Newsletter November 2, 2003
InvestorsFriend Inc. Newsletter – November 2, 2003
Performance of InvestorsFriend Inc. Stock Picks
Performance of the stock picks has just been updated. 2003 has been a very good year for my stock picks with fairly steady gains all year. Down-side volatility has been quite limited.
The 7 Strong Buys picked for January 1, 2003 are up an average of 44% with only 1 stock being down. I also created and tracked a model portfolio which started out with 5 of the Strong Buys and added in 2 high dividend stocks for stability. The model portfolio included trades during the year. As a result of profit taking, the model portfolio did not do as well as the Strong Buys but is up 28.6% on the year. My own personal portfolio is up 27.8% in 2003.
Over the past few years, I have moved away from more speculative stocks and have tended to concentrate on higher quality stocks with reasonable P/E ratios and which often pay a dividend. If I can find high-quality companies that I think can return about 15% or possibly even 40% in a year then I have increasingly decided that that is a better bet than buying a company that is unproven but which might possibly return 1000% if I am very lucky. I don’t buy lottery tickets and I don’t treat my stock picks as lottery tickets. I try to buy stocks only when a rational analysis suggests that there is relatively little chance of loss in the long-term and a relatively high chance of an above average return such as 15% annually. The possibility of a decline in the share price does not bother me much as long as I am confident that the company is strong in the long run.
In summary, I am quite happy with the performance this year and so are our subscribers.
I’m hopeful that the next 12 months will also be strong due to the rebound in corporate earnings and the strong growth in the U.S. economy.
Readers of this free newsletter, who have not already done so, can subscribe to the stock picks by following this link. The cost is CAN $10 per month payable by credit card with no minimum contract period. You can also arrange to pay by check.
If you are looking for miracle promises like high returns every year or promises that none of our stock picks will fall in price, then I can’t help you. But if you are looking for independent, high-quality, concise, plain-language research with clear buy/sell ratings then I think that this product is well worth considering.
Currently InvestorsFriend Inc. has 3 Strong Buy picks available to subscribers. First, an under-followed Western Canada residential property developer with a long history of profitability that is trading at about book value and at about 7 times earnings. Second, one of Canada’s leading paint manufacturers and retailers which has strong profitability and is attractively priced, Third, an auto and commercial vehicle insurer that trades at about book value. This one is more speculative but could have a big up-side.
The general expectation right now is that interest rates are at the bottom of the cycle and the next move is up. As the U.S. economy improves, the Federal Reserve Board will likely raise short-term interest rates. Canadian short-term interest rates will likely rise in response or may rise independently of the U.S. to try to stop the rise in the Canadian dollar. Longer-term interest rates will not likely increase by much but will almost certainly stop declining.
Long-term bond investors have been making abnormally high returns almost every year since about 1982 as long-term interest rates have been in decline. That party is OVER. Money in bonds is likely to return the coupon interest rate at most and is also at risk of capital losses. For bond investors, it might be a good time to look into a real return bond, in order to avoid much of the interest rate risk.
I really like investing in financial service companies. I have heard financial services described as being the biggest and best industry in the world. Financial services are truly the grease of the world economy. Borrowing money has made it possible for people to acquire houses , cars and many other items long before they could otherwise afford them. This drives up the demand for all of those goods and creates employment. Can you imagine how much less business would be conducted if credit cards did not exist?
Financial service companies include all types of banks, insurance companies, and investment managers.
Financial Service companies are almost “virtual companies” in that they don’t create a tangible product. They don’t have to invest in factories or in inventory. This creates an opportunity for high returns. The ideal Financial Service is one that occurs electronically with no human intervention. For example, many millions in profit are made by skimming a small amount off of billions in credit card transactions. Other financial services like loans and insurance contracts are increasingly being automated to remove human intervention and reduce costs. This will likely lead to increased profits in these industries, although competition will insure that some of the benefits go to consumers.
