MARKET WRAP -3 / Weekend Investing Commentary-Reviews 12/11/98
This JCP Wasn't A Pool Of Plenty
By DAN HEALING, Edmonton Sun
Four years ago, Michael Mabey was an Edmontonian with a tiny business, slowly building a market for a fire resistant coating formula he'd brewed up in his garage.
Today, he's lost the rights to his invention, is working as a salesman and is worried about how he's going to pay for his daughter's university fees next year.
He's had to re-mortgage his house (and garage) after losing a court case brought by a bank over a promissory note. He estimates he's owed thousands of dollars in wages which he has little hope of recovering.
What happened?
Mabey sold his rookie company, Marathon Coatings Technology Ltd. of Edmonton, as the major transaction of a junior capital pool (JCP) on the Alberta Stock Exchange.
JCPs are the opposite of a conventional stock play. Instead of putting money into a company, investors put up to $500,000 into a "pool." The manager then has 18 months to buy a company which will hopefully generate a return for investors.
The ASE itself admits: "Disclosure and listing requirements for JCP issuers are substantially less than for other categories of companies at the time of listing."
Most people who buy stocks know that JCPs are high-risk investments. What isn't as well-known is that they can also be high-risk ventures for the companies they pursue.
Marathon Coatings became the major transaction for CTC Crown Technologies Corp. in the fall of 1995.
In a release at the time, CTC president John Tansowny noted the purchase would be paid for via 1.3 million shares, if the company made $650,000 in the following year.
"Their contribution is the business plan," he told The Sun then. "If they deliver on the plan, we deliver money to run the company and do the marketing."
He said he would grow the business from $500,000 in annual sales to $2 million by the end of 1996.
CTC went on to buy two Edmonton software companies Syscom Group Inc. and MotionWare Technology Inc. (CTC placed the latter into receivership a mere six months later, claiming it wasn't viable.)
Mabey was retained as president of Marathon, initially. He claims he was later fired after he complained to regulators that CTC's promised funds were not forthcoming.
In August of 1997, CTC was suspended from trading on the ASE due to failure to maintain requirements of listing. Last March, CTC was delisted from the ASE for the same reason and hasn't traded since.
In October, the Alberta Securities Commission found CTC, Tansowny and a director had failed to provide plain disclosure of material facts in a prospectus and had made an untrue statement of material fact in an offering memorandum.
Tansowny was ordered not to trade in securities or become a director or officer in any Alberta issuer for 18 months. CTC is now an inactive company with no employees or prospects.
Mabey is understandably bitter.
Asked what his advice is for others, Mabey says: "Don't buy a stock on the ASE for ANY price because there's nobody there to keep an eye on it."
Bryn Harman, listing analyst with the ASE, admitted bad things can happen with JCPs. But he insisted there are lots of warning signs.
"It is a very speculative investment ... there is a really high element of risk.
"Just because a company completes its major transaction, it doesn't mean that risk goes away. At the time of the major transaction, you may have a company with a half million in net tangible assets. Maybe they only have a couple grand in working capital.
"A company at that stage is going to be speculative."
He agreed, however, that by the time securities regulators know there's a problem, it's often too late. Companies have six months after their year-end to file an audited annual report.
Harman said many JCPs have worked out. Indeed, of the 1,000 filed since 1986, just 49 failed to make a major transaction before deadline and 801 were completed. The other 150 JCPs are actively looking to deal.
Harman said about 100 former JCPs are now trading on the Toronto Stock Exchange and another 40 are on other senior exchanges.
(Oddly enough, the ASE doesn't appear to track how many JCP companies have failed after their major transaction.)
Mabey's second bit of advice is timely for anyone being courted by a JCP manager.
Get a good securities lawyer. And don't sign anything without him. Anything.
What The Accountants Can Teach Investors
Saturday, December 12, 1998
Andrew Willis - The Globe & Mail
When buying a used car, it's smart to get a mechanic to look under the hood for potential problems.
When buying a stock, it's handy to have an accountant take a glance at the company's books and point out trouble spots.
