High yield Canadian stocks – More Graham-Rea Results

The screen from September 23 pulled an interesting list of stocks. They’re all common shares. Dividend yields range from a high of 9.8 percent to 2.9 percent. Two of the high yielders are companies in trouble: Chorus Aviation (CHR/b) and Just Energy (JE).

Haven’t investigated why Chorus has such a high yield; it’s been up on the year.

Just Energy used to be an energy darling, recommended in various investment commentary, and traded up near $9 in the spring of 2014. In mid May, the stock dropped like a stone, initially to the mid $6 range, and has fallen off since then, to about $5.20 in late September, but so far in October has had a little bounce. So not quite a falling knife, but definitely uncertain. The May drop coincided with its announcement of fourth quarter and fiscal 2014 results.

Whenever such high dividend yields are there, the concern is always about sustainability, and the fear of a cut to dividends. And indeed that’s what was driving some of the concern about Just, possibly by half.

Several of the companies on the list are various “split” corporations. These often hold a small focused portfolio, such as certain financials, in a closed-end corporation that issues a class of common shares and a class of preferred shares. The preferred shares receive a fixed yield, and any other appreciation — sometimes involving covered call strategies — gets thrown at the common.

I have concerns about the sustainability of such dividends on the common shares, given that the underlying securities will only be yielding on the order of 4 percent or so, maybe less (the banks, for example). The recent upward movement of the market has probably enhanced the returns from these split strategies. In a market break, who knows?

The lower dividend yielders on the list are an interesting group of regular companies. Mostly financials, but with some other industries in the mix.

And one of the list was one of the mortgage investment corporations (MICs), which made me curious about that option as a high-yield strategy. About which, more in the next post.

Graham-Rea AAA corporate bond yield screen 23 Sep 2014

I’ve been using the stock screener at TD Waterhouse (now TD Direct). They’ve improved it over the years. Check it out, if you’re a customer.

I ran  a screen based on two of the Graham-Rea criteria:

• Locate the yield on AAA corporate bonds for industrial companies. Sometimes I can find that info at Standard & Poors. Bloomberg has some index information, but it didn’t seem quite to fit. This time, I found the series at the St. Louis Fed, in the Moody’s Seasoned Aaa Corporate Bond Yield page. For August 2014, the yield was 4.08 percent.
• Then screen for companies with:
  • An earnings yield (e/p) at least twice that AAA yield.
  • A dividend yield at least two-thirds of the AAA yield.

So these days, the maximum earnings yield is about 8 percent, meaning a p/e of 1 / .08 = 12.5, and the dividend yield floor is 2/3 x 4 %  = about 2.6 percent. You can add the other Graham-Rea factors if you like.

But on the TSX, those two criteria produce an interesting list. Here it is, ranked by dividend yield. Screen date: 23 September 2014. I’ll say more in another post.

Rank	Symbol	Name	Exchange	Share Type	P/E (TTM)	Dividend Yield	Current Ratio > 2
1	CHR.B	Chorus Aviation Inc	TORONTO	COM	6.48	9.8%
2	JE	Just Energy Group Inc	TORONTO	COM	5.63	9.1%
3	PIC.A	Premium Income Corp	TORONTO	COM	6.72	9.5%
4	BBO	Big Bank Big Oil Split Corp	TORONTO	COM	6.04	8.3%
5	MKP	MCAN Mortgage Corp	TORONTO	COM	8.43	7.9%
6	SBC	Brompton Split Banc Corp	TORONTO	COM	8.33	7.9%
7	TMC	Timbercreek Mortgage Investment Corp	TORONTO	COM	9.04	8.0%
8	MAR	Marret Resource Corp	TORONTO	COM	8.80	7.1%
9	SPS.A	Sportscene Group Inc	TSXV	COM	9.44	7.3%
10	SXP	Supremex Inc	TORONTO	COM	7.95	6.5%
11	CSY	Can 60 Income Corp	TORONTO	COM	11.79	7.9%
12	FN	First National Financial Corp	TORONTO	COM	10.32	7.0%
13	CSE	Capstone Infrastructure Corp	TORONTO	COM	11.52	7.3%
14	TCI	Target Capital Inc	TSXV	COM	3.70	5.6%
15	PHX	PHX Energy Services Corporation	TORONTO	COM	10.39	6.3%	Yes
16	ISV	Information Services Corp	TORONTO	COM	4.30	4.3%	Yes
17	NXC	NexC Partners Corp	TORONTO	COM	8.86	4.5%
18	MPC	Madison Pacific Properties Inc	TORONTO	COM	9.00	4.0%
19	MIC	Genworth MI Canada Inc	TORONTO	COM	8.80	4.0%
20	MPC.C	Madison Pacific Properties Inc	TORONTO	COM	11.50	4.6%
21	LIF	Labrador Iron Ore Royalty Corp	TORONTO	COM	10.13	4.2%	Yes
22	CJ	Cardinal Energy Ltd	TORONTO	COM	7.09	3.6%
23	HWO	High Arctic Energy Services Inc	TORONTO	COM	8.11	3.6%	Yes
24	PRE	Pacific Rubiales Energy Corp	TORONTO	COM	9.34	3.8%
25	WEF	Western Forest Products Inc	TORONTO	COM	7.63	3.5%	Yes
26	LB	Laurentian Bank of Canada	TORONTO	COM	11.54	4.2%
27	TGL	TransGlobe Energy Corp	TORONTO	COM	7.03	3.3%	Yes
28	ACD	Accord Financial Corp	TORONTO	COM	11.69	3.8%
29	PWF	Power Financial Corp	TORONTO	COM	12.25	3.9%
30	NA	National Bank of Canada	TORONTO	COM	11.84	3.7%
31	BNS	Bank of Nova Scotia	TORONTO	COM	12.03	3.7%
32	ITP	Intertape Polymer Group Inc	TORONTO	COM	10.01	3.2%	Yes
33	MFC	Manulife Financial Corp	TORONTO	COM	10.18	2.8%
34	GS	Gluskin Sheff + Associates Inc	TORONTO	COM	9.64	2.7%
35	WRG	Western Energy Services Corp	TORONTO	COM	12.30	3.3%	Yes
36	BBD.A	Bombardier Inc	TORONTO	COM	11.19	2.8%
37	BBD.B	Bombardier Inc	TORONTO	COM	12.08	2.9%

