Uh-oh... the popular press has stumbled onto one of our most enduring investment themes. That's usually bad. But in this case, it's a good thing...
Financial Times' U.S. managing editor, Gillian Tett, has discovered World Dominators...
Tett penned an article called "Sovereign spreads challenging cherished notions," in which she notes credit insurance on U.S. sovereign debt costs more than credit insurance on World Dominators like McDonald's (MCD) and Coca-Cola (KO). Tett noted no less than 70 large U.S. companies are considered better credits than the U.S. government, as measured by the market for credit default swaps (insurance on bonds).
I've said before that debt markets shouldn't price new issues at spreads over U.S. Treasurys, as we continue to do today. We should base interest rates for new bond issues on spreads over the most impeccable credits in a given industry. For example, if you're a software or computer-related company, your debt would be priced at Microsoft plus so many basis points. If you're an energy company, you'd get a spread over ExxonMobil…
These are stellar, stable credits, unlike most governments. Given that governments have more incentives to borrow and spend than to maintain sound finances, it's not hard to conclude they should never be held up as a financial benchmark. Asking governments to function as the foundation of financial markets is like asking Larry King for marital advice. Their only honest input is, "I have no idea what I'm doing… again."
I've been singing the praises of World Dominator stocks for close to five years now. These huge companies are No. 1 in their industries, earn consistent profit margins, generate huge amounts of free cash flow, pay rising dividends, and have balance sheets like financial fortresses. The four remaining triple-A credits in corporate America are typical of the list: ExxonMobil (XOM), Automatic Data Processing (ADP), Johnson & Johnson (JNJ), and Microsoft (MSFT).
The Financial Times isn't the only one that's noticed the new sovereignty of the World Dominators. MSN Money recently noticed Wal-Mart's commercial paper yielding 0.04%, versus similar-dated U.S. Treasury obligations yielding 0.16%. (A higher yield indicates a lower price and more risk.) MSN Money wrote, "Wal-Mart is replacing the government as the gold standard for risk-free investing." I couldn't have said it better.
It's not just America, either. Spanish blue chips Telefonica and Iberdrola are now rated better credits than the Spanish government in the credit default swaps market.
Investors need to find solid ground. They need financial reference points. They need a clear definition of what constitutes an extremely low credit risk. In the past, they used the government. Today, they're increasingly turning to World Dominators as the benchmark for the lowest possible financial risk.
We often say you won't read our ideas anywhere else... I believe it's true that you won't find in-depth investment research on the World Dominators investment theme anywhere but in Extreme Value or The 12% Letter. I've found a few of these passing mentions in the popular press, but they're no substitute for real investment research.
Extreme Value has the most complete coverage of World Dominator stocks, starting in October 2006, with my initial recommendation of Wal-Mart (the new gold standard for risk-free investing, according to MSN Money). I've covered about a dozen of these special stocks since then.
I recently made a new addition to this elite list of stocks that's taking over the world. It's No. 1 in its industry, profit margins are growing thicker, the balance sheet is getting stronger, and it's gushing more free cash flow than ever before. It doesn't pay a dividend today. But if it ever does, I can show you how to get a 10% higher cash dividend than other shareholders in the same company. To learn about Extreme Value and get access to the World Dominators, click here.
As the World Dominators ascend, fiat currencies descend. And there's no more certain indication a fiat currency is doomed than an affirmation of its value by the country's central banker or top political leader.
So, say auf wiedersehn to the euro. German Chancellor Angela Merkel presaged the euro's death when she said in a campaign speech, "Many are worried, but they don't need to be because the currency is stable."
Some folks might not appreciate the subtlety of this excellent contrary indicator, but it's really simple. If the currency were stable, bankers and politicians wouldn't need to talk about it. The only reason you're hearing about it at all is because Merkel is lying. The euro is only as stable as the countries backing it, and they're not in great shape. Remember Bill Clinton's famous words, "I did not have sex with that woman." It's the essential political paradox, a statement that would never be spoken, except as a lie.
