Newsletter April 8, 2006

InvestorsFriend Inc. Newsletter April 8, 2006

Welcome to the April edition of our free newsletter. This newsletter provides thoughtful insights related to achieving success in investing.


One of the things that I love about the stock markets is that in the end it is all about performance. There is nothing judgemental about it. After a period of time the numbers tell the story as to whether an investor has either done well or not. I would not expect you to bother reading this newsletter if my own investing performance was not strong.

My personal experience of being invested in stocks has been very good. Every dollar that I have invested in stocks has now grown on average to $3.00. And it has not taken very long. The weighted average age of my investments is about 7.5 years. So on average I have tripled my money in 7.5 years. I am not sure that I can keep up that pace, but I can say that 2006 is off to another strong start.

Check our our excellent performance in stock picking.

2006 so far is shaping up to be our 7th year in a row of providing market-beating stock picks. This week in particular was very strong.

Financial Engineering, mergers, spin-offs etc.

The Canadian stock market has performed exceptionally well over the past three years. Part of this success has been due to various forms of Financial Engineering.

Financial Engineering includes various ways of repackaging existing businesses to make them more valuable. This can include mergers and acquisitions where two or more companies combine and realize various “synergies” through larger scales of operations, cross selling to the same customer base and other advantages. (Essentially in this strategy 1 + 1 >2). Where a company owns two or more businesses that do not have synergies, financial engineering can involve splitting a company up into parts so that the full value of each business is recognized.

Other examples of financial engineering could involve a company paying a large special dividend so that it will earn a higher return on a reduced level of equity. Even taking advantage of newer lower cost ways of borrowing money such as by “securitization” of receivables is a form of financial engineering.

The Income Trust phenomena is perhaps the biggest example of financial engineering in Canada. Income trusts pay less tax which increases value. But they also distribute all earnings to investors which turned out to add value to the company even when the company may then turn-around and raise new money for expansion.

All of this has been good for investors. However, I worry that much of this financial engineering is effectively a one-time thing. A company can only become an Income Trust once. It seems to me that we can only squeeze so much valuation out of companies. To the extent that we squeeze out a lot of value now, this may mean that there will be less of an increase in value in future years given that in a sense we may have recognized some of the value early.

In summary the danger with financial engineering that surfaces a lot of value at this time is that it may diminish the value available to be surfaced in future.

For the moment it looks like the financial engineering boom will continue, but my fear is that eventually it must slow down and this source of higher returns will be much reduced.

The Economy and a Stock Market Outlook

In the short term, higher interest rates and higher energy costs may put the breaks on consumer spending.

However, over the next few years I generally expect the consumer economy to continue to do well. It seems like now more than ever, there are just so many new gadgets and services that consumers want. To name a few, multiple cell phones per family, plasma / LCD televisions, digital cable service, high-speed internet, new cars with navigation systems and built in movie/television systems, wireless internet for the cottage, bigger fancier houses/apartments and many more things.

I believe that people will continue to do what it takes to able to purchase many of these things. This includes working longer hours and includes multi-income families.

All of this leads to the economy going around at an ever faster rate which leads to a growing value for individual companies and for the stock market generally.

The first quarter earnings will soon start to be released and all indications are that earnings growth was strong and all else being equal this suggests the market could go higher in the next six weeks.

DOW Jones Industrial Average and S&P 500 valuation update.

It is very difficult to predict whether stock indexes like the Dow Jones Industrial Average or the S&P 500 index will fall rather than rise in the immediate future. However, it is possible to calculate whether or not these indexes seem under-valued or over-valued based on reasonable assumptions.

I have just completed updating two important articles and calculations that look at the valuation of the Dow and the S&P 500 index.

I had been expecting that these indexes would look attractive given that earnings growth has been very strong in the past few years. However, my calculations indicate that based on reasonably conservative assumptions these stock indexes are about fairly valued at this time.

This analysis is well worth reviewing if you are concerned about the valuation of the stock market indexes.

(I hope to do a similar analysis for the Toronto (TSX) index for next month. However, the TSX index is not a diversified index due its heavy concentration in energy and financials and therefore such an analysis will be less meaningful for the TSX index)


Note that the articles section of this Site contains a large number of articles that are valuable for both the beginner and the experienced investor.

Boring can be Good – Just ask Bill Gates.

Recently it was revealed that Bill Gates is the largest shareholder in Canadian National Railway Company, with an impressive $1.6 billion stake in the company. A $10,000 investment in CN at the time of its 1995 IPO is now worth about $118,000 and that does not count dividends. That is pretty darn good for what might have appeared to be a boring old blue chip type company. I suspect that Bill’s good friend Warren Buffett may have suggested the investment in CN. Bill bought his shares prior to 2000 and so I suspect he is already up at least a billion on this investment. Good work Bill! On hearing that, most people will just moan about the rich getting richer, but smart investors will instead be motivated by seeing this kind of investment success.

