Newsletter May 4, 2008

InvestorsFriend Inc. Newsletter May 4, 2008

The Economy and the Stock Markets

There are mixed signals regarding the economy at this time. The overall stock market (S&P 500) has done very well in the past six weeks suggesting the economy will improve. Figures indicate that the U.S. economy was not in recession in Q1 as it managed to grow ever so slightly. Unemployment remains low in both the U.S. and Canada. So those are positive signals and seem to suggest that stock markets will continue to do well.

On the other hand house prices and sales of houses continue to decline. Layoffs are in the news. Gasoline prices are up. Food prices are rising. In this environment it is hard to imagine that the average consumer is not going to cut back on discretionary items and big-ticket items. Starbucks reports that people are cutting back. These signals would suggest we should be quite cautious about where the general stock market is headed.

Only one of the two sets of signals above will turn out to be correct.

Warren Buffett and the Stock Market Direction

Most investors worry endlessly about where the market is going in the next month or year. Many also claim to be able to predict where it is going. But what does the greatest investor of all time have to say about this?

On Saturday, Warren Buffett presided over his huge  annual meeting in Omaha Nebraska with about 31,000 investors from all over the world in attendance.

In regards to the direction of markets, reports that Buffett said the following. “Charlie and I have no idea where the stock market is going in the future”.  “We’re not in that business .. It’s just not our game.”

That has consistently been Buffett’s message. In 1956 Buffett started an investment Partnership. At that time or shortly afterward, he developed a list of ground rues for investors. Ground Rule Number 6 was “I am not in the business of predicting general stock market or business fluctuations. If you think I can do this, or think it is essential to an investment program, you should not be in the partnership”.

The man has been remarkably consistent on his approach for over half a century now.

Here is a link to where you can read summaries of Warren Buffett’s answers to questions this weekend. See

News – MicroSoft Withdraws Bid for Yahoo!

Apparently the big-time CEOs at MicroSoft and Yahoo don’t get weekends off. While most of us had the day off on Saturday, MicroSoft upped its bid for Yahoo to $33 per share (from the earlier $27) but Yahoo remained insistent on getting $37. So MicroSoft withdrew its offer.

Let’s take a look at some numbers.

At $33 the bid was $47.5 billion. Clearly that is a lot of money, but we need some context. According to figures on Yahoo Finance, Yahoo made $1.1 billion in the past year or 76 cents per share. And that may have included some unusual gains. The analysts estimates for 2009 were for earnings of just 56 cents per share. Yahoo’s return on equity even at 76 cents per share was an unimpressive 11.0%

On the surface, MicroSoft’s offer of $33 (some 60 times estimated 2009 earnings!!) looks insanely generous. Apparently it was 70% higher than Yahoo’s share price prior to this take-over offer. Sure their may have been synergies and Yahoo may have been seen as a way for MicroSoft to compete with Google, but the economics appear to be very poor. I believe that MicroSoft has done a good thing in walking away.

The Yahoo CEO has played a bold game of chicken with shareholder’s money. Now he has to hope and pray that he can do some deal with Google and that the anti-trust rules will not bar Google from acquiring Yahoo.

Predictions are that the Yahoo share price will plummet to the low 20’s on Monday. MicroSoft shares meanwhile may rise. This could even set off other chain reactions as other over-valued companies fall in price on the realization that acquirers are not always willing to pay insane prices.

Lessons of the Asset Backed Commercial Paper Crisis – If You Must Lose Money – Do It With a Crowd

It’s great to hear that the retail investors in Asset Backed Commercial Paper will apparently get all their money back.

Institutional and corporate Investors are not so lucky, they will not get all their money back. In most or all cases the investors did not understand the risks involved and were directed to these investments by brokers. But only the retail investors (with less than $1 million) will get all their money back.

It appears that constant publicity and public sympathy are a big part of the reason that the retail investors are being treated better than the bigger investors.

