Newsletter October 6, 2006

InvestorsFriend Inc. Newsletter October 6, 2006


I’m spending my Friday night typing out this newsletter. And yet I am in a great mood! Why is that? It’s because I am  on track to make an excellent return in stocks once again this year and to beat the market average return for the seventh straight year. (On average my returns have beaten the Canadian market index by about 12% per year while our Strong Buys have beaten it by 20% per year). Also I have the great satisfaction of knowing that the several hundred subscribers to our well-researched Stock Picks service have had the opportunity to make the same excellent returns.

Just today we saw our Tim Hortons pick jump another 4.5%. And some of our subscribers in effect got their Tim Hortons shares for free (more about that below).

The performance of our Stock Picks on this Site continues to be very good. Since our inception, seven years ago, our performance has been outstanding.

My personal portfolio is up 13% for 2006 to date. While that’s lower than the blistering returns I achieved in each of the past three years, it is still a very good return. Also, because my personal return has averaged over 28% per year for the past four years, my portfolio has grown to the point where a 13% gain in 2006 is a “noticeable” amount in dollars. (i.e. Enough to put me in a good mood!)

Back to the Basics

It’s my firm belief that in any field of endeavor it’s always a good idea to review the basics periodically. Recently I have been thinking about what kind of stocks are likely to deliver a strong return, based on basic mathematical facts.

My basic goal is to identify stocks that can reasonably be expected to go up in price and give me (and our paid subscribers) a good return on investment.

As further explained below, basic finance suggests that we can achieve good investment returns by selecting stocks of companies that are earning (and are expected to continue to earn) high returns on their operations and to further select from these only those that are available at a lower ratio of price to earnings.

To achieve any goal it usually helps to break things down into smaller steps.

If a stock goes up in price we can break the reason for that down into two categories:

1. It went up because its (past 12 months) earnings per share went up, or

2. It went up because its price to (past 12 months) earnings ratio (P/E ratio) went up.

There are many other ways to categorize the reasons for a stock’s price to rise, but if any stock’s price has risen it can be explained by a combination of the two basic reasons above.

This then leads to the very basic conclusion that to make money in stocks we should buy stocks which (ideally) can pass both of the following tests:

1. We expect the earnings per share to rise at an acceptable rate, and

2. We expect the P/E ratio to rise.

Sometimes it will not be realistic to expect to find stocks that pass both tests.  For example if we expect a stock will increase its earnings per share by 20% per year for several years then it will still be a great investment even if its P/E ratio remains the same or falls somewhat.

We should generally avoid stocks where the P/E ratio can be expected to fall materially. In general stocks with very a high P/E ratio are in higher danger of suffering a major decline in this ratio. Logically the best way to avoid investing in stocks where the P/E ratio may fall materially is to focus on investing in lower P/E ratio stocks.

In general we should expect that (on average) companies that have a record of poor earnings per share growth are going to continue to have that record. Meanwhile, it is a reasonable bet to assume that (on average) companies with a long history of strong annual growth in earnings per share are likely going to continue to grow their earnings per share. Companies with a high return on equity are also likely to grow their earnings per share. It is a mathematical fact that if a company keeps on earning 15% on equity and retains the earnings then its earnings per share are going to have to grow at 15% to keep the return on equity at 15%.

So it is a basic fact that to earn high returns on stocks it makes sense to focus on companies with high recent historic growth in earnings per share, a high ROE, and a reasonable to lower P/E ratio (Preferably under 15).

Buying stocks with a high return on equity also makes basic sense from another perspective. If you want to buy and hold a stock and if you hope to make say 15% annually on that stock, then it makes basic sense that the underlying company should itself be earning 15% on its own equity.

If we were investing our money in a bank account it would be immediately apparent that a higher interest rate on our money would lead to a higher return for us. We can think of the interest rate as being our return on our equity invested in the bank account. Similarly it is logical that a company that can continue to make a higher return on its equity is more likely to deliver a high return to investors, all else being equal.

