Newsletter January 13, 2007

InvestorsFriend Inc. Newsletter January 13, 2006

Achieving Your New Year’s Goals and Resolutions

The most important factor in achieving a difficult goal is to make a full mental commitment to achieving the goal.

We see this everyday in small and large ways. Some people will tell you that they will get the job done by next Thursday. Others will tell you that it should be done by next Thursday. You will usually have a lot more confidence in the person who tells you it will be done. You know the second person has not really committed to making sure the job is done.

For example, if one person states, “I’m going to try to lose 20 pounds by Spring” and another states “I’m definitely going to lose 20 pounds by my wedding day, June 21”, most of us would have more faith that the second person was truly committed to achieving their goal.

I’ve often read that a major goal should be broken down into manageable steps following a plan. I absolutely believe that is true – although it is often very difficult to do. Having a plan makes it much easier to achieve a goal.

It’s very difficult to really commit to achieving any goal without having a plan to achieve the goal. The clearer is the plan, the easier it becomes to fully commit to achieving the goal.

Ideally the plan is so clear that achieving it becomes almost a matter of merely waiting for the time to pass. For example, in academic life it can be relatively easy to fully commit to graduating from a program. A student knows that in order to complete a degree one must attend classes and do certain assigned work and it becomes easy to fully commit to achieving that goal since the plan is so very clear, and is not particularly arduous to follow in most cases. I don’t mean to trivialize the achievement of obtaining a college degree. I am just pointing out that it is much easier to fully commit to a goal like that where the path to the achievement is very clear as opposed to a goal like “make a million dollars”, where the path to getting there may not be at all clear.

Longer-term financial goals typically will not have plans that are very clear. You may have a goal to make 50% more in salary in say three years, but in most cases the plan for doing that will be necessarily quite fussy. Therefore you may not be able to take the all-important step of fully mentally committing to your goal of earning 50% more in three years. But you could fully commit to sub-goals that will take you in the right direction, such as committing to complete certain projects, or committing to take certain academic or technical courses likely to lead to a promotion.

Think about your own goals. It may be that a lack of fully mentally committing to these goals is a major barrier to their achievement. If you find you just can’t commit to a given goal, you can then ask yourself whether that is an appropriate goal for you or whether you can work on a plan (something that you can commit to) or identify sub-goals that you can commit to.

Without full commitment, success is unlikely.

Stock Picking Performance

In 2006 our Buy rated stocks were up about 20% each, on average. We beat the market index for the seventh straight year since our inception. In the first two weeks of 2007 my own portfolio is already up 2.5%, while the TSX market is down 1.8%. For full details of our performance, click here.

False Expectations and illogical Investing Strategies

Why do so many people focus on risky penny stocks and ignore much safer blue-chip stocks? Of course it’s because they want too get rich quick.

But I would also argue that it is also because they simply don’t properly comprehend the probabilities and possibilities of getting rich in penny stocks or of losing their money in penny stocks.

I have read that the human brain is simply not wired to easily understand probabilities. If we judge probabilities by “feel” we tend to get it wrong.

To illustrate this, I have analyzed some mathematics around lotteries. The mathematics and general lack of clear thinking that goes on with lotteries may also be at work when people gamble on penny stocks.

Millions of Canadian apparently play buy loto 649 tickets on a regular basis. For the January 10, 2007 draw 1 person won $3.6 million dollars, and the odds of that are listed as 1 in 14 million. 4 people won $64,192 each with odds of 1 in 2.3 million. In terms of lesser prizes, 116 people won $1,828 each with odds of 1 in 55,491 and 5676 people won $181 each with odds of 1 in 1032 and almost 200,000 won $10 or less.

This math tells me it is pretty much totally illogical to waste $2 on one of these tickets in the hopes of making a big win. Lotto 649 only pays out 52% of sales to players. Right off the bat that is a losing proposition. For every two dollars bet, players as a group lose one dollar to costs and profits. The remaining dollar is split among the players.

But lottery tickets are not bought on logic. And frankly I really don’t blame low income people for buying lottery tickets. It gives them hope and that’s a very good thing. But mathematically it’s a pretty much a false hope.

People don’t buy these tickets for the chance to win $5 or $10 or $181 (1 in 1032 odds) or even $1,828 (1 in 55491 odds). They buy them for the grand prize of millions or at least the second prize – which unfortunately tends to be under $100,000.

For the January 10, 2007 lotto 649 draw just 5 people won a prize of any noteworthy amount. The four second place winners overcame odds of 1 in 2.3 million and the grand prize winner overcame odds of 1 in 14 million.

