Newsletter August 4, 2005

InvestorsFriend Inc. Newsletter August 4, 2005

Market Outlook

The second quarter earnings reports for Canadian companies are pouring in and the results look pretty good. However, the market was for the most part anticipating that. The general outlook still seems good for stocks but of course the sentiment can turn quickly.

Inflation remains surprisingly low. I think this must be driven in good part by declining prices for imports, especially imports from China. Even imports from the U.S. are cheaper now due to our stronger dollar. However, I am startingto think higher inflation will have to show up eventually given the rise in oil prices. Also in Alberta I am starting to see signs of wage pressures. Independent gravel haulers recently refused to work unless they got more money. Every fast food restaurant seems to be advertising for workers and they are starting to hold job fairs. In the shorter term this may not be a problem for stocks but eventually it should have an impact through higher interest rates.

Performance of Our Stock Picks

I am extremely pleased with the performance of our stock picks. The model portfolio is up almost 22% this year to date. In 2004 it returned 27% and in 2003, 37%. That’s a 111% return in just over two and one-half years since January 1, 2003. Over that period my own personal portfolio was up an even 100% and the Strong Buys were up an average of 158%. Not only that but these stock portfolios rose in quite a steady fashion. There were very few months where the portfolios went down and these portfolios were able to beat the TSX market, most months, in both strong markets and weak markets.

Recent winners include Wendy’s International which I first “covered” just over 1 year ago introducing it as a (higher) Buy at $37.79. It subsequently fell as a low as $31.80, but I was undaunted and called it a Strong Buy at $35.90 and again at $31.80. My patience was rewarded and Wendy’s is now at $50. My belief was that the value of its 100% ownership of the Tim Hortons franchise company was not being reflected in the Wendy’s stock. Recent plans to sell off a portion of Tim Horton’s moved the stock up just as expected.

In the interests of honesty (which is a hallmark of this site) I will point out that my returns were quite a bit weaker in 2001 and especially 2002, although I still easily beat the TSX index those years.

If you are interested in benefiting from this analysis, consider subscribing to our stock picks. You can subscribe for as little as 1 month at a cost of $10. Also now is a good time to subscribe as we are more active than usual with updates on the stock ratings given the Q2 earnings reports

If you have money invested in stocks (including mutual funds) and if your returns are not satisfactory then consider whether or not you want to try a different approach. There is a saying “if you keep on doing what you’ve been doing, then you can expect to keep on getting what you have been getting”. If you don’t already have a self-directed investment account or a stock brokerage account, articles on this Site explain how to do that. Of course if you are simply not interested in buying your own stocks, then that is fine, I certainly hope in that case that you will find this newsletter and the many articles on the Site to be educational.

Brands Are Everything

When it comes to businesses serving individuals, it seems that brands are everything.

It is becoming very difficult for a one-off, one-location business to compete against the various chains and brand names.

In illustrating the power of brands consider the following.

Authentic diamonds are visually indistinguishable from imitation diamonds. And yet imitation diamonds are worth only a tiny fraction of the amount a similar looking real natural diamond is worth. In this case the “brand” is authenticity. Consumers get a certain satisfaction from knowing they own the real thing. I believe the same thing would apply to Rolex watches, even if the imitations were virtually exact copies, consumers would pay much more for the pride of owning the real thing.

As another example consider NHL hockey in Canada. Fans will pay say $80 to attend an NHL game but for an American Hockey league game it is difficult to get fans out for say $30. I can’t believe that the actual hockey is all that much different. What the lower tiers of hockey lack is the brand power of the NHL logo as well as the brand value of the star players. In order for most sporting events to be successful, the fans have to care who wins. The building up of pride in the home team and of inter-city rivalry is the “brand power”. In my view the actual display of skill and action on the playing field is far less important than the brand power of getting fans to care deeply about who wins.

And consider the brand power that has been amassed by the likes of Tiger Woods, Ophra, Tom Cruise etc. Also consider Harley Davidson, its brand is so powerful that many Airports now have Harley shops selling souvenirs.

On a much smaller level brand power is at work when we choose a restaurant, a beer, an article of clothing, a car etc. When it comes to brands on everyday consumable items like fast food and grocery items, much of the brand value comes from familiarity, lack of perceived risk and simple habit.

When it comes to the higher end brands there is a certain cachet and psychic pleasure which seems to be associated with “high end” names.

