The Most Valuable Investment Secret of All

The Most Valuable Investment Secret of All By Porter Stansberry Friday, November 14, 2014

Today, I'm going to show you one of the most advanced investment skills you could ever master… But I don't want to tell you upfront what today's lesson is about. I want to see if you can figure it out yourself. So don't skip ahead. Think of today's essay as a test. As I always say… there is no such thing as teaching, there is only learning. And there's a hugely valuable investment lesson – the most valuable secret of all – below… Let's start with the big secret about the father of value investing, Ben Graham. (It's not that he was a notorious philanderer… Everyone knew that.) Most people know Graham literally wrote the book (or books) on how to invest: Securities Analysis and The Intelligent Investor.  Likewise, most people know he was a successful investment manager. That's all true, of course. But most people don't know how Graham got rich. Here's a big hint: It had nothing to do with his normal method of value investing. It had everything to do with insurance.  For most of his career, Graham avoided buying insurance companies and never put more than 5% of his portfolio into any individual security. But in 1948, at the age of 54, Graham decided to allocate 25% of his portfolio into insurance firm GEICO. He bought 50% of the company for $712,000.  After the purchase, the Securities and Exchange Commission (SEC) decided investment partnerships like Graham's couldn't own a controlling interest in an insurance company. To get around the rules, Graham distributed the GEICO shares among the various investors in his partnership.  Graham never sold the shares he received from the distribution. By 1972, Graham's stake in GEICO was worth $400 million. He made more than 400 times his money in 25 years. It wasn't a lifetime of careful value investing that made Graham a wealthy man… It was an investment in GEICO. Graham made vastly more money in GEICO than he made in all of his other investments combined. About 10 years after buying GEICO, Graham had made so much money that he quit investing altogether and closed his fund.  The success Graham had with GEICO led Warren Buffett – who was Graham's student at Columbia University – to study the company intensely. In January 1951, Buffett famously visited the company's headquarters on a Saturday, knocking at the front door until a janitor let him in. After speaking with GEICO executive Lorimer Davidson for four hours, Buffett put 65% of his savings in GEICO's stock – a stake worth about $10,000.  He wrote up the stock for his clients in a report titled "The Security I Like Best." The next year, Buffett sold his position for a 50% gain or so. But the lessons Buffett learned from Davidson went on to guide Buffett's entire investing career. Buffett has said publicly many times that those four hours with Davidson changed his life.  Buffett didn't own GEICO shares again until 1976. The company stumbled badly in the early 1970s when government regulations (no-fault rules), inflation, and aggressive plaintiffs' attorneys radically transformed the risks of auto insurance.  The company lost $126 million in 1975 and looked as though it might go bankrupt. The board brought in a new CEO, Jack Byrne, who radically restructured the company. He fired 4,000 of GEICO's 7,000 employees, closed down 100 offices, and exited the Massachusetts and New Jersey markets. Byrne raised insurance rates by 40%. Incredibly, in less than a year, GEICO was back in the black. By 1977, GEICO was paying a dividend again.  In May 1976, Buffett met with Byrne. He was impressed. Buffett believed the turnaround at GEICO would be successful. It's a little ironic, because Buffett is famous for refusing to invest in turnaround situations. He says most turnarounds "don't." But in this case, he had been following the company closely for 25 years… and determined it was the best business he had ever found.  He got to know the CEO. He knew he could personally provide the financing required. That's a much different situation than you or me buying shares of a cheap stock and hoping it goes back up.  Following a dinner with Byrne, Buffett began to buy huge blocks of GEICO shares. The first order was for 500,000 shares at $2.12. He later provided a huge amount of capital to the company – $75 million – through a convertible bond. His cost basis for the stock through this instrument was $1.31 per share.  Buffett's money helped save GEICO. By 1980, he owned one-third of the company. GEICO represented 31% of Berkshire Hathaway's equity portfolio at the time. Like his mentor Ben Graham, Buffett was now poised to make tremendous profits. He had allocated a huge portion of his net worth into the best business he had ever found.  By 1985, GEICO represented 50% of Berkshire's portfolio.  By 1994, Berkshire had received $180 million in dividends from GEICO – seven times more money than Buffett spent on buying the stock. Finally, in 1995, Disney bought out ABC/Capital Cities, whose shares Berkshire held. The deal gave Buffett a huge $2 billion profit. Buffett used the cash to buy the remainder of GEICO that Berkshire didn't own for $2.3 billion. By that point, Buffett had earned 48 times his initial investment in the company.  Today, GEICO's float (the amount of insurance premiums it carries) is in excess of $16 billion – up from $3 billion in 1995. If GEICO was publicly traded, it would be worth something around $20 billion. Buffett's initial $25 million investment would now be worth at least $10 billion… 400 times his initial investment.  Now… with that in mind… let me switch gears for a minute. The chart you see below is unusual. I would wager you haven't seen a chart like this before. It's designed to show you periods of time when you should have been buying stocks. It does so in a simple way: it measures changes to the S&P 500's book value as a percentage below its 24-month high.  