January Is A Month For Fools

The Daily Reckoning PRESENTS: When you read The Daily Reckoning, chances are you’re getting a macroeconomic analysis of what’s going on in the world – from the housing bubble to the price of oil. Today though, we look at the other side of the coin – and let small-cap superstar James Boric “defend his micro territory.” Read on…

JANUARY IS A MONTH FOR FOOLS

I hate January. It’s a month when fools make predictions about what might (but probably won’t) happen in the coming year. Articles are written about absurd phenomena like the “January Effect” – which is about as useful to investors as a six-pack of O’Doul’s is to an alcoholic. And every macroeconomic analyst in the nation thinks this will be the year he “gets it right.”

Truth be told, none of us has a clue what will happen 30 seconds from now, let alone 6-12 months out. You don’t know if oil will go to $100 a barrel…if gold will hit $1,000 an ounce…or if the housing bubble will finally burst.

And you know what? When it comes to investing, you shouldn’t care – at least not very much.

Peter Lynch said, “If you spend 13 minutes per year trying to predict the economy, you have wasted 10 minutes.”

Warren Buffett declared, “I don’t make guesses [regarding the economy], and when I do, I don’t pay attention to myself. Charlie and I never talk about macroeconomics. It’s fashionable for banks to have economists making forecasts. So they say that GDP will grow by 4.3%, instead of 4.6%. So what?”

“So what?” is right!

Look, I don’t hate macroeconomics. But as someone whose office is in The Daily Reckoning war room, I am exposed to far more than 13 minutes of this stuff a year. That can’t be good for my health – let alone my portfolio.

I know we are in a commodities bull market. I know we are on the verge of seeing an inverted yield curve for the first time since 2000. And I recognize that the United States is deep in a pile of its own debt.

But you know what? I’d rather spend 10 hours a day plucking every hair from my body than worrying about trends that may or may not pan out. After all, how long have I been hearing about a housing collapse? How long has the dollar had a bull’s-eye on its back? And how long have we heard about the United States’ impending collapse as a mighty empire?

It’s easy to make predictions. And if you make enough of them, you’ll probably even be right every once in a while (at least eventually!). But I’ve made a conscious choice in my career to leave the prediction-making business to someone else and to focus on something much more concrete, measurable and rewarding…uncovering solid businesses that are selling for discounts to their future worths.

There’s a reason Lynch’s Fidelity Magellan Fund grew from $20 million in assets in 1977 to $14 billion in 1990. There’s a reason Warren Buffett is worth $30.5 billion today. There’s a reason Ben Graham, Forrest Berwind Tweedy, Ralph Wanger, T. Rowe Price and Joel Greenblatt all made millions and millions on Wall Street…

They ignored the market’s fluctuations and the macroeconomic trends of the day in lieu of investing in good, well-run and cheap companies.

Crazy, I know. But if you are up for getting a little crazy today, I have a solid, well-run company to throw by you. It’s one I believe Lynch, Buffett and Wanger would own with their own money today. And it’s the kind of company that you can own and forget about for the next year or two and not lose any sleep over. Check it out…

VAALCO Energy (EGY:AMEX) is a small-cap oil company that cranks out 18,500 barrels of oil a day. I recommended it to my Penny Stock Fortunes readers a month ago at $4.12 a share. You macro guys may be horrified to know that my recommendation had absolutely nothing to do with the price of oil “potentially” rising to $70, $80 or $100 a barrel. And it had nothing to do with the fact that the oil and gas sector is up 54% in the last 12 months.

I recommended VAALCO because its sales are up 74.5% in the last three quarters. Its net income is up 32% in the same time. It is sitting on $45.3 million in cash to only half a million in long-term debt. And at 10 times earnings, a return on invested capital of 180% and an earnings yield of 36.1% – the company is cheap.

But aside from the growth and value aspects, what I like the most about VAALCO is that it has discovered a niche in the oil industry that 1) virtually no one else in the world can touch and 2) most investors are too afraid to act on.

This Houston-based company operates on several oil-producing properties – including a 750,000-acre field that cranks out over 14,000 barrels of oil a day itself – in the tiny African republic of Gabon. The country is roughly the size of Colorado, with a population of fewer than 1.5 million people. And nearly 100% of VAALCO’s oil reserves stem from its Gabon operations.

