Value Library

The following is an excerpt from the ABC Perspective - October 2001 - Pg. 4-5

The people who sustain the worst losses are usually those who overreach. And it’s not necessary: steady, moderate gains will get you where you want to go.

- John Train

The increasing volatility of common share prices is placing a greater burden on investors. Aside from the normal painstaking research and analysis of common stock selection, the undiminished price variations of common shares is pressuring some investors toward greater stock trading. There is nothing wrong in trading securities for small, short-term profits to augment total investment returns. However, quite often the time and effort spent takes away from the precious time analysts devote to fundamental research.

With year to date returns of -22.5 % for the TSE 300, -18% for the Dow Jones and over -39% for the NASDAQ, any little bit of extra return can be very helpful. For instance a handful of profitable trades can mean the difference between a first and third quartile investment ranking. Obviously there are risks to this type of activity as short-term trading can sometimes be quite hazardous. For instance a trading position can go awry and suddenly turn into a nasty loss. The trading position suddenly becomes an investment and will remain frozen until it becomes profitable again.

Among the short-term trading risks is overreaching with bigger and bigger positions. The more trading profits an investor makes the more confidence and larger the future trading positions become. Ultimately an investor may overreach and lose his primary focus. It is my opinion that during these tumultuous financial times it is of prime importance that investors adhere strongly to their investment disciplines. Don't stray from your comfort zone. Try to remain in control. This is particularly true with regard to the preservation of investment capital.

In the past we have often referred to our Ten Commandments of Value Investing in the ABC Perspective. We utilize these self-control/ self-imposed disciplines to guide and to focus toward our goal of superior long-term performance. In the heat of the trading day sometimes one can lose track and miss the big picture of one's investment objective. Periodically, we review our Ten Commandments to refresh our focus.

Of the Ten Commandments there are four particular commandments which we follow most closely:

Low Price to Earnings Multiples

We do not want to overpay for our securities. Unless a company is operating at the trough of its business cycle (e.g. cyclicals) with uncharacteristically high price earnings multiples, generally we avoid high multiple stocks. We search out companies that are trading at under ten times P/E ratios. Many of these securities are deep value stocks that are out of favour, followed by few analysts and with unknown management. Securities of this type purchased over the past year include Canada Bread, Andrés Wines and Groupe Laperriere & Verreault. Once these deep values companies are discovered, they are prime candidates for merger, takeover or reorganization. But quite often as their stock price rises they transform into a growth or momentum stock and become very attractive to a whole new group of investors.

Just as real estate investors focus on location, location, location, we believe successful common share investing must concentrate on cash flow, cash flow, cash flow. Usually corporations that have substantial cash flows are able to withstand periods of adverse economic and industry conditions. Moreover they can rapidly pay back debt, make accretive acquisitions and pay cash dividends. Companies with extremely low cash flow multiples are also frequently acquisition targets by corporations with higher multiples. Generally we search out companies with cash flow multiples less than five times. Typical examples include oil and gas companies, selected industrials and financial corporations.

We hunt for companies that trade at a discount to their book value and or net asset value. Quite often one can come across a "diamond in the rough" corporation, which is under-followed by analysts. Usually these deeply discounted stocks can be accumulated quietly, however, extreme patience is necessary. In some cases public company stocks trading at discounts of at least 50% are available, are profitable and even pay dividends. Several deeply discounted ABC Funds’ purchases over the past couple of years include FPI Limited, Surrey Metro Savings Credit Union, Taiga Forest Corporation and La Senza Corporation.

As a deep value stockholder we want to see this value recognized by the marketplace. The stock needs a value catalyst to create a superior investment return. We define a value catalyst as some significant event or factor, which will push up the price of a security so as to realize the company’s true net worth. Examples of catalysts include: new management with fresh directions, an important sale or purchase of a meaningful asset, an unsolicited takeover bid or disgruntled and impatient shareholders who may put pressure on management to make changes or sell. In addition a published investment analyst report or a media broadcast on TV, radio, the Internet, or in a newspaper highlighting the company can also be a significant price catalyst.

Successful deep value investing requires significant patience, focus and self-control. Sticking to one’s style in a market fraught with huge economic and investment uncertainty is a most difficult discipline. However for those investors who remain persistently focussed, we believe the long-term investment rewards are substantial.

Irwin A. Michael, CFA