Financial Services are also often considered risky because they operate with a high degree of leverage. For example, banks lend depositor’s money, not shareholder’s money. Typically, there is less than $10.00 in shareholder money for every $100.00 loaned out. This high leverage creates risk because if loan losses mount all the losses come out of shareholder and not the depositor’s pockets. But banks are pretty smart about who they lend to most of the time and traditionally banks have earned strong returns for shareholders.
The perceived risks of Financial Service companies often keeps their P/E multiples and price/book multiples in an attractive range, but this varies by company.
Stock Trading Strategies
I have based my investment strategy on intelligent stock picking, rather than on astute trading and timing strategies. However, even a buy-and-hold type investor needs to think about some basic trading strategies.
Here are my thoughts on trading strategies (this has also been added to the Articles section of this Site):
Trading Strategies For Longer Term Investors
This article explores trading strategies for use by longer-term value-oriented investors. This article does not address day trading or momentum type trading strategies.
Trading issues faced by long-term investors include:
– minimum size of trades to efficiently spread out trading costs
– impact of buy/sell or bid/ask spreads
– use of market orders versus limit orders
– use of stop loss orders
– using share price volatility to advantage
– taking profits
– income tax considerations
Trading strategies involve choices and risks which may or may not pay-off.
Trading strategies in several common situations are discussed below.
Minimum size of trades:
Trading charges for self-directed accounts at the major Canadian bank-owned brokerages are in the area of $30 per trade for up to 1000 shares. I consider $3000 to be the normal minimum size for an efficient trade. On a $3000 round-trip trade, (bought and then sold) about 2% is lost to trading fees. I consider this to be high. Even if you buy and hold, 1% is immediately lost to the trading fee. For stocks priced above $3.00, I would prefer to trade a minimum 1000 shares in order to spread out the trading charge as efficiently as possible. However, for most of us that would be unrealistic.
On more predictable dividend-paying stocks, you are more likely to be hoping for a 15% return in a year as opposed to a 100% gain. In these cases the trading cost is important because a 2% round-trip trading charge can eat up a large portion of your expected gain.
For highly volatile stocks, the trading charge may be the least of your worries. In this case you may be hoping for a 200% gain but also risking a 100% loss. In this case even a 5% round-trip trading charge may not be your biggest concern. In this case the minimum trade size is more likely to be set by the maximum amount that you are willing to risk, although you would not want to go so low as to incur a ridiculous percentage round-trip trading charge.
On “penny” shares (below $2.00), the bank-owned brokerages are charging about 1.5% of the trade value, with a $30.00 minimum. In this case as long as your trade is above about $2000 (i.e. $30/0.015) then you are paying 1.5% each way or 3% for a round-trip trade. Therefore, we should try to use $2000 as the minimum trade size, with about $1000 as a lower limit.
Investors should be aware of the trading charges of their particular broker and set minimum trade sizes accordingly.
Impact of Bid/Ask Spreads:
While broker trading commissions are a concern, they are at least highly visible. Buy/Sell spreads in contrast are rather nefarious in that they are a hidden cost of trading. For more detail see our article on understanding Bid/Ask spreads.
The difference between the bid price and the ask price is the bid/ask spread and should generally be considered to be an added cost of a round-trip trade. Sometimes this cost can be avoided when you are in a position to be patient, but the risk then is that the market will move against you while you are waiting for a favorable price.
Market Orders Versus Limit Orders:
A market order means that you will buy immediately at the best available asking price or sell immediately at the best available bid price. A limit orders means you will buy at or below your limit (bid) price or sell at or above your limit (ask) price.
A market order should generally be used when you are very motivated buy or sell and the stock is very liquid (high volumes traded and small bid/ask spread) and you entering the trade during the trading day. Since you are very motivated to buy or sell it is probably not worth the risk to try and enter a limit price to try to get a better price because the market could move against you and you could fail to make a trade that you were very motivated to make.
