The Shining Star of the Silver Screen

 

 

Though the golden age of film launched a slew of great careers, there can only be one Katharine Hepburn. In a sector full of stars with staying power, Silver Wheaton (NYSE: SLW) is one act you'll never grow tired of watching.

This low-cost producer with the unique business model achieved record production of 4 million silver-equivalent ounces (SEOs) during the second quarter, earning a respectable $18.4 million despite a 19% decline in realized silver prices from $17.35 to $14.04 year over year.

The volume of silver delivered to the company lagged attributable production by about 1 million SEOs, so sales revenue for the quarter was based upon flat volume of 2.9 million ounces, while delivery of the remaining produced ounces will boost results going forward. Variable timing of shipments will impact sales from time to time because of temporary snags like the semi-annual freezing of the Yukon River near the Minto Mine in Canada. As I've said before, within a rising long-term price environment for silver, delayed sales can conceal a silver lining.

Although I am vocally bullish on gold, my regular readers know that I have consistently considered silver a superior investment vehicle until long-term historical ratios between the two metals are restored. Now that Coeur d'Alene Mines (NYSE: CDE) is ramping up production at Palmarejo, and Hecla Mining (NYSE: HL) finally carries more cash than debt on its balance sheet, downtrodden miners with significant potential for recovery appear plentiful.

From well-established names like Pan American Silver (Nasdaq: PAAS), to the sheer growth potential of Silver Standard Resources (Nasdaq: SSRI), silver investors have their research cut out for them. Personally, I own them all (did I mention I was bullish on silver?), but I continue to view Silver Wheaton as a shiny standout within a promising sector.

In a nutshell, Silver Wheaton enjoys essentially fixed operating costs of around $4 per ounce, clinching a massive margin advantage over the competition. With additional silver streams coming online, especially Goldcorp's (NYSE: GG) world-class Penasquito mine later this year, Silver Wheaton anticipates 72% production growth over the next four years to 31 million SEOs. The company also reports "spectacular exploration success" from the Minto mine, and retains $450 million in liquidity to pursue additional silver streams.

What's not to like?
This is not a rhetorical question, fools. I take my objectivity seriously. Using the comments section below, or my CAPS pitch for Silver Wheaton, I invite you to poke holes in my glowing praise for this company. Aside from a manageable bank debt of $150 million, as a prospective investment this stock reminds me of a vintage Hepburn performance: virtually flawless.

The Next 3 Dividend Burnouts?

With the S&P 500 still down more than 30% since the start of 2008, many wary investors have been turning to the safety of dividend-paying stocks.

In just the last three months of '08, for example, domestic dividend-focused ETFs that invest in high-yielders experienced net inflows of $1 billion.

Buyer beware
While dividends provide a source of income that helps to smooth out market volatility, crises like the present one are leaving many companies with little choice but to reduce or omit payments. According to data from Capital IQ, some 370 companies cut their dividends last year, and their stock prices had an average return of negative 56% for the year.

Even though some companies -- including ExxonMobil (NYSE: XOM), Costco (Nasdaq: COST), and Procter & Gamble (NYSE: PG) -- have continued raising their payouts in 2009, we've already broken the record set in 2008 for most skipped payments in one year, at more than $46 billion. Black & Decker and KeyCorp (NYSE: KEY) are just some of the latest victims.

So how can you tell whether your company is about to make a cut? In January, I argued that Dow Chemical and Huaneng Power (NYSE: HNP) were risking dividend cuts. (Both have since made cuts.) Among the warning signs these companies exhibited:

• High yields.
• High payout ratios.
• Industry headwinds.

Extremely high yields signal investors' skepticism that the company will be able to maintain its dividend. When National City announced its first dividend cut last year, for example, the stock was "yielding"10%. Since then, the stock plunged, and the company was acquired by PNC. A high payout ratio -- particularly when combined with a difficult operating environment -- suggests that the company doesn't have enough free cash flow to support its payouts.

But these factors don't necessarily imply that a cut is imminent. Many other companies have continued for years to pay dividends they cannot afford. All they've done is damage their own companies -- and the value of your shares.