Down Markets and BMO Floating Rate High Yield ETF

Down US Markets

The US stock markets have been selling off the last few days. Strangely high volume last Friday, way above average, with a down finish, but not much actual price movement. Back to more typical volume to start the week, and the price has started to come off. Take $SPX for example:

 And the Russell 2000 small caps completed their death cross (50 day moving average crossing below the 200 day):

Ran a chart screen yesterday at TD Waterhouse. I compared the broad US equity markets against large caps, small caps and the NASDAQ 100 over the past year. The large caps pretty much matched the direction of the broad market during that time. The small caps started falling behind several months ago, and the NASDAQ 100 started to outperform the broad index at about that time. Might indicate that the NDQ100 is the better bet for those thinking about an inverse ETF.

BMO Floating Rate High Yield ETF – ZFH.to

Decided to do something about the amount of cash in the portfolio. Not liking the equities generally, and ditto for fixed income — not that it seems likely we’ll get a rise in interest rates all that soon, but there has been short term weakness even in the short end of the yield curve, it’s hard to know what to think and do that doesn’t involve taking on significant risk. But it’s horrid sitting on cash at essentially zero interest, meaning actually a negative real return with inflation.

Poked around the BMO website about their ETF products. They’ve done a great job these last few years in bringing ETFs to market, to provide more options in the Canadian context against BlackRock’s iShares or the offerings from HorizonsBetaPro.

Stumbled across the BMO floating rate high yield etf. Weighted average duration of 0.28 years, but annualized distribution yield is over 4 percent (4.24% as at 19 Sep 2014). The price seems stable enough. The extremely short duration takes care of the risk coming from an increase in interest rates on the short end. And the yield is good enough for a parking vehicle. A little higher than the short-term bond ETFs.

I’m not exactly sure how they manage the trick. The info page says they hold T-bills for safety and to provide the short duration, and then manufacture the yield through credit default swaps on higher yielding US non-investment grade debt.

Almost the first rule of investing is to buy what you understand. I can’t really say I understand this one. But it seemed good enough for now, and will provide at least some income until I can find some better opportunities.

Where are we now?

Long time since I posted. Haven’t liked the markets recently, going back to mid 2013 — I read too much Hussman for that. He talks about not cheering before half-time, that investors face an uncompleted half cycle, that the other shoe will drop. Just as happened in 2000 and 2008. But it’s painful to wait. And new highs on the Dow 30 and Alibaba’s launch today don’t ease that pain. Or looking at charts for the TSX or Dow 30 for 2014, both showing nice gains during 2014.

Where are we?

• I updated my asset category ETF strategy (per Ivy Portfolio / Mebane Faber) last night. It’s five major asset categories (domestic equities (which I split between US and Canada); foreign equities; bonds; Canadian real estate; commodities) with a relative strength kicker. Top three or four categories were: Canadian equities; US equities; followed by Canadian real estate. With a footnote that the Canadian ETF for foreign equities (XIN.to), which uses the MSCI index and is CDN $ hedged, had better performance than the Vanguard developed foreign equity VEA, which uses the relevant FTSE index. Can’t explain the difference. Bonds were still above the 200 day simple moving average, but were bottom man on the momentum indicator. And commodities have fallen well below the 200 day sma, so are not eligible under the model.
• You have to pay to play, but given Hussman’s warnings, and others, I have a tough time buying equities at this point. You can’t expect to be the first one out the door when the fire alarm goes — even if you believe it’s possible to hear the bell ringing at the top.
• Small caps had a great 2013, but in 2014 have been flat. Russell 2000 is only a few points away from a death cross of the 50 day sma below the 200 day.
• Large caps at all time highs on the Dow 30, extended well above its 50 and 200 day smas. S&P500 is similar, but not quite as extreme. The thinking is that it’s all because of the Alibaba launch.
• TSX has had a sell off today (last: 15261), taking it decisively below its 50 day sma (at 15394), which had been an area of support over the medium term. But still quite extended over 200 day sma (at 14531). Volume today was much higher than average. Sell volume in September to date looks higher than average volume in previous months in 2014. Will have to see if support around 15000 to 15100 holds.
• Interest sensitive holdings, even short term instruments, have been selling off over the past month. CBO.to, for example, the iShares 1 to 5 year laddered corporate bond etf. Same with long bonds, TLT. Though in both cases, looks like there’s some support kicking in part way between the 50 and 200 day smas.
• Gold has broken decisively below $1,200 US; GLD at $117 today, and 50 day has just crossed 200 day downwards.
• Running certain value screens, there is value out there. I have a list of good companies, and alerts for those companies keep coming in, at new 52 week highs. But not every company has participated in this advance. Of course, even value companies will drop in a market drop.

