I just met this remarkable fellow, full of wisdom on investing, yet hardly known beyond a small group of fans. His name is Thomas Phelps, and he’s had quite a career. He was The Wall Street Journal’s Washington bureau chief, a former editor of Barron’s, a partner at a brokerage firm, the head of the research department at a Fortune 500 company and, finally, a partner at Scudder, Stevens & Clark (since bought out by Deutsche Bank). Phelps retired in Nantucket after a varied 42-year career in markets.

Along the way, Phelps figured out a few things about investing. He conducted a fascinating study on stocks that had returned $100 for every $1 invested. Yes, 100-to-1. Phelps found hundreds of such stocks, bunches available in any single year, that you could have bought and enjoyed a 100-to-1 return on — if you had just held on.

This was the main thrust of our conversation: The key is not only finding them, but keeping them. His basic conclusion can be summed up in the phrase “Buy right and hold on.”

“Let’s face it,” he said, “a great deal of investing is on par with the instinct that makes a fish bite on an edible spinner because it is moving.” Investors, too, bite on what’s moving and can’t sit on a stock that isn’t going anywhere. They also lose patience with one that is moving against them. This causes them to make a lot of trades… and never enjoy truly mammoth returns.

Investors crave activity. Wall Street is built on it. The media feed it all, making it seem as if important things happen every day. Hundreds of millions of shares change hands every session.

But investors need to distinguish between activity and results. “When I was a boy, a carpenter working for my father made this sage observation: ‘A lot of shavings don’t make a good workman.’” As you can see, Phelps is a man of folksy wisdom.

“Investors,” Phelps continued, “have been so thoroughly sold on the nonsensical idea of measuring performance quarter by quarter — or even year by year — that many of them would hit the ceiling if an investment adviser or portfolio manager failed to get rid of a stock that acted badly for more than a year or two.”

What investors should do is focus on the business, not on market prices. Phelps showed me financial histories of a long list of companies — earnings per share, returns on equity and the like. No stock prices. After one example, he asked: “Would a businessman seeing only those figures have been jumping in and out of the stock? I doubt it.” But if they just sat on it, they’d be rich.

And this is the nub of it. Phelps is not a fan of selling good businesses.

He talked about how his friend Karl Pettit — an industrialist, inventor and investor — sold his shares of IBM stock many years ago to start his brokerage business. He sold them for a million bucks. That stake would eventually go on to be worth $2 billion — more than he ever made in his brokerage business.

Phelps told me the story of how he sold his Polaroid stock to pay a steep doctor’s bill of $7,415 back in 1954. “Here is the confirmation of the sale,” he said, which he keeps as a reminder of his folly. Less than 20 years later, his Polaroid stock was worth $843,000. That’s an expensive doctor’s visit.

Phelps also stands against market timing. He told me about how he predicted various bear markets in his career. “Yet I would have been much better off if instead of correctly forecasting a bear market, I had focused my attention through the decline on finding stocks that would turn $10,000 into a million dollars.”

Because of his bearishness, he missed opportunities that went on to deliver 100-to-1. “Bear market smoke gets in one’s eyes,” he said, and it blinds us to buying opportunities if we are too intent on market timing.

“He who lives by the sword shall perish by the sword,” he added. “When experienced investors frown on gambling with price fluctuations in the stock market, it is not because they don’t like money, but because both experience and history have convinced them that enduring fortunes are not built that way.”

Phelps showed me a little schematic that reveals how much a stock must compound its value to multiply a hundredfold:

35 years — 14%
30 years — 16.6%
25 years — 20%
20 years — 26%
15 years — 36%

You’ll note that these are very long holding periods, but that’s the point. The greatest fortunes come from gritting your teeth and holding on. You’ll also see it’s a fairly high hurdle. You need growth.

(Several stocks we own are giving us annualized returns above Phelps’ tough 100-fold hurdles so far: IAG (39%), FLS (28%), MEOH (32%), TIE (25%) and GTLS (70%) — to name those we have held for at least one year. Twenty years is a long time, though…)

Phelps advises looking for new methods, new materials and new products — things that improve life, that solve problems and allow us to do things better, faster and cheaper. There is also an admirable ethical streak to Mr. Phelps’ style. He emphasized investing in companies that do something good for mankind. Finally, focus on cheap stocks, though you have to look beyond past figures.

“There is a Wall Street saying that a situation is better than a statistic,” Phelps said. Relying only on published growth trends, profit margins and price-earnings ratios is not as important as understanding how a company could create value in the years ahead.

Phelps is quick to add that he is not advocating blindly holding onto stocks. “My advice to buy right and hold on is intended to counter unproductive activity,” he says, “not to recommend putting them away and forgetting them.”

And so what if you don’t get a hundredfold return? The point of Phelps’ brilliant teaching method is to focus your attention on the power of compounding, to forget the day-to-day burps and ripples of stock prices. You can see the power of such ideas in the stocks we own: If you had bought Canadian Natural Resources (NYSE:CNQ) 10 years ago, for example, and held on no matter what — through recessions, bubbles, credit crises — you’d have multiplied your money 11-fold. Brookfield Asset Management (NYSE:BAM) went up nearly sevenfold. Buy right and hold on, indeed.

It is an investment tragedy of a sort to think that people have owned these stocks and not reaped those gains because they were trying to time the market or trade in and out. Sometimes stocks take a long time to get going. Phelps had plenty of examples of stocks that went nowhere (or down) for years, but still delivered the big 100-to-1.

“One of the basic rules of investing is never, if you can help it, take an investment action for a noninvestment reason,” Phelps advises. Don’t sell just because the price moved up or down, or because you need to realize a capital gain to offset a loss, etc. You should sell rarely, and only when it is clear you made an error. One can argue that every sale is a confession of error, and the shorter time you’ve held the stock, the greater the error in buying it — according to Phelps.

