The Lesson From a Scandal

By Dan Denning, Editor, Australian Wealth Gameplan 

Is it just me or has everyone forgotten the whole scandal emanating from MF Global about hypothecation and rehypothecation?

A new financial term seems to enter into common use every few months or so. This is probably the nature of a financial crisis that originated in a credit crisis with lots of exotic financial instruments. Hypothecation and rehypothetcation are the latest terms. But what do they mean?

Hypothecation is simply when you pledge some sort of collateral to secure a debt. This happens all the time if you set up a margin account with a broker. Margin accounts require you to post some sort of collateral when you trade on margin to short stocks, for example. Since you're borrowing someone else's shares and selling them, the margin covers the cost of buying the shares back if the price moves up instead of down. 

Without getting too technical, most margin accounts allow the broker to loan whatever assets are in your account to other customers. You consent to this when you trade on margin. As strange as it is to borrow something that's not yours, sell it, get the cash, and buy it back at a lower price for a profit (if your trade works), this is just one aspect of the world of margin lending.

The basic idea is that you can make a lot of money without having a lot of money to begin with. This, of course, is the whole idea behind leverage: boosting your financial returns by borrowing cheaply to bet on a big outcome - and being right. 

Using Your Collateral as My Collateral

What we've learnt is that brokers at MF Global were taking collateral pledged by clients and using it as their own collateral for another leveraged bet. Apparently this is all legal. The same collateral is supporting two separate bets on asset prices. One of the bets is yours. The other bet is the broker's. 

Because MF Global's bets on European government bonds went bad, the counterparties to its trades scooped MF's collateral up. The trouble was, MF's collateral was also the clients collateral. This saw some client's apparently have their trades wiped out and their money delivered to the counterparties on MF's trades. 

One MF victim was US commentator Gerald Celente. Celente is a gold bug. He'd been building to his long-term gold position by buying gold futures contracts, rolling them over at expiration, and eventually taking delivery of physical gold (which is possible in the futures market). Only in this case, MF pledged his futures contracts as collateral for one of its own trades. 

Whether or not other brokers are doing what MF did is another subject. And even if they are, MF was grossly over-leveraged at 30-1 (assets 30 times capital). But Celente's experience would have been enough to cause at least some gold speculators to reconsider whether a margin account and gold futures are the best way to invest in gold. 

You'd presume these speculators have concluded that the futures market is no longer the best, cheapest way to leverage up returns on a higher gold price. 

Gold Stocks A Better Bet

There are two investment takeaways from this whole discussion. 

First: gold is not an investment. It's money. The biggest benefit from owning it as a wealth preserver. In my view, this means taking at least some physical possession of gold bullion.

The second takeaway is that if you're going to speculate on gold through financials then gold shares are currently a lot better way to do that than gold futures.

Yes, gold stocks have their own risks. But at least in the chain of ownership of an actual underlying (physical) asset, the gold companies may own physical gold (assuming they have it). Unless they have sold it forward through hedging, your claim as a shareholder on the earnings from that gold are less far removed from the real asset than your claims as a holder of a futures contract.

Here's a warning. I admit my understanding of the futures market is limited. Probably, in a normal futures market, you could take delivery of your commodity instead of rolling over the contract. This means the futures contract, in a normal market, is a pretty safe claim on an underlying asset. (Assuming your counterparty can deliver the commodity in question.) 

It all comes down to counterparty risk. As a shareholder, your counterparty risk is basically the company itself and its managers, geologists, and financiers. Can they find the gold, extract it, and sell it a profit? It all depends on the company, its people, and the quality of the assets. 

But in the bigger picture, gold shares could be the big winner from the MF mess, since people who want to invest in gold will see that it's much better to do it through shares than futures or even ETFs. Gold miners can lie to you just as well as futures brokers. But at least you have your choice of liars in the share market.

The other big risk to investors in gold shares right now is what impact system wide deleveraging is going to have on stocks and precious metals. Coupled with the move I'm expecting in the Aussie dollar the answer is: a pretty big one.

The bottom line is that all of this chicanery in the futures markets undermines confidence in the financial system as a whole. Over the long haul, I believe that really promotes bullion and hard money (gold and silver). It also means that gold and silver companies may finally stretch their legs and become the preferred way for the investing public to participate in the gold bull market.

If it's correct, this observation will be really useful in 2012. 

The US Treasury must refinance nearly $6 trillion in debt over the next four years. Based on that, I have no doubt the money printing is coming and that it should drive bullion prices higher. 

Between now and then, deleveraging will inflict so much pain on leveraged speculators and stock indexes that the public will practically beg Ben Bernanke to print money. When he does, gold and gold stocks will make new highs. 