In conclusion a review of basic investing math suggests that we should look for stocks with high ROEs (and that are expected to be able to maintain that high ROE) and that are selling for lower or at least reasonable P/E ratios. Stocks with consistently high past ROEs will invariably display either strong historical increases in earnings per share or a high dividend pay-out ratio.

Paradoxes of the Market

There are many paradoxes or contradictions in logic when it comes to investing.

One of the biggest problems is that we have a human tendency to expect recent trends to continue.

For example if the market goes up say 15% per year for three straight years or more, then a part of our mind will definitely be telling us to expect another 15% the next year. In early 2000’s investors had seen the market soar for quite a few years. Investors could not help but be optimistic and yet (paradoxically) it was actually predictable that the market could not keep going up at a high pace. In fact it was predictable that returns would soon be lower to make up for the fact that they had gotten so high. In affect there is a “law of averages” or reversion to the mean (long-run average) that applies.

Similarly if the market declines 15% per year for for several years then a part of our mind cannot help but feel pessimistic about the future. Consider late 2002, the market had crashed hard for two years. Investors could not help being pessimistic just at a time when (in hind-sight) great optimism was called for.

In the last four years Canadians have seen four years in a row of strong market returns. Therefore our natural tendency is to feel optimistic but in reality these higher recent past returns actually signal lower average stock market returns ahead.

There is another common paradox in the market. It is generally agreed that in total, corporate earnings cannot sustainably grow at a faster rate than the economy. And few people would predict the economy to grow faster than 5 to 6%. (Say 3 to 4% real GDP growth and 2% for inflation). This would suggest that the earnings on a broad stock market index should not be expected to grow any faster than 5 to 6% per year. And if we consider that we have been in a period of unusually high corporate profits and that we may be heading into a recession, it then becomes problematic to predict that earnings on a broad stock market index can grow at even 5% on average in say the next five years.

And yet when looking at any individual stock it is rare to see the earnings projection for that individual company to be much under 10%, let alone 5%. Apparently analysts expect almost every company to grow at a rate that is much higher than the average sustainable rate.

For example, figures on the Dow Jones Industrial Average Site indicate that on average analysts expect the earnings of the 30 Dow industrial stocks to grow at 15% in the next year. (Trailing P/E excluding negative earnings is 16.44, forward P/E is listed at 13.92, which implies an average 15.3% earnings growth). That is built up from earnings projections for the individual stocks. And frankly, it looks like a laughably optimistic scenario.

In the past few years such optimistic projections have tended to come true. But it is a certainty that such unsustainable earnings growth cannot continue indefinitely.

When projecting the earnings growth for any individual company it is wise to keep in mind that an average company is going to have trouble growing much faster than the economy or about 5%.

Luckily there will always be some individual companies that can be expected to continue to grow earnings at high rates. On this Site, we look for those exceptional companies.

Interest Rates and the Direction of Stock Prices

When long-term interest rates go down, stocks should go up (all else being equal).

Recently long-term interest rates have been going down again. This, in isolation, could be a positive indicator for stocks. But remember there are other factors that are negative for stocks at this time.

The easiest way to understand why lower long-term interest rates tend to drive stock prices up is to first understand how interest rates affect bonds.

Most investors may be aware that an investment in a long term bond will result in a capital loss if interest rates rise and a capital gain if interest rates fall. If a 30-year government bond issued in 2005 pays 5% interest then that is $50 per year per $1000 of face value. If interest rates then fall to 4% in 2006 then the new 30-year $1000 government bond will only pay $40 per year. The older bond that was purchased for $1000 when it was issued is now worth about $1250 because $50 / $1250 is equal to 4%. The older long-term bond gained 25% when interest rates dropped.

The same math affects stocks because stocks are also expected to pay a stream of dividends in the future or are expected to reinvest the money that could have been paid as a dividend. However, the impact of interest rates on stocks is often obscured by all the factors that can affect the expected earnings and dividends that a stock might pay.

