Newsletter September 13, 2003

InvestorsFriend Inc. – Newsletter September 13, 2003

Sales Pitch

I value all of the subscribers to this free newsletter and I will continue to try and offer you interesting and useful analysis.

However, those who have not already done can consider subscribing to our paid stock picks. The 7 Strong Buys are up over 40% on average in 2003 to date. Our model portfolio which included several blue-chip dividend paying stocks and which was not a high-risk portfolio has exceeded my goal by returning over 27% in 2003 to date. See Performance. (The reason I say “our” rather than “my” is because the newsletter and stock picks are offered through my 100% owned corporation, investorsfriend inc.)

Using Return On Equity to Pick Stocks

I consider a high Return on Equity to be a very positive indicator for a potential investment. However, in picking stocks based on ROE one has to also consider the price to book value or the P/E ratio. A high ROE is a good thing, but we have to be careful not to over-pay. My new article on this subject explains how ROE, earnings growth, price to book value, P/E ratio and the return on your investment all tie together.

Investment Performance (Low Risk equals High Return?)

My own experience in the past four years is that safer portfolios have outperformed riskier portfolios. This should not be surprising as bonds and even savings accounts have outperformed the markets in the past 4 years in total.

However, my own experience is that a well selected value portfolio of low risk stocks has tended to outperform the market whether the market was rising or falling. The usual logic is that in a bull market the conservative portfolios get left well behind. This has simply not been my experience.

At end of 1999 my funds were in two portfolios. The larger one had a fair number of risky stocks. It also had a significant percentage in mutual funds. To a large degree these stocks were picked with broker assistance and were not my own picks. In the subsequent 4 years I was not able to add much to this portfolio but did do a reasonable amount of trading. Over time I moved this portfolio towards my own picks. I continued to take relatively high risks in this portfolio. Over the past 4 years including 2003 this portfolio has averaged a return of about 6%. (The return in 2003 to-date is 28%, as it is now based on my own stock picks).

The other portfolio that I held entering 2000 was smaller but I was able to add significantly to this portfolio in the subsequent 4 years. This portfolio was newer and was based much more on my own stock picks. I always buy the companies that I rate as strong buys and most of the Buy rated companies. It was this second portfolio that happened to usually have cash in it with which to buy those picks over the past four years. It had no mutual funds. This portfolio consistently had a much lower P/E ratio than the other. This portfolio has tended to strongly out-perform the riskier portfolio almost every month. The average return in the last four years on this portfolio has been about 19% per year. In this portfolio I tended to take less risks. I held lower P/E stocks based on my own picks. I tended to take profits such as selling half the position if the stock price doubled.

My experience has been that the low P/E portfolio has been far less volatile and far more rewarding than my riskier portfolio.  As a result I have been moving the riskier portfolio into less risky positions as well.

Air Canada’s Aeroplan

A discussion of Air Canada’s Aeroplan may be useful as an illustration of business concepts that  are important to investors.

Throughout the ongoing “restructuring” (bankruptcy) of Air Canada the business pages have indicated that Aeroplan is a valuable asset of Air Canada that can be sold for some hundreds of millions. I would challenge that assumption.

The way Aeroplan works is that it sells “points” to partners like CIBC for cold hard cash. Later it has to pay-out on these points by providing rewards including notably air travel on Air Canada. One of the great things about this business model is that in general, people collect points for a very long time before they use them. Meanwhile Aeroplan has the use of the cash. In theory Aeroplan is somewhat separate from Air Canada. In theory when Air Canada was handing out points all these years it was buying the points from Aeroplan and so Aeroplan would be sitting on a huge amount of cash with which to later buy the trips from Air Canada as Aeroplan members use their points.

Air Canada’s 2002 annual financial statements do not segment out Aeroplan (even though it is supposed to be such a huge asset). In reality if Aeroplan had any cash it would be given to the debt holders of Air Canada due to the bankruptcy.

If Aeroplan were sold as a separate company, I am almost certain that it would be a company that had little or no cash and which has a huge liability to provide Air Travel to Aeroplan members. Yes, it would have a revenue stream from CIBC, other partners and from Air Canada as points are sold to those entities. This company would almost certainly have a large negative book value. I really can’t see it having much value. CIBC Aerogold credit card holders are already reported to be moving to other credit cards. I have an Aerogold card, but I don’t use it much anymore. I don’t have much interest in building up more points that supposedly entitle me to free trips from a virtually bankrupt Airline.

Aeroplan is a good business model and does have value going forward. But is that value high enough to offset all of its liabilities? In the end I don’t think Aeroplan will be sold for very much at all. Who would want to pay good money to take on the liability for all of those free trips?

ONEX Corporation was going to buy part of Aeroplan for over $200 million. But that did not happen and I doubt it ever will.

This analysis is illustrative of the need for investors to think logically about the business models of all corporations. If the business model does not make sense then avoid the company.

Regarding Air Canada itself. I expect it to eventually emerge from bankruptcy protection. It will in the process legally renege on hundreds of millions in debts and generally fail to meet its promises. The existing shares will likely be canceled and become absolutely worthless. Meanwhile the new Air Canada will be saddled with the same demonstrably inept management and much of its high cost structure including the aging over-entitled over-unionized work force. Its next date with a bankruptcy court will then be a matter of “when” and not “if”.