Financial Statement Manipulation and Fraud: A Dirty Dozen Warning Signs

Controversy again erupted on the stock market recently with first Sino-Forest Corp (TSX: TRE) being accused of illegal deceptive financial reporting and then Silvercorp (TSX: SVM) too being accused of falsifying data. Though the verdict on the accusations is not in for these two companies, it reminds us that financial misrepresentation does happen, ranging from dubious but often legal earnings management through to outright falsification and fraud.

Whether dishonest perpetrators eventually get caught or not, in the meantime investors can lose a lot of money since the inevitable result of the malfeasance is big losses in stock value and often total loss. It's better to detect problems in the first place and either avoid the stock altogether, or for those brave enough, such as those first raising the stink about Sino-Forest and Silvercorp, short-sell the stock.

To that end, we offer a list of warning signs that something may be amiss in a company. Most of these signs are culled from two books: Financial Statement Analysis (4th edition) by Martin Fridson and Fernando Alvarez and; Swindlers by Al Rosen and Mark Rosen (reviewed by CanadianFinancialDIY, by Jonathan Chevreau in the Financial Post and by CorporateKnights)

1. Unexpected turnover of senior management - e.g. the sudden resignation of the Chief Financial Officer or the CEO
2. Late financial statements - companies must publish results within a certain time after quarter and year-end dates; e.g. the Ontario Securities Commission sets out deadlines here
3. Incomplete quarterly statements - e.g. missing the Balance Sheet or Cash Flow Statement
4. Professional financial analysts state they cannot understand the company's financial statements - Fridson and Alvarez note that such was often said about Enron before it went up in smoke. They cite Warren Buffett's trenchant comment - "... if you cannot understand the footnotes [in financial statements], it is because management does not want you to."
5. Board members not sufficiently independent of management or not very experienced or with little ownership stake or simply a Board that is too small - this forms part of overall corporate governance, which we reviewed in our post Stocks and Corporate Governance: Do the Good Guys Finish First or Last?
6. Infrequent meetings of the Board audit committee - on the other hand, it is a good sign when the independent (i.e. not family or business relations of senior managers) committee members meet more than twice a year (see study in next bullet)
7. Members of the audit committee had short term stock options - see Corporate Governance and Earnings Management (download here from SSRN) by researchers Sonda Marrakchi Chtourou, Jean Bédard and Lucie Courteau
8. Management untrustworthy on other grounds - Fridson and Alvarez give the example of insider trading by Richard Scrushy at HealthSouth before it imploded
9. Related party non-arm's length transactions and private companies set up by executives to do business with the public company - these situations present opportunities for the executives to enrich themselves at the expense of the public company and its shareholders
10. Corporate restructurings - where there is the danger that excessive costs are written off, creating a cookie jar account reserve that management can use later to boost earnings as the high costs do not come to pass.
11. Industries that are more susceptible include non-manufacturing, non-retail sectors like finance, credit unions, banks, insurance, real estate and not surprisingly, resources
12. Weasel words in earnings conference calls - we can listen carefully to those post-earnings conference calls where management explains results to professional analysts (which the Internet now makes possible for individual investors to listen in on - get links from the company investor relations website area or a news website like CNW's webcast listing). According to David Larcker and Anastasia Zakolyukina's paper Detecting Deceptive Discussions in Conference Calls, the question and answer time at the end is where "... the answers of deceptive executives have more references to general knowledge, fewer non-extreme positive emotions, and fewer references to shareholder value. In addition, deceptive CEOs use significantly more extreme positive emotion and fewer anxiety words."

None of these warning signs is necessarily sufficient to conclude that hanky-panky is going on. Combinations of factors along with actual digging through the accounting statements is required to arrive at a determination. Nor is it 100% sure that even with the utmost expert due diligence - that was the depressing take-away from the Enron situation where pretty well everyone was oblivious to the fraud - will it be possible to detect every fraud. Nevertheless, paying attention to warnings signs and checking out the situation can help avoid investing grief.

