Peter Cundill is his name. His investment approach is the subject of a new book by Christopher Risso-Gill, who was a director at Cundill Value Fund for 10 years. Titled There’s Always Something to Do, it is a summary of the Cundill approach. The book takes its name from a line from Irving Kahn, a doyen of investing (born in 1905) and still chairman of Kahn Bros., which manages $450 million. Kahn said, “There is always something to do. You just need to look harder, be creative and a little flexible.” So true.

In these pages, we have made the study of great investors part of the regular diet, every bit as valuable (and perhaps more so) than winning stock ideas. So let’s continue that tradition and take a look at what kind of thinking peeled off 33 years of 15%.

Cundill was, like so many great investors, a devoted follower of the ideas laid out by Ben Graham back in the 1930s. Graham has a long list of followers and admirers, including Warren Buffett, the aforementioned Kahn, Cundill and many others besides (including yours truly).

While there is much to Graham’s thinking, a cornerstone of the approach is the idea of a margin of safety. You buy only what is cheap and well supported by some estimate of intrinsic value. It is a persnickety, unfashionable, patient approach that demands a great deal of discipline. It is one that takes more interest in what is happening in the folds of balance sheets and in the crevices of footnotes than in predicting what the market is going to do next. “I’m agnostic about where the market will go,” Cundill often wrote. “I don’t have a view.” His goal was to find undervalued securities. Period.

The book has lots of “war stories” to show how Cundill applied these ideas in his career. But the book also has plenty of pithy how-to investing wisdom drawn from Cundill’s speeches, shareholder letters and personal diaries.

I enjoyed Cundill’s thinking on when to sell, as he used an idea I’ve endorsed in these pages: “When a stock doubles, sell half — then what you have is a free position.” Selling is the most difficult thing in all of investing. No one is good at it. But this seems a reasonable approach that protects hard-earned profits and helps buttress mistakes. We’ve sold half positions often after doubling our money, but now we can give it a name in honor of this great investor. We’ll call it a “Cundill sell.”

There are also many good insights into the investing process. Cundill notes that “99% of investment effort is routine, unspectacular inquiry, checking and double-checking, laboriously building up a web of information with single threads until it constitutes a complete tableau.” I agree completely. And I think back on all the time spent doing routine stuff like listening in on quarterly conference calls, perusing 10-Ks, 10-Qs, proxy statements and the like.

Unglamorous, perhaps, but necessary work. Cundill, too, did his own work. “All I really need is a company’s published reports and records; that plus a sharp pencil, a pocket calculator and patience.”

There are other aspects of Cundill’s ideas that are good to highlight. One: He had a catholic appetite when it came to investing. “If it’s cheap enough,” he wrote, “we don’t care what it is.” This is an important part of my investment philosophy as well. I go where the value is without loyalty to commodities, market caps or any of the other silos that specialists often use to carve up the market.

Cundill was also international in his approach. “I’ve traveled pretty extensively,” he noted. “So I don’t really see much more risk investing in foreign countries than I do investing in North America.”

Where did Cundill look for ideas? “You find bargains among the unpopular things, the things that everybody hates. The key is that you must have patience.” He liked to look at stocks making new lows. He liked to read the news to see what was troubled. He also liked checking in to see what other great investors were doing. “You know good poets borrow and great poets steal. So see what you can find out.”

He was also not afraid to hold cash. Cundill often held large cash positions, sometimes as much as 40%. Many investors would do well to take a page from Cundill’s playbook here.

His idea that investing is a game of generals, not committees, is also one that resonates with me. “To my knowledge, there are no good records that have been built by institutions run by committees… In reality, outstanding records are made by dictators.” Most of the best investors are solitary eagles, though there are, of course, some famous partnerships that work well, too. (Think Warren Buffett and Charlie Munger.)

Cundill liked to concentrate his ideas, rather than spread his money out thin. “My father was a very good birdshot and he always said, ‘Never shoot into the brown.’ In other words, never shoot into a flock of birds without first choosing a single bird.”

Cundill also had the habit of traveling to the world’s worst stock market. He started this while he was living in Vancouver and it was rainy in November. He would travel to the world’s worst stock market to that point in the year. Sounds like a good idea that I may have to try.

There was a stock screening idea in the book that I thought was interesting. It’s called “The Magic Sixes.” Basically, you screen for stocks trading for 60% of book value, at 6 times earnings and paying a 6% dividend yield. (This is a strategy that could be worth checking out right now…)

To Cundill, investing is not a matter of smarts alone. “Just as many smart people fail in the investment business as stupid ones. Intellectually active people are particularly attracted to elegant concepts, which can have the effect of distracting them from the simpler, more fundamental truths.” Well said.

