TSX ENDS FIRST HALF ON A WEAK NOTE

In the last issue (June 20), I expressed wariness about the surge that the stock market was enjoying at the time. I pointed out that the gains on the TSX were confined largely to resources and said that if the key components that make up that sector broke down, we could be in trouble.

Last week, it happened. The S&P/TSX Capped Metals and Mining Index fell 2.92%, the Capped Materials Index dropped 1.44%, and the Capped Energy Index lost 0.91%. Among the key resource sub-indices only gold came out on the plus side with a gain of 0.34%.

Toss in bad performances from Information Technology (-2.87%), Health Care (-2.23%), and Telecoms (-1.57%) and it comes as no surprise that the S&P/TSX Composite Index fell almost 1% on the week to drop back below the 10,000 level where it had resided for a heady two days.

Despite the setback, the TSX finished the first half of 2005 comfortably in positive territory, with an advance of 7.1%. That was far and away the best showing of any North American index. Wall Street’s Big Three (the Dow, the S&P 500, and Nasdaq) are all under water year-to-date while Mexico’s Bolsa, which was blazing hot last year, has gained just 4.4%.

We’re also doing better than the major Asian indices – both Hong Kong and Tokyo are essentially flat year-to-date. The surprise is Europe, which is more than holding its own despite the high euro, the sluggish European economy, high oil prices, and the crushing defeat of the proposed new EU constitution by voters in France and the Netherlands. The Paris market is up 10.7% for 2005, Amsterdam has gained 10.3%, the Frankfurt Dow is up 6.4%, while its London counterpart has added 6.1%. This seems to defy logic, especially with European newspapers full of articles about a looming recession there, but those are the numbers.

So what lies ahead for the second half? Opinions are all over the place. Some highly-respected analysts are warning that not only Europe may be facing recession but also the U.S. as well. The Conference Board reported that in May its index of leading economic indicators dropped 0.5% which their economist, Ken Goldstein, said is an indication the U.S. economy is cooling. However, the U.S. Federal Reserve Board continues to push interest rates higher and has given no indication it will stop any time soon, which clearly shows that Alan Greenspan and company aren’t concerned about a recession in the near term.

Still, we have to remember that the stock market is a leading indicator. Typically, the indexes go into reverse six to nine months before the economy actually begins to stall out. So we need to remain watchful. Irwin Michael believes that there is still reason for optimism, as you will see in his column, but selectivity in stock choices and regular profit-taking remain the keys to success in this environment. – G.P.

IRWIN MICHAEL SAYS MARKETS WILL SAW-TOOTH HIGHER

Contributing editor Irwin Michael joins us for this first issue of July. He has some positive comments about the outlook for stocks in the coming year as well as updates on three of his recommendations. Irwin is the founder and president of the ABC Funds and is widely regarded as one of the country’s leading experts on value investing. Over to him.

Irwin Michael writes:

While the S&P/TSX Composite Index improved 3.1% for the month of June, this performance was not uniform. The increase was largely fueled by energy stocks. For instance, since June 1 Talisman has risen from $41.50 to $45.90 and Nexen has climbed from $32.60 to $37.20. In general, we saw oil and gas share price increases from 10% to 20% during the month. On the other hand, the Canadian chartered banks improved marginally whereas mining and forestry shares declined.

In the U.S., although the Russell 2000 index was up 3.7% for the month, the Dow Jones 30 Industrials was down 1.8% and the Nasdaq declined 0.5%. All three of the major U.S. indices are showing year-to-date declines of 1.7% to 5.4%. Clearly, Canadian equity markets have broken away from U.S. performance with the TSX increasing 7.1% year-to-date.

In spite of the current market thinness and volatility we remain optimistic. While we expect erratic up and down moves in the popular North American equity indices, we believe that they will "saw-tooth" to higher levels over the next 12 months. Our optimism is based on a firm North American economy showing positive growth between 2.5% and 3.5%, contained inflation, improving corporate profits, and a non-threatening interest rate environment.

Once again, we contend that the U.S. equity market is offering numerous undervalued opportunities. We intend to build on our growing U.S. stock positions and will increase our U.S.-country mix to 50% in our two Canadian portfolios as soon as the Canadian budget clears the Senate and receives Royal Assent.

