In Bed with the Right People

A Phillipine gold mine? A stock whose company doesn’t exist? Given the fact that the U.S. stock market is about to finish it’s best October since 1915, you may be wondering how to choose good stocks during a fierce bear market rally. The Oxford Club’s C. Alexander Green offers an insider’s secret…by way of a very ‘bad’ example. Enjoy.

I’d like to recommend one of the worst investment books ever written. The author is a bumbling fool. He stumbles from one investment scheme to the next, one hot tip to another, losing tens of thousands of dollars in the process. His story – except for its fairy tale ending – is a sad and pathetic one.

Yet I believe this book could make anyone who reads it very rich. Especially in the current market. Let me explain why. Several months ago, a successful hedge fund manager I know recommended that I read "In Bed With the Right People" by Frederick M. Weissman, M.D. It sounds like a manual for swingers, but the book has very little to do with sex. The subject matter, however, runs a close second. The subtitle is "How I Made Millions on Wall Street." And – trust me – if Dr. Weissman can do it, anyone can.

His story is a familiar one. You may even recognize yourself at times. You see, Dr. Weissman is an amateur investor. He’s had no formal training in economics or finance. He’s just a guy who worked hard, saved a bit, and decided to put his money to work in the stock market. And, to put it mildly, he went about it the hard way…

His investing adventure starts off when he inquires about a stock offering for a promising young company called Monarch Television. It’s a hot IPO and quite tempting to the doctor. But there’s one small problem. Technically, the company does not exist. And the high- pressure con artist he deals with – whose greatest skill appears to be making his clients believe he has a bigger client waiting to speak with him on another line – is soon indicted.

Demonstrating a firm grasp of the obvious, Dr. Weismann warns us, "If something sounds too good to be true, it probably is!" (Worth the cost of the book alone, I say.)

Chastened a bit by his brush with a nonexistent company, Dr. Weismann sticks quality on his next investment, a penny stock that happens to be a Philippine gold mine. Eight years after he buys it, he notes that the shares are still trading at the same price. A small victory for Dr. Weismann. And so it goes.

The book eventually becomes a recitation of a litany of financial woes. He takes investment advice from a full-service firm and realizes only the broker and his employer are making money. ("And two out of three ain’t bad," as they say on Wall Street.) Frustrated, he takes his business to a discount firm, where he is blissfully free of bad advice and sales pressure. Here, however, he pursues an endless of stream of hot tips and his own misbegotten ideas. The results are far from salutary.

As Bill is fond of saying, investors don’t get what they want: they get what they deserve. If so, we can only presume that Dr. Weismann deserved very little. In fact, by the end of chapter three, after describing yet another miserable loss – this one in a little blue chip called Industria Electrica de Mexico – Dr. Weismann weeps: "There must be a way. Why can’t I find it?"

Eventually, he does. In his unending quest to fail at virtually every investment technique known to man, he eventually stumbles on one that is practically foolproof. Dr. Weismann writes: "In late summer 1990, I noticed that huge quantities of Thiokol, a Utah company, were being bought by insiders. The president of the firm bought 100,000 shares. Then other sizable lots were being purchased in the neighborhood of $9 a share. To me, that was a very good indicator."

Riding on the coattails of the insiders, Dr. Weismann scored his first significant profits…and he didn’t stop there. Next, he "noticed that Lester Crown, one of the vice presidents, had bought one million shares of General Dynamics on the open market at $38 to $39 a share." Dr. Weismann followed suit, and profited handsomely again. "In January 1992," he writes, "I noticed that some insiders had made large purchases at Grumman…"

You get the picture. In the end, Dr. Weismann tells us the end result of selectively buying on the heels of insiders: "By getting in bed with the right people, I have accumulated a portfolio valued at over $24 million, with annual dividend income of over $300,000." Talk about a Cinderella story. And this from a man whose initial instincts were to put his money in foreign penny stocks and companies that don’t exist.

Today, we can only imagine that Dr. Weismann doesn’t worry about money any more. If a problem can be fixed with cash, $24 million will generally cover it. In effect, the doctor stumbled on one of the great secrets of Wall Street.

