Newsletter October 27, 2002



I am excited to announce that Marvyn Hall, B.Sc., MBA has joined as a contract contributor. Marvyn has a strong financial background. This development will enable us to increase the number of companies analysed.

In another exciting development, this Site was listed in the November issue of Report on Business Magazine (on newsstands, Friday October 25th) as a “Handy Web Site”.  Greetings to all the subscribers who joined as a result of that publicity and to all other recent new subscribers. The recognition of this Site by ROB is much appreciated.


We have analysed 9 companies based on on the recent Q3 reports. This detailed research (in our usual format) is offered for sale in two packages of 4 and 5 companies each for just U.S. $6 (instant internet access by credit card sale) or CAN$10 by check.

The companies included are:

1. AGF Management – A mutual fund company
2. First Service Corporation (a successful group of small service companies including College Pro painters and may more)
3. Transat AT – Holiday tour packages and charter airline operator
4. Celestica – Electronics out-source manufacturer
5. Bombardier
6. Canadian National Railway
7. Maple Leaf Foods
8. Home Capital – small  financial institution
9. Aastra Technologies – small telecom manufacturer

One of the above is rated as a weak sell, one is a weak buy, three are speculative strong buy and the others are rated Buy or Speculative Buy. If you hold these stocks or are interested in buying, our reports should add greatly to your understanding of these companies.

Click here to Purchase these reports (instant access via internet) at a price of 4 to 5 reports for U.S.$6


Okay, so the DOW Jones was recently down some 38% from its historical peak and down 27% in 2002. And, until the recent rally, it was looking like the markets could continue down for some time.

In the past year, many stocks that I rated buy or strong buy on this site have fallen. (Though my overall record is still strong). Even many stocks that seemed safe have declined. There seems to have been no escape. Please note that my ratings are generic and not meant as specific investment advice to any individual since I am not an Advisor and also don’t know your individual circumstances.

At this time it is very worth while to evaluate the situation and determine if changes in tactics are needed.

Why have markets fallen so much

My belief is that the biggest reason for the fall is that stocks had become very over-valued by early 2000. Most of us were at least vaguely aware, at the time, that this was the case. Still, it was hard to get out of a market that had given such consistent high returns for a number of years. And, the market had been over-valued since at least 1996 when Greenspan made his famous “irrational exuberance” speech. Investors who retreated at the first sign of over-valuation would likely have missed the great majority of the long bull market that started in 1982.

Adding to the decline is the fact that earnings have temporarily declined and the long term consensus growth outlook has become more modest.

Finally, as we hopefully near the bottom of this bear (and perhaps this has already happened) momentum took over and the market may (or may have) over-corrected to a point where stocks are under-valued. (Though my own analysis indicates that this has not yet happened – maybe it won’t).


I’ve mentioned in several recent articles (including the DJIA article) that a realistic average return expectation from the stock markets is about 6% to 8% annually. When I first read Warren Buffett’s suggestion, of this level of average return, in Fortune, in late 2000, I thought it seemed low.

But I have been through the logic and it is simple and compelling. The economy is predicted to grow at only about 3% in real terms, plus 2% for inflation. Since company earnings tend to remain relatively static as a percentage of the economy, company earnings would therefore grow at only about 5%. Add the current dividend yield of 2% and we get 7% as the long term return from stocks. This is 6% to 8% allowing a 1% long term average error in the above earnings growth forecast.

As a test, I graphed this as a historical relation. We all know that the stock market return was much greater than the above formula would have predicted over the last 20 years. But when viewed over the long term, (see article) this formula has worked remarkably well.

Since the market has recently crashed, you might expect returns in the next 10 years to be above this 6% to 8% range, to make up for lost ground. And it is absolutely true that the lower the market goes the higher the return we should expect in the next ten years. But the market overall has not fallen to bargain levels. It is at best fairly valued and more likely still slightly over-valued. Therefore, we should not expect the stock market return to be more than the 6% to 8% that the earnings growth and dividend yield can justify.

Of course some very astute traders and stock pickers will earn much more than 8% but, as explained below, this must come at the expense of others who will earn less than the average.

What is Stock Picking All About?

Readers of this  newsletter presumably hope to pick better than average stocks and make higher than average returns. Our goals can be broken into two parts:

1. Invest in a portfolio profitable businesses and earn at least average returns as business owners over the long run.
2. Add above average returns by being smart enough to pick under-valued stocks and avoid over-valued stocks.

The first part can best be achieved by investing in index funds but in that case we give up the potential of the second goal, to beat the averages.

My readings of Buffett, Graham and others give me hope that it is indeed very possible to beat the averages through systematic value based approaches. And I feel that my education, diligence and independence leaves me (and by virtue of access to my analysis, and your other due diligence – you) well positioned to compete with other investors.  However, only a moment’s reflection is needed to realise that no more than 50% of investors can beat the market average return. And when commission costs are considered, less (and probably much less) than 50% of investors can possibly beat the  market averages.

