The Rude Awakening
Laguna Beach, California
Tuesday, March 20, 2007 ------------------------------ - Is your money keeping smart company?
- A grim forecast for housing,
- Escaping the Winter chill of Laguna Beach and plenty more…
------------------------------ Eric Fry, reporting from Laguna Beach, California… Last Saturday, your California editor fled the harsh, 70-degree chill of the Laguna Beach winter to thaw out on the sun-drenched sands of Phoenix, Arizona. But he did not merely thaw, he melted. The mercury soared to an astounding 99 degrees on Saturday - setting a new all-time record for a winter day in Phoenix. Amidst the sweltering heat, your editor did not attempt to fry an egg on the sidewalk. Instead, he donned a suit and attempted to create a little sizzle at the 9th Annual Investment U. Conference by delivering a presentation entitled, "What Makes the 'Smart Money' So Smart?" Flanked by a dazzling array of Powerpoint slides, your editor relied on visual effects to overcome his ignorance of the topic at hand. But he disclosed his ignorance at the outset by remarking, "I'm not really sure who the 'smart money' is. But I've got a hunch they're they guys who are always taking the other side of my trades." Your editor devoted the next 45 minutes to examining and discussing the tactics of the investors he has known who always seem to prosper - the smart money. The column below contains a few excerpts from the presentation… ------ The Survival Report ------ The "Second Wave" HOUSING TSUNAMI of 2007-2011 Just when you were hoping we were "done" with plunging property prices… think again…
and then BATTEN DOWN THE HATCHES for what history will remember as the worst
property-led recession of the last 76 Years! Wall Street… Main Street… nobody's money is safe. However, I can give you three very simple, solid ways to "hedge" your retirement and
property savings against this coming mega-bust. Get Your Report Here ------------------------ What Makes the "Smart Money" Smart?
By Eric J. Fry As some of you may know, I lived in New York for several years and moved back to Laguna Beach, California recently. This adjustment is going pretty well so far. But you know, the two places are really not that different. Laguna Beach is really just like Manhattan without bagels or Central Park…or cold weather, or crime, or filth, or air pollution. But I kind of miss the place. I spent the four of the best years of my life in New York…Of course I lived there for 8 years. I was never very thrilled with the six months each year between October 31st and April 1st. Anyway, let's get started… What makes the smart money so smart? Well, first of all, who's the smart money? Who are these folks? I'm not really sure who they are, except that I know they are often on the other side of my trades… So one way to begin becoming smart yourself is to analyze your bad trades. Somebody did something smart on the opposite of your losing trade. So one of the ways to begin to learn how to be a smarter investor is to ask yourself, "Okay, what did this guy do on the other side of my losing trade? What did he do that made him so smart? Sometimes it's just pure luck. Sometimes there's something more to it. But this kind of self-examination is a great way to begin becoming smart yourself… Let's go into more detail now. 1) The Smart Money is focused. It invests only in what it knows…and knows exactly why it invests. Whenever anyone asks me, "What's the main thing I should be doing as an individual investor?" I always answer, "Know your investments. And if you don't really know what they are, then don't do anything." Warren Buffett probably put it best when he said, "Risk comes from not knowing what you're doing." Many of you here today operate in industries that you understand well. Or your education enables you to invest in various top-down ideas that you understand well. Invest in those kinds of ideas. In general, I would guess, if you looked at your own investment successes and failures, you would discover that the majority of your success occurred in the areas that you understood pretty well. And your failures would be in the areas that you understood less well. 2) The smart money is contrarian. It avoids extreme situations…or seeks them out. Whenever I deliver a speech to a conference like this one, I usually just grab an old Powerpoint presentation that I have on my computer and then start dumping new slides on top of the old ones. That way, I don't have to rebuild the template from scratch. So when I started building the presentation for today's speech, I happened to grab a file from a speech I delivered to the New Orleans Gold Show in October of 2003. And in that presentation, I found a recommendation to avoid certain interest rate sensitive stocks: Fannie Mae, H&R Block and General Motors. Back then, a 3-month T-bill was paying less than 1%. And a 10-year Treasury was paying less than 4%. In other words, these securities offered what Jim Grant referred to as "return-free risk." You incur all the risk of a long-term bond, but receive very little return. This was an extreme market. And in the middle of extreme markets, you have to ask yourself, "How much more do I have to gain here?" In October 2003, you didn't seem to have much more to gain by owning bonds, nor even from owning T-bills. Many factors suggested that we were near a low in interest rates at that point. And that, therefore, interest-rate sensitive stocks would begin doing less well going forward…Not surprisingly, the total return for those three securities from October 2003 to the present was minus 16% for Fannie Mae, minus 14% for General Motors and minus 3% for H&R Block. What do these results tell us? They may simply tell us that I made a lucky guess. Or maybe these results