Newsletter November 22, 2003


Where To Invest Now

The TSX is up 17.7% this year. However earnings are also up quite sharply. My belief is that there are still bargains to be found and that the TSX has a reasonable chance to achieve low double digit growth in 2004.

My belief is that there is more danger of interest rate increases than of decreases. Therefore I would prefer to be at least 50% in equities at this time as a long-term investor. Of course, the proper ratio for others depends on a variety of factors.

However, equities are not for the faint of heart. I believe that equities are almost always vulnerable to unexpected drops. Currently I would be surprised if a drop of over 20% occurred but a drop of 10 to 20% is almost normal volatility that is always possible. My hope is that equities will continue to rise, but an equity investor should always be prepared to suffer a material decline at any time.

My own preference is to look for individual under-valued stocks. Another strategy would be to look at different sectors. My current stock picks are available for a small fee.


I could hardly be more pleased with the Performance of the stock picks on this Site this year or with the performance of my own portfolio. The Strong Buy Picks from last January are up an average of 49.2%. One of the Strong Buys has declined 5%, the other 6 are all up with percentage increases ranging from 17% to 168%. Two stocks are up by more than 100%. My own portfolio is up 31.9% this year.

Be Wary of The Greedy Manager

Recently in the news, Conrad Black is accused of raking in huge management fees and of not having proper authorization to collect those payments. What is scary is that it is not the size of the fees that got Lord Black in trouble, rather it was merely the documentation and authorization. When it comes to the size of the fees, basically there was nothing to stop him from siphoning off all of the profits through managements fees. He blamed the lack of documentation on his “underlings” who were derelict in their duties. His use of this term speaks volumes about the kind of self-centered egomaniac that he is.

In another case, Vector Aerospace’s Board of directors was trying to get its executives to renegotiate a severance package worth $35 million that is large enough to destroy the company (good luck with that). It boggles the mind to think that the Directors could have gotten away with approving this severance package in 1998, when, to put the amount in context, the company had a market value of about $130 million. The chairman of the Board who approved this was also the CEO and chief beneficiary. Boards are free to set compensation levels but there has to come a point when Board members are held legally responsible for seemingly wantonly irresponsible actions like this.

Long term investors can only make good returns if the companies that they invest in are profitable and are able to distribute significant dividends and/or to grow in value by retaining earnings.

This cannot happen if management and or the Board of directors is excessively greedy and siphons off excessive amounts of benefits for themselves. Excessive greed is in the eye of the beholder, but certainly in the worst cases is fairly easy to spot. A certain amount of greed is a very good thing and I am in favour of appropriate incentives for executives. But I am more comfortable with executives that display a certain amount of humility and who appear to be motivated by their work and accomplishments rather than strictly by massive amounts of money.

There are many ways in which executives can, with the compliance of the Board of directors, siphon off excessive benefits. These methods include:

Excessive salaries and bonuses (at least these are readily visible). These days it seems like every two-bit CEO thinks that he or she should be paid at least half a million per year, if not multi-millions. This is not much of an issue if profits are over $100 million, but it becomes a significant drain when smaller companies making only a few millions (if any) start to play this game. In my opinion excessive salaries and bonuses are negative signals that indicate excessive greed, questionable ethics, and a lack of proper Board responsibility.

Excessive stock option grants – This can be insidious because a lot of shareholders and Board members don’t understand that options cost shareholders money by diluting earnings per share. In some cases this amounts to executives giving away large chunks of the shareholder’s company to themselves. In the worst cases, I consider it a form of legalized theft by stealth.

Excessive Management Fees – This is also insidious because it disguises executive salaries as regular expenses. Some executives charge management fees via private companies. If this is done to reduce taxes, it makes me wonder if that kind of greed will also lead the executive to attempt to divert funds from flowing to shareholders.

Excessive perks – This is more rare. In the worst cases it involves lavish and expensive entertaining and travel for hundreds of friends.

Excessive severance packages –  Some companies have stunningly rich retirement and severance packages. It seems that getting fired is can be the road to a wealthy life of leisure for many executives. Boards of directors are not doing their jobs when they allow this to happen.

