Newsletter February 9, 2002

Newsletter February 9, 2002

Your Chance to be on TV

An Edmonton television station is considering doing an internet investment feature that would include an interview with myself. It seems the theme will be that there are good sites and there are bad sites. However, they will only do the story if they can find someone from Edmonton who took a bad tip on the internet and lost money (a strong Buy recommendation based on no analysis and probably meant to pump up a stock price through hype). If any members have lost money that way and are willing to talk about it on television then I would appreciate it if you would email me ASAP.


Enbridge , TransAlta and Transat A.T. have been updated since last time. More updates are coming as the 2001 earnings reports roll in.

I will contact members within the next week with an offer of several new research reports for sale. I expect to offer two or three reports at $10 each or two for $15. These will be rated as Buys. It’s not realistic that all my picks will be Strong Buys and  also I don’t want to get in the position of being tempted to rate a stock a Strong Buy so that I can sell a report. The way I rate stocks, a Buy is a stock that I would Buy. Historically, both my Buy and Strong Buy picks have done well on average in the long term.

Some members have suggested a subscription based approach or membership fee to receive all reports. That may happen in the long term but for now I can only offer the reports for sale as I go.

Is the Dow Jones Industrial Average Overvalued?

There is no shortage of people who will predict where the DOW will be in 12 months. But how many of them can show you the math and logic to back up their predictions or statements? My article that determines the fair value of the DOW based on its earnings and standard valuation techniques has been updated.

P/E Expansion and Contraction

Stocks with positive earnings trade at some multiple of their earnings. A stock earning $1 trading at $15 has a P/E of 15. There are two ways that this stock price can increase. First if earnings increase and the P/E remains the same then the stock will rise in proportion with earnings. If earnings double then the stock price doubles. Second, the stock price changes in proportion to changes in the P/E multiple.

In many cases earnings are relatively steady and yet the stock price may gyrate widely. The P/E multiple represents the markets overall judgment about future prospects. A high P/E represents an expectation of high future earnings growth.

High P/E stocks are susceptible to a P/E contraction. In the long run no stock can grow very quickly forever and so we should expect the high P/E to contract towards a sustainable range of say about 20 or less in the long term. Given this, the only way a long term investor is going to make a good return on a high P/E stock is if the earnings indeed do grow very quickly. If the earnings grow even faster than the high P/E requires then the long term investor can do very well. But the danger is that if the earnings grow but still fall short of the very high expectations built into the high P/E then the stock price will usually be hit by a dramatic fall in the P/E. High P/E stocks can offer good rewards in some cases but investors should be very aware of the danger of a sharp P/E contraction.

In contrast a low P/E stock is relatively protected from a P/E contraction as long as it continues to have at least stable earnings. The low P/E stock is not expected to show high earnings growth. But if it does then we can have a P/E expansion. This can be quite lucrative as the stock price will increase first in proportion to the earnings and then again as the P/E rises. Not every low P/E stock is a candidate for this happy fate. But if one can find high growth stocks that have a low P/E then it is quite possible to benefit from a P/E expansion.

Accounting Issues

Post Enron, everyone is suddenly wondering if the accounting can be trusted. Previously it seemed many analysts had no use for GAAP earnings and many companies were evaluated on some type of pro-forma earnings.

It was really quite a amazing I would see press releases and news reports that say Nortel had made $1.00 a share and then I would look at the figures and read page 3 of the press release to find out that the company had actually lost money and only made money before accounting for a host of non-cash and one-time items.

Long time members of this Site know that I support adjusted or pro-forma earnings as long as the process is not abused. In my reports I graph both the GAAP earnings and the Adjusted earnings and I discuss the basis for any adjustments.

Today there are calls for an end to pro-forma earnings and a return to strict GAAP earnings. That is not the answer and anyhow, ENRON in fact had positive GAAP earnings for the last 5 years!. It was only in the final quarter before its demise that ENRON reported 1 quarter of negative earnings. So GAAP versus pro-forma was not the problem with ENRON.

GAAP earnings allow a large amount of management discretion and judgement. For example, under GAAP many expenses that are designed to provide lasting benefits such as product development expenses and various costs of customer acquisitions can be either charged as current expenses (depresses earnings) or capitalized to the balance sheet (shows higher earnings) at the discretion of management.

In the end we put our trust in management. There are no simple answers such as GAAP accounting or cashflow. Investing solely in companies with ethical and trustworthy management is the answer to the problem.

