Newsletter June 9, 2006

InvestorsFriend Inc. Newsletter June 09, 2006

This issue of the newsletter takes a look at important current areas of market concern including thoughts on what to do in a market decline, investment implications of the high Canadian dollar and of higher interest rates, a suggestion that gasoline taxes should be raised, a comment on West Jet and our latest performance figures.

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The High Canadian Dollar.

Our dollar has now risen to about 91 cents U.S. so it now takes about CAN $1.10 to buy a U.S. dollar. This is a HUGE increase in the value of our dollar. For a number of years our dollar had hovered around the 68 cent mark or CAN $1.47 to buy a U.S. dollar. (Our dollar has trended up against other international currencies as well but I focus here mostly on the U.S. dollar)

It’s interesting to think about some of the implications of the higher dollar. And particularly some implications that are not being talked about in the media.

Firstly, I would point out that for the mythical “average Canadian” there is actually not a lot of impact from the higher dollar, just as there was not a lot of impact when our dollar fell through the 80’s and 90’s. For example imagine a government employee who seldom or never vacations outside of Canada. Despite huge volatility in our dollar, the consumer price index has risen at a low and stable rate over the past two decades. Therefore on average for a person who’s income did not change with the exchange rate (the vast majority of Canadians) and who spends almost all their money in Canada (the great majority of us) there simply is very little impact as our dollar changes in value. Oh sure, the prices of some goods from outside Canada do change with the dollar, but the overall impact on the consumer price index was very little.

For Canadian companies that face costs in Canadian dollars but get a lot of revenue from the U.S., the impact is huge – and negative. Imagine a company with a 15% profit margin on U.S. sales when the dollar was 68 cents. If their cost was $1.25 Canadian and they sold at U.S. $1.00, that was $1.47 Canadian for a 15% profit. Assuming the competitive price in the U.S. today is still U.S. $1.00r, then today that is $1.10 Canadian, which is a 12% loss on the same cost of CAN $1.25. This is a HUGE negative impact. The conventional wisdom seems to be that these companies will adjust to our higher dollar. I wonder how any company can simply “adjust” to a 25% fall in revenues simply due to the currency impact. It’s also essentially a myth that they can hedge against this. Sure, a few companies might have hedged for a number of months. But there is no way that very many companies would have or could have hedged for more than 2 years or so. The bottom line – Canadian companies with costs in Canada and revenue in the U.S. are mostly hurting big time. There will be many lay-offs and bankruptcies. All else being equal, most such companies will likely be poor investments at this time.

Canadian companies that have operations with both costs and revenues in the U.S. will be only minimally affected. This could lead to repatriated profits being worth say 25% less than they were when our dollar was 68 cents. But that sure beats the situation in the paragraph above.

Those few companies that have revenues in Canada and costs outside of Canada are benefiting. One beneficiary is retailers. For example Canadian Tire can lower prices on many imported goods and still make higher profits. All else being equal, most such companies may offer good investment returns.

Canadian Tourist industries could suffer greatly. Americans who found us a huge bargain at 68 cents will be far less likely to visit Canada at 91 cents. When you consider that our prices are generally higher than in the U.S. and particularly for gasoline, Canada will not be a destination of choice for Americans. They will simply stay home. Combine this with the pending requirement that Americans have passports (or some similar new document) to leave and re-enter their county as of January 2008 and you have the makings of a real disaster for tourism in Canada by 2008, if not this summer. All else being equal, Canadian tourism operations may be poor investments at this time.

Interest Rates and their Implications

Stock investors should be aware that movements in interest rates are an extremely important factor regarding the returns from stocks as well as bonds. When long-term interest rates fell dramatically from about 1981 to about 2002, this added tremendously to the return from stocks and bonds. Unfortunately, the reverse would be true if long-term interest rates were to rise substantially.

As almost everyone knows, short term interest rates have risen quite dramatically in the past few years. What is less well known is that long-term interest rates had been flat or even continued to decline over much of that period and only recently started to move up.

Generally it is the 10-year bond yield that has the most impact on stock and real estate prices since stocks and real estate effectively compete with such longer term bonds for investors funds.

Here are some historical figures on 1-year and on 10-year United States government bond yields (interest rates) (United States interest rates tend to affect Canadian interest rates and stock prices as well).

Year 1-year rate % 10-year rate %
2003 January 1 1.42 4.07
2004 January 1 1.31 4.38
2005 January 1 2.79 4.23
2006 January 1 4.38 4.37
2006 June 9 5.05 4.98


The above table is yearly data and so it obscures the volatility that occurred within years. But the table clearly shows that short-term interest rates have moved up very dramatically. Meanwhile 10-year rates have moved up only very moderately and in fact remain at low levels compared to the past 40 years.

