Shares of Research In Motion (RIMM – NASDAQ) have undergone a sharp correction in recent days. The market was not impress by RIM Q1 results despite a 23% increase in profits and revenues. After this correction, the gap between current valuation and it’s valuation from two years ago is nothing less than phenomenal! On July 3, 2008, the stock of the BlackBerry maker was trading at $ 115 U.S. or 51 times their $ 2.26 profit from fiscal 2008 (ended March 1, 2008). On July 2, 2010, becoming a RIM shareholder costs a whopping $ 48 equivalent to 11 times the EPS of $ 4.32 from fiscal 2010.

According to Mr. Market, a company that almost doubled its profits and increased its revenues from 6 to 15 billion in two years deserve a price/earnings ratio similar to Pfizer ! In my opinion, such a low valuation is probably the result of the market general pessimism combined with the obsession of the media for a company named Apple. The reasoning seems to go as follows: RIM is not anymore the dominant player in the smartphone market because of competition from Apple and Google, so the company is basically worthless! QED !

It is obvious that a company trading at 50 times its profits must absolutely stay the dominant player in its sector for its shareholders to have any hope of enrichment. The interest in RIM current stock price is that global and interplanetary domination is no longer a need to provide an attractive return. The smartphone market is still in its infancy. The term “smartphone” will itself be obsolete in a few years when all mobile phones will be smart. As sexy are Apple and Google products, they probably won’t have 100% of this market. RIM may loose its number 1 position, but remains well positioned to be a major player.

The skepticism vis-à-vis the Waterloo firm does not date from yesterday. Currently, many analysts fear that the next generation of products to be unveiled within weeks may not be up to par. It could be, but we must not forget that RIM has always delivered the goods in terms of product quality and innovation. Since 1997, the company confounds skeptics on a regular basis. Its CEO and founder Mike Lazaridis is a genius who belongs to the same league as Steve Jobs.

In short, RIM sells to less than 10 times expected profits for this fiscal year. The company is well positioned in a market poised for strong growth in the coming years. Expectations are low despite its history of success. From an investor perspective, the risk/reward equation is very attractive. Buy quality when no one wants has always been the winning recipe of stock market riches.

Related posts:

1. Is Potash stock too expensive ?

Valuing cyclical stocks is a very different discipline from valuing non-cyclical ones. We have read recently in the financial media that Potash stock ( POT – TSX) was clearly too expensive. This Canadian company is the largest potash producer in the world (potash is a basic component of fertilizer). The stock of Potash is said to be too expensive because of its price / earnings ratio of 20, a ratio supposedly too high for a cyclical stock. I am not an expert in the field, but I doubt that the “high PE ratio = expensive stock” equation is really the right way to evaluate a producer of raw materials such as Potash.

Let’s go back in time. At the end of 2004, Potash stock is trading at 30 times profit, the stock was indeed very expensive according to the theory cited above. However, the share was then worth $ 27 and was at the dawn of a surge that was going to lead to a high of $ 230 in June 2008. At that time, the PE ratio  of the stock had fallen to 20. On this basis, the stock was therefore less expensive than in 2004, and despite the multiplication by 9 of its market cap! Most people will find completely illogical that a stock can be considered “less expensive” after a ninefold increase and they are right! In fact, the PE ratio is a poor tool to evaluate a cyclical stock like Potash.

Producers of commodities are cyclical stocks because their profits follow the cycle of commodity prices. Generally, the PE ratios will tend to be high at the bottom of the cycle, because the market is anticipating a price hike of raw material and an increase of the producer’s profit. Conversely, the ratios are low at the top of the cycle, because investors do not pay a high multiple for profits that may decline in coming years. To make money, you have to buy at the botton of the cycle (regardless of PE ratios) and sell at the top (at a generally low PE).

