The S&A Digest: Make an Annualized 38%, Safely, in This "Pairs" Trade

Another mania, another IPO... 'Fannie brakes for home sales'... BAC's currency in trouble... RBS out $12 billion... DB says: 'Buy your own strippers and hookers'... Debt-collection stock picks... Pairs trades...

 Yesterday, I learned the swelling reaction your body has to an injury is almost always an overreaction. That's why doctors tell you to put ice on it right away. Some time ago, doctors thought you should put heat on the swelling, as if to encourage the natural process to work harder. But it turns out that overreacting to a change in the environment is embedded in our very skin in the form of the primordial inflammatory response.

No wonder human beings are such bad investors. We're not only programmed to overreact emotionally. Our anatomy is programmed to overreact, too. Could it be, for just one example, that investors are overreacting to the bull run in agriculture stocks?

 Remember the Blackstone IPO at the top of the private-equity boom? Well, another mania, another IPO... Intrepid Potash, a fertilizer company, raised $960 million with an IPO on Monday. The 30 million-share offering sold for $32 per share, beating the $27-$29 forecast. The offering had already been increased from 24 million shares with an estimated price range of $24-$26 per share.

Look at the following chart for Potash Corp., another fertilizer company. The $66 billion company trades for 11 times book value and more than 60 times earnings. Potash shares have increased 620% since June 2006. They've nearly quadrupled in one year.

I don't care if it's harvesting the dung of Siberian white tigers and shipping it FedEx to Nebraska. Fertilizer is a commodity business. It's not worth 60 times anything.

Most people will look at this chart, and they won't be able to buy the stock fast enough. In fact, Potash simply cannot grow fast enough to warrant its current valuation, but that fact is completely lost on the great herd of speculators, which one might now refer to as "overreactors."

 As the food bubble continues to inflate, the housing bubble continues its long, slow deflation...

Sales of existing homes for March 2008 fell 2% below the February 2008 level, and 17% below the March 2007 level.

One reason home sales are slow and will remain slow for some time is that Fannie Mae raised its minimum FICO score on most mortgages to 580. Fannie also decided it wouldn't accept borrowers who have missed two monthly payments in the past 12 months or who've been in foreclosure in the past six years. Fannie used to accept borrowers who had a foreclosure four or more years ago.

Fannie's new standard not only makes it harder for new homebuyers to get a loan, it also makes it very hard for existing borrowers to refinance their adjustable rate mortgages. Maybe that's why Fannie is making it easier for borrowers to stay in there existing mortgages. Fannie recently loosened the rules on "forbearance" - the payment holidays banks sometimes negotiate with troubled borrowers. These mortgages are still eligible to be bought by Fannie if the forbearance period is six months or less. The old limit was four months.

 Bank of America (BAC) apparently didn't like all the talk about how the "worst is over." It's all nonsense, and BAC has put an end to it...

In the first quarter of 2008, BAC's losses from collateralized debt obligations ("CDOs" are the complex asset-backed securities that Wall Street used to get into this credit crisis) were up. Its nonperforming loans were up. Its charged off loans were up. Its credit loss provision was up. Its leveraged loan loss provision was up. Everything bad was up. Everything good was down.

CEO Ken Lewis says he's not going to cut the dividend, but that's about as credible as when governments say they're not going to degrade their currency. But BAC's currency is already shot. It raised $12 billion of new equity and its Tier 1 capital ratio – a measure of its most liquid buffer against future losses – was still down from 8.57% to 7.51% (below BAC's internal target of 8%).

I expect BAC will cut the dividend on its common stock before the year is out. It'll try to issue preferred stock, but that'll just dig it deeper into the same hole, like borrowing from a loan shark when your bookie is about to break your kneecaps.

 Next up in the "our currency sucks, too" department: the Royal Bank of Scotland. RBS wrote down $12 billion in assets and will raise $24 billion in a rights offering to bolster its balance sheet. RBS better watch out... $12 billion here, $24 billion there, pretty soon you're talking real money.

Paper money is pure, worthless garbage, and banks are in the paper-money business. It's justice that they should have to make like a wasted rock star and choke on their own vomit once in awhile. I wonder if there's a private-sector bank anywhere that's smart enough to own plenty of gold?

 However you figure it, banking just ain't what it used to be. Time was, you could collect other people's money, borrow short, lend long, and have a helluva good time with the profits. Not anymore, at least not at Deutsche Bank, which sent out a memo that reads, "Deutsche Bank does not approve of any adult entertainments and such expenditures will not be reimbursed."

One Deutsche insider said, "In the good old days you could pass off a trip to a knocking shop as a restaurant if the name wasn't too obvious." The bank also warned against using its credit cards for such activities.

In addition to halting strip-club and brothel spending, Deutsche employees have to get managerial approval for taxi use (as opposed to public transport) and lunches of more than $100. Employees leaving on overnight flights for morning business meetings must shower and shave at the airport instead of booking a hotel.

 Everyone knows markets hate uncertainty. Nowhere is that borne out more than in biotech. Consider Basilea, a Swiss drugmaker focused on antibacterial and antifungal remedies. The company's lead drug, ceftobiprole, is a promising treatment for complicated skin infections. But last month, the FDA issued the company and its Big Pharma partner, Johnson & Johnson, an approvable letter - the regulator's notorious maybe-yes/maybe-no ruling.

Without pausing to see if the companies' can satisfy the agency's concerns, investors dumped the stock. It fell from 187.40 Swiss francs to 148.50 on the day of the ruling. It closed today at 150.20.

But these dramatic, emotional reactions give us excellent opportunities to profit. Our own Dr. George Huang has developed a proprietary method for trading these approvable letters. It's a strategy that offers huge upside and very limited downside.

