The S&A Digest: This Energy Trade Returns at Least 17%

Wal-Mart delivers... The black hole of mortgages... Goldman's accounting... Mothball the house... Piling on GM... A bullish bet on energy...

We're beginning to dream about Mexico...

In a little less than two weeks, we'll gather together all of our analysts, our entire editorial review board, the CEOs of a few of our favorite investments, and several hundred of our best subscribers at the Fairmont Mayakoba in Playa del Carmen, Mexico. Over the course of a few days, we'll talk about our best ideas for 2008... and enjoy the camaraderie, the sun, and the tequila.

Last year, at the St. Regis in Aspen, I told the group to buy Verizon and auto parts maker Magna International. Both ideas were very safe, paid a nice dividend... and have gone up more than 20% since then. Dan Ferris pounded the table on Berkshire Hathaway (up a little more than 20%). Tom Dyson explained Westshore Terminals (up about 45%). Put a little bit of cash into a few of our ideas this year, and you'll more than cover your costs of joining our group and flying to Mexico. Think of it as a vacation you pay for with your brain.

If you'd like to be invited to join us next year, join the S&A Alliance. (By the way, if you're a member of the S&A Alliance but you can't make the trip, don't worry. We'll send you a report on all of the top ideas discussed.)

We wrote it, did you buy it?

"I still think Wal-Mart is one of the best stocks you can buy on earth today." - Extreme Value November 2007

Today, Wal-Mart (WMT) posted an 8% jump in earnings to $2.86 billion, $0.70 per share, for the third quarter. Sales rose almost 9% to $90.9 billion. Analysts, expecting earnings of $0.67 per share, cite Wal-Mart's return to a low-cost focus as key to its growth. Shares rose more than 6% on the news.

Private-equity group Blackstone's (BX) president and CFO, Tony James said yesterday the "mortgage black hole" was "deeper, darker, [and] scarier" than anyone imagined. Shares of Blackstone dropped 8% yesterday on losses tied to mortgage turmoil. While James admits no one knows how the mortgage situation will play out, he noted subprime mortgage prices are reaching a point where there is "real value." His firm is interested in buying actual mortgages, not lenders.

Ever heard the term "mothballing?" That's what homebuilders are doing now that home prices are so low. More and more homebuilders not facing margin calls are refusing to sell homes in this weak market. Lennar, a California homebuilder, will soon finish 259 homes out of an 1,100 home development in Orange County and plans to sit on its inventory – mothball it – through all of 2008.

Maybe we're wrong about Goldman Sachs... "We continue to be net short in these markets," claims Goldman's bonus-in-waiting CEO Lloyd Blankfein in response to a question at an investor conference. He also said Goldman will not take any significant writedowns on mortgage-related assets.

OK... maybe it's not mortgages that Goldman will trip over. But there's something down there, we'd bet. Why are we so sure? Over the last three years, Goldman Sachs reported net income totaling $19.6 billion. On the basis of these "profits," the managers took their bonuses and their glory as Wall Street's smartest investment bank. Meanwhile, Goldman produced no net cash flow. In fact, cash flow over the last three years is negative $93.6 billion. There's a $113.2 billion disparity between the amount of cash the company produced from operations and the amount of profits it claimed via its accounting. Even when you factor in all of the returns from its investments (which produce negative operation cash flow), you still end up with a net negative number... –$800 million. I've got no doubt that Goldman has the world's smartest accountants. In fact, I wonder how many of them used to work at Enron...

Speaking (again) of Level 3 assets... Dan Ferris says they're even scarier than our summation implied:

"Calling Level 3 assets 'so illiquid they can't be accurately priced' is essentially correct... but it's actually worse than mere illiquidity. I own and/or have trading authority over thousands of shares of public companies, at least one of which trades no more than once every week or two. That's illiquid. But Level 3 assets are more than merely illiquid.

"If you read the text of FAS 157, the new accounting standard that created the three-level reporting scheme, it says that Level 3 assets are valued based on assumptions about assumptions. Page 21 says, 'Unobservable inputs are inputs that reflect the reporting entity's own assumptions about the assumptions market participants would use in pricing the asset or liability developed based on the best information available in the circumstances.' Assumptions based on assumptions. Why does that make me nervous?