It’s interesting to note though that in most cases where an individual loses money on an investment recommended by a broker, no one rides into the rescue. The general rule is that all markets are risky. You invests your money and you takes your chances. Even government guaranteed bonds are considered to have some risk – for example provincial bonds pay higher interest than federal government bonds. Bank deposits guaranteed by the the federal government have almost no risk. Almost no risk is actually not quite the same as no risk. The bond rating agencies certainly never stated that a  AAA rating means zero risk. Brokers selling the products might have implied that, but the bond rating agencies never stated such a thing.

When you lose money by your lonesome, good luck getting anyone to reimburse you. Even if the the broker is at fault it will take considerable time and energy and perhaps legal costs to get anything back.

One lesson here is to stick with popular retail investments. That way if something goes terribly wrong, you just might be able to get your money back at least in rare situations. There can indeed (sometimes) be safety in numbers.

Analysis of Individual Stocks

So you’re buying a Stock.

What Do You Know That Others Don’t?

Why do you think that stock will go up?

The efficient market hypothesis, believe it or not, suggests that every stock is a basically a hold, neither a buy nor a sell. At any given point in time, the collective wisdom of the market is that each stock is worth its market price, no more and no less. If the market becomes aware of a reason for a stock to move up, or down, then it moves very quickly to a new “collective wisdom” price. If major news comes out and the experts decide that XYZ gold company is suddenly worth double what it was worth yesterday, then the price can move up right away. In this situation there is no reason for the price to move gradually. On such news, prices move fast.

Under the efficient market hypothesis it is actually somewhat arrogant for you or I or anyone to suggest a stock is worth anything much different than its current market price. We may be right, but we are somewhat arrogant to be going against the collective wisdom of the market.

Ken Fisher, an extremely successful billionaire money manager and financial author says in his latest book that if you feel strongly that a certain stock is a better than average buy then you must Know Something that Others Don’t. See our list of recommended books for a link to purchase Ken Fisher’s book

If you don’t know something about the company, that the collective market is missing or ignoring, then you have no basis to buy the stock.

In the absence of Knowing Something That Others Don’t, your best bet is to just buy a broad based and low-management-cost index fund.

The efficient market hypothesis (taught by most finance professors) would have you believe that basically unless you are a company insider it is simply not possible to Know Something That Others Don’t.

But some people such as Warren Buffett and other billionaire investors think it is possible to Know things that Others Either Don’t Know or are ignoring. I think Warren Buffett is correct and the average finance professor is wrong.

It’s worth thinking about what kind of things you might know that others Don’t (Or are ignoring).

I have been analyzing stocks for many years based on published financial statements, an accumulated understanding of certain industries, common sense assumptions about future growth, and some simple valuation ratios.

I have found certain categories of value that the general market sometimes misses:

Hidden Earnings. By no means are all earnings created equal. Most income statements include numerous assumptions and estimates. Assets like building and machinery are counted as expenses through depreciation charges over their estimated useful lives in years. If the estimated useful life is not correct, then the earnings are distorted.

Deferred income taxes can amount to hidden earnings. Some companies may report $100 million in income taxes but in reality on their income tax form they may be able to defer say $75 million of the taxes for some years and so they may only pay $25 million in actual cash taxes. In these cases to the accountant the expectation that $75 million in taxes will be paid in ten years is charged as an expense just as if it was a cash payment today. The economic reality is that a payment that can be delayed for years creates an economic value. As an example, Canadian National Railway for many years has paid substantially less in cash taxes than it reports as the accounting level of taxes. It has been a master at deferring taxes. To my mind a portion of that delayed tax can be considered to be hidden earnings.