We have good data on the S&P 500's book-value ratio since 1978. This chart makes it clear when good opportunities to buy stocks existed. Longtime investors will surely be familiar with these years: 1981, 1987, 2002, and 2009…  During my career – from 1996 to today – I've seen several excellent buying opportunities in stocks…  The first was in August 1998 when Russia defaulted. Many high-quality emerging-market stocks were trading for less than four times earnings.  The second was the end of the tech-stock bubble in 2002. My Investment Advisory subscribers can read the October 2002 issue to see how I described conditions at the time. (On the first page, I asked, "Is it the end of the world?") During this period, many high-quality technology-related businesses were trading for less than the cash on their balance sheets.  The biggest, best-known market correction of my career was in late 2008/2009, when even the world's highest-quality businesses were trading at decade-low valuations. I recall analyzing shares of jewelry company Tiffany in February 2009 and realizing that the stock was worth $24 per share, assuming you just sold the inventory and used the proceeds to buy back all of the stock and pay off all of the debts.  The stock was trading at $22. Tiffany was trading below liquidation value, implying that you could get the brand name, the operating profits, the future growth, and all of the real estate for free. I doubt you'll ever see an investment as good as Tiffany's trading cheaper than that. (As a side note, Tiffany shares trade for around $96 today. The company has paid $6.44 per share in dividends. By simply buying shares in February 2009, you would be up more than 360%.)  Based on these experiences, I've come to expect a good opportunity to buy stocks about once every five to seven years… and a greatopportunity to come around about once every decade. Lo and behold, when I asked Steve Sjuggerud's research analyst Brett Eversole to check the historical numbers for me, he found eight different 19%-plus corrections (declines) in the S&P 500 since 1976.  Again, these dates will be familiar to longtime investors: 1977, 1981, 1987, 1990, 1998, 2002, 2008, and 2011. Investors become euphoric after a period of gains. They become depressed after losses. It's human nature that's being expressed in these charts.  What's the difference between a good opportunity to buy and a great one? Studying the corrections we've seen since the 1970s, a good opportunity is a 20% or so decline in the S&P 500's price-to-book-value ratio.  The 2011 correction saw the S&P 500 fall 19.4%, but the ratio only declined 17.5%. This was the least impressive opportunity in our study, but that's largely because stocks were coming from a super-depressed bottom two years earlier.  In contrast, a great opportunity to buy is after the S&P 500's book-value ratio declines 30% or more, like it did in 1981, 1987, 2002, and 2008. The 1990s – a roaring bull market inspired by falling interest rates – was the only decade in my lifetime that didn't offer a great opportunity to buy stocks.  Keep in mind that if the book-value ratio of America's 500 largest companies has declined by 30% or more, you will be able to find dozens (if not hundreds) of high-quality businesses where book-value ratio has declined 50% or more.  So… What do you think the underlying message of today's essay is? Remember, I was trying to teach you the most advanced skill you can possess as an investor. What's that skill? What do these stories reinforce?  The most advanced skill you can develop as an investor isn't knowledge of arcane accounting rules. It's not developing real expertise in charting. It's not even becoming an expert in position-sizing and risk management.  The most advanced skill you can develop as an investor is simply the emotional discipline to be incredibly patient.  If you want to succeed in investing, you have to be other-worldly in your ability to wait until you get the rarest of opportunities – a chance to buy the businesses you've always wanted at the right price.  Buffett knew all about GEICO. He saw exactly how it enriched his mentor beyond belief. He knew it would certainly enrich him (assuming he bought it at the right price). As a young man, Buffett had foolishly advertised the opportunity and, even more foolishly, he sold the stock rather than simply continuing to buy more.  He then spent the next 34 years waiting for the right opportunity to buy the company. He waited and waited and waited and waited. Then he made 400 times his money.  Think about that the next time you're going to buy a stock. Is it a great time to be buying stocks? Is it the best time you've seen in five or 10 years to make investments in the stock market? Is the stock you're about to buy really trading at the cheapest price you've ever seen? Is it really a chance to make 400 times your money over several decades?  The more patient you become, the better your investments will be. I guarantee it. Patience is Buffett's greatest virtue. He figured out what businesses he wanted to own when he was in his 20s. Then he waited until he got the opportunity to buy them at prices he knew would make him extremely rich.  There's no reason you can't do the same – even if you're older than 50. Don't forget: Graham bought GEICO when he was 54. And Buffett's best investment ever was in Coca-Cola. He started buying the blue-chip soda brand after the 1987 collapse. He was 57 years old when he made that investment.  My advice: Keep a list near your computer or on your desk. When you come across a truly great business – a business that has enriched investors for decades – write down the name. Read its annual reports. Follow its progress. Get to know the business like you know your siblings or your spouse. See how the company responds in good times and bad times. Then… wait for the market to give you a great opportunity to buy the stock.  Regards,  Porter Stansberry Source: Daily Wealth Follow us on Twitter: @blacklioncm

