Liquidity is one of the most overhyped of modern financial ideas. In the context of the stock market, all liquidity means is that you can buy and sell easily. Lots of liquidity means lots of trading volume. It means the bid-ask spread is narrower in a liquid stock than it is in one that is illiquid.

As it turns out, the best opportunities are often the most illiquid. In what follows, we’ll take a look at illiquidity as an investment strategy.

Markets are more liquid than ever these days, but that is not all a good thing…

Back in 1960, investors held their stocks for an average of seven years. No one complained about a lack of liquidity. Today, people hold stocks for on average for four-eight months.

The ability to get in and out of a stock quickly means you have lots of sloppy owners. As Lowenstein points out: “Those who expect to sell out quickly and cheaply are more likely to buy for speculative or foolish reasons and to act as uninformed owners in between times.”

An illiquid stock is, by its nature, more likely to attract a smarter shareholder base. This is simply because the people going in know they can’t get out of it as easily, so they are more careful about how and why they get in.

This may have something to do with the outperformance of illiquid shares.

Roger G. Ibbotson and Wendy Hu of Zebra Capital Management studied the performance of liquid stocks against illiquid ones. They found that illiquid stocks tended to trade at a discount to more-liquid stocks. “Investing in less-liquid stocks thus pays,” they write.

Moreover, they found that less-liquid assets tend to become more liquid over time, thus helping to erase that gap.

Ibbotson and Hu also note that investing in less-liquid securities as a strategy has an advantage in that it “avoids, or invests less in, popular, heavily traded glamour stocks and favors out-of-favor stocks, both of which tend to revert to more-normal trading volume over time.”

That’s all fine and makes sense. But you can really see it in practice by looking at portfolios investors construct.

Nick Padgett and Stephen Mack are the managing directors of Frontaura Capital. The fund invests in frontier markets such as Cambodia or Mongolia. I’ve never met them personally, but hope to someday. I was introduced via email by my friend Doug Clayton at Leopard Capital. They share their shareholder letters with me, and the latest one had an interesting observation on this liquidity idea.

Frontier markets can be very illiquid. It can take weeks, maybe months, to buy even small positions in Mongolian stocks on the Mongolian exchange, for example. This means frontier markets are cheaper, but not always. Frontier markets have some liquid stocks. And the valuation disparity between the liquid and illiquid is great. The most-liquid stocks can trade at the same price-earnings multiples as S&P 500 stocks like Wal-Mart or Intel.

“Thus,” Padgett and Mack write, “those willing to invest beyond the most-liquid frontier stocks could have a performance advantage, provided they remain patient and committed during difficult market periods, when less-liquid stocks may perform worse.”

As evidence of the disparity, consider the MSCI Frontier Markets Index. It is made up of the largest and most-liquid frontier companies. Padgett and Mack don’t own a single stock in this index. “Many of these stocks are good companies,” they write, “but they do not trade at the most-attractive valuations.”

At the time of their letter, Frontaura’s portfolio had an average price-earnings ratio of 6 with a price-to-book ratio of 1 and a yield of 5%. By contrast, the MSCI Frontiers Markets Index had a PE of nearly 11, a price/book of 1.5 and a yield of 4%. Frontaura’s valuations are cheaper in the less-liquid names.

I offer another exhibit of an absurdly cheap illiquid stock: Siem Industries.

This trades on the Pink Sheets under the ticker SEMUF. Siem is a holding company in the oil and gas, marine transportation and shipping industries. Siem owns pieces of Subsea 7 S.A., Siem Offshore and Star Reefers. Siem Industries is another stub play, as these three companies are all publicly traded.

The stake in these three companies is more than double the market cap of Siem Industries.

Siem Industries owns other stuff, too. It owns 100% of Siem Car Carriers, which owns ships that carry cars. It has a stake in a private equity fund that owns a variety of Scandinavian companies. It has stakes in a potash mine and an insurance affiliate. None of this is counted above.

The catch?

The shares don’t trade much. Over the last three months, the average trading volume was 945 shares. That’s a daily volume of about $60,000. And that overstates it. I checked over the last 16 trading days and found that on 11 of those days, no shares traded at all. Not a single share. On many days, you’ll see 200, 400 or 600 shares trade. As I write, the bid-ask spread is enormous. You pay $74 per share to buy and get $63 to sell.

That, I think, is the big reason for the discount. But this is not a situation that will persist forever. In the meantime, there is a whopping discount to the patient shareholder, and probably a rewarding ending.

Note: Siem Industries is not an official recommendation. I think it’s too illiquid for me to recommend here. Too few would get in on the trade.

In any case, liquidity as an investment strategy is a useful idea, as these examples show.

Sincerely,

Chris Mayer
for The Penny Sleuth

Liquidity, Crack and the Quest for Better Returns was originally featured in the Penny Sleuth.

Last year, it was the hype around LinkedIn and Groupon. This year, it’s Facebook. Chances are you’re gonna get suckered. On average, studies have proven IPOs underperform the market by 30% in the three years after going public.

Here’s just one example: LinkedIn.

If you participated, you saw the share price climb as high as $122 on the very first day, before settling to $94 and a quarter. That’s a big jump from the $45 entry price.

However, most individual investors couldn’t see those gains. Institutions get first crack at IPOs. Those who jumped in after Day 1 have seen days of major disappointment when the stock traded as low as $59 and climbed back to only where it was bought at. So much for all the excitement…

IPOs mean buying something the insiders no longer want at a price they’d never pay.

