The two big investment secrets...

In today's Friday Digest... a review of what we believe are the two most important secrets of successful investing.

It's a good time to review our fundamentals of good investing because... suddenly... stocks seem "cool" again. Many of our recommended stocks have taken off – just look at the size of the new highs list. And for the first time in many years, we're seeing celebrities on TV begin to talk about their experiences as investors…

For example, Mila Kunis – who first entered the public eye as one of the teens on the TV program That '70s Show – recently cropped up on the financial news network CNBC, talking about buying stocks. This is one of the first, early signs of a top in the market… when celebrities with no particular financial knowledge or background start bandying around stock ideas.

We'll continue to bring you these small "signs of a top" signals as they appear. We published dozens and dozens of these (maybe even hundreds) in 2006 and 2007.

What should you do as the market heats up, valuations begin to rise, and volatility returns to the market? Focus on these two secrets…

Here's the first secret: On the whole, individual stock selection doesn't really matter. What really matters, over the long term, is asset-allocation decisions. It's not what stocks you buy. It's when you buy stocks versus when you buy bonds, gold, cash, real estate, etc. that matters.

You might find it ironic that a service like ours, which primarily provides advice on what stocks to buy, is publishing a note like this one that says individual stock selection doesn't matter. What can we say? We're addicted to empirical, rational thought.

In 2000, Roger Ibbotson and Paul Kaplan published a great historical study looking at 94 U.S. mutual funds and several asset classes. The researchers concluded the differences in asset allocation among the funds explained virtually all of the variance in their returns. Differences in stock picks made no difference to total portfolio returns.

When you see a particular sector of the market becoming inflated or overheated, don't think you'll end up being OK just because the stock you own isn't as expensive as the others or because the managers you're investing with are more conservative. In the stock market, the baby always gets thrown out with the bathwater. Every time. That's great to remember at market bottoms, when you can buy the best companies at the same low prices as the garbage.

The second critical investment principle is knowing how to properly value a security. In my experience, most individual investors have zero ability to calculate even the most basic measures of value in either stocks or bonds. Where else in life do you make big decisions about things without understanding their price? Think about the care you take when buying a car... buying a house... or buying an engagement ring. In all these areas, you probably obsess about value and price.

But with stocks? It seems like most individual investors just look at a few lines on a chart, or see some kind of star-ranking system, and then push the "buy" button. I would wager that more than 50% of our subscribers couldn't calculate earnings yield on a publicly listed stock.

If you're one of those people, you're likely to get crushed (yet again) when this market really does roll over. Bear follows bull, my friends. Our monetary sins are enormous. There will be hell to pay. And for the people who don't see it coming... or who don't know how to manage their assets... the penalties will be far, far worse.

You can help yourself reduce these risks by following two simple rules…

Rule No. 1: Avoid buying into any particular sector of the stock market – like housing, or gold stocks, or tech stocks – unless you're buying after a 50% correction in the leading shares. This will help you minimize the risk that you're making a poor asset-allocation decision. You wouldn't have bought real estate in 2006, for example, if you had followed this rule.

Not all stocks hit new highs at the same time. Today, you might look at education companies, for example, to find bargains. Or maybe even gold stocks (all of my earlier warnings about commodity companies notwithstanding). The point is, one of the best ways to learn to buy low and sell high is to limit your choices to only those sectors that are clearly no longer trading anywhere near their highs. This will automatically fix your asset-allocation problems and keep you out of sectors that are too expensive.

Steve Sjuggerud calls this the "bad to less bad" approach. You'll end up investing in lots of stocks that are beaten-down and completely out of favor. You won't have much to talk about at cocktail parties... but you'll end up with a lot more money in the long run.

