Harry Newton's In Search of The Perfect Investment
Newton's In Search Of The Perfect Investment. Technology Investor.
8:30 AM EST, Monday, December 10, 2007: The
agony of defeat. Failures hurt more than successes please. I agonize over my
stupidity losing money on a "sure" thing (often from listening to
one of my dumb friends). Since I'm a genius (self-proclaimed) I accept my successes
without thinking. All of us agonize over own stupidity -- some more than others.
Think a continuum. Bonds are for those of us who can't take failure in any flavor.
Investing in individual stocks are the other extreme.
me the BIG psychology is control. If I have it (as in CEO of a business), I
can stand the losses. I caused them. I fix them. Better to worry about fixing
than eating. If it's no control (like buying Citibank and watching their CEO
do dumb things, like invest in bum loans), I can't take the losses. My biggest
returns of 2007 were those adventures I DIDN'T invest in, like Citibank.
The only good part of this "don't invest" strategy is that the IRS
won't touch my "gains."
investment community calls it "your risk profile." To me that sounds
too highfalutin'. My obsession is a peaceful life, with few mistakes. Index
funds fit that bill.
If you still want to test your investment prowess (believing that I'm wrong),
take a tiny piece of your portfolio. Label that portfolio "Prepared to
lose all of this." Then gamble away. But be prepared to lose all of it.
And don't add anything to it with your serious money.
are as dumb as me. Ben
Stein writes in this weekend's
As I was looking
at my stock statements for 2007, I noticed I had done fabulously well
by my very modest standards on my large, broad-market index funds (especially
Fidelity Spartan Total Market and Vanguard Total Stock Market), on my Canadian
and Australian index funds and on an emerging-market index fund and a developed-market
index fund. But many of my individual picks had been clobbered.
My belief is
that I am not alone here. Unless you are a thorough genius like Warren E.
Buffett, buying individual stocks is tricky, especially in a wildly down market
for financial stocks. My resolution for next year is that I will buy only
broad indexes and Berkshire Hathaway, if I have any money left over after
feeding our three dogs, six (yes, six) cats and my endless extravagance.
got killed speculating on takeover candidates. I think I will leave that to
bigger boys than me. Again, I will stick with the indexes.
biggest career mistake my friends have made: They
quit their "dumb" job, panic because they suddenly have no income,
then take the next "dumb" job. I counsel two strategies:
Major research on the Internet and through company annual reports into opportunities
while still at your old job. This is a nights and weekend job.
2. A planned three-to-six month searching hiatus while you're newly unemployed.
key is to plan for unemployment. Then set a daily work/research schedule
that's as rigorous as your old job.
weeks is the BIG test. If you get seriously antsy after three weeks without
a job, you'll take the next dumb job, and be just as unhappy. I've watched this
happen a thousand times.
prices have dropped. Had you bought options
you may be out of pocket. Do not despair. Oil is going higher long-term. Short-term
is a horse of a different color. The only sure (i.e. certain) oil options
to buy are long-term -- perhaps two-year LEAPs. There is oodles of evidence
for long-term. The weekend brought a New York Times piece
Oil-Rich Nations Use More Energy, Cutting Exports. This chart summed
it all up:
And my friend
Jim Kingsdale has a new piece on "The
Price of Oil." Excerpts:
and people want to know why. The only certain answer is that either there
were more buyers than sellers or vice versa. In the case of oils sudden
reversal from a frontal attack on $100 to slipping below support
at $90, the apparent reasons are that the Saudis are upping production,
the U.S. economy is supposed to be weakening, and people think the dollar
may strengthen for a while. It seems clear that the U.S. economy will be weaker
going forward. The Saudis probably have increased their exports. Nobody knows
what the dollar will do, but I suspect it will not rally much more.
that killed the attack on $100 oil is that seasonally weaker spring demand
is not too far away; speculators may not want to be long as it advances, given
Saudi policy and a weaker economy on the horizon. But many times a price will
slip below obvious technical support only to wipe out those owners who have
put sell stops there, and then the price moves right back up.
So it seems truly a waste of energy (no pun) to worry much about short term
oil prices, even though they get all the headlines.
Two things are
more vital. First, the long term trend is up and is far from being broken.
I do believe that the trend is your friend. If there were to be
a shift in the long terms trend, that would be important. Secondly, the movement
away from backwardization of the strip, as noted in my last newsletter,
has continued. In fact, it appears that as you get out beyond 2010, there
is actually a contango, meaning the price gets higher the further out you
go. Actually, the long dated oil contracts experienced an enormous breakout
to the upside in September and October.