Let’s not spend our valuable time lurking about in these statistics in The Journal of Finance. I see far better deals out there in the public offering markets right now. Allow me to share with you the one class of public stock offerings that I think are worth your time and initial investment.

You probably don’t hear about these — even though they routinely beat the S&P 500.

From 2002-March 2012, an index tracking this class of offerings beat the overall market by 226%. Look at recent history and you’ll find companies like American Express, Home Shopping Network and Marriott Hotels directly involved in these deals.

But despite these incredible returns, these offerings get none of the “hype” of IPOs. That’s why I call them “Hidden Public Offerings” (or HPOs)…

They’re hidden because they just don’t get the press that IPOs do, but they’re a great way to exploit inefficiency in the market to help you outperform in your stock portfolio.

How Do Hidden Public Offerings Work?

When company insiders want to maximize the value of an asset they own, they may chose to do so by “splitting off” a section of their business into a wholly separate business. You can buy shares in that new business. This is referred to as a spinoff or Hidden Public Offering.

I consider spinoffs to be hidden because they don’t jump off the investment shelves the way IPOs do. Often, the asset itself is “hidden” on the balance sheet of a company; it’s not the main item that attracts present shareholder interest. Yet the asset will have a real value on the open market (often not the same value it holds on the parent company’s balance sheet). A spinoff helps “discover” the true value of that asset.

There are several benefits to the company (and present shareholders in the parent company) when a new business is spun off of the old. The parent company and its shareholders retain equivalent shares in the new company. They can buy or sell the new shares as they please. New investors can get into the new company at a price they might not have paid for the parent company.

How Can I Track Spinoffs?

If you want to track these stocks as a group, follow the Bloomberg U.S. Spin-Off Index. You can find it under the ticker BNSPIN.

But there’s no super-secret spinoff “tip sheet” that shows you what stocks are planning on spinning off assets in the next, say, 12-36 months. That’s why Mayer’s Special Situations exists, to point out such choice one-time events to readers as these Special Situations develop. It’s not as if I can say to you right now here are the spinoffs, here are the dates, the tickers, have at it! It takes time and research and sleuthing… That’s what a balance sheet detective like me does best.

I sniff out assets that could benefit in the case of a spinoff. I also do as much due diligence on the CEO and the big company directors and other insiders as I can. I’ll even ring a CEO up on the phone. He won’t be able to tell me if there’s a spinoff in the works… but many times, you will find the suggestion or hint of these kinds of value-creating shareholder actions in a public SEC filing or quarterly conference call.

Even if you did have an advance “peek” at the Hidden Public Offering list of spinoffs, you still need to vet out the candidates for investment. As with IPOs, not all companies are good bets to take.

My excitement for spinoffs depends on what price the new company starts trading at and the particulars of the deal. The form I need to see for that is the S-1.

One spinoff to watch out for is one in which the company is spinning off an undesirable legacy business that just might not have a future they want to be a part of.

A case like this is Loews Corp. (NYSE:L). I like Loews because I like the Tisch family, a dynasty begun in true American fashion just after World War II. The Tisch brothers paid out $375,000 for an old New York hotel with help from their parents. They went on to snap up hotels in Atlantic City and Manhattan. In 1968, they acquired Lorillard Tobacco, using that steady cash flow to fund other operations and, most importantly, smart acquisitions. By 1995, you could have found the Tisch brothers on the Forbes 400 list of wealthiest Americans, at $1-2 billion net worth. Loews, their main investment vehicle, continues to deliver solid returns to this day. If you’d put just $1 into Loews in 1959, it’d be worth over $1,622 today. And that’s not even accounting for the dividends Loews paid out over the years.

They follow three simple investing rules:

1. Always assess the downside.

2. Invest in assets, not management.

3. Our day will come.

Now, here’s why I mention it. You can use these same rules to decide why it’s no longer best to keep hold of a business you own. In Loews’ case, the thing to jettison was Lorillard Tobacco.

Lorillard used to be Loews’ cash cow, funding acquisitions during down markets when other assets (like drilling rigs or pipelines) were cheap. But those heady Mad Men cigarettes-in-every-meeting days are long gone. As the legislation changed in America, and as sick smokers started suing, Lorillard became something of a “surprise litigation risk.” It wasn’t a business I liked for Loews down the road, and I was very happy the day they announced they were spinning it off.

Forget IPOs. Luckily for us, we’re in the sweet spot of HPOs.

Joe Cornell, a 15-year veteran in the field and head of Spin-Off Advisors reveals, “I don’t remember the spinoff calendar being this robust. This is going to be the biggest year ever for spinoffs.”

I also think this year could be a record-breaker.

What kind of market are we talking about? Well, 2011’s spinoff values were double what they were in 2010. Back in 2000, the spinoff record was $265.5 billion. That’s the one to beat.

Sincerely,

Chris Mayer
for The Penny Sleuth

Hidden Public Offerings was originally featured in the Penny Sleuth.

At Grant’s conference two weeks ago, the great short-seller gave the audience a half-dozen short sale ideas. I’d like to focus in on three of them. He called them “value traps” because they look cheap on the surface but have serious problems underneath.

You don’t want to own any of these ideas.

The first is the flip side of the shale gas boom. You know the outlines of this story already. New technology has cracked open once-unreachable natural gas. Gushing new gas wells have dropped North American natural gas prices to around $2. That’s a drop of over 50% from last year and 75% from five years ago.

Suddenly, cheap natural gas means coal-fired power generation is in trouble, as more switch to natural gas. U.S. coal prices are down 20-32% from last year, depending on where you are and what type of coal. Coal train carloads are down 18% from a year ago.