Air Canada and Short Selling – (Don’t Try This At Home…)

Anyone who is remotely interested in Short Selling might be interested in the strange and seemingly irrational situation that is happening with Air Canada shares.

For several months now it has appeared as if shorting Air Canada would be a no-brainer way to make money. All the business commentators and even the company itself, seem to agree the common shares are all but worthless…and yet they trade today near $1.00.

One explanation offered for the stubbornly higher-than-rational share price is that short sellers have to buy the shares back in order to cover their short positions. I don’t buy that argument, I can’t imagine that the fact that thousands of short sellers think the stock is worthless is actually driving the stock price up.

Another explanation is that it is due to speculation by uninformed or extremely ill-advised retail investors. Not everyone understands that Air Canada’s debts massively exceed its assets and that, in effect, the creditors own the company. If Air Canada emerges from bankruptcy, the creditors will get only some pennies on the dollar in new stock in the company and it is expected that existing shareholders will get only about 1 cent per share. And even that is almost as a courtesy or token gesture. Strictly speaking the existing shareholders should get absolutely nothing unless the creditors get full payment or full value in new stock, and that is not going to happen.

Air Canada has about 79 million shares. In some ways $1.00 per share does not sound high, because it implies you can buy the whole company for $79 million. But the company is in receivership and technically the stock should be worthless. Possibly a potential buyer or major creditor would want to accumulate the stock in order to have a greater say in the bankruptcy negotiations. But if the stock is worthless then it is not clear that such a strategy has any value. And there have been no news reports that this is what is happening.

I am frankly quite confused about why the stock is still near $1.00. Possibly it is simply stupid investor syndrome. I think stupid advisor syndrome is probably also at work.

As of November 15, there were 12.4 million shares of Air Canada sold short and this was up from 9.2 million on October 31. I would expect that the increase in short sales was due to the proposal for Li Ka-Shing to make an equity investment of about $650 million in return for a 31% ownership stake. Existing debt holders would get most of the remaining equity and all debts would be wiped out. Existing shareholders would apparently get the equivalent of 1 cent per share in new equity. This led to increased short selling as the shares appeared remarkably over-valued at around $1.15 at that time.

This past Friday, 8 million shares traded and the stock increased 11% on the announcement that there was a competing offer. This seems less than rational given that there was no indication that shareholders would get more than 1 cent per share in the end.

When the Li Ka-Shing potential deal was announced on November 10, over 20 million shares traded hands. This is an incredible amount of share turn-over considering that only 79 million shares exist.

One thing for sure is that the brokers and the TSX are making a lot of money as someone madly trades these shares back and forth. It makes me wonder if the brokers are doing something to encourage all of this madness. Perhaps they like those fees. Retail investors are charged about 1.5% for penny share trades, that makes 3% between the buyer and the seller. Therefore the brokers may have taken in up to $600,000 on Nov 10, when 20 million shares were traded. At that rate, the brokers have a fair amount of incentive to generate churn in these shares. And short sales are not considered normal trades and I understand that the fees can reach 3% for each of the buyer and the seller, which is doubly wonderful for the brokers.

It so happens that if you try to short sell Air Canada, your broker will likely tell you that you face the risk of getting bought back at any time and at any price if the broker does not have enough shares to lend to you to make and hold the short sale. This is sweet for the broker because it generates a commission if you are forced to buy back the shares.

Checking insider trading reports on the SEDI system, what to my wondering eyes should appear? … eight tiny short sales and nothing else. Not an insider buy to be seen, I don’t wonder why. Its pathetic really to see that eight executives sold amounts ranging from 196 shares at $1.18 (maybe he needed to buy dinner that day) to 8,108 shares at 82 cents (a rather small amount by executive standards, I would think). You would think that they would be too ashamed to sell off a few paltry shares like that, when they are the people responsible for driving the Airline into bankruptcy. All of these reports were several months old.

The lessons in this appear to be that Short Selling is an extremely risky business. Rational forces do not seem to be at work.

When this is all over, I hope someone investigates it to find out what is going on.

Beware the Bankruptcy Candidate.