That makes perfect
sense to me. I think long dated oil futures prices are still wildly conservative
given the data available for future supply and demand. The idea of, being
able to buy oil for only about $85 to deliver in five years, which is what
the futures market is saying, is just bonkers, given my expectation of an
increasingly tight supply/demand future. In fact, that is the basic theme
for most of what follows.
I believe we
are at the early years of a 10 20 year period during which oil prices
will cycle upward at an accelerating pace.
The data underlying
those beliefs have been discussed in earlier Newsletters, particularly #7,
and more specifically in the work of analysts such as Chris Skrebowski. His
projection of an increasingly tight demand/supply problem for oil over the
next four years is summarized in this graph:
dates and numbers in the above graph are, of course, only estimates that will
clearly be wrong. Supply could be increased beyond Skrebowskis assumption
if Iraq and/or Nigeria begin to produce substantially more oil. Demand could
be lower if there is an extended global recession. Political events could
cause a major spike. But I think his general trend for future oil prices is
essentially correct. In fact, I think it is virtually indisputable. On the
other hand, history has shown the above price projections to be too conservative;
moreover, they seem to me to be essentially inconsistent with Skrebowskis
supply and demand projections. How could the price of oil be only $110 in
10/11 if there is a 8 mb/d difference between supply and demand, as projected?
Given my beliefs
about longer term oil prices, I try to construct a series of investment strategies
that together will provide a superior reward relative to the level of risk
that is taken. I try to balance the inevitability of the trend toward higher
oil (and eventually gas) prices against the reality that the exact timing
is unpredictable, so that the portfolio can yield relatively consistent positive
returns. To be more specific, I want to be positioned today for much higher
oil prices, even though I know they are unlikely to rise rapidly for another
year or so and I also want to make a good return if the oil price does not
rise in the short term.
So if you look
at the portfolio breakdown you will see the following:
26% is allocated to oil services and drilling. Regardless of whether the oil
price is $75 or $175, there will be an unending need to get as much oil as
possible out of the ground fast. The work will require increasingly heroic
efforts costing increasingly more money every year. Companies that do this
work used to be considered cyclical growth stories, but are now clearly in
a secular growth trend. Investments in this sector should provide 20% +/-
annual returns on average for a long time regardless of the exact price of
oil. I would sell if price/earnings multiples become excessive, but they are
generally still reasonable.
20% each is allocated to two strategies: oil sands and alternative energy
investments, both of which provide more speculative appreciation potential,
assuming long term higher energy prices. Alternative energy companies are
individual situations that depend largely on technological and governmental
policy developments but are generally encouraged by higher energy prices.
Oil sands stocks have outsized appreciation potential at higher oil prices
but will not appreciate if the oil price slides back into the low $70s
and stays there.
Note that oil
sands player Petrobank (TSO: PBG) is now a top-5 holding. Its patented
toe and heal technology called THAI is able to recover oil from
oil sands and heavy oil deposits at a fraction of the cost, with more energy
efficiency, and with better pollution control compared with older methods.
The company is developing a broad portfolio of properties that can take advantage
of their technology, which they also license. I encourage readers to do their
own research. The website is: www.petrobank.com. The company provides very
detailed discussions of historical and anticipated operations. I was introduced
to PBG by a thoughtful reader of this site.
10% is traditional oil and gas exploration and development companies which
are obviously leveraged to the price of oil and gas. My choices are either
smaller situations or mid-sized independents like Devon and Anadarko. As I
have written previously, the upside opportunities for the largest oil companies
are limited by their growing inability to replace the reserves they sell.
They are thus depleting assets, although ones with significant cash flow potential
for many years.
10% are mining and shipping companies that will do well in concert with the
continued growth of developing countries like China and India, which would
be aided by stable oil prices, so to some extent these positions provide upside
potential for the portfolio if the oil price does not appreciate rapidly.
also has a component of gold, cash, and short positions that reflect my current
concern that a U.S. economic recession could be deeper than the market has
yet discounted. This judgment will change with changing data and is not energy-related.
on Futures Strategy
us finally to call options on oil futures contracts, the new investment vehicle
that I recently added to the Energy Investment Strategies portfolio: I felt
that the major ingredient lacking in the portfolio soup of strategies described
above is dramatic appreciation potential that is both leveraged to much higher
oil prices and is independent of the stock market. The latter consideration
is key because much higher oil prices, as discussed in Newsletter #7, may
eventually cause a stock market collapse. It would be particularly frustrating
if we were to see our fundamental expectations of higher oil prices fulfilled
but at the same time see our investments in energy stocks be worth less rather
than more because of a huge stock market fall related to the rise in oil prices.
The options/futures strategy assures us against this risk.