Fiat currencies are frauds, but they're not an old fashioned, run-of-the-mill, we're-lying-through-our-teeth frauds. If you want one of those, China is not a bad place to go looking for them...
In June, we told you about the latest Chinese fraud, Longtop Financial Technologies. The company's auditor, Deloitte, resigned, alleging Longtop was misstating cash balances at banks and potentially misstating revenue…
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The latest swath of Chinese fraud to hit the stock market has spread beyond the typical fly-by-night, small-cap Chinese stocks. Longtop Financial Technologies, which blew up in May, was a $2.4 billon software company with real customers and products. What Longtop apparently didn't have, however, was much of the cash it claimed in various Chinese banks. |
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The company's auditor, Deloitte, confirmed Longtop's cash deposits over the years with local branches where the software company did business. However, for this year's audit, Deloitte insisted on getting its confirmations from bank headquarters. That created an immediate panic at Longtop. Its executives admitted they had claimed "fake cash" in the banks reflecting "fake revenue" in the past. Since that May 16 admission, the stock has not traded. We don't know for certain what it is worth – perhaps nothing. |
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This situation, while unfortunate for investors in Chinese companies, also raises a much bigger question. If Chinese banks are deeply involved in these corporate frauds... what can we believe about any of the other assets on their books? – Porter Stansberry, June 20, 2011 Digest |
The New York Stock Exchange halted trading in shares of Longtop in May – amid egregious fraud at many U.S.-listed Chinese companies (including Sino-Forest… which we'll touch on later). The NYSE delisted Longtop shares earlier this month. And yesterday, the company announced it received a "Wells notice" from the U.S. Securities and Exchange Commission (SEC). (A Wells notice is a warning the regulator's staff recommends commencing enforcement proceedings.)
In a statement disclosing the investigation, Longtop quoted the SEC's August 19 notice, saying because its auditor resigned, the company's 2008, 2009, and 2010 financial statements "are now considered unaudited and the company does not have any reports with current reliable financial information available to the investing public. Therefore, Longtop is delinquent in its reporting obligations under the securities laws." The SEC also said it may attempt to suspend or revoke the company's securities registration.
The Longtop investigation comes as the CEO of Chinese timber company, Sino-Forest, just resigned. Sino-Forest shares plunged in June as the hedge fund Muddy Waters, which holds a short position in the stock, issued a 23-page report questioning the company's accounting and timber assets.
On a July 14 conference call, CEO Allen Chan said, "I personally stand by and guarantee that the audited financial statements in the reports filed are accurate, and any material connected parties' transactions have been disclosed in our management discussions and analysis."
On August 28, Chan "voluntarily" resigned pending completion of an independent review of Muddy Waters' allegations.
Sino-Forest's largest shareholder at the time of Muddy Waters' report was John Paulson, the billionaire hedge-fund manager. Paulson owned nearly 15% of the company (34.7 million shares). On June 17, Paulson announced he sold his entire stake. But not before taking an estimated $750 million loss.
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You should always be as worried about return of your capital as you are about return on your capital. Avoiding fraudulent companies like Chinese reverse mergers will help in that department. Reverse mergers are a popular way for Chinese companies to trade on U.S. and other exchanges. In a reverse merger, a privately held Chinese company would merge with a shell company that is already listed on a U.S. exchange. The Chinese company then gains voting and operational control. These reverse mergers allow the Chinese companies to avoid many regulatory hurdles most companies encounter when preparing for an initial public offering.
Before investing in a Chinese reverse merger, ask yourself this question... Considering our contentious history with China, why – when they just begin to build wealth – would they want to share that wealth with U.S. investors (which is what selling equity amounts represents)?
