Value Insight: July 2008

Markets Got You Down?

If the continued market declines have you down and discouraged as an investor I have a few items to share that might be able to cheer you up in the future.

With the market and investors focused intently on financials, energy, materials and agricultural commodities there are more and more companies who continue to release positive quarterly results. A few of my favourites have issued results in the past seven days and have flown under the radar of the mainstream media. Five of the six stocks hold my title of Enduring Value and the other is one of my Value Favourites.

It’s easy for an investor to become distracted in the current market environment, but each of these companies benefits from four main fundamentals that an investor should tune into and focus on in an environment such as this for improved returns to their portfolio.

1. Concentration on margins
   
2. Control of costs
   
3. Products & services that are in high demand
   
4. Management that guides earnings +/- 5% on a consistent basis

What stocks am I talking about?

• Baxter International (BAX)
  
• Keynote Systems (KEYN)
  
• Colgate Palmolive (CL)
  
• Wabco Holdings (WBC)
  
• Exelon (EXC)
  
• Kimberly Clark (KMB)

The added bonus is that all of these stocks continue to trade at very attractive valuations for the long-term investor with some trading at a forward P/E well below their historical averages.

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“The Banks aren’t lying; they’re guessing.”

I had to crack a smile this morning when I read that line from Jason Zweigh’s column, The Intelligent Investor, titled “Is It Time to Tiptoe Into Financial Stocks?” In the article Zweigh discusses a question lingering on the minds of many value investors at this moment of what Benjamin Graham would do with banks today and specifically: Are they a buy?

Zweigh makes the accurate observation that no one would know for sure, due to Graham’s passing in 1976, but I agree with his suggestion that the answer to the question of if Graham would buy financial stocks today can be found in his teachings as a definitive and resounding no.

When you look at the price charts of many financial stocks over the past year you might begin to feel excitement at the possibility of buying into a stock trading in excess of 60-80% below its 52-week high, offering attractive yields, trading slightly above book value and some possessing networks of investment, retail or mortgage operations both domestically and globally. That can be a tempting indicator of relative value, but the financial institutions of the past aren’t likely to mirror the ones of tomorrow. Results from the banks in the future are likely to reflect lower expectations for ROE and growth largely due to the change in appetite for risk, more stringent lending practices and a conservative availability of credit.

“Each quarter, the banks set money aside in reserve against losses on their loan portfolios and say they believe those reserves should be adequate. The next quarter, they find out they were wrong.”
Here is where the significance of the title of this post is revealed. Bankers are smart people – I know a few of them. Even when investors, shareholders and the government begin to question, mitigate or shake their battle armour in an attempt to recoup their losses the brain trusts of the banks are already stewing new and innovative product offerings that hold the potential to increase profits in the future. They’ll find better ways to spread risk, to complicate financial products further and sell them at higher commissions with promises of increased returns.

There’s no doubt in my mind that many of the banks, currently experiencing problems or not, haven’t fully disclosed the extent of their exposure to bad loans, risky credit obligations or derivatives. There’s been a perplexing tune sung by the management of these banks in the absent protection of their brands that leads me, as an investor and student of strategic management, to suggest that an assumption be made about current risks. Full transparency comes at a cost and if Warren Buffett places such high regard on the importance of brands then why are so many of the CEO’s of these companies silent and invisible? There’s been almost no chaos management in this situation on their part.

I’ll suggest that this behaviour indicates that even the banks don’t know yet the extent of their exposure and they’re counting their pennies because every dollar counts. Banks are holding onto assets (both liquid and illiquid) that might be worth $0.20 today, $0 tomorrow or $2.00 a year from now. Some of these assets/obligations will make money on the future gains of losses taken today, but these banks are only writing off as much as their quarterly cashflow will allow. If they write off more, they risk needing to sell attractive assets at fire sale prices, weakening their capital ratios or creating fear that results in a run on the bank. Why an investor shouldn’t invest in some of these companies is fairly simple in my mind:

• There’s a significant lack of transparency and doesn’t appear to be improving anytime soon
• Companies continue to raise capital and issue preferred shares/bonds in an attempt to strengthen their balance sheets
• The public relations, investor relations and marketing departments of these companies haven’t been given the green light to start spending on brand protection and brand development programs yet
• Current losses could expand into catastrophic losses as seen with the failures of IndyMac & Bear Stearns for some of the more exposed financials
• While gains reported on aggressive write offs in the future is likely, the proportion of current losses to future gains ($0.20 today, $0 tomorrow or $2.00 next year) is completely guess work at this time.

Buying a basket might be a strategic investment when you count that a minority groups of banks will fail while the majority survives, but the preservation of your capital or “safety of principal” as Graham often cited isn’t known and that to me spells risk.

Favourite Threads:

The following list of links lead to discussion threads that I’ve found to be informative resources on various topics of investing over the years. For new investors I feel these are worthwhile to read and I have often found myself revisiting each from time to time to reaffirm perspectives or my knowledge of certain topics.

What’s Your Portfolio Allocation?
http://tinyurl.com/5djfmw

Value Investing:
Value I: http://tinyurl.com/688lr4
Value II: http://tinyurl.com/6l2oj2
Value III: http://tinyurl.com/6g92ub

How to pick a good stock-discussion, suggestions, analysis tips:
http://tinyurl.com/5pujsv

General Rules of Thumb for Stock Picking:
http://tinyurl.com/6arf6a

Essential Stocks:
http://tinyurl.com/6on6c3

"The Warren Buffet Way" by Robert G. Hagstrom:
http://tinyurl.com/5w4xmb

Recession Tactics:
http://tinyurl.com/5hdxng

Let's talk about cheap dividend paying stocks:
http://tinyurl.com/5opupt

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30% today vs. 50% tomorrow:

There’s been a significant amount of discussion recently between investors on when an investment should be sold in the face of rising commodity prices and equity valuations. Some have been critical of investors selling out of energy and other commodities after significant appreciations over the past few years when it appears that fundamentals will continue to drive prices higher.

I always assume that every investor in the market holds the same intention of wanting to make money, especially since I have yet to meet someone who purposely enjoys losing it. Yet how much performance is enough and when should an investor know when to take advantage of profits versus holding out for more? This is a question that many investors ask themselves on a frequent basis no matter their trading strategy or desire to time the markets.

Imagine for a moment that you were a buy-and-hold investor who initiated a position in Nortel during a low period in October of 1998 and promised yourself not to sell for 10 years. You would have watched happily as your investment reached its high during the technology bull market in March 2000 after an appreciation of over 375% on your original investment, but check back on its close for 2001 and not only would that 375% have evaporated, but you would be down a stunning 75% from your original purchase price. Today your total investment would be down a staggering 97%.