Talk about scaring the bejesus out of most investors! This company makes its money in Africa, for God’s sake. And nearly 100% of its supply comes from three oil fields in a country smaller than Colorado.

Yikes!

That’s exactly why this is a $5 stock – and not a $10 or $15 stock, like some much smaller oil companies that operate here in North America. But eventually, good ideas get discovered. And this one will too. You see, what most investors don’t realize is that VAALCO is so happy with production in its main Gabon oil field that it just signed a five-year contract extension with the government of Gabon to continue drilling and producing oil. Talk about a niche market advantage over its competition.

While everyone else is drilling in the Middle East, Canada and off the Gulf Coast, this little undiscovered small-cap company has a virtual lock on about 5 or 6 million barrels of oil a year. And at $60 a barrel and relatively low costs of operation (since it is already established in Gabon), it’s not hard to see why its profit margins are almost double the industry average.

I can’t predict that VAALCO will make my readers a dime in profits this year. It may not. But I do know a couple things:

1) The company is cheap and growing. It is trading for a 40% discount to its peers on a simple earnings metric.

2) If the market collapsed today and the housing market went into the crapper, I’d still like this company at current prices.

At the end of the day, we’ll see how this company does. I’ll either look like a genius or a goat. But one way or another, I know you don’t make money on Wall Street by making predictions. You make money by investing in solid, well-run companies on the cheap – companies like VAALCO.

Regards,

James Boric
for The Daily Reckoning,
January 19, 2006

P.S. Some of these solid and well-run companies haven’t hit the stock market yet – and this is where a lot of the biggest money is made. Companies with huge promise, already established products and a growing customer base…that are just on the verge of busting onto the scene…

Catching a company early on, when the private investors and insiders are loading up on shares, can make the handful of these early investors lucky enough to get in at the private level extremely rich…and in my latest report, I detail 12 companies that you can trade at the insider level.

Editor’s Note: James Boric is one of the leading small-cap analysts in the country. He publishes Penny Stock Fortunes and Penny Sleuth – both of which highlight tomorrow’s powerhouse companies while they are still trading for pennies on the dollar today.

Here at The Daily Reckoning headquarters we are carefree worrywarts. We buy gold and only worry for the fun of it.

What we worry about now is the remarkable lack of worry on the part of others. There is something unfair about it. Since others worry so little, we feel we need to worry more. For the moment, we carry all the world’s worries on our shoulders like a demented Atlas. Bond investors continue to accept yields so low they must think there is nothing to worry about. Even the junkiest bonds sell for historically low premia over Treasuries.

Stock buyers load up on Google at prices that make us dizzy; it is as if they thought Google would be the last new thing ever to come along. Volatility measures are as low as they tend to go, advisors are consistently bullish, and even the hedge funds have stopped hedging (there was no money in it, and they thought, nothing to hedge against). Hedge funds have joined the reckless chase for quarterly returns. Managers who prudently hedge against risk underperform their competitors; they are quickly shouldered out the way.

What is particularly odd about the present lack of worry is that there seem to be so many things to worry about.

This week, for example, the yield curve inverted. Lenders got more for short-term loans to the government than for long terms. That is odd in itself, of course. Risk increases with time. As the years go by, the more things that could go wrong will go wrong. Investors normally want a little extra yield to compensate for the extra risk they take. Yet, the yield on a three-month U.S. Treasury note was higher on Tuesday than the yield on a 10-year note. Go figure.

Something has clearly gone wrong already. But investors don’t seem to care. And they don’t seem to care either that an inverted yield curve is a classic sign of a coming recession. There are a lot of recession predictors. But the yield curve humping over in the wrong direction – with long-term yields lower than short-term yields – is the most reliable predictor of on-coming trouble.

Maybe investors don’t read the newspapers. Tokyo had to close its stock market on Tuesday. There were so many people trying to sell all at once – with major tech stocks plummeting – the exchange couldn’t keep up with it. Could that happen in New York? Who knows? But who worries?

