InvestorsFriend Inc. Newsletter July 28, 2013
To understand stocks, you should first understand business.
I think it is safe to say that most investors struggle to figure out which stocks might be a good investment.
There are basically two broad ways to analyze stocks. The first way is by fundamentals (such things as earnings per share, book value per share, growth outlook, competitive advantage, and quality of management). The second way is by analysis of the price chart looking for trends or patterns.
My view is that attempting to analyze stocks based on price trends and patterns and charts is usually sheer folly. This method attempts to figure what “the market” thinks of the price and where the price is headed. A fundamental flaw in this approach is that if the market really thought that a $20 stock should be $10, it would already be at $10. Price or chart analysis may work for some people but I have no interest in it at all.
In order to make any sense of a stock’s value based on fundamental analysis we have to look not at the stock but at the underlying business.
In order to understand stock valuations we must first understand the basics of business.
Every investor who is selecting their own stocks should learn the basics of accounting, finance and competition.
It’s not possible to understand the profitability of any company without knowing something about accounting. You can’t determine which companies might be at risk for financial difficulty without knowing a little bit about how to read a balance sheet and understand debt levels in relation to assets and in relation to profits and cash flows. You can’t judge whether a company is vulnerable to price competition without knowing a little bit about competitive advantages.
Think about the businesses in your City that are busy and that appear to be profitable. How many of them are national brand name businesses as opposed to one-off privately ran firms. How important is brand recognition and advertising to their business? How important is their location. Do they have high fixed costs? Are they forced to offer the lowest price to compete for business or they the only game in town for a particular product or service? How price conscious are their customers, do the customers shop around for this product or service based on price? Do they sell a product or service that people need to buy regularly or is their product more of a one-time sale? Can customers easily switch suppliers with each purchase or are there things that keep them tied to a particular business?
And think about the businesses that have fewer customers or that otherwise appear to be making limited or no profits. What is the problem? Too much competition, bad location, poor service, high costs, too few customers to cover the fixed costs, lack of repeat business, lack of buying power?
The more you think about businesses and which ones appear to be profitable, the more you will understand which type of companies on the stock exchange make the best profits and the better able you will be to select good investments.
The Basis for an Investment Recommendation
The Chartered Financial Analysts code of ethics (part V A 2) requires that CFA members must Have a reasonable and adequate basis, supported by appropriate research and investigation, for any investment analysis, recommendation, or action.”
In my experience this rule is violated routinely by investment analysts appearing on television. In the investment world the amount of diligence and analysis that goes into recommending something as an investment ranges from reports of 50 pages or more prepared by an analyst (or team of analysts) that is familiar with an industry and who has become familiar with a particular company over a period of years to recommendations that are seemingly based on nothing more than a feeling that a stock still has “room to rise”.
At InvestorsFriend our recommendations cannot and do not always turn out to be correct. But we never make recommendations without some basis and analysis behind the recommendation.
Before we rate any stock we first fill out a fairly lengthy standard template that crunches the numbers and summarizes many non-numerical aspects of the company. To add a new company to our list would typically take at least 10 hours of effort and often more. Companies that have been on our list for years often have hundreds of hours of work invested in creating and updating the report and attempting to understand the business over the years. The current recommendation is informed by all of that work. Again, our rating may turn out to be wrong, especially in the short term. But we always have a detailed and fully documented basis for the recommendation. Our stock ratings or recommendations however are always generic in that they cannot and do not take into account the circumstances of any individual investor.
When asked for “our take” on any company not on our list, we will not provide it. In fact we typically have no such “take”. We try hard not to arrive at opinions in advance of analysis. Therefore we have ratings and opinions on a only small group of companies, but backed up by considerable (although not exhaustive) analysis. Many analysts do not appear to follow such a rule.
On television, we see many analysts who are willing to give a buy or sell rating on a stock with what appears to be almost no thought at all. Television loves 10 second sound bites. We don’t think that is a proper basis for investment.
We don’t think the so-called technical analysis of price charts provides much value. And we don’t think it should ever be relied on in the absence of also looking at the fundamentals of the company including the price in relation to those fundamentals.
The next time you hear a stock recommended on television, think about how much of a basis the analyst appears to have for that recommendation.
I suspect that watching investment analysts on television is usually counter-productive because it usually promotes a day-trading mentality and an approach often devoid of any real basis.
InvestorsFriend’s 2013 Stock Picks
In 2013, to date. our Stock Picks are once again performing very well.
The Dow Jones Industrial Average and the S&P 500 are each up 18.7% this year to date. Toronto has lagged significantly and is up only 1.7%.
