The Value Misconception.

Many individuals classify their investing style as being in the value category. Stocks that are out of favour or stocks that show low price multiples are always enticing to these value investors. After all, why pay full price for something when you can get it at a discount? The whole notion of buying companies with a history of profits, dividends and strong balance sheets is a great strategy and makes intuitive sense. Unfortunately, the same factors that intrigue value investors can often be taken out of context or have their significance exaggerated which leads to the purchase of securities that may not be           a value investment at all.

Click here to go to Canadian MoneySaver to read more!

Do...Not...Say...These...Things...EVER!

5i Research Inc.

Five Stock Market Phrases You Should Never Utter

Investors, when talking to their advisors or friends, will often repeat common statements, often thinking there are ‘rules’ for the stock market. Well, sorry, there are no rules.



Here then, are a few statements you should avoid:

1. “I Will Wait For a Pullback In The Market”: This phrase sounds good, because who wants to pay full value? Isn’t it better to get something cheaper? Well, yes, but (a) How do you tell a ‘pullback’ from a bear market? And (b) how long will you wait to buy—and miss out on gains—if you find we are actually in a bull market? You see, you can mess this market-timing thing up on both sides. Just buy some good companies: If you have chosen carefully, they will still be good companies if the market declines a bit.
2. “The Excess Cash on The Sidelines Will Drive The Market Higher”: Um, no. If an investor buys $10,000 in shares of Suncor Inc., someone needs to sell those shares, and take $10,000 out of the market. There is no net cash impact. Sorry.
3. “I Will Take A Profit And Buy It Back Later”: We have said before that selling too early is a big problem for investors. Yes, it is nice to take a profit. But, what if your stock NEVER comes back down? Intuitive Surgical (ISRG on NASDAQ) not than long ago (less than 10 years) was an $18 stock, but had already doubled to that price. An early investor could have scored a quick 100% profit; sold and sat back to wait for a re-buy opportunity. Except now, buying back that same stock again is going to cost him $574 per share. Point made.
4. “The Analysts Say Buy, So It Must Be OK”: Sorry to all those analysts out there, but your track record is just not that good. We think analysts provide good background information on companies and their competitors, and do some good number crunching, but investors need to always remember that Bay Street analysts are not really working for them. Research reports almost always end with a ‘Buy’ rating. Sell reports do not generate much trading traction, and are sure to annoy companies and the investment bankers trying to do deals. Thus, the strength of a “Buy” rating should be diluted down. Case in point: Poseidon Concepts (PSN on TSX). This company had lots of buy ratings less than five months ago, with target prices near $20. Now it is $1.29, and floundering. We suggest you read everything in a research report, other than the actual recommendation, and decide for yourself whether it is a good company.
5. “I Will Sell When I Break Even”: This is so wrong it makes us fall over. The goal of investing, remember, is to actually make some money, not just break even and pay the high salaries of traders and brokers. We have talked to investors who own a $1.25 per share stock that has fallen from their $5.00 purchase price. If these investors truly expect to ‘break even’ then they are expecting the stock to quadruple. If we thought a stock was going to go up four-fold, we would be pounding the table to buy. These investors will likely be better off selling their losing stock, and moving on. “Hoping to not make any money” is a horrible investment strategy.

by Peter Hodson, CFA
CEO of 5i Research Inc.

Question of the Week!

QUESTION OF THE WEEK

by RM Group of Richardson GMP

Subscribe to our newsletter


QUESTION OF THE WEEK

Foreign Exchange has become a hot topic of debate, especially with the G20 meetings currently underway in Moscow. Should we be concerned about a currency war?

Accusations of currency manipulation began in 2010 when the Federal Reserve revved up its printing presses and bought government bonds with newly minted U.S. dollars in an exercise known as Quantitative Easing. Emerging market economies claimed this move intentionally devalued the U.S. dollar and was designed only to boost U.S. exports and grow the U.S. economy at their expense. More recently, those same charges have been levied against Japan, sparking concerns of a global currency war, as governments fight to intentionally weaken their currency and put trade protectionist policies in place. In the case of Japan, Prime Minister Shinzo Abe has promised bold monetary stimulus in an effort to break the Japanese economy out of its multi-year deflationary spiral. Since last September, the Yen has fallen 15% versus the U.S. dollar and 20% versus the Euro.

