Remember when people used to say that when quantitative easing (QE) ended, the stock market would tank? Surely you haven’t forgotten about QE? That’s when the Fed bought bonds to drive interest rates lower.

Well, if you plotted the Fed’s QE program against the S&P 500 (“the stock market”), you saw a nice, clean correlation. Ergo, it appeared that QE propped up the market. That chart got a lot of play.

But QE ended in 2014. And the market kept rolling. And until Wednesday’s sell-off, we were near all-time highs. So much for that!

Still, even today, you’ll find some people citing how the Fed’s actions “explain” 93% or whatever of the stock market’s movements since such and such a date. They’re like Flat Earthers with fancy charts and impressive-sounding lingo. But they’re just as hidebound and wrong.

This is the old “correlation is not causation” that your statistics teacher used to tell you about.

You may remember the old joke about the man on the street corner waving a red flag. Someone goes up to him and asks what he’s doing.

“I’m keeping the elephants away.”

“But there are no elephants here.”

“Then it’s working.”

Right.

And yet we still see nonsense like this example every day. But the nonsense is usually not so obvious. It is subtle. The correlations plotted seem plausible. But as Caltech professor David Leinweber warns us, “Just because something appears plausible, it doesn’t mean that it is.”

As I say, the world is a much more confusing and complex place. Drawing out reliable cause-and-effect relationships that hold firm in financial markets (and life in general) is hard. Maybe impossible.

As ever, humility and doubt are good guides here.

Whenever you see an “If X then Y” statement, you should distrust it. If interest rates rise (or fall), then stocks will fall (or rise)…

The problems here are many. First off, in markets, you can’t change one variable and leave everything else the same. Rates may rise (or fall), but what happens to sales growth? What about profit margins? What about countless other things that also continue to change?

Besides, which stocks? The earnings of brokers, banks, and insurance companies generally rise when rates float higher. We’ll see more about why generalizing is dangerous in a minute.

If the economy picks up speed, that’s good for stocks…

We got the “Trump bump” as the market rallied under this belief. But there are a lot of problems with this. The connection between economic growth and stock returns is murky. You can have a fast-growing economy and a lousy stock market (and vice versa).

There are a lot of other variables at work — such as valuations. And again, you must ask which stocks. (Plus, people throw around “the economy” as if it’s some big animal in the backyard that we can go out and measure. It’s not as if “the economy’s growth rate” is an objective number. It comes from making a lot of assumptions.)

So never be too sure of any prediction, no matter how seemingly logical or plausible it seems, based on such simple cause-and-effect analysis.

What we’re doing when we search for causes and effects is looking for patterns. We are pattern seekers. But that’s a risky business.

It was a physicist, R.D. Carmichael (1879–1967), who said: “The universe, as known to us, is a joint phenomenon of the observer and the observed.”

In short, we play an active role in what we see. Our experiences, our beliefs, our particular vantage point, among other things… all impact what we think we see.

This is why you should value perspectives that differ from your own. There is a chance someone else “sees” something you don’t see.

When I like a stock, I also try to understand the bear’s case. If I think a stock is cheap, I want to know why it is cheap. It may be that I’ve missed something or don’t understand something as well as I thought.

But sometimes, you get a good, firm grasp on what the prevailing thought on a stock is. Sometimes it is clear why people hate it and why it is cheap. And yet, at the same time, you also know why that view is not correct… and will soon be proven wrong.

I am particularly attracted to these situations where there seems to be a hard negative consensus. Those are situations where people are probably not doing a lot of thinking. (As Robert Anton Wilson used to say, “Convictions create convicts.”) I get very excited when I find them…

For example, last year I recommended AIG for Bonner Private Portfolio, the trading service Bill chose to follow with $5 million from his family trust.

We heard quite a howl from the gallery on that one. “AIG? That disgraced insurer? That blown-up relic from the financial crisis? This is madness!” The mailbag showed that more than a few readers were disappointed.

Only a few years earlier, Time magazine had a cover story showing a bomb with a lit fuse and the comment “Why AIG = WMD.” This was a company that had lost a lot of money.

Fast-forward to 2016, and AIG still had a terrible reputation. But all those old troubles were gone. The only thing was… most people still clung to the company’s embattled image.

What I saw, though, was an activist investor — the billionaire Carl Icahn — who had bought $2.5 billion worth of stock. He got himself on the board of directors, too, meaning he was in for the long haul. And he put pressure on management to improve.

But the stock price still reflected — more than reflected, even — all the poor results. Investors who bought the stock when I recommended it took little risk of loss because the stock was already about as low as it could possibly go.

Meanwhile, CEO Peter Hancock — hired in 2015 — had crafted a credible plan for a turnaround. It included selling off noncore divisions and returning excess capital to shareholders.

As of this writing, it’s been almost one year since my recommendation, and the stock is up almost 20% for us. Not only that, but I made it the biggest position in our portfolio.

For sustained success in the markets, it helps to remember that we are not passive viewers on the scene. We see actively. We make our world, in many respects; we see what we want to see. You must always consider the observer(s).

In short, don’t look for certainty. (A variant on a funny old saying: If you want certainty, buy a dictionary. If you want uncertainty, buy two.)

But that’s the key. You learn to embrace the uncertainty, to thrive on it, to make it part of your thinking. You construct a portfolio based on it.

As Bill himself has put it:

For my own money, I’m sitting tight… in cash, gold, and long-term stock holdings, about a third in each category. My investment horizon is likely to be longer than yours; I don’t mind if the current price of any of these things goes down 50% and stays there for years… as long as the real value doesn’t go away permanently.

That’s why I’m still bullish on AIG at current prices. If you want to take advantage of the market’s disconnect between correlation and causation, it’s a strong “buy.”