Rule No. 2: Simply learn how to value a security. It's not hard. You can easily read a few books like The Little Book of Valuation: How to Value a Company, Pick a Stock and Profit. I'd also recommend reading the annual letters of Warren Buffett and Marty Whitman, which are available for free online. But even if you don't ever develop any significant skills as an analyst, you can still use these simple guidelines to buying individual stocks…

The "Rule of 10" – Don't pay more than 10 years' worth of cash from operations for a company. You'll find cash from operations on the cash-flow statement, as opposed to earnings, which are on the income statement. Rely on cash figures over earnings because the earnings figures are a fiction derived by accounting rules. The rules differ tremendously among various industries. Looking at the cash figures makes for better apples-to-apples comparisons.

Don't pay a premium for assets. If you're buying an asset-management business – like a commodity company or a financial firm – never pay more than book value. That's total assets minus total liabilities.

Always get paid to own a business. If you're not going to make at least 5% a year in the form of cash dividends or share buybacks, don't buy the stock.

Keep these guidelines handy… They're essential to valuing a stock…

1. Don't pay more than 10 times cash earnings for operating companies.

2. Don't pay more than book value for asset-based companies.

3. Get at least 5% a year in dividends or share buybacks, on average.

One more thing... it seems to me that most individual investors go wrong because they have incredibly inflated expectations compared with their level of experience. New investors all believe they're going to be the next Jim Rogers or George Soros. They take absurd risks, buying inflated stocks in popular sectors. They quickly get killed (and always blame their newsletter writers).

The more experienced investors become, the more they seem to care about valuation. The more interested they become in beaten-down sectors. And the more realistic they are about their likely investment outcomes. They're expecting not to lose money. They're expecting to make 10%-12% a year, mostly through dividends and share buybacks. And that's when they end up doing much, much better. By eliminating their downside with caution, they find they're able to stay in positions much longer... and earn a lot more. They play the long game and win. I hope you'll try it.

Personal note: My second born, Seaton Reed Stansberry, turns two years old this weekend. Happy birthday, my little blond monster. May you always live with such spirit and intensity. Your father loves you – all the way.

New 52-week highs (as of 3/14/13): ProShares Ultra Biotech Fund (BIB), Berkshire Hathaway (BRK), WisdomTree Japan Hedged Equity Fund (DXJ), iShares Insurance Fund (IAK), iShares Biotech Fund (IBB), SPDR International Health Care Fund (IRY), iShares Home Construction Fund (ITB), PowerShares Buyback Achievers Fund (PKW), Sequoia Fund (SEQUX), ProShares Ultra S&P 500 Fund (SSO), W.R. Berkley (WRB), Abbott Laboratories (ABT), Johnson & Johnson (JNJ), Automatic Data Processing (ADP), Ericsson (ERIC), IBM (IBM), 3M (MMM), Chicago Bridge & Iron (CBI), Consolidated Tomoka (CTO), Calpine (CPN), American Financial Group (AFG), Chubb (CB), Loews (L), Travelers (TRV), Alleghany (Y), Blackstone Group (BX), Kohlberg Kravis Roberts (KKR), Becton-Dickinson (BDX), Chart Industries (GTLS), BLADEX (BLX), Cheniere Energy (LNG), Range Resources (RRC), Procter & Gamble (PG), Union Pacific (UNP), Two Harbors (TWO), CVS Caremark (CVS), Sysco (SYY), GenMark Diagnostics (GNMK), and Activision Blizzard (ATVI).

In today's mailbag… one subscriber offers a contrarian view of shale drilling and the energy boom we've covered. Send your e-mail to feedback@stansberryresearch.com.

"Gentlemen, I would like to respectfully take issue with your pronouncement that the Shale Oil Revolution will change America forever. This play is now twelve years old and has really not provided a whole lot of return on the amount of capital required to develop it.

"These wells feature a 40 per cent annual depletion rate. Within five years they are down to 5 per cent to 10 per cent of initial production levels. They also cost about $10,000,000 to drill. To maintain current production levels will require at least 1500 extension wells per year, around a 1000 for the Eagle Ford. To get America back up to 11,000,000bpd will require an investment in the $300,000,000,000 range, and then you are still 7,000,000 BDP short of what we use.

