Why Hedging Is Critical
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Today... another unexpected twist...
In this week's Friday Digest, I'd like to share a letter I received from a subscriber. We received it yesterday. It's not flattering. But it made a big impact on me. Most publishers would rather light their hair on fire than advertise a subscriber who is canceling or unhappy. As you know, we take the opposite approach. We publish lots of unhappy feedback e-mails – sometimes even when they're incoherent. But this letter wasn't entertaining...
This subscriber is canceling for a good and thoughtful reason. He doesn't need us anymore. I think it's something you ought to think about carefully. You might agree with him.
I would like to cancel my subscription to the Stansberry Investment Advisory. I haven't been happy with the content and recommendations of SIA for some time now, and I feel that I will be better served by canceling this service. I feel like the service has lost focus on the types of long-term, Buffettesque-type picks that originally inspired Porter Stansberry.
I would also like to note that the Digest has been pretty stale lately. It used to be something I looked forward to read daily, but now it just skim through it. It's pretty much all... talk about gold and other macro opinions.
The everyday middle-class investor ought to focus his investing efforts on compounding wealth with equities rather than buying gold, which should be viewed as a store of wealth. Most people aren't wealthy enough to even consider gold as a viable asset class for their portfolio. Just my two cents. Not sure why there is so much focus on this subject rather than companies with durable advantages trading at favorable prices.
Perhaps I was spoiled by Porter for turning me on to these types of ideas.
I think P. Thompson is wrong on the facts. I'll show you why... but that's not the main thrust of my reply. I think something far more important is at stake. It goes to the heart of the "silent relationship" I described last week...
P. Thompson thinks he knows all he needs to know about investing. Maybe he's right. Maybe he doesn't need anything but good businesses bought at fair prices. Maybe he doesn't need gold... or discussions about the macro risks we face... or reminders about position sizing... or recommendations on selling short.
Maybe not. But I suspect he does...
I think he's about to make a huge mistake. It's a mistake I hope you won't make too.
First, though... about the facts...
Over the last year, I've developed what I'm certain is the most important investment idea/strategy of my career. I call the idea "Magic Stocks." These ideas are the result of more than a decade of work on "Buffettesque" investing. We've explored exactly what creates the best kind of business for compounding wealth safely over the long term.
I've shared these ideas repeatedly in the Digest. If you haven't read my Magic Stock essays, I'd urge you to review them. You'll find them here and here. (These were published in the Digest that P. Thompson says has gotten stale.)
We've also built an entire Magic Stock Monitor as part of our Stansberry Data service that's available to all lifetime subscribers of my newsletter. Every month, we update this screen that shows all of the stocks that qualify as "Magic Stocks."
In fact, just last week we unveiled our latest version of the research. We added a small growth component to the formula to make sure we weren't including any "value traps" in our lists.
Adding this small, additional revenue growth hurdle to our other Magic Stock criteria (capital efficiency, great brands, high operating margins, and low volatility) produced even better results.
As you'll recall, we tested our original Magic Stock formula by creating model portfolios based on historical data and seeing what would have happened to investors who followed this approach from 2000 until now. In all, we created 34 separate model portfolios across the period, with durations ranging from one year to 15 years. This gave us a substantial body of data to judge what the actual outcomes would have been.
In that original analysis, the most stringent category – capital-efficient Magic Stocks with great brands – beat the S&P 500 across all periods by an average of 6.3 percentage points a year, with 34% less volatility than the overall market.
So how did adding a revenue growth element change our results? Here's what we wrote in Stansberry Data last week:
Adding the new value-trap criterion... the portfolios beat the S&P 500 across all periods tested by an average of 7.5 percentage points a year, once again with 34% less volatility than the overall market. The average portfolio size decreased from five stocks to four stocks.
These results are outstanding. Instead of beating the S&P 500 by an average of 6.3 percentage points a year, they now beat it by 7.5 percentage points a year. The average return of these portfolios over all periods tested was 13.6% a year, compared with 6.1% for the S&P 500.