Regards,

Chris Mayer
for The Daily Reckoning

The post This Mindset Can Destroy Your Portfolio appeared first on Daily Reckoning.

Rankin Hodgins had humble beginnings…

He was born in 1921 on a farm in Saskatchewan, Canada. He eventually went on to work in insurance and never made more than $65,000 per year.

In 1978, he started investing in the stock market. He began with $200,000. He borrowed another $18,000 from the bank.

By 2012, without ever adding to his account, Rankin’s account was worth $6.6 million. That’s an 11.8% compounded return.

So how did he do it?

His son Douglas answers this question in a self-published book, Millionaire Down the Road: Secrets of the Ultimate Tax-Efficient Investor (2013).

Rankin was an ordinary, hard-working fellow. He was not a professional investor. But he did a few things right.

And he did one big thing that was — and remains — controversial. I’ll get to that below, though I’ve hinted at it already…

First, he had a very simple way of picking his stocks.

He looked for companies that were consistently profitable and growing all the time. He liked dividend payers — especially for a particular reason I’ll get to in a minute. He liked Canadian banks, for example, and had a large portion of his portfolio in those stocks.

He then left them alone to take advantage of the power of compounding, also known as compound interest. If you want to make really big gains, you have to understand how compounding works.

If you earn 20% per year, then $1 becomes…

…$2.5 after 5 years

…$6.2 after 10 years

…$38 after 20 years

…$95 after 25 years

Note how the gains are back-end loaded. This is because you earn “interest on the interest” of your principal investment as time passes. After ten years, you’ve made 6x your money. But wait just 10 more years and you’ve made 38x your money. That’s quite a bit more than 6x.

Compound interest is truly a force of nature. Doug quotes Einstein: “He who understands it, earns it… and he who doesn’t, pays it.”

To leave your stocks alone, you need to suffer through all kinds of economic tides. Rankin’s portfolio began when 6% interest rates were rather standard. Just four years later they were more than 20%. And by 2012 rates had fallen so low they had almost disappeared.

There were also the gut-wrenching ups and downs of the market itself. Rankin lost 20% of his portfolio in the 1987 crash. He lost $750,000 in 2001, as the tech bubble deflated. And he was down millions of dollars in the financial crisis of 2008-09.

But he stood pat. And his stocks eventually recovered.

As his son Doug notes:

How well we manage our emotional response in negative market conditions will go a long way in determining how successful we are as stock market investors, especially as leveraged investors.

Leveraged what?

Here we get to Rankin’s big controversial secret: He borrowed money to invest. Sometimes he borrowed a lot of money. He was leveraged generally from 30% to 50%.

Consider an example:

Let’s say you have $100,000 to invest, but you borrowed half of it. That’s 50% leverage. Now, some very interesting things happen when you have 50% leverage. It magnifies your gains. But it also magnifies your losses.

A 10% gain on that $100,000 means you’ve made $10,000 on your $50,000. The leverage turns a 10% gain into a 20% gain for you. But note what happens if you have a 10% decline. Then your 10% loss is a 20% loss on your capital.

Of course, this is before interest expense. Which is one reason why Rankin likes those dividend payers. He used the dividends to pay the interest on his loans.

I can’t recommend Rankin’s use of leverage to you. If you’re not careful, you could be wiped out. Investing in stocks is tricky enough without having to worry about that.

Then again, if you have a mortgage and a stock portfolio, you are already effectively leveraged.

Douglas goes to some lengths to defend the use of debt. There is, he says, good debt and bad debt. An example of the latter would be credit card debt, which carries high interest rates.

“Good debt, on the other hand,” Doug writes, “is used to purchase long-term assets — things like a family home to live in or investments that compound to create wealth. As with many things in life, when it comes to debt, moderation is key.”

He also recognizes this strategy is not for everybody. It takes a certain calm to stomach the downturns.

The debt has another advantage, too. Rankin could deduct the interest expense from his taxes. And since he held onto his stocks, he deferred paying capital gains taxes. This is a very tax-efficient way to invest. It’s like having a boat with minimal drag, cutting through the water.

Over time, the advantages of Rankin’s approach are remarkable. See this snapshot comparison of his portfolio from 1978 (when he began) to 2012 (where the book ends):

Rankin’s Strategy Pays Him Back Many Times Over (in thousands)

He had over a million dollars in deferred taxes. And he had over $5 million in accumulated profits after taxes. Starting with just $200,000. That’s… incredible.

I love stories like this, because it shows how everyday people can make a lot of money in stocks by doing some relatively ordinary things. Simple stock selection mixed with patience goes a long way.

Rankin added a kicker — he added debt.

In finance, there is a phrase; “other people’s money” or OPM. It’s a well-known fact that many wealthy people used OPM to get wealthy. Warren Buffett is one. What do you think all that insurance money he collected up front and invested was? It was OPM.

Debt is OPM.

And Rankin’s experience as an investor is a case study in why you might think about using some OPM yourself — if you aren’t already.

There is a lot more in the book, which is a fun read and easy to understand. Check it out.

Regards,

Chris Mayer
for The Daily Reckoning

Ed. Note: Sign up for your FREE subscription to The Daily Reckoning, and you’ll start receiving regular offers for specific profit opportunities. By taking advantage now, your ensuring that you’ll be financially secure later. Best to start right away.

The post How to Become a Millionaire… Using Other People’s Money appeared first on Daily Reckoning.

I’m going to tell you a remarkable story…

It illustrates the two key factors that go into a successful investment. Together, they’re the surest way I know to score life-changing wins. And they apply to just about any asset, regardless of what the economy is doing.

I was in New York City recently having breakfast with Ken, a longtime reader and friend. Ken is a sharp-tongued New Yorker who tells you exactly what he thinks, good and bad. He runs a small hedge fund in Connecticut. And made a lot of money in the 1980s and 90s riding stocks like Home Depot and Wal-Mart.