Nortel, while an extreme case, provides an excellent example of why investors should look to take profits regardless of their opinions on how much further a stock has to gain and regardless of stated fundamentals by analysts, advisors or investors in the market.

Gains on investments are a touchy subject for investors and many never stick to a general rule or discipline in when and where they take profits. Investors can have a fear of the tax implications of selling at a substantial gain, costs incurred by commissions, anxiety of missing perceived future gains or uncertainty of where to place cash in an environment of continuing market highs; so they sit tight. Sometimes it simply comes down to greed and chasing returns with abundant exuberance. The best practice I’ve witnessed and practiced is that of a portfolio manager or someone who concentrates on asset allocations to trim positions as they appreciate to maintain an equity in a range within a portfolio; commonly 3-5%. Once an investment becomes overweight, say 6-8%, a portion of those shares are sold for a gain to bring back the allocation to the desired target and proceeds are re-invested back into lagging positions or classes of assets to rebalance. This prevents one sole investment from becoming too much of an overall portfolio and helps to minimize non-systematic risk.

I have always maintained that regardless of how well a stock performs over the short-term, you should never hesitate to sell a portion or all of your position. The simple reason is this: you only make money when you sell. I will always take 30% today in my pocket and look to re-enter a position at another time versus the uncertainty in believing my purchase will continue to rise higher. To many, selling may seem foolish if they believe that fundamentals remain strong, but in the stock market unknown factors are called risk. Risk has the potential to decimate returns for any investor.

Consider stock ABC. You buy a position in the stock for $10/sh because you’ve done your homework, it fits your investing style and you intend to hold the stock for the medium term. Three weeks later ABC’s industry competitor MNO agrees to a friendly takeover by larger rival XYZ for $13.50/sh. Not only does MNO’s stock price soar above $13, but ABC follows to $13 as the market speculates more acquisitions within the sector are imminent. The question I pose to readers is: what do you do as a shareholder of ABC and MNO?

An investor could answer both of those by stating that they’d sit on the shares in the hopes of a higher price, but what if XYZ’s financing falls through, no other competitors enter a bid or sector consolidation doesn’t pan out? What if the economic environment changes in the blink of an eye and a company isn’t interested any longer in pursuing strategic acquisitions? You can sell either stock today for guaranteed returns of ~30% or hold out hoping for more. Hope in this situation equals risk and you have to know what risk you’re willing to take in this situation for some perceived gain in the future even if you feel both are worth $15. An investor always has the option of re-entering a position later with their original capital and proceeds, but by not selling the shares could plummet, lag or remain at the same level.

Add another element to the equation: XYZ states that the deal will be delayed and go through at $13.50 in six months due to “financing constraints” and the share price today hovers at $13.00. Do you wait, expose yourself to risk or book your guaranteed profits of 30% and look elsewhere for opportunities? Yes you miss out on an extra 5%, but consider what would happen if the deal fails to go through and the stock trades back down below the offer price. Is 5% worth the risk premium for you to wait?

Scott posed a question some time ago on the topic of setting a sell target and why we stick to prices so passionately as investors.

“If your view is that a stock is a sell, why are you being so sticky on price…reaching for a few dollars more? When the stock was trading at $29, your view was that the stock was a sell and so you entered a limit order for $33. Now the stock is trading at $25 and you've moved down the limit to $29. Why is the stock less of a sell at $25 than at $29 or at $29 than at $33?”
I don’t hesitate to sell out of a position for a guaranteed gain vs. any perception I have of the stock moving higher when given the opportunity. On more than one occasion I’ve sold out of positions I’ve held just after a buy-out was publicized knowing I was selling at a slight discount to the intended takeout price. In my mind I’d rather take the guarantee today and always re-enter a position if the deal falls through than to sit tight trusting the acquirer to meet all its obligations.

Take the recent announcement that Dow Chemical (DOW) announced with its planned take-over of Rohm and Haas (ROH) for $15.3B. The past few months I’ve been watching a number of large industrial stocks trading at what I consider to be ridiculously cheap valuations. My watchlist included 10-15 stocks with positions this year initiated in Allegheny Technologies (ATI), Rohm and Haas, Tomkins (TKS), Uni-Select (UNS) & United Technologies (UTX). The proposed transaction price for ROH is set at $78/share with the stock trading close to that value (~$74). The deal is an all cash offer, but we’ll say the difference between those two prices (market price & takeout price) remains at 5.5% until the deal closes in a future quarter (say Q4). While many investors would seek comfort in an all cash offer by a much larger competitor, I took my money on July 14th by selling out of my entire position. A larger bid by a rival might come in above $78/share, the current credit environment could worsen or ROH’s board of directors may simply stall the takeover in similar fashion to the fiasco currently seen at Yahoo (YHOO). 5.5% (or a little more) holds too much risk for my discipline and I’d rather have that cash in my hand today to use for future opportunities than place trust in a company I don’t know well, have an existing situational analysis written on or consider to be as valuable in Dow Chemical.

I have the strong belief that taking profits should be admired instead of often criticized. I look for opportunities to take profits in stocks that have moved from significantly under-valued to fair/over valued because I never know when the next opportunity to buy an undervalued stock might be or what unforeseen events might occur in a company I hold. In my view a 10-15% chance of making more on a stock tomorrow vs. a guaranteed return today simply isn’t worth the risk. As a cautious investor you need to be constantly aware of your downside risk and be ready to ask yourself if it is worth sitting and waiting vs. taking your money elsewhere and looking for better long-term opportunities.

It only takes a few stocks that you picked foolishly and lost money on to learn that there’s risk in staying in a position well past when it should have been trimmed or sold. Even when you invest without emotion, its difficult at times to resist the temptation to sit in a little longer awaiting a better price.

The bottom line: As an investor (and especially a DIY’er), you have to protect yourself against risk because no one else is going to do it for you. 30% today vs. 50% tomorrow might appear as a foolish decision at a time when all the hype surrounding a stock pushes momentum further and further, but there will always be another stock, another opportunity and risk at times is completely dependent on factors you cannot see. Selling ¼ to ½ of your position in a stock during a significant appreciation in the share price to lock in profits is never a foolhardy decision and likely something more of us should consider from the perspective of our investing discipline.

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Five Questions:

Authored by: Prof B.

Reflection is often the most underutilized tool absent in the habits of individuals and goes well beyond the sensible application to business practices. A focus I have maintained throughout my years of instruction has been to stress to pupils the importance of self-reflection when evaluating failure in an attempt to understand the challenges you will encounter in the future. History can be an unforgiving tool especially when viewed in retrospect. An individual must first look back on a situation and realize that although no situation is ever entirely the same, through tedious application there is the potential to learn how a specific hardship can serve as a lesson and offer insight into correcting behaviours for the future. The key term I present in this paragraph is learn.

