John Neff's success was no fluke. Year in and year out for three decades, he was in the top five percent of portfolio managers. Proving it's no fluke, in 1980, he took over an entirely different portfolio – the University of Pennsylvania's endowment. Over the next decade, he brought it into the top five percent of all endowments. 

Even more important for you and me, John Neff has seen more bear markets as an investment analyst than nearly anyone alive. He has been an analyst since 1955, when he started with the Cleveland National City Bank – a job he held for eight and a half years. He started managing the Windsor Fund in 1964. He couldn't have picked a worse possible year to start a long-term career in running a stock fund. Get this – on the last day of 1964, the Dow was at 874 and change. On the last day of 1981, it was at 875. Seventeen years, no change. Instead of losing money in that period as most stock investors did, Neff became a household name...

Neff became an investment "star" for his performance coming out of a horrible bear market. Stocks lost a stunning half their value in the 1973-1974 bear market – next to today, that's the worst bear market in recent memory. Coming out of the bear market, Neff's Windsor Fund returned 54.5% in 1975 and 46.4% in 1976.

I tell you all of this because we've been in a horrible bear market for nearly three years now. We're about to close the books on three years of losses in the stock market. We've only had four years of losses once – and that was in the Great Depression. So instead of fleeing from stocks after three years of getting trounced, it's time to start looking for ways to make money coming out of a bear market. (Our 1-2-3 Model has been bearish since 1999, so you should have some cash on the sidelines ready for this one.)

The best way I could think to tell you about this month's recommendation is to tell you what the master of ugly markets, John Neff, is doing with his own money. I was shocked when I found out (and after spending my life doing this, I'm getting hard to shock). You see, John Neff is making a BIG bet. Unlike most portfolio managers, who hold hundreds of stocks and usually not more than 2% in any one position, John has an unbelievable 33% of his personal stockholdings in one tiny sector of the economy – one that you would likely never consider...

Has Neff lost his mind? I don't think so. He may be 71 but he still works five days a week (though he's cut his workday down to 9:30-3:40). He's doing exactly what he's always done. Just like he did when he ran his large and hugely successful mutual fund for three decades. And just like he did back in the early 1960s at Cleveland National City Bank...

As a young research analyst, John Neff constantly found himself at odds with the Trust Committee. You see, the Committee preferred to buy the popular, big-name stocks that would reassure customers, even though those stocks might not make as much money. Neff thought that policy was ludicrous. He knew that ultimately what the customer wants is to make money. While a glance over the portfolio of warm and cozy stocks might make the bank customer feel good over the short-term, eventually, they'll figure out that they're not making money.

It's been a half-century, but times haven't changed. Institutions and stockbrokers pitch warm and fuzzy stocks to the public. Neff actually prefers stocks that a stockbroker will have a tough time pitching to a customer ("it's not always easy to do what's not popular, but that's where you make your money"). That's why Neff is not a household name today. Warren Buffett and Peter Lynch are household names. But consider this: Buffett owns Coke, Gillette, and American Express, while Lynch tells you to "buy stocks in the products you like." That's easy to pitch to the public. Meanwhile, Neff buys stocks that nobody else wants.

But take a look at Neff's top pick in the sector that makes up a full one-third of the stocks he owns versus Warren Buffett's three famous names. Which one looks more attractive to you?

Coke and Gillette haven't made investors money in five years. It shouldn't be a surprise. Over the last five years, earnings growth at both companies taken together has been negative. Yet these stocks are priced as if they're exciting growth stocks. Why are they priced so high? Because people are willing to buy them – they're "sacred" stocks. Maybe they're "sacred." But they sure look like bad investments to me. The growth of these companies can't possibly justify their current prices. You're paying too much. There's no "margin of safety."

Meanwhile, there are astounding companies like our pick this month. Companies that truly offer a margin of safety. It has grown its earnings at 33% a year for the last five years. The stock has more than doubled in that time, but it's still extraordinarily cheap.

This month, I'm going to ask you to do something that's not popular. But, as your mother used to say, "I'm doing this because it's good for you." If you stick with me on this, you'll see exactly how you should be able to double your money or more here.

This company is no young buck. It has turned in 99 consecutive quarters of record earnings. That's 25 years of consecutive earnings growth. 

You'd think that, for a company with that many years, there wouldn't be much room left to grow. But you'd be wrong...

Sales for the latest quarter (ended September 30) were up from $1 billion to $2 billion for the quarter – a nearly 100% increase.

As for earnings, the Wall Street consensus is our pick will grow its earnings by 15% a year for the next five years. Wall Street expects this stock to report earnings of $3.25 a share next year (year end September 30). Yet as I write, the stock is at $18 – for a P/E of about 5.6. Have you ever heard of such a low P/E on such an astounding growth stock? Me neither.