I love Mr. Phelps’ ideas. They are hard to implement, I know. But some people have. He related the experiences of individuals, former clients and old associates who got rich by buying right and holding on. Only the most-exceptional individuals can do it. Phelps wishes he had learned these insights when he was younger.

Now, I have a little confession to make about Mr. Phelps… I didn’t actually meet him. He’s been dead since 1992, reaching the ripe old age of 90. Every quote above comes not from a conversation, but from his book, 100 to 1 in the Stock Market: A Distinguished Security Analyst Tells How to Make More of Your Investment Opportunities, published in 1972.

I recently picked up a near mint copy for $22. This forgotten book should be a classic. Do not let the implausibility of making 100-to-1 on your stocks distract you. The main idea is to know how such returns have happened and what investors needed to do to get them. Aiming a little closer to that goal is bound to improve your results.

Phelps wrote as much. “Just a slight change in a golfer’s grip and stance may improve his game, so a little more emphasis on buying for keeps, a little more determination not to be tempted to sell… may fatten your portfolio. In Alice in Wonderland, one had to run fast in order to stand still. In the stock market, the evidence suggests, one who buys right must stand still in order to run fast.” I think it is superb advice.

I recommend the book, which is a pleasure to read and has plenty of good ideas, analogies and stories. They are particularly relevant now, given all the trouble in the world. I am inspired by his philosophy of buying right and holding on. I think you should try to do more of that, too.

Regards,

Chris Mayer,
for The Daily Reckoning

The Value of a Thief originally appeared in the Daily Reckoning. The Daily Reckoning, published by Agora Financial provides over 400,000 global readers economic news, market analysis, and contrarian investment ideas.

It’s a slim little booklet titled One-Way Pockets by Don Guyon (a pen name for a broker). The book, which was first published in 1917, covers some studies he did on the trading behavior of accounts at the time. What he found was timeless.

The language is charmingly stuck in the World War I era. “At the fag-end of the never-to-be-forgotten ‘war brides’ market,” he begins, “I began, in a casual sort of way, to analyze the accounts of half a dozen of the firm’s most active traders.”

During the “war brides” market of 1914-15, defense stocks and industrials surged in response to the outbreak of World War I. [Editor’s note: “War bride” was a nickname for what we now call “defense stocks.”] But Guyon found that even though such stocks had already made large moves up, his firm’s clients had big stakes in them with small profits. This was not a unique circumstance. Guyon found that this was the way the top of every bull market looked, in his experience in the brokerage business. In 1917, there was a bear market, and these traders lost money.

Why?

This is where Guyon’s studies yield a few interesting results. He looked at five leading stocks these accounts traded: United States Steel, Crucible Steel, Baldwin Locomotive, Studebaker Corp. and Westinghouse Electric. He analyzed the buy and sell decisions on each account and summed them up.

What he found was amazing. All of these stocks scored large gains during the war brides market. Yet “the average price at which each stock was bought for the six accounts was higher than the average price at which it was sold.”

Clearly, people bought them mostly after they had already gone up a bunch. Then they sold them when they fell.

Guyon did another study in which he looked at the order books of his firm’s accounts, plotting the buys and sells day by day from March 1916 to March 1917. A similar pattern emerged. The traders would buy a stock after the stock had risen. They would sell into declines. As Guyon wrote:

This analysis of transactions affords corroborative evidence of the same general trading faults that were revealed in the six accounts previously reviewed. Once again, the public sold too soon, repurchased at higher figures, bought more after the market had turned and, finally, liquidated on the breaks.

Tips, rumors, news — all these things Guyon thought only confused investors, pushing them to make emotional and ill-timed decisions. Guyon’s trading advice later in the book is not so useful, but the main point of his studies stands the test of time. The main point is simply that “the great majority of speculators are…consistent losers in Wall Street.”

Much of this reaffirms what is always true in the stock market. People chase price moves, rather than buy and hold (and sell) based on careful consideration of what they own.

People are also, everywhere, impatient. It makes me think of an old Far Side comic with two vultures sitting on a tree. If memory serves, one says to the other, “Patience, my ass! Let’s go kill something!”

Most people are like that vulture. They can’t wait. They need to “do something.” But as One-Way Pockets shows, “doing something” is often the wrong thing to do. Patience is better.

There are plenty of modern studies that find the same results as Don Guyon. Similar studies, yet more comprehensive, show how increased frequency of trading leads to poorer results relative to accounts with less activity. Other studies affirm that investors don’t even earn the stated returns on their mutual funds, because they take money out after it has done poorly (and the price is low), and add money when it has done well (and the price is high).

This is counter to all the good advice that is out there about investing from such greats as Warren Buffett, Peter Lynch, Seth Klarman, Martin Whitman and others who preach the virtues of buying cheap and holding on. It’s all out there, and you can acquire a first-class education about good investing for very little money. Yet, as Guyon writes, “These venerable Wall Street ‘dos’ and ‘don’ts’ have always reminded me of the ‘Stop! Look! Listen!’ signs encountered on a day’s motor trip, whose number and sameness cause them to be disregarded.”

I don’t know about you, but I find these things endlessly fascinating. That a man writing in 1917 could speak to us so clearly and usefully is one of the charms of markets. No matter what time or place, people are people, markets are markets, and they seem to behave in a universal manner.

Therefore, if we know what kind of behavior loses, we should do something different if we want better results. That would be picking up beaten-up stocks and riding them, rather than trying to guess at price movements and jump in and out of them.

So I’d urge you to be patient with your stocks. In my investment service, Mayer’s Special Situations, I have recommended a select group of promising stocks with tremendous upside potential. Not all of them will work out, of course. But as a portfolio, I think we will continue to have some big winners over the years.

Regards,

Chris Mayer
for The Daily Reckoning

The Most Common and Costly Investment Mistake originally appeared in the Daily Reckoning. The Daily Reckoning, published by Agora Financial provides over 400,000 global readers economic news, market analysis, and contrarian investment ideas.

