The Rude Awakening
Baltimore, Maryland
Thursday, May 17, 2007 ------------------------- - The S&P ego game and how to beat it,
- Four simple questions to ask before every investment,
- "Knuckle-dragging lunatics"…us? And plenty more…
------------------------- Joel Bowman reporting from Edinburgh, Scotland… Here's a question for you: What's omnipresent, forever changing and boasts six and a half billion experts? You guessed it…the weather. Yesterday we committed a cardinal sin of publishing by touching on a touchy issue. You would expect to alienate and/or offend a good portion of any audience by covering subjects such as religion and politics. But weather? It seems global warming is a hot topic. After we ran "Putting the 'Green' Back in Greenland" in yesterday's Rude Awakening, we were called everything from "eloquently insightful," to "raving mad," to, and this has got to be the best so far, "a knuckle-dragging lunatic." Do you have something better for us? Check out the article above and write to us here at aussiejoel@the-rude-awakening.com with your best praise/insults. We'll be sure to run a few choice (profanity-free) emails in next week's Monday's Mailbag. Until then, we'll stick to doing what we do best (or at least to doing what garners the least hate emails), delivering solid financial insights from intelligent people. Introducing Rude Awakening debutante, Chris Hancock… --- Special Investment Report ---
The World's Greatest Retirement Stock Double-digit returns and income checks… from a secret "pension-payout plan" that's otherwise off-limits to everyday Americans… Sound like something you'd be interested in? Click here to learn more: The World's Greatest Retirement Stock ---------------------------------- Rule #1: Don't Lose Money
By Christopher Hancock Beating the S&P 500…That's the focus of modern investing in America. Every professional investor wants to beat the S&P - both for the sake of ego and for the sake of continuing employment. A fund manager's performance relative to the S&P has become like a golf handicap - a source of prestige for the "alpha achievers"…but a mark of shame for the underachievers. The more successfully a professional investor speculates with his clients' money, the better his handicap. But investing did not used to be a game or a competition. It used to be a process for preserving wealth. When my grandfather bought shares of companies such as General Electric and Alcoa Aluminum, he did not care about the S&P 500. He focused on safety - his goal was to save a dollar. Growth beyond dividends, however moderate, was a bonus, like a stroke of unforeseen luck similar to the feeling of finding $20 in your pocket. You see, my grandfather was a child of a cautious generation… a group of people for whom the Great Depression was much more than a chapter or two in the 13th edition of some high school history book. But there's a new American generation…an "entitlement class" weaned on the bottle of instant gratification. This generation scorns single-digit returns…ESPECIALLY when the S&P gains 15% per year. But that type of thinking ignores what Warren Buffett calls the very first rule of investing: "Don't lose money." Successful investing requires a combination of patience, realistic expectations and, most importantly, buying shares of businesses at the right prices. As investors, we're looking for a margin of safety… companies trading near or below their intrinsic value with an established earning power. That's basically it. So here are four basic criteria I pursue in my investment letter, The Free Market Investor. You may recognize the thinking. Warren Buffett coined the parameters. It's a bit cliché, but we'll humbly concede that if the wheel ain't broke… well, you know the rest. We always ask ourselves these four things: 1) Is the business easy to understand?
2) Does the business sell at a fair price?
3) Does the business operate with a long-term competitive advantage?
4) Does the foreign stock trade on a U.S. exchange?
For explanation's sake, we're going to lump the first two rules together in the following example.
