Newsletter September 4, 2005

InvestorsFriend Inc. Newsletter September 4, 2005

Economic Impact of the Hurricane

The Gulf Coast Hurricane is certainly a human tragedy. Although it may seem callous, it is also necessary for investors to consider the possible economic impacts.

We have already seen large jumps in energy and gasoline prices. Perhaps that will now be offset by international efforts to “release” oil reserves. My fear is that this event is going cause a change in the psyche of many consumers. An awful lot of people have been spending liberally on new cars, larger houses, vacations and a thousand other “luxuries” that go well beyond the basic needs. Partly this spending has been fueled by higher house prices, rising investment portfolios, and cheap borrowing costs. But now borrowing costs have already risen fairly sharply in the U.S., this combined with higher gasoline prices and possible fears of an end to the rise in housing prices and stock markets could cause a lot of people to reign in spending either by choice or of necessity. I can’t be sure, but I am afraid that the party may be over for now.

For investors the “affordable luxury” category has been a sweet spot recently. But I fear right now that “basic necessities” might be a better category in the next year or so.

So far, the stock market has held up surprisingly well in the face of the Hurricane impact. So maybe the markets will not drop due to the hurricane, but I think investors might want to be ready to react if the market starts to fall.

My own strategy has been to place some stop loss orders under a portion of my three largest holdings.

Performance of Our Stock Picks

I think I can be justifiably proud of the performance of the Stock Picks provided by InvestorsFriend Inc. Although stock picks are provided all throughout the year, one of the ways I measure performance is to take a “snapshot” of the stock ratings each January 1 and then follow the performance throughout the year. The graph of the performance of the January1, 2005 stock picks shows that almost all of the rated stocks moved in a direction consistent with the ratings. Buys are almost all up (bar on the graph moves to the right). Two out of the three Sell rated stocked moved down (bar on the graph moved to the left).

September 4, 2005

On the Performance page of this site you can see that the graphs for the other years going back to inception in 2000 were also generally very consistent (with the exception of 2002).

Given this consistent track record, those who are not subscribers to the stock picks may wish to consider subscribing

Impact of fluctuations in the Value of the Canadian Dollar

With the Canadian dollar recently reaching 84 cents U.S. and above, it is worth considering the impact of this on individual consumers and on investors.

I believe that the impact of currency movements on “ordinary Canadians” is often over-estimated. Back when our dollar was approaching 60 cents some analysts said that the lower dollar was like a pay cut since our salaries were dropping lower when measured in U.S. dollars. Analysts talked about how the price of imports must be higher due to the lower dollar. In certain surveys measured in U.S. dollars, Canada’s standard of living looked like it was dropping dramatically. But the thing was our $1.00 of pay was still worth a dollar in Canada and inflation remained very low. Strangely foreign cars were cheaper here and some people were buying foreign cars in Canada and shipping them across the border to the U.S. for a large profit. It seems many of the predicted negative impacts of the lower dollar did not happen.

Now our dollar is up about 35% since the lows of around 62 cents. So according to the logic of some analysts Canadians should feel like they just got a 35% pay raise! But oops there has been very little impact of this currency change on our prices in Canada. Import prices have not tended to drop dramatically. Our dollar is still worth the same dollar in Canada despite the huge fluctuation against the American dollar.

Based on this I think the impact of currency changes is overblown.

Thinking about the U.S., the impact of their lower dollar on ordinary Americans is even lower. A recent Article by Abbey Joseph Cohen in the July/August 2005 issue of Financial Analysts Journal indicated that foreign trade makes up 15% of the U.S. GDP. (In Canada the figure the closer to 40%). Therefore the American economy is 85% based on trade and activity within itself. A drop or rise in the American dollar has little or no impact on 85% of its GDP, except to the extent that it causes the foreign trade component to change. The average American is unaffected by the fact that imports from Europe cost more or less because they buy little that is imported and the average American will never travel to Europe.

I don’t want to totally minimize the impact of currency fluctuations but in our day to day lives, for most consumers, it has little impact especially if were are talking movements in the range of 10 to 30% over a period of a few years.

For investors the impact is greater. Canadian investors have to be cautious about investing in companies that are hurt by our higher dollar (primarily manufactures and exporters). Meanwhile we can be more confident of investing in companies that benefit from our higher dollar (for example those using or selling imported products). Canadian investors in U.S. stocks are harmed when our dollar rises.

Stock Price Increases versus Increases in Earnings Per Share

Investors should understand that a share price is always in something of a race with the earnings of that share.

In theory, a share price should equal the value of the future cashflows to be expected from owning that share “discounted” by an appropriate required return or interest rate.

For most companies we should not expect to see the share price and the earnings per share moving in any kind of a synchronized fashion. For example consider a company that develops a new product today that is expected to cause its earnings to jump 50% per year for three years but only after an 18 month development period. If the market “believes” that these earnings will happen, then the stock price would jump immediately. That is the stock price would move well ahead of when the actual earnings increase was expected. This process is referred to as the stock price “discounting” or “reflecting” or “pricing in” the future expected earnings. Normally the future earnings would not be fully priced in since there would be a risk that the earnings would not materialize. Subsequently if the earnings growth turned out to be “only” 30% in 18 months rather than the expected 50%, we could see the stock price drop even as the earnings rose. This example illustrates why stock prices and earnings often appear not to be at all correlated over the short term. However, they do tend to be well correlated over long periods of time.

Another reason that stock prices can move independently of earnings per share performance is due to interest rate movements. If long term interest rates double then we may see most stock prices drop by close to 50% even if earnings are flat.

Investors often lament that at a certain stock price is not fully reflecting the earnings outlook and value of the stock. Investors are impatient and when they see a bargain priced stock they might buy it but then they want the stock to zoom to their view of it’s true value and to do this “right now”. Of course if it does this then the danger is that it has then discounted in the next few years earnings growth. In this scenario if a stock zooms up to reflect the full value of future earnings then it really does not have much room to go higher unless the earnings can be further increased above and beyond the amount already reflected in the stock price.

In Canada a possible example of this is the conversion to Income Trusts. There has certainly been significant gains made asĀ  companies convert to Trusts. Various financial engineering maneuvers such as sale and leaseback of buildings have “extracted value”. But the danger is that once these things are done, then that’s it. The company has been bootstrapped up to the highest value possible. After that if earnings continue as expected then the Trust price can stay up and maybe even rise. But if it has been boosted up by various aggressive means then there is certainly a danger that if anything goes wrong then it can fall quickly.

I am not pointing to any particular stock or Trust, I am simply saying that if the market finds various ways to unlock all the value in a company then it seems logical that the share price growth would then have grown faster than earnings and the pay-back for that would be a period of time where the share price might lag earnings growth. And certainly in this scenario, if earnings growth fell unexpectedly on a stock that had been somehow “pumped up” we would then expect that share price to drop rapidly.

Previous editions of this newsletter can be accessed here.


Shawn Allen
InvestorsFriend inc.