The Bond Guide – Investment Guide to Corporate Bonds:

Background:

A corporate bond is a bond issued by a corporation to investors in order to raise money for activities of operating, expanding or conducting business. The bond will mature (maturity) at some specific date in the future (term) and pays a coupon (interest) on the principal amount over that time. A bond is sold initially at par and its value will move up or down in response to various criteria and events.

Debt investing and equity investing have very different styles both in the method and criteria that an investor will approach a company with. As an equity investor you may be interested in the long-term capital appreciation, earnings growth, dividends or future takeover prospects of a company and this determines how you analyze your prospective investment. As a debt investor your sole objective and focus is on receiving income and ensuring the security of the capital you’ve invested.

Investors new to debt should remember that debt isn’t sexy; it has a function. Investors always hear about individuals who made millions speculating on stocks but will rarely, if ever, hear of an investor who struck it big by focusing on investing solely in debt.

Investing in debt (specifically non-investment grade) is a niche segment of the market that rarely receives much attention from the media. It takes a bit of time, research and patience if you’re used to analyzing equities but the same basic principles apply for any value investor: a strong balance sheet, strong cashflow and understanding the business are all essential.

There are various structures of debt such as convertible debentures, warrants and structured products but for this post we’ll concentrate on the most basic form: bonds.


Risk:

I’ll start with risk because this is a segment of investing that I believe is the most important for any investor (equity or debt) to recognize and understand. There are five main risks a debt investor must be conscious of before they consider purchasing a bond:

• Company Risk
• Credit Risk
• Interest Rate Risk
• Term Risk
• Liquidity Risk

Company risk is what I spoke about before with reference to a company’s balance sheet and cashflow. A debt investor needs to put on a different hat than an equity investor because of the inherently different risks each investor takes with their investments. A debt investor focuses in on companies with solid tangible assets because it provides a better protective foundation for the repayment of the debt’s principal in the event a company experiences difficulties or were to go bankrupt. When it comes to company risk the more asset coverage the better; if a company can’t pay you a debt investor will want tangible assets sold in order to receive their money before common shareholders. A company’s cashflow is another equally important item to examine because this is where you determine the company’s ability to pay the interest payments due on its debt. The more free cashflow that the company has improves their ability to service the current portion of all outstanding debt owed to investors.

Credit risk refers to the credit rating a company receives from rating agencies such as Standard & Poors (S&P), Moody’s and the Dominion Bond Rating Service (DBRS). These rating agencies examine and assess the risk to investors of holding a bond issued by a corporation. The ratings they assign, essentially risk assessments, determine the credit strength of companies and assess their risk for defaulting on their debt obligations. Default can mean either a company is unable to pay interest on their debt or a potential delay in payment of interest on debt. Each rating agency has different ratings and processes for assessment, but they each assess the balance sheet strength, cashflows and business risks that would impair the company’s ability to service and repay debt. Companies with lower credit risk (higher credit rating) often enjoy a competitive advantage over their peers because higher rated companies can sell their bonds at a premium to lesser rated bonds. These companies can issue debt at lower interest rates than their competition and this can significantly lower their cost of capital. If company ABC (Rating: AAA) wanted to issue bonds at 5.00% their competitor XYZ (Rating: AA) would have to pay a higher yield to attract the equivalent investment because of the perceived lesser quality of their debt. Instead of issuing bonds at 5.00% XYZ might need to offer investors a yield of 5.50%. When you issue millions (or billions) worth of bonds the difference in interest payments can be substantial between companies with different credit ratings. Paying a lower interest rate reduces ABC’s cost of capital and leaves more money in the pockets of these companies for other business activities.

Interest rate risk is an important consideration for investors of debt because of the impact interest rates have on the yields and price of the debt held. If you purchased a government bond a year ago for $100 with a coupon of 4.00% ($4.00 interest per year) and interest rates were to rise to 6.00% the market may price your older bond at market value for an equivalent coupon of 6.00%. This would lower your bond value from $100 dramatically to represent the current coupons of new bonds coming onto the market. Likewise if interest rates were to drop to 2.00% the price of your older bond might increase in value to reflect the premium higher yielding bonds would have. Mild movements in interest rates will often have a minimal effect on the price of bonds whereas abrupt swings in interest rates, market sentiment or investor fears, as we’ve observed in markets recently, can change the valuations of bonds dramatically over a short period of time.

Term risk refers to the length of issuance for a bond and when a bond will mature. At some point in the future a company is responsible for calling bonds at their maturity date and returning the principal amount back to an investor at the bonds’ par value. When considering term risk an investor needs to examine the duration or time the bond is exposed to. Generally speaking the longer the term of a bond the greater the sensitivity that bond will have to the movement in interest rates, changes in the credit quality of a company or company risks associated with the business cycle of a specific company, sector or economy.

Liquidity risk is the same concern for a debt investment as any equity investment. The number shares or bonds that trade on the market in any given period of time (minutes, hours, days) dramatically affects an investors ability to buy or sell his/her investment. Debt investments such as bonds tend to be fairly illiquid because a fewer number of investments are issued by a company and they generally trade at much higher prices per investment. The smaller the issue the tighter the market and buying into or selling out of a bond before maturity might force an investor into accepting a price that is prohibitive.


Bond Information – Where to Look:

When looking for information on corporate bonds there are a number of online resources I utilize. For the average investor with a small amount of capital to invest in fixed income bond funds and ETF’s are the most cost effective and best diversified vehicles. Unless an investor had $50,000 - $100,000 in fixed income to allocate individual bonds would likely be too cost restrictive and offer poor diversification for the risks outlined earlier.

One of my favourite authorities on fixed income investing is James Hymas of Hymas Investment Management Incorporated in Toronto, Canada. James, a former Canadian bond fund portfolio manager, is an authority on fixed income investing including bonds and preferred shares. He operates the Malachite Aggressive Preferred Fund, is a monthly contributor to Canadian MoneySaver and his blog PrefBlog is on my daily reading list. For preferred share junkies James also provides detailed information on Canadian preferred shares through prefinfo and a paid monthly subscription newsletter titled PrefLetter. James recently began a series on bond characteristics that prospective debt investors will find informative and useful.

Keith ‘Shakespeare’ Betty operates a website known as Shakespeare’s Primer that offers information on stocks, preferreds and bonds.

Canadian Fixed Income is a site I visit frequently after the markets close to identify changes in the fixed income market for Canadian bonds (government, corporate, municipals and real return)

In Your Best Interest is a site provided by Hank Cunningham of Blackmount Captial, author of In Your Best Interest, The Ultimate Guide to the Canadian Bond Market.

Bill Gross of The Pacific Investment Management Company (PIMCO) is an individual whose monthly commentary offers excellent insights into the domestic and global fixed income markets.

Paul Gardner & Paul Harris of Avenue Investment Management are two individuals I watch when on BNN as regular guests or eagerly read when any fixed income related content is published from their website or in the media.


Bond Valuations – Determining Price:

Bonds will trade at three different valuations: premium, discount or par.

• Premium refers to a price above the par value (price at maturity) and the interest rate is lower than the coupon of the bond at par.E.g.: Company ABC Corporate 2015 6.50 trading at $105 (6.20% yield).
• Discount refers to a price below the par value (price at maturity) and the interest rate is higher than the coupon of the bond at par.E.g.: Company XYZ Corporate 2015 6.50 trading at $95 (6.84% yield).
• Par indicates the bond is trading at its issue and maturity price with the exact yield on the bond as the initial coupon.

Depending on the credit quality of the company’s bond you are assessing the bond will often be classified as either an investment grade bond (BBB or greater) or junk bond (BB or lower).

When determining price I’ve found that an investor doesn’t need to get fancy and develop some elaborate formulation to determine value. As a buyer or seller of a bond you need to acknowledge and accept the decision of whether the bid (offer to buy) or ask (offer to sell) is suitable for your current position; Do you want to buy or sell at the price being offered?