The notion of a currency war serves to distract investors since currency wars are typically the precursor to ‘trade wars’ and protectionism. How does a country stop the pain when one of its trading partners pushes down their currency? They fight the loose monetary stimulus wither with restrictive tariffs or they enact their own monetary easing to weaken their currency as well. Both are outcomes G20 policymakers are currently trying to avoid. Tariffs lead to a contraction of overall GDP because aggregate global economic activity decreases. Retaliatory monetary easing carries the appearance that economic activity is growing but often it is pushed too far, and inflation kicks in. Inflation in countries with high debt loads would force a vicious cycle of further indebtedness, higher taxes, and lowered credit ratings.

The suggestion of currency manipulation to boost exports is short sighted. The objective of Quantitative Easing is to stimulate domestic spending & investment rather than saving & thrift. If successful, QE should eventually lead to higher imports from those very nations that are now crying foul about currency manipulation (Brazil, Russia, etc.) Aggressive monetary action applied to an economy suffering from weak demand and subdued inflation is ideally a good thing for the rest of the world, not bad. The IMF demonstrated that America’s rounds of QE boosted growth in its trading partners’ by 0.3%.

^{Source: Richardson GMP Limited
The opinions expressed in this report are the opinions of the author and readers should not assume they reflect the opinions or recommendations of Richardson GMP Limited or its affiliates. Assumptions, opinions and estimates constitute the author’s judgment as of the date of this material and are subject to change without notice. We do not warrant the completeness or accuracy of this material, and it should not be relied upon as such. Before acting on any recommendation, you should consider whether it is suitable for your particular circumstances and, if necessary, seek professional advice. Past performance is not indicative of future results. Richardson GMP Limited is a member of Canadian Investor Protection Fund. Richardson is a trade-mark of James Richardson & Sons, Limited. GMP is a registered trade-mark of GMP Securities L.P. Both used under license by Richardson GMP Limited.}

We will take your calls!

Canadian MoneySaver editor Peter Hodson is on BNN Market Call, Tuesday Feb. 19th, at 130pm EST to take your calls on stock questions.

www.bnn.ca

Ken Kivenko

“Whenever I meet my financial adviser, I'm never sure if we're reviewing his retirement plan or mine.”

                                                    
                                                    click here to read

BEST INTEREST ADVISORY STANDARD FOR THE ELDERLY

Looming Crisis for Canadian Seniors Must be Prevented

                                                                                Report courtesy of Ken Kivenko and Kenmar Associates.

MoneySaver Contributing Editor, 
Ken Kivenko,  who was recently appointed to an OSC investor advisory panel.

 

Different strokes for different folks!

It’s a theme that’s as old as the dirt on your 20-year-old brogues – do we choose to invest as “market timers” or do we invest by spending “time in the market?” Do we look for short-cycle opportunities to move in and out of the market or do we simply stay the course, looking at our stock holdings as long-term owner/investors?

You can argue this from both sides of the coin because both approaches can work. To do it well the short-term, in-and-out way, you need to be nimble, decisive, quick and confident in your market-timing and market-reading skills. To do it well the long-term, buy-hold way, you need first-rate portfolio-building talents, you need to have an appreciation for asset allocation and balance and, perhaps as much as anything else, you need patience, loads and loads of patience.

This note casts its vote for the latter approach, especially for mature, experienced investors who have suffered through the wild-mouse, stomach-churning market gyrations of the past decade or so. These are the folks who have been handed their heads on a platter, not just once, but at least twice and, more likely, three times over the past 13 years. 

This particular strain of investor may well be at the point where they are interested as much in capital preservation as much as capital gain. They are, in all probability, on the downside of their working lives and have only so much time left to build – and maintain – their nest eggs. They literally cannot afford another body blow, because they are quickly running out of time to recuperate financially before retirement – forced or otherwise – kicks in.

So, bearing all of that in mind, let’s take a look at a few Canadian mid-to-large cap, blue-chippers. Let’s take a broad look at the likes of TransCanada, Royal Bank, TD Bank, Sun Life, BCE, Telus, Rogers, Power Financial, Emera, Davis and Henderson, Inter Pipe and H&R REIT, to name just a few. 