Chinese Wealth Management Products Will Cause the Next Financial Crisis

BY CHRIS MAYER
POSTED 
NOVEMBER 6, 2014

The next financial crisis will begin in China.

This will be the event in financial markets when it happens. In this letter, I’ll tell you about the trouble spots and ripple effects. More importantly, I want to steer you clear of them.

Please read on…

“Troubles in China Rattle Western Banks,” says one Wall Street Journal headline. “String of fraud cases and problem loans stings foreign lenders as Beijing investigates executives, seizes assets,” says the subhead.

A few big European banks recently were on the losing end of a $475 million loan, thanks to fraud. The best part of the story was this quote:

There is plenty of evidence of recklessness in China.

“It was a surprise to all the banks. We didn’t know,” said one executive at a Western bank with direct knowledge of the matter. [Italics added].

“We didn’t know…” Of course they didn’t know. How could anyone suspect there would be fraud in China? Let’s see, there are only about half a dozen lenders involved in a suspected fraud case at Qingdao Port. Those lenders are in for a billion dollars. There’s also the case of Nomura. It lent $60 million to a Chinese shoe company just months before the CEO disappeared… along with the money.

Sarcasm aside, there have been several cases of late. Yet the story I started with was a C4 story buried in the middle of The Wall Street Journal. I want to make the case to you that these kinds of stories will work their way to the front page in 2015 — and why it matters.

To make my case, I draw primarily on two expert witnesses. The first is Yan Liang, an associate professor at Willamette University. She gave a fascinating presentation at the Post-Keynesian Conference I attended in Kansas City in September.

The focus was on the shadow banking system. You have probably heard the term “shadow banking” tossed around and wondered what it was all about. The definition can vary, but generally, a shadow bank is a lending institution that does not have the public backstop that normal banks do. (Read: a lifeline from the central bank.) They can also use greater leverage and evade certain regulations.

In China, shadow banking has quadrupled in size since 2008. Lending is not a business that grows that fast without doing reckless things. There is plenty of evidence of recklessness in China.

Liang focuses on the so-called trusts and wealth management products (WMPs). These are vehicles you can invest in that will then pay you a higher interest rate than a bank deposit will. The problem is people tend to think these are as safe as bank deposits. In fact, owning them is about as safe as swallowing a box of nails.

Trusts, for instance, use a lot of leverage. The average is about 40 times for the largest trusts, Liang says. (See the chart above.)

To show you how fragile a 40-times leverage ratio is, let me use an analogy. Imagine you owned your house at 40 times leverage. That means for every $100 of value in your house, you have just $2.50 of your own money in it. In such a case, just a 2.5% drop in the value of the house means you suffer a 100% loss of your equity.

And it is not like the trusts are investing in super-safe stuff. They make risky loans in infrastructure, real estate and industries with excess capacity. Also, they are opaque. Liang says that “only 29 out of 66 registered trusts disclose capital, and most (except for two publicly listed trusts) failed to report returns.” I imagine the ones not reporting are not proud of the results.

The wealth management products are just as bad. To an investor, they look like time deposits. But they pay higher rates because they take your money and invest it in risky loans to small businesses. Worse, Liang says that shadow banks often issue new WMPs to pay off old ones and dodge reporting bad loans. It’s like a big Ponzi scheme.

In fact, a Chinese regulator, Xiao Gang, did call them a “Ponzi scheme” last year in public. (Amazing that he still has a job. People who say stuff like this tend to wind up behind bars.) It’s easy to hide these things in China. Banks “often act alone in originating, distributing, custodying and managing WMPs,” says Liang. There is no independent party monitoring these things.

The maturity of WMPs is also getting shorter. So in 2007, only 10% of WMPs matured in less than 90 days. More than half were at least a year out. By the end of 2010, about 40% matured in less than 90 days. And less than 20% had maturities longer than a year. “But the funds raised could be invested in long-term projects, such as real estate,” Liang says. “So again, liquidity risk is excessive.” In other words, many WMPs hold long-term assets such as real estate on 90-day financing. Crazy.

Add to all this the fact that companies in China are having a hard time making money. The nearby chart, from Liang’s presentation, shows China’s corporate sector performance. The trend is bad. More and more companies are losers (almost 18% of the sector). And the median return on assets (or ROA) has fallen to under 3%. Weak. And these data are a year old. We can only guess where the numbers are now.

At this point, to further bolster my case, I’d like to call Charlene Chu to testify. I heard her talk at Grant’s fall conference. Her title was “Crash, Boom or Muddle? Casting China’s Future.”

Charlene Chu is the head of Autonomous Research Asia, started in Hong Kong in September 2014. Before that, she was a director at Fitch in Beijing, where she worked for eight years. Chinese banks were her beat at the rating agency. And before that, she worked for the Federal Reserve Bank of New York.

“The China today is not the China of before the financial crisis,” Chu began.

If you go back to the early 2000s, China’s was a banking sector in which there were hardly any other investment alternatives. Everybody put their money in the bank, Chu said. Every bank offered the same interest rate. You had no incentive to move your money from one bank to another. And there was no property market. There was barely a stock market. Chinese banks had virtually no liabilities.

That’s all changed today. Echoing Liang, Chu showed that China has a debt problem.

In her analysis, Chu did not care much for GDP growth, which most people focus on. She said it was the “most politicized number in the economic world right now, and it is not that informative.”

Instead, she focused on the massive loan growth in China. For six years in a row, China’s banks have extended net new credit. The total is an “astonishing amount.” If put in U.S. dollar terms, “we’re talking about $5 trillion of credit being extended for six years in a row.

“Under those kinds of circumstances, I think any country in the world would be growing at a very rapid rate,” she said. “The real question we should be asking about China is why isn’t growth stronger?”

China is slowing down, despite massive credit growth. She called into question the big and wide divergence between the picture in the financial data from banks and what is happening on the ground.

“I was in Beijing a couple of weeks ago,” she continued. “Across the board, everybody is expecting a slowdown.”

To answer the question she posed in her presentation, “Crash, boom or muddle?” she quickly dispatched one scenario. “I don’t see any case for a boom.” Neither do I.

Chu says China will muddle. In the Q&A, she did allow that if it got really bad, the Chinese authorities might have to make choices about who they bail out. Foreign bank claims might, in such a case, get the old shaft.

Commodities China buys heavily… would seem to be vulnerable to disappearing demand.

Meanwhile, stupid foreigners (mostly banks) have been lending money in China as if a boom was a given. Lending rose 47% in the 12 months ending in June, says the Bank for International Settlements. China is also the largest emerging-market borrower by far.

Liang also goes for the muddle-through scenario. “State-owned banks dominate China,” she said, “and the central government has the capacity to write off bad debt and recapitalize banks. Think the late 1990s.”