Another idea: “Sooner or later, the market will do what it has to do to prove the majority wrong.” This is a good thought. It’s important to think about what unexamined assumptions you hold. What do you take as a given? Perhaps you shouldn’t.

I smiled when I read Cundill write: “I’m lucky to have the kind of life where the differentiation between work and play is absolutely zilch. I have no idea whether I’m working or whether I’m playing.” I feel much the same way.

Cundill died earlier this year at the age of 72. This book ensures that future investors will not lose his hard-earned wisdom. A nice addition to the investment library – and plenty of actionable advice as we try to tame these wild markets…

Sincerely,

Chris Mayer
for Penny Sleuth

How This Investor Turned $10,000 into $1 Million was originally featured in the Penny Sleuth.

In fact, from my perspective, this housing market could be the best place to store your wealth in the coming four or five years.

Obviously, this is a turning of tides for us. In December 2009, I showed you the following chart:

As you can see, we were sitting right in the eye of the apparent housing storm that was brewing. Here we are — nearly a year and a half later. What exactly did happen to these rate resets?

Well, we were both right and wrong. Over the past year, when we were supposed to start seeing large increases in option ARM defaults, we did. But not to the degree this chart suggested. In many cases, banks and homeowners worked out a payment schedule. Add in record-low interest rates, which kept the resets from being overburdening and you get a softer increase.

Clearly, we’re still facing an uphill battle. But as you can see in the updated version of the chart, the mountain isn’t as high of a climb:

Surely, option ARM resets will be a source of trouble for both banks and homeowners in the coming year. But with the performance thus far, calling for a double dip (at least the size of one we previously predicted) would make us sound like the “The end is nigh” guy in Times Square.

There are many reasons the mountain of resets has smoothed out since 2009. First, many of these mortgages have already defaulted. With home values falling as fast and far as they have, many homeowners were extremely underwater on their loans. So they walked.

Renegotiated loans also caused the softening of the reset wave. With low interest rates, homeowners could work out more favorable long-term payment options.

Still, there could certainly be a second housing crisis. There are more vacant homes on the market than at nearly any other time in history:

The continued high unemployment rate is still having the largest effect on the housing market. And that doesn’t look like it’ll change anytime soon. But the worst of the job cuts are over. Most companies have already had their largest layoffs. That’s what sent the housing market into a tailspin the first time, but it’s highly unlikely that they can do that again.

The last argument we have for reversing our double-dip prediction is the economics of homeownership. It is now less of a bet on home prices as it was during the housing bubble. It is now just more economical to buy a house.

With the massive crash in home prices over the last several years and remarkably low mortgage rates, more people can actually afford a mortgage now than ever. Take a look at this chart:

According to the National Association of Realtors’ Housing Affordability Index — an industry-standard — more people can afford to buy a house with today’s average income levels, current housing prices and mortgage rates than at any other time in the index’s 40-year history.

Prior to this recent recession, the index had never traveled above 160 — which translates into an average national medium family income of 160% of the mortgage-qualifying rate for a median-priced home. Today, that number is 192.

The number we are watching the closest is new housing starts, which is looking worse every month. In the most recent release, new housing starts dropped a whopping 22%.

Obviously, this is a wildly unpredictable and volatile statistic. But it was surely enough to scare many investors.

Housing starts should flat line for the rest of this year. But in the coming years, we expect it to start increasing again.

So while all of this adds up to no more than flat sales for the housing industry in the short term, we do expect it to boost housing stocks’ top line in the long term. And there are plenty of ways for investors to add housing exposure to their portfolios at bargain prices right now…

Sincerely,
Jim Nelson
Penny Sleuth

April 26, 2011

Editor’s Note: If you’re seeking housing exposure, don’t even think about buying real estate investment trusts (better known as REITs) — they just don’t represent real estate the way investors think they do. Instead, the most direct long-term opportunities come from small-cap homebuilders like Beazer Homes (NYSE: BZH), a stock that we suggested had 48% near-term upside back in July of last year. Since the day that article ran, shares have rallied 38% — and there’s still considerable room to run longer-term.

[Independence Note: As with every company we mention here in the Penny Sleuth, neither the author nor any of the Sleuth’s other editorial staff have a financial position in Beazer Homes. Because of that, we’re completely independent, and able to provide you with unbiased analysis — try holding other penny stock newsletters up to that same standard.]

Why It’s Time to Buy a Home — or This Home Stock… was originally featured in the Penny Sleuth.

Beneath Mongolia’s rugged mountains and slumbering sands lie huge untapped resources of copper, coal, gold, uranium, iron ore, oil and more — only recently discovered. Already, Mongolia’s exports are up 50% from 2009, swelling Mongolia’s cash reserves to $1.8 billion.

But there is a long way to go. Production of coal, iron ore and crude oil should rise 10-fold over the next 10 years. As of now, the 10 largest deposits are worth over $1.3 trillion. For perspective, Mongolia has a $4.5 billion economy.