As Chef Gordon Ramsay says, “A tough decision.”

At the moment, I’m roughly 60% in cash, and the invested balance split with a bias toward bonds in a couple of ETFs that pay monthly income. The price doesn’t do much, but the income does add up over time.

In July 2014, bought some HVU.to, putting about 5% into it, as a hedge against a market drop (etf from Horizons BetaPro S&P500 VIX Short-term Futures), in case Hussman is right in the near term. Still holding it; and it’s hit a new low given the new highs on the S&P500. You have to be a nimble trader to take advantage of these things. They spike, and you have to get out when the getting is good. An inverse ETF would be another potential pick.

Can’t say I see a reason to change. The value investors say one should price a purchase, not time it. But, given the general risk in the equity markets these days, the value would need to be compelling.

Bought RIM Today

Haven’t had much time to post over the Christmas break. I have used some of the time to investigate some companies, and to upload and revise some of my older analysis spreadsheets into Google Docs.

The markets keep going up, on the whole, though gold is having a tough time (I hold some GDX). Richard Russell says not to trade out of your (core) gold positions.

Two days ago, I found a re-issue of Joel Greenblatt’s The Little Book that Beats the Market. He looks for “good” companies, as measured by a return on capital calculation, that are also “cheap”, as measured by a particular price to earnings calculation (not p/e).

I ran a proxy screen yesterday using the Globeinvestor stock screening tool: common shares on the TSX (ie, to exclude securities that are units), with a minimum market capitalization of $123 million (to weed out unlikely smaller companies), and a p/e of 15 or less (to begin to get at the cheap part of things).

The screen returned 164 securities.

I then ranked them, best to worst, based on return on assets (Greenblatt suggests a 25% cutoff, of which there were only 16 in the list). You ignore the investment funds, financial companies and any utilities that appear in the list.

Endeavour Mining Corp. (EDV.to) was the first company to make the cut (p/e of only 2). I don’t trust mining companies (a few years in the late 1980s taking small mining companies public on the old Vancouver Stock Exchange will do that to a guy), so I haven’t looked at Endeavour.

Second on the list was RIM.to (or RIMM on Nasdaq). I’ve also come across RIM recently in one or two other value investor contexts, so that tweaked my interest further. RIM’s recent p/e is only 10.33 and the return on capital is around 35 percent.

I don’t have time for a full analysis. The chart pattern looked promising, and the stock popped today above a recent resistance level on news that RIM had, at least in part, dealt with its security issue with India.

I did manage to run a quick ValuePro analysis yesterday, using recent quarterly numbers and assuming, therefore, they will be reasonably representative going forward. Using only a 5 year excess return period and revenue growth during that period of roughly 10 percent (that is, quite a bit less than analysts forecast), on my usual 10 percent cost of equity capital, RIM still came out as being modestly undervalued (about a 75 to 80 cent dollar).

RIM is the sort of stock that a guy like me never buys. I remember the gyrations of the stock back during the early 2000s. Crazy. Just like my dog, Del, who, at age 2, would leap across (most times — sometimes not all the way!) the dirty water ditch to chase the ducks in a thick-deep muddy field at the dog walk park. The mud up to his chest. Needless to say, we never had duck for dinner.

Del settled down once he turned five. Let’s hope RIM has learned the same lesson.

 

Microsoft Corp. – Is it on Sale?

You can learn a lot just by watching – Yogi Berra

Investors of all kinds are always on the lookout for good ideas. One source is to see what other respected investors are doing. So it can be worthwhile reading the quarterly and annual letters of mutual fund managers you like.

I tend to spread my investment capital (poor as it is) among different ideas. One idea is picking the jockey, which is why I put a portion of my funds into Mackenzie Cundill Value Fund — admittedly more for the past reputation of a fund associated with Peter Cundill (a former associate of John Templeton) than caring about who the existing managers are.

I received the September 30, 2010 quarterly report in the mail a couple of weeks ago, and scanned through their list of positions. One was Microsoft (MSFT-q).

And, taking advantage of Google Docs, I’m beginning to develop some calculation spreadsheets online. One is a free cash flows to equity discount model, with tweaks, contained in Robert Hagstrom’s well-known book, The Warren Buffett Way (2d. ed.).

Here’s my FCFE analysis for Microsoft.

Hagstrom is using a standard DCF two-stage model:

• For “free cash flow to equity”, he uses “owner’s earnings” as described by Buffett: net income, plus depreciation and amortization, minus capital expenditures and changes in working capital.
• The discount rate Hagstrom suggests when the book was written (mid 2000s) is 10 percent, based on his view of what Buffett was doing once the yield on US 10 year treasury bonds dropped below 7 percent. With yields above that figure, Hagstrom says Buffett uses simply the 10 year (or long term) treasury yield as the discount rate. Buffett can dispense with the usual calculation of discount rate (involving beta and an equity risk premium) on the basis that he only chooses companies that have predictable and certain earnings and that he knows what he’s doing (circle of competence).
• The owner’s earnings for the previous year are calculated to start and then grown at a suitable rate for 10 years. Each future year’s earnings are then discounted to the present.
• A terminal value is calculated, using the standard dividend discount model where the owner’s earnings in year 11 are capitalized at “k minus g” (the discount rate minus the long-term growth rate), and then discounted back to the present.

