Newsletter June 4, 2003


Warren Buffett

More of what I learned from Warren Buffett on my recent trip to hear him speak at his annual meeting.

  • Accounting problems are still brewing – Pension and Post-retirement obligations of major companies are grossly understated.
  • Banks have been surprising profit generators with ROEs often over 20%
  • Warren likes businesses where he can invest large amounts at high returns. (They are rare and it is even more rare to find one for sale at a good price, but Warren is always on the look-out).
  • But even most good businesses that generate strong returns on the existing assets will not earn much on their incremental capital spending. (In this case Warren harvests the cash flow and invests it in a different business).
  • Never reward a manager on the basis of growing earnings unless he/she did it without also requiring a commensurate increase in capital employed. In looking at a President’s performance we first need to deduct a fair return on equity and then see if there are any excess earnings left that the manger should be rewarded for.
  • When you do find a really good low risk investment idea, go big, back up the truck!

Benjamin Graham:

Point 1: Warren Buffett is reported to be the second richest person in the world.

Point 2: He made all of his money through investing.

Point 3: He says that much of his methodology was learned from Benjamin Graham and that this method is laid out in Graham’s book – The Intelligent Investor.

Point 4: Although Graham is long dead, and his book was last updated in 1973, Warren still calls it the best investment book ever written.

Point 5: If you have not yet read that book, what are you waiting for!

Losers Lose and Winners Win:

With rare exception, that has been my experience in life, sports and investing. The top student from grade 10 is usually in the top few in grade 11. Last year’s top salesman is extremely unlikely to finish in the bottom half this year. Tiger Woods probably finishes first more often than second, when he has a chance, he tends to find a way to win. Similarly some companies seem to grow earnings year after year, in good times and bad. Loblaws is a good example. Power Financial is another.

On the other hand are those many people and those many companies that always seem to keep coming up short. I followed Hudson’s Bay for a while but the earnings always seemed to disappoint. Similarly TransAlta always seems to find a way to disappoint me. Mapleleaf Foods has been a similar disappointment. Typically these loser companies have lots of excuses be it 9-11, recession or now SARS. High profits always seem to be around the corner but seldom or never appear.

As always there are exceptions but a general rule is do not bet on turn-arounds, they seldom turn. You are often better off to pay a higher (but not outrageous) P/E multiple and go with a proven winner.

Speaking of loser companies…

Air Canada

In my opinion Air Canada has about a zero chance of emerging as a reasonably profitable company. After all, it will have the same executives, the same Board members and the same union staff that together managed to squander a near monopoly position and turn it into a bankruptcy situation.

Look at what they have now done:

The union members have (in desperation) taken a moderate wage cut and agreed to some substantial staff reductions. In effect the staff reductions amount to the older more senior workers sacrificing their younger co-workers (who of course have less seniority). They will likely end up with a bunch of tired and bitter, over-entitled, aging workers who will in no way  be able to compete with a West-Jet. (That is a cruel statement, and in many jobs age is a virtue, but I don’t think age combined with a pay-cut and a history of entitlement will be any virtue for Air Canada)

Many of the pilots will still be earning in the neighborhood of $200,000 per year, notwithstanding that hundreds of highly qualified younger pilots would be eager to do the job for a lot less.

I have not heard, but in all likelihood Air Canada will be limited to only the agreed upon layoffs. Once more their hands will be tied if they need to cut more staff. I was told in business school years ago that it was one thing to pay high wages to a union, but that it is absolutely death to agree to limitations on lay-offs. You then let the union control the company as has been the case for many years at Air Canada.

(Contrast this with the much smarter management at CN who just walked away from a deal to buy a railroad from the Ontario Government. The government wanted a no lay-off clause and CN rightly told them to shove off.)