In theory, one company's financial statements should follow the same basic principles as another -- that is, generally accepted accounting principles or GAAP. But in reality, some executives approach accounting the way the NFL's Oakland Raiders approach football. They play dirty, break rules and don't worry about being hit with the odd penalty flag.
As Raiders' fans know, an aggressive strategy wins the occasional championship. However, in the market, aggressive accounting invariably comes back to haunt a company. Accounting problems are at the centre of scandals that knocked back stocks such as Livent, Philip Services and, for those with longer memories, National Business Systems.
Accounting professors are the first to admit that GAAP is a flexible standard; they earn a living teaching students how to sift through the numbers. Calls to the accounting departments at three business schools produced a checklist any investor can use when pouring through a company's annual reports.
First, recognize that even though an accounting firm has signed off on the report, it can still contain a multitude of sins.
"When a company's numbers are audited, people assume they are safe. They should realize that the numbers may not reflect reality," said Al Rosen, a York University accounting professor. He explains: "The rules set out in GAAP are so wide that you can work all sorts of scams."
Rather than looking at the numbers themselves, accountants tend to look for the underlying philosophy of a company -- aggressive or conservative -- when considering whether to invest.
"I try to understand a company's accounting policies, and I'll go through reports and list any changes they've made over time," said Morley Lemon, director of the school of accounting at University of Waterloo. "If my list shows everything the company has done served to enhance income, I'd be deeply suspicious."
For example, Mr. Lemon says he watches for companies that extend the amount of time they use to depreciate assets, as this will boost the bottom line.
Those who teach the accountants also stress that all the important numbers might not show up in a company's statements.
"I challenge students to find what's not reflected in the numbers," explains Barbara Sainty, a professor at the University of Western Ontario's Richard Ivey School of Business. "For example, you don't see frequent-flier points listed among an airline's liabilities, or the free points a shopper earns with a retailer, but the potential cost is real."
Mr. Rosen is late in a career spent studying, and profiting from, accounting nightmares that include the likes of Philip Services and NBS. He has arrived at three basic red flags that show up in an aggressively run company's financial statements. The warning signs are:
Expenses that get added to assets.
Liabilities that aren't reflected in revenue.
Disclosure in notes to the statements that isn't adequate.
Expenses are deducted from income in an ideal world. But executives may avoid this practice, which hurts profits and stock prices, if they can claim that the expense builds the company's future earning power. Research and development spending at a small pharmaceutical firm may qualify. But Mr. Rosen says adding legal fees or employee signing bonuses to a company's assets may be signs of aggressive accounting.
Liabilities that may arise from today's sales, and often go undeclared, would include the cost of product warranties. Another liability that sneaks up on companies is a good that is sent to wholesalers and booked as a sale, only to be returned for a full refund. Taking this approach to software shipments caused all sorts of trouble for Corel Corp. and its shareholders.
And when it comes to disclosure in notes, accounting professors say one area that Canadian companies are struggling with is how to reflect the potential future costs that will come from lawsuits.
Four Ways To Measure Risk In Your Stock Picks
If the leaps and dives of your stocks leave you in a cold sweat, my risk system can help you choose stocks you can live with.
By Jim Jubak - Microsoft Investor
I've invented a new system for figuring out the risk of an individual stock.
However, I don't think the folks in Stockholm who hand out that prize for economics will be sending me a speaking invitation anytime soon. My system is far too fuzzy and emotional, and I'd be the first to agree that it lacks a certain mathematical rigor.
But I like to think that's actually its strength -- I've designed it to be a bridge between the sophisticated, mathematical risk models that Wall Street has invented over the last few decades and the emotional realities of buying and selling stocks as experienced by most individual investors.
Doing something concrete about risk is difficult. Many investors have a general sense of their risk tolerance. For example, I know that given my tender years and the dead certainty that I'll never inherit a fortune, being 100% invested in stocks is my best bet. (To figure out your own risk tolerance and capacity, take our "Risk Tolerance Quiz." moneycentral.msn.com )
I think investors do care about risk
But when it comes down to figuring out the risk of an individual stock, many investors don't even bother. And when they do take some action based on their perception of risk -- selling a stock because it feels too risky after a big jump in its price, for example -- they often do the wrong thing.
