One of Wall Street’s Worst “Dirty Secrets”

What I’m going to show you today, you’ll rarely see from mainstream financial analysts.

This secret is worth too much. It generates hundreds of millions of dollars every year for the insiders on Wall Street. This secret is why investment banking is such a lucrative trade.

Nobody who’s collecting big profits on this secret wants you to understand it. That’s because once you do, you won’t look at investments the same way again…

Let me give you an example of how this secret works…

[ad#Google Adsense 336×280-IA]Meg Whitman is now the president and CEO of Hewlett-Packard (NYSE: HPQ).

But in 2005, she was CEO of eBay (NASDAQ: EBAY), which paid $3 billion to acquire Skype – a company whose software allows customers to speak over the Internet for free.

The company had no material revenue, nor a viable business model. It didn’t appear to fit with eBay’s business in any way. Two years later, Whitman was forced by her auditors to recognize a $1.4 billion loss on the investment.

Later, after she had joined Hewlett-Packard’s board, Whitman approved the acquisitions of IT giant EDS, smartphone maker Palm, and software company Autonomy.

HP paid around $26 billion for these companies.

HP accountants have determined that HP overpaid by at least $19 billion for these three companies alone.

That’s right… $19 billion of investment losses. Today, the entire company is only worth $28 billion.

Some of the deals were so bad that, even at the time, they were laughable and widely mocked. For example, of the Autonomy deal, Oracle Chairman Larry Ellison said, “Autonomy tried to convince us to buy their company… we thought $6 billion was way too much… and HP just paid twice that!” Just to prove its point, Oracle even set up a website called “Please Buy Autonomy.”

Corporate investment losses like these are one of Wall Street’s dirty secrets. Like I said, putting these deals together generates hundreds of millions worth of profits every year for Wall Street. Nobody on Wall Street wants companies to become more capital efficient or to return more money to shareholders. They want more deals. They want more fees.

And so, nothing negative is ever said about the number and magnitude of very poor investments made by public corporations.

The even bigger problem for shareholders is the compensation structure for top CEOs. There’s a tremendous disconnect between the risks they take with the shareholders’ money and the risks they face personally.

The compensation structure of most of the S&P 500 CEOs allows them free access to the retained earnings of their companies. That means, if they make good investments and earnings increase, they can collect huge, windfall gains from their stock options. On the other hand, if they make horrible investments with the company’s capital, they’re likely to be fired… and to receive a huge, windfall exit package.

The scale of this problem is not widely appreciated because Wall Street downplays it and very few investors really understand the damage big corporate investment losses will have on their returns.

How big are these losses? So far in 2012, S&P 500 companies have written off $40 billion in investment losses.

Here’s the good news. You can completely avoid this enormous risk by simply focusing on companies that are “capital efficient.” In other words, they pay out a large part of their gross profits to shareholders in the form of dividends or share buybacks. These companies generally don’t do big deals, mostly because they get a much higher return on capital by simply reinvesting in their own shares.

We think focusing on capital efficiency is particularly important right now. Corporate America is sitting on a ton of cash.

Deloitte, the international accounting and consulting firm, recently released a study about the cash balances of the S&P 500 and large investment groups. They found S&P 500 cash balances are currently at record highs – and represent nearly 10% of total assets. This is more than double the average for the preceding 14 years… and more than triple 1998, when cash made up around 3% of total assets.

Buffett once noted that management teams with money to burn on acquisitions “behave like teenage boys who just discovered girls.” Corporate America certainly has money to burn right now.

In an environment like this, you want to be very wary of which companies (and managements) you partner with. All kinds of cash sloshing around can create bidding wars, so it’s especially important to steer clear of companies with histories of impairment charges.

Instead, gravitate toward level-headed managers who have shown a history of demonstrating capital efficiency.

Good investing,

Porter Stansberry

P.S. Due to my extensive writing on this subject, many readers know they can conservatively earn 10%-15% per year in these businesses. But thanks to a critical anomaly in the market right now, you can make 50%-100% on these same stocks… every 12 months or so. What’s more, you can make these big gains while taking on less risk than a conventional shareholder. You can learn about this anomaly in a special presentation we’ve put together. Watch it here.

Source: Daily Wealth