Disclaimer: this post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comparisons are not an investment recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a professional advisor.

Getting Started in Value Investing

Our last post reviewed past blog post lists of stocks picked by industry or by certain characteristics. Now is an opportune time to bring up the grand-daddy method of stock selection that is the basis used by most active investors - Value Investing. As Wikipedia explains in more detail here, Value Investors attempt to find bargain-priced stocks through so-called fundamental analysis of accounting data. Often this starts with the ratio of current stock Price to company Earnings, the P/E ratio, with lower P/E being better, i.e. the lower the Price paid for the company's yearly profits the better off the investor is.

Analysis then usually proceeds through a series of other ratios considered to be indicative of a "good buy", like low Price to Book Value, low Price to Assets, high Dividend Yield (dividend over Price) and of safety margin, like low Debt / Equity and high Interest Coverage (by how much the company's earnings exceed required interest payments to avoid a disastrous default). Within the general concept there are many variations in the practical specifics. To get you started, here are a few Value investor examples and some useful tools.

First, let us acknowledge Benjamin Graham, the practical and philosophical inspiration of Value investing. His book The Intelligent Investor, as updated by Jason Zweig, is still an essential read for any Value investor.

Ben Graham Center for Value Investing - headed by Dr. George Athanassakos
The website contains papers, audio downloads, links to data sources, book references. Athanassakos writes a regular column for the Globe and Mail, the most recent of which, The Contrarian Case for Active Investing, tells of his success in picking stocks that have outperformed. In A Faster Way to Identify Value Stocks, found at the Canadian Investment Review he gives more detail on his method, which includes these factors to derive the best combined SCORE to pick the stocks:

1. Low P/E stocks, excluding negative numbers (i.e. companies with negative earnings / losses)
2. Price > $1
3. Smallest Market Cap stocks (small companies)
   
4. Least liquid stocks (small trading volumes)
5. Highest Asset Turnover stocks (ratio of Sales over Balance Sheet Assets)
6. Highest Revenue growth stocks
7. Highest Earnings Per Share (EPS) growth stocks
8. Highest Earnings Before Interest and Taxes (EBIT) stocks
   

Mutual Funds - Amongst the resources listed by the Ben Graham Center are several fund management companies offering services to Canadian investors, who are said to espouse value investing methods, such as Burgundy Asset Management, Chou Associates, I.A. Michael Investment Council / ABC Funds (its principles for stock selection shown here on the Globe and Mail site), SteadyHand and others.

ETFs - Unsurprisingly, there are many Value-based ETFs. Sporting the word "value" in the fund's name, they vary in which factors are used to select the stocks, some using only historical P/E and P/B data, others using analyst forecasts as well. Stock-Encyclopedia.com has a list of Value Stock ETFs here. CanadianFinancialDIY commented on the "slippery" meaning of Value in ETFs and Yahoo Finance describes the different ETF definitions of Value.

Tweedy, Browne Company LLC - The 91 year-old portfolio management company subscribes to Value investing principles, which it explains in its free booklet What Has Worked in Investing. The factors Tweedy looks for:

1. Low P/E
2. Low P/B
3. High Dividend Yield combined with a low Dividend Payout (ratio of dividends to earnings)
4. Insider purchasing - executives and Board members buying shares themselves
5. Small market cap
6. Significant Price declines from highs

StingyInvestor - Investment advisor Norman Rothery lists his current and past stock picks using what he interprets to be Ben Graham's Value principles (e.g. in table 2 of 7 Graham Stocks for 2011). He provides informative comments on the practicalities and on the success of his picks.

Screening and Data Tools - To do your own searches and then assessments for Value stocks, here are some online resources.

