Newsletter April 5, 2008

InvestorsFriend Inc. Newsletter April 5, 2008

To Get Rich in The Stock Market – You Must Start By Saving Money

You can get very rich (eventually) by making 10% per year in stocks. But you can get a lot richer a lot faster if you can make 15% or 20% or more per year.

But if you don’t first save and invest some money then no reasonable amount of return is going to make you rich. 100% of zero is zero. 100% made on $100 is only $100.

We all know that unless we already have a substantial pile of money in the markets, we have to save and invest more money in order to really grow our portfolios.

It’s easier said then done. Most of us have no problem spending our entire take-home pay. Finding “extra” money to save and invest is difficult in a world filled with unlimited spending opportunities.

Here are some thoughts on how to make sure you are saving some money each month or year. (This, is directed to everyone who is still trying to build a portfolio through savings and investment. If you are already at the stage where you are spending your portfolio rather than adding to it, congratulations you can skip this advice).

Strategy Number 1: Grab any and all Free Government Money!

In Canada the government gives us an income tax deduction when we contribute to a registered retirement savings plan. There are also income tax incentives available to Americans to save for retirement. There is a maximum amount that you are allowed to contribute to these plans based on your income and (in Canada) based on whether or not you already have a pension plan at work. For most working people, the basic rule is, maximize your allowed retirement savings. Grab all the income tax benefit that is available. In many cases it makes sense to borrow money to make this contribution. You may not be able to afford to invest the maximum amount allowable. In that case invest what you reasonably can.

Also in Canada there is a registered Education savings plan. The government will contribute 20% of your contribution to a maximum of $500 (you contribute $2500). The money in this account then compounds tax-free. The gains are taxed in the child’s name when they attend post-secondary education and the principal can be withdraw tax free. There is no tax deduction for the initial contribution. However the government’s 20% gift and the tax-free compounding make this program attractive. Most families should attempt to take advantage of this plan to the extent that they can.

Strategy Number 2: make it Automatic – Pay Yourself First

Pay your self first is just about the oldest and most common bit of advice from every financial planner. Set up an automatic transfer from your chequing account to your investment account each week or month.

If you use online banking you may be able to set up an a recurring “bill payment” that transfers money to an investment account. For example this can be done to transfer money into TD Waterhouse accounts. Otherwise visit your bank branch and set up an automatic transfer to an investment account.

This automatic monthly payment can be set up to invest in registered retirement plans, education plans and unregistered savings plans.


If you don’t know what to invest the money in, don’t let that stop you. A financial planer at your bank can easily help you choose where to put the money. You certainly don’t have to put the money into stocks. It takes a certain amount of knowledge and reading to select individual stocks. There is certainly nothing wrong with just putting the money into mutual funds or something that pays interest. In the first 10 years or more of a savings plan the return does not matter all that much. What is vastly more important in the early years is making contributions. In later years returns are everything. This was explained in our newsletter of  March 8, 2006

If you don’t have a lot to invest, don’t let that stop you. Your Bank will be glad to set up a savings plan of almost any size. You can start with $50 or $100 per month and grow from there.

If you are unable to maximize retirement funding and education funding, don’t feel too bad. It is only a small minority of people that are able to maximize all of these. For example, in Canada, with two children, you can contribute $5000 per year to an education plan and receive $1000 in grant money. Most families will find it difficult to do that and to also contribute something to retirement savings. The automatic payment plan approach may help in this situation.

The Law of Unintended Consequences

The Law is Unintended Consequences is constantly at work and can often do substantial harm.

Some (mostly hypothetical) examples are:

The government subsidizes $5 per day daycare. An unintended result is a severe shortage of daycare spaces and long waiting lists. Some stay-at-home moms may also use the service as a cheap baby sitting service while they run errands. That’s fine except that meanwhile working mom’s find a long waiting list.

Government and courts establish rules that make it hard and very expensive to fire regular employees. The unintended result is that companies become reluctant to hire people. They begin to use more contract and part-time employees. If it’s going to be very difficult to ever fire an employee then logically a company has to think long and hard about whom it hires.

The U.S. government makes mortgage interest deductible in order to help people afford homes. The unintended result is that people borrow more than they should. They get mortgages to buy cars, vacations and all manner of things. House prices increase because with interest deductibility people can afford higher payments. The unintended result is that houses are more expensive and are not more affordable as intended.