I don't think this is because investors don't care about risk. Or because they can't do the math required by a risk measure like standard deviation. Or because they don't understand concepts like volatility.
I think investors understand the tools Wall Street has invented to figure out risk all too well -- and that's the problem. Individual investors understand that these techniques don't give them the information they need for the way they invest.
For example, on Investor I can look up beta -- a very common measure of volatility -- for both General Motors (GM) and America Online (AOL). General Motors has a beta of 1, which means that the stock rises or falls $1 for every dollar that the market as a whole moves. America Online has a beta of 2, which means its stock will rise or fall twice as fast as GM's in the same market.
Standard deviation will help you figure out what kind of returns you can expect from each stock. General Motors has a standard deviation of 25.96. Assuming the future resembles the past, that means that two-thirds of the time, the stock will return its average of the past three years (18.6% in GM's case) plus or minus 25.96 percentage points. So odds are that a GM investor is looking at a range of returns somewhere between a 7.36% loss and a 44.56% gain.
With its standard deviation of 56.38 and an annualized return over the last three years of 86.2%, odds are that America Online will return something between 29.78% and 142.58%.
The risk numbers say that I should buy America Online instead of GM -- the extra return is worth the extra risk.
The trouble is, I'm a flesh-and-blood investor with real emotions and fears. Can I hold on through the bad days that I'll suffer with America Online to reap that extra reward? Or will I jump out of the stock at exactly the wrong moment? And what about the other one-third of the time not covered by the standard deviation numbers? How much more can I lose in either stock? And can I stand that loss without doing the wrong thing?
My risk system is designed to answer questions like these. Each of my four measures is based on a rigorous and well-tested Wall Street risk tool, but I've then tried to apply it to the key emotional question that actually drives investing behavior for most of us.
Risk measure 1
What's a stock's short-term volatility?. I'm really only interested in one part of a stock's volatility -- what Wall Street calls downside volatility. Big upward jumps in price don't scare me. It's the big drops that might drive me to the sidelines.
The sizes of stock drops that terrify one investor seem all in a day's work to another. So it's important to figure out exactly what kind of drop you can expect day-to-day from a stock. (The best way to do this is to study the stock's price history chart to get a sense of the size of a typical drop.)
Past year price movement of MCI Worldcom
For example, does a $10-a-share collapse in a day terrify you? Then Yahoo! (YHOO) isn't a great pick for your portfolio. The stock fell $14 on Aug. 31, $16 on Oct. 1, $10 on Oct. 7, $10 on Oct. 8, $11 on Nov. 11, and $24 on Nov. 30. For you, the fact that Yahoo! was up 176% during that period is irrelevant. You would have jumped out of the stock on one of these days -- with a sizable loss.
MCI WorldCom (WCOM) would be a much better stock for a jumpy investor. The biggest drops I can see on the stock's chart during that same period are $2.25 on Sept. 15 and $3.50 on Nov. 11. Sure, MCI WorldCom is up only 54% during that period -- one-third of Yahoo!'s gain -- but a jumpy investor would have been able to stay with the stock to reap the return instead of bailing out.
Risk measure 2
What's a stock's historical long-term volatility? OK, so $10-a-day price moves in Internet stocks don't scare you. What about a longer and deeper downturn? Find the biggest three-month drop in a stock and see if you can live with it. (Again, eyeballing a stock's price history chart is the best way to get a handle on this measure.)
Past year price movement of Tellabs
Take Tellabs (TLAB), for example. On July 20, the stock was trading at $89. In the days that followed, as the company's proposed deal with Ciena (CIEN) looked worse and worse to investors, the stock tumbled. $70… $60… $50… $40… And finally the bottom: $33.50 on Oct. 6, about two and a half months later. The stock still hasn't recovered to that July high, but it's well off the low, trading recently at $68.94 and, in my opinion, headed higher.
Over the course of a year, I think this position will yield a sizable gain. But to see that gain, you'd have to hold on through the pain. Could you?