It is our view that the U.S. Sarbanes-Oxley Act, passed several years ago to counteract the Enron, WorldCom, etc. fiascos, is extremely onerous upon corporate America. We believe that numerous small and micro-cap companies will reconsider whether remaining public and complying with increasing securities regulation is worth the cost and effort. We believe that many companies, as a result, will decide to go private, reorganize, or sell out to larger corporations. In consequence, in addition to searching for undervalued U.S. companies, we are at the same time, hunting for those public entities which will benefit from this Sarbanes-Oxley effect.

IRWIN MICHAEL’S UPDATES

CANFOR CORPORATION (TSX: CFP)

Originally recommended on July 2/02 (IWB #2225) at $11.15. Closed Thursday at $14.70.

Strength in the housing sector generated excellent results for Canfor Corporation in fiscal 2004. The company earned $421 million on sales of $4.3 billion in 2004 compared to $86 million on sales of $2.7 billion in 2003. On a per share basis, Canfor earned $3.22 in 2004 compared to 92c the previous year. The vast improvement could be attributed to the company’s lumber operations, where sales increased 84% to $2.9 billion and operating earnings swung to a profit of $412 million from a loss of $5 million. Unfortunately, with several capital projects on the go, the board of directors decided not to declare a dividend at this time.

Looking forward, existing home sales continue to set record highs despite constant fears of a slowdown, which has supported lumber and panel prices. The National Association of Realtors reported on May 24 that existing home sales rose 4.5% in April to a record seasonally-adjusted annual rate of 6.28 million homes, up from 6.01 million in March. On a year-over-year basis, sales activity was 5% above the 5.98 million mark in April 2004. With the U.S. 10-year T-bill below 4% and 30-year fixed-rate mortgages available for roughly 6% in the United States, the Association is forecasting another record year. They are calling for existing home sales to rise 1.6% in 2005 to 6.89 million from 6.78 million in 2004. Obviously, these levels are very supportive for the lumber and panel industry.

We are heading into a period of seasonal strength for lumber and panel prices for three key reasons. First, homebuilders are increasing their inventories in advance of the summer building season. Second, dry weather in British Columbia and the threat of forest fires raises concern regarding availability. Finally, we are just about to enter hurricane season and any damage will bolster demand for lumber and panel products. For these reasons, we look for the shares of Canfor to strengthen along with the commodities over the coming months.

Action now: Hold

DANIER LEATHER INC. (TSX: DL.SV)

Originally recommended on July 7/03 (IWB #2324) at $10.49. Closed Thursday at $10.20.

After a strong run through the Christmas season to a high of $14, shares of Danier Leather have since retreated. For the first three quarters of the current fiscal year, revenue has declined 4% to $140.9 million, compared to $146.4 million last year, and comparable store sales have decreased 5%. Management has pointed to weak consumer spending on outerwear due to unseasonably warm weather in the second quarter and a lukewarm response to the company’s promotional activities. Irrespective of the weaker than anticipated financial results, Danier Leather has maintained its pristine balance sheet. Currently, the company has working capital of $44.8 million and a cash balance of $20.7 million or $3.16 per share.

Given the weak financial results and the ongoing litigation issues, it is quite possible that Jeffrey Wortsman, president and CEO, is losing his taste for running a public company. He recently closed all three U.S. locations, one in New Jersey and two on Long Island. This removes the potential need to access the capital markets in order to fund growth south of the border. Further, the company has been aggressively buying back stock. During the 39-week period ended March 26, some 402,400 subordinate voting shares were repurchased for $4,583,000. This implies an average price of $11.39 per share, well above the current share price. The company has also just renewed its normal course issuer bid to acquire up to 421,061 subordinate voting shares, representing approximately 10% of the public float.

What would it take to privatize the entire company? The Wortsman family owns 100% of the multiple voting shares so they would only have to repurchase the subordinate voting shares. With 5,319,825 shares outstanding, we assume it would cost between $65 and $80 million. After using the cash on the balance sheet, the company would need to add $45 to $60 million in debt to complete the transaction. At today’s low rates, interest payments would amount to no more than $5 million per year. This expense could be easily covered since EBITDA, excluding litigation provisions, has averaged $20.7 million over the past five years. Under these assumptions, the Wortsman family would still make a sufficient return to justify taking the company private. Therefore, we believe that such a transaction would make financial sense for both the founders and current shareholders alike.