Chanos’ favorite short here is CONSOL Energy (NYSE:CNX). Thermal coal made up 45% of 2011 gross profits. Higher-grade met coal made up 38% of profits. On these coal assets, CNX competes with low-cost exporters from Australia, Indonesia, South Africa and Colombia.

CNX also has quite a bit of leverage. In the last three years, it’s barely produced any free cash flow. Might further drops in coal prices force a crisis at CNX? It seems the Street’s opinion of what CNX will earn is changing rapidly. Just 90 days ago, the consensus was $3.19 in earnings per share this year and $3.62 next. Now that consensus is $2.08 and $2.63, respectively.

Avoid coal stocks in general and CNX in particular.

The next idea was national oil companies, which Chanos pointed out, “are being run for the benefit of the states.” The general model for a national oil company is for the government to retain a big stake in the company, push for costly investments and keep prices at the pump low.

The short idea here is Petrobras (NYSE:PBR), the Brazilian oil company that found the big pre-salt deposits to much ballyhoo. PBR seems a good-looking value story on the surface. It has a forward price-earnings ratio of only 7.5 times. The stock price is down 40% in the last two years. And it has, to its credit, the biggest oil find in the Americas in a generation.

Yet these mask serious problems…

Chanos points to the enormous (and risky) capital spending program out to 2015 — a $225 billion commitment that will require $14 billion in divestitures and $86 billion in additional debt.

Meanwhile, the government pushes PBR around for its own political reasons, like a kitten with a ball of yarn. So there are price caps at the gas pump, thereby capping PBR profits. PBR also must source 65% of its services domestically, handcuffing it in finding the best deals. And finally, PBR is building a huge fleet of ships at a time when there are already too many ships.

As Chanos showed, the end result of all this social engineering is some very poor results. For starters: Production growth of only 1.4% per year from 2006-11 and $13 billion in negative cash flow after dividends in 2011.

I will add here that I think the whole country of Brazil is in a bit of trouble. Longtime readers will not be surprised, as I’ve been warning about Brazil for more than a year now. Let me recount just some of the ways it alarms me:

Brazil’s tax burden is among the highest in the emerging world. It’s comparable to France or Norway and not competitive with its emerging market peers

Government spending is nearly 40% of the economy. Brazil already has a welfare state it can’t afford

In the ease of doing business surveys, Brazil ranks 126th out of 183 countries. That’s an embarrassment. It’s easier to do business in Rwanda, Guatemala and Pakistan than it is to do business in Brazil

Infrastructure is poor and not getting much better. Poor roads and ports lead to long queues, spoilage and wasted time. Investment in infrastructure is only 2% of the economy, compared with the 5% emerging market average.

Crime is a big problem. No wonder Brazil is the world’s second-largest market for armored cars. Eike Batista, Brazil’s richest man, doesn’t go anywhere without a small army. This is normal among the elite.

Why people continue to think Brazil is a good place to invest can only be because of Brazil’s inherent sex appeal. It seems to have everything. My recommendation is go ahead, go to Brazil. Have a good time. Go to the beaches. Enjoy the caipirinhas. Then invest your money someplace else.

The third idea from Chanos that I’ll highlight is iron ore. As China has boomed, so has its demand for iron ore. China alone makes up 66% of global iron ore consumption. China’s boom has taken a ho-hum commodity and made it exciting. Take a look at this price chart:

How sustainable is today’s price? Already, Chinese demand seems to be flattening out. And as Chanos pointed out, iron ore is not particularly rare. You just have to dig it up and get it to the coasts, which is what people have been doing. There has been tremendous investment in rail and mines in the last several years. All of the major iron ore producers are ramping up production at a time when Chinese demand is flagging.

Chanos highlighted Fortescue Metals as the one he thinks will crater. Once again, it seems to have the outlines of a “value story” — it has high profit margins, low costs and plans to nearly triple production by 2013.

The problems: 98% of sales go to China, it has a high level of debt and it suffers from rising costs.

So those are a few ideas from Chanos. Don’t own coal producers, national oil companies or iron ore producers. And especially avoid CNX Energy, Petrobras and Fortescue Metals. I strongly agree with Chanos’ take on all three of these ideas.

This is also a good lesson in trusting obvious figures like price-earnings ratios. You can’t just look at surface appearances and expect to do well in stocks, except by chance. There is much more to handicapping the success of an investment than just looking at what everyone sees and knows about. Chanos proves that out with this suite of ideas.

Sincerely,

Chris Mayer
for The Penny Sleuth

Three Ideas You Don’t Want to Own Right Now was originally featured in the Penny Sleuth.

Somewhere a real estate man with dirt under his shoes and drywall dust on his shoulder must’ve had a hunch that skyscraper booms happen just as things go bust. But it took an economist to put it down on paper and create an index.

In 1999, economist Andrew Lawrence did just that. He created the Skyscraper Index. It showed that the tallest skyscrapers sprouted just as business withered.

Its ability to predict collapse is surprisingly accurate…

In a 2005 paper, economist Mark Thornton took a stab at vetting the index. He wrote that “the Skyscraper Index… does have a good record in predicting important downturns in the economy.” And most recently, Erste Group Research released a report in March that calls the track record of the Skyscraper Index “impressive.”

Here’s how it worked in Dubai. The Burj Khalifa took the crown of world’s tallest building from Taiwan’s Taipei 101 in 2007 — just before the onset of the global financial crisis. Here the Skyscraper Index worked perfectly. (And Taipei 101 itself fits the theory of the index too. Construction began in 1999, just before the tech bubble reached its peak.)