One of the big questions of the year is whether China blows up or not. Hard landing or soft? When will the clock strike midnight on the Chinese? Things are slowing down, and it feels like it’s getting late.

But first, why does this matter? China matters because China is big. If this were 1980 — when China’s economy was about one-seventh the size of the US’s economy, no one would care. Today, the appetite China has for raw materials is no secret, and is one of the main reasons why miners and oilmen are flush with cash. So if you invest in miners and oil companies, then the answer to the hard landing question decides the fate of your portfolio.

For some ideas on this front, I turned to my friend Ben Simpfendorfer, founder of the Hong Kong-based Silk Road Associates (and author of an excellent book, The New Silk Road). He also writes a very good letter focused on China called China Insider. Ben speaks both Mandarin and Arabic and has traveled extensively in Asia and the Middle East. As such, he has an inside look on two cultures that few Westerners will ever see.

I admire his work for these reasons, and also because he is critical and thoughtful about China’s prospects, whereas many others are either unfailingly sunny or permanently apocalyptic.

In his latest letter, which just hit my inbox this morning, Ben addresses the very question I open with: hard landing or not?

“I expect no hard landing in 2012,” Ben writes. As for 2013-15, Ben is much more bearish. As with any prediction, though, the reasoning is more important (and more interesting) than the conclusion. The key is to understand that China still has a lot of spending power. Let’s take a look…

“China could afford to go on another debt binge in the event that the economy appears to slow abruptly,” Ben writes. “Sure, it has implications for medium-term growth (and I’ll get to that in a moment), but the ability to continue borrowing, or further relax fiscal and monetary policy, does rule out the risks of a hard landing in 2012.”

In the past, China was able to skirt the financial crisis because it simply commanded its state-owned banks and state-owned firms to embark on big projects. It has the firepower to continue to do so in 2012. One place it will certainly focus on is housing. Housing prices are falling nationally. But housing markets are intensely local. You should be suspicious of attempts to aggregate them. Ben appreciates this.

“A look at major city clusters around the country shows that property sales have collapsed in areas centered on Beijing, Shanghai and Hangzhou,” he writes, “even as they remain steady in places such as Chongqing, Hefei and Shenyang.”

Ben continues:

“My own experience — traveling through nearly a dozen second-tier cities over the past six months — echoes the data, with some cities clearly about to suffer a horrible property crash even as others look more balanced owing to less supply, but also a stronger local domestic economy (typically the coastal provinces) that is less reliant on fiscal stimulus.”

As to that stimulus, China’s government plans to build 7 million public housing units annually over the next five years. This is a big increase from the 3 million units China’s state-owned units built in the years 2008-10. And it’s also a lot bigger than the 5 million units the private sector created over that time.

But think what this means. It’s an artificial stimulus. Its goal is mainly to keep people working. However, the market itself clearly does not support such an increase. Ben peels back some of the numbers on the profits earned by builders.

The five large state-owned firms earn profit margins of only 8%, according to data compiled by SouFun (a leading real estate data provider). This compares with 15-25% profit margins for private companies in recent years. I’m taking these at face value, though my suspicion is that the data overstate the profitability of the public firms.

You know, though, how economics works. As profit margins shrink, this is the market’s signal that the capital is perhaps best used elsewhere. Governments can ignore this signal, at least in the short term. But private firms cannot. They must serve the wishes of consumers or they will go out of business eventually. They also have owners who will see that the profits no longer compensate for the risks. They will pull back. And this is what’s happened.

This next chart is telling. It shows you the number of units built each year by private and public firms. You can see the big jump in public construction, which was part of China’s stimulus plan. But look at that blue line. It’s leveled out and declined last year:

“In effect,” Ben sums up, “the shift toward construction of more public housing implies that state-owned firms, operating at smaller margins, will capture an ever-larger share of economic activity…at the expense of the more-dynamic private sector.”

So more and more of China’s economy becomes dependent on government spending. We know that such government spending leads to bridges to nowhere. Or, in China’s case, empty office buildings, empty condo towers, empty malls and, indeed, empty cities. That’s a big problem — but it’s probably not a 2012 story.

Ben concludes: “Whether because of chances that a property crash is limited to certain parts of the country, or because of China’s ability to pump more credit into the economy, the odds are that 2012 turns out to be surprisingly dull, with the economy slowing, but still growing at above an 8% rate…”

It’s also an election year in China. Senior leadership will change in China in late 2012. All the more reason to expect massive spending from government coffers to keep the spell unbroken, if only for another year.

The time frame just beyond 2012 is the problem. Maybe the government spends so much that it produces reasonable-looking economic numbers and keeps people employed, but the resulting economic growth would have been a fantasy. Economies exist only to satisfy human wants and needs. They do not exist to produce numbers that look good in economic reports. China’s economy will have failed, just as other state-directed economies have failed, in its essential task of serving consumers. It becomes, then, an expensive fiction. China’s coffers, as rich as they appear, are also not inexhaustible. All of this means there is an inevitable quality to the collapse here, though the timing is hard to call.

At least for 2012, it seems investors can count on China coming to the table with its usual gusto to spend money. But the clock is ticking and midnight approaches.

Regards,

Chris Mayer
for The Daily Reckoning

China’s Cinderella Story originally appeared in the Daily Reckoning. The Daily Reckoning, published by Agora Financial provides over 400,000 global readers economic news, market analysis, and contrarian investment ideas.

My wife, Carol, was standing nearby. “I know what it is,” she said.

I froze.

Later, she told me she didn’t want to say what it was so I wouldn’t freak out and she could flick it off. But when I gazed down at my chest and saw this nasty-looking scorpion making his way up toward my neck as if to finish the job, I let out a yell and brushed the thing off… and improbably, it landed right on to my wife’s hip. She, more calmly, flicked it off and killed it with a flip-flop.

We were in Nicaragua with the family for the holidays. Fortunately, the sting, while painful, is otherwise harmless.

