InvestorsFriend Inc. Newsletter January 20, 2008
Revenge of the Procrastinators
Anyone who procrastinated about putting new money into stocks in past year and particularly in the past month is no doubt glad they procrastinated.
The recent drop in the markets is good news for anyone just starting out as an investor either because of being young or because they of procrastination or because they simply were not financially able to invest until now. And for new investors, the deeper the market drops, the better.
It may be that procrastinators are being given a golden opportunity to get into stocks at good prices. Many world-class companies are “on-sale” at prices in relation to their earnings or their book values that have not been seen in ten or twenty years. For new investors, this is most assuredly a good thing. Sure, stock markets could fall further but hopefully that will allow for future buying at even better prices. And eventually markets will recover as they always do. In the end, continued procrastination will not be a winning strategy.
Wasn’t That a Party?
From late 2002 to the start of 2007, North American Stock markets rose relatively steadily.
The DOW was up 75% from October 2002 to the end of 2006. The TSX index more than doubled, up 109% in that same four year period. During that time we had a few “corrections” but essentially nothing bigger than about a 10% decline, and all declines were quickly reversed.
Four straight years of virtually uninterrupted gains in the market is unusual. In a more typical four-year period we see lower total gains and larger dips than we saw in 2003 through 2006.
It’s fair to say that in recent years investors became spoiled. After about about four years of market gains, the memories of the crash of the early 2000’s started to fade away. Predictably, investors began to think that the markets would likely continue to rise in a reasonably steady fashion.
Now, reality has intruded. 2007 saw the markets lurch down noticeably on three occasions (February, August and November). Each time the market then largely recovered. Now in January we have had yet another lurch downwards. And it’s not clear how deep it will go this time. Nor is it clear that we can expect any substantial near-term recovery.
Investors are now realizing that the the out-sized returns of 2003 through 2006 are not something to be expected as a long term average. Investors who are more aware that a long-term return in the high single digits is actually quite satisfactory and who are aware that stock markets also fairly regularly experience periods when values drop by 20% or more, (even as they rise hundreds of percent over the decades) are less likely to be disappointed and frustrated by current market conditions.
Move Along… There’s Nothin’ to See Here!
The mainstream news media has noticed that stock markets are down. Drops of 300 points in a day and 900 points in a week, make for great headlines.
Many people who have never invested in stocks are quite glad to see investors get this dose of pain. Some will use the news to justify their decision not to invest in stocks. But they will be ignoring the fact that North American stock markets on average are still up about 100% in the past five years or so and up over 1000% since 1982.
A stock market drop of 300 points or 2.5% in a day or 900 points (7.5%) in a week is legitimately news. But in the history of the markets it is simply not all that unusual. In the big picture, it is not really all that newsworthy after all.
Is an Off-Balance Sheet Liability an Obvious Oxymoron?
Big banks in the United States were recently revealed to have had extremely large losses associated with investments that were “off-balance sheet”. (These were among other losses that the banks incurred). The investments were in “Special Purpose Vehicles”. These SPV’s were legal entities that technically were not subsidiaries of the banks and technically they were not owed or controlled by the banks. But in substance they were. Some of the banks were going to “decide” if they would bring some of these SPVs back onto their balance sheets. (This “decide” aspect illustrates that accounting rules are sometimes flexible.)
There is something clearly wrong with this picture. For years investors have been hearing about off-balance sheet liabilities and we heard the term so often that we came to accept it. We seemed to not notice that the very term was a clear oxymoron.
A balance sheet after all by definition lists all assets and liabilities of a company. Initially the term off-balance sheet liability tended to mean a contingent liability, something that could not be put on the balance sheet under accounting rules.
But in recent years off-balance sheet entities were created specifically to keep certain things off the balance sheet. Company accountants used loop holes in the accounting rules to purposely keep certain liabilities off the balance sheet.
This reminds me of Enron. Before it is over we will likely see some executives charged with fraud.
As investors we should be wary of any company that uses off-balance sheet financing. Some of it might be legitimate, but the very term off-balance sheet liability simply smells.
As an example certain mortgage companies “sell” mortgages to Special Purpose Vehicles that were set up for the sole purpose of buying those mortgages but magically, the “sponsor” company that sells the mortgages to that SPV is deemed not to own or control the SPV. In substance it seems to me that the mortgage company has sold a mortgage to itself and has booked a profit in doing so. It may all be legal but it simply smells.
Canada, Quebec and Globalization
I saw a story recently about an Ontario company that is selling certain products to the giant Indian car company Tata that is attempting to produce a $2500 car for India.
The Ontario company said that it was easy to do business in India. “They use the British legal system and everybody speaks english.”
This is very interesting. In India, everybody speaks English! English it seems is the language of international commerce. No doubt, it has some competition from Cantonese, Mandarin and Spanish but English is definitely one of the main languages of globalization.
Meanwhile, closer to home, I understand Quebec outlaws English-only signs. And Canada requires packaging and labeling of almost everything sold in this country to be printed in French and English. This costs money and helps explain why products often cost more in Canada as compared to the U.S. India meanwhile apparently strongly embraces English. Is Quebec on the right track there? Is Quebec embracing the fact of globalization?
The Return of Price to Book Value as a respectable Ratio
When it comes to judging whether or not a particular stock is a bargain, the Price to Earnings or P/E ratio along with growth rates, grabs most of the glory. The ratio of a stock’s Price to its book value or P/B is at best a poor and neglected cousin.
In reality no single ratio can be relied on.
But Price to Book is going to make a come-back. There are several reasons for this.
Firstly, Price to Book fell out of favor by the early 80’s when years of near-double-digit inflation caused book values to fall well below depreciated replacement costs for almost all assets. Now after a couple of decades of lower inflation book values may be closer to depreciated replacement costs for many (but not all) assets.
Secondly, there has been a major movement towards “mark to market” in accounting. This causes the vast majority of financial assets to now be carried at market value. This is causing book values for many companies to be driven towards market value. At the same time it is causing GAAP earnings to become more volatile and therefore P/E to be less reliable and therefore P/B becomes interesting as s supplement to P/E.
Thirdly as the P/E ratio of the markets has fallen over the past six years, the P/B ratio has fallen as well. Several years ago it was rare to find any profitable company trading below book value. Now it is not so uncommon. Intuitively, if you can find reasonably profitable companies that you can buy for less than book value, that sounds like a good thing.
Price to book value is explained more fully in our Article, Understanding Book Value.
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END
Shawn Allen, President
InvestorsFriend Inc.
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