"Reliable sources tell me the Bakken producers are only taking home about $70pb at present which is at or near breakeven to cost. Any significant drop in oil prices below $70 would bring the entire show to screeching halt in hurry. Harold Hamm could make money in your backyard, fine production teams like Kodiak are struggling. Having had experience of my own in the local Haynesville play I assure you most of the wells here cost $12,000,000 or more and have produced less than $5,000,000 worth of gas. Big Time Losers!

"This shale stuff is a promotors dream. Huge initial production, huge reserve projections, with breathtaking depletion rates and probably only 10 to 15 per cent recovery of total reserves. The way to make money off the shale revolution is an old story. Sell the dumb miners the picks and shovels to blow their youth and fortunes." – Paid-up subscriber James Hardey

Porter comment: I hope you won't mind a few actual facts (as opposed to vast generalizations) in response. EOG is the leading shale-oil production company in Texas' Eagle Ford. In only three years, its cash from operations has nearly doubled, rising from $2.7 billion to $5.2 billion. After accounting for the depletion that you mention and other forms of depreciation, its annual profits have increased from $160 million to more than $570 million (256%). The value of its wells continues to increase, too. Total assets are up about $6 billion for the period (28%). This success has its stock trading at close to new highs ($130 a share), up from less than $20 a share 10 years ago.

There are so many other things wrong with your "facts" and figures that I don't have the time or the space here today to correct all of them. (For example, no one I know expects shale oil production to make up 100% of America's oil production. Many conventional wells continue to produce substantial amounts of liquid hydrocarbon, as they will for at least the next decade or two.)

To keep this brief, I'd simply point out that you're saying America's shale reserves can't be developed profitably. But that's clearly not true. Dozens of companies have been successful with shale oil.

On the other hand, I would agree with you on the Hayneville shale. Likewise with many of the other "dry gas" shales and even some wet shales that are a long way from oil operating areas, where added expenses like pipelines and equipment can make operations unprofitable. But... saying that some shales can't be developed profitably right now isn't the same thing as believing none of them can be.

"Black people are not the only problem in Detroit, and Black people are not the only group on public assistance or receiving food stamps. When I go to the grocery store, there are whites, Blacks, Hispanics, Bosnians, Jewish, Croatians, and many other groups that use an EBT card. My rental properties are rented to Section 8 families from many of the groups just mentioned (including whites). Why did you chose to single out the Black community? Your comments are inaccurate and divisive. I would like to think you have more intelligence than to make comments such as these.

"When you make comments like these, I always ask myself how is this helping my investments? They are not. I hope you do better in the future." Paid-up subscriber Darryl Diggs

Porter comment: I must say… I really don't know what comments you are referring to. I am very critical of almost all of America's political leaders… black and white. I have been particularly critical of the political leaders in Detroit, who happen to be black. For the past 50 years, they've pursued a state-benefits agenda, creating political dependency in their districts.

There are numerous examples of long-serving black liberal politicians who've seen their districts socially disintegrate during their tenure. Look at factors like high-school graduation rate, unemployment, incarceration rate, out-of-wedlock childbirths, etc. Incredibly, there seems to be a high correlation between these negative social factors and the security of the political officeholders.

I would argue that's an example of how democracy sometimes doesn't work.

As further proof, remember that almost all these liberal politicians have been convicted of serious ethics violations – and even that doesn't seem to hurt their standing with their almost exclusively black constituents. For example, consider the political careers of John Conyers (Detroit)... Charlie Rangel (Harlem)... Alcee Hastings – who was elected to congress after he was impeached as a federal judge in Miami... Jesse Jackson, Jr. – who was re-elected after a federal indictment for bribery... Chaka Fattah (Philadelphia)... Sheila Jackson Lee (Texas)... and Maxine Waters (California).

As for Detroit… since the Civil Rights movement of the early 1960s, nearly all of its elected political leaders have been black, including every mayor since 1961. Today, Detroit's population is 82% black. If you can't blame the collapse of Detroit on the people who live there... who do you recommend we pin the blame on?

