Newsletter August 31, 2002
INVESTORSFRIEND.COM NEWSLETTER AUGUST 31, 2002
Purpose of This Newsletter and Web Site.
This is the first newsletter since July 7 due to my vacation period which I mentioned last issue. This provides a logical time to re-examine the purpose of the newsletter and Web Site.
During the past three years my Site content has been provided free of charge, except that I did charge for a few reports in the last 9 months.
Starting now, all the educational articles and the newsletter will continue to be free of charge. The newsletter will provided educational comments and links to original educational articles.
Starting now, all specific buy and strong buy rated stocks and research reports will be available for a small charge. This reflects the natural progression of my efforts from a hobby to being now a small business.
I (and future other contributors to the Site) am applying a significant amount of education, knowledge and effort to the analysis. Logically this work should have value to members of this site who have come (or will come) to know and trust this Site.
There is no pressure or expectation to Buy anything from this Site. My hope is that some members will purchase research on those occasions where they have money to invest and are looking for a stock pick. I continue to value all members and visitors to the Site even if you never purchase anything. I get considerable satisfaction simply from the fact that you take the time to read my words. But when the time comes when you are looking for an investment idea, then I would certainly appreciate your business.
In order to keep costs reasonable I will try to bundle a number of reports together each month and offer access at an affordable price.
Here is a link to my current offering Updated Research – Purchase 6 updated reports including a new Strong Buy pick and a new Speculative Strong Buy pick for just U.S. $1.00 each ($6.00 total). Click here for more information.
Note that the “new” reports are updates to reports that I had originally prepared for BayStreet.ca. A few of you may have seen those reports on BayStreet, but they are no longer posted on BayStreet.
PESSIMISM AND OPTIMISM
It’s amazing that during periods of maximum optimism we all tend to see evidence that the good times will continue (remember when people justified Nortel’s price by assuming 30% growth for a decade?). Now during the current pessimistic period there is a tendency to see only risks as the pendulum inevitably swings too far the other way.
History shows that now is the time to be brave and pick up some bargains.
That does not mean that every broken down tech stock is a bargain. But, as an example, I think that Canadian Western Bank trading at a trailing P/E of about 10 will prove to be a bargain. Even if it falls some more yet… This bank will issue its Q3 earnings report in the next week or so. In addition, I think that several stocks from this months research for sale are good bets.
CASH FLOW VERSUS NET INCOME
With the recent accounting scandals, you may hear advice to focus on cash flow rather than net income.
I have always calculated the intrinsic value of a stock as being the present value of the forecast cash dividends plus capital gain over a 5 or ten year holding period. This is the only pure cash to the investor.
In calculating the capital gain I assume the stock will be sold (in 5 or ten years) at a certain sustainable P/E multiple (usually 10 to 15 to be conservative). I forecast the earnings based on current adjusted (normalized) earnings and an assumed conservative growth rate. So, I am focusing on earnings rather than cash flows.
The difficulty with using cash flow in place of earnings is that virtually no companies properly report their free cash flow (after deducting investments in working capital and in maintenance type capital spending). Instead, companies talk about operating cash flow which is typically higher than actual free cash flow. Another difficulty is that Free Cash Flow tends to be much “lumpier” than net income and therefore more difficult to predict.
See my recent cash flow article for an in depth discussion.
However, I have recently started to look at (estimated) free cash flow as a supplement to net income. Normally, net income approximates free cash flow over a period of years. However, there are cases where free cash flow systematically exceeds or falls short of net income as mentioned in the above referenced article.
In conclusion, Free Cash Flow should be looked at as a supplement to net income but investors should not be fooled by looking at operating cash flow reported by businesses, instead the focus should be on Free Cash Flow.
You can calculate Free Cash Flow as Cash for operations less cash used in investments. Both figures are major subtotals on the cash flow statement. The trick is to not deduct capital spending on acquisitions and major plant expansions. (Some companies separate out those kind of major investments). If this Free Cash Flow is substantially less than net income, then you probably should not trust the net income figure.
Does A Strong Balance Sheet Protect Your Investment?
Most of the time a strong balance sheet is “a necessary but not sufficient condition” for a good investment.
A bad balance sheet can mean the company is in danger of going bankrupt and so is something to be avoided.
A good balance sheet with little debt can mean that bankruptcy is extremely unlikely. But that won’t necessarily give an investor much protection.
Most companies trade on their earnings not on their balance sheets. This results in many companies trading at multiples of book value. It’s not at all unusual for a company with good earnings to trade at 3 to 10 times book value. If earnings should drop, and if the balance sheet is strong backed up by valuable assets then its unlikely that the shares would go below book value. But if the shares are trading at say 5 times book value, the fact that the strong assets mean that the price is unlikely to fall below 1 times book value offers little consolation. That would still be a sickening 80% drop in value. So, a strong assets with little debt is great, but it’s no guarantee that the share price will not tank.
When does the quality of Assets become important?
In every case an investor should be concerned if a company has too much debt compared to equity and earnings. Assuming that hurdle is passed then the quality of assets is really only very important when the stock is trading at or near its book value.
For example some value investors look for stocks trading below book value. But if the true value of the assets is much less than book value then you have no bargain. When a stock is trading near book value, then an investor should consider the quality of assets.
In most cases shares are valued for their earnings. The market value of the assets only becomes important if there is a real possibility that the company would be dissolved and the assets sold off.
It would be a rare case where a shares are trading at less than the actual market value of assets. Specialized assets like factories and equipment may be worth little or nothing on the open market.
Stocks that are trading at or below book value may be bargains, but that is usually because the P/E is also low or because earnings are expected to soon recover. If earnings are very low and the assets are thought to be worth more than the earnings then you have to consider how a new owner of those assets would somehow realize higher earnings from the assets.
If you are counting on the asset value to protect your investment then you should check to see what the assets consist of and consider whether they would be worth much if sold off in pieces.
Avoid the Auto Manufacturing Industry
It’s common knowledge that cars are lasting a lot longer these days, like maybe twice as long as in the 70’s.
Car sales have been strong based on zero percent financing and other sales incentives. Also, over the past 3 decades we have gone from usually 1 car per family to probably 2.5 cars per family as there are more and more two income families as well as teenagers with cars.
But something has to give. All else being equal, if a product lasts twice as long then the production rate eventually has to drop by half. All else was not equal for a while as families wanted and could afford more cars. But at some point that factor levels off and we are left with the need to reduce production substantially.
On top of that, North America is saturated with newer cars because of all the incentives in the past few years.
I would avoid buying North American auto manufacturers including also companies that make components and parts for new autos.
My next issue will probably not be sent until about October 1. I’m going to focus my efforts on searching for more strong buy stock picks. Check the Site periodically for updates.