The now smaller Air Canada will still have to support the pension. Pension plans are usually fine as long as the the number of active workers keeps growing a lot faster than the number of retirees. Once you turn that around and have fewer workers supporting more retirees the pension plan has a very difficult time dealing with any shortfalls (like a three year bear market!) and will absolutely suck every available dollar out of the company in that situation.

As I recall, the last time Air Canada was going to save a billion dollars was when they bought Canadian Airlines. Surprise, they never delivered!

In the midst of all their  troubles these idiots have started massive price wars. It does not take a genius to figure out that you cannot make money flying people half way across this country for fares like $200 one-way.

Fighting Sellers Remorse

Investors often hang on to stocks that have gone down when they would really like to sell. There are two main reasons for this.

First, most people really hate to realize a loss and will take a chance of losing lots more if there is even a glimmer of hope that the loss can be reversed. Most people are willing to essentially go “double or nothing” when they are facing a loss.

Second, most people worry that after they sell the stock, it will rise in price and then they will feel remorseful about selling (i.e. they don’t want too have to kick themselves in the Butt!).

Both reasons are based on human nature but are essentially illogical. We should not take bigger chances when we are in a losing position than when we are in a gain position. And we should not worry about what happens to a stock after we sell it. If we worried about every stock we sold and every stock we though about buying and didn’t, we would go crazy.

The way to battle all of this is to have some rules for your investing. Set out (preferably in writing) a rule that says when a stock is down and analysis indicates it is down for good reason and is not a stock you would buy now, then you will sell it. Then you follow your rule and sell it. Focus on the fact that this is a good decision. It may later turn out to have a bad outcome if the company’s fortunes turn around. But that does not change the fact that you made a good decision in selling the stock based on the facts you had.

Writing out rules about investing will help you consistently make more rational investment decisions rather than decisions based on emotions.

Quality of Earnings

My reports always comment on the quality of earnings. The reason is that not all earnings are equal. One-time earnings are not worth nearly as much as sustainable earnings. Some earnings are very conservatively stated in that items like research and development that are meant to benefit future periods are expensed. Other companies capitalize selling commissions and many other expenses that may turn out not to provide as much benefit in future as expected. These more aggressive policies create low quality non-cash earnings that often turn out to be phantom.

For more details see my Articles section and click on Useful Accounting Knowledge.

Foreign Exchange Losses

Canadian investors are going to get a painful lesson in the intricacies of foreign exchange losses and foreign exchange accounting in the next few months when the Q2 results come in.

Those invested in U.S. stocks have already seen directly the hit to values as our dollar rises. One major solace is that your position in U.S. dollars has not changed. If you plan to spend some of your retirement in the U.S., it is logical to have money in U.S. stocks and in that case you should not worry much about exchange rate fluctuations.

Even is you are invested strictly in Canadian stocks, you will see the impacts of our dollar’s dramatic rise.

Companies with assets in U.S. dollars may face a loss on exchange. For the most part this will not flow through the income statements immediately but may show as a separate component of retained earnings. (A nifty and legal way to hide a loss in value) Companies with revenues in U.S. dollars and costs in Canadian dollars will be hit quite hard. Companies with revenues and expenses in U.S. dollars will see a loss as the profit is converted to a lower number of Canadian dollars. Companies with debt in U.S, dollars will benefit. Some companies have recorded a gain on their U.S. debt while (under accounting rules) not being required to report an even bigger loss on the U.S. fixed assets. This may be another accounting debacle in the making.

Finally companies with expenses in U.S. dollars and revenues in Canadian dollars will benefit. (Does anybody, know some good examples?, if so let me know)

When the Canadian dollar was falling, it boosted the earnings of many Canadian companies and in some cases materially distorted upwards the growth rates. But this was not much talked about. Now that we are seeing the other side of the exchange rate coin, it is getting more attention.


Please let me know what you like or don’t like about this newsletter. My specific buys and sell ratings are only available to paid subscribers. My articles and this newsletter tend to focus on basic fundamental investing concepts and often with some thoughts on current business events and news. For feedback email:


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