Your comments seem to imply that you view my remarks as being racially motivated. They're not. They are politically motivated. I'm pointing out the vast failure of the federal government's social welfare programs. I'm describing the people they've injured. I'm explaining the link between politicians who are clearly unqualified to serve and the inner cities of America, which are overwhelmingly black, poor, and dependent on the federal government.

I'm not saying these things happened because the people and their politicians were black. I'm saying these things happened because a poor minority in the U.S. became dependent on handouts from their politicians. It's this dependency, not their ethnicity, that's the problem. If you can't tell that from reading my work... I really don't know what to tell you. I mean, if we're not even allowed to discuss these problems because they have racial overtones, how will we ever begin to solve them?

Regards,

Porter Stansberry
Baltimore, Maryland
March 15, 2013

One of our favorite whipping boys for the past two years has been department store J.C. Penney. Hedge-fund billionaire Bill Ackman took a huge position in the company and recruited Apple's former retail head Ron Johnson to run the company. But their efforts are failing...

J.C. Penney has announced sales decline after sales decline since Johnson took over. And its customers are leaving (thanks, in part, to Johnson's decision to get rid of coupons).

The department store recently announced its worst quarter ever... It lost nearly a third of its sales during the fourth quarter of 2012. And predictions abound that the company is teetering on the brink of bankruptcy.

These problems aren't unique to J.C. Penney. While the company has made some poor strategic decisions, its decline is part of a sectorwide, secular drop.

In general, I (Porter) don't think old-line retailers will do very well. I've been shorting Sears off and on since 1998. And I've been bearish on old-line department stores for many, many years. There are too many avenues of competition for you to make money in that space.

Amazon is the huge disruptor to old-line retail. But there are also lots of smaller, more agile, brick-and-mortar retailers that are killing department stores. The department store concept where you go to one store and shop all the various departments to get everything you need is broken... Specialty retailers – like Williams-Sonoma, the high-end kitchenware retailer – offer a better retail experience. And people can go to one specialty store for one thing and another store for something else...

You don't go to one store for everything... unless it's Target, because it's dirt-cheap. And for these reasons, I don't see how the traditional department store can survive.

I left Wal-Mart, the world's largest retailer, out of the prior discussion... Wal-Mart is the dominant retailer in the U.S. But it's mostly turning into a grocery store (55% of its sales are from groceries).

Wal-Mart is also trying to take down Amazon, which has been taking a bigger and bigger share of Wal-Mart's customers.

Wal-Mart has started a "marketplace" program, where outside vendors can sell their products through Wal-Mart's website. Amazon runs a similar program (with the same "marketplace" name)... but Amazon has 2 million vendors, compared with Wal-Mart's six partners. (That's not a typo: 2 million vendors versus six.) And Wal-Mart's online sales are around $5 billion (2% of total sales) compared with Amazon's $34 billion.

While Wal-Mart is paying lip service to online sales, the company announced it plans to open 130 "supercenters" around the country this year.

Wal-Mart's strategy of expanding its physical footprint goes back to the business' current focus... 55% of its sales come from groceries. And I don't think the majority of people will ever order their groceries from Amazon.

The people who run Wal-Mart are the best retailers in the world. It can deliver the lowest prices... And its stores are still useful because of the locations and products they deliver.

Wal-Mart has countered the Internet with groceries... it's that simple.

I wouldn't put Wal-Mart in the same boat as Sears and J.C. Penney. And I wouldn't put Wal-Mart in the same sphere as Target, either... although Target is trying to copy Wal-Mart's strategy by introducing groceries.

U.S. retail has never before seen an entity as large as Wal-Mart (which is also one of the largest, if not the largest, private employers in the country). It's not a department store. It's a totally different beast. And if anybody can compete effectively with Amazon, it's going to be Wal-Mart.

– Porter Stansberry with Sean Goldsmith