Newsletter August 12, 2007

InvestorsFriend Inc. Newsletter August 12, 2007

Market Direction?

Will the market continue to go down? Should investors pull their money out of the market now?

Its impossible to know if the markets will continue to go down. Some experts say yes, others say that the economy and profits are strong and the market will recover.

I think there is certainly a good possibility perhaps even probability that the broader stock market will go down another 5 or 10%. And there is a smaller chance it could go down more than that.

But profits are good, economies are strong and the market valuation in terms of the price to earnings ratio is not very high (The P/E is higher than historic averages but is no where close to the bubble levels of 2000). This should protect against any very large market plunge.

But the sub-prime mortgage situation and the drying up of certain credit sources is very serious and the problem could spread. Credit has truly been the wonderful lubricant of the world economy. Over the past 60 years or more it has become ever easier for consumers and businesses to borrow. Can you imagine how much smaller the economy would be if all consumer purchasing was done in cash? (Even for cars and homes).

Some people get into great trouble through excessive borrowing. But overall, credit has been a huge driver in growing economies and creating much higher standards of living.

If credit sources dry up in a widespread fashion, that would be a huge problem. Interest rates would soar. House and stock prices would plummet. Central banks will do everything they can to limit the spread of the sub-prime situation and insure that credit markets do not fry up. But so far, I think the ripples are still spreading. Things could easily get worse before they get better.

But no matter what happens, economies tend to grow in the long-run. Stock markets are almost certain to be higher in five years and ten years from where they are now.

Any decision to pull money of of the market is a very individual decision.

If we knew with certainty that the markets will decline and we knew where the bottom was, then almost everyone might want to get out now and get back in at the bottom (The exception might be cases where getting out would trigger big taxable gains). But we don’t know these things. Investors who get out may avoid a dip but then when the market turns back up they may miss the bottom and then feel paralyzed and never get back in. In the long run that would be a mistake.

Younger investors with years of savings ahead of them will benefit from any market decline and in most cases should simply stay the course. Investors with short time horizons and a need for the funds should probably consider reducing their equity exposure, if it is too high now.

In part the decision to pull money out of the market depends on the consequences of a major market decline. For some the consequences are merely regret at lost opportunity. For others the consequences would be a reduced life-style in the short term. The decision is very much dependent on each persons circumstances.

As we think about the risk of a market decline we should put it in context. We have had almost five years of strong market increases. No one is suggesting we are going to be giving up all those gains. The risk is probably that we retrace several more months to perhaps at most a couple of years of gains. In the long run those in the market will come out far ahead of those who remain always afraid to be in the stock market.

lulu (ludicrous) Lemon?

In our previous newsletter, I argued that lululemon was extremely over-valued at  $29.72 Canadian or about U.S. $28. I’ll use U.S. dollars to discuss this stock since it trades mostly on NASDAQ and reports in U.S. dollars.

I also thought that the IPO price of $18 was far too high. The stock opened for trading just a couple weeks ago at $28. It then soared as high as $38 and closed Friday at $36.

So, was I wrong? or is the market simply having a continuing fit of insanity here? Let’s look at the numbers again.

The whole company has a market value of $2.44 billion. It’s hard to have a feel for numbers in the billions, so lets look at things on a per store basis. (But you might get some feel for the numbers by considering that highly profitable Tim Hortons with about 3000 franchised stores and a cult-like following is worth $6.3  billion.)

Lululemon has 59 stores so that is a market value of $41 million per store. But in fairness much of the value represents future stores. The prospectus (at page 84) indicates that they plan to have 50 to 60 additional stores by the end of 2008. So that is a maximum of 119 stores by the end of 2008. So the market value is $20.5 million per end-of-2008 store (and half those stores do not exist yet).

But what should one store be worth? They report that a typical store is 2900 square feet and sells $1400 per square foot per year (see prospectus, page 86). So that’s sales of $4.06 million annually per store. In the most recent quarter the net profit margin was 8%. But as they gain scale they could perhaps optimistically get to say 15% net profit. At 15% that would be $610,000 profit per store. Even with a high P/E ratio like 25, that would be worth $15 million per store. But getting to my value of $15 million per store is really a case of torturing the numbers until they confess that the stores are worth millions. It only happens by assuming a big increase in the net profit ratio and by assuming a high P/E ratio should apply.

