The worst investment mistake in history...

The worst investment mistake in history... Why buying cheap stocks can be deadly... The most famous 'value traps' of the last decade... Our best advice: Don't try to fix anything...

It was the greatest investment mistake of all time... a cumulative loss of more than $200 billion.

It started out as a lie. Then it got worse. It got worse every year for 20 years. But even that lesson didn't really stick. The same investor repeated these same mistakes again and again. The first mistake happened in 1965. The last one didn't liquidate until 2001. That's 36 years of making the same mistake.

As you know, in the Friday Digest, I (Porter) do my best to show you the things I would most want to know if our roles were reversed. Over the years, I've produced hundreds of essays and free podcasts about the risks foolhardy investors take when they buy outlandishly expensive stocks.

We even track the most notably expensive shares – those with market capitalizations of more than $10 billion, that trade at a price-to-sales ratio of more than 10 times – in our Investment Advisory "Black List." But carefully studying the career of investing legend Warren Buffett has taught me that buying very cheap stocks can be every bit as dangerous as buying very expensive ones.

I hope you'll read today's Digest a few times and discuss it with your friends. You have my permission to forward this along to anyone who might be interested. It has a few big surprises below. Some of the things you've been taught about value investing just aren't true...

Let's start with this fact... The investor I describe above – the one who lost $200 billion, who made the same basic investment error again and again – is Buffett. Yes, he's widely admired as the greatest investor of all time. But he also made some of the biggest errors of all time, too.

As you'll see, the core error that Buffett made several different times was getting caught in "value traps." That same error, in at least three instances over 36 years, resulted in catastrophic losses. If you've ever lost money buying what you thought was a cheap (and therefore safe) stock, my bet is you have made the exact same error.

Today, I'll show you the details of this particular kind of investment mistake and a few simple rules for permanently removing value traps from your investing. But as I always remind you, there is no such thing as teaching, there is only learning. So... only keep reading if you're truly ready to think about what I'm saying below and reconsider much about what you've been taught about deep-value investing.

I'm currently writing a book about Buffett's investing errors, called Warren's Mistakes. Researching the book is easy: Buffett wrote continuously about his investing from the mid-1950s until today. Most (but not all) of his annual letters are available for free at www.berkshirehathaway.com.

I have copies of all of the others and a few personal letters that Buffett wrote to his investment partners over the years, too. In addition, a plethora of articles are available on all of Buffett's deals from about 1970 onward in Fortune magazine, the Wall Street Journal, and Forbes. You can also find about a dozen different major books on his career. The best is The Snowball by Alice Schroeder.

Most people don't know the most important and most basic fact of Buffett's investment career. He began his career in the 1950s and early 1960s as a deep-value investor – someone who looked for stocks trading well below their net asset value (book value). His original strategy was to buy the cheapest stocks and find a way to liquidate his holdings at a fair market value. He used the metaphor of finding a cigar butt on the ground to describe his method in his 1989 letter to shareholders...

However... all too often, this approach caused him lots of problems, especially as his operations grew in size and he began taking control of companies. After that point, his strategy proved to be far too cumbersome and risky. Selling the assets became difficult or even impossible. Again and again, he found himself "trapped" with low-quality assets that he couldn't sell for any price.

Working with investors over the past 20 years, I've seen lots of people make huge mistakes buying expensive stocks, whether it was the Internet darlings of the late 1990s, real estate stocks in 2007, or today's social-media stocks (which will crash soon enough).

It's not difficult to learn why this happened and how to avoid expensive stocks... You just don't buy anything that is wildly popular, a newly minted initial public offering (IPO), or trading at 50 times earnings. But learning how to avoid big investment mistakes in cheap stocks is a lot more difficult, as Buffett's track record demonstrates. In many cases, these opportunities seem the safest... which is why they can be particularly deadly.

Let's start with the big one...

In 1962, Buffett began buying shares in a beaten-down former industrial powerhouse called Berkshire Hathaway. The company, which once was among the largest businesses in New England, had been in decline since the end of World War II. Cheaper, non-union labor in the South and a slew of new innovations made the company's mills obsolete.