There are times when miss-pricings occur, just as with equities, and higher credit quality bonds sell at a discount to lower credit quality bonds for any number of external issues (poor earnings, industry concerns, investor fear, etc). As a debt investor you must be prepared to ask yourself an important question when considering an investment in a corporate bond: Am I being adequately compensated for risk versus government bonds, equities and cash?


Buying Bonds:

With all bonds a sales commission is built into the spread by your broker between the price you pay to buy a bond and the price you get when you sell the same bond. The size of the spread depends on how large a purchase you make (typically the minimum is a $5,000 value) and each broker will have different premiums for different bonds. Retail investors should shop around to see what pricing differences there are between competing brokerages since a premium of 1-2% may make a substantial difference in the price you pay to buy or sell a bond. Brokers don’t publicly share this information easily so being informed and searching out resources is very important.


Bond Quality - What to Look for:

Bond quality is really important. Investors interested in fixed income or debt investing should always remember that your number one priority is ensuring the safety, stability and security of your capital. Every investment has risk, but the majority of risk taking should be left to equity investing in a diversified portfolio. Many investors will never want to venture outside investment grade debt (BBB or higher) and will only find themselves holding bonds which are considered junk after the debt has had its credit rating downgraded. The problem with junk debt is that there is little or no liquidity because few investors want to take on the risk of default or of a missed payment. Junk debt will often leave you holding until either one of two things happens: the debt you own matures or the debt is defaulted on. Individual investors should take the time to research the credit rating of the companies and bonds they plan on investing their money into in order to better understand the different risks that can affect the bonds’ price over the length of time it is held. Don’t blindly trust the credit ratings either: analyze the company risk, cashflow and balance sheet in order to make an informed decision yourself in accordance with credit rating information.

For readers interested I wrote a Description of Credit Ratings in PDF for you to download. for comparison between Moody's, S&P and DBRS.


Products:

For an investor who doesn’t have enough capital to create a diversified fixed income portfolio of 7-10 corporate bonds (at $5,000 each) there are a number of products (ETF’s) that invest in corporate bonds to consider:

• iShares Corporate Bond: LQD
  (27% Banks, 10% Financial Services, 10% Pharma/Biotech, 6% Healthcare, 6% Telecom)
  MER: 0.15%
• iShares Real Return Bond: XRB
  (86% Federal, 13% Provincial)
  MER: 0.35%
• iShares Canadian Corporate Bond: XCB
  (54% Financials, 12% Energy, 12% Infrastructure)
  MER: 0.40%

Pitfalls:

James Hymas, mentioned earlier, was kind enough to offer some useful insights for readers who are interested in becoming fixed income investors.

He highlighted two common mistakes made by retail bond investors:

1. Having fixed income portfolios that are of too high quality
2. Having fixed income portfolio that are too short term

Too high in quality refers to a tendency of Canadian investors to invest in Government of Canada bonds (Canadas) or Provincial bonds (Province) exclusively. These bonds are large and highly liquid where investors will pay a premium (lower yield) for the ability to trade large volumes without moving the market by affecting the price dramatically with one trade. He believes that, “most retail investors do not require this level of liquidity” and that there is a, “premium paid for the ability of banks and insurers to hold assets with little or no capital charge.”

Capital charges refer to the calculation of risk-weighted assets that are important for regulatory ratios such as Tier 1 Capital Ratio and Total Capital Ratio. These capital charges are supposed to give a rough measure of default probability although it's important for an investor to realize that they only provided a rough measure of default probability since default probability is a form of forecasting.

James wanted to emphasize that "high quality is often an expensive substitute for diversification." If an investor only has enough capital for a small amount of issues (2-5 different bonds) quality is appropriate, but without enough capital for adequate diversification an ETF is usually the better option than directly holding only a few bonds. For smaller portfolios James would recommend an investor consider a bond fund or ETF in preference to Government of Canada bonds.

With respect to a portfolio that is too short-term James stated that many investors would not go beyond a five-year term. The reluctance to invest in a longer term bond reduces, “the price risk and inflation risk” for an investor, “but it also reduces the yield and increased reinvestment risk.” His suggestion is that the average duration of the portfolio, the average term, should, “reflect – at least to some degree – the time at which you anticipate spending the money.” The one advantage of a shorter term bond is that an investor will have something to sell if necessary.

“To increase the security of income for a longer period, we need to extend term, which increases term risk and inflation risk. To increase security of capital, we need to decrease term, which will reduce inflation risk and term risk, but increase reinvestment risk.” A longer term for a bond can maintain an investor’s income through a period of low interest rates, but will additionally inflate your money away during a period of high inflation.

In summary James offered five key concepts a fixed income investor should pay attention to:

1. Adequately diversify your portfolio with an ETF as a viable alternative to a small collection of only high quality bonds
2. Focus on maintaining good overall quality; portfolio average of an "A" credit rating
3. Maintain a high quality reserve that can be sold quickly to either raise cash or adjust your portfolio for duration
4. Remember that dealers (brokers) are not obliged to bid anything at all for bonds you might later wish to sell
5. Pay attention to liabilities when investing assets. Ask yourself how much money will be coming out of your portfolio over the next ten years?
   Ten years is a prudent allocation to bonds with a conservative allocation of 20 years' worth for withdrawals.

Conclusion:

Simplicity really works in this situation and building a fixed income portfolio should always reflect your needs as an investor as with any equity portfolio. The mechanics of investing in bonds and equities are different, but fundamentals still reign. Risk should always be a focus of any investor and understanding what you invest in is one of the best methods of mitigating risk. Mistakes will happen, companies will surprise with negative news and no investment is every 100% risk-free. My belief remains that, "the best investment decisions are made when an individual considers their risk tolerance and are adequately informed."

ETF’s and cheap bond funds are excellent opportunities for investors to invest in fixed income, gain diversification and take the time they need to study the more sophisticated elements of individual bond purchases and ownership.

My thanks goes out to Scott (Scomac) and James Hymas for taking the time to provide their valuable insights and experiences related to corporate bonds and fixed income investing. I will also thank a number of my dedicated readers who persistently insisted both publicly and privately that they wanted me to undertake the writing of this post. Questions and comments are welcomed as I hope to follow up with further articles in response the needs of readers.


Disclosure: I do no own any individual bonds, but hold a portfolio of fixed income investments comprised of CorTS’, US/European preferred shares, TD Canadian Bond Index Fund (TDB909), CEF.A and cash (high interest savings account).

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The Importance of Business Fundamentals:

Quantitative Data vs. Qualitative Factors

In the comments section of Getting Intimate with Stocks a reader, Mark, asked the following question,

“How much impact does your qualitative data have on your overall perception of a company? Is this a sliding scale depending on the size and scope of the company? I.e. if it is a large multi-national corp. a site visit may not be as reliable as a visit to a small company with a handful of plants.”

Quite simply qualitative data has a huge impact on my perception of a company as a prospective investment. Even when consulting I advocate continuously that investors concentrate on qualitative factors more than quantitative initially.

There is a very simple reason why I spend so much time analyzing qualitative factors of businesses and why I consistently publish about qualitative factors on this website. If a company wants to enjoy quantitative success they have to have solid qualitative fundamentals and business practices. The two concepts are inherently linked and good quantitative numbers depend on good qualitative practices.

Many companies are successful over a short period of time because they simply receive more revenue than expenses and generate profits on that basis. Over the long-term though a company has to have vital components to its operations, strategic management and business model in order to sustain success. There are numerous companies that couldn’t manage their success because of the lack of qualitative fundamentals necessary for their success and usually investors never pay attention to those lessons. We are programmed to look for positive returns; but the contrarian value investor looks to learn from failures with the intention of applying those lessons to his/her future investing approach.

Far too often investors concentrate on financial performance and other quantitative numbers without ever considering what important factors produced those numbers. My clients routinely will hear the following line from me,

“Without strong qualitative performance no company can enjoy sustainable quantitative success.”

Increasing profitability, cashflow, margins, dividends and return on equity could never happen without a company having sound business practices that led to expanding global growth, the development of competitive advantages and a sustainable business.

To put this all in very simple terms:

“Quantitative Data is the past, Qualitative Factors are the future.”