Well, that’s frontier markets for you. There are great reasons to visit Nicaragua: pristine beaches that you will have almost to yourself, the charming architecture of its old colonial cities such as Granada, the inexpensive food and lodging and much more. But it’s still a frontier market with bad roads, unreliable power and a large poor population.

There are great opportunities, but also the potential for painful setbacks. The sentiment, of course, applies to all markets — and life in general.

Welcome to 2012. What opportunities and surprises can we look for in the year ahead? Some thoughts…

Total federal outlays rise again. This one seems unstoppable. The U.S. government will spend more money in 2012 than in 2011, despite everything. It’s incredible to think that as recently as 2007, federal outlays totaled $2.7 trillion. In 2012, we’re looking at $3.6 trillion!

This means the government will likely have to finance an increasingly larger deficit. And why not? If investors are going to be so foolish as to lend the government money for 10-year terms at a rate of 2% or so, it’s like free money. The problem is that interest rates don’t stay low forever and investors don’t stay dumb forever. Just ask certain members of the EU. When doubts surface about your creditworthiness, rates don’t just slowly crawl upward. They jump — and then it’s “game over” pretty quickly.

Will 2012 finally be the year that marks the beginning of the end of the long bull market in Treasuries? I think so.

Multigenerational households in the U.S. rise. People are living longer and outliving their financial resources. The financial crisis of 2008 and the lackluster stock market of the last decade haven’t helped. Plus, medical bills have soared. So where do people turn for help? Family.

As The Wall Street Journal reports, about 39% of adults with parents 65 years and older say they’ve given them financial aid in the past year. And more and more households are becoming multigenerational households.

This is a return to an older order. In 1900, 57% of adults aged 65 and older lived with relatives. I think this is a long-term trend in the making — with unclear investment implications. But it seems a fundamental shift is taking place in the American household. I’d bet the number of multigenerational households rises again in 2012.

The curtain falls on the Chavez regime in Venezuela. The year 2011 was a bad year for dictators of all sorts. I think 2012 will also topple a regime or two. At the top of my list is Hugo Chavez. Venezuela will hold a presidential election in 2012. Meanwhile, the quality of life in Venezuela continues to deteriorate. There are reports of 30,000 people living in shelters awaiting Chavez to deliver on promised homes. There are shortages of basic goods, made worse by a 27% inflation rate. All the while, Chavez is battling poor health. The election will be the spark that ignites the uprising that will end his regime.

The stock market advances. Why? Because it seems improbable, and the market often does what is least expected. It’s easy to draw up an ugly scenario for 2012, mostly focused on the EU imploding. It’s harder to imagine the market having a good year, which is exactly why it will have one.

Now, I have no faith in market calls, as you know. So I make this prediction somewhat tongue-in-cheek. In truth, I don’t waste time thinking about what the market is going to do next. It’s unpredictable, and I’m a long-term investor anyway.

Lots of folks will try to divine market direction using all kinds of flawed tools. For instance, I read over the weekend that the S&P 500 (going back to 1928) has had only nine years in which the return was plus or minus 5%. The average return the following year was 26.3%. Only once did the market fall in value the following year. That was in 1940, the year after Germany invaded Poland. Even then, the market fell only 9.8%. The positive years ranged from returns of 14.3 to52.6%. This, of course, led our market seer toward optimism for 2012.

These kinds of things are interesting but mean nothing. The market is not bound by its own history. Mr. Market does not pull cards from a deck of defined possibilities. It can pull five kings. It can grab two aces of spades. It can draw a card we’ve never seen before. Keep that in mind and stay focused on what you own, not on where the market might go.

Commodities rebound a bit, but don’t top 2011 highs. It was a bad year for commodities. Most fell, as shown by the Dow Jones-UBS Commodity Index. I think we’ll see some rebound, but an unfolding recession in the EU will be too much to overcome, and the index won’t top its 2011 highs.

This doesn’t mean you can’t make money in commodities. If prices for oil stay at $100 per barrel, there will be plenty of oil companies and services stocks that will do quite well.

Gold stocks have a great year. The market hated gold stocks in 2011, especially the juniors. The MarketVectors Junior Gold Miners ETF (GDXJ) is made up of small mining stocks. It fell 38% in 2011. This, despite gold itself finishing the year modestly up.

The market is offering low multiples on gold stocks right now. Price-to-cash-flow multiples, for instance, linger near generational lows. Gold doesn’t have to go up for these stocks to make a lot of money.

However, I think gold will make another run at $2,000 an ounce in 2012 — and exceed it. All the factors that drove gold to new highs in 2011 are still in place. The world’s monetary system is still a mess. And its leading brand, the U.S. dollar, is not well.

Combine a rising gold price with low multiples and you have a kind of financial rocket fuel.

Regards,

Chris Mayer
for The Daily Reckoning

Joel’s Note: Chris’ Mayer’s Special Situations research letter is considered mandatory reading ’round here at (the admittedly diffuse) Daily Reckoning H.Q. His next investor alert is due out tomorrow. Get yourself on the list with this one-page sigh-up form and enjoy 60 days to test drive Chris’ service, risk-free. Worst case scenario, you receive tomorrow’s letter and decide it’s not for you. Best case, you’ve discovered a valuable partner to help guide you through the market tumult ahead. Either way, it takes two minutes to get onboard. Do it here.

My Crystal Ball for 2012 originally appeared in the Daily Reckoning. The Daily Reckoning, published by Agora Financial provides over 400,000 global readers economic news, market analysis, and contrarian investment ideas.

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

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

Beta is the common measure of volatility. If a stock has a beta of 1, it means it moves in step with the overall market. A beta of 1.5 means it moves 50% more than the market. So if the market went up 10%, this stock went up 15%. A low beta of 0.50 means the stock moves only half as much as the market. It’s this last fish that is the choice catch in today’s market.

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

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

Why?