The first thing you will notice is that each and every one of them have paid you to hold and wait through stable and growing dividends. They have provided a steady stream of cash flow, even through the market collapse of 2008 and 2009 – and, generally speaking, they have increased their dividends and distributions very nicely in the years since. And now, lo and behold, here in early 2013, many of these same companies are seeing their stock prices at or near multi-year market highs. That’s a double dose of delight!

Now, let’s take a look at some smaller-cap names that we at 5i Research follow closely. Let’s look at the likes of Stantec and AutoCanada and Brookfield Renewable Resources. Guess what? It’s the same general picture as their better-known, bigger buddies – new dividends, growing dividends, improving cash flow and very sweet stock-price gains to boot.

The question, then: Would you really want to market-time the ins and outs of growing, successful companies such as these? Would you have wanted to risk being on the sidelines over the past six months, looking for a purchase-price entry point, while all around you, the market somehow has worked its way through the European sovereign debt crisis and the American fiscal cliff? And now, here you are, looking for a way back in, knowing all the while that you have missed the first 10 or 15% of the market’s upward move, while capturing nothing in the way of dividends during that period? 

We grant that there are always different strokes for different folks. We grant also that buy-hold-and-prosper may not be the best approach for that portion of your portfolio comprising small-cap or spec stocks. By all means, trade around those little sweethearts if you must, but when it comes to your portfolio core, do what the pros have always done: Buy your stake in a solid, profitable, established company, let it pay you out with dividends or distributions while it and the market sort out their nasty issues and then sit back with a nice goblet of Aussie Shiraz as you ultimately reap the rewards of a rebounding market.

This approach is not the high-speed, 100-meter hare that will race you into a gold-medal world of untold riches; it is, instead, the 42-kilometre, marathon-running tortoise that will get you to the finish line perhaps more slowly, but healthy, happy and a winner!

Beyond the Figures.

Paul V. Azzopardi

When we invest in a company for dividends or bond interest we have to feel pretty confident that the company is going to return to us more cash than we put in. 

There are two kinds of expected cash inflows.  We can expect a capital gain if we believe another market participant will in future pay us more than we paid for the stock or bond.  Or, we can expect this cash inflow to come from the company’s assets, either because it is making a profit or because we have rights over the company which forces the company to pay us even if it is making a loss, such as bond covenants.

These two expectations give rise to two broad schools of thought and investment styles - broadly described as “trading” and “investing” – each of which has its own knowledge base, disciplines, and approaches.  Any one investment approach may of course have elements of both styles.

With income investing for dividends or interest, we are very concerned with the long-term success of the underlying company because it is unlikely for us to even reach break-even if the company is short lived. 

TRACK RECORD

One way to approach this problem – will the company I am investing in today be here in five, ten years’ time? – is to look at its track record because although the past never repeats it does go through the same motions. 

Many investors, therefore, look at the past, particularly at the financial statements, to gain a sense of comfort.  Figures are persuasive because they appear to be precise.  Many financial figures, however, depend on various assumptions and cut-off dates and, even if they were indeed precise, a company could have had a glorious past but faces a dismal future.

Financial analysis of the past can therefore take us only so far.

BUSINESS ANALYSIS

Rather than look only at the financials and the past, we have to look at a company in its totality, as a dynamic entity within a changing economy.

What makes us believe the company will survive and thrive in the future?

In order to answer this question we have to go beyond financial analysis and analyze the business itself, via a business analysis.

THE BUSINESS TRIANGLE

In business, there are three things you have to get right: 

1. the product, 
2. its marketing, 
3. the finances.              

Imagine a triangular table with Product, Marketing and Finance at each corner.  The most important role of management is to keep the table on an even keel.

A company with excellent marketing and finance but with weak products cannot make headway.   Customers are going to use the product and if it flops they will stay away, or, even worse, bad mouth the company.

A company with great products on the shelves and good finance but weak marketing will see others eat 

its lunch because it is not adequately communicating the utility of its products.

But products take money to develop and you can barely do any marketing without money, so good financial management is essential.

The Business Triangle is our first step towards examining a business beyond the financials.