Some of the index’s successful past signals:

• The Singer Building (1908) and the Met Life Tower (1909), both record-setters, began before and were completed after the Panic of 1907 — which Thornton calls “one of the sharpest downturns in American economic history”
• The Chrysler Building (1930), and then the Empire State Building (1931), heralded the Great Depression
• The World Trade Center (1973) and Sears Tower (1974), were both completed amid the 1973-74 economic crisis
• The Petronas Towers in Malaysia (1998) began construction on the eve of the Asian Crisis.

The Erste Group also points out that three of the four highest skyscrapers in Europe were finished in Madrid as the Spanish property bubble was set to pop. There are more examples that fill out the theory, but you get the idea. What first appears to be a fun plaything suddenly looks very real.

What does the Skyscraper Index say today?

It is flashing major warning signs over China and India. A Barclays report in January — written in part by the aforementioned Andrew Lawrence — shows that most of the skyscrapers currently under construction are in China and India.

China has more than half of the world’s 124 skyscrapers under construction. In the next six years, it’ll double its collection. Barclays notes, “China’s skyscrapers are not only increasing in number… but the average height of the skyscrapers that it is building is also increasing.”

In India, only two of its 276 skyscrapers are more than 787 feet tall. However, in the next five years, India will have 16 more. One of these is India Tower, which will be the world’s second tallest when finished.

Barclays comes to the bitter but inescapable conclusion:

“The writing, so to speak, would seem to be already on the glass curtain walling. For if history proves to be right, this building boom in China and India could simply be a reflection of a misallocation of capital, which may result in an economic correction for two of Asia’s largest economies in the next five years.”

Looking further out, the Skyscraper Index flags little Azerbaijan. Yes, Azerbaijan. The small country sits on the crossroads of Eastern Europe and Asia. Size is no impediment to putting up skyscrapers of mind-numbing height. As Erste reports, “The world’s highest skyscraper is currently in the planning stage in Azerbaijan. The Azerbaijan Tower will be 3,444 feet high and thus overtop the Burj Khalifa by 728 feet.” It is set on an artificial island — one of 41 — in the Caspian Sea. The country aims to be the “Dubai of the Caspian Sea.” Construction begins next year and is set for completion in 2019.

Oil and gas account for half the country’s economy. Might the builders of the Azerbaijan Tower be taking high prices for oil and gas as a given? “One could interpret this situation as a long-term warning signal for the oil price,” Erste guesses.

To me, the Skyscraper Index is another caution flag to add to the mix. China’s and India’s booms fuel the need for steel and oil and copper. It is a time to be extra careful investing in these themes.

Sincerely,

Chris Mayer
for The Penny Sleuth

The Skyscraper Index was originally featured in the Penny Sleuth.

Is that possible? An economy growing 50% a year? It is… as I’ll show you.

The economy I’m talking about is Mongolia.

Mongolia first got on my radar in April of last year. I wrote about it in my newsletter Capital & Crisis. Since then, I’ve written a few other updates as I continue to follow the story.

The story is actually pretty simple. Mongolia is rich in natural resources. It’s loaded with coal, gold, copper, iron ore and even rare earths. It has oil, molybdenum, tungsten, phosphates, tin, nickel, zinc and silver. As one friend of mine put it, “Every time someone sticks a shovel in the ground they find something of value.”

The riches are largely untapped. There are two big mines coming online soon.

Oyu Tolgoi is a copper and gold project. OT should start operations in the second half of this year and ramp up from there. It will be one of the three largest copper-gold mines in the world. Then there is Tavan Tolgoi, which is a coking coal project. TT also has large uranium reserves. TT should start production in 2014.

The spending on these mines is what’s driving the economy. Mongolia’s economy basically doubled between 2006 and 2010. That’s four years. It will double again this year in about half the time.

It’s a small economy right now — $8 billion or so. Investment in the country will probably total $50 billion over the next five-seven years. So you can imagine the explosive results that could come from that kind of expansion.

Imagine a place crawling with thousands of mine workers. Think of all the amenities they’ll need. Housing. Food. Clothes. Financial services. The mind boggles.

There are few precedents. One might be Kazakhstan, a somewhat similar former Soviet satellite with a resource boom. From 2002-2008, apartment prices in downtown Almaty (the largest city in the country) rose 833%. Land prices rose 8,000%. Stocks rose 2,425%.

That gives you something on the potential upside in Mongolia.

This landlocked country is wedged between two giants — Russia and China. Not surprisingly, these two are its biggest trading partners. Exports to China alone make up 92% of total exports. Coal is Mongolia’s main export. You can see Mongolia’s dependence on commodities in the next chart.

Mongolian Exports

Mongolia’s imports also come mostly from China and Russia, which accounted for 31% and 25% of total imports.

Mongolia itself is fairly large in land area. It ranks 19th globally and is about twice the size of Texas. The empty Gobi Desert dominates the southern third of the country. The rest is grassland and steppe.

Only 2.7 million people live in Mongolia, making it one of the world’s most sparsely populated countries. For perspective, that’s about as many people as live in Dallas County, Texas. Mongolia’s population is young, with a median age of only 26. About one-third of the population is under the age of 14. A youthful population is a plus. A growing market needs workers. And a young population is also more adaptable and welcoming to change. Finally, there are no overhanging pension issues as in Western markets.