Is the business easy to understand and does it sell for a fair price? To answer the question, let's consider the fictional story of a small biotech company. We'll call the firm "CureAll Pharmaceuticals." CureAll holds patents on two mildly significant drugs that treat a rare blood disorder. Proceeds from those sales pay the rent, but the company continues to operate in the red. The company's immediate future rests on a breakthrough pipeline drug capable of curing prostate cancer. One of the world's most respected financial newspapers reports that the small biotech company CureAll Pharmaceuticals, based in Raleigh, N.C., cleared Phase II clinical trials for a remarkable new drug researchers suspect has a 90% probability of effectively curing early-stage prostate cancer. Anticipation builds. The breakthrough of such a drug would mean a great deal to a great many people. There's no way to quantify the benefits. Even before Phase III clinical trials begin, the company's stock takes off. Two years pass, and FDA approval looms even closer. The stock price continues to climb. Soon, management announces a press conference. Among a host of reporters, doctors and investors, CureAll's management discloses final FDA approval. The room explodes with applause and cheering.Wall Street wholeheartedly jumps on board. The stock climbs even higher… by the end of the trading day, CureAll's shares are going for 250 times future earnings.But here's where our story takes a turn. Amidst all the hype, investors confused the tangible benefits of the drug for the tangible benefits of the stock. Unfortunately for investors, the costs of producing the innovative cancer drug are astronomical. Gross margins are less than 5%. Operating margins are half of that. In other words, the drug is not very profitable for CureAll. Although cancer patients are rewarded, investors suffer. The hysteria surrounding CureAll's drug eventually surrenders to the real-world realities of poor profitability, and the stock tumbles 94% by the end of 2007. The story of CureAll demonstrates the first two precepts of successful investing: First, steer clear of businesses you don't fundamentally understand. And second, never pay too much for an asset, regardless of how great that asset may be. Does the business operate with a long-term competitive advantage? Many of the large, integrated oil companies are classic examples of businesses that possess a long-term competitive advantage. Thanks to their substantial reserves of oil and gas, along with their irreplaceable infrastructure like refineries and pipelines, these companies operate with monopoly-like status. One of the few financial certainties in the world right now is that oil is in great demand, that it's no longer cheap to drill and refine, and that it's not going to get any cheaper. The companies with competitive advantages in this arena will continue to do well. Two such companies are Petrochina (NYSE: PTR) and Sinopec (NYSE: SHI) - the big, national oil companies of China. Here's why these companies possess a moat that even John D. Rockefeller or Cornelius Vanderbilt would envy. China's acceptance into the World Trade Organization (WTO) in 2001 stipulated certain liberalization requirements aimed at opening the Chinese economy to foreign investors.But the arrival of foreign companies like Exxon and Shell will be symbolic at best. First, they will be forced to establish joint ventures with China's two main players - Petrochina and Sinopec. Second, these joint ventures won't be some 50/50 marriage in which every participant gets a fair piece of the proverbial pie. One way or another, the Chinese government will maintain controlling interests in these ventures. "The impact of opening up is almost insignificant because the two domestic oil companies still control the wholesale business to supply oil to the service stations," said Zhang Jiaren, CFO of Sinopec. And here's the kicker: The Chinese government will retain control of import and export licenses for crude oil and refined products. So even if the WTO forces the Chinese to play with the likes of Exxon and Shell, it certainly can't force the Chinese to play fair. Foreign competition, therefore, will never pose a serious threat to either PetroChina or Sinopec's market dominance. The two companies maintain roughly 50% market share of the retail market and 90% of the wholesale market. They will continue to do so as long as the Chinese economy demands oil and natural gas. That's a pretty safe bet. That's the supreme economic moat. Does the foreign stock trade on a U.S. exchange? I always focus on great businesses at good prices. But there's no telling where those businesses will be located. Right now, a majority of the world's growth is taking place in Asia, specifically in China and India. So investments targeting that part of the world feature prominently in The Free Market Investor. However, I always value liquidity. That's why I only focus on the foreign stocks that trade on U.S. exchanges. You wouldn't need a Wall Street broker or some fancy private bank to purchase any stock I'd ever recommend. A simple discount brokerage account would work just fine.And finally, if all else fails, always remember Rule No. 1: "Don't lose money." Joel's Note: Chris' investment newsletter, The Free Market Investor, seeks to marry the exceptional upside potential of international investing with the reliability of tried and true investing methods. If you would like to learn more about the way Chris does things, check out his exciting newsletter, The Free Market Investor, right here: Chris Hancock's Free Market Investor | 