The challenge posed by this type of investment is obviously to determine the point in the cycle we find ourselves now. For this, we must understand the mechanisms governing the supply (easiness to increase production, add new mines, etc..) and demand (who are the consumers?, what is their financial situation?, etc.. ) for a specific resource. We must also gain some  knowledge of the resource historic prices. In the case of potash, the price was long depressed by the collapse of consumption in the former Soviet Union (following the breakup of the country). This created an excess supply which took more than a decade before being absorbed by the market.

In short, it is futile to attempt to evaluate a cyclical stock if we have no idea where the current price of the resource fit in the cycle. Understanding this famous cycle requires specialized expertise that is beyond the reach of a lot of people. In the case of Potash, the stock is not that expensive if potash price is at the bottom of the cycle, but that’s another story if it is in the middle … There is also a theory that fashion that we are currently in a bullish ”supercycle” for everything related to agriculture. This may be true as this may be the ag version of the “Peak Oil“ theory ! Time will tell …

Related posts:

1. The subtleties of the P/E ratio
2. A castle under siege
3. Life and death of a growth stock

Since its founding in 1986, Home Capital Group has concentrated in subrpime mortgages (or Alt-A in the mortgage jargon). These loans are granted to individuals not meeting banks criteria to obtain a mortgage. HCG has been able to succeed at the game through his niche expertise to assess the risk of this type of clientele, its traditional financing by issuing certificates of deposits and its conservative capital structure (high tier-1 capital ratio). In summary, HCG has long feasted from the crumbs that fell from the table of major Canadian banks.

The summer of 2008 arrived and with it came an unprecedented financial crisis which led to a significant lessening of competition in the canadian mortgage market. HCG saw a golden opportunity to enter the “traditional” mortgage market . What was their Trojan Horse? Independent mortgage brokers! The latter, seeing less alternatives for their clients were very happy to welcome HCG in this market segment. From now on, the small Toronto company would sit at the big table!

In Q3 2009, 68% of mortgages issued by HCG were triple-A mortgages insured by CMHC. 29% of the mortgage portfolio of HCG is now CMHC-insured compared to 15% at December 31, 2008. Mortgage brokers seem very satisfied with the personalized service that offers HCG. A service that contrasts greatly with what they get from the big banks. Big banks have their own sales force and have always had an ambiguous relationship of collaboration / competition with mortgage brokers.

In conclusion, Home Capital Group has used the crisis to reduce the risk level of its business while increasing profits. The firm run by Gerald Soloway is another example that the theory stating that we should take more risks to make more profits is in fact … just a theory!

Related posts:

1. Is Potash stock too expensive ?
2. Buy RIM when nobody wants it

Investing in stocks is often a solitary sport where independent thinking is a valuable quality. This does not mean that our success depends to 100% of our ideas. Fortunately for us, there are brilliant investor, with an incredible talent for wealth creation and who are little known to the public (this is not an article on Warren Buffett). The beauty of stock markets is that they allow us to partner with such a specimen when we finds one. What’s easier than buying some shares and then leave it to our “new partner” with the task of working heart and soul to our enrichment!

I believe Chad Wasilenkoff, founder and CEO of Fortress Paper is one of these buffettesque individuals obsessed from an early age with money accumulation. His personnal story is not mundane (he his only 37 years old) and contains some similarities with that of Nebraska most famous investor. At 10 years old, Wasilenkoff hired his friends to recover golf balls lying at the bottom of ponds. He then sold them with a tidy profit to golf club clients (a kid in Omaha was doing the same in the 30s). As a teenager, he developed a business around reselling Atari’s computer games (the teenager of Omaha rented pinball machines in an other era …). Our ambitious teen then expanded its business from the sale of videogames to that of bicycles to that of used car!

Then came adulthood and serious matters. His first big coup was the takeover in 2003 of Dynasty Metals for $ 1 million. The subsequent rise of gold price from $ 300 to $ 700 did inflate the market capitalization of the company to $ 150 million! Wasilenkoff repeated the same trick in 2004 with the acquisition for a pittance of Titan Uranium, while the uranium price was at a bottom. The rest is history… the uranium price exploded from $ 10 to nearly $ 100 a pound and Wasilenkoff had the flair to sell its stake at the top!