Our stocks picks include both U.S. and Canadian stocks.
Our three Strong Buys from January 1 are up 21%, 27% and 23% for an average of 24%. None of these were tiny companies or penny stocks by any means. One of these is a very large U.S. Bank, one is a large Canadian retailer and one is small (but not tiny) Canadian property development company. All pay dividends.
Our 19 companies that were rated in the Buy range as of January 1 are up an average of 14.2%. The individual price changes range from minus 11% (a large Canadian REIT) to a gain of 31% (a very famous U.S. conglomerate). Most of these 19 companies pay a regular dividend and they range in size from small to extremely large. None are remotely close to being penny stocks and none are micro cap companies. (Tiny companies are considered much riskier). In other words our strong returns came from some pretty normal sort of boring companies.
None of our 22 stock picks from January 1 were energy stocks or resource stocks or commodity stocks of any kind.
Since January 1 our ratings have changed somewhat. We currently have just one company that we consider to be in the Strong Buy range. In general our ratings have declined somewhat due to the price rises in our stocks.
To learn more about how to subscribe to our Stock Picks, click this link.
Can Stocks Provide A Decent Return when GDP is growing at 2%?
Some of those who believe that stocks are no place to make money like to question how investors in stocks can even possibly expect the make money if GDP is growing at only about 2%.
It is true that stocks will tend to make higher returns, in the long run, when the economy is growing faster. (Although some of that higher return can be negated by the higher inflation which is usually associated with higher economic growth.)
However, it would be wrong to conclude that you can’t make decent returns in stocks if GDP grows at only 2%.
Firstly, we should remember that GDP growth is almost always stated in “real dollars”, before inflation. GDP in actual dollars is higher because it includes inflation. So if we have 1 to 2% inflation then GDP growth of 2% really means 3% to 4% in actual dollar terms.
Second, we should remember that dividends add to stock returns. A company that grows earnings per share at 4% per year and pays a dividend of 3% can be expected to provide a long term return of 7%, assuming that the P/E (price to earnings) ratio is relatively unchanged in the long term.
So, if GPD growth is 2% in real (inflation adjusted) dollars and 3% to 4% in actual dollars and if the dividend yield is 2% to 3%, then we can easily forecast stock returns of 5% to 7% assuming no change in the P/E ratio.
In the shorter term, P/E ratios change all the time. In the longer term they tend to be relatively stable for the market as a whole.
We should also remember that individual companies grow at vastly different rates. No matter how fast or slow the economy is growing there are always some companies that are growing very rapidly and others that are shrinking. In the case of individual companies however the P/E ratios can be very volatile and one has to be cautious about paying too high of a P/E ratio.
There can also be a significant trade-off between growth and dividends. Growth usually requires that a large portion of current earnings be retained by the company and invested in expanding the business. That leaves less or no money available for dividends. On average, if the GDP rate for the country is going to be lower then companies will be investing less for growth and on average the dividend payouts and yields should rise.
If you think about the businesses where you live, many of them don’t require growth to provide excellent returns to their owners. If a 200 seat restaurant is sufficiently busy and is making a good profit, that situation could go on indefinitely without any growth in the number of customers served. The owner of a single Tim Hortons location may make an excellent living for may years without ever expanding the location and with a constant level of traffic.
The fact is that growth is neither a necessary nor a sufficient condition for a company to be a good investment.
A proposal to facilitate investment portability – To cut the chains that bind investors to a single advisor or broker
Most investors today are effectively chained to a single broker or advisor. It’s inconvenient to switch advisors and it is somewhat inconvenient to deal with more than one broker or advisor. I don’t know the exact history of how this evolved but I believe the following is basically how it happened.
Some decades ago, when you bought bonds or shares through a broker you paid a one-time commission and you soon received the bonds or share certificates in the mail. You kept these in a safe place such as a bank safe deposit box. When you wanted to sell you brought the share certificates to any broker of your choice. You were not tied to any particular broker. You could buy from several brokers and sell through several if you wished.
There are advantages and disadvantages to such a system. In this system your broker did not hold your assets and so you did not receive consolidated statements. Dividend cheques were mailed directly to you. Your broker(s) did not send you summaries at year end for income tax preparation.
With this system brokers could work to sell shares to anyone. They could do a one-time sale to a new customer. In contrast, today a broker tends to get all of your business or none of it. This older system was open to some abuse because it was possible to market shares door-to-door or by telephone and no-doubt some of these turned out to very dubious or outright frauds.
