“When you get debt-to-GDP ratio above 150%, history says the country fails – and this will be a failure eventually.”

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Market Buzz – 9 Steps to Uncovering Explosive Small-Cap Stocks
Below are the 9 simple steps we follow in order to find, research, and analyze small-cap stocks that could put big gains in your portfolio;

Step 1: Growth Trends: Identify growth trends and market sectors positioned for rapid growth in the years to come. Be they sector specific such as energy (oil & gas), gold & precious metals, technology, healthcare, etc. or geographic such as China, India, Brazil, North America, Europe, etc.

Step 2: Old Fashioned Real Research: Actually read over the financial statements and MD&A’s of more than 7,000 publicly traded companies to find relatively unknown, high growth small to mid-cap stocks that display GARP and are positioned to grow.

Step 3: Financial Performance – The Fundamentals are Key: Review and evaluate key metrics in the company’s financial statements to understand historical financial performance. Strong fundamentals within an individual company can often lead us to growth trends within an industry.

Step 4: The Business Matters: Understand the business and industry of the potential investment, including products, services, and management’s ability to run the business.

Step 5: Quality Management: After reviewing the company’s financial statements and reading their MD&A, if the company meets our fundamental GARP based criteria, we find it important to interview key management to understand their strategy and clarify their outlook going forward.

Step 6: Earnings Quality: Look for red flags that indicate anything from cyclicality, financial manipulation or even fraud to avoid investing in these types of situations.

Step 7: Growth Outlook: Develop an understanding of expectations for growth to make valid valuation comparisons.

Step 8: Peer Comparisons: If they are available, we find it instructive to compare relative valuations of companies within the same specific business or industry to provide more “apples to apples” type information on how the market values similar companies or at least those within its industry segment.

Step 9: The Investment Decision: Factoring in all of the relevant information above, and paying particularly close attention to current market valuations, we determine whether or not the investment is a good BUY. If it is, we issue a full report to our clients with the corresponding BUY action and within what price range we find it attractive.

Looniversity – Short Selling Shorts

Contrary to popular belief, short selling has nothing to do with hocking a pair of Bermudas on Bay Street. No, ladies and gentlemen, short selling can be defined as the sale of securities, which the seller does not own. Huh? Selling something I don’t own? Sounds pretty sweet – let’s take a closer look at the mechanics.

Short selling begins by contacting your friendly neighbourhood broker and declaring your intention to short a security. Then, your broker will loan you the securities out of its inventory. Sell your borrowed securities into the market as you would with any other securities you own. Following this, the proceeds of the short sale are deposited in your account. Now, take the money and run (kidding). Instead, you must complete the process by depositing the required margin in your account.

Essentially, profits are made whenever the initial sale price (via the short sale) exceeds the subsequent purchase cost. As such, short sellers are looking for investments (e.g. stocks) which they believe are overpriced and due to experience a price decline over time. Now, if you could only short shares in that guy selling Bermudas on that street corner – we think you would have a winner.

Put it to Us?

Q. Can you give me the quick “411” on stop-loss orders?

– Tania Wijata; Toronto, Ontario

A. Ahh, the stop-loss order – that magical phrase that orders your broker to immediately stop making poor decisions and pay back all of your recent losses. A nice thought, but it ain’t gonna happen.

Essentially, a stop loss is an order to sell shares you already own, which effectively becomes a market order (in this case, the best available asking price) when the price of your shares trades at or below your stated limit (stop) price. Investors use this type of order in two common situations: to try to reduce the amount of loss that might be incurred or to protect at least part of a profit.

In the case of the former strategy, an investor in company BAD ($1.00) may only be willing to lose 20% of his/her investment and therefore sets a Stop Loss Order at $0.80. Whereas, the latter strategy can be applied to a situation in which one has purchased shares in company GOOD, which have subsequently appreciated to the $1.50 level. As a result, he/she may wish to “lock in” at least a 30% profit and therefore set a stop at $1.30.

