The S&A Digest: "The worst is over..."

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

As of 06/20/2013

"The worst is over... " Expecting coins to disappear... Safe bet: Oil prices keep rising... Stock picks from the Value Investing Congress... Is Maurice on drugs?... How to read financial statements...

Government officials keep telling us the mortgage crisis is fading: "The worst is likely to be behind us," U.S. Treasury Secretary Henry Paulson says. Too bad the real estate market isn't listening. Fannie Mae, the largest mortgage owner in the United States, reported a $2.2 billion loss in the first quarter – which was larger than analysts expected. Mortgage delinquencies rose, home prices fell, and the current market value of its mortgage portfolio declined by a bit more than $1 billion. The company increased its loan-loss reserves by $5.2 billion in anticipation of future 2008 losses.

The surest sign of a civilization in decline is inflation. Governments throughout history have resorted to debasing their currencies to meet their expenditures beyond tax receipts. We hardly think twice about inflation anymore. After 70 years of this kind of cheating, we've come to expect it. Luckily for our feckless leaders, it is easier than ever to rob the citizens of their savings, too. In the modern world, the "emperor" doesn't have to bother employing an army of coin clippers. The government simply credits its account at the Treasury with as many digital dollars as it needs. Counterfeiting has never been easier.

But... a funny thing happened along the way to a complete breakdown of the world's monetary regime. The old-fashioned parts of the system – circulating coins – have begun to reveal the fraud. A penny, which isn't even copper anymore (it's 97.5% zinc and 2.5% copper), costs 1.26 cents to make. And a nickel, which isn't really nickel either (it's 75% copper and 25% nickel), costs 7.7 cents. Copper and nickel prices have tripled since 2003, and zinc has doubled. One congressman estimated minting the coins at these high prices cost taxpayers $100 million last year.

Here's a sure-fire prediction: Our government will continue to steal our savings through inflation. Coins in circulation will begin to disappear, as soon as the arbitrage between their value and their price is wide enough to finance melting them down. And when the coins disappear, Congress will blame "hoarders" and simply eliminate coins.

While naifs blame the oil companies for rising prices and demand the counterfeiters in Washington do something about it (ha, ha, ha), we're willing to bet Washington is no better at ginning up oil supplies than it is at running a balanced budget. As such, regardless of what Congress says, oil prices are very likely to keep rising. Our own Matt Badiali is doing a pretty good job riding the bull. He's up 176% on Brazilian oil giant Petrobras (PBR); 61% on Transocean (RIG), the world's largest offshore driller; 60% on Chevron (CVX); and 96% on Occidental Petroleum (OXY). And the huge gains won't stop there. To learn more about the S&A Oil Report and cash in on the biggest energy bull market of our lifetimes, click here...

Dan Ferris sent us this note from the Value Investing Congress in Pasadena:

Hedge-fund manager Carlo Cannell was hilarious. He was talking about shorting stocks again and said he likes stocks that are absolutely about to die. He also said "all restaurants are going to zero" and got a huge laugh because restaurant stocks are so awful, generally speaking. He's shorting Chinese reverse merger stocks. Another guy I know who manages a lot of money says he knows the Chinese are stealing from investors. Cannell is buying a Netherlands company called Hunter Douglas. It owns Alustra Woven Textiles, the biggest maker of curtains and window dressings in the world. It also has a huge investment portfolio... of which Cannell is one of the managers. So it's like a fund of funds, but there are no fees. And the guy who runs the company owns 72% of the stock. That's the sort of closely held, cheap business loaded with cash that I like to own. Cannell couldn't talk about MV Petroleo Nautipa, which is closely related to a small-cap energy company called Vaalco Energy. He was scheduled to talk about it, but at the last minute, his lawyer told him not to.

One of the most interesting things of the day was when Robert Hagstrom [a Legg Mason fund manager] said Yahoo can do without Microsoft a lot better than Microsoft can do without Yahoo. He says he thinks Steve Ballmer is stalling and knows he needs to buy Yahoo so he can compete with Google on the Internet. He also said some day software distribution would make Microsoft's products available for free.

Hedge-fund manager Mark Sellers recommended Contango Oil & Gas last year. It more than tripled since. This year he's recommending Vulcan Materials (VMC) [a building materials company].

Lots of energy picks this year. Three out of eight presentations were on energy stocks.

We'll get another update from Dan tomorrow.

New highs... almost all energy/resource stocks: Occidental Petroleum (OXY), Eni SpA (E), Chevron (CVX), Petrobras (PBR), StatoilHydro (STO), International Coal Group (ICO), Comstock Resources (CRK), Covidien (COV), ArcelorMittal (MT),

Aracruz Celulose (ARA), Sadia (SDA).

In today's mailbag... Jeff reduces a reader to tears and more on financial statements. Please send us your notes, we read every one: feedback@stansberryresearch.com.

"Is Maurice on drugs? I bought the Mot June 9 options at $.70 and sold them today for $1.30, that is an 85% profit! Jeff didn't give the sell, I just decided to take my profits off the table. Geez, what is wrong with these people? Nice call Jeff, anxiously awaiting the next reco." – Paid-up subscriber Sharen Kirkham

"Yes, I have been drinking. I have been a subscriber to numerous of your newsletters and have been saddened so many times. I had to sell Seabridge because my trailing stop told me I had lost 25%. I cried as Seabridge was one of my favorites... I only made 742% and not the 900+%. Boo-hoo. I read another of your rags and bought the Pawn Shop deal. I am only up 30% in a week. Boo-hoo. I read the Dividend Grabber and bought some of your APL and EEP recommendation and received a 94 and 95 cent per share dividend yesterday plus $600 last week on PSEL. Boo-hoo. In one publication someone recommended Smith & Wesson because of the Supreme Court. I am only up 31% in 90 days. Boo-hoo. So as you can see, I am crying all the way to the bank.