Qualitative data has a huge impact on my overall perception of a company because despite any strong financial numbers in the past I’m buying a company today for the future. Without strong sustainable qualitative business practices the financial numbers (quantitative data) in the future won’t matter because the company will no longer be in business. If they are they will either be experiencing a very difficult business environment in their operations or be on the brink of bankruptcy.

General Electric (GE) is an excellent example of this if you conducted an analysis based solely on historical quantitative data. The company’s historical growth (EPS, dividends, shareholder return) had been stellar prior to the past five years. But the business practices of the company in its financial services business had a huge shift in the qualitative fundamentals of the company and currently explains why they’re in the mess they find themselves in. Had I, or other investors, realized these important changes before the market took notice or the financial arm of the company encountered serious problems investors would have saved themselves a lot of pain and money.

Whenever I lose money on an investment I am driven to determine what went wrong and why. I know that I make mistakes, but by learning from my mistakes I hopefully improve my investing process and examining qualitative fundamentals has made a huge difference in my ability to generate positive returns as an investor and business owner.

It really comes down to risk; despite strong financial performance in the past do I want to own a company with weak fundamentals moving forward? The risk, in my perspective, is too great regardless of what they did in the past. In my recent analysis of Pfizer I alluded to this point very clearly to readers when I sold the stock after Pfizer (PFE) acknowledged they intended to purchase Wyeth (WYE).

In the case of the brewing company I toured in Toronto last year they have numerous plants all over North America and touring one of them might have been an anomaly or provided an unnecessarily biased perspective on the problems plaguing the company in one plant. But when I took the qualitative observations I made about concerns with costs and compared them to the corporate financials to look for a trend I immediately saw what I didn’t want to see from a business practices perspective. Margins were falling and well below their industry peers since a merger had occurred. Inappropriate cost cutting was hurting the company because management wasn’t able to engage employees to increase productivity and efficiencies. The company wasn’t operating as a cohesive unit and management was too focused on cutting costs fixed at the expense of the increasing costs of operations and loss of productivity.

In conclusion an investor needs to remember that qualitative factors will in turn drive quantitative success when they are executed effectively. Without the first you can’t easily manage the second and sustainable profitable businesses are what an investor wants to concentrate on for providing positive long-term returns. My Value Rules that I discuss on this site extensively are all qualitative fundamentals that I’ve learnt about from studying companies for investment or business purpose. Focus on fundamentals first before you look at financial performance and you’ll be surprised how quickly you can determine what companies have Enduring Value.

Disclosure: I own structured fixed income shares of GE at the time of this post.

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Getting Intimate with Stocks:

Investors who know me on personal level will often shake their heads at the lengths I will go at times to investigate a company from a balanced perspective. Reading financial statements, studying products/services and listening to conference calls is fine for most individuals, but I often seek any opportunity I have to assess a company from a grassroots approach.

Most of the time I attend seminars and information sessions held by a company to evaluate the sales approach of employees or I meet with local management of a regional headquarters to discuss various topics indirectly as owner of my company. My favourite approach, by far, is having the opportunity to tour operations after contacting the investor relations department.

Many investors would be surprised if they took the time to talk with an investors relations representative about receiving information about the company. Many companies will go to great lengths to serve the interests of their current or prospective shareholders. To date I have never had to disclose how significant of a shareholder I was in the company to receive information, but I have implied at times through my personal appearance or attitude that I hold a significant enough individual stake or that I am representing someone who does. Geographically and financially it’s impossible for me to tour all the operations of the companies I own shares in, but I do make an effort to try and gain permission for a tour or to attend a function whenever possible.

If I have the opportunity for a tour I usually request two: one with a salary employee from HR, investor relations or a mid-level manager and another with a blue-collar employee. I don’t intend to see the same thing twice, but what I’m after is a balanced presentation of what’s going on at both the local and corporate level of the business.

A mid-level manager or HR representative will tell me what the corporation wants me to hear: cost cutting initiatives, productivity goals and the overall strategy for operations. A blue-collar employee will tell me what I need to hear: unbiased, no bullshit, first-hand information on the guts of the corporation.

An investor needs to keep an open mind about the conflicts of interest imbedded in the opinions of who is providing you information on the company. Measuring both will often give you a very good perspective of what is going on within the company despite any differences between what one individual is saying versus another.

Remember: when assessing a company one of my vital Value Rules is measuring how well management maintains their finger on the pulse of the business. No CEO or plant manager is above the duties of a blue-collar worker; his or her job security depends on them. If a blue-collar worker isn’t producing a product or providing a service effectively that directly affects the productivity of the company and its profits.

A unionized vs. non-unionized environment during contract talks is something you want to avoid in order to receive the information you want, but for the most part, if you’re a fair and approachable individual blue-collar workers will spill the beans about all sorts of important information.

Example:

I won’t name the individual company, for intended legal reasons, but in November I had the opportunity to tour a plant in Toronto for a North American brewing company I was interested in making a potential investment in. I was fortunate enough to schedule a full day tour of the plant with an opportunity for one tour in the morning with a HR representative and the afternoon with a unionized labourer.

During the morning tour I heard pretty much the standard rehearsed story about company and plant statistics, productivity gains and where the Toronto plant fit into the new strategic focus of the merged company. But during the afternoon was when my interest in the investing prospects of the company changed dramatically.

My tour guide during the afternoon was a 51 year old gentleman with almost 30 years of experience with the company and soon approaching retirement. He held no punches about any questions I had about the company and for the sake of this post we’ll call him Jim.

Jim was fair for the most part aside from a slightly biased view of management, but his insights were valuable for a number of reasons. After pointing out a few minor problems with management-employee relations we stopped at one of the main fillers on the production line. Being familiar with the layout of a brewing plant I was impressed with some of the updated equipment on the production line and glanced at the label machine on one of the bottling fillers. At first glance the label looked like any other label for a brand of iconic Canadian beer; but it wasn’t. On the top right of the label I noticed the alcohol content of the beer was 4.7% instead of the standard 5.0%.

I asked if I could keep the label and as we walked along the line I asked Jim about the puzzling discrepancy on the labels. He didn’t respond right away, but smiled instead. The answer was both shocking and troubling for me as a prospective investor.

As a cost cutting measure management had decided that beer exported to the US didn’t need as high of an alcohol content. Management had stated they would save $500,000 per year on reduced alcohol content because they could dilute the beer a little more and sell it for the same price. To any unknowledgeable investor that might have seemed to be a fair response by management to reduce costs, but after working in an experimental brewery for two summers during university for a rival company I had learnt a few important things about beer manufacturing.

My next question to Jim was how many brand changes the company underwent each week. The reason for this was very straight forward and he knew exactly where I was going with the question.

(X is the brand of beer discussed)

“Well, Brad, we bottle X for both the Canadian and US market. That line with the new filler will run about 1,500 bottles per minute. At say $1 per bottle you’re looking at $90,000 worth of sales moving through that line each hour. If we ran only 5% X we’d have 5-7 brand changes per week with a downtime of about 1 hour for each. So in lost productivity we have anywhere from around $450k to $630k, but that’s unavoidable since we can’t run the same brand 24/7. Now we’re running 4.5% X and 5% X in almost equal amounts and we change brands 12 times each week now at a minimum. You do the math and tell me what those extra 5 changes per week amount to and if saving $500k per year in alcohol makes any sense to you.”

I did the math on a notepad I had with me: those extra 5 brand changes per week would result in an additional loss of productivity of roughly $450,000 each week. Doing the math over a 52 week period would bring your additional loss of productivity to around $23.4M. Add in what the company pays employees to stand around for that extra hour, the extra heating and other fixed costs and intending to save $500,000 on paper has now cost the business around $25M each year.

This wasn’t the only cost cutting initiative that someone in the “glass tower” (a reference to young management by Jim) had made over the previous sixteen months.

