Newsletter October 23, 2005
InvestorsFriend Inc. Newsletter October 23, 2005
Greetings to all the new subscribers to this free newsletter and to the continuing subscribers as well.
The purpose of this free newsletter is to provide you with valuable comments and analysis related to investing. The focus is on investing in Canadian equity stocks.
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Many people who have received this free newsletter have been motivated to learn more by exploring at leisure the many unique and valuable articles on this Site. These articles include valuable summaries of the sound investment principals that I have learned by “studying and doing the math” and by studying the most successful investors.
In addition, many subscribers to this free newsletter have been motivated to subscribe to our specific stock picks (stock ratings backed up by concise and yet relatively comprehensive research reports). And, most of these subscribers have continued to subscribe for many months or indefinitely. While we offer a refund of the first month’s subscription cost for those not satisfied with the research provided, this refund has only ever been asked for on one or two occasions. I believe that the almost total lack of any such refund requests is a testament both to the quality of the information provided and to the integrity of the subscribers.
Performance – where the rubber hits the road.
The well-documented Performance of the stock picks on this Site has been consistently excellent since the site went live on the internet in mid 1999.
It may surprise some readers, but according to the “efficient market hypothesis” it is actually impossible to consistently predict winners and losers in the stock market. Despite that theory, on this Site, we have documented a six year record of consistently picking winners and losers, which has led to high average returns.
Performance Comparison in 2005 – Recently the National Post provided the year-to-date performance figures for 191 Canadian Hedge Funds as of August 31, 2005. Many of these Hedge funds lost money year-to-date. The average return was just 3.6%. Meanwhile, my own personal year-to-date return at August 31, 2005 was 21.8% and the model portfolio at that time had returned 25.8%. My own performance was better than all but 13 of the 191 Hedge funds and the Model Portfolio did better than all but 10 of the 191 Hedge Funds.
As you may be aware, Income Trusts are able to operate businesses and pay zero income taxes as long as they flow the income through to investors.
In the last few years Income Trusts became very popular with investors. This was mostly due to the high cash yields. Also as interest rates fell, these investments naturally rose in price. And, as more and more investors became familiar with them, investors essentially bid the prices up. This meant that investors enjoyed not only a good cash yield but in most cases received a substantial capital gain on the unit value each year.
Regular corporations which were paying income tax more or less started waking up one-by-one to the fact that converting their shares to an Income Trust structure would provide a big boost in value. Investment Banks liked CIBC and TD banged repeatedly on the door of almost every profitable corporation with a market value of about $50 to roughly $500 million (and in some cases much higher) arguing that the corporation should be converted to a Trust (not coincidently, there would be a large associated fee paid to the investment bank).
By the summer of 2005 the pace of Income Trust conversions was reaching a fever pitch. There was even talk of large Banks carving out business units as Income Trusts. It was starting to look like most of the profitable corporations on the stock market would be converting to Trusts eventually.
The Federal Government was arguably losing a lot of tax money. Some unit holders paid tax on the distributions but Trusts were also held by non-taxable RRSP plans, RESP plans and Pension plans.
In early September the government announced it was looking at options and requested comments due December 31. The trust market shrugged this off since nothing specific had been announced and any action looked to be well into 2006.
But then the government did something rather clever. It suspended the advance income tax rulings that many companies seek before they convert into a Trust. This threw a real fear into the market and many Trusts quickly dropped 10% or more. There was then a partial recovery. But then as it became accepted wisdom (or at least a widespread fear) that the government probably was going to put at least a small tax on Trusts, the market resumed dropping. Other reasons for the drop in October may have included fears of higher interest rates and a general decline in the markets partly driven by lower oil prices.
Many people have protested loudly about the possible taxation of Trusts. While some of these protests are logically built, others are are quite vacuous and do not address the unfair situation between corporations and Trusts but rather just protest the feared tax on the Trusts simply because it hurts them.
In my view something does need to be done to eliminate the huge income tax advantage that trusts enjoy over corporations. Whether that be to eliminate or cut the tax on dividends or whether it involves a small tax on Trusts, something has to be done.
Therefore I think we will not see Income Trusts recover to their former “multiple” of earnings or cash distributions any time soon. Compounding the problem for trusts is the fact that it looks like long-term interest rates are finally going to rise. Also in the short term prices could be driven down as investors rush to sell.
Even if Income Trusts remain non-taxable there is another looming threat to Income Trust valuations that no one seems to see coming. I explain this threat below.
