The "decider" in action... Credit card defaults soar... U.S. defense spending sets new record... Buffett still buying rails... Ted Bywater on the risks in commercial real estate...

Our fearless "decider" addressed the subprime lending crisis today, saying:

"The government's got a role to play. But it is limited. A federal bailout of lenders would only encourage a recurrence of the problem." What does Bush propose instead? A bailout of the borrowers! See... the borrowers are blameless. Why? Because they vote. Guess which state has the highest percentage of problematic subprime loans? Florida. And guess which state's presidential ballots tend to be the linchpin of the election?

Credit card watch: Moody's reports credit card companies wrote off 4.58% of payments between January and May, up nearly 30% from the same period in 2006. According to the administrative office of the U.S. courts, the nation's bankruptcy filings jumped 66% in the first quarter. Who do I call to have President Bush cover my credit card debt? After all, it's the lender's fault, isn't it?

One more tidbit about deadbeat Americans. According to BusinessWeak, "Saturn buyers are 22 times more likely to default than Toyota buyers. In fact, owners of American cars are generally more likely to default than owners of European or Japanese cars." (General Motors owns the Saturn brand.) Maybe George Bush will bail out car buyers too...

I finally understand what compassionate conservative means. You will recall that's how the Bush administration originally sold itself to get elected... before the Republican party turned into the corrupted, preemptive-war launching, torturing, subprime-bailout party of unlimited appropriations bills for all of its members. Compassionate conservative means "We'll spend even more of your tax dollars than the Democrats."

According to Government Executive: "Between the administration's baseline defense budget and supplemental funding for the wars in Iraq and Afghanistan, the Defense Department is projected to receive $624.6 billion in fiscal 2008. You would have to go all the way back to 1946 (World War II) to find higher defense spending (adjusted for inflation); the 2008 Defense budget request surpasses even the peak years of military spending during the Korean and Vietnam wars. The United States spends roughly as much on defense as the rest of the world combined." (Emphasis added.)

Today is Friday, which means it's time for an update on our Correction Opportunity Report. (Three weeks ago, we began suggesting ways to make a quick profit on what we thought was a panic in finance-related companies.) We don't have a new recommendation to make this week – but we're working on one: buying preferred shares of certain banks. They've gotten hit hard, they're yielding more than 6%, and after we've completed our analysis, we'll know whether they're safe. Upside: 50% over three years, plus 18% interest. Here's an update on our other suggestions:

We think Moody's, Quest, and Asset Acceptance are still attractively priced, though we wouldn't be in any hurry to buy Moody's.

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Buffett on the move... Extreme Value pick Berkshire Hathaway bought another 845,000 shares of Burlington Northern Santa Fe (BNSF), bringing his holdings to 15% of the company.

According to our friends at United for a Fair Economy (which we have more appropriately re-named "United for More of Your Property"), CEOs made 364 times more pay than the average worker in 2006. Never fear – the government is here to help. Today, the SEC will fax letters to 300 companies asking them to explain in detail their executive compensation. Some of the companies in question include General Electric, Inside Strategist pick Coca-Cola, and Pfizer. The companies have until September 21 to respond or explain why they can't, and the information should be made public later this year.

We don't know how the whole executive compensation problem (which, yes, we do think is a problem) will be resolved. But there's one thing we know for sure: The government's involvement will lead to more lobbying expenses and more money for Washington a lot faster than it leads to benefits for shareholders.

New highs: Nokia (NOK) and Raytheon (RTN).

We're publishing fewer, and getting more. Keep them coming, you'll get posted eventually: feedback@stansberryresearch.com.

"Damn it, Stansberry – where's the 'Company of the Day'? This is the third time I've asked you, and you've refused to answer. I just searched my e-mail and the website, again, and it looks like the last time it was ever mentioned was with SGMS on August 9. If you've discontinued it for some reason, at least say so. Am I the only one who's missed it? That's hard to believe, but if so, and you're afraid of stirring up the community by responding in The Digest, then answer me personally so I can stop looking for it. I'm warning you; if you don't respond, one way or the other, I'm going to start sending this e-mail every day. I think you'll get pretty tired of seeing it."
– Paid-up subscriber Joe Ely

Porter comment: Yes... we stopped including it. Nobody seemed to understand what the purpose of the piece was. Were we telling you to buy the stock? (No.) Were we telling you to sell the stock? (No.) We were just interested in learning a little bit about a new business every day. It helps to build our internal database of public companies... and we thought you'd enjoy doing it too. But most people didn't understand and it got to be a huge customer service problem, with hundreds of people calling every day saying "I don't get it..."

