Usefulness of market multiples

Stock Market Investment Partner has been recommending that you do your own detailed research when selecting stocks. While we still believe that this is a very good idea, we can't blindly pretend that every single investor does it. Some investors prefer looking at market multiples like the price earings ratio. Hence, using market multiples must not be rejected, and here are the two main reasons why:

- Price earnings (P/E), price to book (P/B), price to sales (P/S) and other market multiples are very simple and available. Using them as a part of stock analysis is less complicated and faster than doing a discounted cash flow model (DCF) for example. Market multiples provide a quick overview of the valuation of a stock and can quickly guide investment decisions.

- Market multiples often are self-fulfilling prophecies. Indeed, since they are so simple to find and to use, lots of investors use them. Since lots of people use them, others don't have a choice to use them also because they feel that multiples now explain (at least part of) market valuations. A chain reaction is created and the majority ends up using them.

For those two reasons, multiples become relevant for stock market investment analysis and should be combined with more complete research.

What can 1-year stock returns teach us?

In light of the current volatile times, Stock Market Investment Partner chose to look at some facts instead of making hypothesis about the fate of the stock market and the economy. The following is an arbitrary selection of stocks and their 1-year returns to see if any conclusion can be reached. Keep in mind that the following is a small sample intended to give a general idea.

Consumer Staples:
Procter & Gamble: -3.18%
Colgate Palmolive: +0.69%
Johnson & Johnson: -2.51%
Kraft Foods: -7.49%
General Mills: +19.05%
Kellogg: +1.58%

High-profile tech stocks:
Apple: -39.21%
Research in Motion: -47.38%
Dell: -46.64%
Amazon: -30.18%
Ebay: -53.83%

Former Darlings:
Crocs: -96.17%
Mosaic: -29.08%
Citigroup: -63.95%

As you can see, a good old (boring) safe portfolio with a good allocation in consumer staples would have outperformed the "fashionable hot stocks" portfolio in the last year. By the same token, your sleep would have outperformed your know-it-all neighbour's! It's an old message, but if you now realize that you can't handle high stock market volatility, allow a bigger portion of your portfolio to stable non-cyclical companies.

Buffett goes shopping again

After spending $5 billion on Goldman Sachs last week, perhaps the world's best known investor found $3 billion for GE preferred shares. In doing this, Mr. Buffett is certainly strongly sending a very strong message about great value investments available in the market. Also, you need to add warrants enabling him to purchase for $3 billion of General Electric stock at $22.25.

On CNBC, Warren Buffett said: “Frankly, these markets are offering opportunities that weren't available six months or a year ago. So we're putting money to work.”

Considering Mr. Buffett's track record, maybe it's time to look at what the "experts" are doing (buying) and stop following the panicking herd (selling).

Warren Buffett invests $5 billions in Goldman Sachs

Warren Buffett, the ultimate "value investor", has stepped in the financial sector of the stock market big time. Indeed, Buffett's Berkshire Hathaway bought $5 billions of Goldman Sachs perpetual preferred stock and has 5-year warrants to buy $5 billions of common stock at $115 per share.

Considering that Buffett only invests in "what he knows" (see my last blog for more on that), this news is a big vote of confidence for Goldman. In a way it indicates that the selloff might have been overdone and value has emerged. That can be associated with the panic and overeaction that I have talked about in the past.

Buffett is not a market timer so this doesn't necesseraly signal the bottom but it certainly is an encouraging sign. I suggest readers of this Stock Market Investment Partner blog imitate Warren Buffett: stay calm, analyze and invest in what you know once you discover value.

Knowledge's place in stock market investing

Long story short, knowledge is key when you wish to be a successful stock market investor. Of course, you need at least basic knowledge of evaluation methods but that is not exactly what I'm talking about.

I bet you would never walk into a restaurant for the first time and then buy the business 1 minute later. However, some investors act like that with stocks. They see it's the biggest intraday gainer... and they buy some shares. They see an uptrend in its 3-month chart... and they buy shares. They hear the story of the friend of their coworker's sister that made money with a stock last week... and they buy shares. Please don't do that.