Its’ not unusual to invest in a company and then it does not perform operationally as well as expected. In these cases the share price usually drops or plummets. In these cases, if the company remains solvent, you can hope for an eventual recovery and at least you will not lose all of your money. The worse cases are when the company runs of of money and becomes insolvent. In that case a 100% loss of your investment is the likely outcome.

To combat this, we could try to avoid investing in bankruptcy candidates.

For example in investing in start-up drug and technology companies that are currently losing money (which they descriptively call the cash burn rate), we need to insure the company has enough cash to last the several years that it will take to reach a profitability stage. In some ways these companies are almost automatically bankruptcy candidates. If they only have one major drug or technology, then if they can’t commercialize it, they are likely to go bankrupt. But at the very least we should check the balance sheet and insure that they have sufficient cash to at least make all reasonable attempts to eventually reach profitability. These companies are probably best approached by investing in several companies such as through a specialized mutual fund or Exchange Traded Fund, in order to diversify the risks.

For more mature operations, we have to insure that cash flows are sufficient to service debts. Generally this means that the operating cash flows, before capital spending, are at least several times larger than the interest payments. Generally if debt is greater than the equity amount it is cause for concern. And even if the debt is smaller than the equity level, there is still a problem, if operating cash flows are negative.

Some companies will report positive net income, because they are capitalizing certain expenditures rather than expensing them. We have to be suspicious when a company capitalizes start-up costs and selling costs. It may be legitimate but it is also a red flag for cash flow problems.

There are many hazards in investing but that is part of what makes it an enjoyable and challenging intellectual pursuit.

Investors who are not willing to dig into all of these issues may be better off not trying to pick their own stocks.

Pension Plans

The pension problems of major corporations have been much in the news lately. I expect the news to get worse before it gets better. Consider the case of CN. It’s pension plan assets are $11.2 billion which is off-set by estimated pension liabilities of $11.2 billion, which indicates no pension deficit or surplus. (More about deficits in a moment…) Meanwhile the company’s equity value is $8.4 billion. This indicates that the pension plan is bigger than the company itself. So, if the pension plan should develop a material deficit, it will definitely have  a material impact on the company.

It does not appear that CN will necessarily develop a pension deficit soon. However, that could happen if it lowered its discount rate of 6.5% due to lower interest rates. And reductions in the workforce and early retirements could contribute to a deficit. In addition a 2003 Federal budget change that increased the maximum pensionable salary could contribute to a deficit.

A bigger concern is that CN’s annual pension expense in its financial statements will likely rise by one or two hundred million dollars. In the past three years CN, far from showing a pension expense, actually showed a profit contribution from its pension plan of an average of $9 million per year. This fiction was the result of assuming that the pension was making a 9% return on its assets or over $800 million per year, even though the plan actual lost a total of $214 million in the last 2 years. That’s a difference of close to $2 billion to the negative side in the past two years. Few experts today would agree that a pension plan, which has a mixture of bonds and equities can rationally assume that it will earn 9.0% per year. This assumption will likely be reduced which will lead to a sharp increase in pension expenses recognized in net income. I would expect that the plan will show a strong return in Canadian equities this year. However, there may be little return on foreign equities due to the rise in the Canadian dollar and there will not likely be capital gains on bonds, which probably occurred in recent years.

My understanding is that CN does not have to calculate an actuarial valuation of its pension plan until the end of 2004. So any potential pension deficit problem may not be unearthed until early 2005. This raises an interesting point. While you and I may check our portfolio values more than once a day, a big company like CN with a pension plan that has more assets than CN has equity, is checked every three years! In what century was that requirement set out by the accountants and regulators!

My bottom-line on this is that CN has a pension plan which is large compared to even the size of CN. Its pension expenses are almost certain to rise materially. It would not be surprising if a pension deficit arises. All of this is probably not a huge problem for CN, but it is an issue which makes me uneasy about investing in the company at this time, even though operationally it is probably very healthy.

I also expect more bad news regarding pensions from most other old-economy companies that have large retired work-forces.


Shawn Allen
InvestorsFriend Inc.

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