But his best investment ever wasn’t in stocks…

In 1999, Ken bought an acrylic painting by Ed Ruscha (Sunset to Pico) for $150,000. His wife thought he was nuts. She pointed out that they could have bought a few nice cars with that money. Nonetheless, Ken was fond of the painting.

Sunset to Pico shows nine parallel lines running diagonally across the canvas, as if seen from a bird’s-eye view. Below each line is an upside down street name – the nine most recognizable east-west thoroughfares in Los Angeles.

Source: www.sothebys.com

Ken hung it in his home and mostly forgot about it. He simply enjoyed having the piece.

Fast forward to 2015. He’s older now. He’s thinking he might sell some art and pay off his mortgage.

He knows the value of the Ruscha painting has gone up over time, but he has no idea how much. He gets Sotheby’s to appraise it. They say they can sell it for $1 million to $1.5 million.

At the high end of that range, it’s a ten-bagger… Remember, he paid $150,000.

So Ken decides to put it up for auction. He puts a reserve on it of $850,000. Meaning, he won’t sell it for less than that. Bidding starts at $500,000.

On the day of the auction, Ken arrives with his wife and daughter. It’s a big event with high expectations… like having a horse in the Kentucky Derby. They settle in and the bidding starts.

It doesn’t take long for the bidding to hit $850,000.

Ken breathes a sigh of relief. He’s sold the painting. Bidding climbs higher. It hits $1 million. Ken’s ecstatic. He takes a picture of the million-dollar bid. He thinks to himself: “Wow, I’ve sold a painting for a million dollars.”

But the bidding keeps climbing higher… and higher.

It hits $1.5 million. Then the bidding stalls. The auctioneer is working the room and ready to hit the gavel, but another bid comes… $1.6 million… and they keep coming. $1.7 million… $1.8 million…

When the gavel finally falls, Ken sells his Ruscha for $2.3 million.

Even if you never buy a painting in your life, there’s a lot to learn from this story…

I’m not advocating that you buy art. I’m always amused when I hear some financial “guru” warn about stocks, and tell you to buy art instead.

What they don’t seem to get is that art prices are highly correlated to stocks. When we are in bubbly stock markets, we also tend to see bubbly prices for art and collectibles. Conversely, the bids for both stocks and art disappear in times of despair – like 2008. Don’t believe that owning art makes you diversified.

But I do recommend buying a great asset and forgetting about it.

One of the first things I said to Ken after he finished his story was: “You’d never ride a stock that long.”

Do you think Ken would’ve been able to hold on to that art piece if he had the price of the painting blinking on his computer screen every day for 16 years?

There would’ve been times when it soared. There would’ve been times when the price dived. There would’ve been long stretches where it did nothing, or maybe drifted lower. He might’ve sold it out of boredom to get something that seemed to be moving.

If it were a stock, he might’ve sold it after it doubled. Those blinking prices on your computer screen are like little siren calls to action.

This is why I tell people not to watch stock prices. Otherwise, you’ll surely get scared out of even the best stocks.

I did a study of all the stocks that returned 100-to-1 from 1962 to 2014. The ups and downs of these stocks are incredible.

From the time it went public in 1980 through 2012, Apple was a 225-bagger. A $10,000 investment in turned into $2.25 million. But you had to suffer through two 80% declines and several 40%-plus drops. Netflix was a 60-bagger from 2002 to 2014. Yet it lost 25% of its value in a single day on four different occasions. There was also a four-month stretch where it fell 80%.

Sometimes it’s not the decline that will cause you to sell, but the sheer boredom of nothing happening…

Warren Buffett’s Berkshire Hathaway has earned a compounded annual return of 20.8% over the past 42 years. But if you bought it in 1997, for example, you had to sit with it for five years before you saw any positive return on the stock. Odds are — if you’re watching stock prices and not paying attention to the business — you’ll probably dump it for something more exciting.

To enjoy really big, life-altering gains in the stock market, you have to learn to sit on your hands. You have to learn that stock prices can diverge wildly from underlying business values.

And you have to learn to screen out the junk…

Ken has a filter he uses before he buys any art for investment. First, he only buys when there is already a market for the artist’s work. Second, he only buys artists who’ve had their work on display at the Museum of Modern Art in New York City. And finally, he only buys art that has been sold at Sotheby’s.

These are quality filters. They help screen out stuff that could go to zero or lose huge chunks of value. Still, there are no guarantees in art… or stocks.

In the stock market, there are a number of quality filters you can use. I recently finished a book called Quality Investing: Owning the Best Companies for the Long Term (2016) by Lawrence Cunningham, Torkell Eide, and Patrick Hargreaves. The latter two are portfolio managers at AKO Capital, a London-based investment partnership. It has delivered double the market’s return since its inception in 2005.

The focus of AKO is to own quality assets, defined by these three characteristics:

• Predictable cash flow generation: You want to own a business that generates a lot of cash. Companies like Apple and Berkshire Hathaway generate a lot of cash. Mining companies generally don’t.

• Sustainably high returns on capital: You want a business that earns a high return on the money invested in it. If you put $100 in a business and it generates a profit of $15, that’s a great 15% return on capital.

• Attractive growth opportunities: This is what propels value over the long term. Imagine owning McDonald’s when it had only 300 stores. Or imagine owning a cellphone company when cellphones were only 5% of the market. You want to see that the business can be a lot bigger in the years ahead.

The book goes into quality in much more detail. But the key takeaway is this: You can’t hold junk for the long term and expect great results. Buy the best assets.

The two things that drive long-term success as an investor — in stocks or art or probably anything — are time and quality. You need to give your ideas time to work. And you need to own high-quality assets.

If you do that, there’s no need to worry about the crazy ups and downs of the markets… or what the Fed is doing… or the state of the economy.