You should invest in what you know. Read a company's annual reports, news articles, its website, research reports, etc. Basically read everything you can find. Make sure that you know everything that there's to know about it. Then, if you still like it, buy it. If you can't understand its products, don't buy. If you don't trust its management, don't buy. If you don't understand some things on its balance sheet or feel that it is not giving you the "whole picture", don't buy.

I chose to write this because the events of the last few weeks made me realise that some investors must not know their companies well enough. We have seen irrational selling in some stocks that made me think "These people are selling great companies because Lehman is in trouble? Company X has nothing to do with Lehman! Company X is unfairly punished because investors don't understand what it does and what factors affect its performance". Also, we're learning now that Lehman, AIG, Merrill and many others had some serious unknown problems. Key word here is unknown. Investors didn't know their exposure to the subprime mess and gambled that they would be fine. Turns out, they shouldn't have invested in stuff they didn't know.

Please, invest in what you know.

Stocks exploring strategic options

With the economic situation apparently worsening, many companies are in trouble and seeking help. One way to do this is to explore strategic options. This is a fancy expression that usually means that the company is looking for a buyer. Let's look at two recent examples of firms listed on the Toronto Stock Exchange.

Last week, oil and gas explorer Verenex Energy (vnx.to) announced a review of strategic alternatives noting that competitors were very eager to find or acquire new reserves. However, one week later there is still no offer officially on the table.

Today, Garda World Security Corp (gw.to) revealed disappointing quaterly results, lost more than 50% of its value on the stock market and started exploring strategic alternatives. The word on the street is that bankers at BMO Nesbitt Burns are close to closing a deal that would see Garda sell its cash-in-transit or armoured car division. The CEO is also thinking about taking the whole company private. This company is known to move pretty quickly and we could see a conclusion to this review faster than Verenex's.

Keep in mind that review of strategic options do not always lead to a sale of the company. With the credit market as tight as it currently is, potential buyers could have trouble getting the financing needed. Entering a position based on the announcement of a review can be considered speculation and should be done only by risk averse stock market investors.

Low-coverage stock brings high return

Well it didn't take very long for me to find a good example to illustrate what I suggested in my last blog "The relative value of stock analysis". Just a few hours after posting, I made a very nice gain because of my analysis of a "low-coverage" stock, ADF Group (ticker: DRX on the Toronto Stock Exchange). After reading everything I could find about this company, I came to the conclusion that I had just found a highly undervalued stock. This company isn't often in the media and isn't covered by any of the major research firms. It seems to be covered mainly by three analysts of smaller firms. Today, ADF Group announced fantastic second quarter results and the stock climbed 12.31%.

Here's some things I liked about it after finishing my research:
-Fast growing order backlog
-Backlog gives revenue visibility for many quarters to come
-Operates in a niche
-Qualified workforce
-Using most recent technology
-Management is financially involved through stock ownership
-High profile contracts which help the company's reputation (Freedom Towers, Encana building, Miami International Airport, etc.)
-Lowering debt brings flinancial flexibility in case of slowdown
-Room to grow since about 50% of capacity is used
-Market punished non-residential construction even if it's situation isn't like residential construction.
-Opportunities to grab new contracts in Western Canada and all over North America (infrastructure needs).
-Currently in the final stages of negociation for big contract(s).

I then found my own price target with 4 methods: DCF, multiples, RIM and EVA. My results indicated that ADF Group was mispriced and I bought some shares.

Today, my well hidden secret was revealed to more market participants through a news release and a conference call. Those participants rewarded my research efforts by pushing the stock price up. By performing what I call value-adding analysis, I was able to find an underpriced company with a great future and have an impressive 12.31% gain once the market discovered my hidden gem.

Stock Market Investment Partner encourages you to take a look at ADF Group and any potentially attractive low-coverage stocks and decide by yourself if they are worth the investment.

Dividend policy

An important element to consider when investing on the stock market is the dividend policy. It seems that the recurring revenues coming from them are either loved or hated by investors. People enjoy dividends because of the nice stable cash inflows provided. Others believe that firms are destroying value by choosing to distribute cash instead of selecting other projects (research, acquisitions, etc.). Opinions vary but one thing is for sure: you need to be aware of key factors influencing companies' dividend policy.

