Newsletter April 16, 2006

InvestorsFriend Inc. Newsletter April 16, 2006


I am totally pumped about our performance this year and in fact every year since this Site started. In the past three calendar years my personal portfolio has returned an extremely satisfying total of 126%! And the Strong Buys have done even better returning a total 190% in the past three years. This strong performance has continued once again in 2006 with the Buy rated stocks already up over 11% on average.

If you have not already done so, right now is an excellent time to take action and subscribe to our stock picks. We update our stock ratings all throughout each year so right now is a great time to subscribe.

The fact that you are viewing this material tells me that you are probably someone who has an interest in taking charge of your investment decisions. If so, I believe that our stock rating service will be of great interest to you.

Somewhat incredibly, we achieved our excellent performance despite choosing to almost ignore the highly volatile oil and gas sector as well as golds and minerals. (Although the model portfolio has a modest exposure to oil and gas). Our success comes from analysis of financial data for each company and does not depend on trying to predict commodity prices.

Some of our big successes in 2005 were… Melcor Developments a small Alberta property development company that was up 132%, Wendy’s International which was up 41% and the TSX Group which was up 74%. Many other picks were up 15 to 30%.

One of the big keys to our success once again in 2005 was the fact that we again had extremely few losers. Out of 18 stocks rated in the Buy or Strong Buy range, fully 15 were up in price and only 3 are down. One of the best ways to make money is to not lose money. One stock that goes to zero needs 5 stocks going up 20% just to make up for the one total dog. By having very few losers we were able to achieve 30% average gains without having to rely on having one or two super-star stocks that went through the roof.

For more information see our performance page.

Toronto Stock Exchange Market Valuation

It’s always easier to make money in a rising market. Therefore it is certainly worth thinking about whether or not markets are likely to rise in the short term. Unfortunately there is no reliable way to predict the market’s direction.

The overall Canadian and American markets have been generally rising for over three years now. That alone might suggest we are due for a decline or at least a pause. And that is certainly very possible. However, the rise in the past three years was after the big declines of the early 2000’s and we are just now back to the previous highs. And earnings have risen a LOT to the point where the price / earnings ratios on the market are a lot lower than they were in 2000.

The following is a summary of the Price / Earnings ratios for the TSX market as of April 16, 2006

TSX Segment Index P/E Dividend Yield % Exchange Traded Fund Comment
Composite 19.7 2.26
Composite (without Income Trusts) 20.6 1.53
Income Trust 14.8 8.28 XTR
60 (Large Cap) 19.6 1.65 XIU
Mid Cap 18.7 2.43 XMD
Small Cap 21.9 4.67
Capped Consumer Discretionary 19.0 1.93
Capped Consumer Staples 19.8 1.52
Capped Metals & Mining 13.6 1.96 Appears attractive but may or may not reflect a cyclical peak in earnings.
Capped Energy 17.4 2.49 XEG Appears attractive but may or may not reflect a cyclical peak in earnings.
Capped Financials 17.0 2.70 XFN
Capped Gold n.a. 0.32 XGD Surprisingly, no GAAP earnings despite record gold prices.
Capped Health Care 149 1.22 Looks very expensive
Capped Industrials 20.4 1.87
Capped Information technology 32.4 0.03 XIT Looks very expensive
Capped Materials 28.9 1.16 XMA
Capped Real Estate 44.4 5.42 XRE
Capped Telecommunications 23.7 3.02
Capped Utilities 19.4 4.83
Capped Energy Trust 13.1 8.6 Sadly, no ETF!
Capped REIT 44.7 6.19

With most of the P/E ratios at 20 or higher, most of these segments do not appear to be particularly attractive. However investors may also wish to consider the expected growth or contraction of the earnings that are driving the P/E for a particular segment. High growth can support a high P/E and low or negative growth leads to lower P/E ratios. Also for some industries like mining and real estate, the GAAP earnings may arguably understate sustainable free cash flow therefore justifying a higher P/E. For more on this see our articles on understanding P/E ratios. Possibly, some segments, which may not have a lot of companies in the sector, like Gold are affected by one or two companies within the sector having unusual losses.

Overall, the above P/E ratios would suggest a need to be cautious. There are always bargains to be found among individual stocks, but when the overall market seems somewhat expensive it obviously bcomes harder to find the bargains.


In recent weeks, long term interest rates and really started to rise noticeably, although they are still at levels that are quite low.

The ten-year government bond yield (market interest rate) is now 4.40%, that is up noticeable from the 3.80% levels reached in the Summer of 2005, but it’s still low considering it was at 4.40% at the end of 2004, and 4.88% at the end of 2002 and 5.44% at the end of 2001 and much higher than that through much of the 80’s and 90’s.

Note that short-term interest rates have increased very sharply over the past two years or more. But it is only in the last 6 months and particularly the last 2 months  (and most noticeably the last 2 weeks) that long-term interest rates have really started to rise.

I believe that the impact of higher rates is already being felt in stock prices for Income Trusts, utilities and other higher-dividend-paying stocks. In theory, higher long-term interest rates immediately reduce the monetary value of all assets (including certainly stocks, bonds, and real estate). However the reduction in value is most immediate and pronounced for assets that provide fixed future cash flows  – and the farther into the future the cash flow is, the bigger the drop in value with an increase in interest rates.

