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Dear Daily Crux reader, Our colleague Dan Ferris is one of the world's best stock analysts. His Extreme Value advisory is read by some of the top money managers in the world, and he's been quoted several times in Barron's, one of the most prestigious financial journals. For the past several months, Dan has urged his readers that most every stock on the market is too expensive to be purchased safely right now. But recently, Dan began researching a small group of stocks overlooked by Wall Street that are still trading at a deep discount to their true value. Dan doesn't say things like "cheap, safe, and plenty of upside" often, so we knew we had to talk with him and get the full story. If you're interested in the one safe sector with tremendous upside in this overstretched market, read on... Good investing, Justin Brill Managing Editor, The Daily Crux www.thedailycrux.com ------------------------------------------ The Daily Crux Sunday Interview Where to find safe stocks with tremendous upside The Daily Crux: OK, Dan... We heard that for the first time in months, you're excited about buying some stocks. In fact, in your latest issue you referred to the sector you're interested in as the "money-manufacturing business." What's the story here? Dan Ferris: Well, the "money-manufacturing business" is just the lending business... the banking business. It's the business where you take in deposits and lend them out. It doesn't sound exciting, but it's a fantastic business model... and a great investment in the right environment. As a bank, when you take in a deposit, the money doesn't belong to you. It belongs to the depositor. But the rules say you're allowed to lend it out. At a basic level, you're able to put that dollar in two places at once, because you're putting it in the depositor's account and you're lending it to somebody else who's going to spend it or deposit it somewhere else. When that dollar is deposited, the next bank will then do the same thing, and on and on it goes. That's the way a lot of money is created every time a new dollar gets into the system. That's a simplified explanation, but that's basically how the banking system works under normal circumstances. Crux: So you're recommending banks? Aren't they still incredibly risky? Ferris: Well, as most people are aware, lending is still quite depressed... so there's not a whole lot of money being "manufactured" in the banking system at the moment. Many banks are still losing a lot of money on loans associated with real estate – so they don't want to lend money – and with the problems of high unemployment, record foreclosures, and things like that, many consumers aren't interested in borrowing more either. But lending hasn't stopped completely, and one day it will pick back up. In the meantime, there are some banks out there that are lending and are ready and able to do more when demand for loans increases. They're well capitalized. They're well run. They didn't make a lot of these risky loans that most banks did, and don't have the terrible losses that go with them. These are the banks I'm interested in – specifically the small ones. These little banks are nothing like the big Wall Street banks everyone's familiar with. And thanks to a special arrangement with the FDIC, some of them have been granted government-guaranteed profits. It's amazing. It's literally free money. Crux: It's amazing what can be done with free money... Ferris: Exactly. If you follow the news, you've probably heard about all the banks that have failed over the past few years. There have been more than 200 bank failures since 2008, and there are over 700 more on the FDIC's troubled bank list right now. So there are likely to be many more failures before this is all over. When these banks fail, the FDIC needs well-capitalized banks to buy their assets. The FDIC has created this arrangement to encourage these well-capitalized banks to do that. To give you an example, one of the banks I like was able to buy about $160 million of loans and real estate for about $120 million... a 25% discount. They paid about 77 cents on the dollar thanks to this arrangement with the FDIC, and on top of that the FDIC will guarantee 92 cents for every dollar of fair value they bought. That's 15 cents of instant profit on every dollar they bought... guaranteed profit. It's guaranteed to be worth 92 cents and indeed, about $15 million in free money dropped right onto their balance sheet after the deal. Now $15 million wouldn't be a big deal for the big banks, but for a small bank like this it's significant. The deal increased their equity... increased their assets... by a few percent. The FDIC is just giving money away to these banks, so if you can find the really good banks – the ones that are super well-capitalized – you've got a situation where the government's creating money-making machines. Crux: So what do you look for in these banks? Ferris: Well, I look for a few things. First, as I mentioned before, I look for an extremely well capitalized bank. We won't get into the details because it's complicated, but a basic metric is the capital ratio. Banks are required to have at least a 5% capital ratio. This implies $1 in capital for every $20 in loans. Again, I'm simplifying for an example. Well, the banks I'm looking at have a 20% or 30% or higher capital ratio. We're talking about banks that are four or five times more capitalized than they're required to be. They're really safe. They're some of the safest banks in the world, let alone in the country. They're safe, well capitalized, and they've got lots of cash on their balance sheets. That's number one. Number two is they've got to be small enough... I touched on this a second ago as well. Most of the banks that are going to fail are going to be small. So to take a small bank over and really increase the size of your bank, your bank can't be too big in relation to the one you're taking over. It's simple but important. If you've got a big bank taking over a small bank's assets, the increase to the big bank's assets will be practically insignificant, so you wouldn't expect to see much growth there. The third thing is the bank needs to be in the right area. We're looking at small banks here, so if a bank is located in the northwest for example, they won't be be taking over a small bank in the southeast. The small banks stay in their own territory. Naturally, you want to look at banks that are located in places where a lot of banks are likely to fail, because that increases the odds of seeing some of these government guaranteed deals. I looked at the top states for failed bank deals. My two favorite banks are near the No. 2 and No. 7 top states for failed bank deals, Florida and Washington, respectively. So you want to look for banks that are either in or near the states where lots of banks are failing and many more are expected to fail. Finally, they need to be cheap. None of this