As the first company or two in each market segment converted to an income Trust structure, they were generally able to keep their prices the same as before and to therefore “scoop” all of the income tax savings for their investors. So far, so good. But imagine what will happen when a large chunk of the businesses in a particular segment have converted to the Trust structure. For example imagine if all the trucking companies are Trusts or all the major mattress retailers are Trusts, or most of the casual dining restaurants are trusts. In this scenario (which was surely becoming a reality as more and more companies converted) the trusts are competing against other non-taxable trusts instead of strictly against taxable corporations.
Soon a little thing called competition would drive prices down and eventually we could expect the largest bulk of the income tax savings to flow to customers and not investors. In this scenario it turns out that, oops, the extra profit from income tax savings was temporary. This scenario probably takes a number of years to play out as Trusts try to resist lowering prices so they can keep their distributions high. But competition is a powerful force and it would eventually squeeze out that income tax saving in most product and service categories.
Of course a lot of people don’t really believe in competition, they think companies are free to charge what they want for products. These people have maybe never been exposed to competition as a business owner or sales representative. And I guess they are blind to all the price drops that have occurred on manufactured items like cars, electronics, power tools and many others.
Why casting a vote as a shareholder is a waste of time.
If you are a shareholder of one or more publicly traded companies, do you mail in your vote or vote online? I used to because it seemed like the right thing to do. But I have since concluded it is a complete waste of time for two reasons.
1. Just like in all elections, 1 vote (or in this case the votes on the typically tiny number of shares held by a retail investor) counts for little. For this reason alone voting shares or voting in any election is mathematically a waste of time, since 1 voter has an extraordinarily small chance of affecting the outcome. Nevertheless I do advocate voting in most elections since if a lot of people decide not to vote then of course the outcome can be changed. Voting is generally the right thing to do and should be done in spite of the fact that mathematically speaking it is a waste of time. (Politically incorrect, I know, but true nonetheless).
2. In voting for directors there is typically only one set of candidates and there is no ability to vote against them. You can withhold your vote, but where only one slate of directors is presented you can’t vote against them. If 90% of the voters withheld their vote, the proposed slate would still be elected. Anyhow withholding a vote is just the same as not voting.
So you see, as a typical tiny retail shareholder your votes count for about the same as does the vote of a citizen in a communist country. It’s rather ironic that such a bastion of capitalism as a shareholder vote has more in common with a communist system than a working democracy.
Yes, there are exceptions to the above such as rare cases where shareholder resolutions are properly put forward or where a dissident group succeeds in putting forth an alternate slate of directors. But I am talking about the usual situation facing a shareholder who wants to vote their shares.
The above situation could be addressed by allowing shareholders to vote specifically against management’s proposed directors or resolutions, rather than merely withholding their vote. The current situation seems less than democratic and it seems to me that something should be done.
At least until the rules change I will not be bothering to vote my shares.
Keeping Shareholders in the Dark
I have recently noted a rather sinister development that either by design or by accident will lead to a situation where fewer investors receive the annual reports of the companies they invest in.
For many years in Canada, the practice has been that all shareholders receive the annual report and the proxy circular to the annual meeting. Receipt of hardcopies of the quarterly reports by mail required investors to send in a card specifically asking for that each year.
Now, under new rules companies are no longer required to mail out annual reports unless the shareholder specifically sent in a card the previous year requesting same. And the request has to be renewed each year. And, it appears that most companies are going to avail themselves of the right not to send annual reports. In the Spring of 2006 I expect to receive proxy circulars from many of the companies I own, but no annual report.
Isn’t that wonderful? many trees will be saved, and landfills will be spared the burden of discarded annual reports. And of course the annual reports are available “on the internet”, so there should be no problem, right?
Except that it is a lot easier to read a bound double sided paper version of an annual report than it is to read such a document online. And printing it from the internet can easily involve 200 unbound pages.
I am certain that this will result in fewer people reading the annual reports. That is ultimately not good for the stock market. Stock markets thrive on the competing views of thousands of educated and uneducated investors bidding stock prices up and down. Fewer educated investors will mean more mis-pricing of stocks and greater price volatility. This will be an advantage for those of us willing to become educated on each company we invest in, but fundamentally this is a sinister development.
And I have to wonder if those companies really want us to mail in those cards requesting the hard copies. Most companies only provide the option to mail in the card. Why is there usually not an option to make this request by internet?