tell us that in the midst of the extremely low interest rates of 2003, the risk/reward of holding interest-rate sensitive stocks was extremely poor. So the smart money avoids extreme situations…or seeks them out. In other words, it seeks out extreme values. Obviously, opportunity resides among the dispossessed, among the overlooked, the forgotten, the places where CNBC commentators and Wall Street Journal writers do not look. 3) The smart Money is selective. It focuses on superior opportunities…and rejects the rest. The Smart Money focuses on the areas where it enjoys the optimal risk-reward proposition. No one goes into a restaurant and asks, "Hey, could you get me some reasonably fresh fish?" But in the investment sphere, we often do exactly that. We invest in things that look reasonably good…but not great. But I would bet that if you looked across the investment returns of your entire portfolio, the investments that have dragged that return down have been the marginal ideas. And if you had just stuck with the names that you really understood to be superior long-term opportunities, your total return would have been better. It is important, therefore, to reject the ideas that do not measure up. There's a guy named Carlo Cannell who used to have an office right next to me, back in 1992 when I was managing money in San Francisco. He had $10 million under management. I had $10 million under management. Today he has about $2 billion under management and I've got…ohhh…maybe $200 in my savings account. One of the things that has made him so successful is that he does all of the things I've just been mentioning. He is the smart money incarnate. He insists on having everything lined up perfectly before investing. On the short side, he focuses on industries that are chronic capital consumers, rather than capital producers. So you would never catch him on the long side of an airline stock. You would never catch him on the long side of a computer hardware stock, or the long side of a semiconductor stock. Those are industries that for more than two decades have consumed capital, in aggregate. And they have not produced wealth, in aggregate, for shareholders. They have produced some individual success stories. But, in aggregate, they've produced losses. 
Over the last 20 years, airline stocks have produced a compound annual growth rate of minus 6%. The computer hardware industry produced a compound annual growth rate of minus 13%. 
So, why invest in these industries? Why buy the best house in the worst neighborhood? The smart money tries to find the worst house in the best neighborhood. The Smart Money tries to find the best value in a robust industry. I love this quote: "If a capitalist had been present at Kittyhawk during the 1890s, he should have shot Orville Wright. He would have saved his progeny some money." This is a direct quote from Warren Buffet, who has gone on record to say that the worst investment he ever made was in US Air. Airlines, overall, between 1947 and 2003 accumulated a net loss of $5 billion. Biotechnology between 1992 and 2003 consumed $41 billion. Obviously, there are some success stories in biotech…and there will be trading opportunities in the airlines. But again, in general, the long-term investor, the smart money, avoids industries that consume capital, rather than produce capital for investors. 4) The smart money is patient. It cares less about lost opportunity than lost capital…but gives its investments time to work. It is slow to act, then slow to react. It doesn't mind missing out on ambiguous risk-reward propositions…It does not chase stocks when they are popular. It waits for moments of weakness. If you know your investments, and you have been selective, then you can invest with confidence. You know you have a solid long-term idea, so you have to give it time to work. All of the great investors - all the Warren Buffet's of the world - have made their money by buying opportunistically, then holding on for the long-term. So if we look around in the stock market today, what are the "smart money" sells? What are the sectors to avoid? Well, I don't know. I'm not the smart money. But I'll just take some guesses about what they might be. Homebuilders would be one of them. A lot of folks think the housing stocks might be bottoming out, even though the housing market isn't. They think we should be rushing in to pick up some homebuilding stocks off the bottom. Maybe…Maybe. But the housing market has become a capital destroyer. For my own money, I don't want to be the first guy back in there. I don't care if it's bottoming. I don't care if it's bouncing. I want evidence that this market has turned around before I'm going to invest in a long-term trend. So is there any evidence of a recovery in the housing market? Not if you ask insiders. If you are sensitive to crude vernacular, then you will not want to read the next slide. But this is a quote from the CEO of D.R. Horton, a homebuilder. "I don't want to be too sophisticated here, but 2007 is going to suck. All 12 months of the calendar year." Nearly every homebuilding CEO has uttered a similar remark. You won't find an optimist. These folks probably know a little something about the homebuilding industry. Mortgage lenders. Same story. To be continued… Joel's Note: One man that has screamed louder than most about the imminent demise of the housing market is Mike "Mish" Shedlock. Right now he is calling for a "second wave" of the housing disaster…a "housing tsunami." If his predictions are right this second wave will dwarf the initial shock. This is one extreme situation the smart money might want to seek out…on the short, that is. Read on for the full housing tsunami report right here: The Survival Report --------------------------------- | 