The majority of the plant had changed to a different set of lights (fluorescents) from the previous high pressure sodium lights because of the savings in wattage and replacement price per bulb. What someone behind the desk had neglected to realize was that the majority of the high pressure lights were on motion detectors and only went on when employees ventured into different parts of the plant. Now the fluorescent lights stayed on 24/7. Jim and others were convinced that no savings in the cost per light would offset the additional electricity used over a twelve month period. As we went along our tour he shared more and more cost cutting initiatives that management had introduced that were actually costing the company more money than the previous method.

When I asked Jim why none of the employees had mentioned this to their managers his response was, “When you were with them this morning, did it look like they gave a shit what we might think? Did you hear any of them saying hello, how’s your day, where can we improve?”

When I went back home and looked over the numbers I had collected on the company there was a very obvious drop in gross margins over the past 24 months and the return on equity was abysmal. There was clearly a direct link between the drop in gross margins with the injection of new management and the comparison to their peer margins was startling; more than 25% lower.

There were other factors that contributed to my decision to not invest in the company, but in retrospect I was very happy that I had taken the time to tour the plant to get a sense of the corporate culture and gain a better sense of management’s role in running the business. This was one situation where management’s inability to engage employees in a meaningful way was costing them millions of dollars per year and the practices are still ongoing today!

“Save a penny to spend a dollar” as Charles once told me are not the types of decisions I look for in management of a company I own no matter the future prospects of growth. I might have found the discrepancies in the margins before I purchased the stock, but $30 in gas and my time potentially saved me a 38% loss based on the company’s current share price and where my intended investment would have been at the time of the tour.

Productivity gains and losses are a very important task for management to focus on in any business. In an industry where competition comes from multiple directions no one can afford to make mistakes attune to $23.4M. If I had been a significant shareholder of that company and found out as I did about that costly blunders ongoing inside one plant I would have wanted the individual, their direct supervisor and anyone else involved in the decisions fired immediately.

Lesson: look to companies who empower and involve their employees in the decisions that affect the business. The CEO doesn’t have the time to walk the floor of his/her plants on a regular basis and no one knows the products, services or customers like the ground level employees. Ground level employees are the ones making productivity gains; not the managers. Leadership is about achieving results through others and when you find a business with that sense of corporate culture you likely have a good prospective investment.

Disclosure: I do not own shares of any global brewing company at the time of this post.

Remember to visit on March 30th for a Guide on Canadian Corporate Bonds and to VOTE for the Canadian Bank you want to read about in a future stock analysis!


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Fixed Income Alternatives:

A vital long-term objective in my investing discipline is to concentrate on the cashflows of the businesses I own and to maximize the cashflow I receive in my core portfolios. Cashflow is important for a number of reasons and one of the most important for a conservative investor is that you can’t always count on making investment gains exclusively from the price appreciation of the investments you own. There will be times in an economic cycle where the real return (return after inflation) is 0-2% providing minimal returns. Cashflow provides a necessary flexibility that each investor should concentrate on, if they don’t already, because of the additional benefits cash provides to returns over the long-term.

One of my objectives last year in 2008 was to expand my investing knowledge beyond common shares and move up the hierarchy of capital towards preferred shares, bonds and debentures. I began by pulling out old notes from business school and asking various investors for information on classifications of securities taking detailed notes for future reference. After a few months I felt confident enough that I had accumulated an adequate amount of knowledge to understand the basics and constructed a watchlist of various securities trading in North America to observe their trading activity. I constructed a list of reading material and began watching for commentary and opinions from various investors well versed in the debt markets and individual fixed income products.

I will admit that the learning curve for investing in fixed income is much steeper than common equities, but the rewards can be just as lucrative without exposing your capital to additional risk. Any opportunity I have as an investor to protect myself from risk and achieve the same return by moving up in the capital structure of a company is an opportunity that I’m keen on pursuing.

Under normal market conditions debt isn’t considered sexy, but as the markets unravelled in October and November of 2008 I could quickly see how tightening business/consumer credit and market illiquidity could present attractive investment opportunities if an investor knew where to look. My focus was on the three basic principles that an investor needs to examine before they consider investing in debt issued from a corporation:

1. Determine the strength of the company’s balance sheet
2. Determine the cashflow that is needed to avoid default on interest payments
3. Determine the credit risk, liquidity risk and term risk

I’ve publicly acknowledged my investing activities in Canadian preferred shares as a method of diversifying my Canadian dividend portfolio (DivG) for risk, future returns and cashflow. With Canada as my home equity market I knew that I didn’t want to become too focused on opportunities with equally as significant turmoil rolling through US, European and global equity markets. Fear of failures in financials, companies not having access to capital and financing rates going through the roof all led to some interesting observations in the markets. Sadly many of these opportunities came too quickly or I found myself priced out during both the October and November declines. I did initiate some advantageous positions, but with limited capital I had to invest in opportunities that I determined to have the highest margin of safety. One thing I did learn quickly was the unique behaviour and characteristics of various fixed income securities.

Diversifying cashflow in my portfolios is a primary long-term objective and I have to be prepared to look beyond common equities as an equity class since we’ve witnessed that they are much more vulnerable to dividend cuts than senior equity or debt higher up on the capital food chain. The problem with fixed income, as an individual DIY investor, is that there are four serious risks I have to assess:

1. Company risk
2. Interest rate risk
3. Liquidity risk
4. Term risk

For company risk you have to be able to evaluate the balance sheet and cashflow statement to determine what risk your interest payments might be exposed to if the company is no longer able to pay those obligations. When a company issues bonds they have a contractual obligation to pay interest to investors but if they don’t have the cash to do so bond holders could be stuck with nothing; affecting both the credit quality of the bonds and their market value. Interest rate risk is important because fixed income securities react to changes in interest rates both over the short and long-term that will effect their face value on the open market as yields rise and fall. Fixed income products are also far less liquid than shares of common equity. A public company might have a trading volume of 1,000,000 common shares or more in a single day but access to buy or sell fixed income products can be much tighter with increased spreads (difference between Bid & Ask). This can force an investor in some investments to sit in the market for days or weeks waiting to buy or sell a specific investment rather than the seconds or minutes it takes for a common share.

For an investor willing to hold a security until maturity interest rate and liquidity risk are often a secondary concern, but a risk-adverse investor needs to realize that having the ability to exit a position quickly (same day) can be worth a lot more than the additional gain you could receive from an illiquid investment.

Trust Preferred Securities (TPS):

Trust Preferred Securities are a hybrid security that trade like a preferred share with a par value of $25 and pay a distribution in the form of a dividend or interest to the individual holder of the security. Interest payments on debt are tax-deductible for corporations and the benefit of some hybrid securities is the flexibility they provide for companies who can issue shares rather than debt. These trust vehicles give a company the best of both worlds: they issue subordinated debt to a trust and still deduct the interest payments when issuing shares.

Corporate Backed Trust Securities (CorTS):

CorTS’ are a derivative product that trade like a stock on the NYSE, yet are not a preferred share or TPS. CorTS’ are issued by Structured Product Corporation which is a company incorporated as an indirect and wholly owned limited-purpose subsidiary of Salomon Smith Barney. Each individual trust directly holds either bonds or debentures of a public corporation. Instead of a corporation issuing a fixed income security for a value of $1,000 such as the case for a bond the trust purchases a large group of the same fixed income product and re-issues shares at $25 (like a preferred share). Payments on the bonds or debentures pass through the trust to individual investors on a semi-annual basis.

The benefit of a CorTS is that they carry the same credit rating as the individual fixed income security and public parent corporation.

CorTS JC Penney (KTP):

Structured Product Corporation created a trust and placed their purchase of a $100,000,000 block of JC Penney bonds issued in 1997 with a coupon of 7.625% and maturing in 2097. The trust then issued 4,000,000 shares with a value of $25. This redenomination of the bonds gives each share a par value of $25 instead of $1,000. The credit rating of KTP is the identical credit rating as the JC Penney 2097 bonds, but allows individual investors to purchase the bonds through a trust on the NYSE.

KTP also carries a unique call-option: callable at any time at a price that would make the yield equal to the 30-year US Treasury bond plus 20 basis points and never less than par ($25). With a 30-year US Treasury trading at a yield of 2.0% JC Penney CorTS is callable at no less than its par value of $25. In the current environment the likelihood of the CorTS being called is highly unlikely as the cost would be prohibitive.