The FDA will issue 55 more rulings in 2008, and we have exact dates for all of them. The next one happens tomorrow. George has written a series of essays explaining his system for Digest readers, which you can read here. We're offering our new service at a big discount until this coming Monday. To learn more about Dr. Huang's S&A FDA Report, click here...

 Our friend Mohnish Pabrai is a Buffett disciple in the truest sense. He only buys companies for less than half their intrinsic value, and he holds until they reach intrinsic value. His strategy has returned 25% a year since 1999. He currently manages $600 million. In a recent SmartMoney interview, Pabrai said, "Our brains are in sync with the speed at which the market is moving and totally out of sync with the speed at which a business is moving. It seems obvious: The market is repricing a company's stock very quickly. I can process very quickly; therefore, I make decisions based on that. You have to learn to dramatically slow your brain, which is very hard for most people. The reality is that you should make decisions based on how that business is changing, and that's a very slow process."

 New highs: Husky Energy (HSE.TO), Petrobras (PBR), Stone Energy (SGY), International Coal Group (ICO), Comstock Resources (CRK), Plains Exploration (PXP), Covidien (COV), ArcelorMittal (MT).

* Feel free to treat us like the Statue of Liberty: Send us your poor, send us your sick, send us your tired. Your poor, sick, tired comments are always welcome here: feedback@stansberryresearch.com.

 "With all of the consumer debt problems, are there any publicly traded companies that we can invest in that deal with debt collections? Any ideas? Names or recommendations? Keep up the great work. I have made quite a some of money thanks to your work. Thank you very, very much." – Paid-up subscriber Greg S.

Ferris comment: There are a bunch of them: PRAA, ECPG, AACC, AFSI, FCFC. A few years ago, I recommended Portfolio Recovery (PRAA), which I consider the best of the breed among debt buying/collection stocks. PRAA is cheap today, at less than 12 times enterprise value/free cash flow. I also once wrote about a very sophisticated investor in San Francisco named Peter Bennett, who essentially runs a hedge fund that buys debt.

Regards,

Dan Ferris

Medford, Oregon

April 22, 2008                                                                                 

Make an Annualized 38%, Safely, in This "Pairs" Trade

By Ian Davis

About nine months ago, I received an e-mail from my managing editor, Brian Hunt, reminding me about a style of trading that protects you from market risk while remaining very profitable...

Here's the trade Brian brought to my attention...

About 3 years ago, one could have gone long Internet advertising/media by purchasing Google. At the same time, one could have shorted print advertising/media with a short sale of Journal Register.

The ratio of Google stock to Journal Register stock back then was five. You could have purchased one share of Google for every five shares of Journal Register that you shorted. Now, with the massive appreciation in Google stock and the nosedive taken by most print media, especially Journal Register, that ratio stands at 132 [as of July 2007].

You would have made 254% in about three years by anticipating this evolution of the advertising industry... and you would have done so with very little market risk.

The e-mail was about pairs trades. A pairs trade is simply an investment strategy where you buy the stock of one company and short-sell the stock of another, similar company. For example, if you think Coca-Cola is a better soft-drink maker than Pepsi, you may short Pepsi and go long Coca-Cola. This kind of trade allows you to play an industry trend (i.e. the success of Coke versus Pepsi), but insulates you from broad market trends.

Here's how it insulates you from broader market risk: If you were right that Coke were to outperform Pepsi, it wouldn't matter if the broader market fell and lowered Coke with it. Yes, your long position may decline some, but Pepsi would be punished more and you'd make a ton on the short.

Similarly, a red-hot market might lift Pepsi some, costing your short position. But if you're right about the Coke-Pepsi relationship, the long Coke position would rise more than enough for you to profit, despite losing on your short.

I've kept this idea in mind since Brian's e-mail, and recently I've seen an intriguing setup for just such a trade...

Quant funds often use pair trades that take advantage of the traditional relationship between two different (but similar) investments.

This kind of pairs trade assumes two similar investments should have a stable relationship relative to one another. When the relationship is disturbed, you buy and short-sell with the assumption things will simply return to normal.

The pairs trade I'm talking about is in crude oil and gold...

As you've probably noticed, commodities have been in a bull market lately. Both gold and crude oil have appreciated by hundreds of percent in the last six years.

Also, for whatever reason, gold and oil have traditionally maintained a fairly stable relationship. Over the last 25 years, one ounce of gold has been able to buy, on average, about 14.8 barrels of oil. Right now however, one ounce of gold won't even buy you eight barrels of oil.

As the following chart shows, the ratio rarely stays this out-of-whack for long.

Gold is Cheap Relative to Crude Oil

In the last 25 years, the gold-to-oil ratio has been below eight only 10% of the time. During these times, gold outperformed oil by an average of 8% over the following three months.

Now is the perfect time for a gold, crude oil pairs trade. If oil maintains its current level, the price of gold would have to rise by 89% before its normal ratio is reached.

The commodity bull market has gripped the world for about eight years now. In my opinion, commodities may be approaching the mania phase (I don't think we're there yet, but commodities sure are becoming popular).

This can be a very exciting time, marked by large volatility, spectacular gains, and horrendous losses. However, if you're not interested in riding this speculative rollercoaster, you may be interested in doing a pairs trade. It will mitigate some of the volatility risk but still leave you open to large potential gains.

Remember, we're insulated against broader market moves, and we don't have to make a precise call on the direction of oil or gold specifically. Oil can stay at $117, or even rise a little, and we'll be fine so long as gold closes the gap (which history says it will).

One way to do this trade, would be to short an oil ETF, like the United States Oil Fund (USO), and go long a gold ETF, like the streetTRACKS Gold Shares (GLD).

Good investing,

Ian Davis

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As of 06/21/2013