LIBOR worries… Profit margins fall… Don't be against the "Grave Dancer"… Avoid taxes, become rich… "Your usual excuse…"

We were discussing the LIBOR problem last night at dinner in Baltimore.

We reserved the corner table at Pazo… one of the fancy restaurants in town. We invited a few friends and hosted a potential new hire. Everyone at the restaurant was dressed up. Beautiful women sat at several tables, sipping wine elegantly. And then there was our table: six or eight empty wine bottles and a raging argument about LIBOR…

On the way home, I thought we might have wasted the night out. Perhaps we should have spent more time enjoying the food… and less time thinking about global economics. But maybe not. Today, The Wall Street Journal put the LIBOR problem on the front page of its investing section. "The LIBOR hasn't been this far above the base short-term rates set by central banks since the Enron and WorldCom collapses in 2001." This was my point at dinner…

What is the LIBOR? Why does it matter? The acronym stands for: London Interbank Offered Rate. It is the annualized rate of interest that banks charge each other to borrow money for extremely short durations. The rate is set by a bank trade association in London… not by politicians in Washington D.C. And the bankers are requiring higher rates, even as politicians are eager for lower rates. Why? Banks are running low on cash. They've made big commitments to fund those huge private-equity deals via the commercial paper market. And the banks that have money are worried that the banks that don't won't be able to repay their interbank loans.

The real root of the problem is that English-speaking homeowners have fueled the rapid growth in credit markets for the last 10 years, via huge property bubbles in America, England, and Australia. Suddenly, the underlying value of all of this collateral is suspect. No more refinancing. Much less credit being issued. That's drying up liquidity in credit markets around the world, making the market rate of interest higher. And it will probably get worse: Most adjustable-rate mortgages are based on LIBOR. Higher rates could lead to higher defaults, lower collateral values, and even less lending.

Here's more good news: Perma-bear Jeremy Grantham cites high profit margins as a major reason we will see more market declines: "So high profit margins offer multiple supports for the market, but they will certainly decline. They are the most dependably mean-reverting series in finance: If high margins do not attract greater competition, then a wheel has fallen off the capitalist machine. For U.S. and developed foreign markets, fair value (defined as normal P/E times normal profit margins) is about one-third below today's level, and for emerging markets it is about 25 percent lower."

Don't bet against the Grave Dancer… There are a few men in finance that you should never bet against. Warren Buffett is usually spot-on with his long-term value plays. Our own Steve Sjuggerud rarely misses a macro trend. And Sam Zell, dubbed the Grave Dancer, is notoriously the shrewdest investor in the game… You do not want to buy what he is selling.

Private-equity group Blackstone apparently didn't get the memo. In February, Blackstone bought Zell's Equity Office Properties for $39 billion – the largest private-equity deal in history. We thought at the time this signaled the end of the real estate boom. As financing becomes harder to obtain, fewer deals will originate and more will fall through. Advisory Board member Ted Bywater explains the downturn here…

New highs: Nokia (NOK), Schlumberger (SLB), and Posco (PKX).

In the mailbag… The raucousness continues, unabated. No matter how much it pains us, we continue to read your notes. And we post a selection of our "best" here. Send yours: feedback@stansberryresearch.com.

"Thanks to your present I digested the book from Levy. A fair good read, unlike Rogers. Levy gives you creeps especially when his cases are compared with your so-called strategy. It is clear from the book that money is made on innovations and farsightedness. Your usual excuse that no one knows where the market is going is just an apology for not having the guts to take an early position… If you would be able to innovate and forsee, or at least spot the things earlier you would be rather running some fund and not writing letters."
– Paid-up subscriber Dr. Ocho

"I think it's sad that anyone who questions the wisdom of our political leaders or who questions our nation's hyperactive foreign policy has to endure being called 'spineless.' Great points – I share your point of view."
– Paid-up subscriber B. Becker

"This past weekend I thought I would do a little thinking about the concept of value investing for the long term from a tax viewpoint. In Alberta, Canada, our capital gains top tax rate is 19.5%, close enough to the American rate of 20% for long term capital gains. This rate applies to both short and long term capital gains. Here is what turned up from a simple solar calculator and some thinking with various effective tax rates for some longer term holding periods:

1 yr hold - 19.5%
2 yr - 15.1%
3 yr - 12.3%
5 yr - 8.2%
10 yr - 4%
15 yr - 3%
20 yr - 2.2%

"I took a standard rate of return..., compounded it for the holding periods indicated above, calculated the capital gains tax and then recalculated the after-tax compounded rate of return. I then divided that rate of return by the pre-tax rate of return and subtracted it from 100 to get the effective tax rate for the various holding periods. This may not be an entirely correct way of doing this calculation, but the principle is very important. Frankly, it was shocking to discover how effective the principle of buying great companies cheap and allowing the returns to compound over time is just from a tax perspective. Even buying something cheaply enough and leaving it alone for just 3 years to compound cuts the effective capital gains rate by nearly 40%. Just some musings from a crazy mind that doesn't really know anything." – Paid-up subscriber Leslie Kasza

Porter comment: Avoiding the impact of taxes, while allowing your wealth to compound over long periods of time, is one of the only true secrets of finance. Your observation is correct… and more importantly, it's wise.

Regards,

Porter Stansberry
Baltimore, Maryland
September 5, 2007

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