John Welch shares a unique gift that is often overlooked by corporate leaders today when they reflect on his contributions to business and strategic management. What made Welch so proficient at his job for so many years, at the helm of goliath General Electric, was not an ability to foresee the changing dynamics that would challenge his business, but in the ability to learn and adapt through reflection in a timely fashion,

“An organization’s ability to learn, and translate that learning into action rapidly, is the ultimate competitive advantage.” – John Welch
In a recent trip to Boston I had the pleasure to meet up for lunch with an old colleague of mine who spoke of a recent conversation she had with Gregory Mankiw; a fellow professor of hers and known in academic circles as a very gifted mind on the subject of economics. Our discussion focused on a discussion paper she had in her possession from early 2006 that was addressed to then incoming Federal Chairman Ben Bernanke from Mankiw congratulating him on his appointment and issuing five questions that today appear to hold more significance than the author previously might have anticipated.

In my past submission I outlined the significance of Bernanke’s appointment to Fed Chairman and how relevant his past academic focus on the monetary system would be to the management of the current credit crisis. In his letter to Bernanke, Mankiw addresses five specific questions that monetary economists, economic historians and future Fed chairmen may wish to consider when they reflect on what lessons are to be learnt from the era of Alan Greenspan and the turmoil of the current credit environment.

The discussion by Mankiw is short and I will spare readers my individual impressions of the questions posed to Bernanke or their current significance. My intention is simply to provide the source in an effort for students and fellow academics to reflect upon the appropriate timing of topics discussed throughout the letter and consider the impact of recent oversight and responsibility undertaken by the US Federal Reserve and its officers.


The Five Questions:

1. How important are monetary rules?



2. Should the Fed adopt inflation targeting?



3. Should you be free with your opinions?



4. Should you be a high-profile public figure?



5. Is it more important to be good or lucky?

Taking Stock in IGM, Preview:

I’m going to take a different approach than my usual Taking Stock in^TM format of stock analysis at the request of a friend, Steve, who’s still new to learning about investing. I’ll let him explain...

“...Too be honest, I find the content of most blogs 'out there', not just yours. I like details and exact points; black & white. Tell me what to do and then I’ll go out there and try it. Sometimes it’s just easier for someone to tell me, ‘Buy when the ratio is this, sell when its that or look at this because its important.’ I need to be told what to do and then I can figure it out on my own. Once I get my feet wet, then I can think outside the box, otherwise giving me a story about what to do means nothing. I get scared and don’t wanna try. I’m looking for exact data, illustrate images, direct me, tell me! That’s all a beginner really wants, why I’m ready to learn...”
What Steve has shared with me I’ve heard from other readers and it might explain the lack of comments I receive to a lot of the content on my site. While the content might be great and insightful, it’s not helping a new investor in getting from point A to B simply because the distance between those two locations at first glance seems too far. You need to see the steps before you can start to take them yourself.

Learning to invest shouldn’t be overwhelming and an inability to see the steps shouldn’t be a deterrent. In this series of posts I’m going to help new investors gain a better understanding of how to analyze stocks and their investment potential. Instead of publishing a long post with lots of data, analysis and value insights I’m going to take readers on a journey behind the scenes of how I conduct a stock analysis in order to give you a perspective into “Seeing the Big Picture” through my eyes. I won’t tell investors what they should do, because every investment decision is ultimately up to them, but I’ll provide the steps of what I do and how to allow readers to decide for themselves if the process is something they want to do on their own.

Each Monday during the month of August I’ll post one component of this analysis in both text & PDF so readers can choose to revisit the site for the content or save the analysis to use at their own discretion. The series will be labelled under a new category, Investing 101, and archived in the New Investor Index under the heading Fundamental Stock Analysis 101.

August 4th, 2008
Part I: The Situational Analysis – Qualitative Data

August 11th, 2008
Part II: The Numbers – Collecting Quantitative Data

August 18th, 2008
Part III: The Numbers – Definition & Interpretation

August 25th, 2008
Part IV: Determining Valuation – Comparing, Analyzing & the Dividend Discount Model

See Also:
Part I:
Part II:
Part III:
Part IV:

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Alternative Value Traps:

Last week I wrote a post on my Ultimate Value Trap discussing the competitive disadvantages and chronic mismanagement of General Motors (GM). Today I thought it might be fun to list a number of other companies to give a perspective of how much capital has been lost as some value investors have perpetually bought into these names over the past twelve months.

While a drop in valuation doesn’t necessarily mean an investment has lost all of its core fundamentals; these stocks have demonstrated an inability to manage risk effectively, have or had poor management, suffer from serious competitive disadvantages and questionable protection by management of shareholder interests.

1-Year cumulative losses (as of July 14th) for the following Value Trap candidates:

Lehman Brothers: down 83.1%
Citigroup: down 71.0%
Wachovia: down 81.3%
Wamu: down 92.4%
National City: down 88.7%
Biovail: down 63.9%
Canwest Global: down 75.9%
Freddie Mac: down 88.4%
Fannie Mae: down 85.2%
Air Canada: down 69.4%
AbitibiBowater: down 77.3%

* GM this morning announced a suspension to their annual dividend.

(I do not hold positions in any of the mentioned stocks)

My Top 10 Must Reads:

There are a number of blog authors who have taken the time to read and review various investing and finance books over the years and done a wonderful job of doing so. In my progression towards a DIY investor I read a lot of these at different times and I won't bore readers with more analysis on them that might come across as repetitive.

Instead I've decided to take a slightly different approach and list for readers the Top 10 investing books that I feel offer a good balance for building a solid foundation of investing whether you choose to pursue a growth, value, index or alternative strategy.

I'm not encouraging each investor to run out to the bookstore and buy these books today. Instead use your local public library, used book stores or yard sales to find these at a much lower price (or free) and keep them on a bookshelf as a reference for times when you might want to review something you've read in them before.

I strongly recommend making notes while you read of important points or lessons you find useful and this list provides something for any readers whether you are a beginner or advanced investor.

I would encourage readers to list their own individual favourites as this post will be archived in the New Investor Index on the site.

1. Security Analysis: The Classic 1951 Edition
   by: Benjamin Graham
   
   
   
2. The Intelligent Investor: The Definitive Book on Value Investing
   by: Benjamin Graham
   
   
   
3. The Templeton Touch
   by: William Proctor
   
   
   
4. Contrarian Investment Strategies: The Next Generation
   by: David Dreman
   
   
   
5. What Works on Wall Street
   by: James O’Shaughnessy
   
   
   
6. Common Sense on Mutual Funds: New Imperatives for the Intelligent Investor
   by: John Bogle
   
   
   
7. Beating the Street
   by: Peter Lynch
   
   
   
8. Bogle on Mutual Funds: New Perspectives for the Intelligent Investor
   by: John Bogle
   
   
   
9. The Investment Zoo: Taming the Bulls and the Bears
   by: Stephen Jarislowsky
   
   
   
10. The Four Pillars of Investing: Lesson for Building a Winning Portfolio
    by: William Berstein
    

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New Investor Index:

I’ve decided to add an innovative element to TMWTFS to help the growing number of readers who visit this site answer their questions on investing fundamentals, where to start their education and where to receive the best unbiased information in order to make informed decisions.