Some people found it convenient to have their broker look after their share certificates for safe-keeping and faster access for trading. Some of these had the shares held in the name of the broker in-trust for the client. In this case the customer was to some degree tied to his or her broker.
Eventually it became normal to leave shares in the name of the broker. Customers became tied to their (usually) single broker. The advent of registered tax advantaged retirement accounts also tended to tie customers to a single broker since the account had to be registered through a broker.
With this new model, brokerages began to think of themselves as in some way “owning” their customers. They began to count their customer’s investments certificates, which they held in trust as brokerage assets under management. This model eventually allowed a move away from paying brokers and advisors only for buy / sell transactions to paying an on-going annual fee for assets under management.
In more recent years, paper stock and bond certificates have become virtually obsolete. Brokers no longer hold your shares as paper certificates. There is a central stock transfer agency that holds the name of who owns each stock and bond. Usually the shares are held in the name of the broker but it is possible to register shares in your own name. Shares held in tax advantaged registered plan may have to be held in the brokers name.
With the demise of paper ownership certificates and the advent of all electronic ownership lists it may be time to rethink some things.
If I own 200 shares of Bank of America, in what sense does my (discount) broker (TD Waterhouse) have those shares as assets under management?
When I bought the shares my broker arranged the sale trough the stock exchange. My broker arranged for the money to flow from my account to the account of the seller at the seller’s brokerage. The share transfer agency recorded that my broker now held those 200 shares. But they are held in trust for me. They are not assets of my broker. My broker retains certain responsibilities for those shares including receiving dividends and crediting those to my account. My broker must also, in the case of U.S. shares not held in an RRSP account, withhold a portion of the dividends as taxes and submit those to the U.S. taxation authorities. My broker must pass along and mail out to me (unless I opt for electronic delivery) certain materials from Bank of America including the annual report and voting instructions. My broker must include the 200 shares of Bank of America on my monthly investment statement. And they provide an online account summary as well. They facilitate my ability to sell those shares online in seconds.
When it comes to something like shares of Bank of America my online broker must do a large amount of administrative work. The only payment they receive from me for that is a one-time payment of $9.99 when I buy or sell shares. This is actually very small compensation especially if I end up keeping those shares for years. They also get the use of any cash in my account which is effectively a short-term deposit that they can use to fund loans since not all their clients will withdraw or spend the cash in the investment account on short notice.
While this model of my discount broker “holding” or administering all of my investments in one account is cost-effective and works well, it does have its disadvantages. It definitely ties me to my broker. If my broker is not participating in a certain initial public offering then I simply cannot buy those shares via the initial public offering. (I could buy at the IPO if I opened an account with the second broker and I can buy when they start trading.) If my discount broker does not deal in certain bonds then I simply can’t buy them in that account. If another broker was recommending a certain stock I could not simply buy the stock through him and have it go into my TD Waterhouse account. I would have to open an account with that other broker, which is inconvenient.
Given that the ownership of all bonds and stocks is tracked centrally through the stock transfer agent, I believe a new or alternative model is possible.
I propose that the stock transfer agent allow retail investors to deal with it directly. In the model I propose, the stock transfer agent would not offer cash accounts to customers. It would continue to simply keep track of who owned what. A retail investor would open a money market or a bank deposit account that trades like a mutual fund. (Banks already offer deposit accounts that can be purchased inside of any investment account, these can be bought and sold like mutual funds).
The retail investor would then open an on-line account with the stock transfer agent. This account would look like existing discount broker accounts. Cash would flow from and to the investor’s designated cash account (typically a cash mutual fund account). Stocks, bonds and mutual funds could be bought and sold on-line just like in existing discount broker accounts. A key difference would be that these accounts would be open access. Investors would be able to buy shares through various third parties like any broker or advisor or mutual fund company or perhaps directly from a corporation. That seller would receive the money and would direct that whatever was purchased would go into your account at the stock transfer agent. Brokers and advisors would charge a one-time fee for the trade. Investors would be tied to the stock transfer agent but not to any broker or advisor. The stock transfer agent would have to take on the administrative duties currently carried out by brokers. The existing system of having your account tied to a particular broker or advisor could also continue in parallel with this new system.
If the above cannot be done then, at the very least I propose that the stock transfer agent record the name of the ultimate owner of each share. That is, all shares and investment would be automatically “registered” in a manner that includes the investors name by default. (Probably with an ability to opt out for privacy.) The issuing companies would be allowed to access the list of their owners and communicate directly with them.
Possibly my proposal solves a problem that does not exist. I’d be interested in your thoughts. Click to email shawn@investorsfriend.com
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Shawn Allen, President
InvestorsFriend Inc.
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