Newsletter October 10, 2010

InvestorsFriend Inc. Newsletter 10 10 10

How to Invest in Companies and Stocks

Before turning to stock investments, let’s think about an ideal scenario for investing in a small business.

Imagine that a good friend of yours has a strong history of success and accomplishment. You highly admire, trust and respect this friend. And imagine that your friend has a private company which is highly profitable and growing and has a great future.  Also you understand the nature of the business and as a result of all of this you are highly confident that your friend’s business is likely to grow and prosper over the years and deliver many years of high profits. You’re happy for your friend but also a bit jealous.

Now, imagine that you have money available for investment and that your friend needs money to expand the business and offers you the opportunity to invest. This is a “ground floor” opportunity. And your friend is offering to sell you say 10% of the business at a very fair price.  If the business grows as expected this will be a highly profitable investment for you. And imagine that everything will be done professionally and written up in a proper legal form.

What I am describing here is just about the ideal investment. It meets the criteria that Warren Buffett has set out for investments. Warren Buffett said in his 2007 annual letter to shareholders:

“Charlie and I look for companies that have a) a business we understand; b) favorable long-term economics; c) able and trustworthy management; and d) a sensible price tag.”

Most investors would agree that the opportunity presented above is a good one.

And after your investment, you would not be thinking of yourself as merely a “shareholder”. You would think of yourself as a part owner of your friend’s wonderful business. This would be a long-term perhaps virtually permanent investment for you. After a few years of ownership you would likely be very interested in how much profit the business was making and how its sales were growing. You would not likely spend much time thinking about how much you could sell your shares for.

So okay, that was a nice fantasy investment but in reality the kind of opportunity discussed above is not likely to come along for most of us.

So let’s turn to investing in Stocks. First here’s the wrong way to think about investing stocks.

90% of the public seems to believe that successful stock investing requires a person to guess which stocks will rise in the short term and buy those.

I would guess that 90% of people would agree with both the following statements:

1. Big corporations are making too much money

2. Owning Stocks is not a good way to make money these days.

It’s difficult to see how both of those statements could be true.

These investors see stock investing as being the opposite of what Warren Buffett describes as his ideal investment. They see themselves investing in companies:

– with businesses they don’t understand (how many really understood Nortel?)
– with long-term business economics that they also don’t understand
– with management that may or may not be capable and is definitely not to be trusted (far from being trusted management are often expected to “rob” shareholders blind)
– and selling at a share price which investors have no idea is fair or not
– and they fear that the stock price will continually be manipulated by powerful traders

In this scenario, investors seem to think that the best they can do is buy stocks on the up trend, hold them for a gain and then sell to someone else before something bad happens. Investors think of themselves as (quite temporary) shareholders, not as partial owners. They don’t think much about owning a share of the companies’ earnings. They think of any gains as coming from dividends and especially from share price increases and they don’t see much relationship of those gains to the actual earnings of the business in many cases.

The above dismal scenario of stock investing has played out far too often in the past decade or so (Nortel, Enron, the Wall Street Banks, seemingly almost every company in 2008…). So, it’s no wonder that so many investors are disillusioned and afraid of the stock market.

And now here is the right way to invest in stocks

Legendary value investor Benjamin Graham said “Investing is most intelligent when it is most businesslike”.

The right way to invest in stocks is to make it as businesslike as possible. Ideally we want our stock investments to be as close as possible to the fantasy scenario described above of investing in a wonderful business, with high profits and a great future and ran by people we like and trust and available at a bargain or at least a sensible price.

It is of course very difficult to find that scenario in the stock market, but it’s not impossible.

It starts with an attitude that you are going to a long-term share owner of a business, not merely a temporary share holder of an abstract stock symbol.

And it’s quite easy to reject businesses which you have no hope of understanding, or where management appears incompetent or untrustworthy, or where the share price is too high.

At InvestorsFriend we try to identify businesslike investments. For every company we look at, we discuss the business and how simple or complex it is and what its competitive advantages appear to be. We discuss management ability. We look at executive pay as an indication of trustworthiness. And of course we spend a lot of time trying to see if the share price represents a bargain or not.

In many cases we don’t have all that much information to go on  for things like management competence and trustworthiness, but at least we do address these topics, every time. And our expectation for growth of the company may not turn out to be achieved. Predictions about the future are always subject to error. So we certainly make no guarantees. But we do think our businesslike approach is the right one and so far our track record is strong.

Information about how to access our Stock Ratings for a modest fee is available by clicking here.

And our article on to get started and open an investment account at your local bank is available by clicking here.

CMHC  – Canada Mortgage and Housing Corporation – A Bankruptcy Candidate?

CMHC  – Canada Housing and Mortgage Corporation provides mortgage insurance so that banks can lend mortgage money to homeowners even when those potential home buyers have very little money for a down payment and when affording the house is not going to be easy.

It’s been much in the news that the American versions of CMHC namely the somewhat comically-named and government-sponsored but shareholder-owned Freddie Mac and Fannie Mae basically blew their brains out, became insolvent  and are now operated directly by the United States Federal Government.

I would guess that the vast majority of Canadians, including investors got through most of their life without even knowing the names Freddie Mac and Fannie Mae. But now, most Canadian investors have heard these names and know that these are two giant government mortgage insurance providers who somehow effectively went broke as house prices in the United States plunged.

Could the same happen here in Canada to CMHC?

The first place to look for financial strength of any corporation is its balance sheet.

