Newsletter September 29, 2005

InvestorsFriend Inc. Newsletter September 29, 2005


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What Industries to Invest In?

In considering companies to invest in most investors would likely prefer to invest in companies that have good industry characteristics and that are reasonably profitable. The following is an example of a poor business and an example of a good business. Interestingly Ace Aviation (the parent of Air Canada) owns both of these.

Airline Madness Continues (What not to invest in)

On September 14, two of the “Big 6” major U.S. Airlines went into “chapter 11” bankruptcy protection. Delta Air Lines and North West Airlines both declared bankruptcy on the same day! Also on the same day U.S. Airway was preparing to emerge from bankruptcy – for its second time in just a few years!

As the above indicates this is one sick industry.

Fundamentally the Airline industry has poor economics for four major reasons:

1. It is perceived by customers as a commodity business. While extra service and various differentiation factors are nice, the customers basically just want to get where they are going and tend not to be willing to pay for extra service of various differentiation factors.

2. Compounding the above is that customers make the purchase decision anew with each trip. Despite loyalty programs customers often tend to just pick the lowest fare available. In this industry you have to win the customer again with every transaction, it’s not like insurance or cell phones or even grocery stores – an Airline can’t count on repeat business unless it has the cheapest fare the next time as well.

3. Facilitating point number 2, is the fact that the fares have become extremely transparent. The Airlines have generally placed all their fares on the internet and it is very easy to shop for the cheapest fare. This is death to profitability for all but the lowest cost Airlines.

4. Many of the costs are fixed and the variable cost of adding one more passenger is arguably very low. This creates a habit of Airlines to sell otherwise empty seats below full cost in order to generate some extra margin on each flight. This works fine if only one Airline does it to fill extra seats. But when they all do it, this leads to losses for all participants.

In Canada, Air Canada emerged from bankruptcy last September. Air Canada managed to become bankrupt despite having a huge market share in Canada. In my opinion, its bankruptcy was largely the result of poor management which instituted constant price wars with its lower-cost competitors (how dumb is that?). Despite this it managed to emerge from bankruptcy with the same apparently incompetent management.

Since emerging from bankruptcy, Air Canada now trading as Ace Aviation has however done some good things……

Load factors are up at record levels (planes averaging over 80% full)

Air fares rose substantially when JetsGo went bankrupt this past Spring

Ace Aviation sold off about 20% of AeroPlan as an income Trust at a large profit. It appears that AeroPlan is a very profitable business and Ace Aviations still owns the majority of this valuable asset.

However, I am now seeing signs that Air Canada is up to its old money-losing tricks once again.

Recently there have been numerous seat sales. Air Canada continues to try to undercut Westjet. I was recently able to fly from Edmonton to Saskatoon at fare of just $79 each way (plus taxes and non-airline fees). I don’t know that much about the costs of running an airline but I am certain that this is a money-losing fare. Fares are easily available at under $200 per stage-length. Fifteen to twenty years ago (when costs were a lot lower) the best prices were usually at or above current prices, and Airlines were barely making money then. This looks to me a recipe for continued losses.

I have the following questions about Airline fares:

Why do airlines show all the prices on their web sites? If I am paying $500 for a last-minute flight I don’t think I really need to be reminded at that point that most of the people on the plane bought seats at much lower prices.

Why do airlines think that it is better to practically give away seats rather than let a seat go empty? Do they not realize that selling a seat below a reasonable cost cheapens their product and leads customers to expect such unrealistically low prices in future as well? Do they not realize that the extra crowding caused by full planes leads to discomfort for passengers that paid full fare? Do they not calculate all of the incremental costs of adding passengers including extra flight attendants and extra call center and boarding lounge staff to deal with additional passengers?

Do airlines not realize that customers might be willing to pay more to fly on bigger and newer airplanes? (The type and age of the plane is not listed when booking flights).

My bottom line is that I would be very hesitant to invest in this industry. In Canada the era of ruinous seat sales seems to have returned. Therefore it seems unlikely that any Canadian Airline will make much money. The one possible saving grace for Air Canada is the profits and gains it may make on AeroPlan.

Aeroplan (A possible good investment)

I have not analyzed whether or not Aeroplan is a good investment at its current price per unit. But I do believe that AeroPlan is a very good business.

Aeroplan effectively sold 14.4% of itself to Aeroplan income Trust for $287 million. Currently AeroPlan has an implied  market value of about $2.4 billion and this is in spite of the fact that Aeroplan has a negative book equity value of about $1 billion. Effectively AeroPlan owes its members for millions worth of trips earned over the years but most of the money that should have been set aside to pay for the flights was lost by Air Canada. But nevertheless the business model is so strong that Aeroplan is worth a lot in spite of its negative book value.