Oyu Tolgoi is one of those big deposits. It is a joint venture between Ivanhoe Mines and Rio Tinto. It is the world’s largest new copper and gold mine, with some 80 billion pounds of copper and 46 million ounces of gold. Here is the mind-boggling part: This one mine will represent about 30% of Mongolia’s economy when it starts producing. Just one mine!

Another big one is Tavan Tolgoi, which is in what may be the largest undeveloped coking coal district in the world, with more than 6 billion tonnes of coal. This is another multibillion project. They’ll start building it sometime this year.

There are staggering piles of wealth for a nation of only 3 million people. Some believe these resources could turn Mongolia into another Qatar or Norway.

Qatar is an example of a country that got rich after exploiting a massive natural resource. In Qatar, it was natural gas. The Qatari stock market went from $4 billion in 1998 to $104 billion by 2010 — a 27-fold increase!

Another example is Kazakhstan, as Brad Farquhar, a correspondent and friend from Regina, Saskatchewan, points out. Farquhar is the co-founder and vice president of Assiniboia Capital. Farquhar has been making regular investing field trips to Mongolia, enthralled by the opportunity he sees there.

“The Kazakhstan stock market went from something like a billion-dollar market cap to $100 billion in eight years,” he writes:

“Mongolia, I think, is on a faster growth track with a more diverse resource base. It also has better logistics than Kazakhstan to access markets in China, Eastern Russia, Japan and Korea. Plus, Mongolia is a free and open democracy… And the Mongolian stock market just surpassed the $1 billion market cap mark.”

That stock market was the best performing in the world last year, up 125%. My guess is that is only the beginning of a long bull market. Eurasia Capital estimates that Mongolia will be the fastest-growing economy in the world over the next decade.

The Mongolian currency, the tugrik, was the second-best-performing currency last year against the dollar, up 9%. Farquhar sent me a neat little stack of fresh Mongolian tugriks. It’s colorful money. The blue-green five spot features Sükhbaatar, an important figure from Mongolian’s struggle for independence in 1921. On the reverse side is a pastoral scene of horses eating grass with mountains in the background.

“I went to Mongolia last summer,” our correspondent continues:

“I came home convinced that the country will do incredibly well over the next decade…. In order to try it out myself, I opened an account on the Mongolian Stock Exchange in early November, and I have been searching out companies on other global exchanges that have significant Mongolian exposure. In the first four months, my own Mongolia-specific portfolio is up 84%, and I have some friends and colleagues clamouring to get in.”

There should be other opportunities, too, outside of mining. Mongolia will need to double its power output in the next five years at a cost of at least $2 billion. It needs highways and railroads. All that mining will need water. Mongolia has water in deep aquifers beneath its deserts and there are northern rivers it could divert, but all this too costs money. Somebody has put all that together.

Mongolia has waited a long time for another turn at bat in a big game. In the 13th century, Mongolia was the seat of the largest territorial empire the world has ever known. The hordes erupted out of Central Asia, conquered Russia, China and most of the Middle East. (Only the powerful armies of the Mamluks of Egypt checked the hordes’ advance at the Battle of Ain Jalut.) Pax Mongolica reigned until the arrival of the Black Death. As far as the rest of history goes, Mongolia hasn’t registered much since.

Now, thanks to its mineral wealth, it looks like Mongolia will enjoy another turn on the big stage with the eyes of the world watching — and some getting rich, besides.

Sincerely,
Chris Mayer
Penny Sleuth

March 14, 2011

Get Rich in the Land of the Blue Sky was originally featured in the Penny Sleuth.

It’s because of this that we’ve been able to lock in gains of 32%, 46% and even 104% in the past two years — and that doesn’t even count the massive gains currently open in LIR’s portfolio.

This month, I may have found the largest Wall Street mistake in my career…

Of course, finding investor errors is the nature of contrarian thinking. If we were following mainstream lines of thought, we would never find undervalued plays. And I’d certainly never find the kinds of yields my readers have been able to lock in.

Contrarian investors, at least good ones, don’t find just out-of-favor stocks. They find hated ones. And despite one of the best years in this one industry’s history, investors have washed their hands of it.

The industry leader is down more than 50% since it came under fire. (My favorite stock in the industry has also seen its share price halved. But its dividend grew 33% in the last quarter — and a massive 166% since the start of the recession.)

The best part, we’re able to lock in a solid yield on this industry for the first time in its history…Thank you, Wall Street!

Before I get into the specifics, let’s dive right into this industry…and investors’ repugnance of it.

The Down-and-Out Industry We Can’t Help But Love

Here’s how bad things look for this industry — or at least how the mainstream media have framed the argument against it.