"Thank you for taking the time, money, and effort to overhaul the website. The design is very slick and very easy to navigate. This is easily my favorite of the Agora Inc. websites. [Note: Agora Inc. is our parent company and a worldwide publisher of books, magazines, and newsletters. – Ed] It's the little things like the My subscriptions area where it shows what I have and what's available to subscribe that make it a pleasure to navigate. I also like The S&A Digest; it's a very useful resource and I can't wait to see the pre-2006 issues back up again... I've only been an 'investor' for about seven years. I started as a buy and hold mutual fund investor until I reached a size where the annual expense ratios (even with cheap Vanguard funds!) started to make round trip commissions on an individual stock portfolio look competitive. I assembled a few dividend-paying stocks and thought I was then set for life. Then greed and impatience (a horrible combination) started to set in, and I thought I could make a killing as a stock and options speculator. Of course, the only thing that got killed was my account. In the process of rebuilding my account, I did pick up some useful tools from the S&A team. I like the trailing stop, and position sizing concepts as it gives me some much-needed discipline. I also like Dan Ferris's Penny Letter as I doubt I would've been able to find any of the stocks by myself. However, value guys like Ferris don't seem to like stops. I have the same problem with Chris Mayer's Capital & Crisis. How does a reader properly position size a portfolio without a stop? Now I realize S&A can't give personalized advice, so I guess I'll tell you what I'm currently doing and maybe someone (perhaps a fellow reader) can provide some comments. A run of the mill position sizing formula seems to be risking no more than 1% of account equity and a 25% trailing stop so that would mean putting no more than 4% (1% divided by 25%) for each recommendation. It seems like the value guys don't like to use stops for fear of getting booted out of a profitable position because of market volatility. In which case why not just use a wide stop like 50%? Although it decreases the amount I can put in a position to 2% (1% account risk divided by 50% trailing stop), it gives me a better peace of mind than no stop at all. The argument against even a wide stop is that the volatility of Penny Letter stocks can get really nasty like WON. In that case would it be prudent to have a 'time' stop? I read the latest issue and it seems that three years would be a good enough time to throw away a crap stock? Anyway, the good work is appreciated." – Paid-up subscriber Wilson

Porter comment: Looks like you've got it all figured out. As we've explained before, there are many ways of protecting your capital and many different types of risk management. Our editors use different types of stops at different levels, depending on the nature of the investment. But none of the stops you use will matter if your position sizes are too big. The bigger the position, the tighter the stop must be. Likewise the wider the stop, the smaller the position must be.

Having said all of this, it's also true that fixed stop losses and deep value investing don't mix. If you're buying a stock because your analysis indicates its intrinsic value is far above its price, it doesn't make any sense to sell if the only thing that changes about the situation is the price. If your estimate of intrinsic value changes, you might have to sell at a loss... But if you're value investing, you shouldn't sell only because the price changes. Thus, to be successful as a value investor, you must be prepared to suffer volatility and a few blow-ups. And that means you have to keep your position sizes small. How small depends on your own tolerance for losses, the size of your portfolio, etc.

Regards,

Porter Stansberry
Baltimore, Maryland
August 31, 2007

Commercial Real Estate Warning Signs
By S&A Advisory Board member Ted Bywater, CCIM

I've recently had several conversations with people I respect and admire in the real estate business, and some of what they are telling me gives me real concern about the near term.

One of the brokers I talked to told me he had a $29 million land-development deal fall apart because the buyer was unable to get financing for the project. He is supposedly backed by the Trammell Crow family and the Hunt Brothers. This is a deal that should make sense...

If you want to shut down the real estate business in a hurry, just cut off the financing. That is the real lifeblood of this business. As a wise person told me a long time ago, if a developer can borrow the money, he will build the project regardless of market conditions. I have also learned from the owner of a very good company in our area that every CEO who he has talked to in the last 30 days says that their business came to a stop in the last two months. This has caused several deals I am familiar with to crash because of the tenant putting his growth plans on hold.

The commercial real estate business is driven by expectations. Business can be booming, but if the business people think it's headed in the wrong direction, they will put all expansion moves on hold until the business climate becomes more bullish. Vice versa, if business is currently lousy, but the future looks rosy, they are out making deals in anticipation of the coming need.

Bad business outlook, no credit – not a good thing for commercial real estate.

In the long run, this could be good for the U.S., as the market has been way overheated for far too long. This has driven prices to levels that in more normal times would make no sense. As an example, a national build-to-suit developer with a great reputation has recently put a brand-new large-distribution building on the market in shell condition (no tenant improvements) for $110 per square foot. I just finished building a comparable building with more than $600,000 of tenant improvements included, and my cost was just under $55 per square foot. Where these people come up with this kind of pricing is beyond my understanding. If such pricing is achievable, my partner and I made a bad mistake not selling the building. We could have made $9 million. Instead we rented it to a good tenant for a reasonable return. How smart are we?

When the market becomes more realistic again, all these people who have bought net-leased properties at low 6% returns are going to find that they have no chance of getting their initial investment back, because the market is demanding a 10%-11% return. I have lots of offerings from 10 years ago when Walgreens was selling at 11% caps. One of these days, when the market finally recognizes that we have a lot of inflation, investors are going to demand those kinds of returns again. That will make the Walgreens, with an annual net cash flow of $250,000 that you paid $4 million for (6.25% cap rate), only worth $2.27 million (11% cap rate). That is not what I call a good real estate deal.

Good investing,

Ted Bywater

Editor's Note: Advisory Board member Ted Bywater is president of The Bywater Company, which has focused on commercial real estate in Central Florida for 30 years now. Ted has participated in more than 2,000 real estate transactions involving hundreds of millions of dollars, and he's organized and led multiple investment partnerships for the acquisition and long-term ownership of investment-grade real estate.

As with certain base metals (notably copper), commercial real estate tends to be a leading indicator of the economy (as Ted explained). You can keep an eye on the market's perception of commercial real estate by tracking shares of CB Richard Ellis (CBG), the largest commercial real estate agency. Looking at the stock over the last three months, we see the market shares Ted's view – at least for now.

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