Newsletter June 5, 2004

InvestorsFriend Inc. Newsletter June 5, 2004

Should You be “in the market” at this time?

I really have no idea whether the market will rise or fall in the next six months. (And anyone who claims to know is probably dreaming). I attempt to pick individual stocks that will do well. Increasingly I have concentrated my own portfolio in high quality companies that I am reasonably certain will not only be around in 5 years time but will be making significantly higher earnings per share at that time. In all likelihood these stocks will be up quite significantly in the next five years. If these stocks should meanwhile fall 20% before ultimately rising, it’s really not that big of a deal. Psychologically, it is always easier if stocks never go down, but that is unrealistic. As long as I am confident in these stocks over the long-term I am not going to get too bothered by shorter-term moves.

So…for myself at least, I believe it is best to largely stay in the market. I will try to keep some money in cash to take advantage of future bargains, but I am still reasonably close to being fully invested in the market at this time.

I believe that the most serious risk to the market as a whole is a significant rise in long-term interest rates. Most of the analysis that I have seen on this indicates that interest rates are more likely to stay reasonably low.

Common Stocks and Uncommon Profits

I recently read a book called Common Stocks and Uncommon Profits and Other Writings which is a new edition of some older writing by Philip A. Fisher. Philip Fisher had a big influence on the investment style of Warren Buffett. I figure if the advice was good enough for Warren Buffett, the world’s most successful investor, then it is good enough for me.

Among other advice, Fisher emphasizes the idea of buying ONLY good quality companies with strong growth potential. But, he would buy those ONLY if they were available at a good or reasonable price. As for more ordinary companies, Fisher’s advice was not to buy them – at any price.

Although parts of this book were written in the late 50’s and the most recent parts are from around 1976, much of the advice is timeless. This book is well worth reading.

Fisher’s advice got me thinking about some of the characteristics of excellent businesses…

(Potentially) Fantastic Business Models

The sale of digital information has to be one of the most fantastic business models ever conceived of. Think about it, if you have digital information that people are willing to pay for, you can potentially sell the same information to thousands of people. Your incremental cost to create another copy of the information is approximately zero. Your incremental cost to deliver the information via the internet is approximately zero. Your incremental profit margin on each additional customer is approximately 100%.

I suppose this was part of the reason that investors thought the rules of finance were being re-written for the internet age. Never before has an incremental profit margin of 100% been a reality.

What kind of businesses am I talking about?

Software is one. Many software packages can now be purchased online. Once the company is set up, the profit on each extra sale can be very close to 100%. Microsoft uses this model. And even when the software is put on CDs and sold in stores, the profit margin on the wholesale price is still reasonably close to 100%.

Gambling and Porn sites are examples. Why do you think there are so many of those sites? It is because the profit potential is enormous.

Lately I just started to see a lot of on-line dating sites bombarding me with their SPAM. As long as they are charging for memberships these are another example.

Databases of information needed by business is another example. Thomson corporation and Reuters are increasingly moving to electronic distribution. Publishing of all kind has always had a high incremental profit margin on each extra sale, but electronic delivery can ratchet the profit margins up from a “mere” 50% to close to 100%.

But don’t get the idea that I am saying that all of these businesses are automatically profitable. Far from it. Many of these businesses require high start-up costs. The costs of acquiring new customers can also be significant. The companies may have high ongoing costs to produce the information. Often many thousands of customers are needed to reach the break-even point. But after that it is often “all gravy”. That’s why a lot of these type of businesses are hell-bent to “grow like stink”. It can be a case of “go big or stay home”.

Investors would be well advised to keep their eyes open for the chance to invest in some of these type of companies. Of course you want to be able to recognize the few that are going to be able to get big enough to reach well beyond their break-even points to reach the sweet spot where the high incremental profits become “all gravy”. Subscribers to my stock picks are aware of examples of this type of company trading on the TSX.

Wanted: Perpetual Cash Flow Machines

In the long-term, a company’s stock price will definitely rise over the years if it is producing steady reliable and growing cash flow that it can use to pay larger dividends or to grow its size. Everything else around this is essentially “noise”. Stocks can go up and down independently of cash flows for a while but eventually the stock price must reflect the true cash generation prospects.