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

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

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

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

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

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

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

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

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

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

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

Regards,

Chris Mayer
for The Daily Reckoning

Volatility is Your Friend originally appeared in the Daily Reckoning. The Daily Reckoning, published by Agora Financial provides over 400,000 global readers economic news, market analysis, and contrarian investment ideas.

GlobalPost expects its correspondents to live in the countries they write about. Co-founder Charles Sennott put together a correspondent’s field guide with key points he expects his writers to live by. No. 1 on the list is simple: “Be there.”

I love this idea. I am also mindful of its wisdom in my own investing adventures. (This is why I rack up a lot of frequent-flier miles.) There is no substitute for being there.

Today, I’m in Nicaragua. It’s morning here as I write you from a palm-fringed house perched on a bluff overlooking a gorgeous stretch of beach at Rancho Santana. Before I visited Nicaragua for the first time, it was simply a place on a map. It was an abstraction. If anything, it was a set of received ideas — bits gleaned from other people, reflecting all the biases you’d expect.

Now Nicaragua means something very specific. It is a house with a pool surrounded by coconut trees. It’s green mountains and white surf and ocean breezes. It’s a warm pile of rice and beans and fried plantains. It’s friendly people and good times.

I was here with a group of readers over the weekend. They were looking at possibly buying real estate here. That is an idea that many people back home in the US would think a bit nutty. Back home, Nicaragua often means something that has little to do with the substance of what it actually is. Nicaragua means Sandinistas. It means Ortega. It conveys a vague sense of menace. To invest here would seem insane.

But the ground truth is different.

On Saturday, Joel Bowman and I delivered the first presentations ever made at the brand-new clubhouse in Rancho Santana. It was a very low-key affair. (I gave my talk in bare feet.) My task was to provide some macro context for Nicaragua. Some of the ideas I included in my talk are below, based on my own ground truth.

The big thing everyone thinks of first is el presidente, Daniel Ortega. Business people and investors in Nicaragua have no particular love for Ortega as far as I can tell. But they also believe he has been good for investors. He has provided tax breaks, carved out free-trade zones and boosted infrastructure investment.

It’s not an ideal free market, of course, but it’s now functionally superior as such to many other markets investors might rank offhand as better. The proof is in the pudding. Hear it from Carlos Pellas Chamorro, the richest man in Nicaragua. He is the controlling shareholder of Grupo Pellas, which has an oar in seemingly every boat: sugar, rum, banking, media, insurance and more.

A reporter once asked him if open and free markets really work in Nicaragua. He said:

“Open and free markets work everywhere when you let them. Of course, there are many obstacles in Nicaragua, as in all emerging nations… Many sophisticated foreign investors like Citibank, GE, Grupo Roble, Cemex, America Movil, Telefonica, PriceSmart, Wal-Mart, Cargill and many others have invested large sums of money in Nicaragua, obtaining very attractive returns.”

Those of us who have been down here have known these things for years. Only recently, though, has the ground truth started to seep into the mainstream press.

Still, most Americans would be surprised to learn Nicaragua is the second safest country in Central America, behind only Costa Rica. Or that the World Bank ranks it as the easiest country in Central America, Panama excepted, in which to start a new business. Or that in “ease of doing business,” Nicaragua ranks well ahead of such perennial darlings as Brazil or India — or even neighboring Costa Rica. A recent IMF report said that Nicaragua was the Central American country that best protected investors’ rights.

There are always uncertainties. But sometimes I think people almost reflexively assume that a foreign place has greater risks than back home simply because they overlook — or have grown complacent — about the risks they’ve lived with for so long.

Realities, too, can change. Places can go bad, like overripe fruit. But they can also re-emerge. In this way, the investor’s chore (or pleasure) is clear: to stay informed, to always seek out and gather fresh insights, to revise opinions accordingly so they do not grow stale and cost you a lot of money.

Great opportunities in markets often emerge simply because investors are relying on old assumptions or on ideas posed by people who have never checked things out up close. There is then an opportunity to get in at good prices and wait for the rest of the world to catch on.

This is always important, but the idea of ground truth seems it will be more important in 2012, as a number of big questions linger unanswered in 2011: What is the fate of the EU? Who will be the US president after the 2012 elections? Will gold get back to $2,000 an ounce? Will the US Treasury bond bubble pop? Will the BRIC countries slow further in 2012 or reverse course? Can commodities rally in the face of tepid economic growth?

It feels like 2012 will be an important year, maybe even a pivotal one, in the changes it could bring. Those who rely on ground truth have a better shot of ferreting out opportunities as the world changes than those who don’t.

So here’s to finding more ground truth in 2012!

Regards,

Chris Mayer
for The Daily Reckoning

The Importance of “Ground Truth” originally appeared in the Daily Reckoning. The Daily Reckoning, published by Agora Financial provides over 400,000 global readers economic news, market analysis, and contrarian investment ideas.

Also of interest is the fact that the price of crude oil has been trending higher, even while the prices of most other commodities have been drifting lower.

The US is the world’s largest consumer of oil. It’s not growing much. Yet there oil sits, with a three-figured handle. I think it is a sign that challenges on the energy front will prove more stubborn than in the past.

One day last week, I found it interesting that the main two financial dailies I read every morning both featured special pullouts on energy.

The Financial Times report had a number of good nuggets:

• This is the first year the average oil price is $100 a barrel. In real terms, it’s the highest oil price since 1984.
• US consumers are on track to spend $200 billion more on oil this year than in 2010.
• Exxon Mobil’s capital spending budget for the first 9 months — $26.7 billion — was a record.
• Supply is tight; production from non-OPEC countries (such as Russia) has been disappointing.
• The US is an exception. It is reversing a four-decade decline in production and imports are down to 50% of consumption, instead of 60% as recently as 2005. (Canada is increasing production, too.)
• Tight government budgets are leading to lower subsidies for alternative energy. The brunt of this will be felt most acutely in Europe.
• China is the exception; subsidies for alternative energy have actually increased there.
• The nuclear renaissance is still a long way off. One article discussed the various phase-outs going on around the world.
• There is a new enthusiasm for LNG tankers.