The creation of Fortress Paper in 2006 by the acquisition of two paper mills of Mercer International follow the same logic. Again, Wasilenkoff buy cheap assets in a sector in disfavor (pulp and paper). Although cheap, those mills are quality assets that he believes will worth much more  in the coming years (see my analysis). As the owner of 25% of the company’s stock, his interest are clearly aligned with the rest of the shareolders.

In conclusion, I am convinced that riding coattails of an investor with such a flair can pay. Of course, nobody is infallible, but why not put all the chances on our side by “partenering” with someone who seems born to make money? If you had the choice between a self-made man like Wasilenkoff or a technocrat CEO who used his political skills to succeed (and his stock options to get rich), which one would you choose? As for me, the choice is already made!

For more info:

An article about the expansion of Fortress Paper

An article about Chad Wasilenkoff

An article of the Globe & Mail

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1. Fortress Paper
2. Warren Buffett and You

TMX Group has published disappointing 3rd quarter results. The  Toronto, Vancouver and Montreal  stock exchanges operator saw its revenues and profits fall 6% and 18% respectively. It would be easy to simply blame the recession, but it would obscure what appears to be the weakening competitive position of the company. Indeed, revenues from the Toronto Stock Exchange fell by 42% (from 26 million to 15 million) because of competition from new alternative trading system (ATS) such as Alpha, Chi-X and Pure Trading. This decrease was significantly higher than management had anticipated.

For years, the TMX Group ruled the canadian stock market as a quasi-monopoly. The company was highly profitable, since it could increase its revenue without large capital investments. The situation has radically changed since last year. The operator must now make significant investments in its technology infrastructure just to keep pace with the new ATS. To make matter worse,  TMX group  must also slash its prices to remain competitive. Needless to say that its profitability is taking a hit and the intensity of competition is not likely to diminish anytime soon …

The recent strategy of TMX group was to diversify by purchasing the Montreal Derivatives Exchange in 2007. In retrospect, it is clear that the TMX group probably pay too much for the Montreal Exchange. According to TMX Group CEO Thomas Kloet, the derivatives market in Canada is flawed. The lackluster earning of the Montreal Exchange seems to confirm his view. Again, the purchase of the Montreal Exchange seems to have been an (expensive) defensive maneuver in order to prevent the latter to make an alliance with a big U.S. exchange. Its 50% stake in the Boston Options Exchange (BOX) is not more exciting. The BOX seems doomed to be a second-rate exchange in the hyper-competitive options market in United States.

In conclusion, I must admit that the TMX Group is no longer the fortress surrounded by a wide moat that attracted me as an investor a few years ago. My feeling is that its moat is now filled with sand, the main gate is down and that enemies are inside the walls! Long-term investment in a stock like TMX Group could be rewarding provided we are able to identify in time the weakening of its competitive position. Which I was unfortunately unable to do !

Related posts:

1. Fortress Paper

The publicly traded companies that post strong revenue and profits growth for many years in a row have proved to be excellent investment. Holding one of these stocks in a portfolio can make all the difference between mediocre performance and above average results. Companies such as Microsoft, Wal-Mart and Starbucks have incredibly enriched their shareholders over the years.

Uncovering and investing in this kind of stock can be very rewarding but it should be understood that the strong growth won’t last forever. It is therefore important to determine in which phase of  it’s “growth stock life” is a corporation. I have identified three major phases based on my personal observations:

1. The arising

This is the phase where the company experienced its first success and the beginning of its spectacular growth. Nevertheless, the stock is still unknown and is not often the subject of articles in the financial press. This is obviously the best time to buy but it’s also the riskiest. The future looks very promising but the company still has to demonstrate it has the ability to maintain a high growth rate for a long time and that its initial successes are not just fleeting fireworks.

