Newsletter July 6, 2008

InvestorsFriend Inc. Newsletter July 6, 2008

Stock Price Declines – Problem or Opportunity?

Prices for Many Canadian Stocks have declined by 20% or more since the start of 2008. (Examples Canadian Tire down 29%, TSX Group down 26%, Stantec (engineering) down 36%. These have all been very strong performers over the past few years. They are also solid profitable companies and may have been considered by many to be lower risk.

For those who bought these stocks at or near the peak, such declines certainly are a problem (at least temporarily). Even for those who bought at much lower prices it is a problem because no one likes to see their stock market gains evaporate.

However, for those with money to invest now, this may be an excellent opportunity to buy. However, whether these stocks are at bargain levels requires analysis to determine if these stocks are under-valued in relation to their probable future earnings.

Investors always tend to feel better about investing after stocks and the market in general has risen over a period of months or years. And they feel uncomfortable investing when stocks and/or the market are down. Logically we know we should buy low and sell high, but often our emotions lead us to do the opposite.

In buying now, the fear is that stocks and the general market could fall further. That is certainly possible. The recession seems to be increasingly taking hold in the U.S. Announcements of job losses are mounting. However, at some point the general
market will reach a bottom and then recover. A reasonable strategy for new investors is to invest gradually over a period of months. An alternative strategy of waiting to see the bottom could be foiled, as often by the time a bottom has been recognized the market has moved up over 10% and the investor may then be reluctant to invest and instead waits for another lower bottom, that may never come.

At times when stocks are down, it is a good idea to remember that good companies are still making money. If you buy shares in profitable, well managed companies that you understand and where you can be confident that profits will continue to rise over the years, then you will do well. For these type of companies a share price decline is an opportunity.

Buying Companies at Book Value

One of the ratios that I like to look at is Price to Book Value. Many analysts ignore this ratio. I agree it is often meaningless. Most companies tend to trade above book value because of a combination of conservative accounting and high returns on book equity.

Regarding conservative accounting, book value is (arguably artificially) reduced when expenses like research and development and certain business start-up costs are expensed even though they may provide benefits for many years. Inflation can cause assets such as land to be vastly under-stated in financial statements. Intangible assets like the value of a customer list that has been paid for in an acquisition may be amortised even though in reality the value of the customer list may be constantly increasing.

The end result is that a price to book value ratio of 3 times is often no cause to suggest the price is too high and even a value of 10 times book or more may be justifiable.

And not every company that sells under book value is a bargain. These are often companies that are losing money.

Where I get particularly interested is where a company with a good history of profitability is available at or around book value. With the recent decline in stock prices for many companies, there are now a lot more companies that are selling for around book value. Although further investigation is needed, these can be excellent investments.

Tax Free Investment Account

When the government gives an incentive for investing, it usually makes sense to take advantage of that. This is why a large number of Canadians tend to “max out” their RRSP contributions each year and, if applicable, their Registered Education Savings Plans. Many investors will borrow money to max these out since the government incentives make it attractive.

Canadians will have a new incentive to invest starting in 2009. Each adult will be allowed to contribute $5000 per year to a Tax Free Investment Account. There will be no tax deduction for the initial investment. Like RRSPs and RESPs there is no tax paid on interest and dividend income or on capital gains made while the money is in the plan. This adds to the ability to accumulate wealth free of taxes. A big (and unique) advantage of the new Tax Free Investment Account will be that when money is withdrawn it is not taxable.

Investors will need to start planning soon to take advantage of this new opportunity in early 2009. For some investors it may make sense to stop contributing to RRSPs and instead contribute to a Tax Free Savings Account.

I expect that the major Canadian banks will have information available on these plans around the end of 2008.

BCE Sale to Proceed

The biggest stock market story of the week in Canada was that the huge BCE sale would proceed.

BCE shares jumped 12.8% on Friday to close at CAN $39.64

The deal is now expected to close on December 11. No further dividends will be paid to existing BCE shareholders. The shares should not be expected to trade at the purchase price of $42.75 because investors who might buy now at $42.75 would not earn any return on their money. A reasonable price for BCE now would allow for say a 5% return (about 10% annualized). This price would be $40.71. And it may trade a little lower than that due to the risk that the deal could still somehow be scuttled or delayed. Or it may trade higher than that if investors conclude that the risk of delay (or worse) is small. $41.50 would allow a 3% return during the five months to December 11.

Since the deal was announced over one year ago the shares have bounced around wildly from as high as $41.76 to as low as $31.80 in the past year.

“Original” BCE shareholders who owned the stock before the company was put up for sale will have made a good return in the past 14 months or. They have collected dividends and will (it appears) ultimately collect their $42.75 on December 11.

All of the stock trading that has taken place over that period has been a zero-sum game. Certainly some investors who bought recently have made excellent returns. These returns came at the expense of shareholders who sold and and who have missed the opportunity to collect the $42.75. Meanwhile brokers and the TSX Stock exchange have collected a tidy fortune in risk-free fees from all the frantic trading that went on.

The opportunity to buy BCE shares at a large discount is over. However Bell Canada bonds are trading at a significant discount due to higher risk caused by the new borrowing that BCE will do when the new owners take over on December 11. If the new owners can sell assets and increase profits and generally reduce debt, then these bonds may experience an attractive capital gain. One bond specialist has suggested that the ideal time to buy Bell Canada bonds may be around December 11.

Understanding the Canadian Economy

Our article on the Canadian Economy is updated. This short article gives you figures for the percentage that various industries contribute to the country’s GDP. For example, it may surprise you to learn that the biggest contributor to GDP is not related to energy or resources. In fact Mining and Oil and Gas extraction combined are one item and are well down the list of contributors to GDP.

Our article also shows you a breakdown of what Canada imports, what it exports and which countries are important trading partners. The results are surprising.


Shawn Allen, President
InvestorsFriend Inc.

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