Potential Situation:

On November 20th KTP closed at $10.25 after reaching an intraday low of $9.30 on a volume of 13,125 shares. If you were fortunate enough to catch a share trading at $10.00 on either the 20th or 21st the yield on your purchase price would have been 19.10% ($1.91/$10.00). A US 30-year Treasury traded on those two days between 3.64% and 3.70%. If an investor decided to hold KTP for five years and the CorTS were called or sold at par the annualized return for an investor would be 39.10% before tax (20.10% annualized plus 19.10%). Again in a low interest rate environment the potential for the call option to be exercised is highly unlikely.

Activities:

I purchased a group (7) of these products throughout November and December as fears of market liquidity, systemic and non-systemic risk caused valuations to fluctuate in extreme directions. Cashflow from operations at each company more than cover their interest obligations and the CorTS’ collectively offer a mix of corporate bonds and debentures in a variety of companies and sectors. The credit risk I’m exposed to is adequately compensated for with the yield and discount to par value for each investment when I consider the additional potential for capital appreciation in the future. I have an objective of holding the group of CorTS’ for a minimum of three years with the likelihood of holding them beyond five.

If US equity markets trade sideways for the foreseeable future (2-3 years) my yield on cost of 13.1% from the group of investments offers more than enough return for my risk tolerance. If I had purchased an equivalent amount of common equities in each of the companies at the same time of purchase my collective yield would be only 3.7%.

My total return with 0% default rate after five years at par value would be 152.8%, 77.0% with a 25% default rate and 26.4% with a 50% default rate. On an annualized basis that’s a pretty decent return considering the income should be tax-free since I hold them within my RSP.

As a Canadian resident these securities would not be tax-advantaged if held in a non-registered portfolio so I hold them within my RSP along with all my other fixed income investments. I can’t say for certain that there are zero tax consequences, but for the moment they look to be free from withholding tax.

Risk:

I want to be very clear with disclosing these investment activities: these are not risk free. The liquidity risk I’ve exposed myself to is significant and I wouldn’t have purchased these securities if I wasn’t confident in the underlying business, their cashflows, credit ratings or business models. The average daily volume in January for each of these investments ranged from a low of 800 to a high of 4,800; that’s tight. I purchased positions in 100 share allotments specifically for the purpose of any future event where I need to exit the position promptly.

There is also risk with Structured Product Corporation since the incorporated, indirect and wholly owned limited-purpose subsidiary of Salomon Smith Barney is owned by Citigroup. A failure of Citigroup or sale of SSB to another party could have volatile results on the price stability of these CorTS’ despite the stability of their underlying holdings.

This group of investments comprises only 8.5% of my overall invested assets (both registered and non-registered) and was not purchased using any amount of leverage. The risk of using borrowed dollars regardless of the yield and higher claim to capital is too great for my risk tolerance.

One positive benefit from a risk perspective is that this group of investments, when measured against their comparable common equity, has a much lower beta than I would have originally expected.

Disclosure: I own shares in the following CorTS’

KNR: Bristol Myers Squibb 6.80%
KTP: JC Penney 7.625%
KVJ: Disney 6.875%
KVM: IBM 7.00%
KVN: Unum 7.50%
KVT: Dow Chemicals 6.375%
KCT: Sherwin Williams 7.50%
KVR: GE Capital 6.00%
Remember to visit on March 30th for a Guide on Canadian Corporate Bonds and to VOTE for the Canadian Bank you want to read about in a future stock analysis!


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Taking Stock in Pfizer (PFE):

This is a condensed public version of the Taking Stock in Pfizer (PFE) stock analysis made available via subscription to SAML subscribers. The full analysis, in PDF form with all accompanying data, can be purchased by readers at the bottom of this post.


A ‘Critical’ Analysis:

(Available with purchase of full analysis)

This segment contains an introductory discussion of Pfizer’s strategic dilemma in handling critical mass and what readers can identify as important fundamental themes during the stock analysis.


Company:

Pfizer is a global research based pharmaceutical company with a long corporate history dating back to 1849. The company strives to demonstrate that their products effectively prevent and treat targeted diseases, improve symptoms and suffering and that the company helps to form the basis for improvements in the healthcare system.

The corporate goal of the company is in “Developing medicines that meet medical need and that patients will take; that physicians will prescribe; that customers will pay for; and that add the most value for Pfizer.”

The company has a large portfolio of established drugs and operates globally in both developed and developing nations with a key focus on emerging markets. In 2007 the company published a number of key focuses that are targeted to improve business operations and increase shareholder value moving forward:

• Maximize short and long-term revenues
• Establish a lower and more flexible cost base
• Create smaller, more focused and more accountable operating units
• Engage more productively with customers, patients, physicians and other collaborators
• Change business operations to focus on shareholder value through growth of revenue and income
• Refocus and optimize patent-protected portfolio for new opportunities
• Create a culture of continuous innovation
• Investment in complimentary businesses
• Remain focused on pharmaceuticals & biotechnology (biotherapeutics)

In 2007 management began focusing on lowering their cost structure by reducing the number of employees across the company by 11,000. The company repurchased $10B in common stock for cancellation and began to aggressively push Phase II compounds into Phase III trials.

The majority of Pfizer’s current revenues are driven by a large group of established patent-protected medicines that in recent years have come under threat from lawsuits, patent expiration and generic competition. Lipitor, their flagship product, competes in a very competitive statin market (cholesterol lowering) and will lose its patent protection in November of 2011 when Ranbaxy is allowed to a sell generic version of the drug for a six month period.

The company has also set a number of commitments on a strategic management basis:

• Optimize product portfolio & accelerate product pipeline
• Establish smaller units of operation
• Expand into emerging markets
• Capitalize on established products
• Align cost structure with revenues
• Attain ambitious cashflow targets
• Refocus on capital allocation to maximize efficiencies

Drug/Clinical Development:

I want to provide readers with some background education on drug trials and clinical development in order for you to be able to put into perspective what Pfizer is currently doing and how successful they may/may not be with their ambitious plans.

There are a few key concepts I want to present first for each reader to keep in mind when analyzing any pharmaceutical company. The most important fact to be aware of is that every drug has a commercial lifecycle. A drug is born in the lab and progresses through clinical trials after which regulatory approval is required to sell to the public. A drug grows through exclusive marketing rights provided to a company and years later its’ patent protection expires where generic competition erodes revenues and margins. Clinical trials compose nearly 60% of total development costs in today’s market and the capital required for funding these programs has accelerated significantly over the past two decades.

A new drug is developed through a series of trials where the objective is to assess the safety of the compound in an environment of very high scientific standards. Through the entire process there is a massive amount of red tape that a company must go through in preclinical testing to advance the drug to clinical testing. Even once a drug makes it to a clinical phase there are numerous review boards and ethics committees who evaluate the danger to participants, the ability to obtain informed consent, methodology of the trial design and strict monitoring of participants for adverse side effects.

Phase 1
In this first phase an investigational drug is administered for the first time to humans after successful trials on animals. This clinical trial is focused on the safety and tolerability instead of the effectiveness of the drug and determines the pharmacokinetics (what the body does to the drug) and pharmacodynamics (what a drug does to the body) in a small randomized population. Investigators assess each participant’s response to the drug, absorption within the body, length of availability in the blood stream and what dosage levels are considered safe and well tolerated.

Phase 2
In the second phase the focus of the trial is to determine the effectiveness of drug in treating an illness or identified medical condition. Data on the safety, side effects and potential risks is collected and researchers work to determine the most effective dosages (tablet, extended release, controlled release, infusion, injection). This trial involves a larger number of participants; this time with participants who have the medical condition that the drug is intended to treat. This is the first stage where a placebo is introduced to determine environmental effect of the trial on participants.