2. Celebrity

After several years of spectacular growth, the stock is now known to all and the financial press is singing its praises. The company is admired and its price/earnings ratio is proportional to the level of admiration (read: very high). Many investors dare not buy it because of its rich valuation. The corporation punishes their lack of courage by continuing to deliver strong results that drive up the price of its shares at levels never seen before.

3. The decline

Curiously, the price/earnings ratio recently declined and is now more in line with the recent years growth (example: a 25 pe ratio for a 25% growth). Many investors see that as an opportunity to invest in a company of high quality at a reasonable price at last. Unfortunately for them, the strong growth of the company is nearing completion. Over the coming years, they will observe a continuous contraction of pe due to the growth deceleration. Worse yet, the company must deal with a bunch of problems it had neglected during his fabulous expansion. The share price has stagnated (at best) or is greatly reduced.

In short, the arising phase is still the most rewarding but also the riskiest. The celebrity phase is less risky because the company is firmly established, but this certainty has a price. Moreover, there is always the risk that the company is at the dawn of its decline. The transition from celebrity to decline is often a little fuzzy. The stock is not loved unanimously like it was before but still has many admirers. A clue of this transition is that the company engages in short-term operations to maintain its growth in earnings per share at any cost.

In conclusion, owning for several years a high growth stock is a memorable experience for all investors. However, it’s no time to rest on our laurels for that growth will not be eternal. We must continue to monitor the business closely and be alert to early signs of decline.

Related posts:

1. Is Potash stock too expensive ?
2. The subtleties of the P/E ratio

In her excellent biography on Warren Buffett entitled “The Snowball”, Alice Schroeder finally reveals the secret behind the success of multi-billionaire from Omaha! His method is simple and very effective: just spend your whole life obsessing about accumulating the greatest possible amount of  money ! Never taking a vacation, having no interest outside the business world, neglecting your wife and children and having an obsessive-compulsive personality are obvious key elements of this method.

Sounds a little harsh? I would say that you can’t accomplish extraordinary things without being yourself a rather extraordinary individual. Picasso and Mozart probably had the same defaults than Buffett … The oracle of Nebraska is a prodigy who began perfecting his art at an early age. At age 7, he read (and memorized !) investment books. At 20, he probably knew as much about business has many company CEOs in their forties. At 40, he probably knew more than anyone else … imagine him now … he his 79 years old…

Many “experts” will tell you that Buffett has succeeded because of his excellent investment principles. These people do not really understand the phenomenon. Buffett extraordinary achievements are the results of the encyclopedic amount of business knowledge he has been accumulating compulsively for over seven decades. The best investment principles of the world are of little use unless they are based on extensive knowledge. Here are some investment principles often associated with Buffett:

The Circle of Competence
Before having a circle of competence, one must have competencies ! Knowing the price and ticker symbol of a stock can hardly be described as competence.  A company fall within our circle because of the in-depth understanding we have of its business. We should not overestimate the size of our circle.

The Margin of Safety
This famous margin is not an absolute number one can read every morning in the newspapers. It rather depends on our assessment of the intrinsic value of a company. And the correctness of our assessment is based on our level of knowledge of the company (back to the Circle of Comptence !)

The Concentrated Portfolio
Again, this method can lead to disaster if we do not have a strong knowledge of the few stocks we held in this type of portfolio.

In conclusion, if there is a characteristic of Buffett we should try to imitate, it’s this one: be a learning machine! You should also be skeptical of anyone claiming to invest like the chairman of Berkshire Hathaway. To invest like Warren Buffett, you need to be Warren Buffett.