On this Site we have at various times been quite bullish on CN. However, at other times we thought it looked expensive, but we always said it was a great company. We also long suspected that its earnings were under-stated because of the way it defers so much of its income tax.

Tim Hortons

As you may know, Tim Hortons was sold in its Initial Public Offering at $27, it opened around $34 and soared very briefly to almost $38 and has now declined to about $30 to $31. Almost all of the IPO stock at $27 was sold to institutional investors, many of whom apparently quickly sold it locking in about a 25% to 35% profit on day one. Meanwhile retail investors had been pretty much shut out of the IPO and if they bought it in the market have now generally lost money.

Almost totally ignored in all the media discussion was the fact that retail investors could easily have enjoyed a profit on Tim Hortons simply by buying Wendy’s shares. Wendy’s recently closed at about $61, but it has a 52 week range of $38 to $66.

Back when Wendy’s was about $38, this Site had it rated as a Buy. In fact this Site was rating Wendy’s a Buy and talking about a possible spin-off of Tim Hortons since mid-2004. Retail investors who bought at that time and who still hold Wendy’s have made excellent profits. Not only that but they stand to receive, by the end of 2006, about 1.3 to 1.35 Tim Horton shares for each Wendy’s share that they own.

Clearly the best time to have bought Wendy’s was some months ago. One year ago, Wendy’s was under $40 and as recently as December it was in the mid forties.

Subscription Based Businesses

I am increasingly attracted to subscription based or recurring income type businesses. Not all of these are attractive but subscription based businesses include cable television, cellular phone service, as well as magazines and newspapers. Insurance companies are similar in that their revenues are recurring month after month.

In many cases these type of businesses compete rather fiercely for new customers and spend heavily on advertising, sales commissions and various incentives to attract each new customers. However, in many cases customers once acquired tend to stay and tend to be quite profitable.

In some cases, where a company is growing rapidly,  the spending to acquire new customers (which is typically partly or fully expensed as incurred rather than being expensed over several years) may depress net earnings. In life insurance this is known as new business strain.

A great example of this phenomenon occurred with  TELUS several years ago. Net earnings seemed quite low and consequently the share price was low as well. At that time I speculated that the expense of acquiring hundreds of thousands of new cell phone customers annually was artificially depressing earnings. In fact I believe at that time TELUS probably could have chosen to spread some of the expenses overseveral years for accounting purposes and this would have increased their reported profits. More recently as TELUS gained more and more customers and as the cost of acquiring new customers came down, the expenses of acquiring new customers began to be dwarfed by the profits rolling in from the existing  customers. It does appear that the earnings of TELUS were artificially low a few years ago due to conservative accounting.

A reasonable investment strategy would be to seek out fast-growing subscription based businesses that are reporting low earnings because of expensing new customer acquisition costs. If the stock is trading on the basis of the (arguably) artificially low earnings, then the stock might prove to be a very good investment. I believe that one or more of the Telcos and Cable companies may fit this description today.

What Subscribers to our Stock Picks Get

Recently I came to the realization that our subscription sign up page was missing something. It did not clearly enough describe exactly what you would get for your money by subscribing to our stock picks. For a description of exactly what subscribers get, click here.

Personal Success

With the first quarter of the year now gone, it may be a good time for everyone to review any goals or resolutions that were made at the start of the year.

I suspect that the reason that many goals and resolutions are not met is that there was never any true commitment to the goal in the first place.

For example if one person states “I will try to lose 20 pounds by Summer”, and another states, “I will definitely lose 20 pounds by July 1”, it’s not hard to predict that the second person is more  likely to succeed. The first person displays no real commitment to the goal.

I believe that for a goal to be achieved we have to truly commit to achieving it (not merely committing to try but committing to succeed). However, in order to truly commit to a goal we have to believe we can do it and that usually requires some kind of clear plan. We have to be able to see the steps in our head. For example it’s usually easy for a student to commit to successfully completing another year of college. After all the path to succeeding at this goal is very clearly laid out and can be completed step-by-step. In contrast a goal of “adding $5,000 to  monthly income” would be very difficult for most people to really commit to unless there was a clear path laid out and one that the person was willing to follow.

So, to achieve goals, make sure you are ready to truly commit to the goal and that you have a plan of action that you are willing to follow.

To view past editions of this newsletter, click here.


Shawn Allen
InvestorsFriend Inc