The S&A Digest: This Free-Money Income Trade Is Up 6% in Two Weeks

The price of world domination... 9/11 and credit cards... No housing bottom in sight... JM is at it again... Zell on Brazil and China... A free-money trade

 What's a world-dominating brand name worth? About 30 times trailing free cash flow. That's about what Procter & Gamble paid for Gillette three years ago. And that's what Mars is offering for Wrigley today. Two different industries, two completely different economic environments. Virtually identical prices.

 Between Extreme Value and PSIA, I count no less than 12 world-dominating brands, all of which were recommended at cheap valuations. I don't know if they're all worth 30 times free cash flow. But I bet you they're all worth at least 20 times, and most of them are trading below 20 times today. Even if interest rates double, are you really going to buy less chewing gum? Probably not. Are you going to stop buying Budweiser? You'll probably buy more of it to drown your worries.

 Stories in the Wall Street Journal and the Financial Times suggest Mars' offer to buy Wrigley will provide stability to the leveraged-loan market. That's a weird idea, though. Leveraged loans are junk. Some of the financing for Mars/Wrigley is coming from Berkshire Hathaway. Considering the target and the source, it's not what I'd readily label as junk. The market for deals like this may have the same mechanics as the private-equity market, but the businesses and the players are in a different, and much higher, league. If I had to bet on the direction of the valuations of Lehman Brothers' leveraged loans, for example, I'd bet down before I'd bet up.

 Remember how the U.S. went after Saddam Hussein and Iraq, even though 9/11 was planned and executed by Osama bin Laden and a bunch of Saudis? Well, the Federal Reserve, the Office of Thrift Supervision, and the National Credit Union Administration are going after credit-card issuers to attempt to make up for the lousy job the government did policing the mortgage industry.

 They want to stop letting banks price risk fairly by charging higher interest rates to customers who don't pay on time. Some government mouthpiece said credit-card practices are not only "unfair," but they're "destabilizing," whatever that means. To me, it means if you spend money you don't have on things you don't need and can't pay the money back, you're definitely not very stable.

 Billionaire Eli Broad, founder of homebuilder KB Home, doesn't think we're "anywhere near a bottom" in home prices. The homebuilding veteran believes we'll see another 15% to 20% drop in home prices before this is all over. Broad says 16 million homes in the U.S. have mortgages that exceed the value of the house. That translates into approximately 1.5 million foreclosures and 1 million or more people just walking away. Broad says the answer to the whole problem is confidence. People won't start buying homes until they think the bottom is in.

 What Broad is talking about, and what George Soros mentions in his new book, is the idea of a market-clearing price. That's a price low enough to attract buyers, but still high enough to satisfy sellers. It's the price that greases the wheels of commerce. "Low enough" and "high enough" are very fluid ideas. Right now, prices aren't low enough for buyers. Sellers are waiting an average of 11 months to sell their homes.

 Broad also sees a drop coming in the art market. He has collected contemporary art for 20 years, and it now costs him more each year to insure some pieces than what he originally paid. The art market has had a huge run the past three to four years, and Broad thinks a bubble is forming.

 Author and economist Peter Bernstein told the Wall Street Journal a few days ago that people who think the housing/financial crisis will bottom by 2009 are wrong. He also said, "Somehow, the housing trouble has to at least flatten out. As long as that is going on, I think the pressure on the credit system is going to persist. It is kind of the leading indicator. It is where the trouble started. We have to underpin the consumer."

The consumer's underpinning ain't looking so good. Aside from defaulting on his mortgage, he's having increasing trouble paying his approximately $7,400 worth of credit-card debt (on average). He probably won't have an easier time doing either when his house falls in value by another 20%, and the bank cuts off his home-equity line (if it hasn't already).

A couple weeks before Broad or Bernstein commented, I loaded the current issue of Extreme Value with charts and data and concluded from it all that, "The housing markets will get worse because average housing prices across the U.S. are still way too high."

 Meanwhile, the banks continue to report losses... Deutsche Bank took at $220 million loss in the first quarter, on $4.2 billion in writedowns. The writedowns were the usual culprits these days: leveraged loans and mortgage-backed securities. Countrywide Financial took $3 billion of credit-related writedowns and lost $893 million.

 John Meriwether, founder of hedge fund Long-Term Capital Management, is blowing up again. Meriwether told investors in his new fund, JWM Partners, they can take their money out ahead of the normal redemption period due to poor returns. JWM's flagship bond fund dropped 31% in the first quarter.

I'm sticking with my maxim: "Leveraged traders always blow up." I learned this through a pair of educational experiences. The first experience was trading futures about 17 years ago. I started with $2,000 and finished six months later with $268. More recently, I made a huge levered bet on a reinsurance company right after Katrina. It went south to the tune of about 70% in one day.

 Billionaire real estate mogul Sam Zell is buying Brazil, "It has the chance 30 years from now of being a bigger economic power than China," Zell told the Milken Institute Global Conference. Zell said the country's 180 million people, skilled work force, and wealth of natural resources has made it largely self-sufficient. He also mentioned Brazil's biggest mall operator was seeing retail sales growth of 10% annually. And what's stopping China? The country's one-child policy, which Zell believes will decrease the number of workers in China and "come back to bite them big time" in 2020.