All of these positives have attracted a lot of attention more recently. The Economist, for example, had a briefing on Mongolia called “Mine, All Mine.” It described the scene in Ulan Bator (UB), the nation’s capital:

“UB is a boomtown on the frontier of global mining. Hotels are bursting; the Irish pubs, of which there are several, are heaving with foreign miners, investment bankers and young local women with very long legs and very short skirts. French bistros serve steaks the size of tabloid newspapers.”

There is no place like it.

Right now is a good time to get involved, too, because Mongolia has elections coming up in June. Elections create political uncertainty. Many investors are holding off until after the elections. The country has been through gut-wrenching changes and not everyone is happy. My contact in Mongolia tells me people expect riots after the election. But then things will settle down, and after the elections — and the removal of uncertainty — the market will likely take off.

There is another big catalyst unfolding in Mongolia, as if it needed another. Brad Farquhar, a friend of mine who runs a fund focused on Mongolia called Nomad Capital, writes about it in his latest shareholder letter:

“The second big story is the initial public offering by the Mongolian government of Tavan Tolgoi (TT), one of the largest coking coal deposits in the world… The government has given shares in TT to every Mongolian citizen, and is preparing to list the company in London and Mongolia simultaneously. The timing is somewhat unknown, and with 2012 being an election year in Mongolia, there is additional uncertainty. But the completion of this offering will put significant new wealth in the hands of every Mongolian. This should be good for share prices in other companies, as well as the overall level of economic activity in the country, as Mongolians spend their new windfall.”

But there are few ways to invest in Mongolia. Investing directly in Mongolian stocks is a trial in patience and not easy. The total trading volume on the Mongolia Stock Exchange averages about $250,000 a day. The whole exchange!

There are a number of private funds lining up capital to invest, but nobody with a track record of any kind. I’ve seen some of the targets in these funds. One private fund aims for annual returns of 30% net of fees. That hints at what investors think is possible.

There are, of course, risks. The government could always muck it up. Inflation could get out of hand. Commodity markets could tank. But the upside is huge. It’s still early in Mongolia’s story… and I think you should own a piece of it.

Sincerely,

Chris Mayer
for The Penny Sleuth

The Fastest Growing Economy on the Planet was originally featured in the Penny Sleuth.

And, to some extent, the casino analogy works. There are parts of the market that are consistent losers for investors…

The initial public offering market is one of those. It’s true that some IPOs are big winners. Anyone who bought Microsoft or Home Depot or Wal-Mart at the IPO and held on got rich. These are people somewhat like those who hit the jackpot playing slots. It’s not a typical experience. Most of the time, if you buy IPOs, you’ll lag the market. In truth, an IPO is when insiders sell something they no longer want at prices they’d never pay.

There are lots of other ways to lose money in the markets. In my book Invest Like A Dealmaker, I cited research by J. Carlo Cannell that showed how restaurants, semiconductor capital equipment companies and computer manufacturers were industries that actually generated negative returns for investors for more than 20 years running.

But the casino analogy falls down in lots of other ways. If you know what to look for, you don’t have to play the loser games. You can choose to play only games in which the odds tilt in your favor. Then, over the long haul, with patience and diligence, you will make a lot of money.

What you want to look for is one of those pools from which investors consistently take money out of the market. These include things like spinoffs, thrift conversions and other quirky sets of ideas that collectively beat the market over time…

For many of these, there are structural reasons for the outperformance. In other words, how the market creates these securities practically bakes in the outperformance.

Today I want to share with you another idea along these lines: a post-bankruptcy stock.

Joel Greenblatt — who wrote the bible on “Special Situations” investing and enjoyed 10 years of earning 50% annual returns doing it — writes:

“The new stock of a formerly bankrupt company may be relatively undervalued because Wall Street analysts don’t yet cover it, because institutions don’t know about it or simply because the company still retains a certain stigma from the bankruptcy filing.”

Bankruptcy is a wonderful thing. It allows a company to hit the reset button and start over. Sometimes good companies go bankrupt simply because they got caught during a bad time with too much debt. Bankruptcy rights that situation and sends the company back out into the world with a better balance sheet.

So you can still find good companies — with good market niches, cash flow and margins — coming out of bankruptcy.

Sincerely,

Chris Mayer

How to Beat the Stock Market Casino was originally featured in the Penny Sleuth.

I know, I know. Nobody wants to read about a stock that is a sell. You want to know about the next big winner, the next Apple.

But hear me out. There is a unique twist to this story that you probably don’t know. This cinched it for me — it is what inspired me to take to the keyboard.

Now, I know it may seem crazy to say anything contrary to the bull thesis on Apple. After all, the company has probably around $100 billion in cash right now. That’s about 20% of its market cap. It grew more than 70% in its last quarter, trades for only 15 trailing earnings and only 11 times this year’s consensus guess.

Hard as it is to believe, Apple looks like a value stock.

Yet the stock has been on fire. As I write, the stock has just put in a new all-time high of $547 per share. It is up 33% in 2012 alone. It’s up 159% since the start of 2010. The market cap of Apple is over $500 billion. It is only the sixth company ever to reach that mark after Microsoft, GE, Cisco, Intel and Exxon Mobil. None of the others held that spot for long. (GE held it for about a year, but it stepped down quite a bit after that. Cisco held it for two weeks; Intel for a day.)

That huge price tag has led to the creation of a whimsical website dedicated to telling you things that Apple is worth more than. For example, Apple is worth more than it cost to build the U.S. highway system. It’s worth more than the U.S. aircraft carrier fleet, more than retail electricity sales in the U.S., more than the global coffee industry, more than the U.S. beef industry. It’s worth more than the National Football League — times ten!