Risk measure 3
What's a stock's potential long-term volatility? Sometimes you can judge a stock's long-term volatility from the historical record. Dell Computer (DELL), for example, hit a long dry spell in 1993. From a high on Jan. 26, 1993 the stock fell 68% by July 14. The stock didn't fully recover to the January price until April 1995 -- more than two years later. Since then, the return has been a little better than OK -- 4,760%. That's right -- up nearly 5,000% from a split-adjusted $1 and change per share.
But an extended bad spell like that is potentially present in all stocks, and often a stock's history won't pick up that potential risk. Wall Street recently has invented a new risk tool called "value at risk" to measure a potential downdraft. The idea is to generate likely future scenarios -- Russia defaults, for example -- and see how big a loss the position might take under each set of events.
Most individual investors can't reproduce the complicated scenarios that Wall Street uses -- anybody out there know what the effect of a collapse in the yen would do to Cisco's earnings per share? But we can do a couple of quick tests.
One that's especially useful for stocks with high price-earnings ratios is to calculate what the stock's price would be if the P/E ratio were cut in half. That isn't quite as bad as what happened to Tellabs, where the ratio went from 51 to 18, but it's bad enough to give you a taste of the unpleasant possibility.
Test Broadcom (BRCM) this way, for example. The stock, a Jubak's Pick, recently traded at a P/E ratio of 119 times projected 1999 earnings per share. If that ratio dropped to a still hefty 60, the price would fall to $54 from a recent $107. Do you believe in the future of this stock enough to sit through that kind of tumble? If not, you belong in a different stock.
I recommend running a fundamental test as well, especially if you invest in small-company stocks or stocks in depressed industries. The thought of a stock dropping from $100 to $50 is gruesome enough, but it's not the worst-case scenario. You could actually lose it all. Stocks do become worthless. What's the chance of that happening to any stock you own or are thinking about buying?
For a Jubak's Pick like Advanced Fibre Communications (AFCI), this is a real possibility. The company still hasn't replaced its CEO. Insiders, including the acting CEO, have been selling heavily, and sales still aren't back on track. On the plus side, the company is still profitable, has no short- or long-term debt, and, in the September quarter, showed a sizable hunk of cash in the bank. The likelihood that Advanced Fibre will go out of business before the company gets its problems fixed seems low, but I certainly wouldn't be risking my kids' college tuition money on this stock.
Risk measure 4
What's the chance that a stock won't get me where I need to go? I admit this isn't a question that normally crops up when investors discuss risk. But I think it should. To my mind, there's not much difference between investing in a stock that falls, leaving you short of your financial goals, and one that performs exactly as expected and still leaves you short of those goals. You can't pay the bills with consistency.
Standard deviation will tell you how likely it is that a stock will do the job you need from it. For example, let's say you've diligently completed your Retirement income calculation on MoneyCentral. You've saved as diligently as you could, but your first job out of college didn't pay very much. So you didn't start saving very much until you were 33. The truth is, the worksheet says, you need to earn 12% on your money in order to retire comfortably.
A 12% annual return may not be possible going forward. A lot of investment experts predict that returns from the stock market will go back to an annual 8% or so after the higher-than-average returns of the last few years. And in any event, it's certain some stocks are far less likely than others to put 12% in your pocket.
Let's put General Motors to this test. Near the top of this column, you'll remember, we calculated that there was a 2/3 chance that the annualized returns from General Motors, based on the stock's history in the last three years, would fall between -7.36% and 44.56%. The potential returns are certainly weighted toward the positive, but there is still a significant chance that this stock won't get you where you need to go.
Exxon (XON), another blue chip, looks like a better bet. The stock's annualized return over the last three years is 31% and its standard deviation is just 14.04. That puts the potential return -- two-thirds of the time -- between 17% and 45% a year.
This measure can also help you reduce unnecessary risk. If you need a 12% return to retire reasonably well, then I can't see any long-range financial planning reason for investing in stocks that promise 60% returns but that also could take a 20% bite out of your nest egg. You just don't need to take on that much risk.