The Senate HELP Committee brought in top players to berate them. A Government Accountability Office report found fraud across the board. And the industry’s independent regulators may even lose their jobs over a scandal. In fact, if events continue to unfold in this fashion, these businesses will lose the majority of their funding — which comes from Washington.

These threats and issues have even caused one CEO to recently say, “Most of [the decline] is based on the fact [that] you have important public policy commentators…as well as significant media who have questioned the efficacy of [our business].”

The industry, as you may have guessed by now, is for-profit education. Those may just be three of the ugliest words in Washington.

As I noted, the industry first came under fire in early August when the GAO report on abuses and fraud was leaked to the press. Shares of every for-profit education company collapsed.

The HELP Committee immediately called a hearing on for-profit schools. From there, arguments for changing how universities are accredited started popping up. Chairman Tom Harkin and Sen. Al Franken laid into the executive director at an accreditation agency. They even dragged in a former admissions representative from a for-profit to give the gory behind-the-scenes details.

When the smoke cleared, nothing was changed. But the damage was done. Harkin is still the committee’s chairman. And this story could still have an unhappy ending for the likes of Kaplan University and University of Phoenix.

But just as everyone is turned against the industry, there are still some golden eggs to be found.

***Editor’s Note: More specifically, there are a number of small-cap for-profit education stocks that could have upside from this point. One of the small education stocks to watch is National American Univ. Holdings (NASDAQ: NAUH), a $328 million college operator that pays out a 1.54% dividend yield.***

Sincerely,
Jim Nelson
Penny Sleuth

March 3, 2011

A Reason to Buy the Most Hated Industry on the Market was originally featured in the Penny Sleuth.

I’ll use a simple analogy to reveal this idea. Let’s say we have two houses. In one, the family that lives there also owns it. In the other, there is an absentee owner who rents it out. If you had to guess which house would be in better shape after 10 years, which would you guess?

If you said the former, where the people who lived there owned it, odds are you’d be right. (There are always exceptions.) It’s a truism in real estate that owners take better care of property than renters.

The same kind of logic applies in the stock market. When the people running the show are also owners — what’s known as the owner-operator model — those companies tend to deliver astonishing results over time.

Steve Bregman, a portfolio manager at Horizon Asset Management, recently shared a little experiment. He looked at “the most successful, iconic constituents of the S&P 500 over the past half century.” The impact of OOs was clear.

These include Wal-Mart (NYSE: WMT). “Think how well it did under the aegis of Sam Walton for 20 years,” Bregman says. Wal-Mart delivered a return of 20.5% annually. But after him, Wal-Mart returned only about 9% per year. Then, there is also IBM (NYSE: IBM). Under the Watson family, IBM returned 6.6% more than the stock market. After the Watsons, only 1.7% better than the market. “Good, but not great,” Bregman says.

The most recent example of an OO’s impact is Apple (NASDAQ: AAPL). Without Steve Jobs for over a decade, Apple turned in a return of 3.1% per year worse than the market. With him, 28% per year better. For the whole list, give the following table a look.

Granted, this is not a scientific experiment, as Bregman notes. (There is scholarly research out there that backs the idea that stocks with owner-CEOs outperform.) But it does show you the importance of that OO.

In only two instances did the company under the OO trail the market. Even then, there is a big qualifier. The table shows that during Jobs I, his first tenure as CEO, Apple trailed the market. But it was only a four-year stretch, which he more than made up for later. And in any event, the table shows results only since the company has been public. If you consider the wealth created by Apple’s initial public offering, a different picture emerges. Apple’s IPO created more millionaires than any company in history. The original venture capitalists that backed Jobs made billions.

There is another advantage to OO-run companies that Bregman points to. The stocks have a low correlation to the S&P 500. In other words, returns were not as sensitive to the overall market as other stocks. Remember, a correlation of 1 means the stock matched the S&P 500 exactly. The lower the number, the less sensitive the stock to overall market movements.

On average, the OOs had a correlation of only 0.52. By contrast, the average of the largest 50 companies excluding the OOs is about 0.70. That is a big difference and meaningful when building a portfolio. The OOs are your stalwarts. They tend not to mirror the broader market.

In any case, this little experiment shows that there is something different about the decision-making process of an OO-run company and that of an ordinary company — and it shows up in returns.

As Bregman points out, there are strategic and tactical advantages to being an OO. You can make decisions that are “at dramatic odds with the mainstream [whereas] most company managements are highly reactive to investor concerns.” OOs focus on the business because they own it. They don’t worry about the short-term stock price. Hired-gun CEOs think differently.

For example, the typical company today has accumulated cash, preparing for known risks, waiting for the “all clear” sign before investing. It seems like a good idea, but it’s not what creates great piles of wealth. As Bregman puts it, they are “reacting to a crisis that already happened.”

