The S&A Digest: The Only Way to Trade Biotech Stocks... Safely

The richest man in the world... On the Subprime Beach... Turkey bracing for a credit crunch... Whitman's diluted Ambac stake... Gross and Ross buying muni bonds... Icahn girds loins to take on Motorola... The S&A FDA Report...

 This could be the ultimate sign of a top, if the top weren't a memory already. Perhaps it's just a sign of miserable things to come for stocks over the next few years. The one man on Earth most often and closely associated with the art of stock picking, Warren Buffett, is now the world's richest man, surpassing friend and fellow bridge player Bill Gates. Buffett is worth about $62 billion. Gates is worth about $58 billion.

From here on out, stock pickers great and small should expect to suffer and suffer badly, as toxic credit problems infect every nook and cranny of the economy.

 In the classic 1959 film On the Beach, the inhabitants of the Southern Hemisphere await the arrival of a lethal radiation cloud that's circling the globe after World War III... killing every living thing in its path. Most poignant in the film is the story of an Australian naval officer played by Anthony Perkins. His young wife is in denial about the crisis, unable to face the prospect of euthanizing her baby before radiation sickness sets in.

The premise is scientifically flawed. No such cloud would uniformly make its way around the globe. Nor would it be powerful enough to kill every living thing in its path. But the story is instructive. Today's lethal cloud is the credit crisis. It's not killing every living thing, but it's killing a lot of financial things.

Take Thornburg Mortgage. Garrett Thornburg and his team have rarely experienced losses over a period of many years. They've built a stellar record investing in mortgages and paying shareholder dividends, one of the best in the business.

But today, Thornburg's stock is trading about 95% below its 52-week high. Due to the deteriorating values of its mortgage holdings, banks are making margin calls. They're basically telling Thornburg they're scared that its assets are too toxic and they want to be paid back while they still can. Thornburg is in a rush to try and sell assets to pay off the margin calls. But it can't sell. Nobody wants its mortgages. Nobody cares about its stellar loss record. One analyst used the "b" word yesterday – bankruptcy.

 Today, the lethal subprime cloud is rumored to be heading for Asia Minor... Atradius N.V., an Amsterdam-based credit insurance company, recently opened an office in Istanbul. Atradius commissioned a study of 200 Turkish companies. Seventy-eight percent of those surveyed said they expect a negative impact on their sales due to the subprime-mortgage crisis. This isn't California or Las Vegas or Florida. It's Turkey. And nearly 80% of businesses there expect sales to drop.

 Several weeks ago, we noted the magazine-cover indicator was telling us a recession was already priced into stocks. But when behemoths like Citigroup and JPMorgan are racing to see who can report bigger new losses, when stellar credits like Thornburg evaporate overnight, and when a recession is brewing in Asia Minor – all of it based on way too many banks in California, Florida, and Las Vegas lending money they didn't have to people who couldn't pay it back... well... it's pretty clear now that the magazine covers didn't go far enough.

 The poisonous cloud that hit Thornburg has drifted into the private-equity world... Private-equity giant Carlyle Group's publicly traded mortgage bond fund, Carlyle Capital, failed to meet margin calls and received notice of default. The company announced it missed four of seven margin calls totaling more than $37 million.

That Carlyle Group (the $20 billion private-equity firm) couldn't come up with a measly $37 million to bail out its bond fund tells me something... The sentiment surrounding mortgage debt is still very bad. And mortgage investors with cash on the books, like S&A Dividend Grabber pick Redwood Trust (RWT), have the buying opportunity of a lifetime.

 No. 1 Extreme Value pick Wal-Mart (WMT) seems relatively immune to the lethal credit cloud. This morning, Wal-Mart reported a 2.6% sales increase at U.S. stores for the month of February and a 2.8% increase at its Sam's Club stores. Sales of groceries, medicine, and electronics were strong. But even Wal-Mart reported slower sales in its home goods business.

Wal-Mart also raised its dividend 8%. Extreme Value readers saw this coming. In my second piece about Wal-Mart, in December 2007, I wrote "slower growth means lower capital spending and more free cash flow – which Wal-Mart loves to return to shareholders in the form of dividends..."

 I was listening to a recording of the January 10 American Express investor conference call last night. One analyst noted in passing that American consumers are a lot less liquid now than they were during the last two recessions, due to higher debt loads and the collapse in housing prices.

 Marty Whitman may be dead-on with his long position in bond insurers, but his stake in Ambac was just cut in half. Ambac, the second-largest bond insurer, halted trading yesterday on the possibility of a "deal." The company announced it will issue $1 billion of common stock, more than doubling the shares outstanding. It will also offer $500 million of units that convert to shares in 2011. The company was going to seek $3 billion from banks, but it instead decided to dilute current shareholders. Shares are down more than 14% today.

 Yesterday, we reported that bond-fund manager Bill Gross recently bought $1.5 billion worth of cheap municipal bonds. Yesterday afternoon, Wilbur Ross, the "bottom feeder," announced a $1 billion purchase. He thinks munis are "an extremely attractive segment of the market."

The Wall Street Journal says the muni bond purchases might be based on more than attractive pricing. They may also be a bet that a Democratic candidate will become president and raise taxes, making tax-free munis especially attractive. I guess that's what you think about when you have $1 billion – who'll be the next president and how much they're going to charge you for it.

