Newsletter, January 26, 2002
UPDATES
Thanks to all the new members for joining.
Canadian National – Great company, I rate it a Buy but I would down-grade to weak buy if the price increases above the current level
Buhler Industries is updated – The company continues to grow slowly but steadily and offers a good dividend. I would consider buying if the stock price falls somewhat.
More updates are coming shortly as the 2001 year-end results start to pour in. (or is that poor in?)
At this time I am gathering information on several companies to add to this Site. The best rated picks from these will be offered for sale. I hope to combine 2 or 3 reports for sale at a reasonable price. I’ll let members know when this research is available.
Also I’m hoping to make my existing research reports accessible only to you the members of this Site via a password. This will still be free but under securities laws it is probably better for me to restrict access to my research.
P/E Ratio of the Dow Jones Industrial Average
Currently the P/E on the Dow Jones Industrial Average (“DJIA”) is 28.0 with the DJIA at 9,840. On June 29, 2001 the DJIA was 22.8 and the index was at 10,502.
Some commentators are alarmed that the P/E is too high at 28. It may be, but I think we need to look at why the P/E rose to 28 from 22.8. Normally when we think of the P/E of the DJIA rising it is because the market has risen while earnings have not kept pace. In that case a high P/E is definitely a cause for caution.
In the present case the DJIA actually fell but still the P/E has risen. The reason is that the earnings have fallen. I find this much less alarming. The earnings on the DJIA may fall temporarily but I believe that it is reasonable to assume that they will soon return to prior levels. That is, if the Dow companies in aggregate have achieved a certain level of earnings then they are likely to reach that level again soon. Currently we are in a recession and earnings have fallen. After the recession I would expect the Dow earnings to quickly return to their historic peak and then to grow from there.
The P/E of an individual stock or even an index should NEVER be relied on without first asking if the current earnings level is representative. For most companies it is better to use estimated future earnings or actual earnings adjusted for unusual items. For the Dow, current earnings are not representative because we are in recession. Therefore it is not appropriate to calculate the P/E using recession level earnings and then to conclude the Dow is over-valued.
The Dow may in fact be over-valued but that has to calculated using normal, non-recession earnings. I will address that calculation next newsletter.
Consider the TSE 300, its P/E is actually negative and therefore cannot be used as a guide to whether the TSE is over-valued. I have updated my article on the TSE 300 valuation. This article is rather mathematical but may prove insightful if you are interested in the math.
HOW TO IDENTIFY AN ATTRACTIVE INDUSTRY SEGMENT
Consider the question of why some business types have very high failure rates and others have low failure rates.
Most people realize that when an independent restaurant opens it has a high chance of failure. Similarly independent clothing stores are highly likely to fail. On the other hand some independent business do well. Examples include independent gift shops and hotels in a tourist town, Independent professional offices (dentists, lawyers, doctors), Independent bars. And most chain stores and services thrive.
The question arises, Is there some way to identify unattractive industries that have a high rate of failure, so that as investors we can keep away from them?
Michael Porter of Harvard University has developed a screen that can help identify unattractive and attractive industries. There will always be exceptions to the screen but in general it does a good job.
In order to be a attractive an industry should possess 4 or 5 of the following 5 characteristics.
1. There should be barriers to entry – If anyone can easily open a business and compete with you, it will be hard to make a good profit. For example house painters must compete with every laid off tradesman who decides he can be a painter too – there is no license required. In contrast the local dentist is protected by the fact that strict training is required and there are only a limited number of spaces at the schools.
2. No powerful suppliers – If an industry is overly dependent on a key supplier then the supplier rather than the industry may garner most of the profit that would otherwise be available in the industry. An example would be an industry which has given up too much power to a powerful trade union. Hockey is an example. Negotiating individually, it is not likely that the players would be taking all of the profits. However, the bargaining system seems to favor the players who are often paid millions while their employers (the teams) usually lose money.
3. No powerful customers – If you are a car parts manufacturer and you happen to sell only to GM, then GM has an enormous amount of power over you and can insure that your profit level is meager. Some commodity chemicals manufacturers face this problem, there are only a very limited number of purchasers for their product.