The ideal business is something like the mythical goose that lays golden eggs. Ideally the goose predictably  lays a golden egg each day and the goose also grows each year and the golden eggs get bigger. Ideally the goose costs a pittance to feed and lives forever, so you are free to spend all the gold. But, in order to make a real fortune on the goose it has to fall into your hands at a low cost, far below its true value. Perhaps you buy a goose that appears ordinary and then it turns golden.

So what kind of investments and businesses look most like the golden goose?

Long-term bonds are a bit like that, except they don’t grow the cash flows and the returns are generally too low to be exciting.

High yield or junk bonds are closer since the return is higher but the problem is this type of goose is prone to dieing early.

Income Trusts can be a good cash flow machines. They offer high yields and also potential capital appreciation. Income Trusts distribute much of the operating cash flow (net income plus depreciation). The best ones will be those that can somehow grow or at least sustain themselves without requiring new capital spending.

Electronic commerce provides some opportunities to find cash flow machines. Credit card companies are eager to have you as a customer even if you pay your bill in full each month. For every dollar you spend the credit card company will receive a commission that is in the range of 1 to 3 cents. From that they have to cover the cost of borrowing to pay the merchant immediately while you will pay the credit card company some 30 days or so later. Ideally, you are a low-maintenance customer who never has any reason to contact the credit company and you pay your bill electronically. Even better, you run a credit card balance and pay the high interest rates but you always make at least the minimum payment. Basically, computers whir without human interaction and money flows to the credit card company electronically. Multiply this over thousands of customers spending say $1,000 monthly and you have a cash flow machine. This is why credit card companies are willing to spend a lot on advertising and direct mail to get you to sign up. After they get you as a customer you generate profits for them but little incremental cost.

And by-the-way, in case you think those credit card interest rates are unfairly high, think about the costs  and risks of serving deadbeat customers. Customers who become delinquent are unprofitable. These customers cause the company to issue letters and make phone calls to customers and generally incur costs. Ultimately if a customer goes bankrupt it takes a lot of other customers to make up for that. If you use credit cards as a loan and incur the high interest charges that is your choice. There is nothing unfair about it.

Cell-phones provide another cash flow business. Once their network is in place there is no incremental cost for a local phone call and on long-distance the only incremental cost is anything they have to share with another phone company. These companies routinely spend in the order of $500 in marketing costs to acquire each new customer. They do this because the profit margin of each customer is very high.

None of this means that all of these companies are good investments. That would depend on the stock price and the particular circumstances. But these types of businesses are good possible candidates to be good investments.

What is the opposite of a cash flow machine?

Some companies are cash sink holes. Money losers like Air Canada would be one example. Even some companies that make accounting profits can be cash sink holes. Some companies are constantly replacing their equipment. They may need heavy capital spending, not to grow but just to stay in business. At times it seemed that cable companies and telephone companies were in this category. Technology was changing so fast that all of the apparent profit was going to replace equipment and that was not to serve new customers but just to maintain service. Possibly, at this time that is no longer the case. This was part of the problem with Airlines. The depreciation allowance was often not big enough to cover the maintenance capital spending.

For a better understanding of cash flow see my in-depth article.

My Stock jumped 50%, should I sell or hold? (will it Keep going up?)

Momentum investors would say hold on until it starts to go back down. In this strategy a stop-loss order is placed perhaps 5% under the current price depending on the normal volatility level of the stock, and the stock is automatically sold if it drops more than 5% in order to limit losses.

Fundamental investors (like myself) would say it depends on the reasons that the stock jumped 50% (or whatever) and whether or not the price jump was justified.

If a stock jumped for reasons that are essentially a one-time event then its not that likely to keep climbing in the short term. For example, if the stock price jumped due to a buy-out offer or due to an announcement that it would convert into an Income Trust, then those are one-time events. Or if the stock price had been depressed for some reason like a patent dispute, or the departure of the President and then that gets resolved, that would be a one-time event.

Ideally, the stock price jumped because of increasing sales and profits. If that is the case and if there is good reason to think that the increasing sales and profits will continue into the future at a high rate then there is much more reason to think the stock price can keep rising.

In there end, there are no simple rules to tell you if you should take profits on stocks that have risen. It could be a stock that will continue to rise steadily for years or it could be one that will soon head back down. Digging into the reasons for the stock price rise and analyzing the future prospects of the company is the best way to determine what to do.

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