Phase 3
The third clinical trial focuses on testing a larger population. This trial is randomized and has a double-blind approach where neither researchers nor participants know if they’re taking the drug or placebo until after the trial ends. This trial is considered long-term since participants are involved from six to twenty four months. Researchers take a more geographical approach by taking participants in different environments to further test the impact of the drug.

Registration
Before a drug can move on to the final clinical trial phase an application needs to be filed with the regulatory health authority. In the US a new drug application (NDA) is filed with the Food and Drug Administration (FDA). A description of the manufacturing process of the drug along with all collected data and results from the previous clinical trials must be provided to the FDA so they are able to determine the safety and effectiveness of the new medicine. If approval is granted, the new medicine can then be sold for use by patients. Only 20% of drugs entering phase one clinical trials ever make it to the registration phase.

Phase 4
The final clinical trial is conducted after the regulatory approval of the drug has been received and is available for sale to patients. This final trial is where researchers collect additional information about long-term side effects, health risks or alternative benefits for other uses and continue for a number of years.


Situational Analysis:

(Available with purchase of full analysis)

This prized segment contains a strategic analysis of Pfizer’s internal strengths, weaknesses, opportunities and threats as well as external political, economic, social and technological challenges.


Management:

Assessing management through a period of stagnating performance or restructuring is always a difficult task because choosing a set of effective evaluation criteria for the challenges facing a corporation are never easy to quantify. It is easy for a CEO or strategic stakeholder to announce cost cutting initiatives, that they are actively pursuing a change in the corporate culture or where the company expects to be. But a corporation will always encounter problems in its operations and these will need to be met swiftly and decisively with management keenly aware of emerging problems before they become public knowledge.

When evaluating management through a restructuring period an investor needs to remind him/herself that financial performance will only be visible once the restructuring is completed and the company finds itself on the other side. An investor can choose to invest in a company now or wait for a period of time to see if changes being made will effectively benefit the corporation over the long-term. My number one priority, when assessing any management structure, is to answer the following question: Does management have their fingers on the pulse of the business?

Management needs to focus on achieving meaningful leadership within their organization. Achieving results on their own will not be enough to save a corporation and secure the long-term viability of a business; management needs to achieve results through others. In a top-down approach management needs to have the ability to empower employees, make strategic decisions that fit the business model and focus on profitability while continuing to operate the business effectively.

When current CEO Jeff Kindler joined Pfizer in 2002 the company was suffering from corporate obesity and critical mass. Jeff Kindler has a background in law (Harvard Law School) and comes from a strong operational background as Vice President at both General Electric (GE) and McDonald’s (MCD) before he became CEO of Pfizer in July of 2006. The fact that he was chosen as CEO over more tenured management within Pfizer signalled, in my opinion, the Board of Directors understanding of the level of importance for the corporate leader to understand patent and legal issues facing the company and the need for a fresh perspective on the future of the business.

Pfizer’s veteran management team has an average 18 years of experience within the company with many having a solid education and work experience in the medical field. Under normal circumstances experience of this level within the management ranks would provide soothing comfort to a prospective investor. In my assessments of Russel Metals (RUS) and Manulife Financial I highlighted the need for senior management in predictable and stable businesses. In a sector such as healthcare that requires a commitment to innovation, achievement and fresh perspectives to maintain a competitive edge in a rapidly changing industry an average of eighteen years means the company has a lot of experience and wrinkles.

The pharmaceuticals industry is changing, sometimes with drastic movements, and investors need only to look to a competitive analysis to determine the lagging performance of many within the group. Reshaping the top 100 leaders of the business to reflect a balance between new and veteran leadership is an admirable goal. But when I assess the senior management of the company and look for innovative leadership or individual who can think outside the established framework to influence the corporate culture of Pfizer I don’t find what I would expect to see.

A serious concern I have with the extent of cost cutting and job losses at Pfizer is the preservation of the corporate culture. When you look back ten years Pfizer was a company that thrived on the successful development of many important compounds found in the drugs they develop and market today. Their productivity within their R&D divisions was unrivalled amongst their peers, but as the company grew through acquisitions and attempted to integrate multiple corporate cultures into their own a number of key resources were lost that were vital to the success the company had enjoyed for so long. Redefining and motivating any corporate culture devastated by job losses, cut backs and significant change is not an easy task and each has a direct effect on the productivity of employees in executing the objectives of the company. Many of the leaders within the company were present during the ugly integrations of previous mergers and the end result, in my view, will continue to be the same without a dramatic shakeup.

No employee can work productively with multiple managers and repetitive oversight of their tasks and the ratio of employees to managers in recent years at Pfizer has swelled at the bottom to as high as 13:1.


Competitive Analysis:

(Available with purchase of full analysis)

This segment contains a discussion of Pfizer’s competitive environment, forecasted industry market share/growth for 2009, market conditions and list of direct competitors with disclosure of what I own in the healthcare industry.


Restructuring:

Pfizer has been in a restructuring phase for a few years now and decided to refocus its product portfolio prior to its Wyeth acquisition.

Pfizer’s new focus will target therapies for Alzheimer’s, Diabetes, Inflammation/Immunology, Oncology, Pain, Psychosis, Asthma/Chronic Obstructive Pulmonary Disease (COPD), Genitourinary, Infectious Disease and Ophthalmology.

Pfizer is exiting drugs and shelving R&D on new compounds for Anemia, Atherosclerosis/Hyperlipidemia, Bone Health/Frailty, Gastrointestinal, Heart Failure, Liver Fibrosis, Muscle, Obesity, Osteoarthritis and Peripheral Artery Disease. The exit from atherosclerosis/hyperlipidemia is surprising considering Pfizer’s dominant position in that market with Lipitor and demonstrates the perceived lack of profitability present. When Lipitor comes off patent Pfizer is expecting a significant decrease in sales of the drug and likely with the exit of professionals who worked on the Lipitor project from the company the intellectual gap was significant enough to warrant exiting that area of expertise. Additionally statins are a group of drugs that are expensive to manufacture and profit margins may be too slim in a generic environment for the company to see any viable reason to remain in the market.

Pfizer has also concentrated on selling non-core assets as best as it can with the sale of its consumer health division to Johnson & Johnson in 2006.

The failure and subsequent abandonment of Exubera is disappointing for the company as Exubera was the first inhaled insulin therapy for the treatment of diabetes developed. Despite launching in Germany, Ireland, the UK and US in 2006 the financial performance of the drug accompanied with the lack of adoption by patients and physicians led to an exit strategy for the drug. The fact that Pfizer was unable to sell the drug and technology to larger diabetes drug companies such as Novo Nordisk was another strategic opportunity missed by the company to recoup some of the costs in developing the drug and delivery technology. Pre-tax charges amounted to over $2.8 billion in 2007 at a cost of 5.8% of total 2007 revenue.

Pfizer’s did attain achievements in 2008 of advancing 14 drugs to Phase 3**. The company currently has a target of placing 24-28 drugs in Phase 3 by end of 2009 and submitting 15-20 drugs by 2010-2012 for approval.

** On February 24th Pfizer announced it was discontinuing development of two Phase 3 compounds, esreboxetine for fibromyalgia & PD 332,334 for generalized anxiety disorder (GAD), due to “current market dynamics” and due to the consideration of it being “unlikely that either compound would provide meaningful benefit to patients beyond the current standard of care.” Although neither drug was abandoned due to safety reasons of patients this is yet another setback in the R&D department for Pfizer. Discontinuing compounds this late in Phase 3 is not as common as earlier withdrawals, but likely competitive and cost factors led to the decision to scrap their further development.

Other achievements include:

Global Approvals of Fesoterodine (US), Maraviroc (Japan), Macugen (Japan), Rifabutin (Japan), Sutent (Japan), Champix (Japan), Genotropin (Japan), Zithromax SR Peds (US), Sutent (Japan) and Revatio (Japan).

Global Submissions of Fablyn (Europe), Lyrica (Japan), Xalacom (Japan), Maraviroc (Japan), Maraviroc (US), Lyrica (Europe), Revatio (US and Europe), Geodon (US), Geodon Peds (US and Europe), Norvasc (Japan), Lyrica (Europe) and Zithromax SR (Japan).