By contrast, look at the OOs. OOs accumulated cash before the downturn. So rather than continuing “to husband cash, they have been investing it assertively for the last two years.”

Bregman gives an example from his portfolio, AutoNation (NYSE: AN). There are 13% fewer dealerships than there were in 2008, which sounds very scary. Yet AutoNation repurchased 17% of its shares during this rough period. The stock today is at 52-week highs and that investment paid off handsomely.

Ironically, it is during so-called “tough” times when investing is safest, because the prices you get are the most attractive. And the assets so acquired become the foundations for great success later on.

So that’s the case for OOs in a nutshell. It doesn’t mean there aren’t great investments without OOs. But OOs do tip the odds in your favor. The main point is to think about who owns and controls what we are investing in.

Sincerely,
Chris Mayer
Penny Sleuth

February 8, 2011

How to Spot the Best Investments of the Next 50 Years was originally featured in the Penny Sleuth.

One of them is that corporate insiders are willing to pay a lot to get growth these days. The prices of some of these deals are rich, as I’ll show you.

It also says something important about our present circumstance to reflect a bit on why they are willing to pay these kinds of premiums. And finally, looking at stock market opportunities through the lens of a corporate buyer points to where opportunities are today.

To begin, let me acquaint you again with the EV-to-EBITDA ratio, which is essential in comparing firms across an industry.

Enterprise value is the market cap of the stock plus debt less cash. It is the value the market imputes on a firm at any point in time. Think of it as the price to buy the whole firm. The EBITDA is the familiar earnings before interest, taxes, depreciation and amortization. It is a broad measure of earnings power.

Therefore, you can think of EV-to-EBITDA as a more comprehensive price-to-earnings ratio. Low numbers imply value. High numbers imply a premium valuation.

So armed, let’s start with PepsiCo’s purchase of Wimm-Bill-Dann Foods, a Russian dairy and juice firm. PepsiCo, as with many large Western companies, is looking for growth. Russia is a high-growth market. Sales forecasts for soft drinks and packaged foods to 2015 show annual growth of 11–12%. This versus the puny growth of only 3% or so in U.S. markets.

By taking over WBD, PepsiCo becomes the largest food-and-beverage business in Russia. It also gives PepsiCo a doorway into the markets of Central Asia and Eastern Europe.

After this deal, PepsiCo will get close to 70% of its business from emerging markets. This is comparable to Nestlé (67%), Danone (59%) or rival Coca-Cola (55%).

The thing that really grabbed me though was the price paid — 16 times EBITDA. This is a very rich price. These ratios vary greatly by industry, but I’d say a deal done at double digits is rich and PepsiCo pole-vaulted that with ease. But it is in line with other deals done recently…

The PepsiCo deal is not atypical these days. I think the pressure to grow is part of it. But the other pressure this deal reflects is what to do with cash. PepsiCo will use some of its cash hoard to pay for the deal.

When corporate bigwigs gather around the old glossy table in the boardroom, they probably have a hard time finding what they earn on their cash. It is virtually nothing, as you well know. The pressure to spend that cash is immense.

Another company, ABB, recently made a similar expensive acquisition. I like ABB as a company. I’ve recommended this company in the past to my Capital & Crisis subscribers, and we did well with it. I continue to follow the name, which makes all kinds of gear for the world’s power systems.

But I think the $6 billion in cash at ABB was burning a hole in CEO Joe Hogan’s pocket. Thus did ABB agree to pay $4.2 billion for Baldor Electric. Part of the rationale was that Baldor gives ABB great exposure to North American markets. (It’s a twist on the PepsiCo deal, but in both cases, companies were looking to grow in markets where their presence was light before the deal.)

ABB paid 13 times EBITDA and a whopping 41% premium. These, too, are rich multiples. But ABB will pay cash and it will be immediately accretive earnings — since it wasn’t earning anything on the cash to begin with.

On paper, ABB can defend the premium, but shareholders would probably rather ABB held the cash or gave it back to shareholders. After all, shareholders could have bought the same stock without paying the 41% premium. ABB has a high hurdle there, in my view.

I think neither of these transactions will prove good returns on investment for either company. The price paid is simply too high.

But there are a few lessons from these typical transactions… Companies with a lot of cash are at risk unless they have strong-willed people at the top that can resist paying these rich prices. On the flip side, it’s a good time to own smaller companies that are possible acquisition candidates because they occupy markets that some big competitor covets. And finally, if you get an offer to sell to an acquirer, you should probably sell, as multiples today are on the high side of the cycle.

Sincerely,
Chris Mayer
Penny Sleuth

January 7, 2011

How You Can Profit from Company Acquisitions was originally featured in the Penny Sleuth.