This leads to the sobering conclusion that attempting to beat the market is by definition, on average, a losing game. For a detailed discussion, see my article on this subject. How the Stock Market Works. (I think you will find this article well worth your investment in reading time).

The conclusion is that most investors should stick to index funds unless they have good reason to think that they (with or without the help of advisors) can beat the market. Still, as the article explains there is hope for those with better than average investing methodologies.

Lessons From Bonds

Stock investors can learn a lot from the far more predictable behavior of bonds, since stocks also react to the same forces as bonds. (But stocks have a lot of volatility that masks some of the reaction).


When interest rates go down, Why do bonds and stocks (on average) both jump in price providing high returns? And will the high returns continue?
Answer: Because they have to jump in price (thereby providing a one-time high return) so that they can provide a lower market return going forward.

This sounds crazy, the bond gives a one-time high return precisely in order to give lower returns going forward. Consider a government perpetual bond that pays $100 per year. If long term rates are 10% that bond is worth $100/0.10 = $1000. Now if long term market interest rates drop to 5% then that bond has to readjust to offer only a 5% return. The $100 payment is fixed, and represents a 10% return if the bond trades hands at $1000. But if the bond price readjusts to $2000, then the buyer will receive a 5% return. So, when interest rates fall, the bond price jumps (giving a one-time) high return precisely in order to offer a lower return going forward.

Investors can easily be fooled by this. Due to gradually lowering interest rates over the last 20 years, bonds have given investors capital gains as the value of bonds that paid the old higher interest rates kept rising in response to new lower market interest rates. Investors viewing this trend might conclude that  bonds will continue to offer very attractive returns as they have done over the last 20 years. But when we realise that those high returns were as a result of a lowering of interest rates which means lower returns going forward we see the complete error of this thinking. With bond yields recently at 44 year lows, I believe that there is near zero possibility that bond returns will be high going forward. (Interest rates would have to fall even further, which seems very unlikely).

In fact, there is a significant risk of capital losses on bonds, since interest rates could rise. The only long term bond I would consider investing in is a real return bond. (Talk to your broker for information on these).

Part of the reason stocks rose so much in the last 20 years was also because stock prices also must (on average) increase when market required returns on stocks reduce (as they have done in response to lower interest rates in the last 20 years). In 2000, many investors thought that the long trend of high stock returns was good reason to think that future returns would be similarly high. But stocks rose partly to insure that future stock returns would be lower to match lower interest rates. (The other reason for the high stock returns of the last 20 years was higher earnings and higher expected future earnings). Investors looking at the trend could easily come to a completely wrong conclusion. Understanding how bonds respond to interest rates and that stocks also respond the same way, on average, leads to avoiding this mis-understanding.

For more on this subject see my article from mid 2001 on how the trend in stock returns has fooled investors who mis-understood the reason for the trend.

Where Do We Go From Here?

I believe that most long term investors should continue to invest regularly in equities. The market at this time appears to be moderately over-valued to possibly fairly valued. Given this and the difficulty of catching the bottom it seems reasonable to continue to invest regularly.

I personally will strictly avoid long term bonds and bond funds due to  the risk of higher future interest rates (which would cause bond prices to drop). Instead I would consider real return bonds, which protect against inflation.

I see nothing wrong with keeping a portion of the portfolio in cash or short term investments in order to take advantage of any further significant drops in equity markets.

For the equity portion I believe that index funds make a lot of sense and that most equity mutual funds are a bad bet. (They face the headwind of higher management costs). Mutual funds may be a good option for segments where an index fund cannot be found.

For braver investors I believe that significant bargains will exist and that it is possible to beat the market index by using value investing techniques to choose better stocks and avoid over-priced stocks.

Timeless Advice  and Quotes From a Master Investor- Benjamin Graham.

Ben Graham is called the father of value investing and was the chief mentor of Warren Buffett, who subsequently has become by far the world’s most successful investor.

Here are some relevant quotes from Grahams classic book, The Intelligent Investor.

Ben on accounting irregularities:

On the matter of special charges. “We find that such losses can be charmed away… with no unhappy affect … on either past or future primary earnings…Could there possibly have been some fine Italian hands at work with the accounting –but always, of course, within the limits of the permissible?”

Hmm I don’t think Ben would have too surprised by ENRON.

Ben on Stock Options (note he uses the alternate term “warrants”):

Let us mince no words at the outset. We consider the recent development of stock-option warrants as a near fraud, an existing menace, and a potential disaster. They have created huge aggregate dollar “values” out of thin air. They have no excuse for existence except to the extent that they mislead speculators and investors. They should be prohibited by law, or at least strictly limited to a minor part of the total capitalization of a company.

Note that in the usual company reports the per-share earnings  are (or have been) computed without proper allowance for the effect of outstanding warrants.

Wow, Ben’s warnings were totally correct and we are only now moving to start expensing stock options and curbing their use some 28 years after his clear warning.


Next newsletter will be published around the end of November.

Shawn Allen

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