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Oil & Gas Income Trusts: The ‘New Class’

Investors in the new wave of energy income trusts won’t notice any difference from the old ones – except a slightly lower yield, says Richard Clark, CEO of Eagle Energy Trust (EGL.UN-TSX), the first NEW energy income trust to go public since the Canadian government changed the tax rules on trusts in 2006.  All Canadian trusts had to convert to regular, tax-paying corporations by December 31, 2010.

“The payout ratios probably were too high” on the old trusts – some were 100% of cash flow, he says. “Perhaps this resulted in more risk for the asset class than was ideal.  And in returning more capital to their unitholders more quickly, the old trusts perhaps overly benefited those early investors.  The taxable component of the distributions was around 20% in the late 1990’s, but by 2006 it was over 80%.”

He said the original trusts – somewhat unintentionally – did some things that he wouldn’t necessarily do again, with a view to keeping trusts more sustainable.

Dennis Feuchuk, President and CEO of Parallel Energy Trust (PLT.UN-TSX) agrees: “I think the new trusts will have more disciplined practise with capital and cash distributions” than the old trusts.

Prior to the Canadian government’s announcement on October 31 2006 that income trusts with Canadian assets would no longer be allowed (the Halloween Massacre), the oil & gas trust sector had an average yield of ~12% (compared to 5% from oil & gas corporations today), says Kelly Nichol, CEO of North American Oil Trust, a private company.

Whereas Clark says “The ideal yield for this new asset class may be more like 7-10%.”

I agree with Clark but would add two points – one in favour of a lower yield, and one not.  One factor favouring lower yields – which can also mean higher stock prices – is what is called “yield compression.”  This happens when there is so much appetite for high-yielding investments that the market is willing to bid up the share price of a stock to accept a lower yield.

Eagle Energy itself jumped 20% in the first three months after its $10 IPO in November 2010, with no change in its payout, as investors were willing to take a lower yield.

Just to illustrate, Eagle Energy is paying out $1.05 a year in its first year to shareholders. At $10 per share, that’s a 10.5% payout. At $12 per share it’s an 8.75% payout.

But the second point is–investors cannot underestimate the greed of the market. The trusts were VERY popular investments vehicles – oil trusts made up $60 billion in market cap in 2006, vs. $600 million today (that’s a 100:1 ratio, BTW) – and the oilpatch executives and the investment bankers were able to raise equity easily to make up for any shortfall in cash a high payout ratio might cause.

I believe Clark’s pioneering efforts in creating these new trusts will become a huge new industry again, very quickly. And human nature says that high-payout-raise-equity game could happen again.

One other difference between the old and new trusts is that the previous trusts had to limit the amount of non-Canadian shareholders to 50%. But this new class of trusts has no such restrictions. This means Americans, who have basically zero interest rate in their home country, can own 100% of these new trusts – creating a much larger demand pool for the stock. (However, the income component of the distributions will be subject to a 15% withholding tax for Americans, that the transfer agent will collect automatically. This will be credited to their US taxes.)

Clark was previously part of the senior management team at Shiningbank Energy Income Fund, a heavily natural gas weighted income trust that was bought by PrimeWest Energy Trust. So he has been intimately involved in the sector before and after the Canadian government ended the trust game. Clark says Eagle Energy Trust will be different in a few key ways.

“Our payout ratio is targeted at 50%, lower than most of the old trusts. This will go part of the way to reducing the projected yields to under 10%. Our return of capital component is also targeted to be much lower than was the case in most of the old trusts. Eagle is also targeting assets with more conventional upside, and so ultimately, hopes to hit a balanced growth and distribution strategy that is sustainable.”

“We want to make the return OF capital as low as we can make it, like 35-40%. And we want to get land where PDPs (Proved, Developed and Producing drill locations) make up less than 40% of the package. That makes for a more balanced income and growth approach – which I believe is sustainable.”

Feuchuk agreed, adding that Parallel Energy will be more focused on the income side of that equation. “We’re trying to bias people towards income. Parallel is not a high-growth investment, it’s income – so we’re hedging and locking in cash flows. Growth will come but you shouldn’t be looking for both. I think that’s going to be a bit of an education process (for the Canadian investor).