1. ADVFN.com (free registration required) - This is by far the most complete and flexible source to screen stocks with numerous and varied criteria. One unique and very helpful feature is that for any metric chosen ADVFN shows the range of values and where the median and average values lie. This tells us what is a high or a low PE value at the moment; for instance, in the screenshot below we see that of all the TSX stocks with a positive P/E ratio (to do that we entered a constraint of PE greater than 0.1), the average P/E is 33 and the median is 12. We might thus set the constraint that a potential Value stock must have a P/E under 12. Adding other criteria results in a shorter and shorter list of candidate stocks. After winnowing the list down to a manageable number the real work of individually assessing each company begins and ADVFN includes a large number of financial ratios going back five years, along with graphs of many key numbers to enable quicker trend spotting and understanding what is driving each company.
2. InvestorPoint.com - This site contains perhaps the one thing missing from ADVFN that Value investors often monitor - Insider Trading e.g. Bank Of Montreal.
   
3. GlobeInvestor's My Watchlist - Quickly construct a portfolio of candidate stocks, with a selection of the key fundamental data in a variety of standard views plus the capability to build your own view with only data of interest to you. It's handy because the Watchlist is part of the GlobeInvestor website of business and investing news.

Methods of Corporate Valuation - The late Prof Ian Giddy of New York University wrote this short readable introduction to the methods of valuing a stock.

RetailInvestor.org - The anonymous investor author gets to the gist of many stock valuation issues with a very practical perspective. He notes many of the potential trip-ups and mistakes that can subvert an investor's evaluations in the sections on Stock Picking and the Cash Flow Debate.

The essence of Value investing is smart detective work. That's what will distinguish the companies and stocks that deserve their low price, as most do, from those that are truly under-valued. As a corollary we also need to keep in mind that sometimes we will be wrong - the detective work, even when done with great care, may give the wrong answer. The idea is that there may well be more losers than winners but the winners' gains will more than compensate for the losses on the losers. It is necessary to keep at it, keep track of new information and not put everything on the line in one stock.

Disclaimer: this post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comparisons are not an investment recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a professional advisor.

Assessing Our Stock Picks - Mostly Good Results, The Remainder Average

It is impossible to learn from our mistakes unless we know what they were, or to learn what investment strategies work and which do not unless we look at actual performance. Let's take a simple look back at the performance of some specific individual stocks we thought looked good in past blog posts.

The Benchmarks: S&P/TSX Composite Total Return and CPI Inflation
Assessing performance needs to be done from several angles. First, there is the absolute performance - did we make money or lose money after inflation (if we don't beat inflation, we have lost purchasing power, so we have lost money in real terms)? Second, we need to compare in relative terms - have we beat the overall average return of similar assets. In this case, our picks were all Canadian stocks so we benchmark against the Toronto Stock Exchange's basic index, the S&P/TSX Composite Total Return.

• CPI Inflation - 2.7% in the latest available figures covering up to the end of July 2011, published by Statistics Canada on August 19th
• S&P/TSX Composite Total Return - 9.5% gain in the one year up to August 24th. Note that Total Return includes both the stock price gain plus dividends. If we buy a stock, we receive dividends so we must compare with the index that includes them. Unfortunately, almost every chart available on the Internet and in news reports uses only the price gain index, excluding dividends, which are running at about 2.7% per year currently. As we wrote about in TSX Composite and S&P 500 Total Market Return, dividends are a significant part of investing profits. Our source for the TSX Composite Total Return Index is GlobeInvestor's Stock price report using the ticker symbol TSXT-I. (Pull up the chart and graph the price-only index TSX-I and see the difference even in one year)
  

Stock Performance
We've used GlobeInvestor's My Watchlist to create the series of mini portfolios. The ones we created are not publicly visible, being under our personal id, but you can easily reproduce them simply by creating a new watchlist of your own and typing in the stock symbols. Apart from being so quick and easy to use, My Watchlist most importantly can show the one-year total returns (again, so many price quote sites only show the price movement of stocks excluding dividends).