Limit orders should always be used for stocks with very high bid/ask spreads. Even if you are happy to take the current bid or current ask, it would not be safe to enter a market order on an illiquid stock since that bid or ask might suddenly change by a material amount just as you attempt to trade.
Limit orders should also generally be used when you are more ambivalent about making the trade. For example you think that XYZ is a probably a reasonable buy at $28 but you are a bit uncertain. In this case you might want to place a limit buy order at say $27. In this case you can take advantage of normal volatility and can often buy at the more attractive price by being patient. Sometimes though the price will rise away from you and you will miss an opportunity.
Orders placed when the market is closed are a special situation. When the market is closed, a situation often arises where there a a number of bid prices that are above the lowest ask price. This can’t happen when the markets are open, because the trades would have executed. When the market opens the orders where the bids and offers have “overlapped” will set the opening price. The stock market will determine a fair price at which all the overlapped orders will trade and this becomes the opening price. For example assume the closing price on a stock was $100, and assume that by the time the market is set to open there is an order to sell 1000 at $98 and another order to sell 1000 at $96, and assume there is an order to buy 2000 at $99. In this case while the market was closed these orders became overlapped. The average sell price is $97 and the buy price is $99. In this case, a fair opening price for these trades is $98. Traders may wish to avoid placing market orders when the market is closed because based on over-night news the opening price can be unpredictable. In this case it is logical to enter a Limit price. In this example if you suddenly became motivated to sell you could enter a limit sell at say $95, but you will receive the opening price if it is higher than your limit sell price.
Use of Stop Loss Orders
A Stop Loss order becomes an order to sell at the market as soon as any trade occurs at the specified Stop Loss price, which is set below the current market. If the market id declining sharply, the Stop Loss order could be filled at a price below the Stop Loss amount.
Long-term value-oriented investors do not tend to make heavy use of stop loss orders. The reason is that these investors tend to invest based on the underlying value of the company. For these investors a price decline may signal a buying opportunity rather than a time to sell. However, there may still be merit for using stop-loss orders in some cases.
The stop-loss order should be set lower than the stock would be expected to move on normal trading volatility. On a $22 stock you don’t want to be sold out at $20 on normal volatility only to se the stock bounce back to $22. However, perhaps a price of $18 is outside the normal range and might be more indicative of bad news that is more permanent.
Stop Loss orders could be used to protect against a large decline when news comes out, such as a disappointing earnings release. Stop Loss orders are much more applicable to very liquid stocks. On thinly traded stocks a stop loss order could see you filled well below the Stop Loss amount.
Stop Loss order are more applicable to riskier stocks where you are not as sure about the underlying value. If you are very sure that the stock is already under-valued, then you would not want to be sold out on a Stop Loss.
Using Share Price Volatility to Advantage
Thinly traded shares often exhibit huge volatility. For example, for shares trading around 20 cents, you may see occasional trades at 30 cents or more and at 10 cents or less and then see the price return to 20 cents.
When holding shares like this it may be advantageous to place a sell order at 50 to 100% above the current price. That way, if a some shares go out at a high rice spike, you can take advantage of it. The danger is that if there was good reason for the price increase, like a take-over offer or major good news, then you might have sold at too low a price. But as long as your sell price was well above the current market this strategy may often be advantageous.
I believe that it usually makes sense to take some profits if and when gains reach 30% to 100% in a short period of time. Generally in these cases the share price has moved faster than the earnings and the stock is at least less of a bargain. A strategy of selling half the position by the time the gain has reached 100% in a short period of time, is probably sensible. However, if the company fundamentals and earnings are growing as fast as the stock price then it may not make sense to sell.
Income Tax Considerations
Investors in taxable accounts should be much more hesitant to take profits. In this case it may be better to risk a price decline than to accept the certain loss associated with paying income taxes. However, if the shares are clearly over-valued then it probably makes sense to take the profit and run.
President, InvestorsFriend Inc.