By the time Buffett took control in 1964, the company's previous nine years of operations saw revenues of more than $500 million... but an aggregate loss of $10 million. The business was no longer competitive in the market. Management responded by closing down mills, selling assets, and generating cash for its balance sheet. The result was a company with far greater assets on its books ($22 million) than its share price... and a lot of cash. This attracted the attention of the Graham-and-Dodd deep-value crowd, including Buffett.

Buffett figured he could buy the stock safely because sooner or later, Berkshire Hathaway's then-CEO (Seabury Stanton), whose family had owned and run the business for decades, would try to buy it back from him. That's exactly what happened. In 1964, Buffett negotiated with Stanton to tender (sell) his shares back to the company. They verbally agreed on a price: $11.50 per share. But when the formal tender offer was published, the asking price was reduced by one-eighth of a point – to only 11 and three-eighths. What happened next was a disaster. As Buffett told CNBC...

Buffett was now saddled with a failing textile maker. To escape the industry's grim economics, he began to invest the company's cash flows in businesses with better prospects. The first thing he bought was insurance company National Indemnity in 1967.

As you likely know, Buffett would continue to use Berkshire Hathaway as his main investment vehicle. He bought stakes in other high-quality businesses like insurance firm Geico, credit-card company American Express, soft-drink empire Coca-Cola, and dozens more. It was these investment decisions that have made him and his fellow shareholders roughly 20% a year since 1965.

But the situation raises an interesting question: Why didn't Buffett simply borrow (or raise from investors) the capital he needed to buy the insurance companies and the other blue-chip stocks? Why did he fool around with Berkshire at all? Putting all of these great assets into Berkshire was a horrible mistake, because Berkshire continued to require a lot of capital. Says Buffett...

Buffett got "trapped" owning a lousy business. He even doubled down on his bet by buying Waumbec Mills (another New England textile company) and merging it with Berkshire. In investment circles, this situation is known as a "value trap." Plenty of great investors have seen their careers ruined because they took an oversized position in a stock that looked really cheap, but was actually worth a lot less than its balance sheet suggested.

Here's the key concept to grasp: It didn't matter how much money Buffett could afford to put into Berkshire. It didn't matter what Berkshire management decided to try next. The economics of its entire industry were being decimated by low-cost competition. More than 250 different textile firms went bankrupt between 1980 and 1985.

As a result, every dollar Buffett put into Berkshire's textile business was going to be a dollar lost – as Buffett found out when he tried to liquidate Berkshire's assets at an auction held in early 1986, which he described in a shareholder letter soon after...

Buffett made at least three separate errors of this same kind...

In 1966, shortly after buying Berkshire, he partnered with Charlie Munger to buy the failing Baltimore department store Hochschild Kohn. They managed to sell it in 1969 and get back what they paid for it. They got lucky.

In 1993, much later in Buffett's career, he bought Maine shoemaker Dexter Shoe, paying $433 million worth of Berkshire Hathaway shares. Buffett already owned HH Brown (another shoemaker) and knew Dexter was in trouble because of foreign competition... just like his original textile investments. Buffett says the Dexter deal ended up costing Berkshire $3.5 billion by the time he finally liquidated in 2001. As Buffett told Reuters news service in 2008, "Dexter is the worst deal that I've made."

Buffett isn't the only person who makes these mistakes. I've watched several great money managers make similar (and even bigger) mistakes, buying huge positions on stocks with marginal underlying businesses, where the company's fundamentals are obviously in terminal decline. A few famous examples...

• Bill Miller at Legg Mason's Value Trust – once one of the largest and most respected mutual funds – bought 32 million shares of film manufacturer Kodak in 2000 and 2001, paying around $41 per share, long after the introduction of digital cameras. He held shares until 2011 – long after digital cameras were ubiquitous in cell phones. His fund lost more than $500 million.