There's got to be a catch right? Sales must be doomed going forward or something right? Wrong again. The company has already sold $3 billion worth of merchandise – that's the next six months of sales... It just can't legally book those sales until it delivers. So it's got a six-month backlog! The big worry in most companies is whether they're going to sell anything next quarter (for example, other companies must worry – are people going to buy Palm Pilots this Christmas? Are people going to see the new Madonna movie?). We don't have those worries. We've got $3 billion in sales already in the bag. That's amazing, when you consider that the entire value of the company is less than $3 billion.

Debts? Lower than the others in its sector. Lawsuits? Nope. Shaky management? Nope – the Chairman has been there since founding the firm in 1978. Nope, nope, nope.

I've had this big wind up because I'm afraid you won't take advantage of this one with me. That'd be a big mistake. I've told you about John Neff to show you that I'm not completely alone in my belief in this story – the king of making money in sluggish markets (and the king of making money by not following the crowd) has most of his chips here. But I've got to let you in... what I'm talking about is homebuilding. Yes, homebuilding.

Okay, bring it on. "Don't you and Neff know that real estate prices have risen too far??? Don't you know that interest rates can't go lower than 6%??? And don't you know that we are in a recession, and people don't buy homes in a recession???"

Now hold on a minute! So now you've stumbled onto the reasons why this stock is so cheap. These are the beliefs that most people have about the real estate market now. These reasons ignore positives. And even worse, they're old wives tales, that don't hold up to critical analysis. That's good for us, creating our amazing opportunity. Let me explain...

Let's look at them one by one. First "haven't real estate prices risen too far?" The answer here is no. Many so-called experts like to make comparisons to Japan. You see, Japan had its stock market bubble burst in 1990. And since 1990, Japanese stock prices and real estate values have fallen by 75%. These experts say the same should happen here. But they're not doing their homework. You see, in the boom years of the 1980s, real estate prices in Japan rose by 300%. So the current fall in Japanese real estate has simply erased the gains of the boom years.

In the U.S., real estate did not participate in the stock market boom. Unbelievably, real estate prices nationwide in the U.S. are still at 1989 levels adjusted for inflation. You may not believe me if you live near the coast or in the northeast, but for the nation as a whole, it's true. From Tuscaloosa to Provo, nothing has happened. While real estate has risen handsomely in the last two years, especially in some pockets of the country near the coasts, the bigger picture doesn't show much action.

For the second question "don't you know that interest rates can't go lower than 6%?" Through most of recorded history, interest rates have been below 6%. In the entire history of U.S. interest rates, interest rates were only significantly above 6% once – two decades ago. Going forward, over the very long run, if inflation stays dead (say around 1.5%) long-term interest rates will likely settle in the 4.0% to 4.5% range. I don't make interest rate forecasts (because I find them to be pretty useless). But this makes sense based on history. 

Even if I'm wrong and interest rates stay flat or rise a bit, housing is still extremely affordable. Interest rates haven't been this low since the 1960s. Meanwhile, incomes have risen. When you run the numbers, homes are much more affordable than they were two years ago. I'm not kidding. Even though home prices have risen, the fall in interest rates has more than made up for it, making homes more affordable today than they were in 2000, even though prices are higher. You see, mortgage rates in mid-2000 were around 8.5%. Today they're closer to 6%. People don't buy on price. They buy on monthly payment.

For the third question "don't I know that we're in a recession and people don't buy homes during a recession?" To that I'd respond, what the heck do you think is going on right now? People are snapping up homes so fast in this recession the supply of homes available is at a historic lows – only four months of supply (during the 1990 recession, inventories stood at nine months supply). We have a serious supply/demand imbalance, which is "solved" with higher home prices in the short term. And more homes being built in the medium term. Both of which favor homebuilders. It's no accident that housing starts hit a 16-year high in September. Homebuilders are starting to expect to sell more homes, and at higher prices. It doesn't get much better. Yet people are afraid to buy homebuilder stocks.

I can't recall seeing such a bargain group as homebuilders are right now. And this month's recommendation in particular, at a P/E of 5.6 having grown sales by nearly 100% last quarter and having grown its earnings 33% a year for the last five years, is one of the greatest investment bargains I have ever seen.

Even better, it has exposure to nearly the entire country – 44 metropolitan areas in 20 states – yet it has no exposure to the Northeast. I think this is good. While many northeastern cities may have mini-real estate bubbles, there ain't no bubble in the heartland. Take Peoria, Illinois... Median home price: $85,000. Median family income $58,000. Percentage of families that can afford the median home: 91%. It's not just the small places. Consider Houston... Median home price: $138,000. Median family income: $60,000. Percentage of families that can afford the median home: 68%. Meanwhile, consider San Francisco... Median home price: about $525,000. Median family income: $86,000. Percentage of families that can afford the median home: 9%. Sign me up for Peoria, Houston, and the rest of middle America – and keep me out of the expensive places, like the San Fran area and the Northeast.