Information: It is assumed that insiders know more about their companies than the general public. Dividends can be seen as a source of information or a signal of management's intentions. For example, a firm paying a dividend for the first time ever could be signalling to the market that it doesn't have interesting projects to invest its cash in.

Cash availability: Profitable companies don't always pay dividends. Some of them have tight cash reserves and can't afford to distribute cash to investors.

Control: It seems that firms controlled by a small group of shareholders use auto-financing more often than firms with many shareholders. A small number of shareholders means that firms don't need to "buy peace" or "spread more information" with dividends.

Taxes: In many countries, capital gains are taxed less than dividends. A clientele effect is in place since firms paying high dividends will attract investors with a low tax rate.

Costs of issuing shares: Since issuing shares is costly, some companies prefer not to pay dividends. Indeed, the cash distributions could mean that the need to issue more shares will come more often.

Net income stability: In response to the negative signal sent by a highly fluctuating net income, firms might want to signal some operations stability with stable dividends.

Whether you like or dislike dividends, it is important to analyze the 6 key factors because they can tell you a lot about firms' future dividend policy. It is another piece of the puzzle leading to successful stock market investing.

Arbitrage profit opportunity

Let's take a look at a low risk way to make money on the stock market: arbitrage. An arbitrage opportunity exists when a close to riskless profit can be obtained by an investor. You may be wondering why this opportunity exists if there is no risk. As mentionned, there is "close" to no risk in most arbitrage trades. If you want riskless investments, don't use the stock market.

Let's look at a current situation. Canadian telecom powerhouse BCE (Bell Canada) is being acquired at a price of 42.75 C$. However, today on the TSX (Toronto Stock Exchange), it trades at 39.79 C$. By the way, BCE also trades on the NYSE. Regulatory approaval has been given and the buyers are confident about getting the financing. So why is it not trading nearer the offer price? One part of the answer is that as long as the 42.75 C$ isn't in your pocket the market considers that there is some risk. In other words, the market participants are protecting themselves in case something goes wrong. This protection is the lower trading price. The second part of the answer is time value of money. The deal is supposed to close in December, so money invested in BCE shares now can't be invested elsewhere. Investors need to be rewarded for that sacrifice. A lower stock price does that.

Let's do the math: In 3 months, you will get a 7.44% raw return on your investment. Not bad for a "low-risk" arbitrage (I stress that no stock is riskless). As always, you should do your own research and see if this is a good trade for your situation.

Arbitrage opportunities can be helpful stock market investments during difficult volatile markets.

Stock market investment in troubled times

Stock market investment is not for the weak. It is for those of us who have enough vision to seize opportunities when they knock on the door. It is for those of us who believe that you have to sweat, bleed and cry before being rewarded.

Now, this mortgage crisis (and dare I say possible recession) is here and we're sweating, and we're bleeding (and yes... some of us might be crying when looking at their broker's statements). But be brave my friends, we will get back up. We always did. Remember that tech boom a few years ago? Remember those Nortel shares? Yeah that hurt. But what happened after that? Right, a bull market. And after that, a mortgage meltdown. And what will happen next? If you're following me, you know the answer. We will eventually return to happy days of stock market profits. It won't be next week, it won't be next month but we will be rewarded.

Rewarded for what? For being patient. Because investors who panic loose money. Buy high-sell low is their strategy... and they loose money. If you're confortable with the outlook of the companies you own why would you panic? Relax, don't "sell low" something that you believe has potential. If it really has potential, you will be greatly rewarded once the panic is over.

Panic is associated with overreaction. Overreaction is associated with opportunties. Yes, I'm impliying that you probably want to slowly build positions in companies that are or will be oversold. After careful analysis, gradually build a position in the names that were punished too much by investors who acted on emotions. So be patient with the good stocks you own and be patient with the stocks you want to own. Your patience will eventually be rewarded because stock market investment is a patient people's game.