Insiders who run a company and are aggressively buying shares in the open market at current prices with their own money are simply the best leading indicator available. Think about it. There are many reasons why an insider might sell shares of his own company that have nothing to do with its business prospects. He may be diversifying his portfolio. Or putting his kids through private school. Or getting a divorce. But what other reason is there for insiders to be greedily accumulating their own company’s shares except that they recognize the company is selling for far less than its intrinsic worth?

After all, these are not just well informed investors. They are the officers, directors and beneficial shareholders who oversee the company’s operations. They know everything that can be known about the company’s products in development, current (but unreported) sales, earnings prospects, customer growth and so on. They know everything they can learn about their suppliers, their customers, their employees and their competitors. They know if the company has just gained or lost an enormous client. They know if the company has received an unsolicited takeover bid. Or if it is considering putting itself up for sale.

And these insiders are legally required to report their buys within 48 hours of making their transactions on a U.S. government Form 4. If you don’t think the smart money is watching what these insiders are doing, you don’t know the smart money.

Here’s a prime example. It’s a company I’ve been buying lately where telltale insider activity has given us an obvious heads-up.

It’s a former technology high-flyer. But the company resides in a beaten-down sector that’s been left for dead: optical equipment manufacturing. As you may know, the telecom market has been saddled with a glut of optical equipment and tons of overcapacity. The result has been tortuous for shareholders. Just over two years ago, for instance, this company sold for more than $100 a share. The price today? About half a buck.

Ordinarily, I wouldn’t give a company like this a second look. But what’s this? It turns out the company is now selling at a small fraction of its liquidation value. It has cash on hand equal to three times the current share price. In other words, you can buy this company for one third of its cash on hand and get the business for free!

If this sounds like a pipe dream, the company insiders strongly disagree. From July 30th to August 2nd, for instance, the company’s new president bought 300,000 company shares. Between August 5th and August 8th, he came back and bought another 200,000 shares. In total, he has recently bought over a million shares.

He’s clearly telegraphing us that this company is an ideal takeover candidate for a stronger player in the industry. Or is poised on the brink of recovery. More importantly, our margin of safety is huge. The company’s book value is more than four times the current market price. Cash in the bank alone is three times the current price.

Here’s the bottom line. Fundamental analysis is all well and good. Technical factors like price action and volume need to be noted as well. But commit serious money to an investment only when you see the insiders backing up the truck themselves. The hapless Dr. Weismann accumulated $24 million that way. What’s stopping you?

C. Alexander Green
for The Daily Reckoning
October 31, 2002

Editor’s Note: Mr. C. Alexander Green, a fifteen-year Wall Street veteran, is Investment Director of The Oxford Club. In addition to writing on global investing for Wall Street Week’s Louis Rukeyser, he has been a writer or contributor to several financial publications including Global Insights, Short Alert, Insider Alert, Momentum Stock Alert, The Financial Sentinel, World Market Perspective, and the US edition of The Fleet Street Letter.

What’s Mr. Bear up to?

Has he really gone back into hibernation – after a 2 & 1/2 year rampage? Or is he just hiding behind a tree…waiting until the campers relax?

We don’t know, of course. But we doubt he has finished his work. Stocks are still expensive and margin debt, while only half what it was at the March 2000 peak, is still far more than it should be for a real bottom.

Stocks are really only worth what they can produce in earnings. And it looks to us that they will produce even less in the future than they did in the past. Consumers have little money to spend and finally seem to be realizing it. What has kept going have been the tantalizing deals from automakers (auto sales now make up 25% of consumer sales) and home refinancings, which will stir some $1.4 trillion into the economy this year.

But what this? Refinancings dropped 24% in the last reported week. They’re down 40% from the October high.

And auto sales are running out of gas too. The Financial Times reports that GM and Ford bonds are becoming "less roadworthy," with Ford’s 10-year notes trading 570 points over treasuries – that is, at junk bond levels.

"Auto sales could be economic ‘time bombs,’" says a headline in USA TODAY. The problem is that consumers have caught on to the zero-financing scheme. When first introduced, it seemed like a good opportunity to get a new car and save money. But now, zero financing has become routine. Buyers have realized that autos are becoming less expensive. They’re taking a Japanese/deflationary point-of-view. ‘Why buy now,’ they’re beginning to ask themselves, ‘cars will probably get even cheaper…’

Three years ago, two years ago…even one year ago…deflation seemed as far away as Japan. Now, the economy’s tectonic plates seem to be shifting both in our direction. Even the mainstream press is warning readers. This from the Philadelphia Enquirer: "Real deflation also wouldn’t feel like an after-Christmas sale. As in the 1930s, the prevalent mood would be pessimism, even fear. People would be inclined not to buy much of anything – either because they felt sure they could get it cheaper later on or because they were too worried about the future to spend more than absolutely necessary.

