The S&A Digest: The Baby in the Bathwater

Stansberry & Associates Top 10 Open Recommendations
(Top 10 highest-returning open positions across all S&A portfolios)

As of 07/01/2013

Buffett's hiring... Investment banks are junk... More dividend grab questions… The Bishop on the loose... Insider trading bust... A possible winner in the subprime market

Porter Stansberry fans, rejoice. Our fearless leader makes his triumphant return to the helm of The S&A Digest on Monday. – Dan Ferris

 Dust off your resumes… In his annual letter to shareholders, Warren Buffett announced that he's looking to hire a young investment manager to help succeed him as Berkshire Hathaway's chief investment officer, or CIO. Buffett already has three candidates in mind for the CEO position, and the board of directors knows what to do about that job if Buffett should shuffle off this mortal coil all of a sudden. But the CIO slot is wide open. Buffett says he needs someone who is smart, experienced, and can recognize and avoid risks, including those never encountered before.

 Also in his letter, Buffett called hedge-fund fees "grotesque." He says paying 2% of principal and 20% of profits is a "folly" and will in no way lead to better returns. Instead, you can invest in Buffett's own "hedge fund," his Berkshire Hathaway empire, for a mere 13 times earnings. You'll keep all of your principal and profits, after brokerage commissions. The compounded average annual gain of Berkshire Hathaway from 1965 to 2006 is 21.4%, dwarfing the average return of hedge funds, at around 7% per year. Imagine paying 2% of principal and 20% of profits and having a 7% return left over! You'd think folks would feel like they just spent a night in a jail cell with a grumpy bodybuilder named Spike. But they're just lining up for more.

 Jeff Clark, editor of The Big Trend Report, comments on gold prices unexpectedly moving in the same direction as stocks during Tuesday's big drop: "Normally, there is a very strong inverse correlation between gold and the dollar. But that relationship has weakened significantly over the past year. In fact, you'll often find periods where gold and the dollar have moved together in the same direction. In the long term, the inverse correlation should hold."

 The derivatives market has come to view Goldman Sachs, Merrill Lynch, and Morgan Stanley as so speculative that their own traders are valuing them as only slightly more creditworthy than junk bonds. Credit default protection for the banks' bonds was trading at Baa2, just two levels above junk. The equity of these big bankers is trading for around 11 times earnings per share. It could easily get cheaper, but I have to wonder, would that make it a mistake to buy now, or simply give you an opportunity to lower your cost? Morningstar says all three of these companies have wide economic moats. That means they're more likely to eat their competition's lunch than give up their own.

 Oil driller Nabors Industries and publisher Sun-Times Media have both admitted backdating options for executives. Neither company has admitted that the problems were intentional. Nabors is an unexpected name to see here. The company has been a long-time holding of Third Avenue, run by distressed-investing virtuoso Marty Whitman. Whitman knows Nabors CEO Eugene Isenberg well. The "scandal" couldn't possibly be overstated by the SEC and the financial press, could it?

 Thirteen people, including current and former Morgan Stanley, Bear Stearns, and UBS employees have been charged with insider trading. The offenders gave advance notice of mergers, acquisitions, and upgrades to investors. Authorities estimate that $15 million was gained from the fraud. If convicted, the offenders will face sentences from 15 to 90 years. They should have killed someone instead. Then they wouldn't face such harsh punishment.

I think they shouldn't do jail time at all. They should have to pay back every penny, with interest, and then get barred from the securities industry for life. That'd hurt plenty, and you and I wouldn't have to pay their room and board for the next few decades.

 A man calling himself "The Bishop" has sent at least half a dozen threatening letters and two dud pipe bombs to financial institutions across the U.S. The man is requesting that the institutions change the price of stocks to $6.66, a reference to Satan. There's a $100,000 reward for information leading to his capture.

 New highs: Valhi (VHI) and Enterprise Products (EPD).

 Yesterday, reader Don D. wrote in about his success "grabbing" the HMA dividend. This morning and yesterday, his comment prompted an avalanche of reader mail, all of it saying he's wrong, that he couldn't have received the dividend yet, and that, since he's sold, he won't get the dividend. One reader called me "Dangerous Ferris," and said, "printing this 'feedback' from a 'successful dividend grabber' shows what a naive and sometimes dangerous 'advisor' some of you guys can be." Another reader says, "Now I know you don't fact check." Other comments were unprintable. Send your outrage to feedback@stansberryresearch.com.

First, let me say that it's positively unconscionable to me that a reader would tell an untruth regarding an investment profit. I'm sure that hardly ever happens. I still don't know if I believe such a thing has actually occurred. That said, it was clearly my most egregious goof for not making a quick check of the terms of the dividend. The strategy isn't anything I do or write about, so I should just defer the whole thing to Sean Goldsmith and Porter Stansberry, who returns next week, to clear up the various issues with the dividend grabber strategy. It's obviously far more complicated than I ever dreamed. Oddly enough, one reader wrote in to express his thanks for the success he, too, seems to have had with the HMA dividend grab, though he seems to have found yet another level of complication…

 "Many thanks for the HMA recommendation, the gain helps me stay in this crazy game. One important note could have been of great help to your readers. I, as I'm sure many of your readers, bought and sold this stock in a relatively short timeframe. Unfortunately, I have since learned that if I had held the stock for over sixty-one days, then the tax rate would 'only' be twenty percent for the dividend. Because I sold in less than the allowable time frame, the gain will be taxed as short-term gains, a much higher rate. You probably cannot give tax advice, but you could give people a warning to check with their tax professionals as this type of transaction has unusual tax implications." – Paid-up subscriber Jim G.

