Newsletter August 14, 2004


This newsletter has comments under each of the following topics

  • Performance
  • Featured Industry Segment for Investment
  • Analyst’s Corner (Tips and tricks for analyzing stocks)
  • Trader’s Corner (Tips regarding trading strategies)


My investment performance figures confirm that I have been able to significantly beat the TSX index in each of the last five years since I began this newsletter and investment Site. I have done this by learning and applying a large body of knowledge regarding “value investing” or investing based on fundamentals. I have closely studied and copied techniques from the world’s very best value investors. I have studied and come to understand the business structures of many industry segments and individual companies (for several years I read annual reports for breakfast, lunch and dinner!).

In applying fundamental accounting and finance knowledge, I have made use of my education as a professional accountant, an MBA and as a professional engineer. Although I was already highly educated, I also successfully pursued and completed the Chartered Financial Analyst program earning my designation last year. However, my best education came from working on my own investments by sitting down and applying my knowledge to dozens of individual companies and from sitting down and writing dozens of articles on how investment math and finance actually works.

In future years, I am confident that I can continue to out-perform the sock market and I am confident that I will amass a reasonable level of wealth in the process.

I enjoy sharing my knowledge with others through this free newsletter and through my the paid subscription access to my individual stock ratings.

Featured Industry Segment for Investment

One Industry that I think offers excellent investment opportunities is the Property and Casualty insurance industry. (These companies offer one or more of: fire/damage and liability insurance on cars, trucks and buildings – both residential and commercial).

As far as Canadian investors are concerned this industry is tends to be overlooked. On reason is that many Canadians buy their property insurance from American companies. Another reason is that we tend to buy our insurance through brokers, we may know the name of the broker but not the name of the actual insurance company. In addition some insurance companies are privately held or do not trade (The Co-Operators, for example).

One of the major reasons that I think that property insurance companies could be a great investment is because of the huge premium increases that are so much in the news. It has got to the point where customers are often paying auto collision repair costs themselves rather report a claim and see a big premium increase. While insurance companies did have some bad years, I suspected a point had been reached where they are now highly profitable in most cases.

I have researched a number of these companies and have recommended several of them as Strong Buys. They tend to trade at very attractive multiples to book value and to earnings.

These property and casualty (liability) insurance companies have some very unique financial characteristics that are not very well understood by investors or even by most accountants and persons trained in finance. They collect insurance premiums, as we all know. About 25% of the premiums are typically used to pay expenses including commissions to brokers. Claims paid out to customers cause total “reported” expenses to rise to an average of roughly 95% to 105% of premium revenue. This causes an average insurance “underwriting” profit of 5% to a loss of 5%. So far this does not sound so good. But the reality is that the claims to customers are typically paid out many months or even years after the premiums are collected. Meanwhile the insurance company holds and invests the proceeds.

Over time, a virtual mountain of invested assets tends to build up. Shareholder’s equity can be on the order of 25% of the invested assets. The assets are mostly supported by the non-interest bearing mountain of premiums that are “reserved” for future claims. In that case if an insurance company earns 4% on investments then this translates to 4% divided by 0.25 = 16% on equity and this is on top of any return on equity earned on the insurance itself. Traditionally, insurance companies were happy to break-even or even lose a bit on the insurance itself and made their profits by investing the premiums. In today’s lower interest rate environment it is more important that they at least break even on the insurance side.

If all goes well, insurance companies behave as cash engines, continually building up their pile of invested assets. Even in years where they report a loss, the cash pile usually keeps growing because the expenses are largely estimates of claims that will be paid out in the future, they have not yet been paid.

However another characteristic of this type of company is that the claims expenses are all based on estimates. It can be very difficult to predict the claims payouts. Accidents occurring in one year can take years to wind through the courts and the ultimate court awards are hard to predict.

Unfortunately some insurance companies have had a bad habit of under-pricing their insurance and then having to continually book expenses related to increases in claims from prior years. In essence the reported profits in the past have often proved to be in a sense partly fictitious.

The result is that “reported” earnings for any year are not very reliable. They may turn out to be be understated or overstated when all the claims are finally settled for that year (which will be some years into the future). These companies are regulated and use professional actuaries to estimate the costs. In theory their earnings reports should be conservative more often than overstated.

Some insurance companies have not experienced significant problems with having to increase their estimated claims for prior years.

Another reason that I like insurance companies is that their customers tend to be very sticky. Once a customer signs up with a certain insurance company, they tend to stay year after year.

I note that warren Buffett made much of his great fortune by owning insurance companies. I feel pretty comfortable following in those particular footprints.

As noted above, I have analyzed a number of insurance companies and I have found that some of these appear to represent compelling buys. These stock picks are available to my paid subscribers.

Analyst’s Corner (Tips and tricks for analyzing stocks)

Here are a few simple ideas to help you better understand whether a stock with a given Price to Earnings (“P/E”) ratio is a bargain or not.

Using the P/E ratio to judge the value of a stock carries with it two implicit assumptions.

The first is that the accounting net earnings are a good representation of the amount of net free cash that the company generates and which is available to distribute as dividends or to reinvest to grow the earnings. See my article on understanding cash flow for a discussion of when this assumption is likely to be violated. The second assumption is that the current earnings are a good representation of sustainable earnings and are not materially affected by unusual “one-time” events.