In summary, does the company you are investing in have adequate finance, competitive products and effective marketing?  And are these three corners of the triangle balanced?

FERTILE SOIL

Although essential, Product, Marketing and Finance will not deliver growth if the company is confined to a market in which it is very difficult either to expand sales or increase profits.

Before investing in a company you must not only make sure that it is competing effectively but that it is earning good returns for its efforts. 

Two examples will make this clear.  

Utilities cannot charge whatever the market will bear since their prices are set by regulators.  The rationale for this is that utilities provide an essential service but operate on such a big scale, and involve such a high capital expenditure, that it very difficult for a new firm to compete with an incumbent.  If you are considering investing in a utility and it happens to have an unfriendly regulator, you would probably be better off investing elsewhere. 

Soft drinks are another example.  It is very difficult for one of the main brands to increase the price of its pop significantly because it will immediately lose market share.  Significantly higher sales can only be achieved by looking for new markets.  If one looks at the history of Coca-Cola (symbol: KO), it always thrived best when it was penetrating new markets, first the United States, then Canada, followed by South America, continental Europe, and recently being re-introduced in developing Asia, a total of  around 200 countries.

In assessing a company, therefore, try and assess whether its Product, Marketing and Financial strengths are likely to be sufficient to take it into new markets, even new countries, in the future.

THICK SHELL

In order for a company to thrive in a market, it must have competitive advantages and it must be able to protect these advantages over the years.    The better the company is able to protect and enhance its advantages, the more it will thrive.

An assessment of a company’s competitive advantages and how these are protected is therefore an essential step in evaluating the likelihood of its long-term success.

Although tomes have been written on this subject, we can say that a company has a competitive advantage if it is profitable.  Profit results from revenues exceeding cost.   In general, the stronger a company’s competitive advantages, the higher its profitability.

What are the main sources of competitive advantage?

We need to ask:

1.     What does the company do to earn a profit? 

2.     What are the company’s inputs, processes and outputs?

3.     What advantages does the company have in acquiring the inputs, processing, and delivering the outputs?

4.     Can the company retain these advantages?  Are they protected by a thick shell?

5.     Can the company enhance these advantages?

What we call “advantages” always boil down to being what economists call “favourable terms of trade”.  The company is acquiring, processing or delivering something on better terms than others. 

These favourable terms of trade should enable the company to make super-profits, i.e. profits over and above those needed for the company to remain in business considering all the opportunity costs of the resources it uses.

What are the sources of these favourable terms of trade?   Some of the most common sources are listed in Exhibit 1 but one has to keep in mind that companies often have one or more advantages fuelling their inputs, processing and outputs.  It is the combination of these competitive advantages and how they are made to work together that determines a company’s overall competitive strength and how sustainable its profit is likely to be.

Each company has to be analyzed individually and in the context of its industry.  A lot of valuable information can be found in a company’s “Management’s Discussion & Analysis” document,  Management Information Circular, Annual Reports, and industry publications. 

THE CORE OF DIVIDEND INVESTING

MacDonald’s Corporation, profiled in Exhibit 2, has a high return on equity and profit margins derived mainly from fast foods,  an intensely competitive business with few barriers to entry.   In spite of this, a study of the company shows how MacDonald’s has built strong competitive advantages in all aspects of its business, on the input, processing and output sides. MacDonald’s has been paying a dividend since 1976 and managed to increase it every year since then.

One has to analyze a company’s financial figures to assess its current position and its track record.  But in order to make a good investment, we need some way of getting a sense of what’s likely to happen in the future.  Dividend investors are lucky because in so far as we can get any predictability on which to prop our decisions, the business model provides one of the best platforms. 

Looking beyond the financial figures at the competitive advantages of a company therefore goes to the core of dividend investing.  A future dividend is as good as future profits and future profits will only materialize if the company retains, grows and puts its competitive advantages to work.

Exhibit 2

Competitive Advantages Example:  McDonald’s Corporation (Symbol: MCD)

MCD operates restaurants, 33,510 of them in 119 countries as at the end of 2011, from which it obtained a return on equity of 38% and a net profit margin of 20%.  Reading these figures one realizes that MCD must have built tremendous competitive advantages!  And it did.