I will dissent from my esteemed China watchers. Markets don’t work so neatly. Big credit problems don’t go quietly into the night. Authorities, even Chinese ones, have no magic wands to wave and make problems go away. Markets boom and bust. I think China’s bust will be nasty and shake global markets to the core.

I would treat Chinese investment ideas as if they have Ebola. Some supposedly smart investors (this means you, GMO!) are bullish on Chinese banks. They cite, among other things, a low price-to-book ratio. But I agree with Chu: “The price-to-book ratios for Chinese banks are not low when you realize that 50% of the capital could be impaired in a very short amount of time.”

Stay away from China. Stay away from firms lending money in China. Those are easy steps. More difficult is to predict the ripples a financial crisis in China would create. Commodities China buys heavily — like iron ore, oil, copper and potash — would seem to be vulnerable to disappearing demand.

I have no doubt China will be a much bigger economy in 10 years’ time. But that doesn’t mean investors have to make money, especially foreign ones.

Regards,

Chris Mayer

Source: Daily Reckoning

Follow us on Twitter: @blacklioncm

The Invisible Power Behind the World's Best Investments

The Invisible Power Behind the World's Best Investments By Porter Stansberry Wednesday, January 8, 2014

Over the years, I've explained a lot of Wall Street's "secrets"… I've explained how discounted bonds are sometimes vastly better investments than stocks. I've covered how selling naked puts is almost always safer and more profitable than buying stocks outright. These concepts (and others) are critical to active investors. They all play a role in giving you the tools you need to increase your returns. You ought to know all about them and be able to use them tactically to take advantage of opportunities in the market. I've written about these concepts many times over the years. And I've said they're the "most important" thing I could teach you from time to time. I wasn't lying. All of these strategies have their "time in the sun." Believe me… having this tool bag and knowing when to use these strategies will make you a much better investor. It will allow you to profit from opportunities the market always creates. But… how can you learn to be patient enough to wait for these opportunities? That's what I'd like to show you with today's essay. I hope you'll print this one out… mark it up… and keep it near your desk. The real secret is in this one… So what's the most important idea I've discovered in finance? What's the one thing I'm going to teach my kids beyond the obvious stuff about saving, compounding, and risk management? What do I believe is the real secret to investment success? And… the biggest question of all…How do I invest my own money in securities?  Over the long sweep of your investing lifetime, strategies that only work extremely well in certain market situations are unlikely to play a dominant role. The big secret therefore is something you can use all the time, for your entire life, as an investor. And here it is: Some companies are much better than others at compounding capital. Much better.  If your goal as an investor is to compound your savings over time, wouldn't it be easier to simply figure out which companies will compound your capital at an acceptable rate, buy those firms (and only those firms) at reasonable prices, and then do something else with the rest of your time?  Here's a simple, but powerful example…  Well-run insurance companies can produce what's called an "underwriting profit." They are literally paid money in advance to manage your capital. And they get to keep not only the investment profits, but profits from the premiums, too.  That's like paying the bank to keep and use your money. No other business can compound capital so consistently.  Insurance companies have other fantastic advantages, too. They're able to legally defer most of their taxes. They're nearly immune from economic factors. They're scalable. I could go on…  They're a focus for us because well-run insurance companies are legendary compounders of capital. Buy them at reasonable prices, and it's impossible not to do well.  In the March 2012 issue of my Investment Advisory, we explained that insurance stocks had rarely been cheaper. We recommended several through the year. Since then, stocks of all stripes have exploded higher… but they haven't outpaced insurance companies. Insurance stocks as a whole – as measured by the SPDR S&P Insurance Fund (KIE) – have far outpaced the S&P 500.  It's not an accident that the greatest investor in history, Warren Buffett, has long focused on insurance stocks and other companies that are highly capital efficient. That is, companies that are natural wealth-compounders.  Starting with his 1972 investment in See's Candies, Buffett gradually over the years shifted the bulk of his wealth into a simple, long-term compounding strategy…  While Buffett didn't abandon all other forms of investing, his largest allocations since 1972 have all used this compounding strategy. That famously includes his 1988 purchase of Coca-Cola… when Buffett put roughly 25% of Berkshire's capital into a single stock! And it wasn't a cheap stock, either. At the time, Coke was trading for 16 times its annual earnings. Buffett had figured out the one, real secret of finance… the one secret to "rule them all."  To use a long-term, compounding strategy effectively, you really only have to answer three questions.  •   First, is the company in question able to produce very high returns on its assets? In other words, is it a great business?      •   Second, are these unusually high returns very likely to continue for decades, without requiring large and ongoing capital investments?      •   Third, can the management of the company be trusted? Will bankruptcy never be even a remote possibility? If the answer to these questions is "yes," then all you have to do is simply not pay too much when you buy the stock.  Most of the companies that fit these criteria are branded consumer-products companies – stocks like McDonald's, Coke, Heinz, and Hershey. Buffett explained in his 1983 shareholder letter how he thinks about these companies. The secret to their long-term earnings power is very simple: It's their brand and the relatively unchanging nature of their products. These companies' products are so well-known (and adored) by customers that these firms can constantly raise prices to keep pace with inflation.  Meanwhile, the brands – while requiring some advertising – aren't like factories, gold mines, or drugs…  They don't require massive investments of new capital. There's no new gold mine to find and build. There's no patent that's going to expire. And there's not even any new product that must be created: Coke's fans went crazy with anger when the company tried to change its product in a small way back in 1985.  All these firms have to do is continue to deliver the same thing, year after year. And that means they can afford to return huge amounts of capital to shareholders.  Merely buying and holding any of the stocks I mentioned above would have made you 15% a year if you'd just reinvested the dividends for the last 30 years. Even if all you did was invest $10,000 and then nothing else – not a penny more – you'd still end up with $575,000 at the end of 30 years. If you invested $10,000 annually, you'd end up with $4.3 million.  And the best part? This approach can be used by anyone.  The math is simple. And is it really that hard to realize that Heinz is the best sauce company… that Coke is the leading soft-drink business… or that McDonald's makes the best hamburgers for kids?  The No. 1 objection I get from readers when I talk about this strategy is: "That's great, Porter. Wish I'd known about that when I was 25. But it's too late for me now. I don't have 30 years."  That's nonsense. Think about it this way… Buffett was born in 1930. He didn't buy Coke until 1987. He was 57 years old. It has been one of the greatest investments of his life – bar none.  If that doesn't convince you, just think about it this way. How often do you make more than 15% on your portfolio in a year? Whether you've got three decades to invest or only one, you should aim to produce the highest possible annual return without putting your capital at undue risk. There's no safer investment approach than this one, as your returns are being manufactured by great businesses. You don't need a "greater fool" to pay too much for your shares to make a profit. In fact… The biggest risk you face is selling at all because that will trigger taxes (in most accounts).  I've written entire issues of my newsletter about this strategy. I've recommended several stocks using this approach. These companies all produce something akin to financial anti-gravity: They earn more and more money, year after year.  It's this seemingly invisible power that allows them to return massive amounts of capital to shareholders, a factor that sets them apart and greatly reduces investor reliance on capital gains. This is incredibly important over the long term.  In tomorrow's essay, I'll share an example of how this works and how different these companies are compared with "regular" companies. This example will show you what I look at when analyzing a business. And it will reveal what makes these "special" businesses the world's best long-term investments…  Regards,  Porter Stansberry Source: Daily Wealth Follow us on Twitter: @blacklioncm

