Newsletter January 6, 2008

InvestorsFriend Inc. Newsletter January 6, 2008

Market Outlook for 2008

Stock markets are always unpredictable in the short term. However, as we enter 2008 there are reasons to worry that stocks on average will fall this year. There is the fact that the U.S. is probably in a recession or slow-down caused in part by declining house prices and tightened lending practices and made worse by high energy prices. There are the massive losses sustained by banks and many other companies due to defaults on sub-prime loans. There is the fact that corporate profits as a percentage of GDP have been at record levels and could easily trend back down even as the economy grows. And there is the fact that markets have had higher-than-average gains over the past five years. Over the long term, markets simply don’t go up every year. And periods of above-average market gains tend to be followed by periods of below-average market gains.

In Canada many companies face unique challenges. The sharp rise in the Canadian dollar is a “game-changer” for many manufacturers and producers. Exporters that were nicely profitable when a sale of U.S. $1.00 paid a Canadian $1.40 worth of wages and rent and utilities and property taxes, may be bankrupted when that same U.S. $1.00 suddenly pays only a CAN $1.00 worth of expenses. Similar scenarios apply for forestry and hog producers and many other exporters. This change in the currency alone is an absolutely devastating change for some businesses. Talk of “adjusting” to this is nonsense. Many businesses will simply go bankrupt if the Canadian dollar stays high. There will simply be no way to adjust to a huge drop in revenues while costs remain constant or rising.

Offsetting this is that fact the Price/ earnings ratios of the markets are much lower than they were a few years again. On this basis many stocks look reasonably priced. And policy makers are rushing to lower interest rates and do other things to support the economy. Perhaps this will succeed in keeping most stock prices from falling.

We also know that over the long term corporations and market values, on average, are going to continue to grow. Stock investors do well over the long term. But 2008 appears to be a year for caution and a year that may test our patience.

It is a cliché, but in times like this it pays to be selective and to invest in better quality companies. Stocks that have been driven by hype and speculation are likely to be hit harder than stocks that are reasonably priced based on their proven earnings ability.

Wanted – Affordable companies that will grow like snowballs

Imagine if you could invest in a company that would reliably grow its earnings per share at attractive rates for many years into the future. If a company can, for example, double its earnings every 5 to 7 years, then over a period of years that is likely to be a very good investment – as long as you did not over-pay for the shares in the beginning.

There are many examples from the past of companies that have grown steadily in size and earnings like snowballs rolling down a slope. Well-know U.S. examples that quickly come to mind include McDonalds, Star-Bucks, Costco, Microsoft, Dell, Fed-Ex, Costco, Wal-Mart, and Home Depot. In Canada, examples include Tim Hortons, Canadian Tire, Manulife, Rogers Communications and all of our large Banks.

While the earnings of these examples have grown in a generally steady fashion for many years, the stock prices tend to be much more volatile. If the market anticipates that a company will grow earnings at a high rate then its stock price will soar. In effect what happens is that investors are paying in advance for future expected growth. If the growth turns out to be lower-than-expected then the stock price can drop even while earnings continue to grow. This is why stock prices of companies with growing profits often tend to be far more volatile than their earnings levels over the years.

Companies that can grow earnings like snowballs will often be great investments. But not if the stock price requires you to pay in advance for most of all of the reasonably expected growth.

An excellent investment would be a company that can reasonably be expected to grow its earnings per share like a snowball for at least ten years and yet which is available at a reasonable price / earnings multiple today. Companies like this are rare but they do exist.

Stupid Banker Tricks

In 2007 we learned that many U.S. Banks had been lending money with incredible stupidity.

Banking is often a wonderful business. Taking money in one door and paying 3% interest on it and then lending that same money out the other door at 6% can clearly be a good business – as long as the borrowers pay it back. Even though the profit after all expenses might be only around 1% that is an excellent return because the bank earns 1% on someone else’s money.

Banking can be risky as well. One deadbeat borrower that defaults on 100% of their loan amount can wipe out all the profit on 50 or a 100 similar loans. The biggest key in banking therefore is to avoid lending to bad credit risks.

However, in recent years banks set up a scenario that guaranteed that they would eventually have lots of bad debt.

Banks began to lend mortgage money to people who clearly could not afford the payments. It boggles the mind that there was even an official class of mortgage loans called “no doc.” where it was official policy to not document that the borrower had the income he or she claimed. Mortgages were given based on “stated income” with no attempt to document that the income was real. These were known in the banking industry as “liar loans”. Imagine it, the banks had a class of mortgage loans known as liar loans and now they are surprised when these people don’t pay.

Equally stupid was the practice of giving mortgages with artificially low interest rates in the first few years, that would then re-set to higher interest rates within a few years. Borrowers who could not afford normal interest rates were allowed to pay discounted interest rates for a few years but were magically supposed to be able to afford higher-than-normal interest rates after a few years. It should have been completely predictable that many of these borrowers would default when the higher interest rates started to apply.

