Why you shouldn't buy commodity stocks...

Why you shouldn't invest in commodity stocks... Understanding the 'cap-ex cycle'... The coming collapse of oil shale... True Wealth Systems Challenge: Can 'value' beat the market…

Editor's note: At the end of today's Digest, Steve puts another investing strategy to the test through his True Wealth Systems programs… Yesterday, Steve showed how a simple trend-following system produces marketing-beating results. Today, he asks, "What about value investing?"

You don't want to miss what he found…

In today's Digest ... a simple warning and a strategy for investing in commodity businesses.

As you know, I (Porter Stansberry) write these Friday letters personally. My goal is very simple: I'm trying my best to tell you the things I wish someone had told me when I got started investing back in 1992.

Most of the critical strategies that successful investors need to know are really nothing more than common sense... But unless you've spent years thinking about finance, there's a good chance these concepts won't occur to you until after you've learned the hard way. Here's a good common-sense rule for investing in commodity businesses: Don't do it.

I'm just kidding... sort of. Investing in commodity companies (companies that produce commodities or make commodity-like products) is a hard way to get rich. That's because of two simple reasons…

First, it's difficult for these firms to produce excess returns on their capital. By definition, they can't differentiate or brand their production. Second, it's awfully hard for these companies to produce growth in free cash flow or profits that can be distributed to investors (in dividends or share buybacks). Usually, the companies require a ton of capital to replace inventory that's been sold.

Consider Newmont Mining, for example. In 1990, its share price was $40. Today, 23 years later, its share price is still $40. And Newmont is a very well-run gold-mining operation. Plenty of things have gone right for gold miners over the past 24 years. Gold prices have gone way up. Political and financial uncertainty has gone way up. Individual investor interest in gold and gold stocks has gone way up. Inflation has gone way up.

But Newmont's share price? It's gone nowhere. The main reason is, when a gold company sells its product, it's selling the most valuable asset on its balance sheet. It's hard to compound your returns when you go to work every day and sell your own balance sheet.

So a good rule of thumb for part-time investors is simply don't get involved in commodity companies. Don't buy oil stocks… or gold mines... or steel makers. Just avoid the entire space. No rule says you have to own these stocks. Plenty of people have made a fortune in stocks without ever touching these kinds of companies.

But... let's say you're stubborn... or greedy. Let's say you recognize that these commodity businesses are deeply cyclical. Let's say you recognize that from time to time, you can buy these assets for next to nothing... or sometimes, nothing at all. It's not hard to figure out that some people made a lot of money buying certain mining assets back at the bottom of gold prices between 1998 and 2001… or buying oil stocks during the same period.

If you're going to speculate in these sectors, you need to understand one very important concept. I call it the "cap-ex cycle."

Cap ex is financial-analyst lingo for capital investments. These are the big purchases commodity companies have to make to buy new properties and equipment. You only want to speculate in commodity businesses at the bottom of the cap-ex cycle – not the top.

Take oil, for example. The bottom of the last cap-ex cycle was in early 2000. That was just after oil fell to less than $15 per barrel in 1998. Nobody wanted to invest in new oil properties or expensive production equipment. At the time, you could buy leading oil-equipment companies (like Patterson-UTI Energy) for less than half of the market value of their drilling rigs, even after subtracting all net debt from the balance sheet.

But... from about 2004 through today... oil prices have been at or near all-time highs, even adjusted for inflation. These high oil prices have driven massive investor interest in buying oil properties, finding new oil properties, and developing new oil-production equipment.

Just consider Suncor (SU), for example. This is a massive company. It owns and produces more oil from the Canadian oil-mud region... er, I mean... oil-sands region than anyone else. Twenty years ago, the company was nearly worthless because the production costs for this type of oil product were so high, no one thought it would ever be economically viable. Today, it's a $40 billion company! Talk about a change in investor perception.

In just the last three years, Suncor has invested almost $17 billion in cap ex. It has only produced about $18 billion in cash from operations. As you can see, this is a marginal business. It requires tremendous amounts of capital... probably more capital than it's possible to make selling the oil. And during those three years, the price of oil was very, very high.

