MARKET ACTIVITY/TRADING NOTES FOR DAY ENDING MONDAY DECEMBER 15, 1997 (2)
What's on Managers' Minds
Gary Lamphier Vancouver Sun
With 1998 dawning and the North American bull market well into its eighth year, stock market pros who have enjoyed big gains in recent years find plenty to fret about.
Topping their list of worries are lofty stock valuation levels, signs of slowing corporate profit growth, Asia's recent economic implosion and the slumping Canadian dollar.
As always, investors are wondering what lies ahead. To help them formulate a plan, The Vancouver Sun unveils its inaugural Investment Roundtable Forum.
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The Forum took place over a two-day period in the Sun's boardroom in early December, and consisted of two separate investment panels. One was composed of Vancouver based money managers, the other local research analysts.
Investment reporter Gary Lamphier asked the pros to share their views on equities markets, and spotlight some of their current stock picks.
This is the first of a four-part series that flows from those sessions.
Today's panelists include:
Wayne Deans, Canada's 1996 mutual-fund manager of the year and a partner at Deans Knight Capital Management, with $2.5 billion of assets; Tony Massie, a money manager at Global Strategy Financial Inc. who oversees $2.5 billion of mutual fund assets; and Bill Wheeler, president of Leith Wheeler Investment Counsel, which manages $2.6 billion of pension fund and other assets.
Lamphier: What are the big issues on your minds in the waning days of 1997?
Wheeler: It's the valuation issue. There isn't a lot of room for much to go wrong with these levels of value in the market. Specifically the U.S. market, when it trades around 24 times earnings.
Those earnings reflect strong sales growth, a strong economy, big pre-tax margins and a lower tax rate. You have the things that make for good earnings already there.
Lamphier: Wayne, would you agree?
Deans: Yeah, the biggest issue that I face right now is [high] valuation levels.
Bill mentioned the S&P 500's price-earnings ratio is now around 24 times. I looked at the TSE 300 at the close of business [Dec. 1] and it was 23 times.
But here's a wild one for you. If you look at the TSE 200 -- which is the 200 smaller companies in the TSE 300 -- it has out-performed the TSE 300 for the last year. Do you know what the P/E ratio is for TSE 200 as of [Dec. 1]? It's 41 times.
That implies earnings for the companies in this index are going to double about every two years, which means that the size of those companies on average will double every two years. That is absolutely impossible.
Lamphier: Tony, are high stock valuations worrying you?
Massie: I don't follow the market as a whole. I'm more concerned about individual stocks and buying a stock in context with the market.
Then you look at yields on bonds. I see the yields are at 5.5 per cent on a 10-year bond, so then I try to find a company that can beat that return.
Now, there's a lot of liquidity out there and valuation levels are at way higher levels than possibly they should be. With the excess of liquidity, it's very difficult to determine what value a stock should trade at.
Lamphier: Your big positions are in stocks like Canadian Pacific EdperBrascan and Atco. Have you seen valuation levels for these big-cap, senior Canadian stocks rising?
Massie: They're still rising but they also have a rising earnings stream as we go into 1998, so I'm quite happy to live with them.
They all have excellent balance sheets, so they look a lot better than a lot of other stocks out there. I do have a smattering of banks as well, such as TD.
Lamphier: Before we get into specifics, I'd like all three of you to describe your investment philosophy, so readers will have some idea of how you find attractive stocks. Wayne, can you start?
Deans: Our philosophy is directed towards small and mid-cap stocks, so the banks aren't in our universe.
We're very specialized. We have basically eight qualititative screens that we look at first. Then we apply value screens to those companies to determine whether or not we're paying a fair price.
An example that comes to mind is Cinram. It's a terrific little growth company, but it shows how valuations have changed over the last three years of this bull market.
We bought it at $8 a share in October 1994. It had demonstrated a 10-year annualized earnings per share growth rate of 40 per cent and it earned 81 cents in 1994. So I paid roughly 10 times earnings.