As I explain in my About section of this site I began my DIY journey fairly young and it wasn’t without its numerous up’s and downs. I understand all too well the frequent frustrations and emotions that investors face when considering where they should start and how best to find their way into the markets. The financial services industry certainly doesn’t make a priority of educating clients and when you consider the high fees they charge you can’t blame them for keeping clients in the dark. Add in the sheer amount of information that can be found on the subject of investing and its no wonder than many new investors immediately feel discouraged.

Any new investor should first consider what path they wish to take to become an independent DIY investor based on the benefits to their own unique situation. The most important factor that shouldn’t be overlooked is to not rush the process. There were numerous times over the years when I become frustrated, simply wanted to forget it all and just try my hand at what I knew (or thought I knew) at one time. I wanted to start making money and generating returns just like everyone else was doing. Luckily I didn't give in to that temptation or the investor I am today might not place such a high emphasis on rational and fundamental investing practices. Time can be a painful reminder, but it also serves as an important teaching tool for your own self interest.

What I mean by that is I can compile all the readings, information, notes and lessons I learnt during the years of my process from new investor to where I stand now, but reading all of that overnight won’t prepare you for the psychological demands that the market places on you in times of volatility, hysteria and chaos. The personal journey for a DIY investor is just as important as the educational journey that you take.

When friends or other individuals ask me for advice on where to start my first reply is always, "Read, read, read and when you think you've read it all...find more."

I'm not lying when I tell them that my first few years of self study were consumed with as much diverse reading material as I could find on the subject of investing. I re-read finance books from business school, nearly all of the get rich gimmicks, books on investing fundamentals and security analysis. Some of them I read twice just to make sure I could wrap my head completely around the main topics they discussed. I read essays on investment returns, studied the biographies of various investors making sure to include each of their biggest wins and losses, read daily national newspapers, columnist views, corporate financial reports and analyst commentaries. Passion and determination were what drove me, but time was what made me a better investor.

Time was responsible for finding a comfort level and developing my individual style using all the lessons I'd learnt from various sources. I’ve certainly benefited from mentorships along the way, but nothing was ever handed to me by any of them and each encouraged me to find my own path and reasoning. When I talk to new investors for the first time I recommend beginning with individual mutual funds before individual equities not because I want them to pay high fees that impact returns, but because it follows a progression of how to best train yourself to one day analyze and invest in stocks. Patience might not come easily to you in investing or other activities, but today I call the entire process, from the starting age of fifteen to finish, my Value Mosaic.

Through this new section I’ll outline resources (my own and others) that I feel serve as important tools for a new investor to learn, interpret and create their own understanding in order to better prepare for creating their own process and mosaic. Content authored by myself and included in this section will now be categorized as Investing 101.

I welcome readers to visit and share the New Investor Index tab located on the top navigation bar of the site and please feel free to send me resources that you use(d) to become a better investor.

Taking Stock in BAP:

This article originally appeared on The DIV-Net on July 5, 2008.

I’ve chosen today to profile a stock in my Taking Stock in^TM series that I consider to be a small gem in my RSP and at first glance might not appear to match my investing style or approach. It’s expensive, has built momentum over the last few years, is not well known and when compared to competitors within the region, such as Bank of Nova Scotia and Banco Bilbao Vizcaya Argentaria, doesn’t strike a special confidence within a value or dividend growth investor.

My belief is that value, growth or dividends don’t need to be separated from each other in order to achieve success when investing. Value is a relative term, dividend investing has many disciplines and any company that doesn’t have tangible growth is likely to be a poor investment for the long-term. Price, while important, is not the absolute determinant for investing in a great company and BAP is an example of this. During a brief selloff in February I bit the bullet and made a purchase that I feel will be an integral component to the global diversification of my RSP.

In an environment of financial chaos, lack of transparency and global credit uncertainty many value investors have avoided or been hurt by domestic and global financial stocks as they precipitously fell from what we now know were exaggerated valuations. Many dividend investors have also succumbed to attractively high yielding investments only to see the value of their shares plummet as dividends are cut, losses mount and the full extent of the credit markets appeared.

My style and discipline at times is a hybrid and leads me to examine sectors with a different perspective as I dig deep for a new perspective. Credicorp impressed me not from its valuation, its dividend growth or its market location, but from its underlying fundamentals of impressive strength. When I look to past generators of growth and innovation in various industries around the world what is immediately clear is that this company understands the needs of its target market, how to best penetrate existing barriers and tailor product offerings to best reach its customers and improve its profitability.

I first came across BAP when I was conducting a competitive analysis in early 2007 on BNS and the stock later led me to BBV during this same activity. At first glance I perceived this financial services holding company as very expensive in comparison to its regional peers, to larger global financials and stuck in a geographical area that didn’t appear to offer much growth. Sometimes as an investor you have to exhibit more patience than you feel is needed and maintain an open mind. As a value investor you might spend hours sifting through information for a chance that you’ll discover some sort of a value stimulus, the stock still turns out to be a dud and you can carry on in your efforts.

Every investor has their process and mine is dominated by a situational analysis. When many investors look exclusively to quantitative data I look at the rest of the story to form my opinion of an investment. After completing a SA on BAP and continuing to dig deeper I found that their strategic focus held an innovative tool that as an investor was rare and something I wanted to be a part of.

Background:

BAP is an ADR for a company that operates primarily within Peru & Bolivia and is surrounded by regional goliaths Brasil and Chile. Peru in 2007 had an annual GDP of approximately $109B US giving it a per capita income of approximately $4600 compared to $6800 for Brasil. While many investors are concentrated through their BRIC investments on Brasil and Mexico, other smaller regional economies offer cheaper valuations with equal fundamentals in unknown and overlooked companies. Noted is the recent acquisitions made by BNS in Peru, Chile and BBV in Latin America that help to demonstrate this point. The financial infrastructure of this region is largely fragmented with many competitors struggling to reach a large rural population in varying geographies that has continues to provide difficulties for operating banks. To solve this issue BAP has been a company of innovation that’s fuelled growth in both its product offerings and how it reaches customers away from the traditional North American/European framework of banking. It’s my belief that many investors have been overlooking the key growth engine for this company just as I did initially at first glance. More on this soon.