I added a few tweaks to the spreadsheet to remind me to calculate different growth scenarios during stage 1 and stage 2, to take a quick look at earnings yield, and to estimate a possible rate of return over 2 years and 5 years if price does indeed rise to estimated intrinsic value over those periods.

I added another tweak to deal with one of the problems in DCF analysis having to do with the “terminal value” — the second part of the calculation.

The issue is this: the intrinsic value calculated under a DCF analysis consists of two parts: the excess growth period (which is 10 years in Hagstrom’s model) and the terminal value period.

Once you run several of these kind of analyses, you quickly learn that for most companies the greater part of the estimated intrinsic value comes from the terminal value period, and not so much from the excess growth period.

This characteristic of a two or three stage DCF analysis troubles people. (A one stage DCF model uses only the terminal value calculation.)

So I tweaked the spreadsheet to show three possible methods for handling the terminal value portion of the calculation. From more aggressive to less agressive, they are:

• the classic residual method explained above (cash flows in year 11 are capitalized using a long-term growth factor; the higher the growth, the smaller the capitalization factor, which results in a higher terminal value);
• a no-growth scenario, under which the year 11 cash flows are discounted at the discount rate (effectively, k minus zero); and
• most conservatively, by ignoring a terminal value calculation altogether, and using simply recent shareholder’s equity as the estimate of terminal value.

What can we conclude from this analysis?

• The first set of factors I ran produced an estimated intrinsic value in the low $60s. This was using a 10% discount rate, and a reasonable 8% growth period. On this basis, even if MSFT takes 5 years to rise to IV, an investor will earn 17% a year from price appreciation and probably another 2.3% per year from dividend yield (more if MSFT increase its dividend).
• Using the 10% discount rate, I then ran a few more growth scenarios, dropping the growth rate both during the excess return period and the residual period. I got closest to MSFT’s current value by using a growth rate of only 3% a year for 10 years, and a terminal value growth rate of 3%. I think MSFT is a better bet than that, but if this is what the future brings, then we should pass on MSFT at this point.
• Those two represent the high and the low. In the middle scenarios, MSFT is not over-priced, but to achieve significant returns, one is counting on Mr. Market to get moving on MSFT’s price within the next two years. How likely is that to happen? MSFT has traded up to $36 twice over the last 10 years. But most of the time has been spent in a tight range of $26 to $30 (apart from dropping below $20 for about 3 months during the 2008 / 2009 financial crisis).
• The current price of close to $28 is at or heading towards the upper part of that trading range. The Mackenzie fund shows an average price of $25.83 for its MSFT holding (one of the top 10 holdings, at about 4 percent of assets), which was at the lower end of the range, and would provide a better margin of safety. MSFT hit its 52 week low at about $23 in June 2010, during a general period of market weakness. It’s risen with the general US markets since then.

On the whole, not a screaming bargain, but perhaps a reasonable buy if its watched after purchase. And if we get that sell-off that Hussman warned may come, it would probably be a clearly worthwhile purchase under $25 or 26.

Bank of Montreal to buy Marshall & Ilsley Corp. – Private Market for Control

On December 17, 2010, Bank of Montreal (BMO-t) said that it would buy Marshall & Ilsley Corp., a small mid-western US bank.

BMO closed down about 6-1/2 percent on the day — commentators interpret the drop as a sign the market doesn’t fully support the purchase. The deal does have some negatives:

• BMO will take a write-off of about $4.7 billion from the M&I books, to accelerate losses that M&I would have claimed (though according to Boyd Erman, in his December 18 column in the Globe & Mail newspaper, some analysts think that amount may be overdoing it);
• M&I was hard hit in the financial crisis — for example, it’s stock price dropped by about 90 percent, from around $50 to around $5 just before the announcement — and it is not expected to return to profitability until mid to late 2011;
• M&I still has to repay its TARP money — about $1.3 billion.

I’ll perhaps look at BMO in another post, to see what a 6 percent drop in its price does in terms of value.

But what I wanted to mention briefly was this point: Value investors buy at a discount to the estimated intrinsic value of their target company. One expects — and on the whole experience shows — that price will eventually rise to value — or, if not to value, then at least suitably above one’s purchase price.

No one knows when that rise will happen, though. These kind of buy-outs are one kind of catalyst in moving Mr. Market along, perhaps before his time. So, as Christopher Browne writes in his book, The Little Book of Value Investing, it is worthwhile for value investors to keep track of what the private market for control of companies pays for their targets.

Not only do private purchases of entire companies help hasten the rise of price to value, but they also establish another benchmark for investors, by helping us to understand what constitutes good value and what doesn’t.

Boyd Erman’s research on the Bank of Montreal purchase shows this:

• BMO is paying 0.6x book value for M&I, against a median price-to-book value ratio of 1.5x for 24 U.S. banking acquisitions (citing Bloomberg);
• BMO is paying about 1x tangible book value, against 1.25x TBV for bank and thrift purchases in the U.S. midwest over the past year (citing SNL Financial);
• When TD bought Commerce Bancorp Inc. in late 2007 (remember, this was pretty much at the peak of the market, before things blew up in early 2008), they paid 2.8x book.

