Newsletter August 16, 2006

InvestorsFriend Inc. Newsletter August 16, 2006

Our Track Record

You would not likely want to bother reading this investment newsletter if we did not have a strong track record in picking stocks. You can check out our excellent track record here.

This free newsletter is designed to offer useful information and insight, however you can benefit more fully from this Site by subscribing to our stock picks. (Click for more information)

The Magic of Compound Returns

Albert Einstein described compound interest as the eighth wonder of the world. I found it takes about 10 years of investing before the impact of the compounding starts to really become noticeable. Last year my return amounted to 33% of the amount I had at the start of the year. But because of compounding, the return on the original money I had ever invested was fully 67% of my original book value or cash invested. The difference is due to the compounding effects or “return on return”.

Is Now a Good Time to Invest in Stocks?

That of course is the question that every investor would like to have answered but is one which cannot be answered with certainty.

Certainly in the past few weeks our Stock Picks on this Site have done very well. Yesterday in particular was a very strong day. Fears of further interest rate hikes in the U.S. were abated by a report showing unexpectedly tamer wholesale inflation. The result was lots of stocks increasing yesterday. My own account was up over 1.5% yesterday alone. Today, the U.S. consumer inflation report was tame as well. It seems that the market may be set for another leg-up as we head towards the end of this year.

When markets move up, they often do so quickly, so if you are looking for good stock picks you may want to act quickly.

Corporate earnings have continued to grow at a strong rate. The price / earnings ratio on the North America stock market indexes is more attractive than it has been for many years. With stocks arguably looking cheap, it seems unlikely that a severe stock market decline would occur. But a possible recession looms which would hurt earnings and could certainly cause some level of market decline.

No matter which way the stock market goes, there will always be some stocks going up – we just need to find them. In each of the past seven years since this Site was started I have had a documented history of being able to do that.

Making Money in a Flat Market

The Dow Jones Industrial Average (DJIA) finished today at 11,327, which is slightly below a peak it made six years ago in April 2000. The TSX stock index closed today at 12,030 which is not much above a peak it reached of 11,600 six years ago in September 2000.

These markets in the past six years started from high historical peaks reached in the huge market run-up of the late 90’s and into 2000. Thereafter the markets crashed severely with a decline of of over 30% for the DJIA and over 40% for the TSX with the bottoms reached in 2002. These markets finally regained their old peaks in 2006, although the DJIA is currently below its 2000 peak.

Some people might use this data to claim that “no money has been made in the past six years”. (Dividends should be added to this but were small and probably mostly eaten up by trading and money management fees).

In truth many average investors made strong returns over this period.

An average investor who was putting money into the market each year since 2000, has made money. While, on average, their original portfolios from 2000 have not made money, they would have made good returns on new money placed in the market in each year since 2000. Young people who were just getting started investing in the year 2000 should on average have made strong returns over the past six years, since a material portion of their savings would have been invested when the market was much lower than it is today.

On the flip side, investors who were taking regular withdrawals from an equity portfolio over the past six years and not putting in new money would, on average have been hurt very badly. Their portfolios would have been down a lot by the time the recovery began and they were not putting in new money as the market rose.

The point is that investors who are still putting in new money in amounts that are material in relation to their portfolios should not fear down-ward volatility in the markets. In fact they should welcome it. Volatility benefits savers through dollar cost averaging but hurts those who are now drawing down their portfolios.

Stocks to Buy Now

In this free newsletter, I can’t go into much detail about the stocks that we are currently rating as Buys and Strong Buys. That detail is restricted to our paid subscribers and it would not be fair to go into detail in this free newsletter. But I can offer some comments.

Tim Hortons

One stock that I can discuss is Tim Hortons. It’s not one of our higher rated picks but we do think it has good potential. Remember that big hoopla about this stock when it went public back in March? The Initial Public Offer (IPO) price was CAN $27. But retail investors for the most part could not get their hands on it at that price. The great bulk of the shares went to big institutional investors. (I am not sure why that was allowed to happen but that’s the way it went).