Ferris comment: Yet another new wrinkle in the dividend grabber game. Dividend grabbers, take note.

 "I was wondering if you could explain some time what would happen if you owned a put on a stock and the company went bankrupt?" – Paid-up subscriber John T.

Jeff Clark comment: The put would be worth the intrinsic value of the position. In other words, if you have a put with a strike price of $10, the put would be worth $10. If the strike price is $5 then the put is worth $5. There is no time value since no one will pay extra for time if the stock cannot fall any further. In fact, you would probably have to sell the put at a bit of a discount to intrinsic value in order to motivate an options market maker to take the position. If the position is held through expiration, then it will be closed out for its intrinsic value.

 "A dissenting voice here. Markets can affect individual stocks for some time if there is enough overvaluation to cast the baby out with the bathwater, so to speak… Few people have the stomach to sit out a one- or two-year swoon in their holdings." – Paid-up subscriber Jim Pursley

Ferris comment: Jim, a long-time Stansberry reader, is reacting to my comments to the effect that market ups and downs are best ignored, and that the value of individual stocks in relation to price is all that really matters. Your observation is true enough, Jim. And yet, the stomach to sit out a one- or two-year swoon in one's holdings is exactly what is required. The fact that the vast majority of market participants are focused on – nay, obsessed with – so-called "market risk," makes it easy for a more rational player to get an advantage by ignoring the market and riding out the swoons. Great comment, Jim.

 "For 7 years I used my GM credit card anticipating their promised rewards in buying a new car. My card had $3,250 when the 7 years was up last month. They were sorry, I could now only use $1,000 of that toward a new car, thereby losing the remaining $2,250. You're correct: GM is on the way out." – R. Van Vorse

 "For those who think S&A marketing touts are at best an inconvenience, one can take them as detective mysteries, as I do when I have enough time. Also, when the touts are still coming for a particular sector, it may indicate the sector still has legs… [I made] a rough return of $60/hr for sleuthing an S&A marketing tout." – Alliance member Scott Maley

Ferris comment: $60 an hour. Sounds like a pretty good job.

 "Porter, you had best be careful that Warren Buffet doesn't make off with a couple of your best folks! When I read his letter yesterday, it seemed like his description of what he was looking for in a young person to take under his wing on the investing side of Berkshire matched some of your folks to a 'T.' Stay sharp and don't let the old man raid you!" – Paid-up subscriber Alan Kisling

Ferris comment: My wife called me up from work shortly after the Berkshire annual report came out yesterday afternoon. She told me to write to Berkshire expressing an interest in Buffett's job. She was totally serious. Rather than try to explain why there's no way Buffett would ever give me the time of day, I just went ahead and did it. I put it in the mailbox yesterday. This morning, she said, "I hope you told Warren Buffett you were in Barron's."

 "Porter Stansberry should stay on vacation forever." – Paid-up subscriber Matt Roberts

Porter comment: Thanks Matt… my wife says the same thing.

The Baby in the Bathwater

For a couple of weeks now, we at Stansberry have been wondering about the best way to take advantage of the rout of the subprime-mortgage companies. I've come to feel that the best advice I can give you is that you could avoid these stocks completely, never pay the least bit of attention to them, and still get bloody rich.

That said, I couldn't resist doing a bit of poking around. To me, it looks like the best underwriter in the subprime-mortgage business is Accredited Home Lenders (LEND).

This company has consistently had loan-loss rates and delinquency rates below the industry average since it opened its doors in 1990. It's a low-cost originator, paying about 1.7% to originate loans, versus 2%-plus by its competitors. It's proven over the years that it's careful with its cash. That keeps you in business when the recalls come in, which has happened to lots of subprime originators lately.

Also, Accredited is not a REIT, so it can retain cash. The retained earnings line grew 24% in 2006, versus a 4% drop at New Century. The company is plenty liquid, too. It has $500 million of cash (including restricted), $2.5 billion in commercial paper capacity, and eight different warehouse lines of credit totaling over $4 billion.

Because it's so conservative with its cash, its book value is solid. The stock is trading around 66% of book value these days. Accredited is a more speculative bet than anything I'd put into my newsletters, but I think it's a decent bet to rise as much as 50% in a year. I can't help noticing a really great investor among the stock's big holders: Ruane, Cunniff & Goldfarb own 6.7%, as of February 14.

One caveat: The company has filed its annual report late, because of the fourth-quarter acquisition of Aames investment Corporation.

Overall, I think Accredited Home Lenders is a good company that's being lumped in with some bad apples. I've told you all I know about the company at this point, so you're on your own as far as due diligence goes. But I think this is definitely the stock to start with, if you want to shop for opportunities in the subprime space.

Good Investing,

Dan Ferris

March 2, 2007

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