The implications of a given P/E ratio can be better understood by observing that the reciprocal of the P/E is E/P or the earnings yield. A P/E of 10 indicates that the company has an earnings yield of 1/10 or 10%. A P/E of 20 indicates an earnings yield of 1/20 or 5%.

An earnings yield of 5% is only attractive if the earnings are expected to grow in a manner that will allow an investor to ultimately earn his or her minimum acceptable “required return” of say 9% by holding the stock. This can only occur if the company is earning more than the investor’s required return on its retained earnings. For example if a company is earning 15% on equity then it may make sense forĀ  an investor to pay a P/E ratio of 20 for the stock. The company is only earning 5% on the investors initial investment but if retained earnings compound at 15% then the investors return should be much higher than 5% if the stock is held for a long period of time. Nevertheless, investors should keep in mind that when they buy a stock with a P/E of 20 (an earnings yield of 5%) then the company has a lot of catching up to do if the investor is to earn say 10% over a holding period. Even if the company continues to earn strong returns, it would take some years for the catch-up to occur. (The above assumes that the market P/E remains at 20).

Another way to think about P/E ratios is to be aware of what the long-run sustainable or justifiable P/E is in the case where the company only earns the “required return” on its retained earnings. For example when required return = 9% and expected ROE also equals 9%. In this case the long-run sustainable P/E can be calculated as 1 divided by the required return. (And this assumes that net earnings are a good estimate of the sustainable free cash flow). A 10% required return implies a sustainable P/E of 1/0.10 = 10. A 9% required return implies a sustainable P/E of 1/0.09 = 11.1, An 8% required return implies a sustainable P/E of 1/0.08 = 12.5. For more see my article on the sustainable P/E.

The implication of this is that assuming a required return of 9%, current earnings justify a P/E of just 11. Most stocks trade at P/Es above 11 and the usual justification for this is that the earnings will grow. But mathematically growth is worthless unless the retained earnings that are funding the growth are earning a return that is higher than the cost of capital (cost of invested money or required return). So… when we pay more than 11 times earnings we are implicitly saying that the incremental P/E that we are paying is justified by not just growth but by highly profitable growth. (The 11 would be 12.5 if we require only an 8% return).

In the late 90’s the average P/E ratio of stocks was well over 20 and investors had apparently forgotten the type of simple math discussed above. Implicitly investors were paying in advance for an expectation of very high and very profitable growth. The reality is that those expectations were too rich, companies could not deliver that kind of growth. This is why we have seen the average P/E ratio of stocks trend ever downward since 2000. As at July 30, the P/E ratio of the Dow Jones Industrial Average was at 16.8 on a trailing earnings basis and at 14.8 based on projected earnings.

In judging whether a stock’s P/E is attractive we can consider if we assume that growth will only earn the cost of capital then it is difficult to justify a P/E of more than 11 to 12.5. In addition we can consider that the average Dow Jones Industrial Average Stock has a P/E of about 16.8 based on trailing earnings and 14.8 based on projected earnings. We then need to consider if our stock is better than average and if it has prospects for highly profitable growth (as opposed to merely acceptably profitable growth which is mathematically worth nothing). The bottom line is that high P/E ratios are difficult to justify and a stock is more likely to be a bargain if it has a lower P/E. High P/E stocks can also be bargains but only in the rare cases where it is likely to enjoy highly profitable growth.

Traders Corner

Short selling – Leave it to the Experts!

Over the past year it seemed plainly obvious that Air Canada’s shares represented a tremendous short-selling opportunity. Many months ago the company stated that the common share holders would receive “no meaningful recovery” in the bankruptcy proceeding. Translation – the shares were basically worthless. And yet the shares traded at well over $1.00. With some 90 million share outstanding this meant that the market was indicating that the company’s equity was worth over $90 million even thought the company plainly said it was basically worthless.

Shorting this company seemed like money lying on the floor waiting to be picked up.

Well, it did not work out that way for most who tried a short sale. The price stayed stubbornly high. Brokers allowed investors to short the company and then when the price rose, brokers often forced investors to buy back the shares at the higher price and the short sellers lost money. The short sell interest was between 8 and 18 million shares at various times and it appears that there was a lot of turnover. Brokers must have made many millions in commissions. Brokers claimed that they ran short of shares to lend to investors and that is why they required short sellers to cover their position.

My sense is that some kind of manipulation was taking place. I shorted at a time when there were about 15 million shares sold short. Several months later when the short interest was under 10 million shares, my Broker forced me to cover. In fact my Broker summarily decided that all of its clients would have to cover, they just were not prepared to lend any shares to anyone at that time.

I was unaware that my Broker could make such arbitrary moves. Getting an explanation from my Broker took several months, many phone calls, and a letter to its President followed by three follow up reminders before I got my answer. And the explanation was not satisfactory to me.

I contacted another Broker and they indicated that they would not allow any short selling on any stock under $5.00.

My conclusion is that retail investors should generally not sell short. It is risky. It is complicated. Brokers have arbitrary internal rules regarding buy-backs. Manipulation may be taking place. I suggest you leave short-selling to the experts and the insanely brave.


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