To get there, the stock has no shortage of boosters. I happened to catch a segment on CNBC recently in which a fluffy-minded blond host had two guests on her show to talk about Apple’s stock. She opened by saying she wanted to have one bull and one bear, but she couldn’t find a bear. So the segment basically turned into a cheerleading session for Apple, with both guests telling us why Apple’s stock was going to move higher.

It’s hard to find anyone willing to take the other side because nearly everyone owns it. The Wall Street Journal reports today that of the 465 funds Morningstar tracks, 400 own shares of Apple. And 320 of them have made it at least 4% of the fund’s holdings. “It’s the stock everyone seems to have to own,” says Richard Nackenson of Neuberger Berman, quoted in the story.

This alone is a telling piece of anecdotal evidence, by the way. When everyone thinks alike, there isn’t much thinking going on, as the old saying has it. The investing annals are full of sure things that evaporated like the morning dew.

But Apple does have a few big problems with which to contend…

The first is obvious, and that is the loss of its visionary founder, Steve Jobs. It is hard to think of Apple without also thinking of Steve Jobs. There is, of course, a very good reason for that. He was instrumental in bringing about the array of beloved products that Apple is famous for producing. I can’t understand how anyone can look past the loss of Jobs and think that the company’s future could be brighter without him than it has been with him.

The loss of Jobs was a dramatic blow to the company, and it will have all kinds of effects that are hard to quantify, or even imagine. I think its ability to reinvent and create is much diminished. Its future looks more like Microsoft’s to me, a tech giant milking past successes but an also-ran in the derby for creative breakthroughs.

But the real reason I take to the keyboard has to do with the sustainability of its most-popular product, the iPhone, which makes up half of its sales.

Here I give credit to Anton Troianovski, who wrote a piece titled “iPhone’s Crutch of Subsidies” in The Wall Street Journal. In the U.S., hardware manufacturers pay Apple about $400 every time a customer buys an iPhone with a two-year contract. By contrast, Google licenses its Android to hardware manufacturers for free.

Let that sink in. Does that sound like a sustainable business model? It sounds to me like the soft underbelly of a mighty beast called Apple.

We’re already seeing this play out in Europe, where a weaker economy perhaps forces people to be more budget conscious. In Europe, Troianovski writes, Android phones cost less than $200 without a contract. The cheapest can be had for about $106. Contrast this with Apple, whose cheapest phone, a four-year-old model of the iPhone 3GS, goes for $535.

No wonder the Android is eating into Apple’s lead. In hard-pressed markets like Portugal and Greece, more than 90% of all smartphones sales were Android sales last year.

Suddenly, the hardware manufacturers are starting to wonder about that stiff subsidy. The CEO of the telecom giant Telefonica Spain said: “We can’t keep subsidies at these levels.” In Denmark, wireless carriers have already stopped paying the subsidy.

Apple is going to lose in Europe. Either it sticks to its strategy and Android eats its lunch, or it lowers the subsidy, which will impact its bottom line.

The bigger prizes out there are the emerging markets. Apple’s CEO said the emerging markets are “critical” to Apple. Yet how do you think this subsidy model will roll out in places like China, India and Brazil?

My hunch is that is won’t be nearly as successful as Google’s “give it away for free” model.

In the U.S., this subsidy issue hasn’t been a problem because people pay a lot for a phone to begin with. But how long will that last? It’s hard to say. But I think the fundamental problem is that Apple’s products are luxuries, and that makes them vulnerable on the price front.

Then there is the issue of the Apple iPad, which is the second-most-popular product, at nearly 20% of sales. There is a lot of anticipation about the iPad 3. Why? Well, it’s supposed to have maybe a higher screen resolution or better touch-screen.

I don’t know, maybe there will be more features. But I have an iPad. I don’t think any of the rumored upgrades are going to induce me to buy another one. It seems to me the biggest innovation with the iPad was the device itself. There was nothing like it before. Now there is. Incremental innovations get much tougher from here, much like with a PC or a laptop, or even a smartphone.

What it all comes down to is this: For Apple, things will never get better than they are today. You can’t improve on perfection. Its products are luxuries, clearly vulnerable to cost pressures. It’s surrounded by hungry and eager competitors. And its most-popular product has a definite soft underbelly that the arrows of competitors will find soon enough.

For all these reasons, if I owned Apple — which I don’t — I’d sell it.

Sincerely,

Chris Mayer
for The Penny Sleuth

Apple Is a Sell was originally featured in the Penny Sleuth.

Joel Greenblatt wrote about it in his 1997 book You Can Be a Stock Market Genius. Greenblatt, at that time, was a relative unknown. But his Gotham Capital had put up 50% average annual returns for 10 years. The book had a big impact on how I think about investing.

What are we talking about? Spinoffs…

A spinoff is simply when one company takes a part of its business and makes a formal separation with the parent company by creating a new, free-standing company.

You don’t have to own the parent to the get spinoff. It’s just that the shareholders of the parent get the shares automatically. You can pick up shares after a spinoff.

Spinoffs as a group have a tendency to beat the market. There have been a number of studies on this point. The most famous might be a Penn State study that showed spinoffs outperformed the market by about 10% per year in the first three years of independence.

That’s a huge edge!

Why does this happen? I think the best explanation is simply rooted in the nature of business. When a smaller group is freed from the parent, there are creative and entrepreneurial energies released as well. There is a management team that can now focus on the spun-out assets alone, without worrying about what the parent thinks or needs. There is some benefit from this focus and freedom.

