Newsletter February 14, 2004


Valentines Day

It’s valentines Day 2004. I love analyzing companies using the principals of finance and accounting to find stocks are more likely to reliably make above average returns. I’d love to help even more people achieve progress on their financial goals in 2004.

I’m already feeling good about 2004 since my investments are up 6.7% in this new year already.

Becoming a millionaire requires a low risk rather than a high risk approach

Most do-it-yourself online investors are recklessly gambling rather than investing. A visit to the message boards on quickly reveals a rabid and frenetic level of posting on highly speculative stocks. Clearly investors on these message boards are hoping to make quick gains of hundreds of percent from companies that often have yet to make a dime. Meanwhile, blue-chip dividend-paying companies that have consistently delivered steady annual returns of 15% and more are all but ignored. For example, the most popular stock on these message boards when I checked today was a company called International Wex Technologies Inc. A quick check of reveals that this company has just $8 million in assets, and $27 million in accumulated losses. Fortunately it has no debt. The shares trade at $7.60 and there are about 24 million shares. Therefore this company with $8 million in assets is trading at an incredible $183 million. Clearly this is a very tiny and incredibly speculative stock. And yet investors are absolutely rabid for it! Maybe it will turn out to be a big winner but for every Wex Technologies that really makes it there are many more that crash and burn.

Maybe people think that they need to take high risks to make big returns. That kind of thinking is a gross misinterpretation of portfolio theory which indicates that the ONLY kind of risk that theoretically adds to return is to hold the market portfolio and add risk by leveraging with borrowed money. And that only works if the markets are efficient and the economy is competitive. In reality many companies have quasi-monopoly characteristics and have histories of making high returns at low risk.

The reality is that lower risk strategies can virtually guarantee that investors can easily amass $1,000,000 or more (in today’s dollars) over an investment lifetime.

For example if you invest $6000 per year at 8% (after inflation) it will grow to $734,000 in 30 years. At 10% it would grow to $1,085,000. At 12% it would grow to $1.6 million.

In reality, 10% after inflation may be difficult to achieve but it is not out of reach by following a low risk strategy of investing in proven successful profit making companies, particularly those which are trading at bargain prices. This strategy is almost guaranteed to insure that your wealth will grow over the long-term. (Though with some volatility in the shorter term) To insure the strategy works an investor could increase their yearly investment amount. In contrast a strategy of focusing on the type of highly speculative stocks that are so popular on message boards has very little certainty of working. You could get lucky, but relying on luck is a very risky strategy.

Business Income Trusts a Major Investment Phenomenon

Business Income Trusts are truly a major investment phenomenon in Canada. Investors have made stellar returns in two ways.

First investors have enjoyed the high yields, often in the eight to ten percent range. On top of this many Trusts have rather unexpectedly delivered capital gains.

Second, investors in corporations have enjoyed huge capital gains of 25% to 100% or more when a corporation had converted its trading shares into shares of an Income Trust.

The high returns for Income Trust holders could continue for several reasons. Many of these Income Trusts have been able to grow by retaining some of the cash flows for growth. In some cases they have been able to grow by acquiring other corporations and assets and bringing them into the tax-free Income Trust tent. However, not every Income trust will grow its distributions. Some of the capital gains that Trust Investors have enjoyed was due to a decline in interest rates. That is unlikely to continue and in fact would cause the unit prices to decline if interest rates rise. Investors therefore have to be selective, but there are Trusts that will continue to offer very attractive total returns.

The conversion of Canadian corporations into Income Trusts is a phenomena that is probably going to pick up steam. The Income Trust Structure effectively eliminates corporate taxation and most companies that are reliably profitable enough to pay large amounts of income tax can increase their value significantly simply by converting. Astute investors who own those corporate shares will enjoy windfall gains as the company converts.

So far, many Income Trusts have been small, in the range of $100 to $500 million, although there have been some larger exceptions. Common wisdom suggests that very large companies will not convert because they are simply too large for the Income Trust market to absorb. I predict that 2004 will prove that wisdom wrong. I expect to see some very large companies convert. The savings in income tax are very compelling and this will entice some very large companies to convert.

It’s interesting to note that a $10 billion market value share company could potentially convert itself to an Income Trust that might be worth $15 billion. This does not mean that $15 billion or even $5 billion has to raised from the market. In fact not a dime has to be raised. Instead the shares that formerly traded at a $10 billion value would become Trust units that could trade at $15 billion without 1 cent being raised in the market. The same thing happens when any company’s shares increase by 50% in the market, the new value is in fact created out of thin air and no new money is needed. Therefore the argument that the Income Trust market could not support a huge IPO is no barrier to large companies converting. One issue might be a barrier is that the current shareholders would not want to hold the new Income Trust shares. That may be true and could limit the capital gain on conversion to a Trust. But ultimately the savings in income tax will still make many deals work.

I have not researched a list of candidates that might convert to Income Trusts (and offer large capital gains to existing investors). However, potential names that come to mind include BCE (particularly its Bell Canada subsidiary), portions of TELUS, Shaw Communications, Rogers communications, CNR, Loblaw, and Canadian Tire. Many of these companies will protest that they are not suitable as they need the cash to grow, but a number of companies that have already converted said the same thing. Other possibilities include Molson, MDS inc. and many more. Effectively any stable cash-generating entity could convert. In some cases companies will spin-off parts of their business into an Income Trust and leave other portions in the corporation business structure.

In my view, the only thing that could stop what is becoming an increasing rush to convert would be changes to tax laws that take away the Income Tax Advantages of Income Trusts.

For more information, see my article on Understanding Income Trusts.

Trading Strategies

Investors often behave illogically due to certain aspects of human behavior. For example many investors who decide not to buy a certain stock at $6 cannot bring themselves to buy that stock later at a higher price even if they think it is a great investment. It would psychologically hurt an investor to buy the stock at $10 since that would seem to be tantamount to admitting that not buying at $6 was a mistake. And investors don’t like to have to admit mistakes. Similarly it can be very hard to sell a stock that starts to decline. Investors who did not sell at the peak feel like they made a mistake if they sell it later at a lower price. The lower the price drops the more psychologically painful it becomes to sell, no matter what the fundamentals of the company are. This partially explains the phenomena of investors holding stocks all the way down to zero. Investors also worry mightily that if they sell a stock, it might then rebound in price, making them look dumb for selling.

To combat such illogical moves, investors can commit to buying and selling based on some type of valuation system. If your model says sell then you should sell and then try to ignore what happens to the stock after that. For 2004, my own plan is have a higher percentage of my money in Strong Buy and Buy-rated stocks. If I rate a stock a hold, I will try to have the courage to sell that stock and move into one of my higher picks.

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Shawn Allen
InvestorsFriend Inc.