A video of Alice Schroeder speaking about Warren Buffett

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1. Warren Buffett and You

The price / earnings ratio is probably the most famous and most used financial ratio in the investment world. It is calculated by dividing the price of a stock by its earnings per share for a twelve months period. For example, a stock trading at $ 10 and having achieved $ 0.50 in earnings per share over the last twelve months will have a price / earnings ratio of  20 (10 / 0,50 = 20). While it is fairly simple to calculate, its interpretation has many subtleties. Here are some that must be taken into account to determine if the price / earnings ratio for a stock is attractive or not …

1. It’s relationship with future profits growth

Usually, the p/e ratio reflects the expectations of earnings growth for the coming years. A company for which the market predict 20% annual profit growth should  trade at a p/e ratio around 20. A stock with low growth prospects will have a low p/e ratio. A common mistake is to consider every stock having a low p/e ratio as a bargain. Some of these stocks may be bargains but most deserve their low p/e ratio because of their the lack of net income growth. Another mistake is to overestimate the future growth of a company and thus purchase  it’s stock at a p/e ratio that is way too high. We must also avoid to stupidly extrapolate past growth into the future (the past is no guarantee of the future).

2. It’s relationship with balance sheet

If the p/e ratio is based on future profits growth, the materialization of this growth depends largely on the financial flexibility of the company. Take the example of two companies (companies A and B) which are both promising a 20% annual profit growth for the next five years to their shareholders. Company A is heavily indebted, while company B has no debt and has ample cash. It is clear that company B is much better positioned to achieve its growth objectives and deserves a higher p/e ratio than company A.

3. It’s relationship with interest rates

The average price / earnings ratio of  stocks depends on the interest rates. Investors are willing to pay a higher multiple for company net income  when interest rates are low and vice versa. In general, the p/e ratio of a diversified stock index like the S & P 500 should have an inverse reltionship with interest rates. For example, if interest rates are 5%, the p/e ratio of an index like the S & P 500 should be around 20 (1 / 0, 05 = 20)

4. Profits visibility deserve a premium

Stocks of companies with good profits visibility are generally traded at higher p/e ratios. Profits visibility is the confidence that profits will be there in the years to come and will not suffer significant decrease. This characteristic is found mainly in large companies with strong competitive position such as Coca-Cola or Johnson & Johnson. Because of their profits visibility, these stocks are generally traded at a p/e ratio higher than their growth rates.

5. Be wary of cyclical businesses

Beware of p/e ratios of cyclical businesses. These ratios are often very low at the top of the cycle and very high at the bottom of the cycle. The reason is simple: markets do not give high profits multiple to cyclical stocks at the top of a cycle because they anticipate that their profits will decline in the coming years. On the contrary, the same stocks will be awarded high p/e ratios at the bottom of a cycle because the market anticipate that the sector recovery will generate strong earnings growth. A common mistake is to believe that a cyclical stock with strong earnings in recent years and trading at a low p/e ratio is a bargain. More than often, it means that we are close to the top of the cycle and the stock is ready to ride the downward slope of it’s sector …

6. Profit quality matters

The profits quality depends on how a company makes its profits. Are the profits resulting from conservative and prudent management or are they the results of  high-risk / high-reward bets? In my opinion, profits generated by conservative management deserve a better multiple than profits resulting from riskier business. Always remember that profits reaped from risky business can disappear overnight if something goes wrong…

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1. The Thirties
2. Life and death of a growth stock
3. Is Potash stock too expensive ?

1. Description Fortress Paper (FTP - TSX) is a Vancouver company that specializes in the production of security papers (banknotes, passports, visas) and non-woven wallpaper  (the wallpaper that peels off easily). Although the company is Canadian, all of its operations are located in Europe. The production of security papers is done at the Landqart mill in Switzerland and the wallpaper production takes place at the Dresden mill in Germany. The company was created from scratch in 2006 by canadian businessman Chad Wasilenkoff when it took advantage of the rationalization of a company called Mercer International to purchase the paper mills of Landqart and Dresden.

2. Past Performance

The company became public in June 2007 through an IPO on the Toronto Stock Exchange of 5 million shares priced at $8.The stock is currently traded around $11 and the company never paid any dividends or made shares buybacks.