Cinram's total market capitalization was $185 million and it had revenues of $145 million, so I paid 1.3 times revenues.
Now, fast-forward to today. The stock trades at about $50. It will earn $1.40 this year, so it's trading now at 36 times earnings, which is pretty close to its 10-year growth rate. It trades at a market cap of $1.5 billion on $500 million of sales, or three times sales.
Now, I don't know what the word expensive means. I only know what it means in relative terms. But almost all the companies I own today are more expensive than they were.
Lamphier: Wayne, getting back to your investment style, you're saying you looking for growth stories you can buy at a discount to their growth rates?
Deans: Yeah, and they don't exist today.
Lamphier: Tony, can you describe your investment philosophy?
Massie: I'm a value investor. I like good balance sheets and I like to consider the macro environment first, then bring it back down into the Canadian equity market.
I try to look at what could go wrong. So I look at all the negatives, and I invest on that basis. That way I won't get surprised.
Lamphier: Is there a stock you own that illustrates this?
Massie: I've liked Canadian Pacific over the last while. And I've liked EdperBrascan and Atco. If the world economies are growing and don't come to a full stop, they'll do fine.
If you don't expect the world economy to be that strong, you try to look for stocks that will benefit more from the local economy. So I try to bring those things into my investment style as well.
Lamphier: Bill, can you give an introduction to your investment approach?
Wheeler: It all starts with a view of interest rates. So we look out over a three year time horizon and say, what kind of returns do we think we can get from the fixed-income market?
For each stock we look at we build a target board three years out, with an expected rate of return. If we can't see an expected rate of return that exceeds what we can do in the fixed-income market, we'll stay in a fixed-income vehicle.
Lamphier: So the key factor is interest rates?
Wheeler: That's a big part of it. So to buy a stock, the more risky it is, the bigger the premium you need over what you can get in the fixed-income market.
If you're looking at a utility, you'd accept a lower rate of return than you would in a highly-cyclical stock where risks are higher. That's where we start.
The way we go about it is, we have four people in the firm who do Canadian equity analysis. We take a bottoms-up approach, and we're pretty strong value investors.
We talk to the competitors, and each analyst has an area of specialization. We bring it back to building a book on the company, complete with a range of target prices over three years.
Lamphier: So you're more value-oriented than growth-oriented?
Wheeler: Yeah. I'd say we look for companies where the stock price seems [lower] than the [fair] valuation.
All of us are trying to do that. But Wayne's focus is on smaller companies. Ours goes right across the spectrum. We own the banks and big-caps too.
The ideal stock to me is a company that has a cloud over it for some reason. There is something that the market doesn't like, and we have a different perspective on it.
Some of the things we look for are companies in depressed industries that are good, low-cost producers that are well run, where we have confidence in management.
Lamphier: How about a current example?
Wheeler: Tembec. It's in the forest industry. Commodity prices are down. People are worried about economic growth rates because of what's happened in Asia, so these stocks are all down.
Tembec has a $12 book value and trades around $8. It's profitable, a good operator, and has a decent balance sheet.
The swing factor is pulp. They also produce lumber, newsprint and specialty papers, but the swing on the earnings side is pulp.
Lamphier: What about Inco? It's a big player in nickel and a low-cost producer. The entire company is now worth less than what Inco paid for Voisey's Bay. Is Inco's stock on your hit list?
Wheeler: We don't own them, but it's a subject of discussion. Inco would be on the radar screen. We own a little Teck too, but we bought it a little early.
Lamphier: Wayne, what are the characteristics you look for in growth stocks?
Deans: One of the most important characteristics is to try to find a company that has a competitive advantage.
The reason I owned Diamond Fields Resources was that there was a reasonable probability it would emerge as the world's lowest-cost producer of nickel. To me, that's a competitive advantage.
Now it isn't always a cost advantage. You can be the sole supplier. Or if you have a patented product, you could have some kind of monopoly on a technology.