So spinoffs are one of those pools of investing ideas I routinely fish in for new ideas. The amazing thing is that despite all the publicity and studies, the anomaly persists! Why? Well, as Greenblatt says, it’s practically built into the system. “The spinoff process is a fundamentally inefficient method of distributing stock to the wrong people.”

After all, people didn’t ask to invest in the spinoff. They didn’t choose to buy the shares. They bought shares of the parent, not the spinoff, which were given to them. So they tend to sell the spinoff. This is what usually happens. And all that selling pressure drives down the shares.

The spinoff, too, is usually a small piece of the parent — maybe 10%, often less. So if you have $10,000 in a stock, you get maybe $500 of this other stock. Rather than bother with it, you just sell it. Institutions do this, too. Instead of spending resources trying to figure out this new thing, they just get rid of it.

As Greenblatt writes: “Does this practice seem foolish? Yes. Understandable? Sort of. Is it an opportunity for you to pick up some low-priced shares? Definitely.”

Why do a spinoff at all then? Each case is different. Sometimes it is a way to get rid of a business that is tough to sell on its own. Tax reasons might enter into it. Or it might solve some other strategic objective. The most-common reason is to create shareholder value with greater transparency. The hope is that the market might appreciate the separate businesses more fully.

One example is General Growth Properties. Spinning out Howard Hughes was a way to package all of its development assets into one company so it could focus purely on running malls. Howard Hughes owns a hodgepodge of planned communities and things unrelated to malls. As a separate company, Howard Hughes can devote its full attention to its development assets. It’s a win-win.

Greenblatt offers a simple three-point checklist to search for winners. Howard Hughes met all three:

• “Institutions don’t want it.” I can tell you there was no interest in Howard Hughes from institutions. Even now, there is little interest in the company. It still has no Wall Street coverage, for instance. It doesn’t fit it any of Wall Street’s boxes. It’s a hodgepodge of real estate with uncertain cash flows, neither fish nor fowl.

• “Insiders want it.” By contrast, insiders loved Howard Hughes. They bought shares. Brookfield was among the big investors here and still owns 6% of the stock today.

• “A previously hidden investment opportunity is created or revealed.” Buried in GGP, Howard Hughes assets could easily be ignored and overlooked. But on its own, with attention and capital, Howard Hughes can advance projects and unleash their potential.

Howard Hughes traded independently on Nov. 10, 2010. It went down after the first week of trading. But by April 2011, it had nearly doubled. Even if you had held the shares from the spinoff to now, you’d be up 25%, versus 5% for the market as a whole.

That’s why you should always pay attention to spinoffs…

Sincerely,

Chris Mayer
for The Penny Sleuth

3 Easy Steps to an Unusual Investment “Guarantee” was originally featured in the Penny Sleuth.

It’s fascinating to see how people cope with the volatility. Their choices and behavior lead to some very odd market price constellations.

A money manager friend of mine sent me a note from Noah Blackstein, the manager of the Dynamic Alpha Performance Fund. He notes that the market is seeking yield and low-beta securities. In English, this means that people are looking for income and for stocks that don’t move as much as the market.

Beta is the common measure of volatility. If a stock has a beta of 1, it means it has moved in step with the overall market. A beta of 1.5 means it’s moved 50% more than the market. So if the market went up 10%, this stock went up 20%. A low beta of 0.50 means the stock moved 50% as much as the market. It’s this last fish that is the choice catch in today’s market.

Because of that, stocks with the desired attributes have become expensive. Blackstein offers up a pair to show his point: Microsoft versus Southern Com… “Microsoft trades at 9 times EPS, has a five-year EPS growth of 13% and yields 3.1% and sits with a balance sheet full of cash. Southern Co. trades for 17.5 times earnings per share, has a five-year growth rate of 3% and yields 4.4% with a ton of debt.”

It’s worse if you look at Canadian companies compared with U.S. companies. He offered up Enbridge, a pipeline company, with a 2.7% yield and a price-earnings ratio of 24 times. It has lots of debt. The stock is up 30% this year. Microsoft, by comparison, yields more (3.1%), offers a lower price-earnings ratio (9) and is stuffed with cash. The stock is down 9%.

Why?

Now, here is the key. Microsoft has a beta of 0.78, versus Southern’s 0.38 and Enbridge’s 0.15. Market participants are willing to pay up for a stock that won’t have them reaching for a bottle of Maalox on days like today. Low beta has won out. “How can this be anything other than a low-beta bubble?” Blackstein writes.

Here’s the thing, though: Though short-term market prices have all kinds of burps that make no sense, the market does sort things out rationally over the long haul. Stocks of bankrupt companies eventually hit zero. Undervalued stocks eventually become fully valued.

The fundamentals may not mean much in the day-to-day and week-to-week trading, but they get sifted out over the course of a few years. This is the basis of all intelligent investing.

I’ve written about Doug Barnett, who runs the Thai Focused Equity Fund, to my Mayer’s Special Situations readers before. His fund had phenomenal performance in a market that is very volatile. Stocks soar and dive on rumor and take emotional roller coasters that test the resolve of its shareholders. But over the long haul, the market does discriminate. Barnett’s 18% annually proves it does. As Doug said, “You get compensated for having a more-volatile path to achieve your goals.”

The second pillar on which to build is the insight that you often make money taking the other side of popular trades. Or more specifically, you get very good prices to take the opposite of a popular trade. This is the bedrock of contrarian investing, which seeks out a hardened consensus and bets against it.

