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Harry Newton's In Search of The Perfect Investment Newton's In Search Of The Perfect Investment. Technology Investor.

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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.

For 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."

The 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.

Others are as dumb as me. Ben Stein writes in this weekend's New York Times,

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.

I especially got killed speculating on takeover candidates. I think I will leave that to bigger boys than me. Again, I will stick with the indexes.

The 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:

1. 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.

The key is to plan for unemployment. Then set a daily work/research schedule that's as rigorous as your old job.

Three 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.

Oil 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:

Prices move 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 oil’s sudden reversal from a frontal attack on $100 to slipping below “support” at $90, the apparent reasons are that the Saudi’s 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.

Another factor 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.

First Principal

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:

The specific dates and numbers in the above graph are, of course, only estimates that will clearly be wrong. Supply could be increased beyond Skrebowski’s 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 Skrebowski’s 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?

Here Are the Strategies

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:

• About 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.

• About 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 $70’s and stays there.

Note that oil sands player Petrobank (TSO: PBG) is now a top-5 holding. It’s 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: The company provides very detailed discussions of historical and anticipated operations. I was introduced to PBG by a thoughtful reader of this site.

• About 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.

• About 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.

The portfolio 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.

The Options on Futures Strategy

This brings 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.

Here’s 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 strategy.

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.

How High 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 of $300.

Looking more closely at the recent past we see that the annual increases during the past four years, taking the year-end price are roughly:

• 2004 – 66%
• 2005 – 20%
• 2006 – minus 12%
• 2007 – 80% (at $90)

Forgetting the 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 80’s. 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.

CERA — 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.

November Report Card

November was 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 comparables.

NBF was a victim of legislative uncertainty and operational immaturity. As I have said before, if the company’s 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 one’s 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 doesn’t hurt either.

So, in conclusion, let us all enjoy this temporary respite in the rise of oil prices.

Time 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.

Apartment dwellers 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 stuff up.

Happy Mental Health day!
The lesson from the love story of Ralph and Edna:

Just because 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 stable.

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."

Edna replied, "He didn't hang himself, I put him there to dry. How soon can I go home?"

Totally disgusting
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 chili.

After fifteen 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 bowl.

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 scanning the Internet for email addresses to spam. I have no role in choosing the Google ads on this site. Thus I cannot endorse, though some look interesting. If you click on a link, Google may send me money. Please note I'm not suggesting you do. That money, if there is any, may help pay Michael's business school tuition. Read more about Google AdSense, click here and here.

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