The inputs are mainly food, labour, equipment, restaurants and advertising.  MCD organizes the purchase of food, equipment and advertising from the same sources thus lowering costs.  It develops and patents equipment and the setup in each restaurant is such that employees need no special skills, so they are paid correspondingly.  MCD acquires and sells restaurants for its own account and engages franchisees who are willing to join the company because its restaurants are successful.

A lot of effort is devoted to creating striking and memorable advertising.  This helps build not only the brand’s market share but its “share of mind” as well.

The hamburger looks quite simple but the processing at MCD is extremely sophisticated.   Restaurant layout and food processing evolved over the years to reach a high efficiency, products are designed according to the markets in which they are sold, restaurants are supervised without dampening franchisees or managers’ enthusiasm, and managers are developed internally at Hamburger University.

The brand is extremely strong, products are adequately diverse and competitively priced, quality is even, and restaurants are well-placed in cities, town and villages across the world.  Main menu items are permanent but the menu changes regularly so there’s new food and beverages to try. 

MCD has therefore put together strong competitive advantages on each of its three critical areas: what it buys, how it manages and processes its operations, and what it sells.  It has also been very successful in seeking out synergies between different competitive advantages and operations.

In my opinion, MCD is also likely to retain these advantages since food is essential for human survival, the company delivers the product at a low price but at a substantial profit, it is innovative and responsive to shifting consumer desires, and continually improves its operations.  It is extremely difficult to compete with the company because of its strong brand, culture and the location of its restaurants.

Throughout its history the company has striven to continually improve its competitive advantages and to apply them to new markets.  These efforts continue to this day and we can therefore feel pretty confident that MCD will continue to maintain and improve its competitive advantages and keep growing its earnings in the years to come.

Exhibit 1

Sources of Favourable Terms of Trade

·       Environment:

o   Geography (mills were built near rivers; ships need deep harbours; certain kinds of trees grow only in British Columbia and Scandinavia; Champagne);

o   Government and regulation (supply agreements in Ontario limiting the quantity of eggs that can be produced; the controlled distribution of liquor; utilities need approval of new rates; governments usually control the sale of water in bulk).

·       Barriers to Entry:

o   Patents, copyrights and trade names built into strong brands (“Coca-Cola”, “McDonald’s”, “Wiser’s Whisky”, Harry Potter novels, US Patent # 174,465 for the telephone issued to Alexander Graham Bell in 1876 );

o   High entry costs such as auction prices paid by telecoms for electromagnetic spectrum, plant and equipment required by utilities creating “technical monopolies”,  high outlays and costs of land points for bridges;

o   Professional associations;

o   Trade secrets.

·       Management:

o   Superior management (this advantage is likely to be short-lived);

o   A culture of good corporate governance (essential for risk control and to put back a company on the right track after it encounters difficulties; likely to last longer than superior management)

·       Profitability (usually, the higher a company’s profitability, the better it can protect and defend its competitive advantages)

·       Networks:

o   Information networks (investment banks’ knowledge of businesses and financial conditions in their markets )

o   Delivery networks (cable companies able to deliver data to each house)

o   Sourcing networks  (information sources to procure scarce resources)

o   Physical networks (railway companies benefitting from eminent domain powers)

·       Nature of the product or service:

o   High switching costs for suppliers or users (a manufacturer producing specialized part for one aerospace company;  users trying to switch IT systems)

o   Maintenance dependence  (users of specially designed software systems)

o   Suppliers with low bargaining power (suppliers of bulk chemicals)

o   Buyers with low bargaining power (patients at hospitals)

o   Cultural products (tartan for Scottish kilts; Lipizzaner horses of Austria)

o   Perishable and unstable products (fresh fish; certain explosives)

o   High complexity (banks; hospitals; national politics)

Paul V. Azzopardi BA(Hons)Accy, MBA, FIA is a VP and Portfolio Manager with Pro-Financial Asset Management Inc.  He is the author of three books including “Behavioural Technical Analysis” and is an Instructor at the School of Continuing Studies, University of Toronto, for the “Choosing Income Investments” course.  pva@pro-financial.ca, Tel: 905 815 6903

(Disclosure:  Long  KO, MCD)

Click Here to subscribe to Canadian MoneySaver Magazine.  24.95/yr/9 editions.