

Today, emerging markets, as measured by their price-to-book value, are more expensive than they were in 1997. Also, the level of complacency that existed before the Asian financial crisis has returned.

It's a very dangerous time to be a buyer of emerging market stocks and bonds.

VALUATION:

The price-to-book value of the DataStream Emerging Market Index is 2.6, its highest level in more than a decade. Price-to-book is a simple valuation measure comparing a company's market value to its accounting "book" value. The following chart (below) shows the extreme that this valuation has reached over the last few years.

When investors are nervous about the economic outlook of a country, they will require that country to offer yields significantly higher than U.S. treasuries. Otherwise, the reward isn't worth the risk. Conversely, when investors are complacent about a country's economic outlook, a relatively small premium will still attract foreign investment.

Currently, the emerging-markets spread – the premium that emerging-market bonds are yielding over U.S. treasury bonds – is at a near all-time low of 1.57%.

In other words, emerging-market bonds are offering only 1.57% higher yields then U.S. Treasury Bonds. This is the spread's second-lowest level in the 10-year data set, behind only May 2006, when emerging markets fell by 20% in about a month and bottomed out at 1.48%.

TRADING STRATEGY

Using three emerging-market indicators – current valuation, investor complacency, and the current trend in emerging markets – I've developed and back-tested a trading strategy that would have been very profitable over the last 10 years.

The strategy I've developed is to buy emerging markets when they are cheap, investors are nervous, and the trend is up. Similarly, my strategy calls for short selling emerging markets when they are expensive, investors are over-complacent, and the trend is down. For periods of time when emerging markets aren't particularly expensive or cheap, and investors aren't clearly complacent or nervous, I would invest based on the prevailing trend in the market.

Over the last 10 years, this strategy returned 32.92% per annum during the years you would have been invested in the market (before taxes and fees). Even after a 15% tax was applied to the trading profits, the strategy still returned 26.12% per annum for the years you were invested in the market. This is significantly better than the 8.5% per annum that a strategy of "buy and hold" would have produced.

The following two charts give you a graphical view of how this trading strategy performed. The first chart shows the emerging markets index in the top section, highlighted blue where the trading strategy calls for a long trade and red where it calls for a short trade. In the middle section, you can get a sense of the emerging-markets climate. The bottom section shows when you should be long or short. The second chart shows you how your capital would have grown had you invested using this trading strategy, as opposed to buy and hold.

CONCLUSION:

Emerging markets are expensive, and investors are overly complacent about investing in these risky markets. Historically, when these expensive valuations and overly complacent investor sentiments exist, emerging markets have performed very poorly. However, since the prevailing trend in these markets is still up, I do not recommend that you sell the market short. However, if you are heavily exposed to emerging markets, now would be a good time to lighten that exposure.

UPDATE ON PREVIOUS PICKS:

On November 6, I recommended Toll Brothers (TOL) at $28.05. The stock closed this Friday at $32.42, up 15.58% since its recommendation. This stock has performed very well over a relatively short period of time, and I believe it still has a lot of upside potential. My recommendation remains a HOLD.

On November 13, I recommended Home Depot (HD) at $36.62. The stock closed this Friday at $40.45, up 10.46% since its recommendation. I believe this stock will continue to perform well going into the future. My recommendation remains a HOLD.

My most recent recommendation, made on December 4, was Thai Fund Inc. (TTF) at $10.92. The stock closed Tuesday, January 9 at $9.27, triggering our stop loss. The net loss on this trade was 15.11%. Although my long-term view on this fund has not changed, my recommendation at this point is a SELL. If you have not sold yet, you benefited from a nice rebound off that low to $10.03 (as of last Friday); however, I still recommend you sell your position. It is important that we honor our trailing stops to prevent us from being wedded to losing positions.

One last note on Thailand: Some of you may be wondering why I recommended Thailand a month and a half ago, if emerging markets are so unattractive. Thailand is a unique country. Unlike most emerging-market countries, it was and still is valued attractively. Also, because of the political strife in the country, investors were anything but complacent. I think Thailand is still a good long-term investment. However, it could see some weakness in the near future, if emerging markets undergo a correction.

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