Consider the portrait these bullets paint. To me, they speak to the challenge in producing enough energy to make a dent in prices. There are also some opportunities in these bullets — producing good old-fashioned oil still looks to be a good business.

The Wall Street Journal called its report “Big Oil Heads Back Home.” Some main points:

• Oil is shifting its attention from the Middle East to the West — oil sands in Canada, deep-water oil in Brazil and the Gulf of Mexico and shale oil in the US.
• By 2020, shale oil and gas will make up a third of US production, which could shift power away from OPEC. (The Saudis are worried.)
• Smart grids are coming. There was an article about energy-monitoring devices and other means to increase efficiency and save money.
• Interesting article on Churchill County in Nevada, which is enjoying a boom in geothermal energy.
• Biofuel companies are getting into other markets, selling stuff for skin care and beauty products. (Biofuels, like other renewables, are in trouble.)
• US battery companies are having a hard time trying to survive as they get strong competition from overseas and the adoption of electric vehicles remains slow.
• Townsville, Australia, plans to lay a cable to take hydropower from Papua New Guinea, some 600 miles away.
• How China slowing its nuclear program over safety worries is creating opportunities for some firms.
• How “clean coal” is a boon to companies selling filters and other means to reduce emissions.

This report was more focused on the ways in which people are changing their behavior, about how people are figuring out new ways to create energy and to get it where it needs to go. It’s also more about the frontiers of energy and how they will contribute meaningful slices to the pie.

It also makes me think about how energy is as much about place as it is about any particular source. In Nevada, they can tap geothermal. In Australia, they are trying an innovative way to tap a river in Papua New Guinea for hydro-power.

You can’t really say geothermal is a great energy source. It is in some places, yet it won’t work in others. Ditto, hydro-power. But these stories show you how innovative people can be. And they show you how things can happen that no one would’ve guessed even a handful of years ago. I mean, US oil and gas production up enough to threaten the Saudis? That would’ve been a surprising prediction not too long ago. Yet it’s happening.

These stories also show how political energy is. Everywhere. Government policy has a big impact on the energy mix pursued. Big subsidies for solar, particularly in Europe, essentially built that industry to a point it would never have reached without the help. But now, with austerity measures and tight budgets, a shift in policy can destroy it.

An energy investor has to keep an eye on a lot of things. Technologies change. Consumer patterns change. Government policies change. But the overall backdrop is pretty strong for the producers of energy. The most powerful evidence is the most obvious: Amidst all the turmoil and slow growth in the big markets of the US and the EU, oil is over $100 a barrel.

Regards,

Chris Mayer
for The Daily Reckoning

$100 – The New Floor for Crude Oil originally appeared in the Daily Reckoning. The Daily Reckoning, published by Agora Financial provides over 400,000 global readers economic news, market analysis, and contrarian investment ideas.

Keynes also divulged a key insight that helped him do it, back in 1936.

“There is no sense in building up a new enterprise at a cost greater than that at which a similar existing enterprise can be purchased,” Keynes wrote. On the other hand, there is an incentive to spend money on projects, even “an extravagant sum, if it can be floated off on the stock exchange at an immediate profit.”

In that paragraph is an idea so powerful it helped Keynes beat the Great Depression. An American economist named James Tobin polished up Keynes’ insight and popularized
it. In 1969, he created Tobin’s Q, which summed up Keynes’ idea in equation form:

Market value of company / replacement value = Tobin’s Q

Replacement value is the cost to build an asset from scratch. You may recognize this now. As Keynes surmised, if you can buy, say, a steel mill for $500 per tonne of capacity in the stock market when it costs $1,000 per tonne to build one from scratch, you buy the stock.

Most businesses will trade for a premium to replacement value because of the time and risk of building from scratch. But to be most conservative, we want Tobin’s Q to be under 1. This works because the market adjusts over time as market participants buy the cheaper asset. This is also where you tend to see buyouts, which is exactly what happened with PotashCorp.

When I recommended this stock to the subscribers of Capital & Crisis, it was selling for about half of its replacement value (a Tobin’s Q of 0.50). BHP made a play for it, the gap closed and the subscribers who acted on my recommendation nearly tripled their money in less than two years.

We own many stocks with Qs under 1 (CVA, KRO and OI, to name just a few buy-rated tickers). And many big gains on the back page are in stocks we picked up at low Q ratios (including TIE, MEOH and GSM, to name three). We also want to avoid the extremes on the other end of the spectrum.

This takes us to the second part of Keynes’ observation. Let’s look at how this works with a real-world example from the telecom industry of the 1990s. At the height of the boom, telecom companies commanded a stock market value of, on average, $6 for every $1 spent building networks. So, no surprise, the telecom industry spent money like drunken sailors.

Level 3 spent $10 billion building out a fiber-optic network. It had no revenues, yet enjoyed a stock market value of over $30 billion. KPN West spent about $2 billion, and the market valued it at $11 billion. Global Crossing traded for eight times what it spent on its network. With that kind of incentive, the industry poured some $500 billion toward creating 150 new carriers — 40 of which were public — and eight new national networks
(with more than 100 miles of optical fiber) from scratch.

As author Edward Chancellor summed up: “When a hole in the ground costs $1 to dig but is priced in the stock market at $10, the temptation to reach for a shovel becomes irresistible.” Of course, the whole thing ended badly. The tech bubble finally burst in 2000. Bankruptcies and massive losses soon followed.

And this is just one example from many. I’ve yet to find a stock market bubble from any country — from any era — that doesn’t show the same stripes.