The brothers stuck to the family business, through one crisis after another. Joesley Batista, in particular, showed a talent for business. And the family firm grew and grew and grew…

That family firm is today JBS-Friboi, the largest meatpacking company in the world. JBS had sales of $29 billion in 2009 — up nearly 2,000% from where it was in 2004. It is Brazil’s second-largest private company, behind only Vale SA. And most of its sales come from outside of Brazil.

The three brothers still run the show, though public investors hold 49% of the stock. And Joesley Batista, “the Meat King,” is its president. He is a billionaire now, one of the most successful of Brazil’s entrepreneurs.

Batista, though, had an assist from Brazil’s development bank, BNDES, which has helped bankroll the company’s acquisitions. BNDES exists to promote the international expansion of Brazilian companies. Taxes fund its efforts. In 2007, BNDES bought 13% of JBS to help it acquire Swift, which was America’s third-largest pork and beef processor.

And in September 2009, JBS bought a 64% stake in another American icon, pulling it out of bankruptcy. The Economist commented on the deal:

This will be a big test for the Batista brothers and for Brazil’s tropical brand of capitalism, which mixes family control with traded stock, and finance from state-run banks with foreign acquisitions. Brazilian companies in other industries are watching how JBS gets on and plotting similar moves themselves.

It is a cocktail that we see more of these days, this mixture of government support and private enterprise, but that is a philosophical topic to explore another day.

With this deal, JBS became the largest meat processor in the world, surpassing Tyson Foods. The Brazilians, by the way, dominate the global meat trade. It’s not just that Brazil is raising the animals and growing crops. More and more, Brazilians are getting into the processing business, which brings greater profits. As Larry Rohter writes in his book Brazil on the Rise:

Three of the 10 largest global producers of animal protein are now Brazilian-controlled companies. The expectation is that Brazil’s role will grow even larger over the decade to come as its production of beef, chicken and pork rises.

This too is an interesting commentary on Brazil and its evolving role in food production. Batista is the poster boy of these big ambitions. He wants JBS to become a global power in milk and dairy products, too. This is another area where Brazilian firms plan to expand rapidly in the next several years.

But what interests us here is this: JBS paid $800 million for its 64% stake of a bankrupt American company. That implies an equity value of $1.25 billion, or about $5.80 per share. The total value of the deal was $2.8 billion, including debt.

Despite a large run-up earlier this year, increased market volatility has pushed shares back down to historic levels.

Today, this stock is trading near penny stock prices. So we have a chance to bet with the Batistas here as their junior partner in the deal — at prices very close to what they paid for it out of bankruptcy.

And it’s likely that the Batistas eventually merge this company into JBS USA, their U.S.-subsidiary, sometime before January 2012, which would likely be good for the share price. I think that a 100% upside could be in store for shareholders… If they get in while this stock remains cheap.

Sincerely,
Chris Mayer
Penny Sleuth

October 26, 2010

The Small-Cap Meat Stock with a 100% Upside was originally featured in the Penny Sleuth.

Why wouldn’t they? It’s long been common knowledge that stocks average 10% annual returns in good times and bad; all you need to do is hold on through the bad times. That all changed during the bear market of 2008…

By the time panic subsided and the dust had cleared, major stock indexes like the S&P 500 and the Dow had finished down on the decade. Long only investors lost their shirts while bearish traders made a fortune by betting that stocks would continue to tumble. Even now, the idea of betting against the market (or, “shorting” the market, in Wall Street lingo) makes traditional investors anxious. But it doesn’t need to.

With the S&P 500 teetering toward “overbought” status, here’s a glimpse at three ways to profit from dropping stocks right now.

First and foremost, let’s get the terms down. When investors talk about their positions in a stock, they generally specify whether they’re “long” or “short”. Those words have nothing to do with the amount of time they’re holding their investments. Instead, they tell us about the direction they expect a specific stock to go. Long-side (bullish) investors are betting that their investments will see an increase in value, whereas short-side (bearish) investors expect valuations to drop.

Obviously, taking on a long position in a stock is fairly simple – you just buy shares. Taking on a short position is a little more complex, and comes with a new set of risks and rewards. With that in mind, let’s take a look at your options…

1. Short ETFs

Short-biased exchange traded funds (ETFs) have existed for a while now, but their popularity increased substantially in the wake of 2008. Simply put, these funds are pre-packaged baskets of investments that are already positioned as bets against the stock market. The beauty of these ETFs, though, is that you can buy and sell them just like stocks.

If you think that stocks are headed lower, you can simply buy shares of a fund like the ProShares Short S&P 500 ETF (NYSE: SH) and watch the fund rise each day the S&P drops.

For investors who want even more exposure to the short side of the market, there are also leveraged short ETFs like the ProShares UltraShort S&P 500 ETF (NYSE: SDS), which moves twice as much as the SH fund above.