Yet another nice thing about homebuilders is they're easy to understand. It's not Cisco or Lucent, where investors can't even name one of their products, much less even know what their products look like. Homebuilders are simple. They build homes and sell them. There's no fancy accounting. They've got finished homes and unfinished home lots. And that's it, except for a few mortgages. Then they've got some debt, as buying land and building homes requires a lot of money. But this isn't rocket science. No weirdo piles of "Intangible Assets" or goodwill on the books. Just shelter and earth. For example, here's the balance sheet of our pick this month...

So that's a net worth of $2.1 billion, as of June 30. That's pretty darn good considering that homebuilding requires a ton of money (you've got to buy the land AND build the homes). Unlike most homebuyers that put 20% down or less, our pick this month doesn't have a ton of debt. It's got 37% in equity. How many folks do you know with that kind of equity in their homes?

Since we're coming from such an extraordinarily low price, our recommended homebuilder this month could double. And triple. And still be cheap. At a P/E of six, if the stock tripled, it would trade at a P/E of 18. About in line with the history of the stock market. Of course, for Coke or Gillette to move in line, they'd have to be cut in half. Which sounds like a better bet to you?

For you to be on board, you've got to believe that real estate can keep chugging higher. Said another way, you've got to believe that a wipeout in prices isn't right around the corner, guaranteed to follow after bad times in the stock market.

So let's consider the last "bad times" in the stock market and see what real estate did. The last major stock market peak was 1968. And stocks did nothing until the start of the bull market in 1982. (Stocks lost 36% from December of 1968 to mid-1970 and lost 48% in 1973-74.)

In the investment classic, "A Random Walk Down Wall Street," Burton Malkiel shows that, from 1968-1979, stocks gained only 3.1% a year (which is a "real" loss, as inflation was 6.5% a year). Corporate bonds couldn't keep up with inflation either. Yet residential real estate (single-family homes) was a real winner, rising a whopping 9.6% a year. Instead of real estate "following" stocks down, it actually didn't care about stocks - rising while stocks fell continuously. Then, like now, real estate is a port in the storm.

In doing my homework, I found that real estate crashes need two things: a real estate bubble and big debts.

On the first question, we are not in a real estate bubble. Remember, the definition of a bubble is when prices rise beyond any fundamental value. Real estate in America yields about 7% in net rent right now – instead of a bubble, it is one of the only places you can earn a return now (when you consider that the bank pays 1.5% and stocks pay less than 2%). Real estate in only a few cities was swept up in the Nasdaq bubble - San Francisco and Boston, for example. And prices in those areas are now falling. For most of the rest of us, it's not a bubble. This is not 1989 Japan.

On the second question, debts, the fall in interest rates has created a windfall of affordability. Nearly everyone I've talked to has refinanced, locking in lower rates and substantially cutting their monthly debt service. By the numbers I showed above, from Peoria to Houston, most families can afford the median home (data on this based on spending 28% of gross income on a home, with 10% down). And while people's debts have been rising, people's incomes have been rising, too.

I expect a real estate bubble to take hold, for a few reasons. First, "bubble money" requires easy credit, and plenty of it. It is there in the mortgage market, and more is coming. Second, because of the huge differential in real estate rental yields (7%) versus the other options (paying 2%), huge piles of money will flow into real estate. It's actually already happening, as huge pension funds are earmarking big dollars to put into real estate.

So we've got individuals trading up. And we've got big investors (and HUGE investors) making a rational investment decision. We've got buyers coming from every direction, and not much out there to derail them. Put simply, there are no investment alternatives right now, other than your mattress.

The only thing holding prices back is DISBELIEF. You don't think real estate prices can keep rising. And that's the majority opinion. Many smart people agree with you. And that's okay with me (don't forget John Neff's quote at the beginning). Disbelief is actually what happens in the middle stages of all bull markets – disbelief that prices can go higher. Indeed, if it weren't for disbelief, prices would ALREADY be higher.

Funny how this works. Imagine if we have a rip-roaring bull market in housing over the next two years, and all that disbelief goes away just like it did in the Nasdaq two years ago. And imagine that I say to you "that's it – the game is over in real estate." Most investors, caught up in the moment, won't listen to me. That's the way it was in 2000...

Three months before the peak of the Nasdaq, in the January 2000 Forecast Issue of the Oxford Club Communiqué (back when I was Investment Director), I wrote in the lead story to my 40,000 readers:

"WE ARE AT THE PEAK OF MOST LIKELY THE GREATEST FINANCIAL MANIA THAT WILL EVER BE SEEN IN OUR LIFETIMES, AND QUITE POSSIBLY THE GREATEST EVER WITNESSED."