Think about these odds! If you bought 1000 lotto 649 tickets per day, 365 days per year, costing you $730,000 per year, for your 365,000 tickets, it would still take you on average 38 years before you wound win. You would also win many minor prizes along the way, but overall on average only 52% of your money would be recovered since that is the ratio paid out. This would be financial suicide.

Of course no one would buy a thousand tickets or even 100 tickets per day. But the point is, the math is totally stacked against anyone buying a ticket.

A 1 in 14 million chance is almost no chance. If any of us could see 14 million people in a massive crowd, we would likely realize that the chance of being randomly selected to win is pretty well zero.

Yes, of course, “someone has to win” but that does not change the fact that the chances of you being the winner are basically zero.

On the extremely rare occasion (less than once per year) that I happen to buy a ticket, I tend to get the illogical feeling that fate will intervene and I will win the big prize. But of course around 14 million others feel the same way.

I am not saying everyone should stop buying lottery tickets. If $2 gives someone hope, even a false hope, then that is a good thing. But if any particular individual actually expects to win big (ever!) the fact is that it is a false expectation. At odds of 1 in 14 million if you buy 2 tickets per week it would take on average about 134,615 years before you will win! (14,000,000/104). In other words if you buy 2 tickets per week for 40 years, your chances of winning the grand prize over that entire 40 year period are only 1 in 3,365. That may not sound so bad, but remember that this means there is 3364 chances out of 3365 or a 99.97% chance of never winning the grand prize even if you play twice a week for 40 years.

So, the point is that millions of Canadians play the lottery faithfully even though they have almost zero chance of winning the coveted grand prize. And I believe that this is partly or mostly because they really don’t understand or accept how the odds are stacked so very high against them.

People see pictures of the various winners and they get a totally false feeling about their chances of winning. They identify with the winners and think, “that could have been me”. Seeing those pictures on television makes people forget about the 14 million to 1 odds. (Maybe they should have a show about all the non-winners, but it would take years to show them all.)

But what do lotteries have to do with investing?

Most people seem to invest with the same totally false sense of probabilities that apply to lotteries.

In investing the odds should be a LOT higher in favor of the investor.

Lotteries are definitely a negative sum game with (in the case of lot 649) about 48% of the “investment” siphoned off by costs and profits. Investing is a positive sum game. Investors buy pieces of corporations, which are on average profitable. Investors as a group, reap these profits less various trading and investment management costs. Those costs are substantial, but at the end of the day investors as a group, do make money (unlike lotto 649 players who collectively lose 48% of every dollar bet). As a group the total profits that investors make come from the customers of the corporations in which they buy shares and not from other investors.

Many or most investors seem to reject investing in blue-chips because they perceive the returns as low. Who cares about making 6 to 20% in a cable company when a tiny gold company might pay off at 1000%?

The problem is that quite often, the odds are that rather than making 1000% the investor is going to lose 100% by betting on risky penny stocks. Sure, some investors can become skilled at penny stocks. But I suspect most who play in that area get burned.

I believe that if investors properly understood the risks and probabilities then they would more often stick to safer blue-chip type stocks. The same features of human thinking that leads us to buy lottery tickets, also often leads investors to favor riskier stocks rather than safer stocks.

There are plenty of wise older folks around who have accumulated several million dollars or more by steadily investing in proven, profitable, dividend-paying stocks over a life time. In contrast penny stock millionaires seem to be notable for their absence.

Subscribe to Our Stock Picks

With RRSP season upon us, you may be looking for good Stock selection ideas.

Also you may want to consider some different stocks to replace any under-performing stocks or mutual funds that you own.

I’d like you to consider whether our Stock Rating Service might be of value to you.

Frankly, it’s not for everyone.

Most of our subscribers are mature and experienced investors. I don’t think our subscribers are looking for guarantees. As mature experienced investors, they tend to realize that there can be no guarantees in the stock market. But they are looking to improve their odds. They tend to think our track-record of handily beating the market indexes for seven straight years is probably a lot more than luck. They tend to like that we do the math and make stock ratings based on things like earnings and cash-flows and outlook. Our subscribers tend to believe that this is more logical than a system which simply invests (blindly) in whatever stock happened to go up the most last month.

If you are an investor who prefers penny stocks to blue-chip money-making corporations, then I wish you luck but I don’t think our Stock Picks will be of much interest to you.