The stock was expected to “pop” and open trading at a higher price. And that is what happened. It opened trading at around $36.21 and closed at $33.10 that first day and then fell to the $30 range within a few days. Apparently almost all of the initial buyers who got it for $27, took the opportunity to sell very quickly. In fact while only 29 million shares were issued, 44 million traded the first day. It would appear that many of the IPO buyers sold on the first day and many shares must have traded hands more than once that day.

Fast forward to today and the stock closed on Friday, August 11 at $26.92 or approximately its initial offering price of $27. So, the big institutional players made some fast money and then sold, either to other institutions or to retail investors who have then (so far) lost money. The fact that the IPO buyers made fast money does not bother me but the fact that retail investors were mostly shut out of that action does.

But I can’t change that. The question now is whether or not the Tim Hortons stock is a good buy.

Clearly, Tim Hortons is a great business. When I look at the line ups at all their locations at all hours of the day, it seems clear that this business is going to continue to grow. By all accounts it has been one of the best managed businesses in Canada for many years. This seems unlikely to change. I believe it would take a major catastrophe like finding out that the coffee was cancer causing or otherwise contaminated to put a major dent into their business.

Right now it appears that “the market” is skeptical about their chances for growth in the U.S. Indications are that they plan to expand slowly into the U.S. building brand recognition over time. In my view Starbucks is not that much of a direct competitor since the price points are so different. And I don’t think Dunkin Donuts holds a candle to Tim Hortons. In addition, given their line ups, there is probably still lots of room to grow in Canada, although “the market” is skeptical on that point as well.

One factor that is weighing on the stock is that in early October, the approximately 82.5% of Tim Hortons that is still owned by Wendy’s will be distributed to the Wendy’s shareholders. The fear is that these are mostly Americans who know little about Tim Hortons and who will rush to sell their shares causing the price to drop. Maybe so. Then again if the Wendy’s share holders have been paying attention, they will know that a large portion of Wendy’s profits in the past few years have come from Tim Hortons. In any event such a price-drop, if it happens, would be a purely temporary event and will have absolutely no impact on where the Tim Hortons shares will be trading two years from now.

Warren Buffett has said that he would rather pay a fair price for a great business than a bargain price for a mediocre company. By all accounts Tim Hortons is a great business. According to its initial public offering, CAN $27 was a fair price back in March. Nothing much has changed since then. This would suggest that buying it at about $27 is likely to work out well in the long run.

If investors regretted not being able to buy it for $27 last Spring, it seems odd that there is little interest now that the price has dropped back to about $27.

Home and auto insurance stocks

Property and casualty insurance is a sector where this Site has had some Strong Buy rated stocks for several years starting in 2003. My theory back in  2003 was that automobile insurance rates had overshot the mark and were at highly profitable rates. In each of the 10 years prior to 2003 the Canadian property and casualty industry as a whole had lost money on their insurance operations (they made money after considering investment returns but the industry average return on equity (ROE) was below 10% most years). In 2002, the industry average ROE was just 1.7% despite steeply rising  automobile rates. But in large part the low 2002 returns were related to claims from 2001 and prior. I calculated that if the problems with those past years were cleaned up then the industry would be quite profitable. In addition by 2003 the industry was starting to convince governments to put caps on certain pain and suffering claims. And by 2003 consumers were becoming very reluctant to make an auto insurance claim because they had heard the horror stories about rates being jacked up 100% or more after a claim or two. This really seemed like an ideal recipe for profits ahead.

Fast forward to 2006 and the industry has indeed recorded record profits in 2004 and 2005. It has not all been smooth sailing though as some of the Canadian companies had exposure to the U.S. hurricanes of 2005. And some of the insurance companies continued to face large surprise expenses related to claims from prior years. Also “the market” has been quite reluctant to place a high valuation on the insurance company stocks. Essentially “the market” does not believe that these good times will last. Most of the Canadian property and casualty stocks that we follow trade at price to earnings ratios of under 10. Price to book value ratios are also mostly well under 2.0.