3. Some figures

The company revenues for 2009 are estimated at 200 million Cdn and net income is estimated at $1.10 per share. Hence,  the stock is traded at a price / earnings ratio of 10. The balance sheet is healthy with 31 million of debt and 28 million in cash. Book value per share  was $8 at September 30, 2009.

4. What distinguishes Fortress

The crown jewel of the company is without any doubt its banknote printing activities. Despite its appearance, the paper money is a product with high technological content (some banknote have more than 30 security features) that can be sold with high margins. Barriers to entry are significant, because it is a sensitive area where customers (sovereign states) are very reluctant to try new suppliers. The Swiss paper mill of Landqart has been well established as a producer of banknotes for decades.

5. Growth Prospects

Fortress Paper will expand its Landqart mill in 2010 (the completion is scheduled for January 2011). Specifically, the company plans to invest 50 million in order to quadruple the production capacity. This major investment could double the net income of Fortress according to some analysts. The company justifies this expansion by strong demand for its security papers. The firm was even forced to politely refuse customers in the last year. Fortress is already pre-selling its future production. In addition, the company does not exclude the possibility of making acquisitions if attractive opportunities arise in the field of security papers.

6. Risks

The paper machine rebuild in order to quadruple production could experience technical difficulties and delays. However, the company has successfully managed similar operations in the past. The non-woven wallpaper business could face increased competition in the coming years as competitors convert their production to this new type of wallpaper.

7. Conclusion

Currently trading at a PE of 10, the company seems significantly undervalued given its growth potential and the fact that it went through the recession without much damage. The market seems to give Fortress a multiple similar to traditional paper producers (a declining industry). Yet, Fortress security papers are niche products with high margin and value-added technologies that deserves a multiple closer to technology companies. The stock could be worth much more in two or three years from now if the company is successfull with  its expansion plan. The current share price of $11 seems to be a good entry point.

For more information:

A Powerpoint presentation of the company

Portfolio manager Irwin Michael’s opinion on Fortress Paper

Related posts:

1. Riding coattails
2. A castle under siege
3. Is Potash stock too expensive ?

The high government debt load and monster budget deficit  are scaring many people right now. This is unquestionably the number one fear of investors and the argument most often invoked to justify an imminent fall of the stock market. For a lot of people, it is completely illogical to have used excessive debt to fight a crisis caused by… excessive debt ! They said it would have been better to purge capitalism by allowing irresponsible companies and individuals to go bankrupt.

This is exactly the advice that U.S.  Secretary of the Treasury Andrew Mellon gave to President Herbert Hoover in the days following the crash of 1929. Here is it’s most famous quote:

Liquidate labor, liquidate stocks, liquidate the farmers, liquidate real estate … it will purge rottenness out of the system.

Despite his misgivings, President Hoover eventually followed Mellon’s advice since it was the most popular way of thinking back then. Interest rates were increased and therefore the government restrained spending to balance its budget. Rising interest rates had also intended to protect the gold reserves of the Federal Reserve. At that time, the U.S. dollar was convertible into gold at a fixed price. The high interest rates then incited people to keep their investments denominated in U.S. dollars rather than convert them into gold (and thus empty the gold reserves of the Fed).

The result of this monetary policy was a total disaster! Ten years of misery and poverty that had a traumatic effect on the mind of several generations. The election of Franklin D. Roosevelt at the end of 1932 led to a 180-degree turn in monetary policy, but the damage was already so great that it was not until the end of the decade (and the beginning of an horrible war) that we got out of the doldrums.

With this historical perspective in mind, it is very easy to understand why central bankers around the world have adopted an approach diametrically opposed to that of the Hoover administration. The Fed chairman, Ben Bernanke (himself an expert of  the 30s), certainly did not want to repeat the same policies that led to the Great Depression. A common conception is that man does not draw lessons from history. Fortunately for us, this is not always the case.

Related posts:

1. The subtleties of the P/E ratio