With an average annual return of 13.6%, a $100,000 investment would grow to $680,000 15 years later. The S&P 500's average annual return of 6.1% would only grow to around $250,000. Beating the S&P 500 by an additional 7.5 percentage points a year over 15 years would translate into an additional $430,000 in your pocket. And remember, these results are accomplished with far less volatility than the overall market."
In my newsletter, over the past 18 months, we've recommended 30 different equities, roughly half of which would qualify under a test for capital efficiency.
These were high-quality businesses like computer and electronics giant Apple, baby-formula maker Mead Johnson Nutrition, handbag label Coach, agricultural supplier Monsanto, soft-drink maker National Beverage, and glass manufacturer Corning.
No, these investments didn't work out great. Altogether, over the past 18 months, the average return from our long recommendations is flat. That's not a big surprise given the market's decline. But that doesn't mean we've stopped trying to add quality and excellence to our portfolio on the long side. In just the last three months we've recommended three more great capital-efficient investments: auctioneers Ritchie Bros., money-management firm Oaktree Capital, and high-end grocer Whole Foods Market.
I can't see where a subscriber would get the idea that we've abandoning our core strategy. We haven't. Not in any way. Not at all. In fact, the very opposite has occurred. We've refined our best ideas. We've added more coverage. And we've continued to recommend high-quality, long-term investments as some stocks have fallen into our buy range. So his criticism that our work has changed or that we've "lost focus" on finding great long-term investments is simply false.
On the other hand, we also know that during a bear market it is difficult to produce good results without hedging. That's why we have recommended 14 different short-sale positions, roughly one for every two long recommendations.
On average, these recommendations have done great. On an annualized basis, our short portfolio is up 15% over the past 18 months. It's these recommendations – along with our gold and silver picks (see how much NovaGold is up over the past six months) – that will smooth out the volatility of your portfolio and help us achieve positive total returns, no matter what happens in the world around us.
But the main reason to hedge your portfolio isn't financial; it's emotional. And that's my main concern for P. Thompson and other investors like him who disregard our macro warnings and ignore our advice about hedging and other bear market strategies.
For real-life investors, the ability to continue to perform even in a bear market and the ability to reduce volatility is absolutely critical. Nobody wants to lose money. And almost no one can stand losing a lot of it – even temporarily.
But most people also ignore our advice about risk management (position sizing, trailing stop losses). As a result, there's no way they can stick with us. It's only a matter of time until they "blow up."
Likewise, most subscribers ignore our advice about hedging (short selling, holding precious metals, certain trading strategies). What most people do instead is exactly what P. Thompson describes: They find a strategy for buying stocks. They refuse to learn anything else. They don't allocate properly. They don't follow stop losses. And so when the market falls 10% or 15% (like I believe it will again this year, at least) they end up watching their portfolio completely disintegrate. They sell, right at the bottom.
And then, the kicker: They blame us. They tell everyone that following our advice cost them their savings. Meanwhile, they never followed our advice at all. Not even once.
Here's a tip. If you have more than 5% of your portfolio in any one stock (at the beginning of your investment)... if you don't know exactly what your exit strategy is going to be (if you don't know precisely when you will sell)... if you're not using TradeStops (or something similar) to monitor your portfolio... if you don't own any gold... and if you won't ever sell a stock short... then it's only a matter of time until you get clobbered.
It will happen. It's only a matter of time.
So please... take the time to learn how to become a successful investor. Learn how to manage your portfolio in good times and bad. Learn how to allocate appropriately. Learn how to hedge. You can learn how to make money in every market environment – and it's not even hard. Yes, learning to invest in capital-efficient, safe, Buffett-like companies is a great skill to have. It will help you generate fantastic, long-term capital gains and plenty of dividend income over time. That's a big part of being successful. But it won't protect you from watching your savings disintegrate in a bear market.
As I always tell you, there's no such thing as teaching, there's only learning. There's nothing I can do for you if you don't want to learn. On the other hand, there's so much I can do for you if you'll only try.
If you want to learn everything I know about making money in bear markets, please consider signing up for our next educational series. It's called the Bear Market Trading Program. It's cheap – just $49 for each module. And it will teach you things like merger arbitrage, pairs trading, and various options strategies that are completely "market neutral." These are all ways to make a lot of money, in the short term, regardless of the market's direction.