• O. Mason Hawkins, one of the most respected senior value-investment managers in the U.S. and founder of the Longleaf Value fund, began buying shares of carmaker General Motors in 1999 at $65 per share. He eventually held 44 million shares. This was after more than 30 consecutive years of declines in GM's global market share and decades of losses in the car business. Plus, the company was being forced to maintain a "jobs bank" where it paid thousands of employees who didn't work.

Hawkins held shares until August 2008, when it traded around $12 per share. On the eve of the global financial crisis, he took the proceeds of his GM share sale and invested in the company's Series B convertible bonds, at one point owning one-third of the entire issue. These bonds were sold days before GM filed for bankruptcy at less than 20 cents on the dollar.

• Bruce Berkowitz – once named one of investment-research company Morningstar's money managers of the decade from 2000 to 2010 – began buying shares of retailer Sears Holdings in 2005 at more than $100 per share. As the company has closed locations and starved its stores of badly needed capital improvements, Berkowitz has added millions of shares to his position, mostly at prices above $100 per share. Now, with the company borrowing money from shareholders to avoid bankruptcy, he's still buying. Berkowitz bought more than 3 million shares in the first quarter of 2014, at prices above $40. Today, the stock is trading around $27.

Writing in his 1989 shareholder letter, Buffett commented specifically on why these "value traps" usually don't work out...

How can you use these lessons in your own investing? Buffett says just to stick with the stuff that's easy: "In both business and investments, it is usually far more profitable to simply stick with the easy and obvious than it is to resolve the difficult."

That's a lesson I should have remembered before I thought I could help turn Devon Energy around. Shares have now fallen more than 20% since I wrote my letter in July asking management to sell its oil-sands project before the price of oil fell, due to massive increases in supply. (We've "unlocked" a copy of the issue here.)

Here are a few good rules of thumb.

First, use a little common sense. Before you buy your next deep-value stock, ask yourself if it's likely to turn out as well over the long term (10 years) as doing something "easy and obvious."

Right now, you can buy shares of blue-chip consumer-products company Apple (AAPL) for around 10 times annual cash earnings. That's reasonable for a well-managed company that has great brands (plenty of goodwill), and holds $180 billion in cash. Plus, activist investor Carl Icahn says Apple is worth twice as much as its share price is trading for today. One thing is for sure... a lot of people will still use iPhones, iMacs, and iPads a decade from now. They will continue to use Apple TV and iTunes to view, store, and manage their digital content.

That deep-value stock you're thinking about buying might turn around. It might make you a lot of money. But is it really more likely to outperform Apple over the next decade? I wouldn't bet on it. Why do what's hard when you can simply do what's easy and obvious?

Second, learn to avoid – at all costs – any publicly traded company whose revenues have not increased over the last five years. If a business can't grow over five years, there's probably a good and obvious reason why... one that's not going to change after you buy the stock.

Third, beware of companies writing off goodwill. "Goodwill" is the capitalized value of a company's intangible assets – like its brands, customer base, and the relationships it uses to distribute its products. Goodwill is a critical asset, but it's hard to measure. When goodwill is growing, it's usually far more valuable than what's represented on the balance sheet. But when goodwill is in decline, the opposite is often true.

The public's relationship with brands is fickle. Sears at one time had a brand so strong that store openings were a triumph for local politicians and developers. Having a Sears in your town meant you were a "real place." Today, having a Sears at your mall is a sign of doom. It means your retail center is most likely dangerous and deserted. What was once the company's greatest asset – its strong reputation for merchandising and service – is now a significant liability.

The 12 companies listed below are not currently short-sell recommendations at Stansberry Research. But I suspect that they are "value traps." These companies look cheap... but they are far more likely to cost investors huge money over the next few years than they are to turn into profitable investments. We will keep an eye on them for you and check in with these stocks from time to time. (Full disclosure: One of my analysts disagrees with me on one stock, Real Networks. He very well could be right.)

My beautiful wife Andrea turned 39 yesterday. We've been together for 15 years and married for 10. We have two sons, one gun-shy bird dog, an expensive fishing habit, and a home filled with genuine love and acceptance. I hope all of you have known love like the kind we share. Honey, nothing that really matters has changed in 15 years. And I know it never will. Happy birthday.