4. Few or no substitute products – One of the problems that a restaurant faces is that customers have not only the choice of other restaurants but also the choice of eating at home. Meat processors like Maple Leaf face the problem that if meat prices are high, then customers can consume significantly less meat and substitute with hundreds of other food products.
5. Limited Tendency to Compete on Price – Industries that produce commodities or that have heavy fixed costs are notorious for competing on price to the point where most companies are losing money. Airlines and Steel are examples. Other industries such as cosmetics and pharmaceuticals do not tend to compete on price.
I have applied this powerful but simple screen to many industries. It has helped me to understand why some industries are winners and will likely keep on winning. It also helped me to understand why Airlines and Steel companies are (on average) likely to offer mediocre returns at best.
Admittedly the screen is subjective, for example barriers to entry are never total and price competition is usually present to at least some degree. Still, the above screen provides a useful way to think about whether or not an industry segment seems to be attractive or not.
Note that screen can and should also be used if you are considering purchasing or opening any type of business. It would be wise to stay away from industry segments that seem to fail 1 or more of Porter’s requirements for a good industry.
Death of the Family Farm
As a practical example I can apply the above screen to the Farming Industry. Consider commodity farms (wheat, potatoes, dairy, chickens, eggs, pork, beef).
In the absence of government quotas there are no barriers to entry (Strike 1). These commodity producers are forced to sell at a market price determined by competing on price (Strike 2). The consumer can usually select from many substitute food products (Strike 3). It’s pretty clear that on this basis farming is an unattractive industry. In this situation only the most cost effective farmer is likely to make a reasonable profit. And that would usually be the corporate factory farm, not the family farm.
The family farm survives in Canada because of subsidies, food import restrictions and various government quota and price fixing schemes. Fundamentally, the family farm is an inefficient producer in an fundamentally unattractive industry. Bleating about the need for food self sufficiency or the cultural need to save the farming life style does not change these facts. Economics, unfortunately dooms the family farm in the long run. The reasons become clear by applying Michael Porter’s simple but powerful screen of industry attractiveness.
I mean no disrespect to the hard working farm families of this country. But my conclusion is that they are in a very tough industry. I suspect that few of them would argue that point.
Of course a few niche family farms will survive by finding ways to compete on a basis other than price.
The Canadian Loonie
The funny thing about the massive decline in our dollar is how painless it has been to most of us. If our dollar is worth less, our prices should be rising. We should be feeling the pain of higher priced imports. But strangely our inflation has been lower than U.S. inflation.
In terms of purchasing power I am told that our dollar purchases here, what 80 cents purchases in the U.S. This suggests that our dollar should be at 80 cents. Americans should be flocking across our borders to buy here. Indeed our exports are doing very well. Based on the exchange rate, cars and everything else in Canada should cost about (1/0.62) = 61% more in Canadian dollars than they do in the U.S. in their dollar. But this is not the case, we may be paying 25% more, but not 61%. In fact I understand that it is possible to purchase a car in Canada and then sell it to a dealer in the U.S. at a substantial profit.
This situation cannot be sustained. I believe that one of two things must happen. Either the Canadian dollar must rise above 70 cents or purchasing power parity must be restored through massive price inflation in Canada.
I have been waiting for the dollar to rise for many years. Now there is talk of us converting to the U.S. dollar. If that happens our savings will be converted to U.S. dollars and our pay checks as well. My fear and expectation is that prices would fall but not by the 38% or so that would be needed to keep us whole (and which would result in cars and most everything else continuing to be cheaper in this country) but rather will decline by only about 20% so that prices are about equal to U.S. prices. Our standard of living would then clearly fall. (38% cut in wages, 20% drop in prices = 18% decline in spending power.)
The bottom line is that Canadians would be well advised to begin accumulating U.S. dollar assets in order to protect themselves from the potential impact of adopting the U.S. dollar.
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Regards and thanks for your interest,
Shawn Allen
Editor
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