This is the best trading education we've ever put together. Going to grad school to learn these same ideas would cost 100 times more. But you don't have to spend a fortune to learn how to make one in the markets.
In my view, you ought to have all of these "tools" in your toolbox as an investor... especially right now. To learn more about the new Bear Market Trading Program, click here.
Finally... one more word about gold.
In an environment where two out of the three dominant central banks (the Japanese and the European) are openly pursuing negative-interest-rate policies and where the largest and most dominant central bank (the U.S.) is openly discussing the possibility of such policies... you should not blame us for focusing a large amount of our attention on macro issues and gold. You should thank us.
Do you have any idea how high the price of gold will go if all three major central banks institute negative interest rates? Where will you put your savings if keeping money in the bank actually costs you money every year? How will the global economy function if there's not a safe world reserve currency in which to store value and exchange trade receipts? Nobody knows. Nobody has any idea at all. And yet, that's the policy that's most likely coming.
I can't give you any details (yet), but I was in New York last week for a series of meetings with high-profile investors and policy advisors. Among the things I heard was a plan that's being formulated to use the gold in Fort Knox to mint a new gold dollar, while retiring a large amount of Treasury debt. It would only be done in a currency emergency to regain control of a plummeting U.S. dollar.
These kinds of discussions are taking place right now at the highest levels of finance and government. They're happening because nobody knows how our central bank is going to manage the ongoing global currency war and the crushing debt loads that are strangling all of the major western economies.
Believe me... this is not the time to put your head in the sand and ignore the macro forces. We're approaching a major inflection point as the world's entire paper currency regime seems like it's falling apart.
Investors like P. Thompson have become convinced – after a seven-year bull market and a big rebound over the last month in stocks, bonds, and oil – that they have nothing to worry about. They believe "the water is safe." Or at least, they have come to believe that the macro forces don't matter enough to change their investment strategy.
It's certainly possible that he's right. It's possible we've reached the peak of policy madness and that interest rates, commodity prices, foreign currencies, high-yield bonds, and equity prices will all begin to act "normally." No one can predict the future.
But we can assign odds. And the odds are NOT in our favor. Far too much bad debt has been issued to students, subprime car buyers, foreign companies (whose countries have devalued their currencies), oil companies, and corrupt governments (like Brazil and China). We are in the early stages of an enormous debt default cycle – a cycle policy makers are desperate to stop, just like they did in 2009. We know their playbook: They will issue new debts and a vast amount of new currency. The result will be crashing currencies and huge market volatility.
And so... my fear is that subscribers like P. Thompson, having discovered our work and having enjoyed some success making safe investments, will now decide that they're long-term "buy-and-hold" investors. Describing their strategy in this way, they believe they have no reason to hedge their portfolios. After all, Buffett doesn't. And why buy gold? Buffett doesn't. Buying gold isn't investing at all, they rationalize.
Well, you ought to realize that three times in his career, Buffett saw the value of his Berkshire Hathaway holdings decline by more than 50%. And that's the portfolio of the best capital allocator the world has ever seen. My hunch is that no matter how good of an investor you think you are... when you see your portfolio decline by 50%, 75%, or 80%, you're going to panic. You're going to sell. You're going to discover that you're not a buy-and-hold investor. You're just another buy-and-fold investor.
But remember: It doesn't have to be that way. You can learn to be successful in every market environment. It's not hard. You just have to try. Again, to learn more about the new Bear Market Trading Program, click here.
I'd like to share another letter I received recently from a subscriber. It's from D. Harper. He has been a subscriber for several years. He has learned some lessons that I hope you won't have to learn the hard way.
Porter – your Bear Market Survival Program was incredibly valuable! I am writing to let you know that your training does pay off. For years I was a "buy and fold" investor. I have now been with you for several years, and I have made the greatest gains of my lifetime. I have gained experience shorting stocks, buying options, holding some gold and silver bullion, recognizing value in equities, and value in distressed credit. I am lightyears ahead of where I was several years ago. So I am really writing this note just to say "thank you."