How are our Canadian banks (and one insurer) doing on that score today? (data from Globeinvestor.com):

• BMO is trading for 1.5x book, with a recent return on equity (ROE) of 14.5%;
• Bank of Nova Scotia (bns-t), for 2.14x book, with ROE of 18.1%;
• CIBC (cm-t), for 1.96x book, with ROE of 19.2%;
• Canadian Western Bank (cwb-t), for 1.99x book, with ROE of 13.2%;
• Laurentian Bank (lb-t), for 1.11x book, with ROE of 11.1%;
• Manulife Financial (mfc-t), for 1.15x book, with a negative ROE this year;
• National Bank of Canada (na-t), for 1.6x book, with ROE of 16.9%;
• Royal Bank of Canada (ry-t), for 1.88x book, with ROE of 15%;
• TD Bank, for 1.5x book, with ROE of 12%.

Note that most financial services in reporting “book value” include goodwill and other intangible assets in their calculation. Tangible book value excludes those items.

I listed the return on equity for these companies because price to book value and return on equity are two “investing twins” — factors that arise from the discounted cash flow equations used to calculate intrinsic value of companies. (The other set of twins are the price to sales ratio and net margin.)

So in judging price to book value ratios, an investor who considers the respective return on equity (ie, the earnings on that book value) will have more information than one who ignores ROE. In general, higher ROEs will support a higher price to book value (PBV) ratio. So, if two companies are trading at roughly the same PBV ratio (as we see for BMO” and TD in the list above), the better value is the company with the higher ROE (in this case, BMO’s recent ROE is about 2 percent higher than TD’s).

Damodaran points out that one can rank companies using a ratio of ROE/PBV. The higher the result, the better. Use decimals for the ROE numerator. For BMO, the ratio is o.145/1.5 = 0.09667, and for TD is 0.12/1.5 = 0.08000. In his Investment Valuation textbook, he presents research studies showing that investing in the better ranked stocks can produce market-beating returns.

If we work out the algebra behind the ratio, we find that it reduces to a form of earnings yield: ROE = net income / book value; and PBV = price / book value. In dividing ROE by PBV, we flip the PBV ratio, so that the expression becomes: NI/BV times BV / P. The BV terms cancel each other, and we’re left with: NI / P. Divide top and bottom by the number of shares outstanding, and you get the E / P ratio (sometimes called “earnings yield”), which is the inverse of the better-known P / E ratio.

It then becomes interesting to see how the market’s P/E ratios stack up to that kind of calculation. For BMO, it’s current p/e is 12.2, which gives an e/p ratio of 0.082, and TD’s p/e ratio is 14.05, for an e/p ratio of 0.071.

Again, BMO is better valued on this basis than is TD, so the rank order is preserved. Note, though, that the market’s earning yield obtained by inverting the p/e ratio is lower for both banks than the earnings yield obtained by the ROE/PBV ratio.

I don’t know what to make of that difference, except that it may indicate that like the rest of us, the market is merely estimating value, and no one factor is definitive. On these numbers, the best we can say is that the earnings yield for BMO falls in the range between 8% and 9.6%, while the earnings yield for TD is lower, in the range from 7% to 8%.

Doing the ratios for the other companies listed is left as homework for the keen reader.

But before we leave the post, we should look quickly at little Laurentian Bank. It’s ROE/PBV ratio is 0.111 / 1.11 = 0.10 — slightly better than BMO. The p/e for Laurentian is 10.32, for an earnings yield of 1/10.32 = 0.0969. Again we see the pattern that the market p/e ratio for the company is a bit lower than the earnings yield we get from the ROE/PBV ratio, though the two are closer in Laurentian’s case than for the larger banks. It’s range of earnings yield is quite tight: 9.7% to 10%. LB may warrant further investigation as the better-valued bank out of these three.

Hussman Warns – Risk Management Considerations

John Hussman is one of a number of value investors I respect. His weekly commentary makes Monday mornings somewhat more bearable. He’s concerned mostly with value, but also brings data from the technical side of stock analysis to bear.

In his weekly commentary published December 13, 2010, he warns about a group of indicators that in the past (so far, at any rate!) has reliably signalled a coming decline in the general US stock markets.

He writes:

In recent weeks, the U.S. stock market has been characterized by an overvalued, overbought, overbullish, rising-yields syndrome that has historically been hostile to stocks. Last week, the situation became much more pointed. Past instances have been associated with such uniformly negative outcomes that the current situation has to be accompanied by the word “warning.”

The following set of conditions is one way to capture the basic “overvalued, overbought, overbullish, rising-yields” syndrome:

1) S&P 500 more than 8% above its 52 week (exponential) average
2) S&P 500 more than 50% above its 4-year low
3) Shiller P/E greater than 18
4) 10-year Treasury yield higher than 6 months earlier
5) Advisory bullishness > 47%, with bearishness < 27% (Investor’s Intelligence)

(bolding in original)

Regular readers of his commentary will recognize that although Hussman has been cautious about the value of the stock markets over the past year, he hardly ever uses the term “warning”. (And he cautions readers that his commentary is not advice — anything he mentions is usually at least a week old — something he’s already acted on for his investment funds.)

Hussman’s warning raises the issue of how value investors manage risk in their portfolio. Books could be (and are) written on the topic, but today I’ll just highlight a few ideas. It helps me to get my thinking straight, and will, one hopes, be useful more generally.