Warren Buffett has an iron clad rule, he simply refuses to invest in a company with managers that he does not trust. Following on that theme my Web Site has long provided readers with several clues as to management trustworthiness and accounting reliability. I specifically address the following in each research report I produce:

Quality of earnings measurement: In this section I specifically address whether or not the earnings seem reliable and real or instead are heavily based on management judgement. I long ago specifically rated the earnings quality for Nortel to be quite low and noted concern about JDS and other companies. Very recently I noted concerns about Biovail’s quality of earnings as I rated the company a weak sell (in retrospect I should have said simply Sell).

Quality of Assets measurement : I often use this section to point out that companies like Nortel and JDS had huge amounts of intangible goodwill rather than hard assets.

Liquidly and capital structure: In this area I warn if debt appears excessive.

Accounting and Disclosure issues: I flag problems that I see here. I may not catch all the problems, especially fraud, but I do look for problems.

Executive Compensation: Call me crazy, but when a  C.E.O. has arranged with his boardroom buddies to pay himself obscene amounts of money I consider that a huge red flag against the company. I pointed out obscene pay levels sometimes well beyond $10 million per year for JDS Uniphase (the single worse offender I have seen), Nortel, Bombardier, TD Waterhouse, Biovail and Power Financial. Respect for shareholders and mega million dollar compensation practices are unlikely to well correlated in my opinion.

Quality of management: I base my opinion of management quality on past results and on things like full disclosure and reasonable executive compensation.

Taken together, the above items are often enough to raise a red flag. If the P/E ratio looks attractive but some of these items make you uncomfortable with management then take a pass on the investment. I  believe that there are always good investment opportunities to be found so if something smells bad just pass on it and wait for other opportunities.

To conclude, it’s good that other analysts are now waking up to accounting issues. Fortunately, I have been addressing these all along. These factors helped me to recognize that many tech stocks were dangerously over-valued in 2000, as evidenced by my sell ratings on the likes of Nortel and JDS.

True Confessions about Enron:

I never did analyze Enron in detail or post a research report to this Site but I did partially analyze it when it had fallen from the $80 range to about $11. In all honesty I thought it was cheap although risky at that price (P/E was about 7) based on its reported earnings. I did report in the comments section of this Site that I had bought the stock (see October 30). Enron appears to have been a fraud and even if I had looked more closely I would not have realized that the figures were simply not true. When I look back at my notes on Enron, at $11.00 it looked cheap to me but it failed 5 of 9 Buffet tenets. I had no comments on accounting at that time as I had not looked closely. Foolishly  I proceeded to buy a few shares at $12 based on a stop buy that I had placed when the share price was $11.30. Subsequently things looked good when the shares went briefly to $14. They then turned around and the rest is history. As soon as the shares turned around I noted on my Site that they were likely in free fall but stubbornly hung onto my own shares.

The lesson for me is not to buy a stock that fails 5 of Buffets tenets (these were: not simple to understand, high debt, low profits on sales, poor outlook because of being in the commodity business, and had some management problems). Under those circumstances I should not have bought no matter how low the P/E looked. However I got greedy…and paid the price.

RRSP Foreign Content Restrictions

Big pension funds were in the news this week strongly suggesting that the 30% foreign content limit be removed from pensions and RRSPs.

My view is that if the Government gives us a tax break for investing in RRSPs and Pensions, then they have the right to make restrictions.

Speaking of the huge tax breaks available for Pension and RRSP contributions and the tax free compounding, have you thought about who else has to pay more tax so that some people can enjoy those tax breaks?

It should be self evident that in the absence of those tax breaks our overall tax rates would be lower. I say scrap not just the foreign content rules but scrap the whole system and give us lower tax rates.

Since I am a member of a pension plan and contribute to an RRSP., I am actually a beneficiary of the whole mis-guided and outdated system. But it bothers me that people without pensions and without the funds to contribute to an RRSP are forced to subsidize my savings through unnecessarily and unfairly high tax rates. If you think about it you will realize that it is not possible for the government to give a tax break on RRSPs and Pensions (given that their spending needs are unchanged by that decision) rather what they are doing is simply creating cross subsidies in the tax system. It’s not the government that ultimately pays for the tax break, its other taxpayers. No wonder low income people are suspicious of the government, they are being forced to subsidize the pensions of the middle class, isn’t that special?

Of course the government should work to lower tax levels in general, but that’s a another story. I want lower tax rates, but not at the expense of having lower income people subsidize the middle class.


This newsletter is kept brief and usually only sent once each two weeks. I hope that you will all stay on the mailing list of this site. However, you can unsubscribe by simply replying with the word “unsubscribe”. I would appreciate knowing the reason.

Regards and thanks for your interest,
Shawn Allen