The Twelve Ultimate Buy and Hold Stocks - original post of June 2010 here

• Inflation-beaters: 67% (8/12)
• Index-beaters: 50% (6/12)

That's not great results over one year but hey, maybe we should think longer term as these companies have all been around for over a century. e.g. look at the bottom of our list:

• George Weston (TSX: WN) - continues to be profitable every quarter; though its profits are up and down, it keeps paying its dividend
• CP Rail (TSX: CP) - continues to be profitable every quarter; though its profits were down the last two quarters, it increased its dividend in the most recent quarter
• Great-West Lifeco (TSX: GWO) - continues to be profitable every quarter; though its profits are up and down, it keeps paying its dividend

In short, things could be a lot worse than the situation of these companies.


Food Companies - original post of September 2010 here

• Inflation-beaters: 75% (3/4)
• Index-beaters: 75% (3/4)

These results look good. Our only loser is Canada Bread Company (TSX: CBY), which had a loss in the March 2011 quarter but rebounded in June and more than tripled its dividend at that time.


Electric Power Utilities - original post of January 2011 here

• Inflation-beaters: 100% (4/4)
• Index-beaters: 100% (4/4)

What's not to like about such results? Steady profits and dividends have found market approval in price gains.


Split Share Capital Shares - original post of December 2010 here

• Inflation-beaters: 100% (3/3)
• Index-beaters: 67% (2/3)

The only stock that has not beat the market benchmark is NewGrowth Corp (TSX: NEW.A). Its bank holdings have been holding it back. Is that a problem or a buying opportunity, given NEW.A's use of leverage? It all depends where one feels Canadian banks are heading.


Dividend Growers - original posts of April 2011 on High-Yielders here and of May 2011 on Low-Yielders here

• Inflation-beaters: 84% (16/19)
• Index-beaters: 53% (10/19)

It is pushing matters to do a performance assessment so soon after the original posts, so we will leave our comments at saying the results so far look reasonably positive.


Overall, the performance results support the idea that looking at the numbers for stocks and companies is worthwhile to help find good investments. We must temper our enthusiasm and consider that it is to some degree by chance that our very short term success rate is so high since even professionals do not on average achieve much above 50% success. Our blog post assessments did not delve very deeply into each company so we should be wary. Still, those dull-looking numbers merit our attention!

Disclaimer: this post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comparisons are not an investment recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a professional advisor.

Stocks to Drown Your Sorrows or Lift Your Spirits

Let's face it, the stock market has not been very strong lately, what with European and USA debt troubles and other assorted ills of the world threatening another recession or another Lehman crash. It's enough to drive an investor to drink! Instead of drinking maybe the thing to do is invest in distillers, wineries and breweries.

Why Booze Stocks?
That this is more than joking possibility, do a Google search with words like sin stocks (among which booze is counted) and recession. There will be a raft of articles, many of them saying that such stocks do well in bad times, e.g. The Virtues of Vice Stocks at Kiplinger.com and Living with Sin Stocks at Forbes.com. There is even an academic study Sin Stock Returns over the Business Cycle that found " ... the abnormal return on the sin portfolio is higher during recessions than during expansions ..."

The following chart from Google Finance for the Alcoholic Beverages sector appears to add support for the idea as it shows it outperforming the S&P 500 through the last recession, though most of the gains seemed to occur once recovery was underway.


Finding the Stocks and their Data
The first step to look at the sector is to find the booze companies listed in Canada and the USA. There is not one source or tool that contains everything. This blog's data is an amalgam of these sources:

• TMX Money's Stock Screener - set the Sub-industry choice to Beverages - Brewers or Wineries and Distilleries under Consumer Goods
• Yahoo Finance's Industry Center under the Investing tab - pick Beverages - Brewers or Wineries and Distilleries
• Google Finance - pull up a quote for a company in the sector such as Diageo (NYSE: DEO) and the result will show other stocks in the sector with their key financial ratios.
• GlobeInvestor's My Watchlist - enter the stock symbols to create a portfolio to get most of the financial data we present below. Export the data to your own spreadsheet and then you can enter missing data using the other sources. N.B. Every investor must acknowledge that all data sources are subject to incompleteness and error - yes, sometimes the published numbers are wrong. Anything that looks unusual bears double checking with other sources, or with the company's own annual or quarterly reports.