1. As usual, we can start with Buffett and his two rules of investing (which if you think about it probably is meant to reference another, better known set of two commandments, found in the New Testament, to love God and and to love one’s neighbour). Rule 1 being “don’t lose money”, and Rule 2 being: “refer to Rule #1”. (And like the Great Commandment, those rules are probably broken more often than followed.)
2. For a value investor, the first line of protection is to buy well. Graham called it a “mystery”, but experience does show that price will return to value. In addition to his comment about not buying a stock unless one is willing to hold it for 10 years (and his 20 hole lifetime investing punch-card comment is to the same effect), Buffett has also said that a real investor must be willing to hold through a 50 percent decline in price. You can only do that when continued review of your position shows that Mr. Market continues to be irrational in failing to recognize the true value. It’s an issue of what will turn out to be a temporary loss of capital (to be borne) versus a permanent loss of capital (to be avoided). Again, easier said than done. All investors have to live life forward (referencing Graham quoting the philosopher Soren Kierkegaard).
3. Investors who come from a trading background recommend a firm rule for selling, usually on the order of 7 or 8 percent (Investor’s Business Daily) to perhaps 10 percent (Loeb, I think) or possibly 20 percent. Most of us are wired so that taking losses of any amount is painful. The idea is to take losses quickly, so they don’t weigh you down emotionally.
4. Graham’s general advice from Intelligent Investor for portfolio construction was to hold 25 percent in fixed income securities and 25 percent in equities, at all times. This on the basis that one never knew what the stock market would do — for good or bad. And then to vary one’s exposure to the market (up to 75 percent in equities) depending on one’s general view of the state of the market’s value. I can’t say that I implement this advice faithfully. But over these last dozen years, it’s advice I come back to, and it seems always reasonable — I haven’t come across anyone with a better solution. Hussman is, of course, telling us that now would be a good time to be reducing exposure closer to the 25 percent level for equities.
5. There is of course the old saying about selling down to the level that allows you to sleep at night.
6. If you’re not going to sell, it is possible these days for general investors such as us to hedge general stock market exposure through one of the inverse ETFs. Be careful here, to be sure you understand what you’re buying. Inverse ETFs come in two main flavours: those that move on a one-to-one basis with the stock market they cover, and those that are leveraged and therefore move on a two-to-one or even a three-to-one basis inverse to the stock market they cover. For Canadian investors hedging against a decline in the S&P 500, for example, the Horizons BetaPro S&P500 Bear ETF is available. About.com has a list of inverse ETFs. ProShares is a company offering US-market based leveraged ETFs.
7. More sophisticated investors who are investing outside registered plans will have other avenues for hedging, such as options on a stock market index.

A little more about inverse ETFs: These are short-term holdings only. You have to be ready to get rid of them quickly. And unless you’re in a position to pay attention literally hour by hour, I would stick with the plain 1 to 1 inverse ETFs.

The leveraged ETFs are re-balanced every day, and the daily volatility of the stock market does unexpected things with the math behind the return results. In short, they will not move in tandem with the stock market index they cover, and will often move much worse. If you get lucky and hit the right down day and sell before the close, you’ll be ok — but no one should expect such luck.

The general markets have had a nice uptrend since August. Economic news is weaker than people would like, but certainly in many places in Canada — and here in the Vancouver area — there’s a fair bit of optimism. So nothing clearly on the horizon that will stop the trend.

But as the briefing sergeant used to say on Hill Street Blues: “Let’s be careful out there.”

Low Price to Cash Flow Screen

The free data available to investors these days is amazing, even compared to the late 1990s when the internet and online investing took off.

I just spent the last few hours messing around at Zacks.com. You’ve probably seen a credit to their stock data on other general stock research websites,  such as Globeinvestor or Yahoo!

They offer free and paid memberships. The free membership gives you access to their stock screener, which is probably the most comprehensive I’ve come across so far.

As a test, I created a Graham-like screen. Toward the end of his life, Graham was mentioned in articles as saying that he favoured very simple criteria, that there was no need to get fancy when it came to choosing stocks for investment.

In that spirit, the screen I ran today is based on Marty Whitman’s (Third Avenue Funds) “safe and cheap” mantra. Whitman  uses different criteria, but there’s enough flexibility that the general idea comes through without following him slavishly.

For safe, I screened for stocks have long-term debt to equity of no more than 5 percent (that is, no more than 5 cents of debt for every $1 of equity) and a current ratio of more than 2 (that is, $2 of current assets for every $1 of current liabilities).

For cheap, I used a price to cash flow ratio of no more than 5. I could have used p/e, or p/b, or p/s ratios. In the p/cf ratio, cash flow is usually defined as cash flow from operations (taken off the cash flow statement), which is net income plus depreciation and adjusted for changes in working capital. That last adjustment gets at operational efficiency — companies that don’t require much investment in working capital as they grow will generate more free cash for their shareholders.

The one thing to watch for in this ratio is the amount of depreciation compared to net income. Companies that require significant capital assets will generate more depreciation, but the capex requirement ultimately will reduce the free cash available to shareholders.

I added the requirement for return on equity to be more than 15 percent in order to find companies that do produce actual earnings.