I couldn't have been more emphatic. Yet most investors didn't listen. The Nasdaq rose another 20% from 4,000 to 5,000 in just three months, before crashing towards its current levels near 1,000.

My suggestion to you now is to not miss out. To buy shares of D.R. Horton (DHI), my top recommendation among homebuilders (and John Neff's top recommendation too). And to ride this coming real estate "mania." It could be a double. Or a triple for us. Or more. And all I'm asking you to risk for a triple is 25%. That's 300% upside versus 25% downside – good odds in my book.

Let's step aside when the mania peaks, exactly as we have done in this bear market by successfully investing in alternatives to traditional stocks. How will we know when the housing mania is over? When the skeptics have converted, and nearly everyone you know thinks you're crazy to consider selling. We're not there yet.

I can't make any guarantees on how high it will go, or how bad it will be when it ends. If it gets as wild as Nasdaq 5,000, the outcome, scarily, could be the similar (Nasdaq 1,000). 

We don't know how far the real estate bubble will go. One thing I think we can reasonably say is that has likely just begun.

Buy shares of D.R. Horton (symbol DHI) today with up to 4% of your portfolio. And use a 25% trailing stop. Your upside? Hundreds of percent. Your downside risk? 25% tops, with our trailing stop. 

However, what I think doesn't matter nearly as much as what our 1-2-3 Model is saying. The 1-2-3 Model was dead accurate when it turned bearish in late-1999. It not only has served us well during this bear market, it's record of success is three-quarters of a century long. Unfortunately, it is firmly entrenched in SELL MODE, as the charts show. This is because, in the big picture, stocks are still expensive, and market action is not good. 

So we need to continue to dance around regular old stocks, as we've done with great success since this newsletter began. As you know, our True Wealth guideline for the proper allocation to stocks while in SELL mode is 100 minus your age, divided by two. So if you're 60 years old, that's 100 – 60 = 40 / 2 = 20. So 20% in stocks is about where you should be under these dangerous conditions. If we move into YELLOW LIGHT mode, the guideline for the same 60-year-old would be 40% in stocks.

Two great places to dance around the stock market are our "virtual banks" and our bond fund recommendations.

When it comes to Annaly and Anworth, our virtual banks, business is good. The spread [what they earn (4%) versus what they borrow at (2%)] is still wide at 2%. No worries here. These are still a buy – Annaly up to $18 and Anworth up to $13. Put up to 4% of your portfolio in each of these (a total of 8%).

THE BIGGEST WORRY HERE IS GETTING STOPPED OUT. These are relatively small stocks. If you bought Annaly when we first recommended it, your trailing stop would be $14.75. (So we can all use the same numbers, stops are determined using the "Adjusted Prices" on the Historical Prices section of a stock quote on Yahoo.) Your stop on Anworth is $10. If you've bought recently, determine your own stops.

I really don't want to get stopped out, as I think these are excellent investments. But that is the very reason we have stops – to prevent us from heading off a cliff. Maybe a huge spread tightening is just around the corner. Maybe Fannie Mae really is about to implode (hard to believe the government would let it happen). Who knows? Nobody.

That's exactly why we've got to limit our losses. We can never let a small loss turn into a big loss. And the only way to do that is by limiting our downside through trailing stops. If Annaly closes below $14.75, or if Anworth closes below $10, sell the next day, no exceptions. This strategy has served us well through the bear market. I'm pleased to report that we've never had a catastrophic loser in this newsletter. Just this month, we stopped out of two positions, Singapore and Korea. And as the back page shows, the damage is negligible.

For our recommended bond funds, you can put up to 8% each into the Vanguard High-Yield Corporate Fund (VWEHX), Bill Gross's Fremont Bond Fund (FBDFX), the I-shares Corporate Bond Fund (LQD), and the Vanguard Inflation-Indexed Fund (VIPSX).

Our 1-2-3 Model for real estate stocks is still in YELLOW LIGHT mode, having fallen out of GREEN LIGHT mode recently. Therefore our recommended real estate stocks are still a HOLD. However, homebuilder D.R. Horton is, of course, a strong buy.

For other recommendations, Monsanto is out of the gate nicely, and we collected a dividend as well. Also we collected a nice dividend on our recommended Freeport McMoran Copper and Gold preferred "C" shares. This one is still a buy, at a cheap $23.50 a share (remember, you get the price of gold divided by 10 in three years here).

We may be getting close to a bottom. Then again, we may not. Either way, we've now bought our first two outright stock purchases of 2002 – Monsanto and D.R. Horton.

We're not going to get crazy here though. The 1-2-3 Model is still in red light mode. So the right course of action is to play it safe.

Good investing,

Steve Sjuggerud
October 22, 2002