Mathematically, investors in lululemon are paying up in advance for a big increase in profitability to maybe 15% which I think is almost unheard of for a clothing retailer. (100% mark-ups lead to 50% gross margins and it’s difficult to have even 10% left for net profit after paying all expenses and taxes). Investors are also paying up also in advance for a large increase in the store count.

When you buy a stock you typically hope that the stock price go up as the company grows and becomes more profitable. But here, investors seem to be paying in advance for the continuation of very brisk sales at each store, for a huge increase in the store count, and for perhaps a doubling in the profit ratio. Having paid for a huge amount of growth and success in advance, it’s hard to imagine that there would be much further growth to cause the share price to rise.

It seems clear, lululemon is trading purely on hype, speculation and momentum. Yahoo is not showing any analyst recommendations for this stock. Reasonable forecasts of growth and profitability cannot support this stock price. I predict it will fall. But I do not recommend shorting the stock. Shorting is exceedingly risky and also the market may continue to price this stock in an irrational manner for months or even years to come.

The point is, sometimes the market does insane things. It might be tempting to jump into a momentum stock. But stocks that are not supported by fundamentals can fall hard and fast. Most investors will be better served by investing in stocks with much more reasonable valuations. Why pay up in full today for growth that may not fully materialize?

The Ultimate long-term arbitrage

One way to think about the reasonableness of a stock price is to think about what it would be worth in cash flows if you “simply” held it “forever”.

For example, imagine you hold a stock that pays a $1.00 dividend that is expected to grow at 5% per year. Discounted at a required return of 10% per year, this stock is worth $20 ($1/(.10-.05)). By holding it “forever” you can expect to collect future dividends with a present value of $20. If the stock trades in the market at $12, investors can buy it and even if the stock stays under valued they can “simply” keep it forever and expect to realize the full $20 in value.

This is the concept that Warren Buffett talks about when he says he wants to hold stocks where it would not bother him if the stock market closed for ten years. By buying a stock at or below its long-term intrinsic value, Buffett then does not have to rely on selling the stock to realize value. He simply keeps it forever and collects the dividend.

This works much better for Buffett when he buys the whole company. In that case he controls the dividend and can make sure the company flows all excess cash to him.

In Canada, Income Trusts were a sort of substitute for buying the whole company. (In a way they let little investors do what Buffett did in buying the whole company.) Income Trusts pay out as much cash as possible and therefore it was easier to adopt the long-term hedge strategies. Investors in Income Trusts would not let the Trust prices fall too far since they had the opportunity to “simply” hold “forever” and collect that cash distribution. With the new taxation of Trusts in Canada their values naturally fall. But after the price adjusts to the lower level, the Trusts are still suitable for the long term arbitrage if their prices fall below the value of the (now lower) expected cash flows.

Now consider lululemon. Is there any hope that an investor who bought the whole company for $2.44 billion could ever collect back enough profit to make that worthwhile? Consider that 2006 sales were $150 million and profits were about $8 million. Sales would need to increase a lot and be highly profitable to ever generate enough cash profit to justify the $2.44 billion market value of the company. Clearly lululemon is not a long-term play. Rather it’s a game of pass the hot potato before it inevitably cools.

Foreign Exchange Rates and Implications

Coming to America – Price increases on imports

The U.S. dollar has fallen against the Euro from about 1.05 euro in 2002 to 0.85 euro at the end of 2005 to 0.73 today.

I suspect there has been a delayed reaction, the lower purchasing power of the U.S. dollar in Europe has not yet been fully reflected in prices for European imports. So, Americans can expect price increases on European imports. The price of European cars should be rising. However because European cars face stiff competition with domestic U.S. cars and cars imported from other countries, the price increases on European cars has likely been delayed and will likely never match the full currency change. Still, U.S. citizens in the market for a European made car might want to buy now.

The U.S. dollar has fallen substantially against the Canadian dollar from about CAD $1.55 in 2002 to CAD $1.05 today. This is important to Americans since Canada is (I believe still) the largest source of imports to the U.S. This has already driven up energy prices for Americans as those tend to be passed along quickly to consumers.