An Easy Guide to Shareholder Letters: Look for These 3 Things

An Easy Guide to Shareholder Letters: Look for These 3 Things By Dan Ferris, editor, The 12% Letter Wednesday, November 27, 2013

It was an unusual research project… Not one in 1,000 investment advisors or newsletter writers would ever consider it. Over the last month, my research partner and I read every shareholder letter issued by companies in the S&P 500 index. I got the idea from billionaire super investor Warren Buffett. A couple years ago, Buffett talked about a one-page fax he got from the CEO of a potential acquisition: The quality of the business, he said, "jumped off the page." During our project, we found a few shareholder letters that were that good… And if you study what I'm about to teach you, you, too, will be able to identify companies that "jump off the page" as wonderful investments you'd like to own one day. You won't have to pick stocks anymore. They'll pick you! And it's easier than you think… I found three valuable types of insight in the best shareholder letters…  1.   How the company spends the excess cash it earns.   2.   How to keep the company accountable and measure its success.   3.   How the CEO describes the company and what makes its approach to the industry different and better than other competitors. The first and most important insight a great shareholder letter will give you is about the company's approach to cash…  It's great to own a piece of a profitable company… but if the management team squanders the profits, they'll destroy shareholder value instead of preserving and growing it.  Take Wall Street mega-bank JPMorgan Chase (JPM), for example. It is the only S&P 500 company that says growing its dividend is the most important thing it does with excess cash… even more important than growing the business!  Here's the relevant passage from the 2012 annual shareholder letter by CEO Jamie Dimon.  Our fortress balance sheet… provides us with excess capital to invest, and we always are thinking way ahead about the best ways to deploy it. As we have said in the past, after steadily increasing dividends, our favorite deployment is in growing our businesses. After investing in the growth of our businesses, we look at other ways to use the remaining excess capital. One use we consider is buying back stock – but only at a price we think is good for shareholders. The priorities for investing excess cash couldn't be clearer. First, JPMorgan will grow the dividend. Second, it will consider ways to grow the business. Third, it will look to spend cash in other ways, including buying back its stock.  When you find the companies that allocate excess capital wisely – like JPMorgan has – well, I can't stress enough how highly valuable that is to you as an investor. It's like knowing who's going to win an Olympic gold medal before the event begins.  Second, great business leaders want to be held accountable. They want to give you, the shareholder, an objective benchmark for measuring their success.  Consider 3M (MMM), a conglomerate that produces everything from Post-It notes to welding goggles.  Its shareholder letter provides investors with a crystal-clear set of financial benchmarks they can refer to in the future, to make sure management is performing well.  Here's what 3M Chairman and CEO Inge Thulin said in the 2012 shareholder letter:  Finally, we set out financial goals for the next five years. We now have targets that are both realistic and aggressive, and that provide a real possibility of upside. The five-year goals are as follows: •   Grow earnings per share 9-11 percent per year, on average •   Grow organic sales 4-6 percent per year, on average •   Maintain return on invested capital above 20 percent •   Free cash flow conversion of 100 percent Shareholders can note these objective benchmarks and know in five years if management is performing up to speed or not.  Most shareholder letters don't do this. They aren't crystal clear about how to gauge success because they fear they won't measure up. But great managements believe in what they're doing. They want to be held to an objective standard.  Humans are ego-driven. They want recognition. But they like their recognition to come with as little effort and commitment as possible. So it takes a special kind of person to draw a line in the sand and let the world know that's the point from which his future progress will be measured.  There's one more big idea you'll find in many good shareholder letters. Simply put, you want a manager who can explain the industry he's in and what makes his company's approach to it different and better… For example, here's a clear explanation of how and why apartment REIT Equity Residential (EQR) changed its business…  Approximately ten years ago, we made a monumental shift in our company's investment strategy away from two- and three-story walk-up garden apartment properties with surface parking in suburban locations across the 50 largest cities in the country, towards higher density, urban properties in a handful of gateway cities in the northeast and West coast… We also wanted to invest where the construction of new housing would likely continue to be constrained, such that demand would exceed the supply of all forms of housing. Letters like this – that explain the company and the industry in plain English – provide a free, high-quality (and sometimes entertaining) financial education that will take very little of your time.  Those are just three examples of several great shareholder letters we read during our project. We found 79 that show the companies are dedicated to paying out their excess cash to shareholders… keeping themselves accountable… and explaining their business and industry in plain language.  Of course, there are great companies that don't have great shareholder letters. But it's hard to find the opposite – a really great shareholder letter that isn't written by a great CEO of a great business.  I've never heard about anyone undertaking a project like we did… But I believe in those kinds of "manual" methods of stock screening. It's easy for computerized screening tools to miss things an experienced human being carefully poring over the same data would find.  To be a great investor, you have to be willing to look at the stock market in ways most other people don't.  Reading the shareholder letters of the companies you invest in is invaluable when it comes to understanding the business, the industry, and what you can expect from your management team. Especially when you find one that's sending the right message in a clear, credible way.  Good investing,  Dan Ferris Source: Daily Wealth Follow us on Twitter: @blacklioncm