For stock investors the 10-year yield is the most important. All else being equal, a higher 10-year interest rate drives down the price of all stocks. However, since the 10-year rate has really not moved up very much, investors should be perhaps concerned but certainly not panicked. As of June 9, 2006 the Dow Jones Industrial Average had a trailing P/E of 17.3. That equates to an “earnings yield” of 5.78%. Given that stock earnings tend to rise over time (while yields on a given bond are fixed), a 5.78% earnings yield on stocks seems competitive with a 4.98% yield on 10-year government bonds. Over the past few years the P/E ratio on stocks has been declining because earnings were rising faster than stock prices. The result is that stock prices appear to be competitive with bond yields at this time. Based on this, the current 5% 10-year interest rate is certainly not  cause for panic.

Right now the “yield curve” or interest rates for various periods from 1 day to 30 years is extremely flat to slightly inverted. Investors in United States government bonds are basically willing to accept approximately the same 5% to invest for anywhere from about 6 months to 30 years.

There are several implications of this. Investors usually require higher rates to lock up their money for longer periods. It appears that these bond investors expect interest rates to fall in the future. That is why they are willing to accept only 5% on a 10-year investment at this time – they fear that in a year or so the 10-year rate will be lower than 5% so they grab the 5% now. Interest rates usually fall when the economy is slowing down. Therefore it appears that these bond investors are expecting a recession. These investors appear not to be expecting much inflation in the long term. They would not tie up their money for 30 years at 5% if they expected much inflation.

This scenario, apparently predicted by bond investors, would be bad in the short term for stocks but probably good in the long term. In a recession corporate profits would fall and so would stock prices. However, the subsequent recovery and low interest rates would boost the stock market.

Overall, interest rates are giving a mixed signal regarding the attractiveness of stocks. The current P/E ratio on stocks is reasonable compared to the 10-year bond rate, suggesting stocks are a reasonable investment. On the other hand the bond market appears to be predicting a recession which would hurt earnings and stock prices.

What to do in a Market Decline?

Over the past several weeks the TSX market has been declining, although in a volatile fashion with several strong days mixed in with the more numerous bad days. It is down about 7.6% to 11,391 since its close of 12,328 on May 9.

Let’s face it, most investors with money in Canadian stocks are quite worried that the slide might continue and might get a lot worse.

It’s impossible to know for sure if the market is headed for a prolonged slide or will instead soon reverse course and begin rising once again.

It may be instructive to review some recent history. In the past five years, the TSX moved mostly sideways and substantially down from the 8000 level in mid-2001 to under 6000 around October 2003. Since then it more than doubled to about 12,000 by May this year. Even after the recent slide, the TSX market index on June 8, 2006 at 11415 was 100.0% higher than its close on October 9, 2002 of 5695.

Selling stocks right now, because of the recent 7.6% dip, might or might not turn out to be a wise move. But it is instructive to note that on its way from 5,700 to about 12,000, the market had at least three dips that were larger than the current dip (so far). Most recently in October 2005, the TSX dipped  7.9%. From March 1 to May 17, the market dropped 8.5%. And from Jan 16 to Mar 12, 2003, the TSX market dropped 8.8%. Anyone who sold on any of those dips probably missed out on much of the 100% market gains that occurred since October 2002.

On the other hand, of course anyone who sold when the TSX market started dropping from its peaks in September 2000 and was smart enough to stay out until precisely the fall of 2002 would have done extremely well.

The point is that it is impossible to know if any market dip will be minor and temporary or instead will turn into something ugly.

I think it is reasonably safe to say that 2006 will not turn into a huge decline such as the one that began in 2000. Back in 2000 the TSX was over-valued with an average P/E ratio well above 30 and a dividend yield around 1%. Now the TSX P/E ratio is a much more reasonable 17.8 and the dividend yield is 2.5%. This P/E ratio is not low by historical standards, but neither is it high, especially considering that interest rates are still low. Corporate profits are high and apparently still increasing. If markets are going to fall substantially from here, that would seem to imply that corporate profits are also going to fall substantially or that long-term interest rates are going to rise substantially. That could happen, but there appear to be few signs of either such event.

At the end of the day, the decision to get out of the market or to stay in, is a personal one and depends on a host of personal circumstances. There are risks of staying in the market and there are risks of getting out. History shows that staying in works out well in the long-run, but it it can be a bumpy ride. And of course a successful market timer can beat a buy-and-hold strategy (however, such persons seem to be extremely rare).

In a Market Decline, think Like  a Business Owner

As a stock investor you would be wise to think of yourself as a part owner of various businesses rather than merely an owner of essentially pieces of paper called “stocks”.

Most stock investors are currently worried about the value of their holdings. At this time it may be instructive to think about how the owners of (private non-trading) businesses might be reacting in the current environment.

As you can imagine the market price of private businesses tends to cycle up and down just as does the price for stocks and real estate. At one point in time business might be selling for 10 times earnings and at another time might sell for 15 times earnings on average. Generally speaking such price fluctuations are less pronounced than stock fluctuations. But they do occur. Recently the prices paid for most businesses may have reached a cyclic peak and there is a risk such prices will fall.

Most of the owners of the successful businesses in your town or City are probably not very concerned that the market value of their business may have dropped somewhat due to (moderately) higher long-term interest rates or the (probably faint) signs of recession ahead. For one thing, such drops are not likely apparent to them. They can not look up the market value of their businesses ten times a day like stock owners can. These business owners are probably focused on their revenues and profits and not on the market values of their businesses.