New 52-week highs (as of 10/9/14): Invesco Value Municipal Income Trust (IIM) and short position in Washington Prime Group (WPG).

In today's mailbag, subscribers continue to warn S&A Global Contrarian editor Kim Iskyan to be careful for his upcoming trip to Venezuela. Send your e-mails, thoughts, and concerns to feedback@stansberryresearch.com.

"Triple Canopy, a northern Virginia-based company, recently bought a company called Clayton Consultants. Clayton is a top-tier firm in providing kidnap, ransom, extortion solutions worldwide. Currently, they service AIG's kidnap, ransom, etc., insurance policies. I suggest you buy a policy for Kim before he lands." – Paid-up subscriber Rich Barron

"My wife is from Venezuela and I've been down there a few times. The last time was last October. I know a guy down there that Kim would find interest in talking too. Alas, he has been in jail for a while now as he was an opposition leader, and there is no end in sight to his release. Venezuela is a beautiful place and wonderful people (the majority who are not thugs) but we won't be going back anytime soon, at the insistence of my wife. Having a young son, and it is just too scary to worry about him being harmed, let alone us, as kidnappings and robbery are a way of daily life down there.

"My wife has quite a large extended family down there, including her mother, and she keeps in touch with them regularly. The day to day consequences of price and currency controls are quite evident when talking to her family. Inflation makes things more expensive each time one goes to the grocery store. There is a corn meal that people there use to make 'arepas,' basically their staple bread type food. It is rare to find it on the shelves down there, but we can readily get it in our hometown of Anchorage, AK!

"And perhaps worst of all: the young, educated folks have left, if they can. My wife has cousins and friends all over the world: Canberra, Australia; Fort McMurray, Alberta, Canada; Germany; Abu Dhabi; Montreal and lots all over the US of A. Doesn't bode well for the future leadership of Venezuela. Oh, and some call oil 'The Devil's Excrement' down there. Seems to be the case. Safe travels Kim and be safe." – Paid-up subscriber Ben Monshor

"To whom it might concern: I'm not a subscriber for S&A Global Contrarian but I understand you are going to send people to Venezuela to try to find investment opportunities. I just feel the need to tell you a few things about that idea: DO NOT DO IT! That would be playing with fire to say the least. I was born in Venezuela in 1970 and, like many others had to escape from what became a living hell in the last decade. After many years of struggle I established in South Florida with my wife and my daughter.

"My intuition was right. I knew (or had a very good idea of) what was going to happen. Back in 1998. a deteriorating political process allowed a group of criminals to seize the power and they slowly took control of all the institutions: congress, supreme court and the whole judicial system among others. They have been implementing a very sinister plan that consists on annihilating anyone and anything that could stand in their way and they have been very successful. They established a communist regime that have evaporated every form of civil liberty. They have record in human right violations. The private property is almost a tale of the past and there's a plan to implement a form of political power that have been successful in Cuba to control and subdue the whole population (google the phrase 'comunas en Venezuela').

"I'll try to make this story short but let me first explain who is the mastermind of that Dante's inferno: Fidel Castro. The same dictator who is responsible for the death of thousands of people and has impoverished and slaved his own people for 56 years and counting. In case you don't know it, he came up with a plan after the collapse of the Soviet Union (circa 1989). That plan would allow his regime to survive the termination of the very generous economic support they received from the now extinct Soviet Union.

"That plan is known as the 'Foro de Sao Paulo.' (Sao Paulo's Forum). The Wikipedia page has a very benign explanation of what it is, but a little research would help you understand that it is an organization whose only purpose is to kidnap and seize control of several Latin American countries, and to create a force that could stand against the USA. (I doubt they could come even close to it but that doesn't make this any better.) I won't elaborate on this since this is not the purpose of this message, but in a few words, this organization is the ideological engine behind Colombia's Farc (socialist guerrillas), the creation of militias in Venezuela inextricably linked to the said Farc, ISIS (Islamic state) and any leftist guerrilla in South America among others.