The conclusion we drew from the rampant Chinese fraud…
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You'll recall the data showing that China, which contributes about 10% of the world's GDP, has been consuming more than half of the world's concrete and almost half of the coal, along with a sundry list of other strategic commodities. These numbers, best summarized by measuring the rate of fixed-asset investment, suggest that China is caught up in a huge – and unsustainable – investment binge. |
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We've long suspected at least some of China's supposed economic might would be revealed as nothing more than a new credit bubble. And now, we're more certain than ever that's the case. Furthermore, we're more and more convinced the next big blow to the world economy will be the growing recognition that China's banks are thoroughly corrupt. Given the huge expansion of the banks' asset base since the fall of 2008, that's going to be a big problem. – Porter Stansberry, June 20, 2011 Digest |
China isn't the only country where banks could be misstating their books. In a letter sent to the European Union regulatory agency the European Securities and Markets Authority, the International Accounting Standards Board (IASB) noted the inconsistent way banks and insurers wrote down the value of their Greek sovereign debt.
According to people familiar with the IASB who spoke with the Financial Times, the intervention was unprecedented (meaning the board is likely worried some large, European financial institutions are going down). Banks and insurers have already written down billions of dollars from the value of their Greek debt holdings after the country's second bailout... However some institutions have written the bonds down by half, while others have only taken a 20% haircut. For the record, our money is on the 50% figure, though even that may be generous.
The letter didn't point out specific offenders. According to a source quoted in the Financial Times, the IASB is concerned about French bank BNP Paribas and insurer CNB Assurances. Both wrote down their Greek government debt holdings by 21%. They said there was no "fair value" for the debt, so they used "mark to model" valuation. I seem to recall another time "mark to model" valuation was rampant... around late 2007.
The results of Italy's $11.2 billion bond auction are in... Yields on the 10-year debt remained at 5.22%. That means one thing... the European Central Bank (ECB) is still buying huge quantities of Italian debt. It's just doing so in the secondary market (not directly in the auction). According to Reuters, the ECB bought a "significant amount" of the 10-years.
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New 52-week highs (as of 8/29/11): McDonald's (MCD).
We've advised you repeatedly that if you're going to be in the stock market today, you must short stocks… But before you short a stock, you need to know what shorting a stock means... Details in today's mailbag. Send your feedback to feedback@stansberryresearch.com.
"I would like to thank you very much for your Friday Digest discussing gold versus paper money – great job, as always. I found it very informative and helpful, and welcome similar articles in the future. I would hope such an article would lead to a lot of new subscriptions today (Monday) rather than cancellations. How could you not appreciate the education! You provide a great service to your readers!" – Paid-up subscriber Chuck
"Please tell me how do you short a stock? I know you recommend it in your newsletter, but I do not know how. I am very new to this, but am enjoying learning. Thank you." – Paid-up subscriber G. Kent
Ferris comment: If you have an online account, it should offer an option to "sell short" on the screen where you enter orders. Select that option, and you're good to go. If you have a regular broker, just call him up and tell him the number of shares you want to sell short. When you exit the trade, you'll make an order to "buy, to cover" the shares you shorted.
Behind the scenes, the transaction is more complicated. Your broker borrows the shares and sells them into the market. When you exit the short sale, the broker buys back the shares and returns them to wherever he borrowed them. But you don't need to worry about any of that.
And remember, if the share price declines before you "buy, to cover," you make a profit. If the share price goes up, you lose. Short selling is risky.
In Extreme Value, I've got a great short sell. It's a company that was once a hypergrowth stock, but whose hypergrowth has disappeared. It's valued these days around 340 times earnings. And at precisely the moment when stock option expense went through the roof a little over a year ago, management decided to start reporting a different earnings number... which conveniently didn't include this enormous new expense. I think this stock could easily fall 90% before it's all said and done.
If you want to learn more about Extreme Value and get access to that recommendation, click here.
Regards,
Dan Ferris and Sean Goldsmith
Medford, Oregon and Baltimore, Maryland
August 30, 2011
World Dominators ascending... Wal-Mart: The new 'risk-free'... The euro: Officially doomed... Revisiting Chinese fraud... Avoid reverse mergers... What is Greek government debt worth?... Italy's debt auction a success, kind of...