Banks make it easier get a mortgage without a down payment. Interest rates are low and long amortization periods are used. The intended result may be more affordable housing. The unintended result is that house prices are immediately driven up. Houses are not more affordable.

Smart banks securitize mortgages (they bundle a group of mortgages together and sell them to investors) to realize the profit on mortgages immediately rather than waiting for the profit to roll in over many years. Eventually an unintended consequence is that the bank gets careless about who it gives mortgages to. After all the mortgage will soon be sold to someone else. It will not be the banks problem if the homeowner does not pay. Eventually all this smart activity creates a sub-prime loan crisis and an awful lot of supposedly smart bankers look very stupid.

Some investors in the early 80’s learned that executive pay packages (which were not fully publicly disclosed at that time) were extremely high and believed that by forcing the companies to disclose the salaries and bonuses, the companies would be embarrassed and these big pay packages would be cut. It came to pass that disclosure was made. The unintended consequence was that whichever company president was paid lower ended up getting a raise to be closer to the top guys. The highest paid did not get pay cuts. Executive salaries ratcheted up for years not in spite of disclosure but directly as a result of the disclosure. Executive pay basically rose to the highest common denominator instead of dropping to the lowest. (Lesson, be careful what you wish for).

Rent controls are introduced. The unintended result is that no new apartments are built. Existing apartments become run down. Existing tenants may be able to secretly sublet at a profit.

There are many other examples all around us all the time. Often unintended consequences occur when governments try to interfere with free markets. Programs that are very well intentioned can cause major damage through unintended consequences.

The Corruption of Initial Public Offerings (IPOs)

An Initial Public Offering occurs when a private corporation for the first time offers shares to the public and the company begins to trade on the stock market.

In some cases these can be wonderful investments. It can allow investors to get in on ground floor of a company that has many years of rapid growth ahead of it.

But the process can certainly be abused. Some people joke that IPO really stands for “Is Probably Over-priced”.

A given company’s IPO might proceed in one of three ways.

Ideally an IPO would be a company that has prospects for profitable growth but needs more investor capital in order to grow. Ideally in this scenario the founders of the company are somewhat reluctantly giving up a share of their company because they need money to grow. Ideally these founders are confident that they will make loads of money in future from the profits of the company. They think of the IPO investors as partners who will share proportionately in the future profit of the company. They price the IPO shares in a fair manner. They don’t give away the IPO shares but they don’t try to gouge investors.

In the next type of IPO perhaps the founders are not quite so sure that the future will be profitable. They hire an investment bank that hypes the IPO shares as much as possible. The future is presented in as glowing a terms as possible. The founders will immediately be rich based on the high share price of the IPO. The founders may be looking to sell some of their shares soon after the IPO. There is little concern about whether the IPO shares are a fair investment. The goal is simply to maximize the IPO price.

In the most dangerous type of IPO, the founders claim to be highly confident of the future. But in reality they are not so confident. They want money now. They do not want tons of shares in the company because they really are not confident that the profits will materialize to make the shares keep going up in price. Rather than the company receiving all the money from the IPO, they arrange to sell some of their own shares to the public. They combine this with hyping the shares to make sure a high IPO price results The result is that the founders walk off with great bags on money at the time of the IPO. The founders are rich no matter what happens to the stock price. I would avoid this type of IPO.

All three of these IPO types might work out okay but I far prefer the first scenario. The third scenario where the founders are getting some of the cash from the IPO (instead of all the cash flowing to the company) is a major red flag. I would not invest in that type of IPO.

Ethical founders and managers attempt to make money for investors. They make money from customers. Unethical founders and managers attempt to make money from investors. If they are not confident that they can make money from customers it may just be easier to make money from investors. It may also be very tempting when certain fee-hungry investment bankers convince them it is the right thing to do.

One way to judge an IPO is by the amount you would pay compared to the book value after the IPO. If you pay $20 and the shares will have a book value of $10 that is 50% diliution. That may be perfectly okay and even 90% dilution may be okay. On its own it does not indicate a bad investment. But it’s a nice number to know. At one time in Canada every IPO clearly stated the dilution that the investor would suffer. This information is still required in the U.S. Amazingly at some point in Canada the law was changed and IPOs no longer have to indicate the amount of book value dilution the investor will suffer. Presumably some greedy investment bankers convinced the regulators that this dilution figure was meaningless.


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Shawn Allen, President
InvestorsFriend Inc.

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