Today, Canadian oil-mud (er, oil-sands) producers are only getting $44.92 per barrel for their crude. That's because higher-quality crude oil is available now from Bakken wells, which is displacing Canadian crude in U.S. pipelines. And it's also because the U.S. is drowning in oil. According to the federal Energy Information Administration, U.S. domestic products exceeded 7 million barrels per day in November and December, the highest volume in 20 years. Likewise, oil in storage today is now 1.1 million barrels. That's the highest level of oil in storage ever recorded during the month of February.

Investors who have spent tens of billions developing marginal resources in places with very high operating costs (like Canada or deep offshore in Brazil) are learning a painful lesson about the risks of the cap-ex cycle. Don't be late to the party. Make sure, before you buy any commodity stock, that there hasn't been a multiyear boom in major capital investments before you invest. Look for commodity sectors that have been in multiyear bear markets... where major cap-ex spending has been declining for years. That's where you'll find the best opportunities.

My friend Rick Rule is a master at this style of commodity sector investing. He puts the harsh reality of commodity investing into a simple rule of thumb: In commodities, you're either a contrarian or you're a victim. Just remember that the next time you're contemplating a commodity speculation.

New 52-week highs (as of 2/28/13): Berkshire Hathaway (BRK), WisdomTree Japan SmallCap Dividend Fund (DFJ), iShares Biotech Fund (IBB), ProShares Ultra Health Care Fund (RXL), Pepsico (PEP), Hershey (HSY), Kohlberg Kravis Roberts (KKR), Range Resources (RRC), Government Properties Income Trust (GOV), and Two Harbors (TWO).

In today's mailbag… one subscriber describes his success with real estate, and another offers his thoughts on our portfolio. Send your e-mail to feedback@stansberryresearch.com.

"I've acquired (12) rental properties the last few years... Some cash and most financed at 4% or less. Average ROI is 15%-18% annually. Depreciation greatly offsets the tax consequence of other investment income and capital appreciation over time will be icing on the cake (particularly given the Fed's monetary policy).

"Purchased a mountain home in Colorado last August for 50% of what it listed for in 2007. It rents for $4,800 a week... 6 weeks of rentals covers all operating expenses for a year. It's a great time to purchase real estate!" – Paid-up subscriber RD

"Porter – Before I get into my recommendation, I just want to say I agree with your outlook for our country. It is, indeed, very sad; I worry about what my grandchildren's country will look like down the road. As long as people feel entitled to what they consider 'freebees' from Uncle Gov't – and these people vote – I doubt we'll ever see a conservative in high office at least during my lifetime.

"Now to my recommendation: Down here in North Carolina there are a lot of hog farmers. A feeding trough may hold a dozen or so hogs. For whatever reason when one hog leaves its space around the trough, another will take its place.

"Is there a reason why your Model Portfolio couldn't resemble this trough? Say the 'trough' is a $100,000 portfolio. Only so many companies can get into it. When a new recommendation is made, either it has to wait until one of the existing recommendations is sold or just patiently wait until a space opens up.

"Your customers/clients only have so much money to invest (in this case $100,000), and while they may want to add another company to their portfolio, if the $100,000 is already fully invested, they either have to sell one of their holdings or just do without. Doing this, I believe, would make your Model Portfolio much more realistic and would really focus on who is going to get to the trough. It would also enable you to publish a truly realistic track record that no doubt would be very successful and thus add new subscribers." – Paid-up subscriber Phelps Salter

Regards,

Porter Stansberry

Miami Beach, Florida

March 1, 2013

Trend or Value… What's More Important for Investors?
By Steve Sjuggerud

Yesterday, we showed that simply following the trend in stocks is an easy way to beat the market… but what about using a value-based system?

Of course, buying stocks at a good price should lead to better gains down the road. But can we use that as a signal for when to be in or out of the market in general? We put our True Wealth Systems computers to the test for proof…

We looked at the overall stock market by using data for the benchmark S&P 500 stock index going back to 1928. For our value measure, we kept it simple. We used the price-to-earnings (P/E) ratio.