An Honest Letter from the Chairman of General Motors

Editor's note: Porter Stansberry first started reporting on the debacle at General Motors back in 2007, with a "tongue in cheek" letter from the company chairman. This letter and his follow-up proved to be so prescient that many subscribers thought they were actually written by General Motors' chairman. Of course, no figurehead would be so honest about his company's problems. So once again, Porter is stepping into the role… An Honest Letter from the Chairman of General Motors By Porter Stansberry Wednesday, October 2, 2013

Dear shareholders, Moody's Investors Service recently upgraded General Motors' rating. The major credit-rating agency bumped our rating from Ba1 to Baa3 – its lowest tier of "investment grade" credit. Nobody was more surprised than me. Let me tell you plainly, I do not believe our company is an investment-grade credit. Nor are our operations likely to improve in a way that would have led any reasonable analyst to conclude such. That is why all of the other major ratings houses (S&P, Fitch, Egan Jones) continue to rate our corporate obligations as "junk" – speculative debts that have a significant risk of default. I now understand what Bill Gross means when he says investors shouldn't trust Moody's ratings because the company has become a de facto arm of the U.S. government. Or as he put it recently: Moody's and the U.S. Treasury are just one big "happy family." Gross manages hundreds of billions of dollars in private capital for the investment management firm PIMCO. So he has the luxury of being able to say whatever he wants in public. I don't have that luxury. I'm the chairman of a publicly owned corporation, whose debts are soaring, whose margins are collapsing, and whose capital structure is still controlled by the government and our unions. So when the reporters called me to ask about the Moody's upgrade, I said: "Good things happen when you build great cars and trucks and deliver strong financial results." It's a great line. It still makes me chuckle. Read it carefully. You'll notice… I didn't say anything about GM. What I couldn't say is that our business is already beginning to collapse, again. Look at our core automotive operating profits. In the first six months of 2012, we generated $2.8 billion in automotive operating profits. In the first six months of this year, we made a little more than $2.1 billion. Thus, our core, global automotive business has seen its operating profits decline substantially… by more than 24%. We are approaching another crisis at GM, one that has its roots in the bailout of 2008/2009. The faulty bankruptcy process caused this crisis by failing to address our largest obligations (pensions and retired employee health care). And the crisis results from the motivations of our government owners – motivations that do not square with capitalism. Like my predecessor, Rick Wagoner, did… I plan to write to you from time to time, privately, here in these pages. I will tell you what is actually happening with our great company – an institution that was once the largest privately financed endeavor in human history. You'll get the truth here, even if I'm not allowed to say it anywhere else… What's happening with GM is a microcosm of what's happening with the rest of our society. Where once we sought only a fair opportunity for greatness, now we seek the false security of collectivism. I see it happening right in front of me every day. I believe an honest discussion of what's happening with our business could help educate the public about the failure that's inevitable when resources – like our capital, plants, and people – are governed by politics rather than by markets. At GM, we abandoned capitalism in 2010 when we emerged from bankruptcy. Instead of treating all of our creditors fairly, we gave the lion's share of the company's assets to the federal government and the UAW health care trust. Meanwhile, we didn't do anything to mitigate our enormous pension liability, which today stands at $26 billion. At the end of the bankruptcy process, none of our 400,000 retired workers lost a nickel. On the other hand, our shareholders, creditors, and many of our suppliers were wiped out. That's not the way capitalism is supposed to work. And still today, GM isn't really privately owned. Instead, the company is a kind of public-private "partnership," where actual control rests with the government. Today, GM is more like a Ponzi scheme than a real business. How so? Ponzi schemes don't generate any actual profits. They require greater and greater sums of money to work. Sooner or later, there simply isn't enough capital available to maintain the mirage of a functioning business. That's exactly what's happening at GM. Don't take my word for it. Consider the facts below. Then, decide for yourself. Is GM a real business, owned by capitalists, driven to create real profits, to be shared by its owners as they see fit? Or is it a kind of elaborate, government-sanctioned scheme, meant to enrich a few chosen, special interests? PART I: Who Are the Real Owners?  All of Our Profits… and More… Are Going to Retired Workers Since GM emerged from bankruptcy protection in mid-2010… we've done great. The last few years are the best years in the history of our company. We've never built better cars. The market research firm JD Power says GM has the highest-quality cars of any major carmaker. Our trucks, it says, compete with Porsche for the highest-quality vehicles made anywhere in the world. We've never generated more revenue. In total, we've made about $26 billion in operating cash flow – what our main business generated before paying capital expenses and similar costs – since we emerged from bankruptcy. It all sounds good, I know. The bad news is that our business requires massive amounts of capital to sustain its operations. These so-called capital expenditures consumed roughly $20 billion of those operating profits. That left us with roughly $6 billion-$7 billion in actual cash that we could, in theory, return to our true owners (our shareholders) or re-invest into profitable lines of business. So where did this money – the so-called free cash flow – go? All the money – and a lot more – went to retired workers, unions, and the government. In total, we've sent around $18 billion in cash to these interests – far more than we've been able to earn. These payments started with $3.9 billion in dividends on special "preferred" shares the union, the U.S. Treasury, and the Canadian government got during the bankruptcy process. Keep in mind, our creditors got none of these shares, and we've never paid a cash dividend to regular, common stockholders. Another $8.5 billion went to repay debts to the U.S. Treasury and the union, obligations that we were saddled with in bankruptcy. And that's not all. In 2012, we announced with great fanfare that our operating results were so good, we were going to begin buying back shares. Normally, that's great for common shareholders. But in this case, the $5.1 billion worth of stock we bought back ALL came from the U.S. Treasury. No former creditor or any other public shareholder was able to sell to us. That's not all… We paid a $2-per-share premium to the actual market price of our stock. We simply gave the U.S. Treasury another $400 million "gift" for allowing us to buy back the shares it held. Remember… private investors didn't have a chance to sell their shares to GM at a $2 premium. That deal was nothing less than a crime. It was the U.S. Treasury stealing $400 million from the shareholders. If any other business in the country did something like this, it would get hit with a hundred lawsuits overnight. But when GM did it? The press cheered. How can you explain that? So we continue to owe far more to unions and governments than we're earning. If that were our only problem, perhaps we could envision a light at the end of the tunnel. But these obligations are only the beginning… That $26 billion in operating cash flow already accounted for about $8.8 billion in cash payments we made to support our pension plan and other retirement benefits. Without those obligations… our number would have looked even better, with operating cash flow of nearly $35 billion. That anchor around our neck isn't going anywhere. In addition to the cash, we contributed in 2011 60 million shares of stock (worth $2 billion) to the pension plan. No, that wasn't a cash expense. But believe me, shareholders should wish it was, as the expense will end up coming out of their pockets, instead of ours. Just think about what that means… Instead of the workers supporting the shareholders… at GM, the shareholders are supporting the workers. Sounds a little bit like communism, doesn't it? Well, just wait. The nonsense is only getting started… In 2012, we announced a big deal to eliminate our entire legacy, white-collar-salary pension obligations. We paid the Prudential insurance firm around $3.5 billion to manage $25 billion worth of our pension liabilities, taking them off our books. Don't forget… we also gave Prudential $25 billion from the pension fund to manage. Think about that for a little while. When is the last time you had to pay your broker 14% of your assets upfront to manage your account? Hedge funds normally charge 2%. They're considered expensive. Paying 14% sounds a little steep, doesn't it? No one ever explained it to me, either. My guess is a lot of that fee ended up in union offices or political piggy banks. Whatever happened, all of the money is gone. In the three years after bankruptcy, we made roughly $6 billion-$7 billion in "free cash flow." Somehow, that cash was supposed to cover $18 billion in obligations… including almost $1 billion a year in preferred-stock dividends to the union's health care trust and the Canadian government. That also includes the $400 million "gift" to the U.S. Treasury and the $5.1 billion worth of shares we bought from it. And for our common shareholders, our real owners? We haven't paid a cent. So who really benefits from our brands… our research and development… our decades of investment… and the tens of billions of capital we have at stake? Is it our shareholders? No, it isn't. It's the union. It's the retired workers. And it's the government. Is any of this likely to change any time soon? No, it's going to get worse… a lot worse. Look at our preferred shares. They were created to make sure the union got most of the value out of our remaining assets. (Our bondholders didn't get any of these preferred shares.) The shares pay a 9% annual dividend. Try to find any other preferred stock issued by a major corporation that pays a coupon that large. You won't find another example. We were simply hijacked by the bankruptcy court and the Obama administration. And we have to pay this dividend before we pay anything else. If we don't, these obligations accrue, a situation that would rapidly warp our entire capital structure, placing the whole company in the union's control. So one of my most important jobs is to buy back these securities as quickly as I can. The problem is, they're extremely expensive. I've just negotiated a deal to buy back 120 million preferred shares at $27 each from the union's medical trust. That's $3.25 billion. Believe it or not, the medical trust will still own 140 million of these preferred shares. The Canadian government also owns a few of these shares (16 million). We can redeem all of these remaining shares in 2014, but it will cost us almost $4 billion – in cash. To pay off the union then, we'll have to borrow money… billions. Now, you know the real reason why Moody's just raised our credit ratings. I'm sure the government told Moody's to help GM raise the money so we can pay off the unions. Shall I feign indignation that the country's most politically powerful union is able to manipulate Moody's credit ratings? PART II: Since Government Can't Let Automakers Fail, Overcapacity Is Getting Worse and Worse I'm proud of GM's cars. As I mentioned, we've made huge strides in increasing the quality of our vehicles. But guess what? So has every other carmaker in the world. The competition makes it harder and harder to make a profit. Just look at our actual numbers. In the first six months of 2012, we sold $74.5 billion worth of cars around the world (automotive revenues). We made an operating profit of $2.8 billion. That's a minuscule operating profit margin of 3.8%. The situation is getting worse. In first half of 2013, we sold $74.6 billion worth of cars around the world, fractionally more revenue. But we earned a lot less, only $2.1 billion. Our costs rose, and we could not pass these costs on to our customers. Our