Some of the reasons that Aeroplan is a great business model include:

It sells “points” to Air Canada, CIBC and many other businesses for cash but it typically averages three years before it ever has to incur the expense of paying for a trip or other reward. Meanwhile it receives interest-free cash. Furthermore it estimates that 17% of the points earned will never be redeemed.

This is effectively a virtual or pure financial business. It does not have to produce or even handle any tangible product. It does not directly provide a service. This results in low capital costs and low operating costs.

Aeroplan enjoys a large market penetration in Canada.

Airline rewards are the type of reward that most people will hoard and save up for a umber of years. Most of us are not interested in cashing in our points for a movie or whatever so that allows Aeroplan to hold the money received for the points for an average of about three years.

Due to the difficulties of competitors achieving market penetration and scale, Aeroplan does not face a large amount of competition. Air Miles is a competitor but due to exclusivity agreements I believe there are many businesses where Air Miles would not compete with Aeroplan. For example if Air Miles are offered exclusively at one supermarket chain in a region, then Aeroplan may be free to strike a deal with a competitor supermarket chain in that chain.

Aeroplan is an example of a company where net earnings would systematically understate free cash flow. For example revenue and earnings can only be booked when points are redeemed but the cash comes in as soon as the points are sold. Bizarrely, the company has recently been encouraging members to cash their points which will increase reported earnings and revenue but which is actually fundamentally bad for the company since it decreases cash. It would only be good if cashing points somehow led to members getting an even bigger appetite for collecting points.

Again, I have not analyzed whether or not Aeroplan Income Fund is a good investment. But it does have great business characteristics.

I prefer to try to largely restrict my stock holding to companies with great or at least good business characteristics. After all it seems self evident that it is easier to make money in a stock of a money-making company than in the stock of a money-loser. And companies in industries with good business fundamentals (chiefly a lack of ruinous competition) tend to have a much easier time making money.

Using Stop Loss Orders to Protect Your Portfolio

Stop Loss orders are used to trigger the automatic sale of stocks that an investor owns, if the price falls to or below a specified level. A stop loss order can protect against the risk of a major decline in a stock’s price.

The mechanics of a stop loss order are to place a “stop loss” order to sell if the market price falls to or below a certain “limit price”. You must also specify another lower stop limit price below which you do not wish to sell. If the market price falls to the limit price that you set, then the stop loss order becomes an order to sell at the best available market price, but not below the stop limit that you have set.

For example I recently held a thinly traded stock that had very rapidly increased from the $60 range to almost $100. Due to the thin trading and the rapid price increase I was worried that if the stock did start to fall it might fall fairly hard. I entered a stop loss order at $93 with a stop limit of $88.

I had set the stop about 6% below the then current market price because I did not want the stop loss to be triggered on just a minor dip in price. In actual fact it appears that I set my limit too “tight” because the stock price dipped down and my shares ended up selling at $90, there was then a trade at $89 and then the stock recovered to $93 and then $96 and then $104. In retrospect this particular stop loss was triggered too early.

The ideal scenario for using a stop loss is to place a stop loss “under” the current market price. If the stock then falls your stock should be sold and then in the ideal case if the stock then continues to plummet, your stop has protected you from a large loss. However, even this scenario can turn out bad if the stock soon recovers and then zooms well above the price you sold at with you no longer holding it.

A negative aspect of a stop loss order is that it can lead to selling a lower price than the current market price when the stop loss order is entered. (i.e. you could have simply sold rather than placing a stop loss at a lower price – but then you lose the possible upside if the stock keeps rising).

One danger in using stop losses is if the stop limit is placed too close to the the stop price then the market could “blow through” your stop without your shares being sold. For example if you place a stop at $80 with a stop limit of $75 and the stock actually gaps from say $82 down to $70 then you will not have sold and will not have been protected from the loss. On a liquidly traded stock this would be unlikely to happen during the trading day but it could happen if news was released after close of the market that caused the stock to gap downwards at the next day’s open, and it could even potentially happen during the trading day.

If an investor believes that there is a very high probability that a stock will in fact fall substantially then it makes more sense to use an immediate sell order rather than using a stop loss order which would be expected to end up selling at a lower price.

Investors may ask whether or not it is wise to use stop loss orders. There is no easy answer to that question because it depends on circumstances.

Active traders who buy stocks that are rising, with little regard to fundamentals, may consider stop loss orders to be absolutely essential. They may wish to hold the stock only as long as a current rising trend stays intact. If the stock falls a few percentage points they often just want to sell and move on. These traders would usually keep increasing their stop loss price as the stock price rises.

Investors who hold stocks based on fundamentals may be much less inclined to use stop loss orders. If an investor has confidence in a stock for the long term, then a price dip is seen as a buying opportunity rather than a cause to sell.

Stop loss order probably make more sense  for stocks that have been bid up to high multiples of earnings and/or high multiples of book value due to investor enthusiasm. These stocks can fall hard if the enthusiasm cools and so a stop loss could prevent a large loss. Value oriented stocks trading at low multiples are (in most cases) less susceptible to sudden drops and therefore a stop loss order is less likely to be effective.