By the way, if you can name more than one or two stocks that are in the property and casualty business then you are more knowledgeable than most investors. Many Canadians buy their insurance from companies that do not trade on the stock exchange in Canada. In addition most Canadians buy their insurance through a broker and they may not even know the name of the insurance company. There are in fact only a handful of Canadian property and casualty stocks. And if you are looking to invest in a company that insures “ordinary” Canadians then the list is even smaller. Several Canadian property insurance stocks specialize in “high risk” drivers and those stocks are usually considered riskier.

The bottom line is that the industry is currently highly profitable and the stocks generally look cheap. But it takes some specialized analysis to understand whether or not these are likely to be good investments.

Stocks that we have done well on so far this year include the following:

A cable television company. Cable companies are adding lots of new customers and picking up revenue from higher value services like digital cable and pay-per-view movies. But investors also need to check if the stock is well priced or not.

A boring little paint company. This boring little company did nothing but make money every year. Growth was not spectacular but  this year the company got bought out for a nice gain.

A small company that owns a network of about 50 insurance brokers and also has some complimentary financial services. Small companies can be risky, but also sometimes offer the opportunity to get in early on something that will eventually grow quite large.

If you are interested in finding out all about our current picks, you can sign up for just $11. (And we are so confident a that you will like our analysis that we offer a refund if you notify us within three weeks of sign-up that you are not satisfied with the analysis provided).

Why Most Analysts Will Not Place Clear Sell Ratings On Stocks

Investors and the business press often complain that analysts are biased and hardly ever put explicit Sell ratings on stocks. (On this Site we do have some Sells, we started the year with two Sells and three  Weak Sell/Holds, out of 31 rated stocks).

But the fact is that the market really does not want Sell ratings. The market wants cheerleaders and optimists and does not want gloomy outlooks.

Consider that many companies complain bitterly about short sellers. Sometimes they accuse short sellers of manipulating prices down and occasionally they take a short seller to court. Apparently it is illegal to short sell a stock and then “bash” the stock and write negative research reports in the hopes of driving the stock down. And I suppose that should be illegal.

But consider what happens if someone buys a stock or buys stock options and then shamelessly promotes the stock and issues glowing research reports. This is just as dangerous since if the hype is not warranted it will drive the stock up to an unrealistic level and then when it falls back to a more realistic level, some investors will be hurt. But I have never seen companies complain about analysts that are over optimistic. Such behavior is often considered acceptable (even commendable) except in extreme cases called “pump-and-dump” which usually applies to penny stocks.

Analysts that issue sell ratings can be black-listed by companies. The company can refuse to meet with the analyst and even refuse to take his or her questions during analyst conference calls.

Generally individual investors also do not really want to see Sell ratings. If you hold a stock, you are generally hoping for further gains and you usually don’t want to be told to Sell. If you don’t hold the stock you generally don’t care about the Sell rating. The result is that there is a very limited market for Sell ratings. For example, a “Strong Buy” rating on say Canadian Tire, might be of interest to most Canadian investors as they could consider investing in Canadian Tire. If the analysis turned out to be too optimistic, few people would ever complain. In contrast a “Strong Sell” rating on Canadian Tire would surely be greeted by howls of protest. The offending analyst would be subject to severe public criticism, and possibly even to threats. His or her career could be at risk.

In summary analysts do not often issue explicit Sell ratings because the market wants cheerleaders and usually does not welcome negative opinions. Therefore analysts are not particularly motivated to issue clear Sell recommendations. That is not likely to change as long as investors on average continue to react in a generally hostile manner to Sell ratings.


Shawn Allen
InvestorsFriend Inc.

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