operating margin declined to less than 3%. These are razor-thin margins. Margins this small are dangerous to operating companies, like ours, that have huge volumes. If anything were to happen to consumer demand – for example, if the economy were hit with a recession or we were unable to finance our customers (more about this below) – these puny margins would disappear overnight. The result would be sudden, large losses. You should know: An "accident" like this is inevitable. It's going to happen. And it's going to happen soon. The auto industry suffers from a tremendous glut of capacity. According to different sources, 20%-30% of global production isn't profitable. My counterpart at Nissan, Carlos Ghosn, is one of the few senior executives who has spoken honestly about this major problem. At a recent car show in Geneva, he said, "All of the car manufacturers have capacity problems – all of them." Sergio Marchionne, the chief executive of Chrysler and Fiat and the president of the European Automobile Manufacturers' Association, estimates the auto industry needs to cut capacity in Europe by 20%. Automakers employ or support 2.3 million people in Europe. Just like in the United States, the auto industry is too politically powerful to be allowed to fail. It's the same thing, all around the globe. So how likely is it that any automaker, anywhere, will be able to significantly reduce production? Capitalists making tough, but realistic, decisions no longer control this industry. Instead all of the capital-allocation decisions are being driven by politics. Whether you call it "welfare," "socialism," or "communism" doesn't matter. As long as this continues, it's inevitable that GM's operating margins will continue to deteriorate. And that means, it's only a matter of time before we're dealing with huge quarterly losses. Bernd Bohr is the head of the automotive group at Bosch, the privately held German company that's the world's largest manufacturer of car parts. He explains the current problems by pointing out that none of the major carmakers was allowed to fail in 2008/2009. "It was a peculiarity of the 2008-09 crisis," Bohr said, "that practically no capacity was taken out of the market due to state intervention…" While hard to fix, the problem is easy to understand. As long as no carmakers are allowed to fail, the ability of the entire industry to earn a profit will be greatly compromised. GM is the largest car company in the world (roughly tied with Toyota). It has the highest labor costs. It is heavily burdened by its pension obligations. It has, despite my best efforts, several weak brands. In this scenario, GM is extremely vulnerable, the most vulnerable large carmaker in the world. My advice? Don't pay attention to our revenue figures. Watch our margins. It's overcapacity that will kill us this time, not quality or a lack of demand. PART III: We're Doing It Again: Selling Cars to Unqualified Buyers Think about the dead-end GM faces strategically. We can't compete on brand. No one under 40 years old would rather drive a Cadillac than a BMW. Almost no one at any age would rather have a Chevy Malibu than a Honda Accord. And even though our trucks are great, Ford's are just as good (if I'm being honest). We can't compete on price because we don't have the cheapest costs. Instead, we have the highest. And no matter how much money we make, all of it (and more) will end up being siphoned off to either the union's health care trust or the pension fund. What would you do in this scenario? I've thought about this question every single day for three years. There's only one answer. And it's a lousy one. GM will have to compete on credit. We'll have to work out a deal with Wall Street to borrow billions and billions and funnel the money to car buyers who the other makers won't lend to. Our only chance is to, once again, become too big to fail. In the fall of 2010, we acquired a financial business, now called GM Financial. It exists to provide financing to buyers of our cars in dealer showrooms. You might recall that our company's last foray into finance didn't end well… huge losses at our former finance subsidiary were one of the primary reasons our company spiraled into bankruptcy back in 2008. We're doing it all again. As our margins have declined, we've attempted to grow by making more and more loans. Our loan book has ballooned to $11.5 billion. We made about 75% of these loans to borrowers with FICO scores lower than 600. Unbelievably, we're even lending billions (more than $3 billion, actually) to folks with FICO scores less than 540. It seems implausible to me that these loans will work out for us in the end. By the end of 2012, nearly $1 billion of these loans was already in default. Just imagine what will happen to these weak borrowers when we eventually enter another recession. Just as our sales are declining, all of these bad debts will come due. All the repossessed cars will flood the market, driving down recovery values and destroying demand for new cars. Haven't we learned anything from the last financial crisis? Apparently not. You will see as we move forward, our margins will continue to decline because of the global problem of overcapacity. Charities – which is what all of the major car companies have become – don't make a profit. As our margins decline and our cash flow disappears, the union and retiree demands on our remaining capital resources will grow more intense. We'll have to borrow more and more simply to fund our pension obligations. We will also be borrowing, massively, from Wall Street to finance our car buyers. Sooner or later, we will end up losing money on every transaction, while trying to make it up on volume… and financing that volume using our own balance sheet. It's insane… unless you understand it's my only hope. I've got to borrow billions and billions over the next few quarters. I've got to scale up, so that we're so big we can't be allowed to fail. It will be the same madness we saw in 2008 all over again. But this time, it won't take decades to unravel. It will happen much faster. My guess is within five years, we'll be in a crisis again. And our stock, which is currently valued at $50 billion, will be worth nothing. Please invest accordingly. Best regards, The Chairman of General Motors Source: Daily Wealth Follow us on Twitter: @blacklioncm