Getting back to what we were talking about earlier, I'm having more trouble buying companies at prices I can feel all warm and gooey about.
Lamphier: Tony, your thoughts?
Massie: Well, everybody's perception is different. Some people want income, some want capital gains, some want a quick return, and others want a long-term growth situation. It just depends on what you're after.
Another reason why the stock market has done so well is that interest rates have been dropping. Today, there's a lot more money that's feeding our equity market, so valuation levels have to reflect that.
As long as that money stays there, valuation levels are going to stay at these levels for another four or five years, maybe.
Lamphier: Tony, you know the gold stocks better than anybody here. What do you see ahead? I'm not asking for a price forecast, but what is your perception of market psychology, and where it's headed?
Massie: Investors always live in hope, especially on the gold side. They're always hoping gold will go to $800, and they pay a premium for gold stocks because they expect them to do well in the future.
In the past, an awful lot of money flowed into that area. We all kept on buying one another's stocks until it became absurd. Then we had the Bre-X thing.
Lamphier: Bre-X? I think I've heard of that stock. Was the Bre-X disaster a watershed for the gold market?
Massie: It was going to happen anyway. It just pushed it ahead by three or six months.
Lamphier: But was it a trigger that helped investor psychology turn negative toward golds?
Massie: Not really. It was going to happen ultimately anyway. As for the oils and the base metals, I think efficiencies are having an impact, and there's just too much inventory around. So that's going to affect earnings, and people are scared. So I've stayed out of that area, basically.
Lamphier: So how do you buy gold stocks in this environment?
Massie: You buy the high-quality names and you get rid of anything that's going to use up capital. We have a Gold Plus fund, so we can use the "plus" part of the portfolio to buy some oil and gas, some diamonds and other stocks, and hope we can generate a return on that until gold bounces back.
Wheeler: Personally, I think gold will maintain its role as a store of value. There's 2,000 years of history and it isn't going to go to $35 an ounce. But I don't think you can find a logical argument why it should be at $350 or $450 or $250.
Lamphier: What are your views on the Asian situation? Is this a long-term workout that might take two or three of four years to play out, or will it be just another blip?
Deans: I think we spend too much time worrying about it. I don't know what's going to happen in Southeast Asia. I don't know what the effect of these massive bailouts will be. So I've stopped trying to figure it out. I focus on what I can see, which is the price of companies I want us to buy.
Lamphier: But on the commodity side, isn't it important for you to know what the effect will be on zinc, copper and other metals?
Deans: We don't know what the effect will be, Gary
Lamphier: Bad.
Deans: Well, you're telling me it's bad. But that's conventional wisdom. It's already been bad. Is it going to get worse? I don't know.
We're seeing extreme price levels in a whole bunch of commodities. That's usually the time to buy.
Now, I'm not a cyclical player. That's not why I buy resource stocks. It's not based on my view of commodity prices. None of us can predict these things. [Barick Gold's chair] Peter Munk wouldn't have bought Arequipa Resources from us at $30 (Cdn) a share after we paid $4 for it, if he knew the price of gold was going to go from $415 US to $290. And he runs the most profitable gold company in the world.
So let's get realistic. We're talking about things we know nothing about. What's going to happen to the price of zinc? Who know?. If I did know, why would I tell anybody?
Anybody who tells somebody doesn't know, they're just guessing. So, deal with what you know.
Lamphier: So if mineral deposits that were worth a lot of money two years ago are worth a lot less today, does that mean this is a good time to buy selective resource stocks?
Deans: It's a better time, not necessarily a good time.
I remember writing to all our clients back in June 1996, and we said this is a pure speculative bubble going on among junior exploration stocks, fed by [takeover deals such as] Arequipa Resources, International Musto, and Diamond Fields Resources.
Things became ridiculously over-priced. Now, it's swung back the other way. A lot of people are putting forward the doomsday scenario for metal prices, that gold is no longer money.
Well, maybe it isn't. But somehow, I'm not inclined to throw out 2,000 years of history.
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