Implications of brands

Companies with brand appeal tend to be able to sell their products at higher prices and higher profits. They can be very good investments if purchased at reasonable (though not necessarily bargain basement) prices. This was the strategy of Warren buffett in purchasing shares in Coke, Disney Gillette and American Express.

If you are considering opening a business that serves individual consumers then think long and hard before you go up against the established brands. Think about tapping into the brand phenomena by opening an established franchise rather than an independent business. If you dare to go up against the chains then I think it will take more than lower prices. You will need a real niche market to succeed. Businesses that serve other business rather than consumers have not yet been widely franchised and branded and so independent businesses can still do well in this area.

Risk Adjusted Returns?

You will occasionally hear market commentators talk about “risk-adjusted-returns”. This concept is essentially based on the observation and theory that in an efficient market higher expected returns are generally associated with higher returns.

For example, with government of Canada treasury bills and bonds, the interest yield goes up as the time lengthens. Longer term bonds expose investors to more inflation risk and more risk that you are locking in a return that turns out to be below market. Recent government of Canada yields were:

3 month 2.58%

2 year 3.04%

5 year 3.34%

10 year 3.86%

30 year 4.27%

The stock market is generally accepted to be higher risk than 30 year bonds and although the current expected yield on the stock market index cannot be observed it is generally hought to be in the range of 7 to 9%.

Some market commentators mis-understand the theory when they say things like, “On a risk adjusted basis you should be indifferent between 4.27% on the 30 year bond and 2.58% on the 3 month treasury bill”. They are sort of correct since the market is saying that the mythical “average” investor is in fact indifferent to these two choices. However, no real investor is “average”. For example because I fear that interest rates will rise, I would not invest in the 30 year or 10 year bond, even if the yield was say  1.0% higher than shown. I would rather take the the 2.58% on the 3 month treasury bill. But more to the point as an investor with a long time horizon, I don’t view stocks as being more risky than bonds (in the long term). Therefore I would (and have) take my chances on the expected 7 to 9% return on stocks in place of the bond yields shown.

Now, imagine I achieve 8% on the stocks. I think for anyone to suggest that this is somehow equivalent to getting say 4% on bonds on ” a risk adjusted basis” is rather absurd. This becomes clear when we note that if I had achieved minus 20% ion the stocks no would suggest that this is equivalent to the bond yield after considering the risk.

Quite often the “risk adjusted return” crowd uses this line of reasoning to dismiss the validity of anyone who makes say 20% in stocks. They will sniff that this is only because of the risk the person took. Often they may be partly right, but if a mutual fund or investor has a strong track record of beating the market then I think more than just risk is at play (perhaps it is skill). In any event if theory suggests that stocks return more, on average, than bonds, then in the end the stock investor would usually have a lot more money and it would be cold comfort in 30 years for the 100% bond investor to be told that “on a risk adjusted basis” his $250,000 is “equivalent” to the the stock investors $750,000.

If any advisor starts to talking to you about risk adjusted returns he is most often just spouting the company line and probably does not really understand the subject. So just be a bit skeptical when you hear that term.

For a lot more information on risk and return, see the articles section of this  web site.

Why did Your Bond give you a capital gain?

A lot of investors have experienced the following phenomena in recent years. They bought a bond or bond mutual fund that was expected to return say 6%, and instead they got the 6% yield plus an unexpected capital gain as the price of the bond rose.

This phenomena happened most years all the way back to about 1981. Many investors might assume that because bonds have given capital gains and therefore high returns for a quire a number of years, then this is likely to continue.

However, in reality the market is signaling just the opposite. A bond gives a capital gain in 1 year because that it what it has to do make its yield go down as interest rates fall. A capital gain on a bond signals lower returns ahead. Almost everyone agrees that long-term interest rates are now at or near their low point and much more likely to rise than to fall. So the bonds that gave capital gains for many years would now be expected to provide only their current interest yields (3.9% for a 10-year government bond), and if interest rates rise these bonds would give capital losses.

So paradoxically a string of unexpected gains on bonds signals lower returns ahead.

To a certain extent the same thing applies to stocks. As long-term interest rates fall then the required returns on stocks also fall. In order to give the lower return going forward, stocks on average must increase in price (giving a high return this year) but signaling lower returns ahead.

If this seems confusing, it is. Investing is not always easy but it certainly helps to understand the basic math.

To see past  editions of this newsletter, click here

END

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

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