First let’s look at BAP’s structure:

Credicorp operates as a holding company of financial subsidiaries that include Banco de Credito del Peru (BCP), Banco de Credito de Bolivia (BCB), Atlantic Security Holding Corp, Pacifico Peruano Suiza (PPS) and Prima AFP. Together they employ over 16,000 and conduct a variety of activities that includes insurance, personal/commercial banking, wealth management and operation of a large regional pension fund. The banking component of the business is run through BCP, and its smaller partner BCB, ASHC operates the wealth management business, PPS operates the insurance division and Prima AFP is their pension fund management company.

Infrastructure:

In 2007 BCP spent $70M on infrastructure by opening 36 new branches, 93 ATM’s and 670 Agentes units. In 2008 they have budgeted $150M in spending (over double) with the intention to open an additional 75 branches, 150 ATM’s and 350 new Agentes BCP’s. Included in this budget is continued spending on business equipment, business software applications and two computer centres currently under construction. Since 2005 their number of ATM’s has grown by 36%, branches by 25% and Agentes by 1900%.

Value Stimulus:

Agentes BCP (or Agent BCP in English) is a network of individual low-cost, high volume transaction centres that allow customers to pay bills (telephone, utilities, credit cards, school tuition), make cash deposits or withdrawals and do miscellaneous banking without the need for travelling to traditional branches for routine needs. These booths often have a single employee, are located in markets, residential or commercial zones that benefit rural and high-density populated areas where infrastructure may not be available for extensive branch development. While to a North American investor these might first appear to be make-shift cardboard box deployment of services, the technology implanted is industry standard and it serves a very real need in developing economies where individuals may not have the time, money or transportation available to do their banking safely or often. When you examine the rise of personal banking deposits in the past few years for the company the net effect to profitability of this innovative service offering is crystal clear. Instead of needing to travel long distance customers can walk to a number of locations close to their home or businesses with minimal effort. The company now has an opportunity to reach a higher number of new or existing customers and these clients have an opportunity to use banking services more frequently. The end result is a higher number of deposits, increased transactions and higher overall usage that at pennies per event generates a high level of fees for the company.

Note that the Peruvian economy grew at 9% in 2007 (highest since 1994) and was fuelled by construction, manufacturing and regional/international commerce. Trade and regional development increased significantly through various projects such LNG projects (Camisea), mining (Las Bambas & La Granja) and infrastructure projects of local governments. While exports declined in real terms due to increased regional competition, inflation was moderate at 3.9% which was well below the LA average. Lower tariffs on international trade and recent free trade agreements for the country and region continue to help the economic zone to mature and real incomes to increase with inflation forecasted to decline slightly to 3.8% in 2008. In April of this year a key event occurred when FitchRatings raised Peru’s government debt rating to investment grade that further opens the market for a higher level of foreign investment.

Operations:

The banking division of the company, BCP, has been in existence 1882 and takes pride in its conservative roots when it changed its named from Italian Bank to BCP in 1942. The bank has been largely unaffected by recent global turmoil over the past twelve months as total assets and deposits continue to conservatively outpace its’ total loans. The bank operates in a conservative environment and possesses adequate margins of safety that place its depository obligations well above loan amounts. Their loan quality (past due loans over total) declined to 1.9% in 2005, 1.3% in 2006 and 0.7% in 2007 from a high of 8.5% in 2001. This decrease largely has been in part to high quality corporate business loans that have continued to compose more than 60% of total loans outstanding backed by higher levels of tangible assets and operating income. It is noted that historically the Peruvian banking market has held lower past due loan rates on average than larger markets in Brasil and Columbia with BCP’s loan quality continually being below industry averages for banks in the region during the past ten years. ROA has increased steadily from 1.0% in 2004 to 2.3% in 2007 and BCP, as of Q1’08, had 32% market share of loans with 37% derived from retail. YoY transaction growth from their retail segment was up 20.6% with internet use up 31% and Agentes usage up 310%. BCB, their Bolivian bank formerly known as the People’s Bank of Bolivia, has continued to enjoy a mirror of effects as BCP continues to innovate, implement new product offerings and focus on infrastructure to drive successful growth in BCB’s markets. While Spanish might not be your first language, a quick look at the BCP website demonstrates a clear focus on their mission, vision, values and adherence to ethical principles.

As an investor who concentrates on strong and clear strategic management, BAP’s corporate strategies and execution have continued to impress me. The single clear goal among its units is to become a leader in each segment of operation and sustain current activity and market share. The company’s focus remains to grow the business of BCP through improved product offerings, expanded retail banking, distribution channels & network expansion while maintaining a conservative approach to risk. Their insurance business continues to restructure in order to expand into personal insurance through differentiation, product offerings and service with an additional focus on a partnership with AIG. Prima AFP, their pension fund, intends to increase its fee structure, generate higher profits from fund management, increase volume of funds and search for synergies with other BAP subsidiaries. Their asset management division, ASHC, continues to look for opportunities to grow through integration within each business segment.

Quantitative:

Q1 results for 2008 came in with EPS of $2.23 which comprises 51% of their full 2007 EPS. Past due loans did rise 0.1% to 0.8% with loan growth YoY for corporate at 35%, retail at 81% and foreign currency corporate loans at 60%. Total assets grew by 52% and BCP reported that Agentes locations increased 11% to a total of 1358. Overall expenses declined 8.9%, fee commissions from retail banking increased 27.7% YoY and wealth management volume in mutual funds rose to 43.7% of total market share which is currently double their closest competitor (BBV). They continue to be a leader in market share both in loans & deposits.

Five and ten year profit growth for BAP stand at 54.5% and 29.0% respectively after growing from $20.3M in 2000 to $351M in 2007. Currently the company’s dividend sits at $1.50 per share providing a yield under 2%. While this might exclude the company for consideration by investors who seek yield the five year growth rate of the dividend sits at a very healthy 23.7%. The company has recently stated that they are focused on financing growth by using 60% of operating earnings versus raising further capital or using expensive debt facilities. The current payout of 34.1% leaves ample room for continued growth of the dividend as the business grows profits at their current pace. Return on equity for 2007 was 22.9% and stands at a very respectable seven year average of 13.3%.

Threats:

Investors shouldn’t perceive the strong growth of BAP due to a lack of serious competition in their operations. In Peru BCP competes directly with operations of three large international banks (BNS, BBV and InterBank) and a few smaller competitors (Interfondos, Del Trabajo, Mi Banco & Falabella).

The earthquake in southern Peru in August of 2007 also impacted their insurance business when claims rose to $103M. Premiums did grow 25.4% to $467M to help compensate for those unexpected losses, but this has put into question the stability of the region for potential future losses. RIMAC, a fellow insurance competitor, has demonstrated an ability to be quite competitive in PPS’s market and is noted as a serious competitor to further growth in market share as each has similar products and established networks in the market.

One impressive observation I did make during my initial analysis was that the company’s financial statements are audited by Ernest & Young. This in my opinion adds an additional level of transparency to a company that operates in an environment where investors often express hesitation due to historical failures of financials in the region.