Iran is also in the news lately. The neocons are threatening to bomb the place. We worry about a chain reaction that sets off explosions in the oil market, in derivatives, in emerging market debt, in Russia, in China…who knows where else? What if oil shot up to $100 a barrel? That seems like the least that might happen.

But again, we worry alone. Investors see nothing to worry about. We read in the Financial Times that Iran’s neighbor, Iraq, is planning to sell bonds – $2.7 billion of them. Who would buy bonds from Iraq? One who never read the paper? One who knew no financial history? One with brain damage? We can’t imagine an investor, prone to worry, who would do such a thing – unless the yield was spectacular. Yet, according to the FT, Iraq’s bonds will mature in 2028 and pay a coupon of only 5.8%!

Meanwhile, America’s federal debt pushed over $8 trillion recently. The money supply is exploding at a 20% annual rate. The trade deficit swells…along with the feds’ deficits. The economy looks like it has been stung on the face by a wasp. We Americans can barely look at ourselves in the mirror without feeling a little queasy.

Housing also seems worth a worry…or a mass. Early figures (and anecdotal evidence) tell us that buyers are disappearing. House prices are buckling in many areas. Inventories are rising. Does anyone bother to look on the wall; there must be some handwriting on it. If real estate prices stop going up, householders will lose an important source of easy money in 2006; the ATM machine in their bedroom will be closed down. Consumer spending and housing are 90% of GDP growth. Without the housing boom, the economy is almost certain to go into recession. Two million people declared bankruptcy last year – even with house prices rising at double-digit rates. Imagine what will happen when the boom ends?

Let’s see…in 2005, the median down payment on a new house was only 2%, on a $150,000 house. Nearly half of the buyers didn’t put down a penny. What happens if the house goes down in price by 2%? The buyer’s entire equity has disappeared. What if it goes down by 10%…or 30%?

We can already hear the refrain on drive-time radi “Take this house and shove it.”

Already, the highways out of California are getting crowded with people leaving the state. No wonder. The typical house in Los Angeles sells for $495,000. This is remarkable on several levels. First, have you seen the typical Los Angelino’s house? It is a misbegotten affair, designed by a company that specializes in schools and prisons, glued together with cheap materials, and graced with no natural charm. It is comfortable, but people feel no loyalty to it; they will get out when the getting is good.

Meanwhile, an equally disagreeable barrack can be found in another part of the country for less than half the price. In Jacksonville, FL, for example, the typical house sells for only $181,000. Pay levels in both cities are about the same. So, people are leaving the Golden State at the rate of about 100,000 a year. Shouldn’t California prices fall?

But do you worry about that? If so, welcome to a very small confrerie of worriers. The rest of the country is worry-free. Sans souci. Delightfully, blissfully, happily unconcerned.

Or maybe they notice the threats but figure they will offset one another…like a fire on a sinking ship…or a fat man who takes up smoking so he won’t have to worry about a heart attack…or a presidential race where both candidates are morons. Money supply growth is hyperinflationary, but debt defaults are deflationary. China is stealing our business, but China could blow up at any time. They are printing up new dollars by the billions, but people need more of them to pay their debts.

House prices are peaking out, but maybe now more people will be able to afford them. How will it end?

We not sure, but it never hurts to be prepared…and to grab the asset everyone will rush to buy when housing prices crash:

More news from our currency counselor…

Bill Bonner, back in London with more opinions…

*** “The flat tax is NOT THE ANSWER!” writes one DR reader in response to yesterday’s Steve Forbes essay.

“Initially proposed at 17% [while even Russia proposes only 13%], how long before the level becomes voted up [by Congress, of course] to 20%, then 23%, 25%, 30%, there is no limit to the voraciousness of an empire-building government. The tax would traverse the same route as has the postage stamp. I remember penny postcards and first class letters sent over 500 miles overnight for only $.02 !! The government now requires 195% more and delivery time is no longer overnight, despite advances in the qualitry and speed of transportation!!”

Addison’s response:

“Steve’s plan would require that a 60% majority vote in Congress would be needed to raise the flat tax once in place. A sixty percent majority? Like that will ever happen.