The Numbers:

In the spreadsheets provided I’ve listed the past five years of data
(Data dating to 1991 available with purchase of full analysis or to SAML subscribers).



Whenever I look through the operating numbers of a company I’m looking to evaluate three main items:

• A consistent theme of performance
• Conservative fiscal management
• Emerging trends that hold the potential to influence the company either positively or negatively in the future

One important habit for an investor to get into is not to focus too exclusively on historical data. While I use historical data to reveal important trends, fundamentals and a fair market valuation of a company I constantly remain conscious of current operations, the strategic focus of management and how a number of other factors will contribute to its future success.

When you examine the historical numbers of Pfizer there’s not a lot that makes an investor enthusiastic about its future prospects. The dividend grew at a substantial rate for over 40 years but has now been cut in half and growth in profitability has stalled dramatically. The future loss of revenue from Lipitor will dramatically affect the business and despite commitment to new drug development the company has performed poorly on executing and achieving strong results with its R&D spending.

Revenue growth has outpaced expense growth over the past five years and that is positive, but revenue growth over the past five years has been anemic at 1.8%. The company has established an impressive history of return on equity (ROE), but their return on investment (ROI) related to research and development costs have been abysmal bringing into question management’s ability to achieve results in this key department. Despite lowering SGAE (as % of net sales) from a historical average of 37% to ~32% the bottom line hasn’t adjusted sufficiently indicating other fixed costs are dragging down profitability and heavy job cuts are only a short-term solution.

Book value growth per share (BVPS) has averaged only 3.3% over the past five years versus a historical average around 8%. In real terms (after inflation) management has likely returned zero book value growth which is not something that I regard as positive as a value investor.

Pfizer relies on its pharmaceutical division for over 90% of revenues. Their animal health division has continuously generated 4-6% of revenues which amounts to a questionable benefit to the company’s operations and with no growth in revenue this division should be a candidate for a non-core asset sale.

Pfizer had an excellent history of dividend growth with a historical average of over 18% per year before cutting it by 50% in 2009 to $0.64 per share on an annual basis. This likely won’t be forgotten by investors seeking a stable yielding investment and future dividend growth will be tempered at 5-6% annually as the company looks to tackle new debts taken on through the Wyeth acquisition.

At some point the company must tackle the massive amount of goodwill sitting on their balance sheet that stands at 21% of their market capitalization at the end of 2008. Compare that to Coca-Cola (KO), owner of the most valuable brand globally, with goodwill of 4% of market capitalization and the premium offered to Wyeth shareholders in order to purchase the company will only further compound this serious obstacle for Pfizer.


DCF Valuation/Target Price:

(Available with purchase of full analysis)

This segment contains access to a dedicated online discount cashflow calculator (DCF), historical numeric summary, current financial data and DCF valuation with target price.


“You’re Pfizered!”

(Available with purchase of full analysis)

This segment contains a discussion of Pfizer’s recent purchase of Wyeth (WYE) including identified synergies and conflicts, an update on Pfizer’s current restructuring, a discussion of influences to corporate culture and future investing prospects of the two combined companies.


Disclosure: I own shares of Coca-Cola (KO), Russel Metals (RUS), Manulife Financial (MFC), Johnson & Johnson (JNJ) and structured senior debt of General Electric (GE) at the time of this post.

Read more about The Stock Analysis Mailing List (SAML) including format, pricing, delivery method and disclaimer.

Purchase your individual copy of Taking Stock in Pfizer (PFE)
Each 22 page PDF includes:
- A 'Critical' Analysis
- Company Description
- Clinical Trial Description/Outline
- Extensive Situational Analysis
- Management Analysis
- Critical Competitive Analysis
- Restructuring Analysis
- Examination of Operating Results
- DCF Valuation with Target Price
- "You're Pfizered!"
- 18 years of Organized Financial Data (excel document)

Craving more? Visit the TMWTFS Stock Analysis & Reviews page for a full list of analyzed stocks and comments written by my peers.


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The Ultimate Value Trap – Bankruptcy Needed:

Last summer I published an article that focused on my pick for The Ultimate Value Trap in 2008; General Motors (GM).

GM closed that day at $10.78 after dropping 57% since the beginning of the year (it is now subsequently down another 86%). I received some harsh criticism from individuals sympathetic to the automakers, but I stood by my assessment that the company was struggling with not one, but several competitive disadvantages.

There’s been a lot of news, discussion and suggestions on what to do with GM, Chrysler and Ford with many claiming that their singular or collective failure would plunge the North American economy into a more severe recession. These suggestions have often come from individuals with a serious conflict of interest in seeing GM, and others, succeed (unions, management, & industry interests). The real problem with GM hasn’t been resolved yet and no finite amount of financial relief will change the infinite number of serious issues at hand in the industry.

This company is very ill and needs a DNR order: Do Not Resuscitate.

Either allow the company to die outright or provide the assistance it needs to restructure under creditor protection.

GM is septic and the pus is oozing from every orifice it has. Not only is GM bleeding equity and cash at an astounding rate, but it continues to be run by incompetent management who are unable to effectively make the decisions needed to save the company. Stalling any longer won’t help the situation and will likely cost more money in the long run than over the short-term.

Life support isn’t an option at this point as the financial systems of the company are already shutting down. Bankruptcy protection would save viable components of the company that can be utilized in the future after emerging from creditor protection. Right now there is too much chaos within the company, abundant excesses in the operations and contractual obligations that are crushing the company under their immense weight..

Gross mismanagement isn’t something that can be changed in the past, but it should has to be dealt with in the future. No bailout, funding or government assistance will make any sense or difference without a dramatic change in management at all levels of this company. The process for building a car and operating a car company are no different than any industrial good made by hundreds of global corporations and sold to customers (retail or business). Research that is years away won’t save them, insignificant cost cutting hasn’t made a difference so far and it’s no longer a question about the quality of their cars.

The facts facing GM and all stakeholders in this process are pretty simple and have not changed.
There is:

1. Too much supply
2. Too little demand
3. Too many brands
4. Too high a cost structure
5. Too much ineffective management

I read over the annual report for 2008 this week and I’m afraid there’s not much positive news to report. Frankly, the annual report read like an obituary with the discussion provided by management as very negative on the prospects of the company without billions in financial support.

Highlights were that the company now has a Total Shareholder’s Deficit (yes…that’s deficit) of $86.1 Billion dollars. That’s the equivalent market capitalization of a company the size of Coca-Cola (KO), Genentech (DNA) or Pfizer (PFE) but in the opposite direction of dollars. Cashflows from continuing operations results were positive as they sank for the third straight year, but improved to -$30.8B (2008) versus -$43.3B (2007).

One section of the annual report that I especially liked read as follows:

“In addition, our Viability Plan relies upon financial projections, including with respect to (1) revenue growth and improvements in earnings before interest, taxes, depreciation and amortization margins, (2) growth in earnings and cash flow, (3) the amounts of future pension contributions, (4) the value of unconsolidated subsidiaries, (5) the value of expected asset sales and (6) the amounts of other restructuring costs, including those related to Delphi. Financial projections are necessarily speculative, and it is likely that one or more of the assumptions and estimates that are the basis of these financial projections will not be accurate. Accordingly, we expect that our actual financial condition and results of operations will differ, perhaps, materially, from what we describe in our Viability Plan. Consequently, there can be no assurance the results or developments predicted by our Viability Plan will occur, or, even if they do occur, that they will have the anticipated effects on us and our subsidiaries or our business or operations. The failure of any such results or developments to materialize as anticipated could materially adversely affect the successful execution of our Viability Plan and our ability to continue as a going concern.”

Now…from a group of managers who have dramatically mismanaged the company to date shareholders are now being informed that financial projections are “speculative” and likely that “one or more of the assumptions” won’t turn out to be accurate at all.

We are talking about billions of taxpayer revenues that the governments in North America are considering placing in the hands of current management with the perceived trust they actually know what to do with it. I’m all for saving jobs, but not if the cost won’t significantly make a difference in the sustainable development of our economy. We would be better to support the retraining of automotive employees for other jobs such as trades than to simply inject capital into a company already running a deficit nearly double the assistance they require.