Consider an investment in Micron Technology (MU), for example. Let's give the stock the benefit of the doubt and assume that performance will bounce back from the 6% annual return of the last three years to something like the 48.3% annual return of the last five years. The stock's standard deviation (using that five-year period now) is 67.51. That means -- with two-thirds likelihood -- that your expected annual returns on this stock range from a 19.2% loss to a 115.8% gain. Micron, it seems, comes with the promise of dazzling returns far higher than you need, coupled with a potential for loss that could put a real crimp in your strategy. (Unfortunately, Investor doesn't carry standard deviation numbers. You can get a feel for a stock's deviation by studying its chart. The statistics are also available from sources such as Value Line.)
I think this last measure also gives you a framework for starting to put all this data together. In the process of thinking about how much return you need, according to the financial plan you've built, you'll also be considering how much each extra dollar of return is worth to you.
When head and heart disagree
Obviously, some stocks carry so much risk -- by one of these personalized measures or another -- that they don't belong in your portfolio, no matter what the potential return. You won't be able to live with them long enough to reap the long-term returns they might deliver. They just aren't right for you. Forget about them.
Other stocks may offer you a decent trade-off. Nothing about them seems like a deal breaker; none of the risk measures is so high in comparison to your risk thresholds that you'll dump them at the wrong moment. And they promise enough potential gain to make the pain seem worthwhile.
I know that's fuzzy. But I think any risk system has to be if it's to have any chance of actually working. It's impossible to take emotions completely out of investing -- at least it is for anyone I know. The best that we can do is understand our own fears and hopes and then try to pick stocks that won't put us in emotionally impossible situations.
It's really tough to make money in the stock market if your head and heart are headed in different directions.
Picking up on telecom mergers
Finally! On Dec. 8, Tellabs announced the long-awaited first customer for its new ATM voice/data switch. Tellabs valued the multi-year deal at more than $100 million. But the amount is less important than the vote of confidence that this gives to the company's new product line. The stock climbed about 20% between rumors that the deal had been inked and the announcement itself.
The real winner of the AT&T deal
Broadcom rammed through my March 1999 price target of $102 and kept charging. On Dec. 9, the stock climbed as high as $118 before closing at $107.125, a gain of $6.38 on the day. That prices the stock at a rather amazing P/E ratio of 119 on projected 1999 earnings. Still, influential chip analyst Mark Edelstone recently raised his price target to $130 a share and I know many investors believe that Broadcom is a "must-own" stock for anyone who wants to profit from construction of the next-generation communications system in the U.S. So I'm going to hold onto the stock for a few days while I figure out if there is such a thing as a "must-own" stock. See my Dec. 18 column for my answer.
Picking up on telecom mergers
I'm lowering my price target on Advanced Fibre Communications. While this stock is now very cheap (much more so, unfortunately, than when I added it to Jubak's Picks), I'd say it's for gamblers only. Most worrying is heavy selling by Donald Green, company founder and acting CEO. If the company can sign a contract with one of the regional Bell companies, the stock could well double. Absent that deal, I'd expect only a very gradual recovery as the company begins to rebuild revenue and earnings growth in the second half of 1999. My price target is now $15 a share for October 1999.
Jubak's Picks
Check out Jim's top stocks for the next 12 months.
moneycentral.msn.com
Jubak's 50 best stocks in the world
I think these 50 stocks have a good chance to outperform the market with less than market risk. That's a tall order, but each company here is set to take advantage of our increasingly global economy and has a sustainable competitive edge in its industry that should keep earnings growing over the next five years at rates higher than analysts now predict.
In contrast with Jubak's Picks, which are stocks I plan to follow for a 12-18 month period, this portfolio is designed for long-term buy-and-hold investors who can keep these stocks for at least five years. My Buy ratings are based on my estimate of an attractive entry price for building or adding to a position.
The rest of the stocks on this list are holds -- great stocks that I'd buy on any significant dip. I don't list sells -- when a stock becomes a sell I drop it from the portfolio. I update my recommendations on or about the first of each month.
moneycentral.msn.com
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