Newsletter May 30, 2005

Investorsfriend Inc. Newsletter May 30, 2005

Purpose of this Newsletter

In this free newsletter, I share educational articles and thoughts on the market with anyone interested in investing.

Many readers of this free newsletter also become subscribers to InvestorsFriend Inc.’s stock rating service. Performance of the stock rating service continues to be excellent. As of this week, the return on the model portfolio and on the Editor’s actual personal portfolio surpassed 10% for the year to date. This is an excellent return, particularly considering that the the overall TSX is only up 4.0%. And note that the Strong Buy picks were up 79% in 2003 and 25% in 2004.

If you have money to invest in stocks, then you may wish to consider subscribing. You can subscribe for as little as just 1 month, at a cost of $10. Now is a good time to subscribe as most of the picks were updated recently for the Q1 earnings reports.

Direction of the Stock Market

The overall direction of the the stock market is notoriously hard to predict, particularly in the short term.

However, I am optimistic that the Canadian stock market will continue to rise for several reasons.

  1. Corporate profits have continued to rise at attractive rates.
  2. Long-term interest rates are setting record lows. The 10-year government of Canada bond yield slipped under 4.0% last week setting a new multi-decade low. That’s a price to earnings ratio of 25, with no possibility of any growth, if held to maturity. Meanwhile the average Price / Earnings ratio of the TSX composite index is 17.7, which results in an earnings yield of 5.65%. To my mind, an earnings yield of 5.65% and which earnings can be expected to grow over the long term, is easily more attractive than a bond yield of 4.0%. (Not only that, but many individual stocks yield 3% or more in dividends). Recently, there were fears that the stock market would be hurt by higher long-term interest rates. But the fact is that despite the sharp rise in short-term interest rates in the U.S., long-term interest rates have continued to fall and this is good for the stock market.
  3. Other positives include the continuing conversion of corporations to income trusts. This tends to provide at least a one-time boost on the conversion.

Which Stocks to Invest In?

There are many theories on how to pick stocks. I favor an approach which has been used by many of the world’s richest investors. In simple terms it consists of buying mostly or exclusively stocks in companies that are proven profit-making winners and that are available at reasonable prices. I have laid out the details of this approach in the articles section of this Site, in series of articles on how to pick individual stocks.

Picking your own stocks can be a fascinating and rewarding endeavour. But it does take a lot of time and analysis and requires a certain amount of knowledge and business sense.

Another approach is to use the services of a stock rating service or newsletter or a the services of an advisor. Many people use a combination of approaches.

InvestorsFriend Inc.’s stock rating service has an excellent track record…

Exchange Traded Funds

For broad exposure to the stock market or to certain sectors, one alternative to consider is Exchange Traded Funds (ETFs). I have updated my article on ETFs which gives you the price earnings ratio of these funds and gives you the trading symbols you need to buy these. You can buy and sell ETFs just as you would a stock.

Not All Commodity Businesses are Bad Businesses

It has often been said that commodity businesses tend to be bad businesses with low profits since there is no way to differentiate the product and therefore no way to charge more than the competitors.

According to this wisdom, these commodity businesses tend to compete ruinously on price. Most players in these industries lose money or make inadequate profits. The only exception is that if a shortage of the commodity develops, then all players can make money. In this theory the only way to insure a reasonable profit is to be the low cost producer. With a substantial cost advantage a commodity provider can make good profits.

One of the problems with this theory is that there are some commodity businesses where all or most of the players seem to make money almost all the time. Consider banking, what can be more of a commodity than a mortgage or a bank loan? And yet banks are notorious for their profits. How do banks make high returns on equity in a commodity business?

The answer lies in the fact that not all commodity businesses have the same characteristics.

I divide commodity businesses into the following three types.

1. High fixed cost commodity business with high customer switch rates.

This is the classic commodity business where all but the low cost producers often lose money. With high fixed costs and low variable costs, some desperate players will sell at prices that cover their variable costs but which do not cover the fixed costs. This brings in cash to pay the variable costs but lowers prices for everyone in the industry. In this category customers also show no loyalty, they shop around with each purchase decision and take the lowest bid.

Businesses that fall into this category include all basic commodity businesses such as mines, steel producers, commodity chemical producers, and also Airlines.

At most times the lower cost producers may be quite profitable. But in times of great surplus it is likely that all players lose money. In times of shortage all players can make money.

In many ways Airlines should not fit into this category. Surely people will pay more to fly with a company with better service or a better safety record? – sadly, no, it appears that most of us buy Airline tickets strictly on price. Frequent flyer programs help to keep customers a bit more loyal, but when it comes down to saving $100, most people forget the points and go with the lowest fare.

2. Low fixed cost, high variable cost commodity business, with high customer switch rates

This is a much better situation, since no rationale competitor will price below its variable costs. Therefore the price competition tends to be less severe. I believe mortgage lending is an example. Banks will not lend money at less than the cost that they have to pay to get the money that they are lending out. This partly explains why Banks do not typically suffer periods of pricing at a loss, while steel companies and other basic commodity business with high fixed costs often do. The same would apply to gasoline retailing, there is never any incentive to price below the variable cost of obtaining wholesale gasoline. (Of course occasionally a completely irrational competitor will price below its variable costs in an insane attempt to build volume).

3. Commodity business with low customer switch rates.

This is the best type of commodity business. Consider your chequing account. It’s a commodity product, any of the big five banks in Canada can give you about the same service. However, it has become a huge ordeal to switch your chequing account to another bank. Many of us have numerous automated payments coming out of our chequing accounts . And our pay cheques are usually electronically deposited. The average working adult might need to contact at least 10 or 15 businesses if they were going to change banks. The result? Twenty years ago, when we manually did deposits and payments it was no problem to switch banks. At that time fees for chequing accounts were non-existent or very low (any we got our cashed cheques back in the mail for our records) Today, most deposits and payments are electronic and we no longer get the cashed checks back in the mail, all of which should have driven costs way down, but fees are instead way up (as are bank profits). The explanation is that with high switching costs, the banks can charge these fees and we sigh and bear it. These days the banks may compete vigorously to get a new chequing account customer, but once in they are not shy about charging us.

Another example of this is how banks price credit cards. Once customers start to actively use a particular credit card, they may be reluctant to switch. For example, certain monthly charges may be automatically going on their credit cards and it would be a hassle to switch. Banks tend to compete extremely vigorously to get credit card customers. But they don’t seem to compete too heavily on interest rates or on the fees charged to merchants. Credit cards are known as a high profit business, despite being a commodity business


Just because a business is dealing in a commodity product or service do not assume that it can only make high profits in times of a shortage. If the industry has low fixed costs, that is a plus. And if customers find it very inconvenient to switch suppliers than that can be a huge plus. Cell phone service probably fits into this category.


Shawn Allen
InvestorsFriend Inc.