Putting it all together:

I mentioned earlier that BAP was an unusual investment for a value investor such as myself for a number of reasons. While it fits my criteria for enduring value in my RSP, when I bought the stock I paid a very rich P/B of ~3.5 times which is much higher than most other global or regional banks in this environment. But as I examined the company’s fundamentals, organic growth and ability to create innovative product offerings that are well adopted by their target market I felt that a traditional valuation for a bank made little sense. While P/B has swelled in recent years their book value growth has averaged an impressive 12.4% and the company’s returns to investors has consistently been over 25% per annum. The company also reports its earnings in USD, but its assets are purchased and utilized in a different currency. Their underlying infrastructure assets need to be put into proper context since BCP’s operations, existing infrastructure and development are based upon simple, mobile and low-cost operations and company owns very little real estate. This inflates their P/B on a relative basis and makes them appear expensive in comparison to earnings or other global financial institutions with substantial RE assets.

In conclusion BAP offers a distinctly different investment for a long-term investor. They are well positioned to benefit from long-term growth in Latin America, have adequate earnings, abundant cashflow to fuel growth organically or through acquisition and have a stable foundation of operations in their banking divisions to expand the financial services of their subsidiary divisions.

The high valuation in respect to its peers is clearly a deterrent for an investor initially, but the company offers excellent opportunities when you examine their operations.

For disclosure purposes I hold a relatively small position in BAP when compared to the number of shares I own in BNS and BBV which are both more global organizations. While growth should continue for BAP in the region there is an obvious need to expand into new markets to help balance out regional risk and I expect management to continue operating on a growth platform while integrating their supplementary businesses.


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Templeton's Touch

Yesterday in my post I discussed a piece of advice that I received years ago that helped to form the foundation of my value perspective by studying not only the successes of various investors but also their failures.

Sir John Templeton died yesterday at the age of 95 after a lifetime of involvement in global equity markets, philanthropy and founded the highly successful Templeton Growth Fund, Templeton Prize and Templeton Foundation.

John Templeton was one of the first investors that I focused on during my early years of studies on value investing and his global focus, investing discipline and contrarian habits are well observed in both my current discipline and a few of my Value Rules.

Rick at Value Discipline has done an excellent job today of summarizing nearly two dozen lessons that Templeton offered to William Proctor for his publication titled The Templeton Touch in 1983.

1. For all long-term investors, there is only one objective-"maximum total real return after taxes."
   
2. Achieving a good record takes much study and work, and is a lot harder than most people think.
   
3. It is impossible to produce a superior performance unless you do something different from the majority.
   
4. The time of maximum pessimism is the best time to buy, and the time of maximum optimism is the best time to sell.
   
5. To put "Maxim 4" in somewhat different terms, in the stock market the only way to get a bargain is to buy what most investors are selling.
   
6. To buy when others are despondently selling and to sell what others are greedily buying requires the greatest fortitude, even while offering the greatest reward.
   
7. Bear markets have always been temporary. Share prices turn upward from one to twelve months before the bottom of the business cycle.
   
8. If a particular industry or type of security becomes popular with investors, that popularity will always prove temporary and, when lost, won't return for many years.
   
9. In the long run, the stock market indexes fluctuate around the long-term upward trend of earnings per share.
   
10. In free-enterprise nations, the earnings on stock market indexes fluctuate around the book value of the shares of the index.
    
11. If you buy the same securities as other people, you will have the same results as other people.
    
12. The time to buy a stock is when the short-term owners have finished their selling, and the time to sell a stock is often when the short-term owners have finished their buying.
    
13. Share prices fluctuate more widely than values. Therefore, index funds will never produce the best total return performance.
    
14. Too many investors focus on "outlook" and "trend." Therefore, more profit is made by focusing on value.
    
15. If you search worldwide, you will find more bargains and better bargains than by studying only one nation. Also, you gain the safety of diversification.
    
16. The fluctuation of share prices is roughly proportional to the square root of the price.
    
17. The time to sell an asset is when you have found a much better bargain to replace it.
    
18. When any method for selecting stocks becomes popular, then switch to unpopular methods. As has been suggested in "Maxim 3," too many investors can spoil any share-selection method or any market-timing formula.
    
19. Never adopt permanently any type of asset, or any selection method. Try to stay flexible, open-minded, and sceptical. Long-term top results are achieved only by changing from popular to unpopular the types of securities you favour and your methods of selection.
    
20. The skill factor in selection is largest for the common-stock part of your investments.
    
21. The best performance is produced by a person, not a committee.
    
22. If you begin with prayer, you can think more clearly and make fewer stupid mistakes.
    

If you haven’t read the article by Rick or The Templeton Touch I would strongly encourage novice and experienced investors looking for helpful insights in today’s markets to take note of the extensive experience Templeton offered during his life.

At times some of the simplest strategies yield the most consistent results. Returns are often measured far too often over a short period of time and the long-term focus of individuals such as Templeton serve as an important reminder to young investors to look more broadly at the whole picture.

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The Ultimate Value Trap:

One of the lessons I learnt as a young value pupil was to take note of my surroundings and learn to view investing with a slightly different perspective. One lesson taught to me by Charles was an insight that an investor is often “far too eager to discuss their investing successes than they ever will be in talking about their failures” and this should serve as an important lesson for where my investing education should build its foundation. For as all the individual successes I’ve studied of various investors I’ve examined a greater amount which have failed. It’s easy to label Warren Buffett as the most successful investor of all time, but very few of ever consider or study his mistakes and what we can learn from them.

My Value Rules serve as a reminder of all the successes and failures that I’ve studied, learnt from and experienced in business. While they don’t guarantee success they serve as a template and instructional tool for evaluating an investment from a number of different perspectives. In my Taking Stock in^TM series I discuss companies that I invest in that hold a number of value criteria or Enduring Value characteristics. These posts might be a great teaching tool for readers about investing, but do they help identify companies that are of less or no value? What would a post in that series look like if I analyzed a company that I wouldn’t invest in? I discuss the impact of competitive advantages for companies, but what about a competitive disadvantage?

My post today is to discuss my pick for The Ultimate Value Trap: General Motors (GM).

It’s no surprise that in recent years GM has had some difficulties in a number of areas…well, a lot of areas. When you examine the company not only is a value stimulus difficult to find – it’s possible that none exists. Well I won’t speculate on the recent rumours of potential bankruptcy there is amble evidence at this time that the company is in some serious trouble.

When I examine investor activity in GM over the past four years I encounter what I like to call a Value Investor Casualty List. The list includes a number of value oriented investors who currently hold or have held GM shares in the past few years.

