INVESTORSFRIEND INC. NEWSLETTER AUGUST 22, 2003
PERFORMANCE
Performance of the stock picks available to
paid subscribers continues to be very strong in 2003. The market in general has
been strong in 2003 and our stock picks have been much stronger than the general
TSX market.
WHAT TO BUY NOW
Perhaps you have been thinking about subscribing to our stock picks (if you
have not already done so).
Right now, our reports include several strong buys. One is an auto insurance
company that is highly profitable and yet selling at only 1.35 times book value
and a trailing price / earnings ratio of about 8.1. With today's high auto
insurance rates does this not sound like a good business to own? Another strong
buy is a highly profitable property development company in Alberta trading at
under book value and with a trailing P/E around 6.
Click here to learn how to Subscribe Now to our
stock picks.
HOW TO ACCESS CANADIAN INSIDER TRADING REPORTS
At long last Canadian insider trading reports are available free on the
internet.
Insider share transactions are now posted to a Web Site called SEDI.
www.sedi.ca
This is not a very user friendly site and you have to dig down several pages
to see the reports you need. The URL to the page you need is
https://www.sedi.ca/NASApp/sedi/SVTItdController?locale=en_CA
Go to this page and then choose "issuer name" from the drop-down list in the
box. Then enter the name of the company you want. Ignore the date range and
scroll down to the equity section and check "select all". Then scroll to the
bottom page and hit search and your report should appear.
Note that data is only available starting in early June this year when the
system finally went live.
I believe that these insider reports can be valuable. I get nervous about
buying a tock if I find out the insiders are selling.
However, the exercising of stock options muddies the picture. There are some
cases where insider selling may not be cause for alarm.
When an executive exercises stock options, he or she has to pay the
option price to the company. In order to cover that cost he or she will
typically sell at least some of the acquired shares to cover the cost of
purchasing them. Typically in fact they sell all the shares. For example an
executive exercises 100,000 options at $10.00 when the current market price is
$30.00. The executive needs to pay the corporation $1,000,000 for the exercise
price of the options. Most executives don't have that kind of cash and so they
are almost forced to sell at least the number of shares to cover the option
cost. Since there is a profit on selling those shares, they need to sell even
more shares to cover the taxes. So, it is not surprising that when executives
exercise options, they almost always then sell most or all of the shares.
The result is that we should not get upset when executives sell shares in
association with exercising stock options. But it should give you more comfort
when the executive sells only some of the shares.
Executives also sell shares as part of planned sales. Their financial
advisors might advise them to diversify and sell some shares. I still get
nervous about this. In my mind if they were really confident about the company
they would not be so eager to sell.
Insider buying can be a very good signal. When you see executives taking
their own money and buying shares then that certainly adds to my comfort level
in buying shares.
However this is also clouded, you may see insiders acquiring options. These
are gifts and therefore mean little. Also insiders may be given shares by the
company which also means little. You may also see stocks being purchased on a
planned purchase basis. These could be purchases by the company and may mean
little.
You may also see reports that the company itself is buying its own shares. I
don't take this as very much of a signal about the share price. The company may
be delusional about the value of its own shares and may be buying them when they
should not be.
You can also look at the net holdings of the executives. If the executive
exercises options and then sells all the shares to hold no shares or very few
shares, then I really have to wonder why I would want to hold any.
The bottom line, is that insider trading reports are a useful tool, but you
have to look closely and interpret what you see.
THE LIMITS TO STOCK MARKET GROWTH
Remember the 90's when we almost all believed that the stock market could
keep on gaining 15% or more per year? We tended to be oblivious to the fact that
in the long run the stock market can't grow any faster than corporate earnings
(otherwise the P/E ratio keeps rising to infinity). And corporate earnings can't
rise any faster than the nominal GDP growth in the long-run (otherwise,
corporate earnings eventually get larger than GDP, a mathematical
impossibility).
My article on limits to growth
argues that the overall stock market will not and cannot deliver more than about
a 7 to 8% return given realistic forecasts for GDP and inflation.
Now as long as only a small percentage of investors uses value investing
techniques, you and I and Warren Buffett can make higher returns than average by
taking advantage of "ninnies" (see last newsletter) that are selling profitable
value stocks to chase some hot stock that they don't understand at all and which
probably has no earnings or a P/E that is sky high. (We can't make higher than
average returns unless someone else is below average, that's the way it works).