Profitability and Growth
Most of these companies have been steady performers through the last five years, earning profits every year, even through 2008 and 2009. The number of good performers shrinks when other measures of company quality, such as Operating Profit Margin and Return on Shareholder Equity. Less than half managed to grow profits in the latest year. Only one company looks very weak - Craft Brewers Alliance (Nasdaq: HOOK) with profits in only 3 of the past 5 years, low operating margin and low return on equity.
Best Stocks on these measures:

• Brown-Forman (NYSE: BF.B) - Earnings every year including growth last year, high operating margin and return on equity, dividend growth. Provides Southern Comfort, literally and metaphorically.
• Companhia de Bebidas das Americas ADS (NYSE: ABV) - Giant company that has been growing profits and dividends at an astonishing pace given its humongous size. Outstanding operating margin and return on equity.
  
• Molson Coors Brewing (NYSE: TAP) - Solid numbers across the board, better than the similar Canadian company.

Value - Which are Cheaply Priced Right Now?
There are a number of companies cheaply priced relative the industry average Price / Earnings (P/E) ratio and where Price to Book Value is near or below 1.0 or where the Price to Sales ratio is very low. Amongst the previous set of solidly profitable companies only one, Molson Coors, seems cheap. The other highly profitable companies, especially ABV, look to be getting a high market valuation.


Returns and Market Sentiment
Reading this table, we are lead to question whether the future may not be like the past. A different set of companies has experienced strong positive returns and enthusiastic Strong Buy recommendations from professional stock analysts. The one exception is ABV, which seems to be favoured by a Strong Buy despite its already phenomenal growth (No, the target price is not an error being below current market, that's what the data source shows, a reminder that numbers are not always correct. I double-checked the Strong Buy from My Watchlist against the one in TMX under the stock quotes research tab for ABV and it shows the same analyst recommendation so the target price must be wrong.)


Safety - How Risky is the Company and How Sure is the Dividend?
Debt is the principal danger to companies trying to weather economic storms so the amount of debt relative to various company metrics gives us a quick view of which companies look solid or dodgy. Constellation Brands (NYSE: STZ) and Diageo (NYSE: DEO)both have a lot of debt compared to the equity in the company, while Andrew Peller (TSX: ADW.A) has a high level of debt compared to cash flow, as does Constellation.

Four companies already pay out a high percentage of earnings as dividends (see table below), indicating a lesser likelihood of increases in the near future, though none is so high that dividend cuts would seem likely. Companies with 30% or less payout ration, highlighted in green numbers on the table, may be inclined to increase it, while those paying out nothing at the moment have the potential to start doing so if they have been consistently profitable. An example of the latter is Magnotta Winery (TSX: MGN).


Overall

Best Prospect - Molson Coors for its combination of consistent profitability, record of rising dividends and good valuation metrics

Fully-Valued but Solid Companies - Diageo, Brown-Forman, Companhia de Bebidas and Compania Cervecerias Unidas (NYSE: CCU)

Turn-around Prospect - Constellation Brands Inc. (NYSE: STZ) which has hit a rough patch but claims it is fixing things

Note that the above is based only on this preliminary assessment using the numbers in the tables. Further investigation of each company's prospects and conditions will be needed to confirm good and bad situations suggested by the numbers. Otherwise an investing hangover may result!

Disclaimer: this post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comparisons are not an investment recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a professional advisor.

Bank Stocks: Alternative Ways to Invest

Many investors these days are casting their eyes towards the Canadian banks for any number of reasons: generally they are in good shape; they are amongst a raft of stocks offering attractive looking valuation numbers as we remarked in last week's Summer Stock Sale post; and finally, they have above market average dividend yields, which even have the potential to go up further according to this GlobeInvestor article looking ahead to their quarterly earnings reports of the next few weeks.