Disclosure: I own shares in Coca-Cola (KO)

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Value Update I, 2009:

With another slide in equity markets I thought I would take a moment for a regular update on some of my trading activities over the past month.


RSP Activity:

Part of my investing discipline is choosing companies which have Enduring Value and I believe every portfolio needs a solid collection of generals; strong and strategic. General Mills (GIS) fits these criteria as a boring, stable and growing business with sustainable operations in a global food industry dominated by giants. I hold a number of consumer staples companies, but I hold GIS in a higher regard for the fiscal responsibility of its management team, their achievements in tight cost controls and the diversified nature of their core product portfolio. I doubled my position at $52.00 which I feel offers attractive long-term value for a company with a solid dividend of $1.72 (3.31% yield, 45% payout), forward P/E of 13.7 (2009 EPS: $3.80) and equally impressive ROE.

Smuckers (SJM) is another consumer staple that I own and reported very strong operating results for their third quarter. The acquisition of Folgers from Proctor & Gamble (PG) in 2008 had an immediate positive effect on both margins and cashflow even though earnings were down slightly related to implantation costs of the acquisition. I doubled my position at just under $36.00 with SJM offering a stable dividend of $1.28 (3.60% yield, 37% payout), impressive EPS and book value growth and manageable debt.

United Parcel Service (UPS) is a company I’ve had my eye on adding to since first acquiring shares in May of 2008. This is a company with a significant operating moat that continuously operates against its competition with impressive margins when you consider their global scale. With fuel costs coming down, a concentration by management on further cost reductions and a dividend of $1.80 (4.68% yield, 51% payout) this is a company that has often been cheap during periods of economic weakness and expensive during periods of economic strength.

I also sold another significant component of my holdings in the PowerShares Crude Oil Double Short ETF (DTO). This is part of my Canadian dollar hedge strategy that I’ve been weaning down over the past six months as the price of crude oil slipped along with the CDN$. I have been asked my a few readers to outline this strategy and I will post this at some point in the future.

Portfolio as of February 28th
YTD Return: -10.8%
Yield: 4.54%


DivG Activity:

There should be no surprises that I added to my positions in Fortis (FTS), Bank of Nova Scotia (BNS), Royal Bank (RY), Manulife (MFC), Sunlife (SLF) and Saputo (SAP) over the past month. Each of these companies is a core holding of my portfolio and despite market concerns over their operations I believe their current valuations are quite attractive.

The Canadian banks have all reported quarterly earnings and despite some weakness their capital ratios are strong, dividends at historical highs and loan loss provisions increasing. There will be losses for these banks as the economy worsens, but their relative strength against global peers and an ability to now expand operations into new markets with weakened competition make them excellent long-term investments. While the short-term focus of the market remains pessimistic a long-term investor has to take the proper perspective. I like to explain my continued investments in TD Bank (TD), BNS and RY to my investing peers as if I were standing in the middle of a dense forest. As giants fall to the ground after losing their balance from rotting foundations (US/Global Banks) there are trees with stronger roots that will race to fill the void of sunlight that rushes in. It would appear to anyone captivated by the bearish sentiment of the media that the global financial system is in ruins, but it’s important to realize as a long-term investor that there will always be companies that thrive in an environment of chaos and seek out strategic opportunities during period of weakness. Our banks are well capitalized and as the economy turns to a recovery at some point in the future (2009? 2010?) they will deploy the additional capital they carry into new business opportunities, acquisitions and strengthening their core retail operations. The void left by crumbling financials around the world is leaving a vacuum of prospective business that other companies will fill just like in every crisis within an industry. The strong get stronger.

FTS and SAP should be self-explanatory; each has suffered a decline in valuation as nearly everything is hit with the deteriorating expectations of the market. Both companies have stable earnings, adequate cashflows to cover their dividends and are trading at valuations that a long-term investor should be seriously examining. These stocks are considered defensive and for a portfolio heavy with financials or commodities they offer an element of diversification that is often required to avoid significant volatility. Each is boring and rarely report exciting news, but their growth prospects are attractive as they continue to expand their operations led by management teams that are fiscally conservative.

Portfolio as of February 28th
YTD Return: -12.03%
Yield: 6.76%


Fixed Income:

The Bond Guide will be published later this month, but I continue to observe the debt markets with a keen interest as a student who continues to learn about investing. I consider debt investing as the final frontier in my path to securing a balanced education in DIY investing. While I don’t have $5,000 to throw around towards 4-5 individual corporate bonds for the fixed income component of my overall portfolio I have been watching with interest to see what I can learn from the current market for future opportunities.

Global financial companies (bank & insurance) have been slaughtered the past 18 months; that’s obvious. European banks have been nationalized, US based financials weren’t far behind them and nearly every other bank has seen their market capitalization crumble regardless of the strength of their operations or earnings. Banco Santander SA (STD) is the largest bank in Spain and biggest in Latin America. I wasn’t interested in holding the common equity of STD since I already had adequate exposure to the common shares of its fellow Spanish bank Banco Bilbao Vizcaya (BBV) but I’ve patiently watched STD’s four sets of preferred shares (A, B, C & I) for advantageous opportunities.

Preferred shares, which I’ve talked about here before, are a special breed of equity that generally trade at face value ($25) and pay a regular dividend on a quarterly basis. The benefit of preferred shares versus common is that an investor gains preferential (hence “preferred”) claim to profits, dividends and capital of the company. Cutting or cancelling the dividend of the common stock is a common practice of companies of late, but in order to cut the preferred dividend all dividends on the commons would have to cease first. Cutting the preferred dividend would be the equivalent of capital suicide (see Nortel) since a company would be indicating to investors they no longer had the cashflow to cover payment of their dividend obligations and this would subsequently cause them to have trouble raising equity in the debt markets.

The A-series of preferreds of STD (STD.PR.A) were issued in November of 2007 at a value of $25 with a dividend of $1.70 per share (6.80%). As they traded down in value below $15 the yield on the preferreds increased above 11%. When I assessed risk reward of the investment I came to the conclusion that I was being adequately compensated in both the potential of dividend income and capital gains for the equity I planned to invest. On an adjusted cost base (ACB) of $12.40 I stand to receive an annual yield of 13.71% and eventual capital gain (if it ever reached $25) of 101.6%. If I intend to hold the investment, STD is able to remain well capitalized and payments of the dividends are sustained over a five year period the return on my investment (ROI) could be substantial. The risk of course is that the common dividend is suspended, the preferred dividend is subsequently suspended and the bank fails. But on a risk/reward basis I felt the investment was prudent and made a choice based on my analysis of the company.

Two other fixed income investments I made were in KVT & KVR. These two securities are a different breed of investment known as a CorTS. I won’t go into detail here, but I will be posting on my activities with these securities on March 16th.

Disclosure: I have invested interests in all companies mentioned in this post.

Remember to VOTE for the Canadian Bank you want to read about in a future stock analysis!


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Canadian Corporate Bonds:

There’s been abundant discussion from investment pundits in the media the past 4-6 months about the attractive investment potential of corporate bonds due to the historically high basis point spread between corporate, government bonds and historical equity returns.

I’ve received a few questions from readers recently about bonds, specifically:

• How to value a bond?
• Where to find information about them?
• What affects the pricing of a bond?
• What are the risks?
• How do you buy bonds?
• How do you assess a bond?

I’m currently working on a post where I hope to answer the majority of these questions and a few more. There are a number of differences between equity investing (stocks) and debt investing (bonds) that adds to the difficulty of bringing together all of these questions. My hope in the next month or so is to prepare an article that’s concise, answers the list of questions, is easy for novice/experienced equity investors to understand and that encompasses the important aspects of evaluating a bond for investment purposes.

If you have additional questions to add please feel free to comment or contact me. I will add feedback to the list of possible content to be addressed and try my best to incorporate every question into the resources and assessment criteria I provide in the post.


Read: The Bond Guide - Investment Guide to Corporate Bonds


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