works if the price isn't right. Today, you're not going to find many of the small, well-capitalized banks trading at a discount to book value, but there are still several trading just over one times book value. To give you a point of reference... before the crisis, when one bank acquired another bank they would typically pay anywhere from 1.5 to three times book value. These days, you won't see anything near that, but I think the top banks we're talking about here are still worth between 1.5 to 2.5 times book. So I'm willing to pay up to 1.25 times book value for the right stocks... the top-quality banks that are willing and able to participate in the FDIC's guaranteed arrangement. That still represents a great value to me. Like I said in my most recent newsletter, it's like paying $1 for each $1 of net assets, and getting all the banks future earnings for 25 cents. It's like a cheap call option on future earnings. Crux: If these banks are such high quality, why are they still trading at a discount? Ferris: Well, it has more to do with the banking industry as a whole than with the individual banks. There's still a lot of uncertainty right now. Commercial real estate in particular is just doing horribly, and most of the commercial real estate loans were made by banks. They're not held by insurance companies. They're not held by the other financials. They're mostly in banks. When the collateral goes down and down, that means banks have less capital. That hurts capital ratios and hurts lending... the banks are less able and less willing to lend. And when banks are lending less, they earn less. So you've got this situation where valuations on the entire industry are depressed. But as time goes on, the market will begin to separate the good from the bad, and we'll likely see the good banks trading at a premium to those that aren't. In fact, I think we're beginning to see it already. The banks I'm looking at were trading below book value until recently. Frankly, they deserve to be trading at premium. The banks that were too aggressive and lent out too much money... they're just running in place right now. They're just trying to survive. But these banks I've found are ready today to start doing more lending. They wish they could make more loans. They've got so much money to lend, but they can't find enough people to lend it to right now. So I think these banks are fantastic investments right here. In fact, there's another big reason I love them that I haven't discussed with anyone before... and it has to do with the way our system works. The way money is introduced into the banking system. The easiest way to explain it would probably be to use the example of a counterfeiter. Suppose we have a guy who's manufacturing dollars. For the sake of the example, let's suppose he lives in a small town with $1 million in circulation, and money doesn't go outside that town. When he first begins to spend his counterfeit money, there isn't a noticeable effect. But over time as he spends a hundred... a thousand... 10 thousand... 100 thousand... then he's really starting to increase the money supply. If he spends 100 thousand, he's increased the money supply by 10%, so the general price level would eventually rise by 10%, other things being equal. But here's the interesting thing... Our counterfeiter doesn't experience these price changes. He gets to use the money first, before it makes it into the economy and raises prices. He gets all the benefit and none of the negatives. As the money makes its way through the town's economy, prices begin to rise as people bid up the same amount of goods with more dollars. The second person to get the money... those who get paid by the counterfeiter in this example... still gets a great deal of the benefit. Prices haven't had a chance to move up much yet. So it goes until eventually the money makes it to the last guy... which in our society is the wage earner. The wage earner gets royally screwed in our system. He gets almost no benefit from the new money, because prices have already risen before he gets it. But he gets all the negatives... the higher prices. In our monetary system, the Federal Reserve is the counterfeiter. They create the money... so they're the first beneficiary. Most people don't realize it, but they profit from this process. They're a private bank that basically makes money by counterfeiting. And the first guy to get paid by the counterfeiter? It's the banks. The banks in our system get the money before anybody else, and they get all the benefit. OK, so where am I going with this? People talk about inflation and how you don't want to own dollars. Well, that's true in theory, but there are exceptions. If you're a business that benefits from the flood of new dollars, then dollars aren't a bad thing. And the business that benefits the most from new dollars is banking. The more currency units are created, the better they do. Companies like Visa and MasterCard and insurance companies are great to own in inflation for similar reasons, but they're still farther down the chain than the banks. You want to keep that in mind when you're buying banks. And to take advantage of this phenomenon, you obviously want to own a bank that can take on more assets... more deposits. That can raise money if it needs to. In other words, a really healthy bank that can do a lot of business if the opportunity arises. There are reasons to own banks in general... but there are fantastic reasons to own the small, really healthy ones. Crux: That's a great point, Dan. Any final thoughts? Ferris: Well, one last point to consider is that many of these small, well-capitalized banks could be taken over by one of the larger banks looking for quality assets. The banking world is constantly consolidating, because that's how banks grow... even without these failed bank transactions. Banks grow by acquiring each other and growing in their territory. Bank deals, like I mentioned before, usually happen at anywhere from 1.5 to three times book value or more. The banks I've found trade just over book value, so they're at a discount to what they typically are bought at. And these are the absolutely highest quality ones, so they're definitely worth more. I wouldn't be surprised to see any of them acquired at two times book in the next couple years, or to just keep growing and become a regional bank that's worth billions. Right now, their market caps are only about $200 million, so there's a lot that can happen. I'm excited about these stocks. Crux: Alright, Dan. Thanks for talking with us. Ferris: Thank you. My pleasure. Editor's Note: To learn about the two small bank stocks that Dan thinks are unquestionably the best in the world today, click here. You'll also get the details on the only gold stock good enough to make the Extreme Value recommendation list – a stock so promising that Dan flew around the world to meet with management. Dan thinks early investors could make at least 2,800%... or more.