I'll spare you all the details
A fascinating 2004 survey explains how and why. A team of four professors from Duke and Cornell, surveying more than 400 financial executives, discovered that 94% of executives "strongly ... or very strongly ... agree that they try to avoid reducing dividends." Many admitted to selling assets, laying off employees, borrowing heavily, or omitting important projects before cutting dividends.

See, these managers know that the market reacts negatively to dividend cuts. Several executives noted that Wall Street's response is an especially important consideration during liquidity crises -- such as the present one -- because they wouldn't want lenders to think their company is struggling.

But let's get back to payout ratios. Unfortunately, if a company isn't generating enough free cash flow to support its payout, the extra cash has to come from someplace else. Aside from raising revenue or cutting expenditures, there are four basic ways a company can collect the cash it needs to make such payouts:

• Burn existing cash reserves.
• Borrow money.
• Issue shares.
• Sell assets.

And while some of these practices may be acceptable temporary fixes for a difficult year, none is sustainable over the long term. A company that pursues these strategies for too long will eventually burn itself out and damage its shareholders in the process. Even worse, it will probably end up having to cut its dividend anyway.

So which companies might fit that description today?

Three companies risking a burnout
These three companies have paid out more in dividends than they took in as free cash flow (or were free cash flow negative) over the past three years:

Company	Net Income Payout Ratio	Free Cash Flow Payout Ratio	Total 3-Year Shortfall*	Funding Method
American Capital	N/A	161%	$434 million	Stock, debt, sell assets
Consolidated Edison (NYSE: ED)	58%	N/A	$460 million	Debt, stock
Linn Energy (Nasdaq: LINE)	21%	N/A	$3.6 billion	Stock

Data from Capital IQ, a division of Standard & Poor's. *Calculated as total dividends paid minus free cash flow.

As a regulated investment company, American Capital is required to pay out 90% of its taxable income in the form of dividends. For the past few years, the company could afford to do so by diluting shareholders and issuing debt (and, last year, selling investments).

Annualizing the upcoming distribution shows the stock yielding more than 130%. But investors should be aware that it could become more difficult to support the dividend in the future. That's because the private equity firm's cost of capital is rising because of a recent credit downgrade and $2.3 billion of unsecured debt currently in default.

While Consolidated Edison and Linn Energy may appear to have adequate net income to cover their dividends, it's important to remember that net income is an accounting construction that doesn't always reflect how much cash a company actually has left over to cut your check. Free cash flow payout ratios often provide a more accurate picture. Neither company has produced free cash flow in years, though both have continued to pay a hefty dividend -- for now.

The silver lining ...
Dividend stocks have a history of putting money in investors' pockets, but choosing the right dividend stocks for a down market is critical to protecting your portfolio. Paying close attention to how your company funds its dividend will help you achieve the golden returns that dividends offer.

China's Bubble-icious IPOs

It's off to the races for investors in Chinese IPOs! China State Construction Engineering (CSCE) came to market in Shanghai on Wednesday -- and showed a stunning 56% first day gain -- rather impressive for the largest IPO globally since Visa (NYSE: V) went public last year. Demand for the shares wasn't lacking -- the retail portion of the offering was nearly 50 times oversubscribed! But that performance pales compared to Sichuan Expressway, which floated on Monday, registering a stunning 203% first-day gain.

It's contagious
The fever has spread to Hong Kong, where BBMG, Beijing's largest cement supplier, gained 56% on its Wednesday debut -- retail demand for shares exceeded supply by 775 times.

Chinese authorities ended a 10-month ban on IPOs in June, encouraged by strong market performance (the SSE Composite Index is up over 80% year-to-date).