Deferred Revenues. Some companies collect revenues up-front. An excellent example is the TSX Group. It collects listing fees for new companies going onto the stock exchange. Prior to 2005 these non-refundable listing fees were (as one might expect) booked as revenue when received. In 2005 the accounting regulators decided that such fees should be deferred and brought only gradually into revenue over a ten year period. This rule (in isolation) lowered the TSX Group’s reported earnings even though from the perspective of economic reality, nothing had changed. My view is that the older accounting was correct. Those fees were one-time in nature, the TSX faces little  incremental costs in keeping a company listed each year. The incremental costs of keeping a company listed are likely covered by trading fees that the TSX charges on every share traded. In analyzing the TSX group I add back the increase in deferred listing fees (net of income tax) and treat it as additional earnings.

Customer Acquisition Costs. Many companies pay sales commissions and advertising costs to acquire new customers. And most customers tend to remain as customers for a number of years. Some companies such as insurance companies and mutual funds routinely defer these expenses and spread them over several years. Other companies immediately expense all such costs. The accounting rules and practices seem to differ by industry. Back in 2002, Telus appeared to be making very little money on its cell phone business. But they were expensing huge customer acquisition costs that in reality would benefit them for years into the future. This was creating hidden value not reflected in earnings. Life insurance companies call this “new business strain”. They face paying high sales commission to acquire new customers. In the first year a new customer may show as unprofitable. But the economic reality is usually that the new customer is going to be very profitable over the life of the customer. A company that we follow in the home alarm business went from reporting large profits to very small profits after it was forced to start expensing its marketing costs as incurred rather than amortizing them over several years. As a fast growing company I believe that the immediate expensing of marketing costs under-stated the net income given that the acquired customers would on average remain as customers for many years.

At one time when a company was acquired at a price higher than its value, the excess amount was called “goodwill”. It was arbitrarily required to be amortized as an expense over a period of 40 years. However, smart people like Warren Buffett pointed out that this amortization was usually not a “real” expense at all. At the end of the 40 years the goodwill was not usually “worn out”, unlike a building that might get worn out or outmoded it did not need to be replaced. The accountants finally caught on and they now no longer require goodwill to be amortized as an expense. But they also no longer allow all of the purchase price less book value to be all called goodwill. Now they require all purchased assets to be re-valued at fair market value. And they require the value of customer relationships and contracts to be valued an “identifiable intangible”. I consider the amortization of an identifiable intangible to be every bit as imaginary an expense as was the amortization of goodwill. The accounting rules result in reported profit of an acquired business being lower as soon as it is acquired, even though the economics may not have changed. The bottom line is that for some companies  I know that the true economic profits are higher than those reported by the accountants.

There are numerous other examples of items that cause reported earnings to be either conservative or over-stated. By looking for these we can Know Things That (most) Others Don’t.

Car Prices and Inflation

The cost of living is always rising. Yet there are some examples where prices are dropping –  a lot.

The prices that Canadians pay for cars has been coming down to reflect the high Canadian dollar. Last week Chrysler slashed prices on 13 vehicles. The Dodge grand Caravan is slashed an eye-popping $6,500 to $19,999.  I paid $23,000 for a very plain Grand Caravan back in 1997. Today’s version is a better vehicle and yet now costs considerably less. GM is advertising Uplanders and Montanas with 240 hp 3.9 liter engines for $19,999 including freight and PDI. They come with five-year 160,000 km warranties. Hyundai has a car for under $10,000.

BMW has taken a large write-down on the value of used cares coming back off lease.

If you are looking to buy a car, new or used, and if they have not already slashed prices, then be patient and don’t be afraid to make an offer well below the asking prices.

These new lower car prices are not just due to the high Canadian dollar. I suspect it also has to do with a slowing economy. Canadians are just not rushing out to buy vehicles. Cars are lasting longer than they used to. The fact is that very few of us NEED to buy a new car. (And no one really needs a brand new one as opposed to a reliable used model.) With talk of recession and higher gasoline and food prices, it is an easy decision to delay buying a new vehicle.


Shawn Allen, President
InvestorsFriend Inc.

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