"You can see how this might feed on itself. Less spending means lower sales and profits, forcing companies to lay off workers or go out of business, which makes more people afraid to spend, and so on.

"There would be other unpleasant side effects as well. As incomes and profits shrink, it becomes harder to repay debts. (By contrast, inflation favors debtors, letting them pay back with cheaper dollars.) Rising defaults would put banks and other financial institutions at risk.

"Needless to say, this wouldn’t be good for investment assets such as stocks or real estate. Falling values would add to the general sense of fear and uncertainty, fueling what would amount to a shrinkage of the entire economic pie."

When the economic pie shrinks, Mr. Bear comes out of hiding, and stocks get mauled…

We repeat our advice from yesterday: sell stocks, buy gold.

And now, over to Eric. What’s the latest news?

———

Eric Fry in New York…

– The stock market put in another respectable showing yesterday. The Dow rebounded from early morning losses to chalk up a 58-point gain to 8,427. The Nasdaq jumped 2% to 1,326. Semiconductor stocks paced the advance on the Nasdaq…a throwback to the glory days of 1999. The SOX semiconductor index spiked more than 6% yesterday, spurred by hopeful comments from IBM’s Chief Executive Sam Palmisano.

– Shortly before noon, Big Blue’s newly minted CEO remarked during a speech here in New York, "Perhaps we’ve hit bottom…" CNBC ran with the story, breathlessly reporting the remark as if it were the Gospel truth, rather than simply one man’s self-serving opinion. A flurry of stock-buying – especially tech- stock buying – followed almost immediately thereafter.

– Palmisano’s proclamation clearly reflects more hope than substance, but that suited investors just fine. After all, the current rally on Wall Street is the love-child of hope and self-delusion. For proof, one need look no farther than the SOX Semiconductor Index. This hapless collection of ‘earnings-challenged’ stocks has skyrocketed 45% since October 9th.

– Nearly all semiconductor companies are producing losses these days. And most of them have warned their shareholders to expect continuing losses for some time. Undaunted, swarms of hopeful bulls are buying semiconductor stocks anyway. "The economy will recover," they tell themselves, "and then the semiconductor companies will make money again."

– Maybe…Maybe the economy will recover briskly, sparking strong demand for computer chips and enabling the semiconductor companies to produce robust profits…And maybe I will leap from the Empire State Building and fly across the Hudson River to Newark…Anything could happen, right?

– Stocks in the oil-refining sector also raced higher yesterday, thanks to a surprisingly strong earnings report from Valero Energy, a stock that has been recommended both by Dan Denning’s Strategic Investments and by Lynn Carpenter’s Fleet Street Letter. Valero shares jumped $3.89 yesterday to $34.46. Shareholders are no doubt pleased with the yesterday’s big gain. But Valero shares have been on a rocky ride for the last few months – tumbling from nearly $50 in March to less than $24 earlier this month. So it hasn’t been easy to hang in there with this one.

– But Dan tells me that the company’s prospects now appear to be improving. In an environment in which most companies are reporting disappointing earnings, Valero announced profits that were almost double what analysts had predicted – 50 cents a share versus the estimate of 27 cents. If yesterday’s report is any indication, Valero might finally begin to reward the patience of its shareholders…

– A word of warning to our bearish readers (of which there may be one or two), the attendance was standing- room-only for last week’s Grant’s Interest Rate Observer Conference in New York – appropriately so, as the confab was as thought-provoking as always. As a contrary indicator, however, the spectacle of bearish investors crammed into a large conference hall suggests that the current stock market rally might last a while longer. The Grant’s conferences are so notorious for attracting a bearish crowd that a friend of mine refers to them as "bears’ pep rallies."

– Three years ago, during the peak of the market bubble, the Grant’s conferences were somewhat less enthusiastically attended. Everyone knew that stocks always go up, and they also knew that there was nothing more to know. So why bother attending a conference featuring informed contrarian ideas? 4,000 Nasdaq points lower, a few folks suspect that there might have been something more to know after all.