What about Chinese stocks that are available to U.S. investors?
To answer that, I put together my own market-weighted index made up of the 43 Chinese companies traded on major U.S. exchanges with a current market value greater than $500 million. These are the results in terms of returns and valuation:

	Year-to-Date Total Return	Quarter-to-Date Total Return	Price-to-Book Value
Baidu (Nasdaq: BIDU)	169%	17%	22.00
Yingli Green Energy (NYSE: YGE)	129%	3%	2.78
Suntech Power (NYSE: STP)	65%	8%	2.46
JA Solar (Nasdaq: JASO)	14%	6%	1.23
Focus Media (Nasdaq: FMCN)	(7%)	5%	0.94
LDK Solar (NYSE: LDK)	(15%)	(1%)	1.66
Market-Weighted Average (43 stocks)	45.7%	10.3%	3.43
S&P 500	7.5%	10.9%	2.06*

Source: Author's calculations, based on data from Capital IQ, a division of Standard & Poor's. Returns and price-to-book multiples are as of July 30, 2009.
*Approximate value (price-to-book value multiple of the SPDR S&P 500 ETF (SPY)).

Bigger gains, more expensive
It's clear that U.S.-traded Chinese stocks have far outpaced U.S. stocks, even during the recent mini-rally. Furthermore, they're quite a bit more expensive on a price-to-book value basis as well. Ah, but Chinese companies promise untold growth, bulls will counter. Perhaps, but the other side of the coin is this: This set of companies -- let alone any one specific name -- also present higher risk than the S&P 500; investors need to account for that in valuations, also.

U.S. investors need to be wary, too
Why this bubble in China? Wei Jianing, an economist at the Development Research Center of the State Council, estimates that 20% of the unprecedented amount of credit banks have extended during the first half of the year has found its way into the stock market. For the BBMG IPO, Hang Seng Bank offered margin loans at a record low rate of 0.5%.

Once Chinese authorities move to cool the market, it could have a very nasty effect on stock prices. It is perhaps ominous that CSCE's strong debut didn't prevent the Shanghai market from falling 5% on Wednesday -- its largest decline of the year. Investors in Chinese stocks -- here and in China -- need to be wary.

 

You Are Right to Own This Stock

Here's a little tip most Wall Street types would prefer you not know: The recipe for great long-run success in the stock market is startlingly simple.

You heard me
You might find that hard to believe, since we're in the midst of the worst bear market since the Great Depression. How can it be true? Well, empirical research from professors Eugene Fama and Kenneth French, along with that of Jeremy Siegel, supports the notion that excess returns await those who look for value-priced stocks.

But scholarly research is one thing. Application is another. If you're looking for a real-life example of the power of taking a long-run, value-focused approach to investing, look no further than the jaw-dropping success of one of the world's richest men: Berkshire Hathaway's Warren Buffett.

How it works
This proven process for beating the market is actually pretty straightforward:

1. Buy great businesses.
2. Buy them cheap.
3. Be patient ... but bold.

Want more color? Let's dance.

Buy great businesses
Businesses with quality management and durable competitive advantages (a.k.a. economic moats) drive supreme long-run value for their investors. These competitive advantages allow companies to consistently earn returns in excess of their cost of capital, helping to fund growth, share repurchases, and dividend hikes -- and, of course, boosting share prices. Put simply, moats make money.

Durable competitive advantages come in several forms. A few of the most valuable and well-known are:

• Network effects: Think FedEx (NYSE: FDX) or UPS (NYSE: UPS).
• Cost advantages: Think ExxonMobil (NYSE: XOM).
• Intellectual property: Think IBM (NYSE: IBM).
• High switching costs: Think Automatic Data Processing (Nasdaq: ADP) or Intuitive Surgical (Nasdaq: ISRG).

A quick way to judge whether a company has a durable competitive advantage is to look at its historical returns on invested capital. If they're consistently strong (generally speaking, higher than 13%), you're probably looking at a strong business.

2. Buy them cheap
Finding great businesses takes you a long way toward market-beating returns. But there's just one problem: Great businesses rarely look cheap by traditional metrics. Let's look at some of the top-performing S&P 500 stocks from 1957 to 2003, according to the work of Jeremy Siegel:

Company	Annual Return	Average P/E
Altria	19.8%	13.1
Abbott Laboratories	16.5%	21.4
Bristol-Myers Squibb	16.4%	23.5
Tootsie Roll	16.1%	16.8
Merck	15.9%	25.3
S&P 500	10.9%	17.5

Source: Jeremy Siegel, The Future for Investors.