Action now: Hold

TECK COMINCO LIMITED (TSX: TEK.SV.B)

Originally recommended on Aug. 6/01 (IWB #2128) at $11.65. Closed Thursday at $41.34.

Copper inventories have hit 30-year lows and prices have hit 16-year highs of US$1.62 per pound. The zinc market is also tightening up, with treatment charges dropping as smelters scramble for concentrate. In consequence, the zinc price has remained firm at around US59c per pound. Therefore, it is no surprise that shares of Teck Cominco have rebounded sharply since mid-May.

In the first quarter of 2005, Teck’s cash balance grew $240 million, to $1.15 billion. The company now has $524 million of net cash after deducting all debt. In fact, Teck recently doubled its annual dividend to 80c per share.

With the net cash position forecasted to grow to $1 billion by year-end, it now becomes a question of what to do with the money. Interestingly, Teck Cominco has just filed a shelf prospectus for up to US$1 billion of debt securities or Class B subordinate voting shares. We recently attended a presentation by the company where they expressed interest in leveraging their open-pit mining expertise and diversifying their asset base. These comments have opened up the possibility of purchasing an interest in an oil sands project, such as the Fort Hills venture in Alberta which is owned jointly by UTS Energy and Petro-Canada. Other possible uses of the huge war chest include a copper or zinc acquisition, a debt refinancing or even a special one-time payout to shareholders. In any event, we will update our readers once the decision has been made public.

Action now: Hold

- end Irwin Michael

WHY WE SOLD AEROPLAN

On June 27, we sent out a Special Bulletin advising members who were fortunate enough to acquire shares in Aeroplan at the IPO price of $10 to sell. At the time, the issue was trading on an “if, as, and when” basis at $11.55. Here’s why we made the call.

When the Confidential Information Memorandum outlining the terms of the offering was distributed to the financial community in early June, it projected an initial cash-on-cash yield of 7.5% to 8.5%. Obviously, both Aeroplan management and the underwriters felt this was a fair and reasonable return for the risks involved.

These documents are supposed to be for internal use only by brokers and institutional investors, but that’s nothing more than a convenient fiction. Brokers use this information to promote new issues to clients and the media inevitably gets hold of the key details. In this case, the high profile of Aeroplan ensured that the anticipated return received wide coverage.

That helped to fuel demand for what was already destined to be a hot issue. Brokers were overwhelmed with orders and eventually had to ration their allotments carefully, with only top-level retail clients getting a piece of the action.

Shortly before the issue was formally priced, Aeroplan and the underwriters decided to take advantage of this situation to raise the ante and pocket more cash for themselves. They announced that the actual cash-on-cash yield would be even lower than the bottom of the originally projected range, coming in at between 7% and 7.25%. In the end, the 7% figure was chosen – big surprise!

This is not the first time this sort of thing has happened, but it raises some serious ethical questions in my mind. Investors placed their orders in good faith on the basis of information that had been provided to them by the underwriters. Yes, they had the option of cancelling once the actual pricing was announced but given the high demand it’s likely that few people actually did so. All this has a faint whiff of bait-and-switch about it and our securities regulators should take a close look at such practices.

Despite the greatly reduced yield, the shares took off from the moment they started trading on the TSX (the symbol is AER.UN). On June 23, the first day they were listed, more than 12.6 million shares changed hands as investors who had been shut out of the IPO rushed to take a position while those who had been fortunate enough to get in at $10 took quick profits. The price touched $11.93 that day before settling at $11.81.

Every day since then has seen lower volume, with 871,200 shares traded on Thursday. This suggests that the institutional investors are sitting on the sidelines and that the buyers at this stage are primarily retail investors who still want to get in the door.

The price has moved back up to $11.80 since we made the sell call, and the shares have traded as high as $11.95. However, I am not making any apologies. At these levels, Aeroplan is just too expensive, at least on the basis of what we know at this time.

At $11.80, the shares are yielding 5.9%. By comparison, Yellow Pages Income Fund (TSX: YLO.UN) is yielding 6.4%, RioCan REIT (TSX: REI.UN) is yielding 6.3%, and Citadel Diversified Income Trust (TSX: CTD.UN) is yielding 8.3%. These are all proven entities with well-established distribution records. It makes no sense to me that a newcomer like Aeroplan should be trading at a significant premium to all of them. Yes, I like the fund and I believe it has growth potential. But investors are already pricing in that future growth, long before we have any reason to believe it will actually happen.