Despite Q’s powers, I don’t find many investors using it. Maybe it’s because Q takes some digging to figure out. That’s part of its appeal. One group that does use it is Marathon Asset Management. The folks behind Marathon put together a book with Ed Chancellor in 2004. It’s called Capital Account: A Money Manager’s Reports From a Turbulent Decade, 1993-2002. If you want a more-detailed look at how this all works, I’d recommend the book to you.

The money managers at Marathon are the only ones I know of who put Tobin’s Q — which they call a “truly remarkable investment tool” — at the heart of their investing process. “The stock market is really a market in replacement capital,” they write. It gives off signals where investment dollars get the biggest bang for the buck, for good or for ill, as we’ve seen.

Marathon has used these signals to great effect. In May 2000, Marathon warned the “capital flows unleashed by the new economy” — all that money flowing into tech, telecom and media — would lead to big losses for investors. High Tobin’s Q ratios kept Marathon away. Instead, they steered clients to stocks in which Tobin’s Q was low. At the time, this meant hard assets — such as commodities. It was a smart move, as hard assets enjoyed a stellar decade. Meanwhile, tech, telecom and media blasted away fortunes.

What does Tobin’s Q say to buy today?

US housing. As it happens, Tobin used the housing market to explain how Q worked, which is worth recounting, given what we’ve been through with the housing bubble. Tobin talked about how home prices far in excess of the cost to build them would lead to a building boom as builders took advantage of the profits available. Over time, though, the market would adjust. “In the longer run,” Tobin wrote, the building boom would “bring market values in line with replacement costs, lowering the former and, possibly, raising the latter.”

This is exactly what happened. Prices came way down. The wide profit premium that came from building houses vanished. Today, in some markets, houses trade below replacement cost — a Tobin’s Q below 1. And that’s why we’re building new houses at a rate of around 500,000 annually, down from a 1.6-2.0 million run rate pre-bubble.

If he were alive today, Keynes would be a buyer. Following the indicator inspired by his idea, count me bullish on housing as well.

Regards,

Chris Mayer,
for The Daily Reckoning

The Power of “Q” originally appeared in the Daily Reckoning. The Daily Reckoning, published by Agora Financial provides over 400,000 global readers economic news, market analysis, and contrarian investment ideas.

That’s the curious thing about water. There always seems to be either too much of it or not enough. What follows is another look at my favorite commodity and the opportunities of investing in it.

At breakfast at the Raffles in Phnom Penh, I read a story about how Levi Strauss is trying to minimize its water use. A pair of blue jeans will consume over 900 gallons of water in its lifetime. That includes everything from the water to irrigate the cotton crop to multiple washings of the jeans.

The pressure is mounting on Levi, and other companies, to reduce their water footprint. Miners, food companies, tobacco companies and beverage makers all face pressure to use less water. In many places where they operate — such as India or China or Africa — fresh water is in short supply. This forces a re-examination of everything — from favoring drought-resistant crops to creating new ways to sanitize things.

Companies are also looking to use all of this to their advantage in marketing. Imagine idyllic farms in India with a smiling farmer using new efficient irrigation methods financed by Levi Strauss. However it may reflect reality, such an ad would appeal to the feel-good consumers of today.

The one part of the story that caught my eye was on a 15-acre cotton farm some 90 miles west of Mumbai. The farmer uses drip irrigation, a method of delivering water and fertilizer piped through veins spread over his fields. It’s vastly more efficient than flood plain irrigation, as the water gets right where it needs to go. There are also fewer weeds and less need for power, a not small consideration in a country in which periodic blackouts, however brief, are as common as flies. The farmer reports his water use is down 70% since using drip irrigation.

A group called the Better Cotton Initiative installed the irrigation equipment. The founders are a group of organizations and retailers, including Gap, Ikea and Adidas. Ikea hopes to use only “better cotton” by 2015. Adidas promises to do so by 2018. You can see how this is appealing to the companies.

There was a time when US companies didn’t really want to know what went on in their factories overseas. That time has passed, probably for the better. In an age when any competitive edge can be a difference-maker, why not try to gain an edge in customers’ minds this way and do some good for the world in the process?

The market is saying it approves. Early research indicates customers like to think they are changing the world for the better. Products that meet that need will enjoy an edge over those that don’t.

Given all of this, I think it is a profitable exercise to think about what kinds of companies benefit in such a world. What kinds of companies enable such a world? As it turns out, there are plenty of them.

Water is a $500 billion industry. You could break that into two giant buckets.

The first is water infrastructure. These include the water utilities — some 250,000 of them globally. These are necessary assets of vital importance wherever they are. They absorb a steady amount of spending that tends to be pretty resilient, regardless of what’s going on in the economy. Population growth drives the creation of new utilities every year. See the chart below on US water and sewer construction spending.

If anything, we’ve underinvested in these facilities over time, leading to leaky pipes and contaminated water. There will be a lot of pressure here to gain efficiencies.

The second big bucket is applied water. You can think of this as irrigation and industrial water uses (such as those used in the manufacturing process). Irrigation is a big one, representing some 70% of applied water use.

Emerging markets play a big role in all of this. Just over the next five years, China alone will spend nearly $50 billion on water, mostly on water treatment systems and flood control projects. In India, there are plans for 30-plus power plants by 2017 — all of which will use heavy amounts of water for cooling. India also has large irrigation projects on the docket, which will divert rivers and soak parched farmland. In Africa, where mining companies are busy cracking open the earth to get at much-sought goodies, there will be a great need to manage the water use of these projects.

As you can see, water touches almost everything — from energy and mining to basic food production and manufacturing. You want to talk about shale gas and the great revolution in American energy? Well, water management is going to play a big role there — testing it, filtering it, recycling it. You want to talk about feeding 9 billion people by 2050? We’re going to need to manage our water assets more intelligently. You want to talk about technology? New smart phones, computers and lifesaving drugs? All of the companies that make these things use tremendous amounts of water. And they need the water to be pure and meet strict standards.