If this is the case, and if as a stock owner you think of yourself as a business owner, then maybe you should spend less time looking at the market value of each of your stocks and more time looking at the earnings and revenue per share of each stock you own.

This is not to say that you should ignore the market value of your shares. But if you are a long-term investor and not a day-trader then you can probably become less uncomfortable about stock price declines as long as you are confident that the under-lying business is sound and that the stock is priced reasonably in relation to its current earnings, interest rates, and probable future earnings stream.

Gasoline Taxes – Should they be higher?

Most people would instinctively argue that gasoline taxes should be lower.

I suppose we would all like all prices and taxes in the economy to be lower while our own incomes remain the same or rise. But that is simply not realistic.

Gasoline taxes should be viewed by the public and by governments as a “user fee” rather than simply a tax.

In a free market, prices tend to arrive at the “correct” level – whether we like it or not. To the extent possible, government user fees should also be set at the “correct” level.

When we drive our vehicles we “use” roads and we add to pollution in the air. It seems to me that gasoline taxes are almost an ideal way to pay for roads and to pay the cost of dealing with vehicle pollution. It seems quite illogical to pay for roads out of property and income taxes. Roads (like food, clothing, shelter, and even hockey tickets and beer) should be paid for by users and a gasoline tax is an extremely easy way to make that happen. The more you drive the more you pay… Drive a heavy polluting and road busting vehicle and you pay more… you should pay a “fully compensatory” amount just as you do at the grocery store.

Unfortunately at this time, gasoline taxes go into general government revenues.

My view is that gasoline taxes should go 100% into the cost of roads (including even the cost of the government departments that look after roads). Conventional wisdom has it that the amount we pay in gasoline taxes far exceeds the amount spend on roads. But when I hear about single interchanges that cost $50 million, I find it hard to believe that current gasoline taxes would cover the full and total costs of all municipal, and provincial roads, let alone the cost of dealing with vehicle pollution.

In Alberta, which is a rich and generally free enterprise province it is farcical that drivers essentially have to beg politicians for improved roads – and wait many years for action – when a higher gasoline tax is an obvious user-pay solution (and toll roads is another).

Free markets are good and generally increase the standard of living for almost all members of society. To the extent that government services can be raised by user fees, that is closer to a free market solution and will generally be a good thing.

In summary, gasoline taxes should be set at whatever level is required to pay the full capital and operating and administration costs of all roads and to deal with vehicle pollution. Correspondingly, all federal and provincial gasoline taxes should be dedicated solely to these purposes. I suspect this would cause gasoline taxes to rise (and other taxes could be and should be then reduced accordingly). However, gasoline taxes would then be at the “correct” level and the spending on roads would also be at the “correct” level. If the average driver found the tax too high, he or she would reduce their driving leading to less congestion on roads and less need for spending on roads and less money for spending on roads. Or if driving was not reduced then the extra money would pay for better roads. Basically a free-market solution the thought of which warms my capitalist heart.

(The truth be told, toll roads might be an even better solution but might lead to higher costs and would be even more politically unacceptable – therefore for now I would settle for a “correct” gasoline tax, be it higher or lower than current levels).

West Jet – has it totally lost its way?

I am not overly familiar with West Jet but it seems to me to have really lost its way. It started out as a low cost operator using older used airplanes, all of the same model and flew only point to point. It avoided the costly Toronto Airport in favor of Hamilton. It had lower wages and young energetic employees. They did not interconnect with other airlines. Employees mostly owned shares in the company. The company was profitable, all was good. They described their chief competitor (Air Canada) as a high-cost brain-dead entity. They were very confident of their competitive position. I suspect most employees felt very good about working for West Jet in those earlier days.

But now they are buying brand new planes, with leather seats and seat-back televisions. The cost of their billing system project unexpectedly ballooned to $40 million  – partly to interconnect with other airlines. They have admitted to unethical behavior, authorized at the top levels, in (as I understand it) using the password of a former Air Canada employee to access the seat-sale records of Air Canada many thousands of times. It appears that they built a computer system to do this. I suspect a lot of West Jet employees suddenly feel a whole lot less smug and and a lot less energetic.

Somehow, the Airline industry seems to destroy most who dare to go into it. I’m not saying that West Jet would be a bad investment right now (I have not analyzed it), but I would certainly be cautious about it.


Our stock picks did not completely escape the market decline of the past month. But overall we have done well in the year to date and extremely well over the past years.

Here is our performance summary as of June 9, 2006

Year 2003 2004 2005 2006 (to date) Compound Avg. Annual Growth per year Total Gain Since 2003
Editor’s Personal Portfolio Return 40% 21% 33% 5.5% 28.7% 138%
Average Strong Buy Increase 79% 25% 30% 1.3% 36.9% 194%
Average Buy Increase 46% 25% 28% 11.2% 31.9% 159%

For full details see our performance page

For information on our our buy/sell stock rating service, click here.


Shawn Allen
President, InvestorsFriend Inc.

To view older editions of this newsletter, click here.

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