“Our interest in this subject came about while doing research for Empire of Debt. Before the Revolution of 1913 – the implementation of the income tax, the direct election of Senators and the establishment of the Federal Reserve – the feds didn’t have a blank check on the future. They had to raise the money they spent through tariffs and what not. After the income tax was in place, Congress felt free to borrow against future revenues with abandon.

“Then in the 30s, after FDR had racked up more debt then all the presidents before him combined, he needed a rationale for his plans. Along came “7 Economists From Harvard And Tufts” with a little book called A Planned Economy for the American Democracy. If ever there was an Orwellian socialist tract, this bad boy is it. I have it sitting on my desk as a reminder to the absurdities politicians get up to. In the book, they give the empire builders the justification they need to rack up debt ad infinitum. ‘It’s a public debt,’ they say, ‘And we owe it to ourselves. Therefore, we never have to pay it back.’

“Oy.

“It’s been a thread in the political fabric of the nation ever since. While we’re not sure, starting with an abolition of the IRS – a revocation of Congress’ blank check on the future – seems like a good place to start. We’re a resilient nation. It would be a shame to let the scaliwags in Washington ruin it for the rest of us.”

More tomorrow.

[Ed Note: The challenge to putting the IRS out of business is in the details. Both the Fair Tax and the Flat Tax have their pros and their cons. But let’s get this discussion started, eh? Stir the pot. If you go to Amazon, both books are available together at a discount:

Flat or Fair?

*** Gold might finally be correcting. We hope so. We would like to buy more. But instead of falling and consolidating recent gains, it keeps racing ahead of us. Early in a real bull market, there are typically major setbacks to test investors. Weak ones drop out. “Well, I guess that’s over,” they say to themselves. Or people who never believed in it at all are emboldened to crow: “See, I told you it would never take off.”

The bulls are discouraged. Many of them sell. The price drops. Often, it stays down for a surprisingly long period…building up another base. Then, it begins its upward march again.

Gold has doubled from the summer of 1999, when we first recommended it in The Daily Reckoning. Is that all there is? We doubt it. But we’d like to see a real correction to shake out the weak buyers and give us a chance to buy more at a lower price.

Richard Russell tells us that the average ratio of gold to the Dow is about five to one. That is, going all the way back to 1885, it took about five ounces of gold to buy a share in all the Dow stocks. That ratio went to an all-time high on July 16th, 1999, when it took 43.85 ounces of gold to buy the Dow stocks. It was about then that we announced our “Trade of the Decade” – sell the Dow, buy gold. Since then, stocks have eased off a bit and the price of gold has shot up. Currently, it takes about 20 ounces of gold to buy the Dow, a lot less than six years ago, but still a lot more than usual.

Will the normal relationship between the Dow and gold be re-established before the end of the decade? How? Our guess is that gold will rise, and the Dow will fall to meet it. The day is gold at $1,000 and the Dow at 5,000 is easy to imagine. We doubt it will stop there. Once in motion, markets tend to overshoot the averages. Briefly, in 1980, you could buy the entire Dow with just one ounce of gold. That day could come again too, says Russell, who guesses it will come with both the Dow and gold priced about $3,000.

*** Recently, walking home from work, we thought we saw our son Edward, 12, with a beautiful blonde. “No, it couldn’t be,” we said to ourselves.

But it was. He was walking her to the subway stop…so engrossed in conversation he had not even noticed his father on the other side of the street.

Elizabeth had just come back from a parent/teacher conference:

“They say Edward is doing much better. He’s paying attention in class and not yakkety-yakking with his friends,” she reported.

We asked Edward about it at dinner.

“Edward, your teachers say you’re doing better this term. They say you seem to have a much better attitude. Congratulations. We’re very proud of you…and glad to hear it. But what happened? Why the change in your comportment?”

“Dad, I just got tired of the teachers yelling at me…and not doing very well on my notes. And you told me that if I just paid attention and did my best, that everything would be OK and every day would be a good day.”

“Well, of course you can’t control everything. You’ll still have some days that aren’t so good. But if you’re doing your best…no one will be mad at you.”

“Oh…”

Later, Elizabeth revealed more of the secret.

“Maybe you didn’t get a good look at that tutor. She looks like a movie star. And she is very nice. Edward adores her. He loves it when she helps him with his work.”