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Weekend Edition

The Best of The S&A Digest
Saturday, July 7, 2007

 Investors in hedge funds, beware. Over the years, we've seen that they can become "roach motels" for capital: Your money can check in, but it can't check out. John Devaney, who invests in subprime mortgage bonds, restricted redemptions for his Horizon Strategy hedge funds to protect them from a fire sale. Devaney manages a total of $619 million.
 
 What's happening with the Horizon fund is typical of what I call the "paradox of finance." What often works for a small amount of capital proves to be disastrous when a large amount of capital tries the same thing. In the subprime case, as long as most of the mortgage market was well-disciplined, then you could make a lot of money lending to marginal borrowers on the fringe, because you could hedge with plenty of good borrowers.
 
But... in 2005 and 2006... subprime lending became the mainstay of the mortgage market. Instead of lending to a few marginal borrowers on the fringe, subprime became the largest single component. The credit quality of the entire industry collapsed – just as a huge wall of money found its way into mortgages. What started out as a good idea turned into a farce... and ended up as a fraud.
 
Ah... you might say... that's why I only invest in index funds. Doesn't matter. You can't escape the paradox of finance. Any investment idea, no matter how sound, at some point will be ruined if too much capital tries to follow the same strategy.
 
Index funds were, at one time, a great idea. They allowed you to "piggyback" for free on the handicapping that was done by the majority of other investors, who actively managed their portfolios or who paid for active management. But... as soon as most of the money in the market was "indexed" – which happened in U.S. stocks sometime around 1998 – then you were investing in a farce.
 
If most of the money in the market goes into indexing, then everyone is buying stocks on the basis of market cap (since indexes are normally weighted by market cap). That means most of the money is going into the most expensive stocks... simply because they're the most expensive. Hopefully you can see that the future returns of a strategy that seeks to buy the most expensive stocks, purely based on price, aren't likely to be good (and they haven't been).
 
The fraud stage of indexing is now occurring. Funds that are really actively managed and have high fees and costs have begun to call themselves "index funds." Now folks who think they're indexing, aren't.
 
How do you avoid the paradox of finance? Well... it's difficult for most people. You have to think for yourself. You have to employ your capacity to reason. And... as I'm sure you know... most people would rather do anything but think for themselves.
 
 Signs of a top in private equity... More people work for Kohlberg Kravis Roberts & Co. than live in Atlanta, Miami, or St. Louis.
 
 Famed investor and commodities bull Jim Rogers was interviewed by Bloomberg News this weekend. While his message was no surprise, it's still smart to listen to one of the world's greatest investors...
 
To start, Jim thinks commodities are the best place to be for the next 20 years. He's particularly bullish on water but says the best way to play it is to buy water-services companies.
 
On the other hand, he's worried that there are too many speculators and bulls in the gold market. He suggests waiting for a correction to shake them out before getting back in. Likewise, he's sold out of nearly all emerging markets, griping that there are too many MBAs exploiting them. Again, he hopes to buy back in after a correction. The only emerging market Jim didn't sell is China.
 
 Signs of a top in metals prices... The beer industry expects to lose hundreds of thousands of kegs and tens of millions of dollars this year as customers steal kegs and sell them for scrap metal. The Beer Institute, the industry's main trade group, expects many customers to forego the $10-$30 deposit in order to sell the kegs as scrap for $15-$55. The institute also expects many people to steal kegs from bars and restaurants. Last year, brewers lost $50 million in kegs industrywide.
 
 S&A Oil Report pick ConocoPhillips said it could take many more months to come to terms with the Venezuelan government over compensation for its operations in the Orinoco Valley. The company will likely write off the investment as a $4.5 billion "impairment" in the second quarter. The stock seems unfazed by the news... it hit a new 52-week high Friday.
 
Regards,
 
Porter Stansberry




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