The most dedicated of these value investors was Irwin Michael who held 360,000 shares in three of his ABC Funds at an average cost of $56.95 per share. After a loss of over 80% on the original value invested in the company it was shared with fundholders on July 4th that ABC had liquidated all of its shares of GM that were held in the three funds. Other investors who have been burned badly on GM include David Dreman, Dodge & Cox, Brandes Investment Partners, Kirk Kerkorian and Bill Miller of Legg Mason Capital Management.

Investors know that GM has obliterated billions in market capitalization, that its shares currently trade near fifty year lows or that the number of manufacturing jobs that GM has cut or indirectly caused is in the tens of thousands. But I’ll take a different route and look at the qualitative side as I go through a brief history on GM to identify what warning signals should have been appearing to investors as the troubles began to brew.

It should be no surprise to an investor that GM has a history of missteps by management, massive pension obligations to its retirees, an expensive workforce, far-sighted union leadership and too much inventory. Still many value investors were seduced by a high dividend yield in a company with consistent payouts, low P/E and P/B ratios, a long-standing member of the Dow Jones 30 and operating within an industry that provided predictable cyclicality. With 15% global market share as the largest automotive manufacturer in the world investors saw the competitive forces at work and made assumptions that earnings growth would return as the financing division of the company (GMAC) performed well by providing consistent earnings over the interim. Add that the company’s CEO Rick Wagoner was buying shares and the stock looked to be mis-priced and undervalued. But remember back to how I organize my information on a stock: the situational analysis: SWOT & PEST.

What’s missing? What important or unseen factors have been overlooked or ignored?

Whether intended or not it appeared that no one recognized or heavily discounted some tragic flaws in GM. For years the company had been paying its unionized employees wages and benefits well above what would turn out to be competitive and realistic levels. Through various negotiating means union leaders created an ability to collectively wrestle the Big 3 into lucrative union packages where no one bothered to compare wage levels with those of similarly qualified workers in industries such as healthcare, education or other manufacturing sectors.

In 2005 came what the market generally expected with the rating cut by Standard & Poor’s of GM’s corporate debt, over $300B worth, to junk status. S&P at the time made the following comment, “The downgrade to non-investment-grade reflects our conclusion that management's strategies may be ineffective in addressing GM's competitive disadvantages.” By 2006 investors watched diligently as management cut the dividend by 50% (its first since 1993), cut benefits of salaried workers and made cuts to executive pay including trimming Wagner’s annual wage by half. In Q4 of 2006 profitability returned to the company, the shares appreciated more than 35% from their February low and reached a high of $42 in late 2007 despite some moderate write downs. Through all of this investors had missed some of the most crucial flaws of the company: managements’ inability to address the most pressing issues.

For years GM and its employees had enjoyed the benefits of high demand for its even higher margin SUV products and the impact from the US housing collapse and later credit crisis was finally felt and brought GMAC down to its knees. For too long GM’s management had been swimming without any clothes on and when the tide went out, as Buffett might say, it wasn’t a pretty picture. GM went to the UAW & CAW and got concessions for a two-tier wage structure that would drastically decrease their costs of labour and created a UAW controlled VEBA that took $51B of retiree medical benefits off GM’s books in addition to offering a staggering number of buyouts to many of its senior unionized employees.

After all of these events investors are still left asking themselves, “Does GM offer value today?” GM currently trades at a yield that hovers near 10% (assuming there’s no cut), trades at a significant discount to its value a few short years ago and at some point an investor might assume that its assets that are worth something. The difficulty of looking at a company like GM is that it still feels like a Value Trap even after already catching a number of investors. GM has now taken drastic measures with plant closures, more buyouts of employees and reorganization of their retiree obligations to cut costs, but will it be enough?

To put all this into a better perspective (The Big Picture) let’s look to just 4 of my Value Rules for some insight into why I wouldn’t invest in this company:
- Importance of Brands
- Do What You Do Best
- Strategic Management
- Never Compete on Price

In the past decade GM has sold automobiles under the brand names of Buick, Cadillac, Chevrolet, Daewoo, GMC, Holden, Hummer, Oldsmobile, Opel, Pontiac, Vauxhall, Saab, Saturn…Neptune…Pluto…get the point? Not only are there too many product lines in this company, but there’s overlap and duplication that borders on insanity; it simply doesn’t make economical sense. The Silverado & Sierra are the same vehicle. The Yukon & Tahoe are the same vehicle. The Solstice & Sky, Cobalt & G5, etc, etc are all the same vehicles. The only differences between them are a few changes to the trim, logos, interior, options and where they’re sold. Instead of doing one or two things as best as the company can it’s done a lot of everything and lacks a core focus.

The core focus for GM’s management is best defined by three letters: S, U & V. For years now GM has gotten fat on the SUV and its manufacturing infrastructure is largely built on high margin, large framed vehicles. They’ve developed little in the way of innovative products that consumers want and have done an even poorer job of forecasting future consumer demand and perceptions. They do sell a lot of vehicles, but they also run on a very dangerous structure of competing on price. We’ve been here before but to summarize there are few serious problems with this approach. Once consumers get in habit of getting cheap they expect cheap or want cheaper. Consumers to some degree make comparisons among similar products and can associate quality with a product or service of a slightly higher price. When you compete on price and you’re competition can make the same product cheaper you’re dead in the water. Your competition will simply match your price, get fat off their higher margins, wait to take you out for next to nothing or let you self-destruct.

To make a comparison Toyota, GM’s top competitor, has only two brands: Toyota and Lexus. In each product category the brands have only one product offering and management focuses intently on consumer needs, demands and expectations for each product. Toyota spends a lot of time on market research, connecting with customers and its repeat purchases from existing Toyota customers are top in the industry. Walk onto any Toyota lot today with the expectation of them competing on price and you’ll be quickly disappointed. Toyota doesn’t want to compete on price because it doesn’t have to. A company still has to remain competitive, but Toyota’s products are in high demand, they have limited excess supply and the cost of their workforce is a fraction of their competitors in GM, Ford and Chrysler.

When you’re a lower cost producer and the competition decides to compete on price your margins will speak for themselves. Not only is Toyota gaining market share but they’re making money, investing in their infrastructure and making inroads into product categories that have been dominated by the big 3 for decades. Add in high energy prices and consumer demand for more fuel efficient vehicles and the comparison quickly tips in Toyota’s favour. While GM closes plants Toyota continues to open more. When GM makes cuts to its R&D Toyota expands with new product designs and technologies to meet higher demand. If product quality, price and all other comparisons are equal Toyota will come out ahead based on its ability to make money and its positioning.

General Motors might appreciate significantly from here and an investor might assume that at this valuation the risk/reward premium is heavily weighted in their favour. But I would encourage any investor looking to invest into a troubled company to consider a few of the points I made in this post and to ask themselves if any of them apply. History does repeat itself and there are always exceptions, but generally in business you’ll find that managers run into corners more often than you realize.