 International Strategist editor Tom Dyson is also hot on Brazil. He took an agricultural tour of the country earlier this year. In his travels, he found the future of the world's agricultural production, Protein City. This mega complex will produce the world's cheapest commodities and make an absolute fortune shipping them all over the world. Tom found the best way to profit from Protein City, and his pick is up 25% in less than two months. He holds three Brazilian stocks in his portfolio, and all three are up double digits. And he's got three more Brazilian stocks on the radar. To learn more about International Strategist, click here...

 The IRS started mailing the economic stimulus checks yesterday, and Goldman Sachs already compiled a list of the 10 companies that will benefit most from the extra cash: Cheesecake Factory, Best Buy, Darden Restaurants, Home Depot, JCPenney, Kroger, Kohl's, Royal Caribbean, Safeway, and, of course, Wal-Mart. Wal-Mart was an easy guess considering that 8% of U.S. retail sales already go there.

Goldman Sachs' list looks a little strange to me. It includes no bars or lotteries. I guess you can get a drink at Cheesecake Factory or Darden, but geesh... who wants to? I'd like to know how much of the money will go toward paying down credit-card debt or even making a mortgage payment.

When you lend your brother-in-law $600 and then get it back a year later, is your financial situation better? Of course not. You've actually lost money on the interest you didn't charge him because he's family. In the same way I wonder if any grown man or woman actually thinks the TSA makes air travel safer, I have to wonder if anyone actually thinks a bunch of $600 checks – which were confiscated from us to begin with – will do the economy any real good. The stuff grown men and women take seriously is really unbelievable.

Also, I know little about cruises, having successfully avoided taking one thus far, but what's Royal Caribbean doing on Goldman's list? A $600 cruise? To where, Cleveland?

 New highs: Sadia (SDA), U.S. Natural Gas (UNG), Comstock Resources (CRK), Health Care REIT (HCN), Stone Energy (SGY).

 Are you spending your $600 stimulus check at Wal-Mart, or do you have more original plans? Are you dumb enough to think the TSA makes air travel safer? If so, write us at... feedback@stansberryresearch.com.

 "I read your Gartman quote with interest. Sounds really valuable however I used to work in a gold refinery and personally did a bit of work on the value of extracting gold from computer chips. As this was only from the chips, the proportion of gold by weight was considerably higher than the phone quote. At that stage gold was only around $400 per ounce but it was not viable for us to extract. The main issues were the waste disposal - take out 150g gold, 3kg silver and the 100kg of copper you still end up with a 900kg mess of waste products – and the highly specialist extraction processes needed to remove then refine the metals for such small amounts of product. I guess someone could try it but I doubt it is economically viable even now." – Paid-up subscriber Steve Page

 "Lump me in with the 10% of your readers who have purchased gold. I have purchased several gold coins over the past few years, based solely on Steve's recommendations. I would buy more but my wife is not on board – yet. I keep forwarding the Digest to her, however, and I think she is beginning to see the light. My mistake so far is that I put them on my credit card. Next time I pay cash! One sign of a gold top: My sister called a few weeks ago and asked if it was OK if she sells some of mom's old silver at a pawnshop. I told her she can sell her half to me. I also put quite a bit of money into Steve's stamp recommendation in 2005 and have done quite well in capital appreciation as well as the strength of the pound. My contract is up in November of this year, so I have a big decision to make. Do I roll over or put the money in gold? I suspect it is a no-lose situation, as long as I keep the government out of the matter.

"Finally, my two cents on buying international, especially Canadian: I use Interactive Brokers and have never had a problem. They charge a monthly market data fee for the Canadian exchanges but their commissions are low and executions are quick and fair. Thanks for the great reads and the great reco's! Looking forward to the next Alliance conference." – Paid-up subscriber Rich Gustafson

Regards,

Dan Ferris

Medford, Oregon

April 29, 2008

This Free-Money Income Trade Is Up 6% in Two Weeks

By Ian Davis

Real estate investment trusts (REITs) are similar to bonds...

REITs (like bonds) are considered income investments. By law, they must pay out at least 90% of their taxable income in the form of dividends. This steady cash flow is similar to the coupon payments Treasuries pay to bondholders.

At the beginning of March, REITs were yielding 5.1% (a large yield compared to 10-year Treasury bonds, which only yielded 3.5%). And whenever REITs yield significantly more than Treasury bonds, REITs tend to perform exceptionally.

The following chart shows the performance of the Datastream REIT index in relation to the yield spread between Treasuries and REITs. (The yield spread is simply the difference between the two yields.)

REITs Soar as High Yields Draw Income Investors

As you can see, whenever REITs yield significantly more than Treasuries, they perform very well during the following year. The last four times the REIT-to-Treasury yield spread has gone above 1.5, the Datastream index has returned an average of 36.8%.

This is why I call it a "free-money" trade. It works every time.

I recommended this trade to my readers of Quant Trader two weeks ago. In that short time, we're up almost 6%.

Unfortunately, it may be too late to get in this time. REITs are now yielding only 0.6% more than Treasuries, and REITs have already risen 28% off their lows.

However, I often discuss similar free-money situations in Quant Trader. Right now, it's only available to S&A Alliance members. Check your inbox soon for details on how to join.

Good investing,

Ian Davis

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