Remember, the P/E ratio is simply a company's share price divided by its annual earnings per share. The easiest way to think about it is to imagine a rental property… If you buy an investment property for $200,000 and it generates a net annual rent of $10,000, you paid a "P/E ratio" of 20 for that property.

To find out if you make money when buying "cheap," we focused on the lowest 25% of P/E ratios… Any time the P/E for the S&P 500 was in its lowest quartile, we "bought" for the following month.

The table below shows the results of this value-based system versus a simple trend like we described yesterday…

As you can see, using our value strategy beats the annualized return on stocks. But you'd only be invested 25% of the time. The simple trend-following strategy we described yesterday (based on the S&P 500's 10-month moving average) beats a value-based strategy and keeps us invested 65% of the time.

So value works… But maybe we could improve on these results. What if we held for a longer period of time than one month?

We had our computers look at buying and holding the market for various time periods, based on our cheap P/E ratio. The annualized results are below…

Buying stocks when the market is cheap and holding for a few years crushed the overall return on stocks. Based on these tables, using a three-year holding period gave you the best outperformance over indiscriminately buying and holding the market.

These results are pretty simple… And they show buying value works, particularly if you're willing to hold for a few years. Of course, buying in an uptrend works too… as we showed yesterday. And putting the two together works wonders.

So whenever you get the opportunity to buy stocks when they're cheap and in an uptrend, take it!

It doesn't happen often, but when it does, the odds are really stacked in your favor for beating the market.

Good investing,

Steve Sjuggerud

Three great wines I drank this winter…

Editor's note: Bordeaux blends are Porter's favorite wines. In today's Digest, he shares some of the fantastic wines he has recently enjoyed… and how to get some for yourself.

To continue reading, scroll down or click here.

As some of you know, I (Porter) am a big fan of fine wines…

And I've been enjoying a lot of new wines this year. The man in South Beach I normally buy wine from sold his business, so I'm using a new broker (the acquiring firm). And this winter, he sent me a lot of wine I had never tried before.

I'd guess I drank 10-12 cases the broker sent to my Miami home. I'll share some of my favorites that I discovered this winter…

My favorite wines are Bordeaux blends, especially those from Argentina and California (particularly Napa and Santa Barbara, California).

A Bordeaux blend is usually a mix of three grapes that are traditionally associated with the French wine-making region of the same name… A Bordeaux blend always has Cabernet Sauvignon and Merlot. The third grape varies. It can be either Petit Verdot or Cabernet Franc. I prefer the more common Cabernet Franc.

A world-class example of a Bordeaux blend is called Peter Michael Les Pavots. It's a Cabernet-Merlot-Cabernet Franc blend with a touch of Petit Verdot. It's absolutely delicious. If you have never tasted a Les Pavots, I would recommend trying that first.

I also recently had a fantastic Bordeaux blend from Argentina. And it was a low-priced wine, which is surprising as these wines are usually expensive. I tried it at a restaurant called The Forge in Miami.

The Forge has a fantastic wine program… All its bottles are set up in a vacuumed device, so you can have a single glass of wine from almost any bottle off the list. (With most restaurants, if you want a good bottle of wine, you have to buy the whole thing… They don't want to open it just to pour you one glass.)

Back to the Argentine wine…

Bordeaux's famed Cheval Blanc opened a vineyard in Argentina called Cheval des Andes. Because land and labor are much cheaper in Argentina, the winemaker is able to make wine there that is similar to the ones from its French vineyard at much lower prices.

I tried the Cheval des Andes – a Cabernet-Merlot blend – at The Forge. And it was great.

I also ordered another Bordeaux from my new brokerage, JJ Buckley. It was a 2004 Leoville Las Casas Bordeaux. It's a little more expensive, but it's very good.

If you'd like to contact my wine broker, his name is Ian Conroy. And his e-mail is ian.conroy@jjbuckley.com.

And if you mention my name, Ian will offer you $25 off your first order, compliments of JJ Buckley. (I do not receive any compensation for mentioning JJ Buckley or Ian.)

– Porter Stansberry with Sean Goldsmith