You’ll be like Ken, holding on to his painting all those years. And one day, with a little luck, you’ll discover you have a fortune.

Regards,

Chris Mayer
for The Daily Reckoning

Ed. Note: Sign up for your FREE subscription to The Daily Reckoning, and you’ll start receiving regular offers for specific profit opportunities. By taking advantage now, your ensuring that you’ll be financially secure later. Best to start right away.

The post The Most Successful Investments Have Two Things in Common appeared first on Daily Reckoning.

As Bill Bonner and I embark on a new investment project, I’ve been sending him notes about great investors. The idea is simple: We want to know how they invested so well, and what we can learn from them.

I recently sent Bill my notes on a book I read about legendary investor John Templeton (1912–2008). It’s called Templeton’s Way With Money: Strategies and Philosophy of a Legendary Investor by Jonathan Davis & Alasdair Nairn.

The lessons from this book are in many ways foundational to how Bill and I will approach the Bonner family’s personal portfolio… and the new investment opportunity I’ll be sharing with you soon.

But first, some background on Templeton…

He started his flagship Templeton Growth Fund in 1954. He ran it until 1992. The average return was about 16% per year for 38 years. This was almost four points better than the market over that time… an astonishing achievement. He did it without using debt and often had excess cash.

If you had put $10,000 with Templeton in 1954 and left it there, you had $1.7 million when he stepped down in 1992. That’s a 170-fold return.

So how’d he do it? Authors Davis and Nairn sum it up this way:

His only criterion was that a stock should be cheap at the point of purchase… The biggest crime an investor can commit, in his view, is simply overpaying.

In his latest issue of Bill’s newsletter, The Bill Bonner Letter, Bill wrote:

You can use cash flow, sales, profits, or dividend yield to measure “cheapness.” But the results are always about the same: The cheaper the stock (or the stock market), the better the resulting returns….

On this, we are in complete agreement. Templeton’s philosophy is one we want to emulate.

Buying cheap is step one.

But there are other important lessons from Templeton’s career. And they may surprise you…

Step 2) He was happy to hold high levels of cash and bonds when cheap stocks were hard to come by. In 1969, he had a third of his fund in cash/bonds because the high-flying market did not offer many cheap stocks. He was not a market timer, but he stuck to his knitting even if this meant trailing the market when it went nuts.

Step 3) His field was the world. Templeton went where the opportunity was. For example, he invested heavily in Japan in the early 1970s when it was out of style to do so. There he found rapidly growing companies trading at cheap prices. In 1974, he had 62% of his fund in Japanese stocks. Meanwhile, the World Equity Index, a benchmark for global markets, had just a 12% weighting in Japan.

Step 4) He was not afraid to change his mind. By 1978, he had less than 10% of his fund in Japanese stocks. As the stocks grew pricey, he sold them. By 1989, when the World Equity Index had a 40% weight in Japan, Templeton’s weight was 0%. The Japanese market would never recover the heights it climbed in 1989. What’s important here: Templeton did not wed himself to any of his ideas. Everything was for sale at the right price.

Step 5) He was not afraid to concentrate his holdings. He often made big bets on things he had high conviction in. In 1969, for example, his largest holding was 15% of his fund. And as I discussed above, he once had over 60% of his fund in Japanese stocks. This was a pattern throughout his career.

Step 6) He traveled — a lot. Templeton wrote that it was important travel abroad not only to find ideas but also to learn about the world. “[Travel] teaches us to question the economic theories and fads popular here,” he wrote. “It gives us deeper respect for the fact that the most unexpected things can happen and often do.” (Bill and I certainly do more than our share of traveling.)

Step 7) His performance improved when he moved away from Wall Street. Templeton moved to the Bahamas in 1968. There he worked alone, over a thousand miles from Wall Street. Sometimes he would do his research for only a couple of hours a day. He was patient and thoughtful. Many great investors today work off Wall Street.

Step 8) He wasn’t good all the time. This is critical to understand. The best investors often have periods where they look bad. Templeton was no different. His fund lost money in 10 of those 38 years — almost 25% of the time!

From 1971 to 1975, he trailed the market in three years out of five. Every time he did, the media would write stories about how he lost his touch. Incredibly, for the first 10 years of the fund’s life, Templeton trailed the MSCI World Index. Today’s impatient investors would likely fire such a manager.

Step 9) He held his stocks for four to five years on average. He also urged his investors to judge him on five-year returns. Few investors hold their stocks for even a year or two. They are like gardeners pulling up their tomato plants before they get their tomatoes.

Step 10) His best years as an investor were his last 20 years. And he quit running his fund when he was almost 80 years old. I told Bill he has a lot of years yet!

As I mentioned above, Templeton’s approach is one Bill and I strive to emulate… and part of the foundation of our new venture. I think you’ll be as excited about it as I am.

Regards,

Chris Mayer
for The Daily Reckoning

P.S. Be sure to sign up for The Daily Reckoning — a free and entertaining look at the world of finance and politics. The articles you find here on our website are only a snippet of what you receive in The Daily Reckoning email edition. Click here now to sign up for FREE to see what you’re missing.

The post Ten Lessons from One of the World’s Most Legendary Investors appeared first on Daily Reckoning.

“Depending on how bad a crisis gets, gold ranges between being the best answer and the only answer.”

— John Train, Preserving Capital and Making It Grow

Gold, an inert, unchanging metal, is immune to the foibles of human beings. Gold stocks are not.

I would like to share with you how big-brained and highly paid mammals drove gold stocks into the ground even though gold itself has not done badly. The yellow metal has doubled in the last 10 years. Meanwhile, gold stocks have been halved.

At Grant’s Fall Investment Conference, I heard a thoughtful presentation by John Hathaway. He is the co-manager of the Tocqueville Gold Fund. Hathaway joined Tocqueville in 1997, though his investing career began in 1970.