The biggest drawback of short ETFs is the fact that these instruments paint with broad strokes. In other words, you can’t short specific stocks – instead, your options are relegated to major indexes or sectors that already have ETFs in place. Ultimately, short ETFs are an easily accessible option that investors can turn to for broad-bets that the market is headed lower. For more surgical trades – and higher gain potential – you’ll want to turn to other short strategies…

2. Short Selling

Short selling is perhaps the most well known way to bet against stocks. With short selling, you’re able to bet against specific stocks, not just industries or sectors. As a result, it’s possible to develop lucrative trading strategies by shorting especially volatile stocks on the way down.

While most investors have heard of short selling at one time or another, not all know how it works.

Let’s say that you wanted to short 100 shares of Bank of America (NYSE: BAC) last month when the stock was trading at $13.68. To do that, you would have gone to your broker and borrowed those 100 shares, then sold them on the market for proceeds of $1,368. The money would sit in your brokerage account until you were ready to “cover” your short, and close out the position. To cover, you’d just buy another 100 shares of Bank of America – now trading 8.5% lower at $12.52. That would cost you $1,252.

The difference between those two numbers – $116 – would be your profit…

Not surprisingly, there are risks to shorting stocks. The biggest risk is what could happen if you’re wrong. Unlike long-side investing, where you can only lose your initial investment, shorting exposes you to hypothetically unlimited risk as share prices rise on the stock you’re betting against. Had shares of Bank of America risen to $15, you’d be sitting on losses of $132. If the firm discovered a secret gold mine under its corporate headquarters and shares jumped to $100, you’d be out $8,632.

There are also other downsides to shorting (like margin calls and interest charges) that we won’t touch on today.

Because of the complexity of selling stocks short, this isn’t a bearish strategy that I’d recommend for newcomers to the investing world.

3. Options

The final short-side strategy we’ll touch on today is options. Like short selling, options are a tool that I’d recommend new investors stay away from. For those who understand the risks at hand, however, options can be one of the most profitable ways to take on a bearish trade.

Options are derivatives – that means that their value is based on something else. But don’t let the word derivative scare you… Essentially, an option is a contract to buy (call option) or sell (put option) a stock at a specified price. To bet against the market, the simplest way is by buying put options, which allow you to sell shares of a stock higher than a predetermined price (strike price).

Because smaller movements in share prices can move an option above and below its strike price, options offer investors amplified gains. Those amplified gains come with one big caveat: options carry an expiration date, which means that their value is directly impacted by time. The biggest benefit to options is that investors can bet against individual stocks while still maintaining finite risk – unlike short selling a stock, buying put options only risks your initial investment.

While betting against the market may seem anti-intuitive to buy-and-hold investors, it could be the only move that can save your portfolio during a bear raid. That’s not to say that you should just dive head-first into placing short-side bets… If you’re new to the three strategies I described, I strongly recommend that you paper trade to avoid putting real cash behind rookie mistakes.

Cheers,
Jonas Elmerraji
Managing Editor, Penny Sleuth

October 14, 2010

3 Ways to Profit from Falling Stock Prices was originally featured in the Penny Sleuth.

Here’s a look at how to profit from the coming decline in the trucking business.

You see, some capital spending mistakes are obvious (including supply gluts in residential and commercial real estate). But mistakes were made in asset classes you might not expect, like building too much capacity in the trucking industry.

If businesses react to misleading price signals, they can easily make capital spending errors. Credit bubbles cause misleading price signals. These signals are unhealthy because they act to pull future demand into the present.

This artificially boosted demand sends the signal to businesses to add capacity. Then, once the growth in credit slows, or even reverses, demand can fall far below supply. The industries that were most aggressive during the boom are left with excess capacity. Even the best businesses within each industry suffer from the investment enthusiasm of their peers, which winds up suppressing prices and profits.

Governments implemented huge stimulus programs, which ease and delay the adjustment process. This temporarily restores some of the earlier boom conditions. But sooner or later, prices adjust until supply and demand fall into balance. In 2011, when the fading stimulus plan stops boosting GDP and state governments continue their necessary restructuring, we’re going to see more adjustment in the U.S. economy. Prices and volumes in the trucking business should head south.

In fact, according to the transportation analysts at Baird, conditions are already softening. Growth in the Baird Freight Index and the American Trucking Association index is slowing, after peaking in spring 2010:

In the Trucking Business, Inventories Matter

As the global economy adjusts to post-credit bubble reality, it remains to be seen how much inventory of physical goods is sustainable. The desire to hold inventory is critical for the trucking industry. Lower demand for inventory translates into less-frequent deliveries from 18-wheeler trucks. Inventory is in a constant state of flux, and reflects businesses’ estimates of their customers’ demand.