Here are the results (sorted in p/cf ascending order):

Company Name	Ticker	Debt / Equity Ratio	Current Ratio	Current ROE (TTM)	Price/ Cash Flow
CHINA CRESCENT	CCTR	0.03	5.7	21.9	0.1
PREFERRED VOICE	PRFV	N/A	69.0	810.3	0.3
SUNWAY GLOBAL	SUWG	N/A	7.8	819.3	0.9
JIANGBO PHARM	JGBO	N/A	2.8	24.5	1.6
RINO INTL CORP	RINO	0.03	7.1	24.3	1.7
INSTACARE CORP	ISCR	N/A	3.3	28.6	1.7
CHINA KANGTAI	CKGT	N/A	3.8	28.8	1.8
HALLWOOD GROUP	HWG	0.05	3.4	27.3	2.2
CHINA SKY ONE	CSKI	N/A	8.8	21.3	3.0
ZIM CORPORATION	ZIMCF	N/A	6.1	23.3	3.3
BENNETT ENVIRON	BEVFF	N/A	9.5	48.9	3.7
USA MOBILITY	USMO	N/A	5.2	24.8	3.8
BROADVIEW INSTI	BVII	N/A	7.0	21.9	3.9
DIRECT INSITE	DIRI	0.02	2.2	32.5	3.9
NET 1 UEPS TECH	UEPS	N/A	2.1	26.6	3.9
OPTI INC	OPTI	N/A	9.5	96.6	4.0
WESTERN DIGITAL	WDC	0.05	2.3	29.2	4.3
EXCEED CO LTD	EDS	N/A	6.5	40.8	4.4
EMERSON RADIO	MSN	N/A	2.1	33.3	4.4
ARTIFICIAL LIFE	ALIF	N/A	5.9	19.2	4.7
MIND CTI LTD	MNDO	N/A	4.3	22.7	4.7
CHINA EDUC ALNC	CEU	N/A	18.5	21.8	4.8
EARTHLINK INC	ELNK	N/A	2.2	15.2	5.0

This kind of list is hard-core value. A bunch of small, mostly obscure companies. This sort of list is only the beginning of a search for investable value, but here are some general comments, in no particular order:

• Emerson Radio — which is not to be confused with the much larger Emerson Electric, though one wonders if there is a connection way back when, since Emerson Radio counts its history from 1912 according to their website. Radio trading at about $2 per share, having risen in stages to that price over the last couple of years. During 2010, it paid a special dividend of over $1 per share — management realizing that the company didn’t need to keep excess cash in the company. You might have seen the company’s radio, small refrigerators, coffee makers or other licensed products when shopping. Emerson has returned to profitability over the last couple of years (hence the special dividend), with perhaps more to come.
• Western Digital is the former tech high-flyer of the late 1990s. You probably have owned a Western Digital hard drive at some point; more recently, I’ve come across them for external hard drives.
• OPTi Inc.doesn’t seem to an active business anymore (according to a Wikipedia article on the company). It’s latest SEC quarterly report shows licence revenue. The Wikipedia article says that OPTi Inc. sold its technology to a company called OPTi Technology. If you research it further, be sure to keep each company straight.
• Bennett Environmental‘s symbol is for the Pink Sheets in the US, but investors familiar with Canadian companies will recognize the name as a former high-flyer some years ago. It’s trading for about $2 on the TSX under symbol BEV. A current p/e of 2.5, and a forward p/e just under 7.
• It’s interesting that a lot of apparently Chinese named companies show up.
• I get a little uneasy when the numbers look too good to be true. So the companies with a p/cf ratio below about 3, don’t really interest me on that point alone. Same for weirdly high current ratios (anything over maybe 6 or so — worthwhile businesses simply don’t have current ratios much higher than that)  and unsustainably high return on equity (you might see ROE higher than 30 or so in an exceptional year; values over that level probably point to something weird and better ignored).

As I said, a screen like this is only a place to start one’s search for investable value.

Tale of Three Telecoms: BCE, TEF, and DT

I backed into writing this post. The Globe & Mail newspaper publishes weekly listings of certain major stock market indexes, showing the yield and p/e ratio for the index. A couple of weeks ago, I noticed that the Spanish stock market index was priced better than the others, with a p/e ratio of about 10 and a dividend yield of about 5 percent.

You can buy the iShares single-country etf for the Spanish index, under EWP.

But I thought that if the entire index was reasonably valued, maybe there were particular bargains in individual issues. So I started looking at the constituent companies and found Telefónica SA (TEF-n), which is notable for a dividend yield of almost 8 percent. (On New York, TEF trades as an ADR, where 1 ADR equals 3 Telefónica ordinary shares.)

And then, over at Google Finance, if you bring up the quote results for Telefónica, Google handily lists its competitors. And there today was Deutsche Telekom AG, also sporting an almost 8 percent dividend yield.

And since I’m in Canada, I thought I’d bring in Canada’s largest telecom company, BCE, because it’s always good to compare one company with another. BCE’s dividend yield is about 5 percent.

By itself dividend yield doesn’t say a whole lot. And I’ve only scratched the surface of these companies. They’re large, well-established, dominant in their respective countries. Telefónica in particular has a great website for investors, with a section in English.

For a Canadian investor, to hold DT or TEF would provide diversification out of North American business activity and out of the Canadian dollar.

For example, the 2009 TEF annual report says that it operates in 25 countries, and generates 64 percent of its revenues outside Spain, primarily from Central and South America (40 percent) and Europe (17 percent). They have 8.37 percent interest in a Chinese telecom, which contributes a sliver to revenues.

Deutsche Telekom reports in five operating segments: Germany (35.4 percent of revenue), United States (including operations in Canada, the US, Mexico, and two countries in South America: 21.6 percent), Europe (13.9 percent), Southern and Eastern Europe (13.5 percent), and Systems Solutions (12.3 percent), plus a headquarters allocation (3.3 percent). Based on 2009 figures.

BCE operates mostly in Canada.

Sites such as Reuters, Google Finance, MSN Money and, for Canadian stocks in particular, TMXMoney and Globeinvestor will give you all the quick ratios and summary financial statements a person could ask for, to investigate further. I used those websites to work up a quick and dirty ValuePro valuation for each company.