"Man... How would you like to have your money in assets that are valued on inputs upon which you are not permitted ever to gaze and which can never consist of much more than someone else's assumptions based on their assumptions about what other people think of similar assets? It's like saying, 'If there were a liquid market for this – which there isn't anything close to right now – what would the price be today?' Impossible to answer. And yet, that's what the accounting requires.

"By the way, Level 3 includes private-equity assets, not just the financial exotica that's in the press today. Debt has been cheap for everyone, so everyone has had an incentive to misuse it one way or another. And just like at Goldman Sachs, private-equity folks live for fees and bonuses based on the value of the assets they own. Not exactly a big incentive there to take write-downs."

Steve Sjuggerud tells you why the guru of insider trading is bullish in today's DailyWealth.

New high: CurrencyShares Japanese Yen (FXY).

In the mailbag... more subscribers pile on GM. Send us your thoughts: feedback@stansberryresearch.com.

"If GM stock sold for $60 in 1960 and is $30 today, that's not a 50 percent drop, or even close. A 1960 dollar is worth $6.92 in 2007 dollars. If the $60 had merely maintained its value in inflated dollars, it would be worth $416 today. If GM had lost only half is value in real dollars, it would now be selling for $208. $30 in 2007 dollars equals $4.32 in 1960 dollars. So the stock has actually lost 93 percent of its value. (Presumably, there have been lots of dividends along the way, and possibly some splits or whatever. My point is simply that it is crazy to ignore inflation over the course of a half century.)" – Paid-up subscriber Dennis Hayes

"When [is Goldman Sachs] giving the year-end bonus... I feel like buying some puts before that!!!" – Anonymous

"Porter, you've been touting the fall of Goldman Sachs for weeks now, and your logic makes perfect sense. That being said, nobody on your team is suggesting buying any puts on the stock for next year. Are you willing to put OUR money where your mouth is?" – Paid-up subscriber Darren Nelson

Porter comment: Shorting stocks successfully is awfully difficult. Even with the GM situation, you'll have to be very patient... For most people, knowing which stocks to avoid buying is the best way to deal with struggling companies. For more experienced traders, shorting these stocks at the right time and price will probably be very lucrative.

"Two stocks to keep or buy? Definitely Markel (MKL) for No. 1. The second depends on the timeline. Near term – 3 to 4 years – Potash (POT). Longer term, Celera (CRA), Nuance (NUAN), or Sino-Forest Corp. (SNOFF), with the nod to Sino-Forest. While their trees may not grow to the sky, the stock seems to have made a fair start, up 514%." – Paid-up subscriber Pat

Regards,

Porter Stansberry

Baltimore, Maryland

November 13, 2007

This Energy Trade Returns at Least 17%

By Ian Davis

Today, I'm going to show you a trading strategy that returns an average of 46.8% in a year.

At its most profitable, this trade netted investors a tidy 91% in a single year (before taxes and fees). At its least profitable, you would have pocketed 16.7%. Let me explain...

On October 1, oil was at $80.25 per barrel. Today, it sells for $91.15, an increase of 13.6% in just the last month and a half.

This large move has provided us with a rare opportunity...

The price of natural gas tracks the price of crude oil. That's because the two energies are somewhat interchangeable: The Energy Information Administration found that about 18% of natural gas usage can be switched to petroleum products... Also, the two energies compete for many of the same resources, like labor and drill rigs.

The reason the price of crude oil affects the price of natural gas, but not vice versa, is the difference in size between the two markets.

The global crude oil market is vastly larger than the global natural gas market. The natural gas market is simply not large enough to have an impact on the global price of oil... though this may change at some point in the future.

As you can see, when natural gas is cheap in relation to crude (when the ratio of natural gas to crude oil is low), the price of natural gas tends to rally as people switch from expensive petroleum products to natural gas.

Buy Natural Gas When It's Cheap Compared to Oil

The average one-year return in natural gas after an extreme low in the gas-to-oil ratio is 46.8%.

Currently, the natural gas-to-crude oil ratio is near all-time lows at 3.99. (The ratio has been below this level less than 5% of the time.) So if you want to make a bullish bet on energy, then my advice to you is skip oil and buy natural gas instead.

In this Friday's Quant Trader, I'll show you my favorite play on this cheap commodity.

Good investing,

Ian Davis

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