For the past five years, Clark has made it a mission to re-invent the energy income trust in Canada – because in 2006 the government actually made it very clear the trusts could continue — They just had to use foreign assets.

If it was that simple, why did it take four years for the first new trust – Clark’s Eagle Energy Trust – to get listed?

“A lot of people understood the essence of the rules, but they were accountants, not entrepreneurs,” says Clark, adding that new Canadian rules surrounding foreign asset trusts came out in “dribs and drabs” right up until 2010, making it difficult to move before then.

Other factors, he said, included:
It was not until 2010 that the market finally focused on all the companies that were LEAVING the trust sector, making it difficult to get traction      with investors on new companies ENTERING the trust space.
In the oil patch, there are the “trust guys” and there are the high growth “exploration guys,” and these two groups have somewhat different technical and business skill sets.  Very few of the “trust guys” had oil and gas operating experience outside of Canada.  And the U.S. has some key differences in how the oil and gas industry is structured, and in taxation, that require a strong knowledge of the U.S. energy patch.
Many people believed that the MLPs in the US – Master Limited Partnerships – already have this market covered.
Next issue:  Will these trusts change the way junior E&P companies operate – as they did in the last trust cycle?

Note: Two offers Keith Schaefer is making available to the Money Talks audience:

1. A Discount on Regular issues of the Oil & Gas Investments Bulletin

2. A FREE Special Report on the Bakken Oil Shales, one of the top new oil plays in the world that is just warming up.

– Keith Schaefer

Follow this link for Part 1 of our story on Energy Income Trusts: A Comeback in the Making.

After the recent spate of volatile trades, where is the hottest commodity–silver–heading?

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THE DOLLAR’S TERRIBLE FATE

My readers are familiar with my forecast that the US dollar is in terminal decline. America is tragically bankrupt, unable to pay its lenders without printing the dollars to do so, and enmeshed in an economic depression. The clock is ticking until the dollar faces a crisis of confidence like every other bubble before it. The key difference between this collapse and, say, the bursting of the housing bubble is that the US dollar is the backbone of the global economy. Its conflagration will leave a vacuum that needs to be filled.

Mainstream commentators often discuss three main contenders for the role: the euro, the yen, or China’s RMB (known colloquially as the “yuan”). These other currencies, however, each suffer from a critical flaw that makes them unready to carry the reserve currency role in time for the dollar’s collapse. When it comes to fiat alternatives, it appears the world would be going out of the frying pan and into the fire.

EURO: FRAYING AT THE EDGES

The euro is a ten-year-old experiment in uniting divergent political, economic, and cultural interests under one monolithic fiat currency held in the hands of one very powerful central bank.

If managed correctly, such a currency could serve to keep its member-governments honest – but that is not the world in which we live. Instead, the fiscally irresponsible members are discussing ditching the currency at the first sign of trouble. That is, they’d rather have their own national currencies to inflate in order to cover over their burdensome public debts. So, in order to keep the euro together, creditor states have been strong-armed into bailouts of the debtors – even though such measures violate the compact that created the common currency.

The question becomes: how long do Germans – still wrought with the memory of Weimar hyperinflation and the rise of the Third Reich – want to keep printing euros to pay the debts of the spendthrift Greeks? How many German politicians will ride to electoral victory on promises of unending bailouts and higher prices across Europe? This is the fundamental flaw of the euro.

And, of course, Greece isn’t the only problem. Ireland and Portugal are vying for second-worst debt crisis in Europe. Spain, representing over 12% of eurozone GDP, saw sovereign yields jump from 4.1% at the beginning of 2010 to 6.6% by the end of the year. Yields on most other eurozone countries have been rising as well – a clear indication that the eurozone is an increasingly risky bet.

While a euro secession by the PIGS could actually leave a stronger currency region at the end, it would be a traumatic event. That prospect is undermining confidence in the euro at just the time when the world is considering where to go next.

Perhaps a mature currency that didn’t falter so easily amidst the recent global financial crisis would be a good contender for the world’s reserve. The euro, by contrast, is both young and in serious trouble. If less than two-dozen nations are too immense a burden for the euro to shoulder, should we expect better results when it’s stretched across two hundred?