As the last column suggests, great businesses almost always look a bit pricey. What should investors do, then?

In the order of operations, finding a great company is first and foremost. Once you've identified said company, keep an eye on it until it comes down to at least a good price -- because it is possible to turn a good company into a bad investment.

Coca-Cola, for example, rarely looks cheap. But when the shares were beaten down in 1988, Buffett backed up the truck for the wide-moat beverage giant, making a killing in the process.

To quote Roger Lowenstein's Buffett biography:

By the latter part of 1988, Coca-Cola was trading at 13 times expected 1989 earnings, or about 15% above the average stock. That was more than a Ben Graham would have paid. But given its earning power, Buffett thought he was getting a Mercedes for the price of a Chevrolet.

Great company, good price. Buffett has built a fortune using that simple rule.

3. Be patient ... but bold
As I said earlier, great businesses don't often fall into the realm of cheap. When the rare fat pitch does cross your plate, though, don't be afraid to take a hard swing at it. Now, you might be thinking "I'm glad Mr. Buffett was able to cash in on Coke 20 years ago, but pitches that fat just don't come along very often."

Au contraire, my friend. Bear markets such as this one, where investors are shouting doom and gloom from the rooftops, are a perfect time to find great businesses at cheap prices.

Case in point? How about my latest recommendation to Inside Value members, Campbell Soup Company (NYSE: CPB)? Campbell sells its products in more than 150 countries, but the real cash machine is the U.S. condensed soup market, which Campbell utterly dominates. Campbell's scale, brand, and distribution network keep plenty of would-be competitors at bay, and the company is able to squeeze out fat cash flows and profits as a result. I peg the shares as worth about $38. Blend that 20% upside with a solid 3.2% yield, and you're looking at a risk-adjusted bargain.

If you own shares of Campbell Soup, you are right to own this stock -- it's a great business trading for a good price.

So is value investing right for you?
Buffett-style value investing isn't right for everyone. Even if you're willing to take the time to identify outstanding companies with lasting competitive advantages, only a unique individual can confidently stroll into a market when peers are running for the exits.

Still, for those with the dedication and the right temperament, the intrinsic and financial rewards can be substantial.

Stocks Worth Buying Again

 

It's always fascinating to read stories about average, everyday people who built fortunes by regularly investing small amounts over long periods of time in companies such as Merck (NYSE: MRK), 3M (NYSE: MMM), and Bristol-Myers Squibb (NYSE: BMY).

If you worked for these companies and/or regularly "trickled" money into them over the years, this is quite feasible -- Merck, 3M, and Bristol-Myers Squibb have returned roughly 13.1%, 11.9%, and 12.3% annually over the past three decades or so, respectively, even after taking into account the losses each stock has seen in the past 18 months.

But you can also get market-beating returns by buying into great companies at more opportune times -- whenever the stock goes on sale. Rather than regularly investing small, fixed amounts, investors can use the simple method of buying a stock in portions to manage risk and boost returns. And now would definitely count as one of those opportune times to buy cheap stocks.

First, find a solid business
Of course, every situation is different, but big returns on investments always come on the backs of fundamentally strong businesses. And if you're confident that you've purchased shares in a great company, why wouldn't you consider buying again, particularly if the stock price is significantly below intrinsic value? Especially in pessimistic markets (like today's), fundamentally strong businesses can be bought for good prices -- or even downright outrageously cheap.

For large, stable companies, buying more shares when the outlook for them is bleak can be rewarding. For instance, buying more Altria back at the peak of investors' pessimism over tobacco lawsuits would have juiced your returns considerably -- investors have gained more than 530% from the stock's low in 2000 with the benefits gained by spin-offs of Kraft Foods (NYSE: KFT) and Philip Morris International.

For younger, riskier companies, a strategy of acquiring shares in portions is a smart play. It limits your initial outlay and reduces your exposure to significant drops should the company falter or broader economic conditions change.