For those interested, there are three main ways to invest in bank stocks:

Common shares - Very straightforward, what you see is what you get. There are no extra management fees or expenses and they currently offer higher dividend yields than Split Capitals, as our comparison table below shows. There is no leverage either in common shares (of course, banks themselves use leverage internally and that is one of the risk factors for the common shares but we are referring to leverage applied by the investor in making the investment).

ETFs and Mutual funds - Among ETFs, the most concentrated is BMO's S&P/TSX Equal Weight Banks Index ETF TSX: ZEB, which only holds the big six banks in equal proportions. The iShares S&P/TSX Capped Financials Index Fund (TSX: XFN) contains healthy doses of bank shares but in the interests of diversification, it holds a much wider mix of stocks than just bank stocks, such as insurers and investment companies. Neither of these ETFs apply any leverage. There is an ETF with leverage, the Horizons BetaPro S&P/TSX Capped Financials Bull+ ETF (TSX: HFU) but it is quite a different animal, a tool only for the day trader since its returns equal 200% of the daily performance of the index.

Split Capital corporations - These are companies with the sole function of investing in stocks. The split share corporations issue preferred shares paying a fixed dividend rate, which in effect is borrowed money from the perspective of the capital share owners (see our previous posts on Split Capital Shares and Split Preferreds for more explanation how each works). Through this, Split Capital shares have the unique property of leverage, which amplifies gains - and losses too, raising their riskiness. The Split's leverage may thus be of special interest now if the banks are now back on a growth path. Dividend growth by the banks will also accrue only to the benefit of Split Capital owners since Split preferred share dividends are fixed.

Split shares currently a mixed bag of attractive and scary -

• Scary - Original Commerce Split (TSX: YCM.X) and New Commerce Split (TSX: YCM.A), both based on CIBC, look destined to produce large losses for an investor today - a negative Net Asset Value (NAV) and a price far above it. The Split corporation is not even able to pay the Preferreds' dividends. A little less scary but still quite worrisome is TDb Split Corp. (TSX: XTD), trading at a value almost 75% above its NAV.
• Attractive - Again, based on the view that bank shares and dividends are on the upswing, two of our list look best to us - Allbanc Split Corp. II (TSX: ALB) which holds more or less equal proportions of the top six banks and 5Banc Split Inc. (TSX: FPS), which holds only the big five and not National. Both have higher leverage, promising a bigger boost if the banks do well. Both have a fairly good discount of market price to NAV of about 7%, which provides some downside protection and the extra upside potential that the price may move closer to NAV. Both are also healthy enough to pay a decent dividend rate to the Capital shareholders as well as the required dividends to the Preferred shares. Though FPS is due to be redeemed and go out of existence December 15th this year, its managers TD Securities earlier this year announced an intention to examine the extension of the corporation's life. Amongst the single underlying stock Splits, the Royal Bank based R Split III Corp. (TSX: RBS) looks reasonably good - 7.8% discount to NAV and wrap-up scheduled for May 2012 which means that discount must be eliminated by then; decent dividend of 2.7%; and lots of leverage 2.5x though in this case the nearby wrap-up date means the stock price has to move up by then for the benefit to be gained. RBS is a play on short-term expectations.

Canadian Bank Share Alternatives Comparison


With bank stocks down along with the market these days, it takes fortitude to go ahead and invest. The investor must make the fundamental choice between the risk and possible reward of equity investment versus the stability of GICs and such. But for those who want to take the plunge, the alternatives are there.

Disclaimer: this post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comparisons are not an investment recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a professional advisor.

Summer Sale Event! 15% Off on Stocks

Every shopper knows and likes sales. It is an opportunity to buy the same item for less. So it is in the stock market. The same companies are now selling for less. The market declines over the last few months and especially in the last few weeks have cut 15% off the TSX index price since year highs in early April as seen in this chart copied from Google Finance.