Investors should be aware of the mechanics of stop losses and should consider using them when they conclude that it is appropriate to do so.

Regression to the Mean (Are we due for a Market Correction?)

Annual percentage stock market gains (or losses) exhibit “regression to the mean”.

This implies that several years of very strong (and therefore above average) stock market returns are more likely to be followed by several years of below average stock market returns. This is necessary if the average stock market return is to remain approximately at its long-term historical average. (which has been an average compounded return of 10.4% for U.S. large stocks)

Regression to the mean does not imply that after several strong years the next year MUST be weak, but it does imply that it is more likely to be weak, all else being equal.

Some analysts speak of the “stock market” as exhibiting regression to the mean. This is using the term loosely. After all, the stock market is not destined to decline to its average historical level. It is the annual returns on the stock market that exhibit regression to the mean and not the stock market level itself.

As of late September 2005, the stock market has exhibited strong returns over the past 3 years.

On September 30, 2002 the TSX index was at 5935. It was recently up 86% to 11,042. This is equivalent to a compounded gain of 23% per year for three years straight.

Regression to the mean would suggest that the return in the next 12 to 36 months will be not only lower than it has been in the past few years but significantly lower than the long term average of 10.4%.

Possibly there are some mitigating factors. When one considers that the returns in the last three years were high partly to make up for the very poor returns of the early 2000’s then maybe the we can expect the the next three years to return to the average level.

Also when we consider that a large part of the reason for the strong returns of the past three years was due to lower long-term interest rates and if long-term interest rates are expected to be stable then there would be no expectation that this would cause lower returns in the next three years.

In addition when we consider that part of the reason for the high returns in the past three years was due to unusually strong corporate earnings growth, then this factor would not suggest below average returns in the next three years.

In summary after three “fat” years we should  not be surprised if we now get three “lean” years or perhaps at best three average years of returns.

In Investing as in Baseball, you don’t need to bat “1000” – or anything close to that…

My knowledge of baseball is shaky at best but I understand that even a really great baseball player bats well under “400”, which means that he fails to get a hit in the majority of his attempts.

Something similar is true in investing. A good investor will still make many mistakes. A hypothetical perfect investor (with the power to predict the future perfectly) could “simply” put all of his money into the one stock that would turn out to rise the most each day in the market and keep switching into the new best stock for each day every morning. This strategy could turn $1000 into multi millions in an extremely short time.

Of course no such perfect investor exists. Even very good investors will very often sell stocks well below their peaks and buy stocks that end up falling. A good investor is an investor who can consistently match or beat the market over a period of years. This can be achieved in spite of numerous “mistakes” as long as the overall investment strategy is sound.

For example, this year I missed out on being in oil and gas stocks, I held almost no Income Trusts and I held none of the major banks. Nevertheless with a return of over 22% year-to-date I have beaten the Canadian market index by a good margin. I believe that the reason for this is that my basic long term strategy of selecting bargain prices stocks was still able to work even if I was not in some of the stocks that did very well.

The lesson I take away from this is to adopt a sound investment strategy and to focus on the overall results. I try not to worry about my inevitable bad moves and missed opportunities. There will always be more missed opportunities in the world than I could possibly ever have taken up. What is important is the return on the overall portfolio based on the investments made.

Signs of the end of good times?

I have said before in this newsletter that times are good, the economy is strong. Sure some people will complain about apparently stagnant after-inflation earnings, inflation or government debt or a hundred other things.

My response is “if things or so bad, then why are things so good”? Why are the streets full of new cars?, why are new houses averaging well over 2000 square feet? why have houseprices risen so much? Why are the restaurants so busy? Why are all the Cosco’s and Home Depot’s so busy? and why are so many new stores opening? (My point being that things are undeniably good for most Canadians).

But I am seeing signs that a slow-down (or worse) is coming. The higher prices for gasoline and particularly for home heating will inevitably cause a cooling in consumer spending. The prime lending rate in the U.S. has risen to 6.75% and this will also take its toll. And a report today indicates that the number of credit card bills that are at least 30 days over-due has risen to a record 4.81% – and this from the April to June period – before the increase in energy prices.

To a large degree the good times enjoyed by consumers in the past few year has been due to incredibly low interest rates and easy financing. If bad credit problems cause lenders to begin tightening up their lending policies then consumer spending will take yet another hit.

It seems almost inevitable that there will be a significant slowing in consumer spending in the next 6 months and this will surely cause the prices of certain consumer sensitive stocks to drop. Financial stocks would also take a hit.

I will be watching this development to try and insure that I am not invested in stocks that are vulnerable to this expected development. My stock ratings and the reasons for each rating are available to subscribers.

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Shawn Allen
InvestorsFriend Inc.