CMHC’s balance sheet for 2009 is available here:

http://www.cmhc.ca/en/corp/about/anrecopl/upload/CMHC_AR2009_ConsolidatedFinancialStatements.pdf

Assets are $272.8 billion (so far so good), but liabilities total $263.6 billion and owners equity or net worth is a comparatively tiny $9.3 billion. So that means that the equity is just 3.4% of assets. That’s pretty hilarious isn’t it? That’s less equity than the minimum 5% down that home buyers have to pay! It means that if the the assets of CMHC were to drop in value by just 3.4% they would have  a net worth of zero. That is often know as insolvent. But not to worry, the government would no-doubt bail it out.

The great majority of these assets are invested in mortgage receivables. So, as long as Canadians keep paying their mortgages, CMHC should be okay as far as the value of their assets. But, if a significant number of Canadians were to stop paying their mortgages (due to job loss and or bankruptcy), well then CMHC could quickly see its equity disappear and would have to go to the Canadian government looking for money.

As an insurance company we also have to look at their liabilities – since some of the liabilities are only estimates and could be understated . They show $1.3 billion as the amount they expect to pay out in claims for mortgages currently insured by them, in respect of defaults that have already occurred.  The amount of insurance in force is $472.6 billion. So they have just 0.28%% of their insured mortgages recognized as a liability. There is no liability booked for mortgage defaults in the future on the existing block of insured mortgages. Those would be covered by future revenues including a portion of the $7.2 billion in already received revenue that has not yet been booked as revenue. There may be a huge risk that this $7.2 million will turn out to be inadequate to cover defaults on the existing block of mortgages, in the event of a recession or if a large drop in house prices causes too many Canadians to declare bankruptcy.

If mortgage defaults were to rise, CMHC could increase insurance fees on new mortgages. But the fees on the entire block of existing mortgages have already been paid and could not be adjusted upwards to cover the higher loss.

The other main place to look at to determine the financial health of a company is its income statement. CMHC has booked a profit of around 1 billion per year for the past few years.

Here is something interesting. In 2008 they paid out $0.372 billion in claims (payments to banks to cover banks losses on foreclosed homes) . In 2009 they budgeted to pay out $0.279 billion in claims but the actual came in at $1.112 billion. So that’s triple the 2008 level and more than triple the 2009 budged amount!

When I then look at the $1.3 billion they have recognized for claims on defaults that happened by the end of 2009 that seems pretty small considering they paid out almost that amount in 2009 alone – which given the time delays involved, probably largely reflected defaults that occurred in 2008.

Consider that the recession never hit Canada all that hard and housing prices did not drop much and then they recovered and rose to new highs. And yet in 2009 CMHC saw its claims triple. I shudder to think what would happen to CMHC if there was a severe recession and if house prices dropped materially. It seems obvious that they would wipe out their equity pretty quickly.

I notice also that in 2009 CMHC paid out $2.6 billion to support low income housing programs. That may be a great government initiative. But I have to wonder why a mortgage insurance entity is using mortgage insurance premiums to subsidize housing. This expense for housing programs is considerably higher than the expense for insurance claims paid out.

It looks to me like CMHC is very weak financially. It probably has not recognized realistic amounts for future claim payments to banks in the event of continued recession or a large slump in house prices. I will certainly not be surprised if CMHC ends up like its America cousins, Fannie and Freddie, and comes begging to the government for money in the next few years.

The High Cost of Free

It’s great when stuff is free isn’t it? Well not always. A wise person once told me “nothing is free, free just means someone else is paying for it”.

Not a whole lot in this world is free, and there are good reasons for that.

Free tends to lead to over-consumption and line-ups and ultimately lack of production. (Who is going to produce what is not being paid for?).

Think about free medical care in Canada. Yes, it has it’s advantages and it may be a great idea overall. But there are some costs. Most of us have to wait to see a Doctor. The waiting time in emergency rooms can easily be 8 hours. And what can you say?, not much. You are not directly paying for the visit and so you are at the mercy of the system.

I asked my Doctor about getting a certain medical test done that is recommended for men my age (50). He said no, and explained that while the test was a good idea, there were no enough doctors to do the test and unless I had a specific family history, I simply could not get that test. Also, when you get a routine blood test done, they don’t test for sort of everything. There are dozens of diagnostic tests that that simply don’t do – even though these tests might warn of a critical illness developing. The tests are considered too expensive.

Would you like to get a whole body scan done just in case? Well too bad, you will not receive that free on demand in Canada. Would you like to pay for it yourself? Well, again, too bad, it’s generally not available in Canada, and its generally illegal for a private clinic to set up and offer that to you on a fee for service basis. Would you like such a scan for your dog? In that case you can probably pay to get it.

The point is while free medical care in Canada is arguably the best system, it certainly comes at a high cost. There is the direct cost of possible waste and over-use of the system. But perhaps more seriously we  give up the right to seek and pay for the best medical treatment and tests that we can afford. In some cases people will ultimately give up their life as a result of that.

What about the high cost of (nearly) free money?

Governments can now borrow at some of the lowest interest rates in the history of the world. Even you and I can access mortgage money at as low as about 2.2% per year interest. Financially strong corporations can borrow money at rates like under 2% for 2 years and under 5% for 30 years. That has its advantages but it comes at a huge cost.

Savers are being offered interest rates like 1% for a one year term deposit and 2.1% for a five year deposit.

Pension funds and Life Insurance companies that invest in government and corporate bonds are in danger of becoming insolvent due to the low returns on fixed income investments.

Investors may feel almost forced to reach for the higher yields (but higher risks) of preferred shares, lower quality corporate bonds or high yield stocks.

All of these groups are paying a very high price indeed so that governments can have (nearly) free money.

To the extent that extraordinarily low interest rates are the result of manipulation by government rather than free market forces, they are likely to cause untold damage to the economy.

END

Shawn Allen, President
InvestorsFriend Inc.

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