The beauty of water as an investment theme is that “inevitables” power these trends. There is really no way to get around it. If you think about the pressures applied by population growth and urbanization, you can readily see how important efficiency and sustainability will be.

You don’t have to get a lot of things right, either. You don’t need to know what the world’s favored energy source will be in the future — coal, natural gas, nuclear or alternative energy — it doesn’t matter. They all use water, and lots of it.

Water was the key theme that kicked off my Mayer’s Special Situations newsletter in the summer of 2006. The original Blue Gold Portfolio unveiled five stocks with exposure to powerful trends emerging in water — the need to purify it, preserve it and move it. That portfolio delivered an 87% return in its first year and has been a solid winner ever since. We’ve added names since then and over time have sold off some or watched them get bought out. Now only two stocks remain, both part of the original set.

Water remains one of my most favorite investment sectors.

Regards,

Chris Mayer,
for The Daily Reckoning

Water – Still Blue Gold originally appeared in the Daily Reckoning. The Daily Reckoning, published by Agora Financial provides over 400,000 global readers economic news, market analysis, and contrarian investment ideas.

My friend Brad Farquhar is the co-founder and vice president of Assiniboia Capital, which invests in farmland. We had just driven through a canola farm some 50 miles outside of Regina, Saskatchewan. And apparently, the canola crop can get sucked in the car engine and cause a fire.

Worried about a smoky smell, we pulled over to check it out. But we were clean.

You may recall I wrote about Brad and canola investing in the August 2010 issue. (Note: Assiniboia’s canola partnerships are open only to non-US citizens. Blame the SEC and IRS for the draconian rules they impose.) What follows is an update, plus, a pair of new ideas from my Saskatchewan field trip.

The yellow flowers of the canola plant dotted the Saskatchewan prairies while I was there. The plants were full and tall under deep blue skies. Prices for canola are healthy. “This should translate into a net return to investors of between 20-25% for this year,” Brad told me. “We won’t know the final numbers until the crop is completely harvested and shipped, but about 80% of the variables are now removed. The final results may even edge up a bit more as some pretty good-looking fields get combined.”

Last year was a tough year, a kind of worst-case scenario. Excessive rains soaked the prairies. It tested Assiniboia’s business model, which aims to keep risks low by using crop insurance to cover the downside. The partnership broke even, a victory given the conditions. In a best-case scenario, the partnership could double its money in a season. Not a bad set of outcomes.

I like these kinds of ideas, and not only for the payoffs. Whatever happens in Europe
or in the debt markets, the intrinsic usefulness of farmland and food crops seems to offer a relative safe house — with a good shot at making a lot of money as well.

There is another reason, though, to favor such assets. It has to do with something called EROEI, which stands for “energy return on energy invested.” It is an expression of the idea that it takes energy to create energy.

Stephen Johnston at Agcapita is another one doing similar activities up here. I know Stephen as well, and he pens an interesting free monthly letter. (You can get it here.) In his September letter, Stephen talked about “EROEI decay.”

“I feel confident that EROEI is an acronym that will receive much wider recognition over the next decade,” he writes. “Because we are in the process of transitioning from high EROEI sources of hydrocarbon energy to low EROEI sources — think Saudi Arabia versus the Alberta oil sands.”

Stephen points out that more and more of our energy is coming from sources that require more and more energy to extract. He gives us some approximate EROEI ratios for various energy sources:

1970s oil and gas discoveries: 30 to 1
Current conventional oil and gas discoveries: 20 to 1
Oil sands: 5 to 1
Nuclear: 4 to 1
Photovoltaic: 4 to 1
Biofuel: 2 to 1.

Currently, the world produces around 86 million barrels of oil per day. But 86 million from high EROEI sources is much different than 86 million from less-efficient sources. “Effectively,” Stephen goes on, “the net energy left over to drive economic growth is significantly lower in the latter scenario.”

Why does this matter? Simply put, a lower mix of EROEI sources means higher prices for many commodities, because it will take more energy to produce them. This doesn’t automatically mean commodity producers win, however, because people can adjust their behavior.

For instance, when gasoline prices get too high, people cut back on their driving and find ways to save on gasoline. Economists call this the “elasticity of demand.” It means that demand can give and bend, like an elastic band, limiting how high prices will go.

But not all commodities bend so easily. Food is one. EROEI predicts higher food prices, because modern agriculture depends heavily on fossil fuels for irrigation, fertilizers, herbicides, storage and transportation.

Stephen gives examples. The most striking is with irrigation. “Irrigation accounts for approximately 20% of US farm energy use,” Stephen writes. In areas where water is scarce, such as in India, over half of all farm energy use simply drives irrigation pumps.

So in a world in which EROEI is on the decline, those assets with lower energy intensity will enjoy an advantage over less-efficient competitors. Might Canadian prairie farmland, which has no need for irrigation and low fertilizer needs, thrive in such a world?

I believe so. And this is one reason I’ve directed readers of my Mayer’s Special Situations letter toward investments in the province. Most of my field notes on Saskatchewan wound up in that letter, because we own a pair of companies based there.

One is a company called Viterra. It is one of my favorite long-term agribusiness holdings. Viterra processes grain, getting it from the farm to markets worldwide, as well as storing grains in a network of silos and sheds. It also sells seed, fertilizers and equipment to farmers. It also turns raw materials into animal feed and food ingredients. The stock is under my buy price of C$11 per share and trades for about 12 times earnings.

Viterra’s headquarters are in Regina. In fact, its main building was only a few blocks from my hotel. But it has a global presence with trading hubs, terminals and processors in Asia, Australia and Europe.

I like Viterra as a play on Saskatchewan’s bountiful harvests. And recent market woes have put the stock on sale.

Regards,

Chris Mayer,
for The Daily Reckoning

Crack This Code: EROEI originally appeared in the Daily Reckoning. The Daily Reckoning, published by Agora Financial provides over 400,000 global readers economic news, market analysis, and contrarian investment ideas.