Storewide Sale - To continue our analogy, the decline has affected every sector from financials, through energy, mining, telecommunications, consumer staples and consumer discretionary. It has not been quite to the same degree everywhere, with energy being hit harder and telecomms less so. Nevertheless the effect is that there are companies selling at much-reduced and potentially attractive prices.

Featured Companies on Sale - To find where the biggest bargains might lie, we have searched through equities within the TSX Composite using the TMX Money.com Stock Screener. We will define a stock to be attractive when it is cheaper than the overall TSX market average and pays more in dividends as well. At close of market on August 9th, a rare day of an upward market (though we see from our chart above it has not made much of a dent in countering the cumulative decline) the TSX Composite Price/Earnings (P/E) ratio, our measure of "cheaper", was 16.89 and the average dividend yield, our measure of "pays more", was 2.76%. (These figures are updated every day on TMX Money's page here). Using Stock Screener, the stocks we selected meet these criteria:

• P/E under 15 (this number is also the approximate long term average P/E for the TSX). These companies necessarily are profitable - in order for P/E to be a positive number, E must be above zero.
  
• Dividend Yield between 3 and 10% (we set an upper limit of 10% to start weeding out companies which are paying out unrealistically high amounts and may be forced to reduce dividends, a result we don't want)

Our search uncovered over 100 stocks (TMX limits results to 100), many of them amongst the biggest and most solid companies in the country, starting with all the banks. There are also utilities, life insurers, energy companies, telecomms providers, real estate investment trusts, in short a smattering of all sectors. The table below takes only the 30 largest companies, which means all have a market cap over $2 billion and ranks them top to bottom by amount of price fall since their respective 52 week high. There are many big discounts on offer for high quality companies these days. Re-run the search to get the rest of the list, which of course will change somewhat as stock prices continue to gyrate.


All Sales are Final - If you buy any of these stocks, there is no money back guarantee. They could fall more in price or get into financial trouble and go out of business. There is a lot of talk of a possible coming recession and some companies may suffer. Shareholders of such companies will suffer too. That's why more than blind buying is required.

Make Sure It's a Real Bargain - Sometimes shoddy merchandise goes on sale. That's not a bargain. As additional indication of the checking to do on the safety and staying power of these apparent stock bargains, we used the Stock Screener to extract data that can help. If recession strikes or credit freezes up again, companies with low debt and strong cash flow are likely to escape better and perhaps even grow at the expense of weaker rivals. Our comparison table thus includes three extra indicators (from the Stock Screener's extra columns selector) - Net Profit Margin (the higher the better), Total Debt/Equity ratio (the lower the better) and Price / Cash Flow (the lower the better). Note that safe levels of these indicators can and should vary by sector - for instance utilities can sustain much higher levels of debt than other companies because of the stability of that business and profit margins will be lower due to control of rates by regulators.

To find out more about the companies and their financial indicators, a handy free tool is GlobeInvestor's My Watchlist. By entering the trading symbols, we can build the portfolio of our stocks and obtain other data such as debt to cash flow, dividend or profit growth, price to sales and many others, as well as links to news, quotes, charts, analyst recommendations.

Caveat emptor but happy stock shopping. Who knows how long the bargains will last.

Disclaimer: this post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comparisons are not an investment recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a professional advisor.

Investing Risk: The Harmful Effect of Rising Required Rate of Return

In this last post of our series on the most important investment risks, we examine how much the required rates of return on investments varied in the past. It may seem odd to call the rate of return a risk since return is the reward for investors. The problem is that if required return rises, the price of the investment asset will fall. For example, in order for a bond that has a fixed interest coupon rate to provide a new higher return, the price of the bond must be lower so that the bond provides a capital gain in addition to the fixed interest received. The existing bondholder experiences a capital loss. Similarly, stocks with given earnings and dividends must fall in price to provide capital gains to reach the higher required return.