Overall, higher interest rates are like a gravitational force on the value of both bonds and stocks. Lower interest rates are like a weakening of gravity that allows bonds and stocks to float up in value.

With that background it is useful to look at how interest rates have moved lately.

10-Year Government of Canada bond interest rates
October 4, 2006 3.96%
June 28, 2006 4.63%
August 31, 2005 3.78%
July 2004 4.82%
July 2003 4.78%
July 2002 5.23%

Short-term interest rates have generally been rising steadily in Canada. The Bank of Canada overnight rate target rose from from 2.0% in July 2004 to a current 4.25%.

Meanwhile (and less well known) long-term interest rates continued to move lower well after July 2004. They briefly hit a bottom of about 3.8% in late August 2005. Since then the 10-year interest rate has been volatile. It briefly rose as high as 4.63% in June 2006. (Remember the stock market decline around then?) But since then 10-year interest rates have slid all the way back to just under 4.0% in recent days.

In part, it has been this most recent slide in long-term interest rates that has propelled stocks (other than resource stocks) up in recent months.

At this time most predictions are that long-term interest rates will stay low for the next year or so. In isolation this should help stocks.

However, if part of the reason that interest rates are low is because we are headed into recession then that factor could drive stocks down significantly.

Overall, although interest rates are low, I am cautious on the direction of markets. Canada has seen strong markets almost steadily since late 2002. It would not be surprising if the market retraced some of that gain. Also profits of many Canadian companies have been hurt by higher energy prices and more particularly by our higher dollar.

I consider energy and resource stocks to be highly unpredictable and I have no opinion on where these are going.

My strategy has been to build up my cash weighting to be ready in case the market falls. Meanwhile I still maintain quite a high weighting in stocks and for these I focus on individual stocks that I think will do well based on profit growth.

How Some of Our Subscribers got “free” Tim Hortons Shares

In the fall of 2004 we rated Wendy’s a Strong Buy at prices as low as U.S. $33 to $31. Our investment “thesis” was that the value of Tim Hortons was not being recognized in that price. In fact we observed then that the 2500 Tim Hortons stores were contributing about 50% of Wendy’s total profits even though there were some 6500 Wendy’s restaurants. And we observed that American stock analysts focused on the (low growth) same store sales of the Wendy’s restaurants and pretty much ignored the (high growth but unfamiliar) Tim Hortons part of the company.

Now, two years later, those who bought Wendy’s and hung onto it now still own the Wendy’s. Last week Wendy’s was at U.S.$67. Wendy’s then gave out 1.35 shares of Tim Hortons for each Wendy’s share. The Wendy’s shares then declined since they no longer own Tim Hortons. So those late 2004 investors may still own the Wendy’s which at $33.80 is worth about what they paid for it. Meanwhile, for each Wendy’s share they own, they just received “free” 1.35 shares of Tim Hortons which today are worth 1.35 times U.S. $27.75 or U.S. $37.46. So this was over a 100% gain in two years on what appeared to me a lower risk investment.

And last Spring when the financial media was reporting that retail investors could not get any Tim Hortons Shares at its IPO, our subscribers were fully aware that they could simply buy Wendy’s shares and then wait for the Tim Hortons shares to be handed out to them. This was no secret but the financial press focused on the more interesting story of the shortage of Tim Horton IPO shares.


For those on our mailing list for this free newsletter, who are not already subscribers to our Stock Picks service, there is never any pressure to subscribe to the paid service. We realize that not everyone has funds to invest and not everyone has a self-directed investment account. Some visitors to this Site have subscribed to the paid service the same day they first visited this site. Others may wait a year or more before deciding to access the Stock Picks.

But, if you are looking for stocks to invest in then why not subscribe now? Remember the cost is just CAN $11 per month or $99 per year. When you think about the potential returns from just one well-researched Stock Pick, you can see why our subscription service has been a great investment for our subscribers.


Shawn Allen
InvestorsFriend Inc.

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