If you do not have or are not prepared to open a self-directed investment account then our Stock Picks are probably of little use to you. If you are not prepared to do some thinking on your own and ultimately take responsibility for any investments you make, then our Stock Picks are not for you. (Like I said, there can be no guarantees in the stock market and if you are looking for guarantees then stocks are not for you and I would strongly prefer you not follow our Stock Ratings if you are looking for guarantees).

If you do have a more mature attitude toward stocks and are looking for Stock Picks with a great track record, then please consider subscribing today to our Stock Picks.

Our subscription price is $15 per month or $120 per year. The $120 per year option equates to $10 per month or just 33 cents per day. Further we offer a money-back guarantee on the subscription cost if you not satisfied with the stock research provided and if you request a cancellation and refund within three weeks of subscribing.

Bonus Offer

Subscribe for 1 year at a cost of $120 by Monday, January 22 and you will automatically have a chance to receive a full refund of your subscription price. 1 new subscriber during this period will be randomly selected to receive a full refund and therefore to receive free access to the Stock Picks for one year.

Income Trusts

Income Trusts were “invented” essentially as a way for certain businesses to distribute pre-tax income to investors. The Income Trust did not have to pay any income tax on its profits as long as it distributed the profits to investors.

In contrast, corporations pay income tax on profits whether they retain the profits or distribute them out as dividends.

Recently it was announced that Income Trusts will, starting in 2011, be treated like corporations and their net incomes will be taxed, whether they distribute that net income to investors or retain it for growth. My understanding is that the conservative government made this change because they viewed the favorable tax treatment of Income Trusts as a threat to income tax revenues and they felt it provided an inappropriate incentive for many corporations to become Income Trusts.

It was unfair that the government made this change after stating that it would not. That promise should never have been made. But I think the government was right to equalize the tax treatment between Trusts and corporations.

But maybe they should have simply allowed corporations to also claim dividends as a tax deduction. Corporations and Income Trusts both get to claim full deductions for interest paid to investors. So why not for dividend distributions? Historically, interest has been tax deductible and dividend payments have not been.

If all dividend distributions were made tax deductible to corporations then there would be less net income at the corporate level and more tax paid by individual investors.

This might be a very good system. All corporations would have an incentive to pay out most or all of their earnings as dividends. I believe that Income Trusts have demonstrated that a high dividend environment has a powerful motivating factor for management. Management is basically forced to constantly work hard to generate cash to pay dividends. When management wants new money they are forced to go to investors with a share issue and justify the need for the money.

It appears that Income Trusts have demonstrated that these incentives worked well. If all corporations were treated this way we might have a system where a lot less money would be wasted on over-priced corporate acquisitions or other questionable investments. This could be very good for our economy. Basically, all profits would be distributed out to investors and then corporate managers who wanted money to invest in new projects would need to convince investors to buy more shares to fund the new projects.

Would this “starve” corporations of needed money to invest and improve and grow their businesses? Yes, it would starve weaker companies who could not convince investors of the merits of their new investment proposals. But it would in no way starve better companies who could put solid investment projects in front of investors. Basically it would reallocate investment capital from weak companies, with poor opportunities, to strong companies with good opportunities. And this would be a very good thing indeed. This could have the potential of greatly improving the productivity and strength of Canadian companies, simply by reallocating capital to the best opportunities.

But there would be problems. The government would worry that net tax revenue would be lost because much of the dividends would land in RRSP, RESP and pension accounts where it would not be taxable until withdrawn, many years in the future.  This could be solved by making money in these accounts taxable to some degree. Pensions and RRSPs both enjoy tax full tax deferral (with upper limits) on contributions and also enjoy full exemption from taxation of gains within the accounts, until withdrawn. It seems to me that a small tax could be imposed on those gains if they are viewed as indirectly sheltering too much corporate income from taxation.

If corporate dividends paid out were tax deductible to corporations then we would likely see many corporations increase dividends to at least the full level of their earnings. At that point many corporations, like Income Trusts, would begin to trade in the market on a yield basis. This would further encourage corporations, again like Income Trusts, to distribute even more cash including depreciation cash flows. This could provide stability to stock prices. Corporations would be less likely to become either greatly under- or over-valued in the market since the distribution of cash would tend to set the market price to a large degree.

In summary, I believe the government should consider a system where instead of taxing income trust distributions they begin to make corporate dividend distributions tax deductible to corporations. This would greatly improve the allocation of capital in this Country. Capital would flow to where it should go, the companies with the best and most profitable investment opportunities.


Shawn Allen
InvestorsFriend Inc.

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