Hathaway is a gold bull, but he lacks the fangs you’d normally associate with that crowd. Then again, running a gold fund for the last 10 years ought to be enough to humble any gold bug.

Hathaway’s gold fund track record is the kind of thing that gives money managers nightmares. Down 23% year to date. Annualized returns of minus 30% for three years running and minus 20% for five years. Meanwhile, the S&P zips along at 12–13% annually. For a decade’s worth of work, the Gold Fund has produced an annual return of negative 0.2%, versus 6.8% for the market overall.

As bad as that is, it’s a lot better than gold stock indexes. So Hathaway showed, in a way I’m sure he’d rather not repeat, his stock picking chops. A man with a lot of scar tissue, he took the podium and quietly shared what I thought was an astounding slide, pictured below.

This chart really fascinates me. And I think part of it is the inescapable irony. Gold’s great appeal is that it isn’t paper and you can’t dilute it. And here gold stocks have diluted their shareholders (doubling the shares outstanding!) and leveraged up more than 40-fold!

If you want to know why gold stocks have done so badly, you can start with this chart.

What’s also interesting is that all this capital thrown into mining hasn’t done much to expand the supply of gold. “Mine life in the gold industry is currently 13 years,” Hathaway said, “which is one of the lowest levels over the past 30 years.” Discoveries have slowed to a trickle.

Now, for the first time in years, many gold stocks are cheaper than the cost to rebuild (or replace) assets. Replacement value is a good anchor to windward. If you consistently buy good assets below replacement cost, odds are good you won’t lose money.

That’s because markets respond to incentives. So, either two things happens: The stocks get bought out by bigger miners looking to add production or the gap narrows as the demand for new mines rises and the existing supply runs off. Replacement value isn’t going down. And gold isn’t going out of style.

Hathaway offered some speculations on the gold market itself and where the gold price might go. I’m far less interested in that question, because it is unknowable. I was more interested in his stock picks.

How to Thrive in Any Gold Market

After listening to his recommendations, I was surprised he did not mention any gold royalty or streaming firms such as Royal Gold and Franco Nevada.

Royalty and streaming companies don’t do any mining themselves. They finance part of a mine’s development in exchange for a percentage of what the mine produces over time. They are akin to financiers. As such, they escape a lot of the dirty work of mining. Their returns on their capital are better. Yet they still have upside to the metal itself.

In the gold stock universe, they’ve held up remarkably well. A 10-year look back at Franco-Nevada, the largest of the royalty/streamers, shows a price return of 325%, excluding dividends. This during a time when gold stocks, as measured by the GDX, were cut in half.

The question is always what to pay. As businesses, their return on invested capital is still low. ROICs for this group have been sub-5% for the last couple of years. And 2016 doesn’t look to get better. See this table, which shows the estimated 2016 ROIC for each, from Canaccord Genuity:

Investing is not just about finding a neat business or betting on something that’s worked in the past. You need to justify it based on the price you pay today. The basic way to price any business is to think about what it earns on the capital invested in it.

So Franco-Nevada is a great company. But is a business that earns a sub-5% return on its invested capital worth 2 times book value?

The analysts at Canaccord Genuity asked the same question in a May report titled Royalty Returns. They compared the royalty companies to banks. Which is not a bad comparison, considering that the royalty companies are, in essence, financiers:

The banking sector is generally valued on a price-to-book basis. Bank of America is at 0.72 times, while Goldman Sachs trades at 1.04 times. Bank of Montreal trades at 1.54 times, and Toronto-Dominion at 1.80 times. Scotia is at 1.68 times. Even assuming the average is 1.5 times, royalty/stream companies trade at a substantial premium to this metric.

These financials earn higher returns on their equity than the royalty stocks.

Yet the analysts come down on the side that the royalty companies deserve the premium because of the upside leverage to gold and silver, an upside absent from the banks. That makes sense as a hypothesis, but I’m not sure it should be that way.

In any event, I wouldn’t buy the group. I’d buy the best-in-class player: Franco-Nevada. It is really without peer. Another interesting note from Canaccord:

Since 2008, FNV averaged an annualized ROE of 10.7% per quarter. The company’s dividend policy has returned 18.4% to shareholders since inception, and in terms of yield (assuming a three-year trailing purchase), the company also stands alone. In its worst quarter, Franco generated breakeven ROE. In its weakest time, it recorded a $108 million write-down (or 3% of shareholders’ equity at the time).

That is a heck of a record for a precious metals stock.

And regardless of what I think the price-to-book should be, the market has been consistent in rewarding FNV with a multiple that closely tracks the price of gold (which, in turn, influences FNV’s return on equity).

Arguably, there is a lot more opportunity for FNV now. With gold miners struggling, capital is harder — and more expensive — to get. FNV has plenty of dry powder for deals. It ought to face less competition.

If you have a high conviction on the gold price, these royalty stocks belong in your portfolio. FNV, in particular.

That’s all for now. Hard to believe we’re almost done with 2015.

Thanks for reading, and I look forward to writing you again soon.

Sincerely,

Chris Mayer

P.S.: Get insight, insider scoops and actionable investment tips twice a week with Daily Resource Hunter! Just click here for a FREE subscription!

The post This Gold Royalty Play Is A Buy! appeared first on Daily Reckoning.

The Mistake in New England: The first is Berkshire Hathaway. In 1965, when Warren Buffett took control, it was a struggling New England textile manufacturer. The share price was $19. It was a high-cost producer in a commodity business. Nothing indicated that buying it would be a good move. Buffett himself called it a mistake.

“The only thing that made it better is that he realized his error and set about investing whatever funds Berkshire produced into more economically productive assets,” Gayner said. “He did that relentlessly and continuously.”