And... one more thing... If you like my approach to finance, I know you'll appreciate how much research and care went into the radical design of my new men's luxury razor – OneBlade.
I promise you've never used a razor like this before. It combines the safety and ease of cartridge shaving with the precision and comfort of a straight-razor shave. It also puts the world's finest steel and the world's most perfect shaving blade on your sink. I know that if you try it, you'll never shave with anything else again. And that's why I've made a deal to send you one for free. But you can only get a free razor with this offer for another 15 days, so please act now. Click here to learn more.
New 52-week highs (as of 3/10/16): Franco-Nevada (FNV), SPDR Gold Shares Fund (GLD), Kaminak Gold (KAM.V), Coca-Cola (KO), Lundin Gold (LUG.TO), Altria (MO), NovaGold Resources (NG), Seabridge Gold (SA), SEMAFO (SMF.TO), Sysco (SYY), and AT&T (T).
In the mailbag today... it appears not everyone is unhappy with our work. What do you think? We'd love to hear your thoughts at feedback@stansberryresearch.com.
"I don't usually take time to comment. I get a lot of mail because I look at a lot of information and give out my e-mail to look at it trying to learn. I don't have much money to invest yet, I live on a compound in the Middle East where the Wi-Fi sucks and I work six days a week.
"That being said, your letters and advice have been the most helpful of everything I have looked at and I am learning. You see, the first thing I had to learn was to trust your advice. Yes, I paid a fee to get it but that doesn't mean I started reading it fully trusting. Trust is earned, and you have earned it. I wish I could afford to get more of your letters and maybe 6 months from now I will be able to. Many of your opportunities are interesting to me but I just am not ready for them yet. That day will come too. In the meantime, I plan on building up my trading account with the advice I can apply and learning from your letters...
"Sir, I am about as blue collar as you can get so what I need is blue-collar advice. I don't know who actually reads these, but I just want you to know I do appreciate the letters. I don't always have time to watch everything you send me but I try to take time to read the letters. v/r." – Paid-up subscriber Ernest L.
"Porter, I have been an Alliance member since 2007, after discovering Stansberry Research randomly on the Internet in 2006. At the time, I was a weather forecaster on a military base and I was trying to learn about investments. My family and friends had taught me about the importance of saving and being generous, but not the nuts and bolts of building wealth long term.
"I grew up in southern Anne Arundel County, MD, so learning that you were headquartered in Baltimore created an immediate affinity. Fast forward a few years, I switched careers, and am now a financial advisor in Arkansas working for a regional bank. I am on a team with a couple of older guys, but I am personally responsible for about $30 million in assets.
"You and your company have 'taught' me more about this business than anyone else, and I don't think I could be where I am today without the years of reading and learning from you. So thank you, and I hope our business 'marriage' continues for decades to come." – Paid-up subscriber Jeff M.
"In response to your Friday e-mail, I always look forward to your [Digest] e-mails and especially appreciate your Friday Digests... I have been a Flex member for several years and consider my subscription to your service to be an EXCELLENT value." – Paid-up subscriber B. Mayne
"Porter, for quite some time, I'm afraid, I have been considering if my favorite part of the day (and week) made me a bit... pathetic?
"Is it pathetic how much I look forward to the Digest, every day? And especially Friday? Well, it's true. So there you have it. Thank you. Now I'll work on becoming a little more well-rounded." – Paid-up subscriber B.T.
"You all hit another home run with your comment last year (April 2015) that 'one really only needs one precious metal royalty stock – FNV.' I remember that the comment was accompanied with a link to a presentation by the CEO of FNV. The presentation was impressive enough for me to take a position in FNV, paying between 46 and 51 per share.
"FNV is now trading in the lower 60s. That's a nice gain – and it continues to push higher. And it also continues to pay nice dividends from the royalties it collects. Good show!
"You all cannot formally take credit for this because you did not specifically recommend FNV, at least not in any of the services I subscribe to. Once again, though, Porter was prescient in this. If I remember correctly, he made highly favorable comments about FNV's CEO." – Paid-up Goetz O.
Regards,
Porter Stansberry
Baltimore, Maryland
March 11, 2016
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