Consider a $100,000 bond that pays a market interest rate of say (5%) or $5000 per year and then returns the principal amount in 10 years. If market interest rates for this bond rise to 6%, then the value of this bond, will immediately drop and there are formulas that can tell us the precise amount of capital loss on this bond.

In contrast the value of stocks is usually based on an estimate of future earnings. Because of the uncertainties involved there are no precise formulas to tell us how stocks will react to higher interest rates. But directionally we know that (all else being equal) they will drop. The stock price will drop because the value of its future dividends will drop even if those dividends are unchanged. Furthermore, if the market senses that the higher interest rates will slow the economy and hurt the earnings of the company then the stock value could drop even more than a bond would.

Of course some stocks will continue to rise even if interest rates rise. Stocks with sharply rising future earnings can over-come the gravitational pull of higher interest rates and keep rising.

The point is that if we expect long-term interest rates to continue to rise, then this is generally a negative indicator for both stocks and bonds. For stock investors, in this scenario, it will pay to be selective and look for stocks that will be less harmed by higher interest rates.

It is not a certainty that long-term interest rates will continue to rise. Therefore many investors will choose to remain invested in long-term bonds and the more interest sensitive stocks. Remaining in such investments can be a rationale strategy for many reasons.

Stock Option Expenses

For many years corporations were not required to expense the value of stock options. Now they are required to do so. Somewhat surprisingly, this has not had much impact on earnings.

Some companies have scaled way back on issuing stock options and have chosen other ways to compensate and motivate executives. Given that many companies were handing out options like candy (sometimes transferring obscene amounts wealth from shareholders to executives) this is generally a good thing.

Sadly, many companies are reporting stock option expenses that are clearly much lower than the true expense (I would estimate about 10 times lower in many cases). One reason is that they may show only the expense for the options that “vest” in a particular year and exclude the expense associated with options issued this year, that will vest in future years. That would not be such a bad thing except they also are usually excluding the vesting of some prior years options that were issued before the accounting rules changes but which vest this year. But that problem will fade away once the new rules have been in place for about 6 years.

Another reason for low option expenses is essentially the ability to choose parameters of the stock option valuation formula which produce nonsensically low results. Essentially a company can issue options with a highly valuable life of 10 years but in the valuation can assume that they will be cashed out in say three years on average. Due to that type of assumption I have seen companies report values for 10 year options that are actually below the value of similar options which trade on the market with a life of under 6 months. 10 year options are worth vastly more than 6 month options and it is nonsensical for management to use such results. Yet it is all legal and is blessed by auditors.

There is really nothing that investors can do about this. Even analysts are not likely to try to adjust the option expense to a higher more realistic figure. I would only consider worrying about this in cases where the company seems to be granting excessive amounts of options since in that case the under-stated expense could be material. Hopefully regulators will deal with the problem in future.

The Abundance Mentality

Do you operate from the abundance mentality or the scarcity mentality?

The scarcity mentality holds that essentially all things in life are scarce. For these people, clearly money is scarce and must be guarded and not shared to any great extent, which frankly most people would agree with to a very large degree. But also in this mentality things like praise, trust, kindness and love are scarce. Someone with a lot of this scarcity mentality would generally not praise a co-worker, particularly in front of the boss. After all, using up scarce praise on a co-worker might mean that there is less for the individual. In extreme cases people with too much scarcity mentality will tend to hoard and withhold time, money, trust, praise, kindness, love and most everything else from most of the rest of the world, including possibly their own families.

The abundance mentality in contrast holds that most things in life are abundant. Certainly praise and kindness and love are for the most part abundant and indivisible. Giving praise, trust, kindness or love, in the vast majority of cases will not only diminish the amount of the same that a person will receive but will in most cases vastly multiply it and these will be reflected back on the giver. Some people even believe that the abundance mentality even applies to money, that for example giving to charity will lead to rewards through good karma. Most people would not agree to go too far in applying the abundance mentality to money but it may be worth trying with a certain portion of our funds as budgets allow.

I must admit that I have not held to the abundance mentality as much as I should. But I think I am getting better at it as time goes on. I am always impressed by people who display unusual amounts of the abundance mentality and who for example offer heartfelt and sincere praise on a frequent and consistent basis. And I have noticed that some of the most successful and popular people exhibit such an abundance mentality. On reflection, that is not surprising.

In terms of picking stocks, I have always been turned off by managements who blame their problems on others, or who disparage their competitors. In effect that is a form of the scarcity mentality. Companies that acknowledge (and maybe copy) some of the good things that their competitors are doing probably have an abundance mentality. Also, too often I have been a bit too suspicious of the claims made by various companies. Sure there are a lot of scams out there and we have to careful. Things that look too good to be true may indeed be. But sometimes we will miss out on excellent companies to invest in or excellent products to buy because we are overly suspicious and fail to acknowledge a good thing when we see it. (On that note I will end and also remind those of you who are not subscribers to our stock research that you can subscribe now).


Shawn Allen
InvestorsFriend Inc

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