The U.S. dollar remains strong against the Japanese currency. It had fallen about 20% from 2002 to the end of 2005 but has since recovered. Therefore Americans should not expect price increases on Japanese imports.

The U.S. dollar also remains relatively strong against the Chinese currency which is pegged to the U.S. dollar and which has been strengthened against the U.S. dollar by only about 8% since 2002. Therefore Americans should not expect to see any significant price increases on Chinese imports caused by exchange rate changes (unless China raises the value of its currency, which it may do).

The extent of the price increases in the U.S. will be mitigated by the substantial competition from domestic suppliers and other countries. When the U.S. currency drops against some countries and not others, rather than price increases we may see those exporters having to “absorb” the currency impact or we may see consumers simply shift their buying to domestic suppleness and to those countries (like China and Japan) where the U.S. dollar is still strong.

Americans are affected by changing exchange rates. But not as dramatically as are other countries. That’s because the U.S. compared to most countries is more of a self-sustained country. Imports and exports do not account for a huge percent of its GDP. (For example Canada’s trade with the U.S. represents roughly 33% of Canada’s GDP and close to 3% of the U.S. GDP.

The average American consumer (who is not shopping for a BMW) does not have to be concerned about currency exchange rates.

Coming to Canada – Price decreases on imports

The Canadian dollar is now worth about 95 cents U.S. In 2005 the Canadian dollar was worth only 80 to 85 cents. And five years ago it was worth about 65 cents. So the Canadian dollar now buys a lot more in the U.S. than it used to.

In terms of the European dollar, the Canadian dollar had risen from about 0.62 euros in 2004 to 0.72 euros at the start of 2006, but then fell back to 0.65 early this year and is now at 0.69 euros. So there has been volatility but not really a dramatic change over that period.

In terms of the Japanese currency, the Canadian dollar has strengthened substantially from 80 yen in much of 2004 and 2005 to 111 yen today. Therefore the Canadian dollar buys a lot more in Japan than it used to.

In terms of the Chinese currency, the Canadian dollar has strengthened by about 39% since 2002.

Therefore, in theory, Canadians should expect to see or have seen price reductions on everything that is imported from the U.S., Japan and China.

To some extent this has definitely been happening. When you look at the low prices for items like tools and even “Quads” and small motorcycles at Canadian Tire, the higher Canadian dollar is responsible for some of those price drops. Prices for consumer electronics are also down likely partly because of the currency.

But some prices do not seem to have dropped. A classic example is book and magazine prices stamped with high Canadian and low U.S. prices. Prices for clothing do not seem to have declined. And prices for cars in particular do not seem to have responded.

Canadians should expect and demand lower prices on Japanese cars. I believe there is a huge opportunity at this time to buy a new or used car in the U.S. at much lower prices and bring it back into Canada. I pity the Canadian auto worker because the competitive position of building a car in Canada has substantially weakened compared to building the same car in the U.S.

I believe Canadians should and will take up cross-border shopping with a vengeance. If prices on imports are not reduced then it makes sense for Canadians to start shopping a lot more in the U.S.

In addition with our dollar near 30-year highs, I believe many Canadians would be wise to move more of their cash and investments into U.S. dollars. If the Canadian dollar continues to rise then there will be even better opportunities to do that ahead. But I would start now rather than waiting and hoping the Canadian dollar goes even higher.

Chinese exchange rate

The Chinese essentially peg their currency to the U.S. dollar. Over the past five years they have adjusted their currency upward by about 8.5%. America wants the Chinese to move their currency a LOT higher. China is essentially accused of keeping its currency artificially low thereby flooding the U.S. with cheap imports from China. Clearly this hurts U.S. manufacturers. But U.S. consumers benefit greatly from the lower prices (except of course those who lose their manufacturing job). China also receives less for its products than it could get. It’s a bit odd to “accuse” a country of selling you stuff too cheap. If someone wants to sell me something “too cheap” I don’t complain.


Shawn Allen, CFA, CMA, MBA, P.Eng.
InvestorsFriend Inc.

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