Therefore, if the market wants yield and low volatility, then it follows that you will get more value for your money by taking stocks with no or little yield and high volatility.

So… you would want to avoid utility stocks. Even though they look attractive based on the 10-year Treasury yield (which, frankly, is a Fed-manipulated number), they are the classic low-beta-yielding securities the market loves right now. They suffer in comparison to what else you might buy (see again the Microsoft versus Southern Co. comparison).

You would, instead, look at smaller-cap stocks, which are traditionally high beta. By the way, you can find betas easily. You’ll see it, for example, on Yahoo! Finance under the “Key Statistics” section.

Junior mining stocks and small-cap oil and gas producers are stocks that have been whacked hard of late. These are areas where pricing is good. For most of these, the betas are around 2. Most small-cap stocks have high betas, and hence, the market is shunning them.

I would also say you can still get good yield in high-beta stocks.

Of course, you have to wait it out. If you are going to fret short-term swings, you are going to fray your nerves, sell near bottoms and pretty much make yourself miserable and poorer. You have to decide whether you can play the game or not, and if you do, you have to be willing to suck it up and hold on…

Sincerely,

Chris Mayer
for The Penny Sleuth

One Indicator That Will Help You Beat Volatile Markets… was originally featured in the Penny Sleuth.

It frees up massive amounts of crude oil from deposits on dry land once thought to be inaccessible. While most investors don’t know anything about this extraordinary phenomenon, it’s filling the coffers of some little-known American oil companies with tons of cash.

It’s a big breakthrough for the nation’s oil industry.

As the Natural Resources Defense Council points out, it, “would give America access to large, domestic oil resources — potentially more than four times the proven U.S. reserves, or up to 10 full years of our total national consumption.” That’s a quadrupling of U.S. oil reserves.

Now here’s where the action is the hottest: The Bakken trend. This U.S. region lies in the giant Williston Basin and stretches across parts of the Dakotas, Montana, Manitoba and Saskatchewan…

In the 1990s, geochemist L.C. Price, working for the U.S. Geological Survey (USGS), compiled a stunning report on the Bakken trend. He concluded that it contained 200–500 billion barrels of oil. In 1999, he turned in his report to the USGS, but nothing happened. In 2000, Price died, but the USGS still had the report. The USGS refused to release it. Price’s story of Bakken was the province of oilmen telling stories in bars… until today.

It took the force of a North Dakota senator to press the USGS to take up where Price left off. But finally, the Bakken has the world’s attention. New work on the area confirms the essence of Price’s research, if not his 200–500 billion barrel estimate. Some 2006 estimates place 300 billion in North Dakota and Montana alone.

Also, geologist Julie LeFever, who worked with L.C. Price on his initial report, published a paper adding that additional barrels lie in various layers of the Bakken.

What does this mean for the smart oil and gas investor? Prospects of returns far better than anything you’ve ever heard of from the Canadian oil sands or Colorado’s shale.

“The Bakken formation estimate is larger than all other current USGS oil assessments of the lower 48 states,” the report says “and is the largest ‘continuous’ oil accumulation ever assessed by the USGS.”

Who knows exactly how much oil lies beneath the Bakken? On April 10, 2008, the USGS issued a shot heard round the Bakken. Its newest estimation reveals a 25-fold increase in the amount of oil that can be recovered from the Bakken formation. North Dakota and Montana’s Bakken alone have an estimated 3–4.3 billion barrels of oil that could be recoverable with today’s “magic drug” technology. The Bakken has suddenly become one of the hottest crude oil plays in North America. Already, investors from Norway, the United Kingdom, France and Italy are in on the game. Private equity predicts Asian investors will be next…

Bakken, you see, is just that big. Predictions for peak daily production range from a healthy 300,000 barrels per day (bpd) to a whopping 700,000 bpd. That kind of production could last 10–15 years. Meanwhile, the Gulf of Mexico produces half what it did 10 years ago. The Bakken is the future of U.S. energy.

And there’s even bigger news… a new formation under the Bakken shale. Three Forks-Sanish could prove just as good as the Bakken. This is just what geologist Julie LeFever suggested back in ‘06. Three Forks’ sand and porous rock could offer up 1.9 billion barrels of oil using current technology. At least that’s the latest number I have from North Dakota’s Industrial Commission. But Harold Hamm, CEO of Continental Resources (a key player in the Three Forks) claims there could be as much as 8 billion barrels.

Getting oil and gas out of the Bakken has never been easier. Since just 2008, Bakken’s experienced drill teams have whittled down the time it takes to drill over two miles down into the shale. What once took 45 days now takes only 19.

Right now, the Bakken has put a record number of rigs to work. Things haven’t been this busy since 1981. About 6,000 wells produce in just the North Dakota Bakken alone. The region added over 1,000 new wells since 2008, when I first started covering this resource bonanza.

Early investors in shale oil and gas have made fortunes.

Take Range Resources, for instance, a company that locked down a lot of shale acreage early in the other big shale finds — the Barnett and Marcellus. It’s up 2,294% in the last 10 years.

Specifically in the Bakken formation, my readers cashed out on shale player Kodiak Oil & Gas for 113% gains.

So there is a ton of money to be made from this new technique. And if you take advantage of this tidal wave, it could make you wealthier than you’ve ever thought possible…

Sincerely,

Chris Mayer
for The Penny Sleuth

You Could Make You 3,800% Gains from This Technology Breakthrough was originally featured in the Penny Sleuth.