I invested 3%
of portfolio assets in a series of call options on oil futures contracts that
give me rights to buy oil at prices between $100 and $120 per barrel up through
dates ranging from 11/20/09 through 11/20/12. If I am right in believing that
the price will exceed $300 per barrel by late 2012, these options are sufficient
to double the value of the portfolio. If I am wrong, and if the price does
not rise beyond $125 per barrel in three to five years, I will have lost 3%
of the portfolio.
an example: a contract that gives you the right to buy 1000 barrels of crude
for $120 per barrel in November, 2012, costs about $5,000, so breakeven is
$125 per barrel. At $150 per barrel, the profit is $25,000 500% in
five years or less. At my expected price of $300 per barrel the profit is
$175,000. You figure out the percentage gain.
Note that tax
impacts of this strategy are different from investing in stocks. You pay taxes
on profits or get tax credits on losses at the rate of 40% at
your ordinary income rate and 60% at your long term capital gains rate. Moreover,
your portfolio is marked to market every tax year for tax purposes.
Obviously, investors should consult their own tax counsel (as well as investment
counsel and perhaps psychiatrist) before deciding to follow such a
If you are really
paying attention you will have noted that I said I invested 3% of the portfolio
in options on futures and yet the allocations show only 2%. That is because
this brilliant strategy has already cost me a little more than 1%. The loss
is partly compulsory and partly a matter of chance. The compulsory part is
that you buy the options at the ask price, but they are priced
in your portfolio at the bid. In this market, the spread between
bid and ask is significant; this is not the most liquid market in the world.
The chance part
results from the fact that I bought them when the front month oil contract
was in the $93 - $98 range. In other words, at the top. As oil has moved below
$90, the longer dated futures have also declined and the options on them have
declined too although the total decline in the price of the options
is a much smaller percentage than the percentage decline in the near term
futures contract price. Which also suggests that if/when the oil price increases,
the option price will increase more slowly as well. That is, until the near
term price exceeds the option exercise price (say $120), after which the appreciation
will be quite rapid.
is Oil Going?
In the four
years since 2003, the oil price has risen from about $30 to about $90, a compounded
annual growth rate of 31.6%. A similar rise in the next five years would bring
the price in late 2012 to about $355 not far from my personal guesstimate
closely at the recent past we see that the annual increases during the past
four years, taking the year-end price are roughly:
2006 minus 12%
2007 80% (at $90)
arbitrary annual benchmarks, we experienced a 150% jump in price from late
2003 through August of 2006, then a normal correction from $75 to $50 or 33%
through early 2007. Then the price nearly doubled in the ten month period
February through October, 2007. Clearly the price is due to rest for a while
at this point, but a similar pattern of explosive growth followed by retraction
and/or rest followed by another explosive growth would not be unusual. In
fact, it is a typical pattern of growth for unusually explosive upside trending
commodities or stocks. Therefore, a compounded annual growth rate exceeding
the 30% plus seen since 2004, is not a radical idea, I believe.
On the other
hand, analysts on Wall St. are not forecasting anywhere close to this rate
of growth for the oil price. In fact, a Goldman Sachs analysis a few months
ago called for prices to peak in the $105 area and then fall back over a few
years into the 80s. Do they think developing countries (not least the
oil exporting countries) are going to suddenly stop growing? Or that production
decline rates are going to suddenly improve, reversing the trend toward increased
declines each year? Do they believe that somehow large new heretofore unpredicted
fields will start producing oil despite the long lead times required? It is
not clear because they do not make their assumptions explicit.
the oil consultancy run by the famous Dan Yergin also forecasts much
lower oil prices than I do. They do make some of their assumptions explicit
but their assumptions are wildly optimistic in terms of new discoveries, the
time to bring them on, rates of depletion, and the ability of the world to
produce large amounts of fuel from heretofore unexploitable reserves of things
that might be made into oil some day but never have in the past, such as Western
U.S. oil shale.
I think the
inability of most mainstream analysts to face the reality of much higher oil
prices longer term is a simple career risk/reward analysis. To forecast $300
oil in 2012 would be high risk for the analyst, since it is several standard
deviations greater than the typical forecast. If one were to take that risk,
what would be her return? Well, first she would aggravate every top oil executive
and top government official, none of whom wants the public to become frightened
and demand controls or taxes on oil. Second, she would be fired if her forecast
did not come true. Her reward? Not clear. The street generally plays it safe
and safe is the herd mentality.