Most mainstream economists expected inventory replenishment to boost GDP growth in recent quarters. We doubted this in December 2009, and it’s turned out that inventories haven’t driven GDP, as was expected at the time. Inventory levels in 2006-2007 levels were simply unsustainable.

How much inventory do businesses really need? This is something that each business must decide for itself. But with hindsight, we know that retailers in particular held far too much inventory heading into the 2008 collapse in retail sales. Inventory planning has its trade-offs: Too much inventory leads to weak profit margins and returns on capital, while too little inventory leads to missed sales opportunities. Most retailers remain conservative, choosing to forgo some lost sales, but avoiding the potential for painful inventory liquidations. Many retailers and manufacturers went out of business and are no longer in need of trucking services.

The “great” recession forced every business involved with physical trade — from manufacturers to distributors to retailers — to reassess how much inventory is appropriate to hold. The inventory-to-sales ratio provides a rule of thumb. This ratio has historically trended downward as more businesses adopt just-in-time inventory management. But during the 2008 crisis, this ratio spiked as sales dropped much faster than inventories.

According to the U.S. Census Bureau, the economywide inventory-to-sales ratio was 1.26 at the end of July 2010, down from a 2009 peak of 1.45. This ratio is now back near the 2004-2007 average of 1.3, so unless final demand picks up dramatically, the expected inventory rebuilding cycle will be tame.

With many businesses still shell shocked from the crisis, it’s unlikely that we’ll see a rush to preemptively build more speculative inventories. Yet the trucking stocks are still trading at valuations that require robust recoveries in freight volumes and pricing.

That mispricing gives us a good opportunity to bet against trucking right now…

[Ed. Note: The iShares Dow Jones Transport ETF (NYSE: IYT) provides an accessible way to bet on tucking exposure. But I’d strongly recommend taking a look at Dan’s research on one specific trucking stock – and his exact recommendation on how to bet against it for potential 150% returns.]

Regards,
Dan Amoss
Penny Sleuth

October 12, 2010

How You Could Make 150% Gains as Trucking Stocks Decline in 2010 was originally featured in the Penny Sleuth.

For many, it’s an ugly city, but I loved it right away. While gloom and doom hover over the economies of the U.S. and Europe, it is impossible to maintain a sense of pessimism in São Paulo — or Brazil, for that matter. It’s a showcase for the kind of changes sweeping over the emerging markets.

São Paulo had a humble beginning. Jesuits founded it on the banks of the little Tietê River in the 16th century. It was for hundreds of years an insignificant settlement. Even as late as the 1870s, it had only 26,000 inhabitants, cobbled around narrow streets.

But it would go on to put up perhaps the greatest population growth curve of any major city in human experience (as the Fernand Braudel Institute maintains). A great coffee boom in the 19th century was the kindle that sparked São Paulo’s growth. By the 1890s, the population tripled. And today, there are 20 million people in greater São Paulo.

The state of São Paulo has 45 million people and makes up nearly a third of Brazil’s economic output. Half of the country’s tax base is here. If it were its own economy, the state of São Paulo would be the second largest in South America — behind only Brazil and ahead of Argentina and Colombia. It is also home to Brazil’s stock market, the fourth largest in the world by market cap.

São Paulo did not grow up slowly around a center, as did the cities of Europe. Rather, it grew hastily and in an improvised manner. You can see the consequences of that process today. Traffic is horrendous. It can take more than an hour to move only a handful of blocks. The subway system is not up to the task of serving the entire city. And record car sales overwhelm the construction of new roads.

There is also an acute housing shortage, which is where an interesting investment opportunity lies. There are a lot of ways to show the data on housing. One common way to measure housing shortages is to look at how many families have three people per bedroom. This measure shows about 13% of families live in substandard housing. Expressed as a number of units, Brazil needs nearly 6 million new homes.

That’s really not surprising when you think of the swelling ranks of the middle class. Millions of people have become consumers in the last decade. Housing has not yet caught up with that demand. By some estimates, Brazil needs to build about 1.6 million homes every year just to keep up with new families entering the market.

In São Paulo, you can also see the shortage in the price of homes. New construction often takes three years. People now taking delivery for housing units bought three years ago find that the value of their dwelling doubled.

All that frothiness has some people worried about a housing bubble. Brazil’s mortgage market, too, is in hyper-growth mode. Take a look at the total loans to homebuilders and buyers.

It looks impressive, but the starting base was very low. Brazil’s home lending market is still only a fraction of that found in other Latin American countries, such as Mexico or Chile. Brazilians also have much more equity invested in their homes. Typically, loan-to-value is 70–75%.

Eventually, supply will catch up with demand, and maybe even exceed it. Then you’ll have a correction. But that day seems years away.

Sincerely,
Chris Mayer
Penny Sleuth

October 11, 2010

How to Profit from São Paulo’s Housing Boom was originally featured in the Penny Sleuth.