– Notwithstanding the bullish signal being flashed by the "Grant’s conference indicator," the keynote speaker at the Grant’s conference, Jeremy Grantham, of Grantham, Mayo, Van Otterloo & Co., provided plenty of reasons for caution.

– "After a great bubble, such as the one we just experienced," said Grantham, "you’ll have a lot of pain. If however, you do everything right, you’ll still have a lot of pain."

Sounds about right.

——–

Back in Ouzilly…

*** More and more economists seem to be worried about deflation. Earlier this week, former Fed member Wayne Angell urged Greenspan to lower rates to 1.25% to fight it. "The essence of deflation is that business leaders know they do not have the pricing power," he wrote, in the Wall Street Journal. "Yet in the first several years that business leaders experience a lack of pricing power, they are apt to view the condition as temporary – they believe that it is the result of recession or cyclical downturn. They expect that pricing power will return with a recovery…This is precisely what’s happening in the US economy today."

Global Insight, an economic forecasting firm, said the Fed should cut rates by as much as 1%.

In January, nearly every respectable economist in America expected the Fed to increase rates before the end of the year. Here at the Daily Reckoning, we took the opposite view, just to be contrary. We had noticed that America seemed to be following the Japanese script – where rates fell to zero and stayed there for years. Nothing has happened since to change our view: America is entering a long, slow, soft bust – just like Japan’s – with rates near zero.

This view seemed preposterous when we first proposed it 3 years ago. Now, writes economist Stephen Roach, "maybe it’s not so far-fetched after all to [be] worr[ied] about Japan."

But success is often worse than failure…and being right is often more painful than being wrong. The publishing house, John Wiley & Sons, has asked for a book on the subject. Your editor is now stuck inside on another beautiful fall day laboring on it.

*** Why gold? Sun Valley just released a thorough report on how gold performs in deflation. Turns out, gold is one of the best things you can own. When times get tough, businesses go belly-up and loans go bad. People begin to wonder about the quality of the paper they hold. The dollar, the world’s most ubiquitous paper asset, could take a big drop. Investors look for safer places to put their money. What they find is gold, the money-of-last resort, the anti-paper asset.

Will gold go to $1,000 per ounce? Maybe not, but it probably won’t go down much either. Here at the Daily Reckoning, our needs and ambitions are as modest as our talents. A investment that doesn’t go down in a major bear market is the best we hope for. *** "Europe is on the brink of collapse," reports Scotland on Sunday. French exports are falling for the 7th month in a row. Confidence is dropping. Germany’s economy is "catastrophic."

It’s the end of the world as we have known it. Enjoy it.

*** How much do you think an AIDS vaccine would be worth? According to PirateInvestor.com, Porter Stansberry and David Lashmet, who’ve been tracking the progress of the only drug to make it into the FDAs phase III trials, the potential market for such a drug is enormous. Porter writes: "Look at the numbers. If 300 million people in the developed world receive a total of five doses, and each dose is priced at $10 (a low estimate), that’s $15 billion. And that’s not counting the developing countries, where perhaps twice as many people will need to be vaccinated.

"The Wall Street Journal noted on February 27, 2002 that ‘only one experimental HIV vaccine…is in large- scale human efficacy trials.’ While the company won’t be into the full production and sales mode of this vaccine until 2005, if the results come out as I expect in January, The Wall Street Journal and other major newspapers will be all over this story…and the share price could skyrocket long before the company ever sells a single dose of the vaccine."

*** We drove out to the local graveyard yesterday with chrysanthemums; tomorrow is the All Saints holiday in France. The cemetery was alive with activity. One old woman scrubbed a tombstone. Others carried pots of flowers. Hardly a single grave was left unadorned.

We placed the flowers on our aunt’s granite and noticed a new grave next to it.

"He was only 21 years old," my mother calculated.

On the fresh dirt were a number of flower pots, but also a plaque with the young man’s name and birth date. It also hinted at the cause of death, for there was a drawing of a motorcycle next to the name.

"You never know," said my mother, who recently celebrated her 82nd birthday. "You just have to do your best…and pray…"

And, then after a moment of reflection…

"And stay off of motorcycles," she added.