So while $19 was not justified at the time, Berkshire became an astounding investment. Shares today go for over $200,000. “Even if you paid 10 times as much [as $19],” Gayner pointed out, “you would still have had something special.”

The point is that people spend most of their time thinking about what something is worth right now and over short time frames. They ask things like: Can it trade for more over the next 12 months? What’s the Fed going to do with interest rates? What about the refugee crisis in Europe? What’s going to happen with U.S. budget issues? Who’s going to be the next president? What about China? And so on and so on…

“All of those are important questions,” Gayner admitted, “but they are all fundamentally unknowable.”

He continued: “What is somewhat knowable, or at least worth working on, is the task of finding a manager who can successfully produce earnings growth and reinvest those earnings properly over long periods of time. The example of Berkshire shows there is no more important task.”

He related a good anecdote from the financial writer John Train. (Read his books!) Assume you had been on the committee of the Sistine Chapel and had the task of getting the ceiling painted. You wouldn’t focus on the training of various painters, what kinds of paints to use, how many people you should hire, etc. “Instead, you go out into the world and look for a Michelangelo,” Gayner said.

“We spend all of our time trying to find the Michelangelos of today,” he said. “Sometimes they are specific individuals. Sometimes they are teams or systems that produce great results over time.”

I do this as well, which is why I spend so much time focusing on the individuals behind our names — David Baazov, Steven Udvar-Hazy, Thomas Petterfy and so on. These are our Michelangelos.

Markel’s portfolio represents “a congealed pudding of our vision of companies and leaders that fit this ideal.” His portfolio includes companies like Berkshire-Hathaway, Walgreens Boots Alliance, Walt Disney, Brookfield Asset Management, Marriott, Home Depot and Deere. “If we get just one or two ideas right, we will continue to produce outstanding results.”

Fair prices often scares investors. What if something bad happens, they ask? Gayner continued with his second example: American Express.

The Salad Oil Scandal: The year was 1963. American Express had already been a successful business for over a century. In 1963, though, it did something stupid. “It lent a large amount of money based on warehouse receipts of salad oil to a man named Tino De Angelis,” Gayner said.

De Angelis was 47 years old at the time. And he was already a shady character with a documented history. American Express should have suspected something. But they did not. Turns out the receipts were bogus. When his scheme collapsed, AMEX collapsed too.

Buffet bought 5% of the stock, about $20 million. It would become one of the building blocks of his great subsequent track record. “Bold, daring and brilliant,” Gayner said of the move.

But what if you bought AMEX the day before the scandal came to light? You would’ve thought you were a dummy. But your investment returns over time would’ve been close to Buffett’s. So close, “it’s not worth arguing about,” Gayner said. “You would’ve compounded your capital at high double-digit rates.”

Time is the key. The mind-blowing 100x-type returns often come after 10 or 20 years. Looking at his own portfolio over the years, Gayner says the one-year return for any one of his holdings was random at best. In one year, any particular stock could be way ahead or way behind the market. “I have no way of knowing which one will do what,” he said.

As time goes by, however, the underlying returns earned by the businesses themselves start to dominate. “As [Charlie] Munger says, investors are doomed to earn the same returns in their shares that their businesses earn on their equity over time.”

This brings us to his final example.

The Nifty Fifty: The Nifty Fifty was a group of large-cap stocks that dominated the market of the 1960s and early 1970s. They were popular. They were also expensive, trading for price-earnings ratios more than double the market’s average. McDonald’s went for 86x earnings; Disney, 82; Polaroid, 91. These stocks collapsed in the ensuing bear market and sunk to gut-wrenching lows by 1982.

“It’s trotted out as a cautionary tale,” Gayner said, “about the danger of growth stocks and being price insensitive. But a closer look reveals those lessons are not so cut and dried.”

A $50 investment in the S&P 500 in 1972 would’ve grown to just over $2,900 by the end of 2014. How did the Nifty Fifty do? There is no definitive listing, but Wal-Mart is included in almost every one.

In 1972, Wal-Mart had 50 stores in five states, sales of $78 million and net income of $3 million. Today, it has 11,000 stores in 27 countries, sales of $480 billion and $16 billion in net income.

In the early 1970s, Wal-Mart’s return on capital was in the low 20% range. Today, it’s in the teens. One dollar invested in Wal-Mart in 1972 would’ve grown to just over $1,800. While that’s not enough to top the market, you had 49 other stocks to go.

“They did not all go to zero,” Gayner said. You would have had $1 in Philip Morris (now Altria) and $1 in Anheuser-Busch. “Your $3 handily outperforms the market by double digits,” Gayner said, “even without including any of the returns from the remaining 47 stocks.”

These 47 did include some giant losers, such as Polaroid and Kodak. But you also got Disney. Johnson & Johnson. Procter & Gamble.

So Gayner finished where he began: Why is this investing stuff so hard to do? It’s hard because we don’t give our investments time. And we need to recognize something else: “You only need to get one right.” This is something I like to repeat as well. It’s true.

The greatest investors are often great investors because of one or two or three really great moves. And even if your timing seems awful at first — as with the Plaza Hotel in 1907, Berkshire in 1965, American Express in 1963 and the Nifty Fifty in 1972 — time and patience will do the work for you to succeed.

In the quest to make 100x your money, these lessons from Gayner are indispensable.

Regards,

Chris Mayer
for The Daily Reckoning

P.S. Be sure to sign up for The Daily Reckoning — a free and entertaining look at the world of finance and politics. The articles you find here on our website are only a snippet of what you receive in The Daily Reckoning email edition. Click here now to sign up for FREE to see what you’re missing.

The post The New England Mistake, Salad Oil Scandal and Nifty Fifty appeared first on Daily Reckoning.