Dan Denning
Editor, Australian Wealth Gameplan

How to Pick Winning Stocks in Five Easy Steps

How to Pick Winning Stocks in Five Easy Steps

You can see just how important politicians are.

While Julia Gillard and the Fairy Ruddfather try their best to win the prize, how has Australia coped?

The shelves were still full at the supermarket.

The traffic lights still worked at intersections.

The electricity companies kept the power on.

And we're sure even the Telstra BigPond outage wasn't directly anything to do with the Labor Party leadership spat.

That's because it's just noise. It isn't worth listening to. And once you filter out the rubbish, you figure out things are still working OK.

You see the same effect in the markets. In a moment, we'll show how you can filter out this noise and pick up bargain stocks others have discarded.

First, let's get something off our chest...

A Lot of Noise

Aside from creating a few basic laws for property rights and individual freedom, everything else politicians do just isn't needed.

In fact, their meddling is more of a business inhibitor than a business creator. Businesses the width and length of Australia must be relieved that at least for the next week or so, the pollies won't try to "fix" something in the economy.

Even so, you'll often hear people say that a particular politician is a "visionary". That they've helped create prosperity.

Wrong. We say politicians are sick in the head.

What else can explain the fact that their only purpose is to sit in an office and come up with new ways to tax successful ideas?


No. The real visionaries are the people who take risks... the folks who invest their own hard-earned money in a project or idea. They know if they get it wrong, they could lose everything.

But if they get it right, they could make a fortune.

If a pollie gets it wrong, they just raise taxes and say it was a good idea, it's just they didn't spend enough money on it.

A bit like the home insulation bungle. Or the Vietnam War.

The point is politicians make a lot of noise. And it's the noise that gets all the attention.

This brings us back to the financial markets. Where the same thing can happen:

• Greece will default.
• The U.S. government owes USD$16 trillion.
• The European Central Bank is thinking up another bailout plan.
• The Reserve Bank of Australia will/won't raise interest rates.

Don't get us wrong. You should know this stuff. And you should consider it when you make your investment decisions.

And heck, we've spent half the past three-and-a-half years bringing it to your attention.

But it's also important to remember that when the noise is at its loudest, that's often when you can make your best investment decisions...

Opportunities in the Din

Don't forget, despite the noise, businesses still carry on doing business. The tills still ring (or beep). Miners still mine. And explorers still find big new resources.

And as we look at the market today, we can see market "noise" has beaten down many stocks. That goes for some blue-chip stocks as well as the small-cap tiddlers we look at.

Until recently, we were struggling to come up with stocks worthy of making it into our monthly investment advisory, Australian Small-Cap Investigator.

But today, we're struggling to come up with a reason for keeping stocks out. We won't deny it. It's good to be in that position.


The only thing is, which stocks should you go for?

In the world of small-caps, that's not hard. You look for stocks trading for pennies. And there are plenty of them. Stocks that were more than a dollar a couple of years ago are now only five, 10 or 15 cents.

Of course, there's usually a reason why the stocks have fallen so much. That's where you have to put in the extra work to find out why.

That means ignoring the big picture noise (Greece, U.S. debt, the RBA, etc.) and instead focus on the company specifics.

Five Steps to Picking Winning Stocks

To do this we look at five things:

1. How much cash the company has and how fast it's likely to spend it (this is important for small-cap stocks because they typically don't make a profit. Their only way of getting cash is to sell more shares or borrow money.)
2. What's the outlook for the company and its industry? In other words, are they claiming typewriters are about to make a comeback... or are they in a leading-edge industry, or developing a product in high demand?
3. Next, we look at price action (actually, we usually look at this first). What has the share price done? Right now, we're looking for beaten-down stocks. Companies that for some reason are trading near their lows. If we can find a stock that's been unfairly hit by investors, it can mean there's a lot of upside to come.
4. Then there's risk. Here you need to know the potential downside. For small-cap stocks, it's usually no more than a few cents... because they're trading for no more than a few cents! If we see a stock at five cents, we know the maximum downside. But what we also need to work out is the upside. If it can only go up to six cents, we're not interested. But if it can go to 20 or 30 cents, we're all ears...
5. That brings us to the reward. As we say, if the reward for a five-cent stock is a gain of 20 or 30 cents, it's worth taking the risk. Here we're after 200%, 300% or 500% gainers. But you can apply the same strategy to blue-chip investing. If you think a stock will only gain 5% a year, why would you buy it? You're better off sticking the cash in the bank. At least you'll compound your returns.

In short, it's important to make note of the big picture stories. Because that's how to frame your portfolio and asset allocation.

But when it comes down to picking individual stocks, you're often best off leaving the big picture at the door.

The big picture helped you get there, but from that point on you should focus on what the company does, how it plans to make money... and most important: how much money you'll make if it all goes to plan.

Cheers.
Kris.