"Venezuela was an important target due to its vast oil reserves which they would use to finance this international crime organization. I know this might sound unreal, but the real fact is that Venezuela is drowned in a chaos that seems to get worse everyday. Some analysts say there is a real chance that a civil war could start very soon. In my opinion, the situation in Venezuela could take years to turn positive. Venezuela has become the paradise for international crime and terrorist organizations, all sort of scum from around the world. You could find there the worst of the worst from Iran, China, Russia, Belarus, Cuba even North Korea. Sadly, I really doubt there could be a turnaround in the economy let alone any chance to conduct any legal business down there. Last, don't send anyone there if you expect them to come back alive. Just in 2013, more than 23 thousand people died a violent death. Venezuela is part of the 10 countries with the world's highest murder rates." – Paid-up subscriber Hugo Escobar

Regards,

Porter Stansberry

Baltimore, Maryland

October 10, 2014

The bullish case for a recent Stansberry's Investment Advisory recommendation...

In August, Porter and his research team recommended a biotech company with huge upside.

In today's Digest Premium, lead research analyst Bryan Beach explains why they expected shares to soar higher...

In the August issue of Stansberry's Investment Advisory, we recommended biotech firm Durata Pharmaceuticals (DRTX) on the basis of its new antibiotic named dalbavancin, intended to fight drug-resistant "superbugs."

Research analyst Dave Lashmet – the Stansberry's Investment Advisory team's biotech expert – has written at length about the world's need for new antibiotics and why now is historically a great time to buy into the trend. But that's outside the scope of today's lesson. Today, we're just talking about Durata.

We felt that Durata was in a perfect position to benefit from this big-picture trend. And we had a hunch that management had essentially hung a "for sale" sign in the company's front yard. Here's an abridged version of what we wrote in that issue...

We're recommending a company with an approved drug ready to be brought to market. Usually, speculating in biotech involves pinning your hopes on a company whose drugs are still in trials and could be years away from paying customers, or shelved by the FDA altogether. That's a high-risk trade. The process of winning drug approval is long, expensive, and subject to the whims of government regulators. Many promising drugs fall short of approval.

In this case, we are able to skip those steps and buy a company whose product is both in demand and being brought to market. That reduces lots of the usual risks of biotech investing. This is a one-drug company with no reported sales, and no net debt.

So what's next for dalbavancin and Durata? We think buying shares today can play out one of two ways. First, Durata could keep bringing the drug to market by itself. In that case, dalbavancin could be worth $30 million in sales by Year 1 and $90 million in sales by Year 3, for what's currently a $340 million firm. But we think another scenario is more likely and brings a faster payout.

Right now, a Big Pharma firm that needs a new antibiotic for its sales channel has a ready-made solution in dalbavancin. And we know biotech firm Cubist bought two other antibiotics firms in 2013 for $800 million each. So the acquisition price for Durata could easily be double what it's worth today. We suspect Durata's management would consider such offers. That's why we think Durata is a prime acquisition candidate, by any Big Pharma that wants into the "price for cure" antibiotics market, in the age of superbugs.

When we recommended Durata, it was only a $340 million company. And, as mentioned above, we predicted that the acquisition price for Durata could easily double the company's value, which would make the company worth $680 million.

Due to our number of subscribers, we rarely recommend companies with market caps this small. But we loved the company's upside, so we decided to make an exception. We told subscribers to buy shares up to $16.

We warned them not to chase the stock above our maximum buy price: "We know you hear that advice a lot... but it is especially critical with a stock like Durata. This stock is much smaller than most of the stocks we recommend in Stansberry's Investment Advisory. A burst of buying interest could cause the price to spike higher."

We were right... Subscribers piled in and pushed the share price higher. And in Monday's Digest Premium, I'll explain why the Stansberry's Investment Advisory research team made a big mistake... and how we'll avoid it in the future.

– Bryan Beach