For most of the companies that I hold, I have not mailed the card back in (and often you have to supply your own envelop and stamp). If I don’t receive the annual reports in2006 then I will have to contact the companies to request same. This is a needless pain and is a step backward for small investors.
Financial Education bargains and non-bargains
Recently I was somewhat disturbed to read that the cost for the one-year executive MBA program at the University of Western Ontario is $56,000 for tuition alone. I have a lot of experience with financial education programs. In my opinion many of these programs and designations are losing their way and may be displaced in the market place by programs that offer better value.
On the one hand, good for Western, they have one of the top brand name reputations in Canada for MBAs and they are capitalizing on it.
If you have an MBA or are working towards one, then good for you. Even if the price paid was high, what you have learned is invaluable and if you can capitalise on it , the investment in time and money will be worth it. But I am disturbed by certain aspects of the MBA program.
As far as I am aware there are few or no international standards for what constitutes an MBA program. I believe that any accredited university can grant an MBA and perhaps on whatever basis it wishes. In Canada I believe the provincial Ministers of Education have to approve of the MBA program, but that is not a national standard, much less an international standard. If there are standards, then I have difficulty understanding how executive MBA programs were allowed to come into existence and magically offer in two years part-time a program which was historically two years full time. Many MBA programs seem to be striving for volume and have done away with the requirement to post an acceptable score on the Graduate Management Admissions Tests (GMAT). As far as I am concerned the MBA market is relatively saturated. Because of the saturation, the value of a brand-name MBA does increase and hence we see the increases in tuition for top schools. But should a university be taking advantage of its brand reputation to raise its prices rather than by keeping the price affordable and using its reputation to attract only the best students from all economic backgrounds?
I also have a CMA (Certified Management Accounting) designation. It’s a good program and designation but I also have some concerns here. It used to be that getting a CMA designation was strictly about taking courses and proving that you knew the material. Now the program requires a university degree, but it’s okay if the degree is in English or whatever. Is this a step forward? Recently they have had an initiative to allow people with other designations or experience to obtain the CMA on an accelerated basis. It used to be that CMA training was heavily focused on accounting, including management accounting (using accounting knowledge to drive management decisions). But lately the CMA program has changed and is being marketed as more of an all-round management designation. This seems to lead the CMA into the MBA territory and leaves me, and I think many others, confused at just what a CMA can typically do. While I do like that there is a single national body for the CMA, and I like that it has tough standards; it seems to me that they are projecting a confused market position and contributing to a saturated market.
In contrast the CA (Chartered Accountant) program has, to my knowledge, not wavered from its long standing requirements of a degree followed by very rigorous national exams and including a mandatory articling period that is heavily structured. The CAs can be accused of not keeping up with the times and they have had problems attracting candidates. But the CA designation remains by far the most prestigious of the three major accounting designations in Canada (sorry my fellow CMAs but that is reality as I see it). I believe the CA program does offer good value for money. While an articling student is paid relatively little it can definitely make financial sense to pursue this route rather than paying for an MBA degree.
I have a CFA (Chartered Financial Analyst) designation. To my mind, this program offers extremely good value for money. It is delivered entirely by home study, which has proven to be a very cost effective system. I believe the total costs for three years of exam fees and books is something under $5000 Canadian. And the CFA designation is a marvel in maintaining its focus and specialty and in gaining enormous market acceptance in its narrow niche. The CFA program focuses on rigorously testing a candidate’s knowledge of the material required to conduct the analysis of individual stocks and bonds and to manage an investment portfolio. The program includes subjects such as accounting, statistics and certainly finance. But all of these are strictly geared to the investment analysis and money management process. Since its inception in the early 60’s this designation has achieved enormous acceptance within its target industry. Many jobs in stock and bond research and in portfolio management require this designation. And it has even been accepted by Canadian securities regulators who have included the CFA designation in the requirements for certain securities industry positions (although the legislation does also allow alternatives to the CFA designation). In summary I believe that the organization that grants the CFA charter has done an exceptional job and has set up the delivery of its program in an manner that costs a fraction of what it would cost to teach the same material in a university setting. The only problem on the horizon for this designation is that it is so popular that there is a danger of market saturation here as well.
There are other home-study programs that are very cost effective as well as widely respected. These include courses offered by the Canadian Securities Institute.
In summary when it comes to acquiring a finance education do not rely on the old adage of “you get what you pay for”. In fact there are some very effective and prestigious low-cost programs that are well worth investigating.
Shawn Allen, CFA, CMA, MBA, P. Eng.
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