I was recently at Grant’s Fall Investment Conference in Manhattan at the historic Plaza Hotel (owned today by an Indian conglomerate, incidentally). I’m going to share some highlights with you from an excellent presentation I heard there. These are essential for 100x investing.

Before I get to the conference itself, a brief digression on the Plaza Hotel…

When conceived, it was to be the most luxurious in the world. The chief architect of the Plaza was a man named Henry Janeway Hardenbergh. He drew up the plans amid an economic and stock market boom in the early part of the 20th century. No surprise there, as that’s exactly when you’d expect such grandiose idea to excite the minds of moneyed people.

This reminds me of something called the Skyscraper Index, a bit of whimsy created by Andrew Lawrence in 1999. It shows that economic booms often tend to peak as the tallest towers rise. Perhaps there is something similar for new luxury hotels.

The Plaza Hotel opened for business in October 1907. Just in time for the Panic of 1907. (Panic being a charming old word for a financial crisis.) The Knickerbocker Trust, New York’s third-largest bank, failed. The stock market would fall 50%. Commodities tumbled. Unemployment doubled.

Every time I go to the Plaza, I run through this little episode in my head. The hotel is a tangible reminder of the cycles of markets.

But there is more to the story, something that my interest in 100-baggers made me rethink. It turns out that the old Plaza was not such a bad investment as I might’ve guessed. It cost $12.5 million to build. In present-day dollars, that’s about $325 million. An Indian conglomerate paid $4 billion for it last year, making the Plaza a 320-bagger (excluding dividends), or a 12-bagger even after adjusting for the value of the dollar..

So the old hotel returned roughly 6% compounded over a century, not including dividends. That’s double the rate at which the dollar lost purchasing power. Meanwhile, the stock market returned about 9.5% over this time. If you guess that dividends made up a third or so of the Plaza’s return and add that in, it gets very close to the market.

The point of this digression is to show, once again, the power of compounding. You could’ve invested $12.5 million at what seemed a terrible time. But the power of compounding year after year turned it into a rather good investment.

Cycles come and go, but the essentials of good investing outcomes remain the same. This brings me back to Grant’s.

The speaker was Tom Gayner, who is the chief investment officer of Markel. It is often compared to Warren Buffett’s Berkshire Hathaway. Markel has an outstanding long-term record.

Gayner’s approach is simple and much like my own. He looks for profitable businesses with good returns on capital that do not have a lot of debt. Businesses that have ample opportunities to reinvest profits and earn high returns again and again. He wants to acquire the stocks at favorable prices. And he wants an honest and talented management team.

The most important of these is the ability to reinvest at high returns. Gayner called it the “most nuanced aspect of investing.” He said: “A fair price might be a lot more than you think it is if profitable reinvestment can really take place.”

He had three striking examples. Read on for a detailed account of why these three examples prove that a fair price for an investment might be a lot more than most people think.

Regards,

Chris Mayer
for The Daily Reckoning

P.S. Be sure to sign up for The Daily Reckoning — a free and entertaining look at the world of finance and politics. The articles you find here on our website are only a snippet of what you receive in The Daily Reckoning email edition. Click here now to sign up for FREE to see what you’re missing.

The post Gayner’s Secret for 10,000% Gains appeared first on Daily Reckoning.

The post The Devil’s Financial Dictionary appeared first on Daily Reckoning.

I have a scary story to share. It has to do with U.S. oil stocks. As bad a run as they’ve had, it could get worse.

“I want to warn the investors here,” Jim Chanos began, “whether you are a bear or a bull, I do not recommend that you become a potential purchaser of certain securities in the oil patch in the U.S.”

Chanos, founder of Kynikos, is famous for calling a number of financial disasters, such as Enron and, more recently, Valeant. I’ve been following Chanos for a long time. His views are always worth considering.

He gave a thoughtful presentation on oil and gas at Grant’s Fall Investment Conference at the Plaza Hotel in New York. I want to share some highlights from that talk below.

To get right to the meat of it, most oil producers don’t produce any net cash. I’ll show you proof in a minute.

Not producing cash is a big problem when you’ve taken on a pile of debt. Fueled by cheap interest rates, oil producers gorged on debt to fund ambitious drilling plans. Now they can’t pay it back.

Not producing cash is also a big problem when you have to spend all the cash you produce just keep production flat. If they stop spending, they’ll start shrinking.

And the incentives are all screwed up. Most short-term management compensation focuses on production growth. The valuations on the stocks, too, depend on showing production growth. There’s no incentive to produce a cash return on what you spend. Not yet. What happens when you consistently spend way more than you make?

Yes, the end result is that many leading E&Ps are in trouble. (E&P is the handy term to describe firms in the business of exploration and production of oil.) I thought this chart below, from Chanos’ presentation, was rather eye-opening.

It shows five-year summary results for five of the largest E&Ps. Across the top are the tickers for Devon, EOG Resources, Chesapeake, Continental Resources and Pioneer.

There are a lot of numbers here, but let me point to a few of the most important. First, you can see none of them produced any free cash flow. Whatever cash their operations produced they put right back in the ground (capex).

And even though they produced no cash, they all paid dividends. The way they funded this was take on a lot of debt.

Finally, you can see that “economic return on capital” line at the bottom. Those numbers are abysmal. I’ve talked a lot about the importance of earning a high return on capital and being to able reinvest and earn those returns again and again.

These oil companies consume a huge amount of cash and produce a poor return on their assets.

The oil industry, for the most part, doesn’t think about return on capital. They focus on making more and more oil.

Over time, they’ve weakened their financial strength. There are a couple of old-fashioned ratios that help you see this: the current ratio and the quick ratio.

The higher the better. You want both to be over 1 at a minimum. Ratios over 2 mean you are usually quite comfortable; you can meet your obligations as they come due, with assets to spare. Ratios under 1 can often signal upcoming financial distress. It means, as of that moment, you can’t meet your obligations as they come due. You need to sell assets or raise cash or borrow more somehow.