Banks were fooled by surprisingly low mortgage default rates since about 2001. What happened was that as housing prices soared very few people defaulted on their mortgages. People who had difficulty with their payments were able to borrow additional money based on the rise in the value of their house. Borrowers with substantial equity in their houses tend not to default on their mortgages. Instead they sell the house or they borrow to make the payments.

I believe that the banking industry in the U.S. and in Canada has trained people to borrow new money to repay old loans. People were bombarded with offers of home-equity loans and credit cards. If you miss a couple payments on a loan, the bank knows something is wrong and starts harassing you for the money. But if you lose your job and borrow on a credit card to make the mortgage payment and then take out a new credit card to pay the first credit card, the banking industry will probably INCREASE your credit rating and offer you even more loans. People quickly learned that borrowing to make loan payments was the path of least resistance.

In this easy-credit world, banks lost their early-warning system. By the time the average borrower had exhausted all their sources of credit, they were not just a little behind on a couple of loans. Instead they were massively in debt and about to declare bankruptcy.

When house prices recently started to drop, many borrowers had no equity in their homes and began to default in droves. With no equity, the logical thing to do was to let the bank take the house.

Previously, the easy money system created a virtuous cycle where home prices trended ever upwards because banks made it easier and easier to borrow large amounts, making it easier to afford more expensive homes. But now, a vicious cycle is in place. House prices are falling causing mortgage defaults. In turn, banks are making it harder to borrow money, which means fewer buyers and which drives house prices down, which depletes the equity of ever more homeowners, which causes more defaults.

It is not a pretty picture. It is going take several years for this to work out.

Conrad Black

Conrad Black has been found guilty in the United States of fraud and obstruction of justice and sentenced to over six years in prison.

The essence of the crime was that when publicly traded companies (Hollinger Inc. and Hollinger International) controlled by Black sold newspaper properties, Conrad Black and others personally collected non-compete fees which amounted to diverting some of the proceeds from the newspaper sales from shareholders to themselves.

Black deserved the guilty verdict and the jail time.

But there are many ironies.

The biggest irony is that Conrad Black could easily and legally have collected the same money by simply having Hollinger pay him the money as bonuses rather than paying the money as non-compete payments. They structured the payments as non-compete payments because for mysterious reasons those were not subject to income tax. This turns out to be a very expensive way to avoid taxes.

It is also ironic that in regards to most of the non-compete payments, Black was found not-guilty. It was only three of the more “tortured” cases where Black was found guilty. In some or all of those cases the purchaser of the newspaper did not want to pay any non-compete payment but Black and company insisted that some of the purchase price be allocated that way.

I believe what Black finds so hard to accept is that he is going to jail for taking money that properly should have gone to shareholders. But as Black knows that is normally completely legal. There is usually NOTHING illegal about paying out huge bonuses. Even the non-compete payments are usually completely legal. It may be immoral and wrong to loot companies for the personal gain of executives but the fact is that most of the time it is completely legal.

One of the factors that I always look at in evaluating a company is the size of the executive compensation. If the executives are taking obscenely large salaries and bonuses and stock options then I am very hesitant to invest. These huge payments are normally completely legal but they tell me that the management and the Board of directors have little respect for ordinary shareholders. I simply don’t trust companies that pay out what I consider to be obscene compensation. Therefore, legal or illegal, I likely never would have been an investor in Conrad Black’s companies.

But I am not vindictive toward him.

Another irony in this whole situation is that shareholders would have been much better off if Conrad Black was never charged or pushed out. The large non-compete and bonus payments that he took are nothing in comparison to what the companies have paid to pursue him in the courts. It is obscene and should be criminal that literally hundreds of millions were spent by his former companies in pursuing him. I am not suggesting that he should have been allowed to get away with criminal activity. I simply point out that it is ironic that shareholders are much the poorer for having pursued the matter.

I consider Black as now worthy of some sympathy. He has already lost hundreds of millions but was found guilty of improper payments in the $6 million range. He faces a much longer time in jail because he cannot serve his sentence in Canada. This is because he gave up his Canadian citizenship.

In my view he gave up his citizenship only because Jean Chrétien for inexplicable reasons refused to allow the United Kingdom to make him a Lord while he was still a Canadian. I do not think Canada should be in the business of preventing its citizens from being honored by another country. In my view Chrétien’s actions were despicable and personally motivated and Canada should right that wrong and restore Black’s citizenship.

Black did wrong, but I don’t believe in being smug and vindictive in this case. The man has been and will be punished quite brutally with loss of fortune, reputation and soon freedom. In my view, it is mean-spirited for people to now continue to kick at him and deny him things such as Canadian citizenship.


For those investors who are looking for thoughtful analysis of stocks, and who also realize that there can be no guarantees in the stock marker, we offer a subscription service. The cost is CAN $15 per month or $120 per year. For this price we share the results of many many hours of analysis.


Shawn Allen, President
InvestorsFriend Inc.

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