The Rise and Fall of Required Returns - Required returns do not stay constant. Through the years there has been much variation. In the chart below from Retail Investor, we see that yields of all maturities of fixed income have fallen steadily since the early 1980s. That trend continued through the mid 1990s to today, despite the fact that inflation has remained consistently in the Bank of Canada's 1-3% target range throughout. This illustrates the important point that required returns in the form of interest rates can vary independent of inflation.


What has come down once went up. From the 1930s to 1982, interest rates and yields followed a general upward trend, as illustrated by this chart of US Treasury Bill rates since 1920 from the Gold versus Paper blog. Within that trend however, there was significant variation through the decades.

To those who may think that the current ultra low interest rates are due to rise soon, this chart shows us that near-zero-rates persisted for about a decade during the 1930s.

Similar Canadian historical rates for Federal Government T-Bills and Long-Term bonds can be found at the Bank of Canada here.

Several lessons stand out for the investor:

• rates have varied from virtually zero to over 20%
  
• upward and downward trends have persisted for several decades
• spikes and dips of 5% or more within a couple of years have often occurred within the longer term trend; those spikes will hurt!
  

The Current Situation of Required Returns

1) Bonds and Fixed Income - In the case of bonds or other fixed income investments like Treasury Bills and GICs, the current required return is easily visible. It is the current yield found on websites where current market fixed income quotes are available - such as GlobeInvestor, CanadianFixedIncome.ca, or any online broker. For example, the Canadian Federal Government bond maturing 1 June 2037 with a coupon rate of 5.0% yields only 3.31% as of August 2nd according to GlobeInvestor. T-Bills are now yielding around 0.9%.

Such rates are at historically low levels. The risk seems to be at its greatest as interest rates can seemingly only rise. The question is how soon; as history shows, that might be years away.

The Duration metric tells us how sensitive a fixed income investment is to a change in interest rate e.g. a duration of 5 means a bond price will fall by about 5% if interest rates rise 1%. Our example Federal Government 2037 bond has a duration of 15.79 according to the GlobeInvestor listing. A 2% rise in required return / yield would see its value drop almost a third. Thus, we can see that long term bonds are very exposed to severe capital losses from rising interest rates.

2) Equities / Stocks - It is not quite as easy to figure out what return investors currently require since the calculations incorporate assumptions about the evolution of company earnings, dividends and the economy. The proper more complicated method involves taking the current dividend yield and adding an estimate of the future dividend growth rate (see explanation on Tipster). A simpler first approximation is to turn the Price/Earnings (P/E) ratio upside down, i.e. E/P equals company profits over the stock price. As of close of market July 29th, the TSX Composite Index P/E stood at 18.46 according to TMX Money; thus E/P is 5.4%.

The historical range of market P/E ratios gives us a realistic idea of possible changes in required return and the corresponding implication for stock prices. According to the chart in Wikipedia entry on the P/E Ratio, the US S&P 500 Index has fallen to a P/E as low as 4.78 in 1920, or an E/P of 21%. If the all-time low were to happen again, it would mean prices falling a stupendous 78% from the current 21.64 S&P 500 P/E. The average P/E since 1880 is about 16.4. Markets have been going down lately but clearly they could credibly go much lower.

While a rise in required return causes stock prices to drop, companies that have pricing power and are able to raise earnings, thereby restoring the arithmetic that allows a higher price - as E(arnings) rises, so can P(rice) in our E/P formula. Thus the risk impact of rising required return may not be the same for all companies as some, utilities for example, may be more affected in the short term and take longer to recover due to regulatory controls on profits. Industry sectors may also go out of favour, with higher required returns being required to entice investment, which of course means their stock prices will fall. Or the opposite may happen, sectors become favourites - required return falls and stock prices rise.

It must be said again that the above maximum downward numbers look scary. But they are no means inevitable or imminent and the countermeasures outlined in the first blog post in this risk series should go a long way to reduce the negative effects.

Disclaimer: this post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comparisons are not an investment recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a professional advisor.