Well, there is a lot bad stuff about to happen to oil producers if these ratios hold true.

I want to share another eye-opening chart from Chanos. This shows you many more E&Ps. It also shows you the current and quick ratios, along with a couple of measures Chanos flags as areas of concern.

Take a look.

The stocks with shaded areas are the ones with troubling figures. Print this out and check your portfolio against it. Doing so could save you from enduring more losses down the road.

Less dire but still really interesting is to look at are the big oil producers: BP, Chevron, Exxon, Royal Dutch Shell and Total.

They’ve all spent way more than they’ve brought in. They’ve all taken on lots of debt. And they’ve all — every one of them — seen their returns on capital fall since 2009.

Again, math is math. Investing is ultimately a numbers game. Maybe you can trade these and make some money. But these figures are not a recipe for compounding gains over time. They are signs of firms that are in trouble. Big Oil is self-liquidating.

Cycles in finance take a long time to play out. We had a great boom in the natural resource sector. With the passage of time, it looks more and more like it was a bubble. It’s popped, and it’s over.

Now begins the process of building a new base for the next bull market. But it will take time. If history is any guide, we’ll see more bankruptcies first. Chanos noted that there have been eight oil and gas bankruptcies so far this year, compared with just three in the prior three years combined.

We’ll need to see these firms fix their balance sheets. This could be painful for stockholders as these companies tap the market for more funds, selling stock at depressed prices because they have to.

We’ll see consolidation as stronger players take out weaker ones at cheap prices.

We’ll need to see production come down, too, to firm up the price of oil. U.S. production will probably be up around 6% this year, despite a 59% drop in the rig count. (Again, a lesson in human ingenuity. Don’t bet against it.) Though, as Chanos pointed out, it looks like oil production will fall in 2016 by about 4%. It’s a start.

I remember when people thought oil and gas and other commodities would protect them against money printing and low interest rates and inflation. What irony it is, then, that the low rates and easy money instead led to the creation of a huge surplus of these commodities. Instead of helping oil prices, they destroyed them.

The scary story is we’re not done yet.

If I had to pick a positive way to end this story, I’d say that not all oil and gas firms are so terribly run. However, I’m with Chanos here. I do not recommend you become a purchaser of certain securities in the U.S. oil patch. Too many tricks and not enough treats!

That’s all for now.

Thanks for reading, and have great week!

Sincerely,

Chris Mayer

The post Buyer Beware: Horror Show Not Over In Oil Stocks appeared first on Daily Reckoning.

We are partway through third-quarter earnings. About a third of S&P 500 companies have reported results already. It is worth discussing this sample, because something has happened that hasn’t happened in a long while.

If you picked up a copy of The Wall Street Journal this Monday, you saw it there in black and white on the front page. “Companies to Post First Decline in Both Earnings and Sales Since the Recession.”

FactSet is even more specific:

For third quarter (Q3) 2015, the blended earnings decline is negative 3.8%. If the index reports a decline in earnings for Q3, it will mark the first back-to-back quarters of earnings declines since 2009.

If you want to know why the market peaked in May, this is your answer. The market seemed to figure out around then that earnings were about to shrink. And at the moment, next quarter will also be one of earnings declines. FactSet says earnings growth isn’t expected until the first quarter of 2016.

That’s a problem because growth is what the market is all about. It’s what helps fuel rising price-earnings multiples and stock prices. In this market, growth is getting harder to find.

No wonder, as FactSet reports, investors are “rewarding upside earnings surprises more than average and also punishing downside earnings surprises more than average.”

That’s your overview of the kind of market we’re in.

It has the feel and taste of a late-cycle bull market. Even anecdotally, there have been an awful lot of blowups of late.

There is Glencore, the giant commodity trading firm, whose shares are down nearly 90% since their listing in 2011.

There is Valeant, the giant Canadian pharma stock, down 58% from its highs in July and August.

These are not small firms. And there have been plenty of others. At the end of September, about half of the S&P 500 stocks were down 20% or more from their recent highs. That 20% is the hurdle many typically use to declare a bear market.

It’s been easy to stumble. Valeant’s fall ensnared many great investors, including Bill Ackman, founder and CEO of Pershing Square Capital Management. He also owns Platform Specialty Products, which is down 60% from its high in June.

David Einhorn at Greenlight Capital is another. He’s down 17% this year. Consol Energy and SunEdison were among his biggest positions. Both were cut in half last quarter. If you’re having a bad year with your stocks, you have lots of company.

So there you go.

But heeding Phelps up top, the above earnings discussion is mostly a rationalization of the present. It’s backward-looking. The future could look very different.

Further, if there is good news, it is that not all sectors turn in the same scorecard. Energy has been particularly awful and can’t get out of the bunker. But the telecom group has been in the fairway for both quarters, and earnings are still growing there. There is room for stock picking.

That’s what makes my latest project to find the next 100-baggers — stocks that return $100 for every $1 invested — so exciting. These stocks are out there right now, dozens of them, ripe for the picking. And they can be found under all market conditions, including these. That’s why it’s so important to maintain a long-term view when it comes to investing, as I explain below.

In the spirit of Back to the Future, I take a look back over the past 30 years to record the stocks you could have bought in 1985 that became 100-baggers. You’ll see how they got there… and what we can learn from them in our quest for the next 100-baggers.

Regards,

Chris Mayer
for The Daily Reckoning

P.S. Be sure to sign up for The Daily Reckoning — a free and entertaining look at the world of finance and politics. The articles you find here on our website are only a snippet of what you receive in The Daily Reckoning email edition. Click here now to sign up for FREE to see what you’re missing.

The post One More Sign the Bull Is Fading… appeared first on Daily Reckoning.