For example, look at Mobile Mini. You've probably seen the company's portable storage units around construction sites and parks -- the company converts shipping containers into storage lockers and then leases them for use in commercial and residential markets. From 1997 to the beginning of 2002, Mobile Mini's stock soared nearly tenfold as the company capitalized on rising demand for storage units. Then, in an abrupt six-month period afterward, the stock shed roughly 70% of its value.

When demand for portable units dropped with the slowing economy, margins began to shrink, and investors poured out of Mobile Mini stock. But the fundamental business operations remained intact. Investors who bought at the peak but continued to hold the stock have still matched the broader market return.

But money invested when the outlook was bleak is now up more than 200%.The larger economic conditions had only a temporary impact on Mobile Mini's solid business model.

Buy again
Other companies, such as Celgene (Nasdaq: CELG), Boeing (NYSE: BA), andOracle (Nasdaq: ORCL) have experienced big drops in share price at some point, only to come roaring back. Investors who focused on the underlying businesses rather than the stock prices were more likely to turn the event into an opportunity.

 

These Are the Market's 10 Best Stocks

 

The best stocks? Is that really what I'm going to write about, after a year (2008) in which the S&P 500 dropped by nearly 40%?

It is, actually. You learn pretty rapidly in this business that the best way to make money in the market is to invest for the long term, and you recognize that volatility is part of the ride. And when you commit to the long term, you quickly discover that the stocks that offer the best returns today aren't well-known, widely owned names.

But I'm getting ahead of myself. Before I can get to the takeaway, I have to show you the data. This is a simple list of the top-performing stocks of the past 10 years. I compile this list at the end of every year, and every year, it yields the same fascinating insight:

Company	Return, 1999-2008	Jan. 1, 1999, Market Cap
Hansen Natural	4,891%	$53 million
Celgene	4,214%	$252 million
Quality Systems	4,130%	$26 million
Clean Harbors	4,129%	$16 million
Green Mountain Coffee Roasters	4,122%	$19 million
Deckers Outdoor	3,551%	$19 million
Almost Family	3,171%	$9 million
Southwestern Energy	2,990%	$187 million
FTI Consulting	2,879%	$16 million
XTO Energy	2,839%	$343 million

Data from Capital IQ, a division of Standard & Poor's. Includes only U.S.-listed stocks with verifiable stock price histories on major exchanges.

The trait that sets these stocks apart
What does an energy-drink maker (Hansen) have in common with a biotechnology leader (Celgene)? A home-nursing practitioner (Almost Family) with the makers of Ugg boots (Deckers)? A natural-gas driller (XTO) with some guys who sell java (Green Mountain)?

On the face of it, not much. But if you look closely, you'll see that these were all very small companies when their amazing stock market runs began.

To see just how important it is to start small in the market, take a look at the returns that the 10 best large caps offered over the same period of time:

Company	Return, 1999-2008	Jan. 1, 1999, Market Cap
China Mobile (NYSE: CHL)	574%	$20 billion
BHP Billiton (NYSE: BHP)	554%	$16 billion
Telmex	546%	$19 billion
Royal Bank of Canada	243%	$15 billion
Southern (NYSE: SO)	237%	$20 billion
Bank of Nova Scotia	232%	$11 billion
ConocoPhillips (NYSE: COP)	143%	$11 billion
Rio Tinto (NYSE: RTP)	187%	$16 billion
Nike (NYSE: NKE)	184%	$12 billion
ExxonMobil (NYSE: XOM)	171%	$178 billion

*Data from Capital IQ and is adjusted for dividends.

Even after giving these companies credit for their hefty dividends, their returns still don't stack up.

Here's what's special about very small companies
And although companies such as Celgene and XTO are big-cap market darlings today, tracked and owned by big institutions such as Goldman Sachs and TIAA-CREF, and the New York State Common Retirement System, the next Celgene and the next XTO are being ignored and undervalued -- just as Celgene and XTO were 10 years ago! That's because companies like these are too small and too obscure to be worth Wall Street's "valuable" time.

So if you want to buy the best returns, you have to look at stocks today that are:

1. Ignored.
2. Obscure.

And, most of all:

3. Small.

That was the case at the end of 2005, 2006, and 2007 as well.