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Construction Notice:

If you didn't have enough summer detours in your travels then here's one more to add to your list.

I’m sending out a quick notice to readers that over the next few days TMWTFS will be experiencing some construction and routine maintenance as I implement a new template and format that I’ve been coding.

Instead of a weekend post here I’ve provided The DIV-Net with the first Associate Member post in my Taking Stock in^TM series.

If you need to access the site prior to Tuesday, July 8th you might experience a few difficulties in locating content or glitches, but my hope is that the integration and re-organization will be completed by early Tuesday morning when I post "The Ultimate Value Trap".

Recession Proof – Searching for Evidence:

Recession proof…what is it?

There’s been abundant discussion of late in the business media, among investors and in economic circles about the probability/inevitability of a US recession, its global effects and how to best position an investment portfolio against those risks.

A recession, by definition, is two consecutive quarters of negative GDP growth in an economy. But recessions, by this definition, have grown increasingly scarce in recent years as economies instead have felt the effects of an economic slowdown in activity due in some part to the effect of globalization. Currently we’re witnessing an increase in the jobless rate among western economies, a drastic increase to energy prices and inflation concerns appearing publicly on the minds of consumers and Central Banks around the world.

But there’s a group of individuals who continue to use the term “Recession Proof” without truly examining the criteria of what makes something invincible to a slowdown in business and consumer demand. There are certainly recession proof occupations, but what about services, products or businesses?

In The Foster Effect I dismissed the term recession proof in favour of something I define as distinctly different: recession resistant. Recession proof leads an investor to believe that an investment is immune to economic factors or risk-free. In truth very few (if any) businesses today are positioned to continue operating and growing their business as well or better in a period of retraction than in any period of growth. A company can position itself to maximize opportunity and minimize risk, but at the end of the day they are providing a good or service that can be replaced with something else or nothing at all. In periods of growth there are abundant excesses and in periods of retraction those excesses are used up or abandoned completely depending entirely on demand. If such a business did exist their competitive advantage would not only be sustainable but have a moat encircling their operations as large as an ocean.

Recession resistant in my view is a much better term to use when examining an investment that does not immediately appear to be economically sensitive. There will be exceptions, but for the most part resistant should be the term used.

Let’s look at the following industries that are often categorized as “Recession Proof” and examine them with a qualitative perspective of an individual consumer or business:

Consumer Staples:

Investments in consumer staples are a very popular strategy in times of economic uncertainty by a large number of investors. Consumer staples are viewed as frequently purchased products that are used on a daily basis and not something many can easily go without. These include items such as food, personal hygiene products, household cleaning products or diapers. The problem with labelling a consumer products company as recession proof is that they’re still economically sensitive due in part to how their products and pricing are structured. Remember back to my series on The Importance of Brands and how many of today’s leading consumer products companies manufacture and sell both their own individual label brands and generic versions for wholesale or discount retailers. The difference in the profit margins between a premium and generic brand at times can be in excess of 50% or more. When consumers are placed in an economically sensitive environment price can play a very tangible role in their choice between a premium and generic brand when the cost-benefit analysis in their eyes is equal. Assume for a moment that a company sells premium/generic brands during a normal economic period in a ratio of 75/25. What happens during a period of slower consumption if that ratio shifts down to 60/40? For a company with annual sales in the billions the impact to their bottom line could be in the millions of dollars. Often management balances this shift by cost cutting initiatives in anticipation of changes in demand and some price increases can help, but if corporate leaders are behind the ball it can take a number of quarters to catch up to the trend and re-align their operations to current demand.

Funeral Homes:

This is an area where many investors proudly advocate that they’ve found a truly recession proof investment. People live, people die and when they die they like to go out in style. The issue with an investment in the memorialisation products, mortuary or funeral business is that these products and services are still dependent on consumer demand and available finances. While some individuals have the foresight to secure life insurance, pre-pay for plots or set aside funds for their planned departure; many others leave the financial burden to their families and not everyone can afford what they might like in both good times or bad. While alternate services might still not be relatively cheap, there are options such as cremation, less expensive caskets or flat vs. elevated headstones to keep costs realistic. Families can elect for a smaller funeral service, spend less on flowers, transportation or other higher margin, less necessary services for the funeral homes.

Utilities:

An investor should first recognize that many utilities operate within a regulatory environment that involves significant political influences and controls over what rates they are able to charge residential and commercial customers. As anyone with a teenager in their home knows all too well, trying to cut your household utilities costs such as water, electricity heat gets you termed as a “cheap-ass” parent and it’s something than many of us do even without children. This is a direct result of our attempt to control costs in the household that might otherwise result in higher monthly bills and the behaviour increases as money tightens. In an environment of economic sensitivity there are a higher number of issues that come up for utility companies: an increase in the number of late payments or cancellations among customers, rate reviews lengthened by regulatory boards and pricing is exposed to higher levels of scepticism by those regulatory committees that are filled with politicians intent on protecting the cost to consumers. This can lead to higher project cost deferrals or absorption on project developments that otherwise would continue if/when rates are increased.

Telecoms:

While the bulk of revenues for these companies continue to come from regular subscriptions of landlines, mobile and cable products; fees play a large part in the profitability of pricing models telecommunication companies design and utilize. Maintenance fees, call display, messaging features and airtime incentives are all components of pricing. While a current subscriber may be stuck paying those fees until the end of their contract, new customers or those changing to new plans may elect to defer non-essential services for a period of time until their discretionary spending is in appropriate order. The high cost of infrastructure to drive per unit costs down continues to be a heavy burden for many companies to overcome. The increasing competitive pressures on margins, consumer/business hesitation for limited data plans and a high number of non-essential features/accessories might also have an effect on profit growth in a measurable way during a slower economic period.

Dividends:

When you compare the recent increases of dividends, or absence of, among these groups of stocks the dividend achievers are becoming easily distinguishable from the dividend believers. Companies with a history of consistent moderate dividend growth and strong management continue to position themselves for new economic challenges and investor expectations for conservative growth. Their competitors on the other hand who have raised their dividend and payout substantially over the past few years during a prolonged growth phase are now encountering a more challenging environment and are electing to instead protect their current payout and indicate indirectly to the market that profit growth might stall or retreat.

While many of the companies in these industries continue to profit and grow from the need by consumers and businesses for their products or services, none are completely immune to relative changes in demand based on the economic climate and sensitivity of consumers. Some of these companies will continue to perform well while others struggle. An investor should be aware of the risks in grouping a category or sector of stocks as recession proof and instead view those investments as recession resistant depending on their level of economic sensitivity.

Those select companies that have weathered the storm before might do well again with similar performance, but an investor shouldn’t make the mistake of assuming that a product or service is invincible or impervious to changes in demand or behaviour.

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