We’ll skip the details, but here’s some general indications. I used a 5 percent 10 year treasury yield, and a 10 percent cost of equity capital.

BCE: Trailing 12 month revenues of CDN $18,306. Recent quote: $35.07. Operating (EBIT) margin is healthy at an average of 17.5 percent, but revenue growth during the 2000s has been dismal — essentially flat, so I used 1 percent growth in the future, with a 10 year competitive advantage period.

BCE pays a fairly low tax rate; a recent average of 21.5 percent, sometimes lower. Capital expenditures are quite high, and consistent, at about 16.5 percent of revenue, and depreciation expense is also consistent, at 14.5 percent of revenues, as one would expect from a mature company. Working capital as percent of revenues fluctuates significantly, from about 9 or 10 percent to double that. The number for 2009 was quite a bit lower than previously, so I went with 14.5 percent. Balance sheet items for debt, preferred shares, and short term assets and liabilities were taken from the September 2010 balance sheet summary at Globeinvestor.

ValuePro says intrinsic value for BCE at $18.24. A Morningstar valuation up at Questrade’s website for BCE puts its value at $35, with medium uncertainty. The basis for that valuation is not stated. ValuePro gets that valuation if:

• BCE increases revenue growth to 6 percent; or
• at 4 percent growth, if operating margin increases to 19 percent and the average tax rate going forward drops to about 17 percent. Those amounts are pretty much the 5 year average calculated by Reuters.

The growth requirement to achieve fair value seems optimistic (as low as it is). The year over year increase in revenues for Q2 and Q3 2009 to 2010 is 1 percent in each quarter.

Debt to equity is about 0.64, so there is reasonable safety there. Interestingly, its current ratio is consistently below 1.0x.

On a simple p/e valuation model, per a Standard & Poor’s company report on BCE, the high p/e over the last 8 years is 15.3 and the low p/e 10.8. Under the 2011 estimated eps of $2.89, the price range for BCE is between $31 and $44. And an average price of $37, which is close to Morningstar’s valuation. (And again what one expects from a well-known, widely followed company.)

Deutsche Telekom (ADR symbols: DTEGY.pk and the lower volume DTEGF.pk):  Statistically, DT has some tempting values — at least on the surface. Not p/e currently (around 18), but p/s is 0.7x (though net margin is only 4 percent, so the low p/s is probably justified); p/b of 1.1 (return on equity is only about 6 percent, which again would justify a low p/b); and a price to cash flow of 2.7x compared to 4.5x for the industry.

As with BCE, current ratio is below 1.0x. Long-term debt to equity is reasonable, at 1x. (Per a Reuters Provestor Report dated 8 Dec 2010)

Revenue growth the last 5 years has been low, at 2.41 percent (but slightly better than BCE’s flat revenue). It’s operating margin isn’t as good, at about 9.7 percent.

Tax rate is hard to judge. The statutory tax rate is about 30 to 35 percent over the last few years. But the effective tax rate over the last 3 years has been much higher, at about 55 percent. Reuters reports the 5 year average effective tax rate at only 21 percent. For ValuePro I went with 35. In 2009, part of the higher taxes arose from a goodwill impairment item.

The rest of the items were calculated using the 2009 through 2007 financial statements at the DT website, and using an exchange rate of USD 1.32 to Euro 1.

With those inputs, ValuePro estimates intrinsic value for DT at $14.81, which is essentially where DT is trading as an ADR in the US: $13.14.

If the tax rate going forward will be closer to 50 percent, then estimated value drops to about $11.50 per share.

P/e ratio analysis for DT is not as helpful as for BCE because there is quite a wide range over the last several years, with two of the years not having meaningful p/e ratios. Eyeballing the S&P summary of high and low p/e ratios, and being conservative, DT has a p/e range similar to BCE: a low of 10 and a high of 15, for an average of 12.5. The ttm eps is roughly US $1.02 per share, which prices the shares pretty much right in the middle of their range.

That value is more congruent with the estimate from ValuePro. So there may be a bit less fluff in the price of DT compared to BCE.

Telefónica: Had a recent close of US $68.99 for its ADRs (remember, 3 shares equals 1 ADR).

Statistically, TEF is trading at a p/e of 7.11 (ttm); a p/s ratio of 1.33 (ttm) (with much higher net margins than BCE and DT — 18.9 percent in the most recent year, and a 5 year average of just over 13 percent, justifying the higher p/s ratio); a quite high p/b of 3.53 (for which we seek an equally strong return on equity and find it a about 55 percent most recently and a 5 year average of almost 40 percent); and a p/cf of 3.88, which is higher than the industry p/cf ratio of 2.91, but much lower than that for the general S&P 500 (almost 11).

The dividend yield of almost 8 percent is higher than the 5 year average dividend yield of just over 4 percent, and the dividend payout ratio (ttm) is reasonable at about 63 percent. The company has said it intends to raise the dividend in 2011.

One weakness is that debt is higher than we like to see. LT debt to equity is about 2.30x, compared to the industry, at 0.55x. Graham suggests than anything above 1x is too risky. In Marty Whitman’s mantra, even if TEF is cheap, it doesn’t look all that safe, because of the debt levels.

On a 5 year chart, TEF is trading in the lower portion of its price range.

Standard & Poor’s proprietary valuation model puts the estimated value of TEF at about $55.

ValuePro disagrees, showing around $90, with only 2.36 percent revenue growth, operating margins of 22.45 percent and a tax rate of 23.79 percent.

Of the three, TEF seems the best bet.