 Democrat or Republican, the U.S. dollar needs a dose of Viagra. The euro is at an all-time high of $1.5347, oil hit $105.96 yesterday, and gold and copper both hit record highs.

 Carl Icahn, the billionaire Wall Street investor, has raised his stake in Extreme Value pick Motorola (MOT), the struggling U.S. mobile phone maker, to 6.3% from a previously reported 5%. Motorola had a wonderful thing going and got fat and lazy. It used to be No. 2 in cell phones. Now it's No. 3 and waning. The company has lost so much creative talent, the best idea the new CEO could come up with is breaking up the company.

Icahn's higher Motorola stake was disclosed on Wednesday in an SEC filing. Icahn is certainly averaging down. But he's also getting ready to put some more pressure on management ahead of its annual meeting on May 5. The new purchase is a sign to Motorola that Icahn hasn't forgotten about them and he's not letting up.

 New highs: Covanta (CVA), Sabine Royalty Trust (SBR), NGP Capital Resources (NGPC), Plains Exploration (PXP), streetTRACKS Gold (GLD).

 How's your portfolio weathering the storm? Let us know... feedback@stansberryresearch.com.

 "I was a happy Penny Letter subscriber and was sorry to see it's demise. I'm holding FUR, RGR and RVI because I like them and agree with you that they should be in a position to do even better. However, about the monthly updates, I have yet to receive one and they don't seem to be available on the website." – Paid-up subscriber Steve Pattison

Ferris comment: I sincerely apologize, Steve. I've heard this complaint from others. Our IT people are working to rectify the situation. Everyone who subscribed to The S&A Penny Letter should be receiving the monthly updates. And they should soon be available on the website, too.

 "'Our business thrives when we give you the absolute best research possible. It's true our company policy bans us from owning stocks we recommend, but I promise you are getting our best ideas.'

"Can I infer from your answer that completely rationale, logical, and intellectual analysts at your company are willing to place their own hard-earned cash into their second- and third-best ideas? Wow. Your policy seems to have an implicit illogical rationale to human self interest." – Paid-up subscriber Sharaz Ahamad

Ferris comment: Nothing I'm holding in my own account could possibly have as wide a moat at as cheap a price as Wal-Mart (WMT). If I weren't absolutely forbidden to eat my own cooking, I'd pig out right now. By the way, I've e-mailed our corporate counsel more than once. Every time, he says the same thing: "It'll never happen."

Regards,

Dan Ferris

Medford, Oregon

March 6, 2008

The Only Way to Trade Biotech Stocks... Safely

By Dr. George Huang, editor, The S&A FDA Report

Biotech stocks are the most volatile in the world. Indeed, this volatility gives biotech trading a bad name and scares off most investors.

But after eight years of successfully navigating and investing in this tumultuous sector, I've developed a trading strategy that not only sidesteps the volatility... it thrives on it.

The biggest culprit behind biotech stock volatility? The United States Food and Drug Administration, commonly known as the FDA.

Before ending up on pharmacy shelves, every new drug needs to pass through a series of regulatory hurdles dictated by the FDA. Without the FDA's blessing, a drug – no matter how great it may be – cannot make it to market. Sadly, the FDA approval process is arduous, costly, and often arbitrary, creating significant uncertainty for every biotech trader.

When a biotech company has finished all the necessary development steps for a new drug, it bundles together all the testing data and sends it off to the FDA in the form of a new drug application, or an "NDA." Johnson & Johnson's schizophrenia drug has an NDA pending with the agency now... and a decision is due by August 29.

In general, the FDA's response amounts to:

1. Yes – a thumbs-up, outright commercial approval.

2. No – a thumbs-down, the new drug is rejected.

3. Maybe – the FDA issues an "approvable letter," meaning the company must complete a few missing requirements before the agency can approve the drug.

For our trading purposes, we are most concerned with the third outcome... the approvable letter. The FDA sends an approvable letter when it is prepared to approve the company's application once the company has satisfied certain conditions.

The "conditions" can be as benign as a request to change the proposed commercial brand name of the drug. Or they can be more costly – for example, more clinical trials with 10,000 patients. Depending on the specific conditions outlined in the approvable letter, a delay of anywhere from six months to five years or more is possible.

The investing world absolutely hates approvable letters. Inevitably, investors can't dump the stock fast enough. Downward drops of 50% or more are common.

So the secret to trading biotech stocks with little to no downside is... Buy shares of the company only after the FDA has issued an approvable letter.

That's right. The best time to buy these stocks is in the midst of the confusion, havoc, and panic. The results surprised us... but the numbers from our study don't lie.

Looking back across the last five to seven years, if you bought the stocks of every company that received an approvable letter, your average one-year return would have equaled about 12%.

Such returns are nothing to scoff at, especially since the Nasdaq Biotechnology Index has only returned more than 7% once in the last six years. But I'll be frank, 12% gains aren't what we're seeking for S&A FDA Report subscribers...

Based on our analysis, we've developed a stringent set of four criteria for each and every approvable letter. If you invested in only the approvable-letter situations that meet the specific criteria, these no-brainer trades would have generated average one-year returns of 75%.

Over the next few days, I'll describe the various aspects of this lucrative trading strategy. Tomorrow, I'll talk about the value of being able to precisely predict when these events take place...

Good investing,

George Huang

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As of 06/21/2013