BOARDWALK EQUITIES - (Needs a Lesson In Basic Finance Math?)
Last year I was quite bullish on this company and in fact I made some money
as the price rose. I felt that they should benefit because they own a huge
number of apartments in Alberta and the economy here is strong and home prices
are rising rapidly and rents have been rising. I expected to see rising profits
and cash flow. I also felt there was a good opportunity for the company to
maximize value by selling properties into an Income Trust.
But now the stock price is up but the expected profit increase has not
arrived. I understand that they have put some buildings into a Trust but they
have not yet sold the Trust to the public (nor announced any plans to do so).
I also have long been bothered by management's focus on Funds From Operations
rather than on free cash flow or net income. Management has long claimed that
net income is not an appropriate measure of their cash flow generation (where
have you heard that before? - think dot bomb and telco).
Even if I agree that net income understates their true cash flow generation
then I would not use Funds From Operations. Funds From Operations essentially
asks you to ignore the fact that a certain portion of their depreciation is a
very real cash expense - in the form of maintenance capital spending. They are
spending money on paint, carpets and appliances as they wear out. It is simply
not correct to focus on Funds From Operations. (And I don't care if that is the
real estate industry standard way of doing things).
To learn more about cash flow measures
see my article on that topic.
When you look at their balance sheet it is really quite pathetic. Assets are
$1.74 billion, which is quite an accomplishment. However debt is about $1.3
billion so they mostly operate on borrowed money - which is typical for real
estate companies. Share capital raised from the stock markets is $270 million.
Retained earnings or the sum total of all their historic profits (less a tiny
amount paid as dividends) is a paltry $37 million. I don't like that ratio, $270
million raised in the markets mostly some years ago and only $37 million in
retained earnings. Of course they will argue that net income is not an
appropriate measure. And I agree to an extent, we can probably add on the $67
million in so called future income taxes. These are taxes that are not owing. If
they were allowed to do their taxes on a cash basis this amount would have been
added to net income. Even so we would be at about $100 million total historic
earnings and that was based on $270 million raised in the markets, most of that
quite some years ago now.
Maybe they are sitting on huge capital gains in their buildings. But if the
buildings are so valuable, then where is the cash and net income that such
valuable buildings should generate?
They don't seem to disclose the age of their building but I suspect the
average age is well over 20 years. That means that many of these buildings are
possibly getting out of date in terms of kitchen and bath sizes and layouts and
these buildings could continue to require major capital spending.
In the latest quarterly report they brag about buying a building for 50% of
replacement cost. I wonder if they understand that a replacement building would
be brand new and ultra modern. They don't tell us the age of this "used"
building so why should we think 50% of replacement cost is a good deal?
Finally they brag that the dividend has just been increased to 30 cents per
year. At the recent share price of $15.60 that is a yield of 1.9%. That is not
that impressive for a company that claims to be generating lots of cash.
In the end they may be able to create great value by selling properties to an
income trust. Or maybe a big increase in net income is just around the corner.
In the meantime I am not sure that they understand what their own financials are
telling them. I sold my shares because I don't trust that they know what they
are doing financially. I do think they have been very successful as building
owners, they do a lot of things very well, I just don't see the evidence that
they understand how to generate cash for shareholders. Just my opinion. Maybe
they will prove me wrong.
Understanding the Price To Book Value
Companies are valued for their earnings and not directly for their assets.
Therefore it may seem that price to book value is not very relevant. But there
are some fundamental finance relationships that investors should be aware of. A
highly profitable company making a sustained 20% return on equity would be a
great investment if you could get it for book value. But if you pay four times
book value (which is hardly uncommon) then you are accepting an earnings yield
of 20%/4 = 5%. This may be fine if the earnings are growing rapidly. But
investors should understand that a higher price to book value ratio means that
it becomes more difficult for the accounting net income to justify the price
paid for the shares. The higher the price to book value then the higher ROE
and/or growth in earnings per share that is needed to justify the price paid. To
learn more see my article on understanding book value.
END
Shawn Allen, Editor
INVESTORSFRIEND INC. NEWSLETTER