The irony is
that for four years we have seen a 30% compounded annual rate of growth in
the oil price and yet not one Wall St. analyst sees anything like this rate
of growth continuing in the future. The implication is that the past four
years have been an historical aberration. Frankly, that seems to defy logic.
not a good month for the EIS portfolio. ... The portfolio was down 8.2% which
compares unfavorably with all the comparable indices: the OIH down 7.3%, the
IYE down 3.0% and the SPY down 3.9%. As mentioned above, the new options/futures
position cost me 1% which was mostly the difference between the starting ask
and the ending bid. More disastrously, the largest position in
the portfolio last month, a speculative alternative energy stock, Nova Biosource
Fuels (NBF) was off 42% for the month causing a 3.5% drop in the portfolio.
Aside from these two items the portfolio performed essentially in line with
NBF was a victim
of legislative uncertainty and operational immaturity. As I have said before,
if the companys technology succeeds in turning low cost feedstock into
diesel fuel, it should make a lot of money eventually, regardless of government
policy. I do not know anything that would make me question the technology.
But there is a rule that one should cut ones losses and I broke that
rule on NBF and I continue to break it. So we shall see.
I do think that
in the not terribly distant future we will see a dramatic growth in the popularity
of diesel engines in the United States. They already dominate in Europe because
they are cleaner and about 20% more fuel efficient and perform at least as
well as gasoline engines. If the U.S. increases its fuel efficiency laws,
that will give diesel another boost. Also a Congressional mandate for more
use of ethanol mixed with gasoline will also hasten the trend toward diesel.
Ethanol is inherently expensive because it pushes up the price of corn, its
primary feedstock, and because it is only 75% as fuel efficient per gallon
as gasoline. If the Congress insists, as seems likely, on increasing the mandate
for increasing the ethanol content of the gasoline/ethanol mixture, I believe
the result will be higher priced and less fuel efficient gasoline. So more
consumers will chose a diesel engine. That is not a great reason to own NBF,
but it doesnt hurt either.
So, in conclusion,
let us all enjoy this temporary respite in the rise of oil prices.
to keep your mouth shut:
NEW YORK (AP) Dec 7 -- A Manhattan doorman has been suspended for
having bad breath. Jonah Seeman, who has been ushering tenants into a four-building
complex on East 89th Street for 40 years, was told not to come to work Friday
because of halitosis. Seeman said he has stopped eating garlic, uses mouthwash
and takes breath mints on the job. The Brooklyn resident, who supports his 81-year-old
mother, has been suspended twice before for bad breath -- one day in May and
then again in July.
at the Gracie Gardens complex expressed surprise over Seeman's suspension and
came to his defense.
"His job, which he does well, is opening the door -- not opening his mouth,"
said Adam Reingold.
I don't make this
Mental Health day!
The lesson from the love story of Ralph and Edna:
someone doesn't love you the way you want them to, doesn't mean they don't
love you with all they have.
Ralph and Edna
were both patients in a mental hospital. One day while they were walking past
the hospital swimming pool. Ralph suddenly jumped into the deep end. He sank
to the bottom of the pool and stayed there. Edna promptly jumped in to save
him. She swam to the bottom and pulled him out.
When the Head
Nurse Director became aware of Edna's heroic act she immediately ordered her
to be discharged from the hospital, as she now considered her to be mentally
When she went
to tell Edna the news she said, "Edna, I have good news and bad news. The
good news is you're being discharged, since you were able to rationally respond
to a crisis by jumping in and saving the life of the person you love. I have
concluded that your act displays sound mindedness. The bad news is, Ralph hung
himself in the bathroom with his bathrobe belt right after you saved him. I
am so sorry, but he's dead."
"He didn't hang himself, I put him there to dry. How soon can I go home?"
A young cowboy walks into the town cafe. He sits at the counter and
notices an old cowboy with his arms folded, staring blankly at a full bowl of
minutes of just sitting there staring at it, the young cowboy bravely asked
the old cowpoke, "If you ain't gonna eat that, mind if I do?"
The older cowboy
slowly turns his head toward the young wrangler and in his best cowboy manner
says, "Sure, go ahead."
Eagerly, the young
cowboy reaches over and slides the bowl over to his place and starts spooning
in it with delight. He gets nearly down to the bottom and notices a dead mouse
in the chili. The sight was shocking and he immediately barfs up the chili into
The old cowboy
quietly says, "Yep, that's as far as I got, too."
This column is about my personal search for the perfect
investment. I don't give investment advice. For that you have to be registered
with regulatory authorities, which I am not. I am a reporter and an investor.
I make my daily column -- Monday through Friday -- freely available for three
reasons: Writing is good for sorting things out in my brain. Second, the column
is research for a book I'm writing called "In Search of the Perfect
Investment." Third, I encourage my readers to send me their ideas,
concerns and experiences. That way we can all learn together. My email address
is . You can't
click on my email address. You have to re-type it . This protects me from software
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