YUAN: CAPITALIST COUNTRY, COMMUNIST CURRENCY

The investment community is slowly coming around to my long-held excitement about the miraculous growth of China. This is no frenzy. In fact, if anything, I think many are still too skittish when it comes to this market. Yet, those that are jumping on the bandwagon are now proclaiming the Chinese yuan as the logical successor to the dying dollar. But while China is becoming an immense economic force, the yuan itself is hobbled by the country’s communist past.

Foremost, China enforces stern capital controls on the yuan. A reserve currency must be freely and easily exchangeable with other currencies. Even within China’s borders, one cannot exchange large amounts of yuan for dollars or any other currency.

China is slowly undertaking reforms to relieve these controls, but remember they were not put there arbitrarily. The controls allow China to suppress the value of the yuan, thereby maintaining artificially high exports, among other consequences. If China allowed the yuan to trade freely, it would lose the power it maintains over its money – and by extension, its people.

Let’s remember that all fiat currencies are routinely manipulated and inflated. The People’s Bank of China has reported M2 growth of over 140% in the past five years – almost entirely to maintain a stable exchange rate with a depreciating dollar. Given rampant inflation, combined with exchange restrictions and a serious lack of transparency, the yuan is simply not ready for primetime.

YEN: BLACK HOLE OF DEBT

The Japanese yen is the third amigo at the international fiat fiesta. While it doesn’t suffer the structural risks of the euro, the yen is subsisting in an environment of massive sovereign debt. Japan’s debt-to-GDP ratio is the highest of any developed country at 225%, meaning there is a perpetual impetus to print more yen to pay it back. The yen must endure this debt-noose, making it a poor alternative to the USD, which suffers the very same problem.

While I believe Japan is in a much better position because it generally maintains a net trade surplus and because most of their debt is held domestically, it’s still not a stable unit with which to conduct world trade.

Perhaps more importantly, with a world seeking yen reserves, the price of yen would increase drastically. This is politically unpalatable in Japan, where the export lobby is constantly trying to push the yen down to boost their sales overseas.

These two factors combine in such a way as to make the yen a plainly infeasible reserve currency. The appreciation in yen value would simultaneously make Japan’s debt problems worse and cause its export industry to suffer greatly, meaning that Japan probably doesn’t want this role any more than we want her to have it.

As an aside, if you type “yen as reserve currency” into Google, it will ask, “Did you mean: yuan as reserve currency?” I guess even the world’s smartest search engine doubts the yen could fill that role.

THE SIMPLEST ANSWER IS OFTEN THE BEST

As J.P. Morgan famously said to Congress in 1913, “gold is money and nothing else.” Morgan meant that gold was unmatched in its effectiveness as a store of value and medium of exchange.

Given that his namesake bank started accepting physical gold bullion this past February as counterparty collateral, why should the trend of a widespread return to gold be considered only a remote possibility? On the contrary, it should be expected – if for no other reason than every other currency is fundamentally dismal.

Markets are powerful things, and require a reliable medium of exchange. The call for sound money is not just philosophical; it is derived from the market itself. Throughout human history, merchants have always turned to pure gold and silver over every pretender. This is not the first experiment in a paper money system, nor is it the first widespread debasement of money. In fact, the lessons of history were impressed upon our well-read Founding Fathers to the point that they included the following clear language in the Constitution: “No state shall… make any Thing but gold and silver Coin a Tender in Payment of Debts.”

While it has always been possible that another fiat currency would rise up to take the dollar’s place, and thereby keep this irrational experiment in valueless money going awhile longer, the particular circumstances that abound today make it seem less and less likely to me. Instead, I’m seeing signs that the world is moving back to gold at a breakneck speed.

This is a return to normal and has many positive implications for the global economy. It’s certainly a trend we can all welcome, and profit from.

Peter Schiff is president of Euro Pacific Capital and author of The Little Book of Bull Moves in Bear Markets and Crash Proof: How to Profit from the Coming Economic Collapse. His latest book is How an Economy Grows and Why It Crashes.