"About 3 weeks ago I decided I would call Customer Service and inquire about the Alliance membership since I had several subscriptions and that same day you sent out a notice that you would be opening the Alliance again with information to be sent the end of April, so I waited. You made me an offer I could not refuse, so I am now a paid up for life Alliance member. Now all I can do is sit around, drink, and cry all the way to the bank... Seriously, thank you for making me a really great offer on your products. I expect to be crying for quite some time following the Alliance information." – Paid-up subscriber Fred Fleming

"Thanks for your thoughts on the need to read financial statements. Do you have information available on how to read financial statements? What information is most important to look for when reading a company's financial statements? I would really like to know what you, Dan and Steve consider most important when reviewing financial statements. Thanks for your help!" – Dean S.

Porter comment: A lot of folks use two books as reference guides: How to Read & Understand Financial Statements When You Don't Know What You Are Looking At by Brian Kline and Reading Financial Reports For Dummies by Lita Epstein. I think both books are hard to read and understand, if you don't know a little bit about accounting and finance to start with... and frankly, I wouldn't recommend trying to read either of them straight through. While having these books might help you when you get stuck on something you've never seen before, I recommend you learn how to read financial statements by actually doing it. Start with a small, simple business that you know well. You want something that doesn't have too many moving parts – like dozens of subsidiaries, etc. And don't worry about understanding what every single number means – just focus on the big numbers.

The easiest financial statement to read – the balance sheet – is the one you should look at first. It's a listing of all of the company's assets and liabilities. Obviously, as an equity owner, you want to avoid companies with large liabilities. However, there are some important exceptions to this general rule. For example, insurance companies have large liabilities – future claims to be paid – that are really more like assets because the liabilities are only estimates of the future claims and will only be paid out over a long period of time. Likewise, bank stocks show deposits as liabilities, but of course, they function more like assets.

Assuming a company isn't overly indebted, the main things I'm looking for on a balance sheet are current assets (how much cash does this business have), goodwill (lots of goodwill indicates the company has acquired a lot of other companies, which can lead to problems), retained earnings (which lets you know if the company has been profitable historically), and the number of shares outstanding (you typically don't want to own a business that's constantly diluting existing shareholders with more stock).

On the balance sheet, the hardest number for most people to understand is goodwill. When a company acquires another company, it almost always pays more than book value. The difference between the acquisition price and the book value is called goodwill. It can be a real asset, as it reflects the intangible value of going concerns – like trademarks, customer lists, trade secrets, etc. But more often than not, companies end up paying way too much for other businesses. Eventually the excess goodwill must be written off the balance sheet and charged to income. And that usually causes the share price to decline.

Next, go to the income statement. Most of the things on this page should be self-explanatory – like revenues. When I look at an income statement, I look for a few key things. Are revenues growing? What's the gross profit margin? Are margins expanding or decreasing? How much research-and-development expense does this business require? What about corporate overhead (selling, general, and administrative) expenses? You can tell a lot about the culture of a company by looking at the SG&A line expense. Another key line on the income statement is interest expense. Using various kinds of debt instruments, management teams can try and obfuscate how much debt they're using. Look at whether or not interest expenses are growing or falling.

While I look at the income statement for the numbers I mentioned above, I don't pay any attention to what the bottom line says because net income is an accounting fiction. It's a made-up number that takes into account estimates of depreciation expenses and other "guesstimates" about what the company earned during any given period of time. What I care about is how much cash the company earns, how much cash the company spends each year to run its business, and how much cash is returned to shareholders each year. You get that information from the cash-flow statement, not the income statement.

On the cash-flow statement, the main number you're looking for is cash from operations. With most companies, that number is going to be net income plus depreciation expenses (which are not cash charges and so get added back on the cash-flow statement). But when you see big numbers for things like "adjustments to net income" or "changes in liabilities," you have to find out what's going on by reading the notes in the annual report or simply calling the company to ask. (The best way to learn to read a financial statement is to simply ask a company's investor relations officer to walk you through what the numbers mean. Assuming you've done a little homework before you call, they're usually happy to help you.)

The other key number on the cash-flow statement is capital expenditures and investments. That's the money the company spends each year on itself – building new plants, buying new equipment, acquiring other companies, etc. Most investors who focus on "earnings" don't pay nearly enough attention to this number. Companies can make all the money in the world, but if they spend it all to continue their operations, then they won't have any money left over for shareholders.

Finally, at the bottom of the cash-flow statement, you see what the management team has done with the cash it had left over after capital expenses – the so-called "owner's earnings." Is it paying dividends? If so, that number will be here. Is it buying its own shares or selling more stock? When I'm buying an established operating company, I expect to see at least as much capital being returned to investors via dividends and buybacks as is being spent by management on capital investments. Some companies return virtually every penny they make to shareholders because they have almost no capital expenditures – like WellPoint (WLP), for example. I believe the stock market woefully under appreciates these firms because most investors focus on the income-statement earnings instead of cash-flow numbers.

The only good way to learn to read financial statements quickly and accurately is to read a bunch of them. Start with companies you know well. You'll find it's easy to piece together what's happened to the business just by looking at the numbers. Then, try looking at a company you don't know well. Knowing the numbers before you know much about the business will enable you to learn a new business much faster than before. Financial statements are like the outline of a story or the frame of a house. You can tell a lot about what the final picture will look like just by looking at the numbers.

Regards,

Porter Stansberry

Baltimore, Maryland

May 7, 2008

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