That’s why I advised selling, and why I’m reiterating that advice again today for those who held on. When a security becomes too rich, it is time to take profits and move along. Let someone else assume the risk of buying in at these levels. – G.P.

UPDATES

PETRO-CANADA (TSX: PCA, NYSE: PCZ)

Originally recommended by Gordon Pape on Sept. 23/02 (IWB #2234) at $48.77. Closed Thursday in Toronto at $79.75. Closed Friday in New York at US$67.75.

Petro-Canada moved through our $82 target price on June 27, trading as high as $82.70. It dropped back on the decline in crude oil prices, ending the shortened trading week in Toronto at $79.75. However, the stock moved up US$2.61 on the New York Stock Exchange on Friday, where it trades under the symbol PCZ, ending the day at $67.75. In Canadian dollar terms, that’s about $83.

On June 27, management held a conference call in which the company updated analysts on its situation. The upshot was that despite a production decline in the past two years, due mainly to reduced North African netbacks and mature fields in Syria, Petrocan expects that a number of new projects will contribute significantly to cash flow and profits in the next few years. The company also has a large stake in the Alberta oil sands.

Following the call, RBC Capital Markets issued an updated research report in which it maintained its target of $87 on the stock, which analyst Gordon Gee and associate Mark Polak say represents a 16% discount to Petro-Canada’s estimated 2004 NAV of $103.53, based on NYMEX futures. They also point out that most integrated oil companies trade at or above their NAV.

Nonetheless, I think it would be prudent at this stage to take some profits, especially if you have a relatively large position in the company. Depending in your holdings, I recommend selling between 25% and 50% of your shares for a profit of 73% since our original recommendation, including dividends of $1.40 a share.

Action now: Take part profits. – G.P.

NORANDA INC. (TSX: NRD.LV, NYSE: NRD)

Originally recommended by Gordon Pape on March 30/98 (IWB #9811) at $21. Closed Thursday on Toronto at $21.02. Closed Friday on New York at US$17.84.

Shareholders approved Noranda’s amalgamation with Falconbridge at a Thursday meeting by an overwhelming margin, meaning the two companies will come together under the terms previously announced and reported here.

Ironically, although Noranda is widely seen as the senior partner in the deal, the combined company will go forward under the Falconbridge name. Starting July 6, the shares will trade on the TSX under the symbol FAL.LV and on the NYSE as FAL. However, holders of Noranda common shares will not have to exchange their certificates for new ones. Each old Noranda share will be worth one share in the amalgamated company.

Hopefully, the merger will lead to cost savings that will enhance profitability and improve the return to shareholders.

Action now: Hold. – G.P.

PEYTO ENERGY TRUST (TSX: PEY.UN)

Originally recommended by Gordon Pape on Sept. 22/03 (IWB #2334) at $9.93 (split-adjusted). Closed Thursday at $29.25.

In mid-May, Peyto shareholders approved a two-for-one stock split. The shares started trading at the post-split price later than month and we have adjusted our original recommended price to reflect this. So for every 100 shares you owned, you now have 200.

On May 11, Peyto released first-quarter results. They showed a production increase of 31% from the same period a year ago (27% on a per unit basis), a jump of 37% in per unit funds from operations, and an increase in cash distributions per unit of 40%, with a low payout ratio of 46%.

Investors were especially pleased by the news that monthly distributions are again being increased, this time to 12c a unit (post-split) from 11c previously. At the time of the original recommendation, the distribution was the equivalent of 7.5c a unit, so we have seen an increase of 60% in less than two years.

Members who made purchases at that time are currently sitting on a capital gain of 195% and are receiving a cash yield of 14.5% based on the original price.

Although income trusts in theory are supposed to be static, low-growth enterprises, Peyto is one of an increasing number of exceptions to the rule. The trust spent $99 million on exploration and development in the first quarter and has drilled a total of 42 wells (gross) so far in 2005. Total capital expenditures for 2005 will come in between $260 million and $300 million, which represents a 30% increase over 2004.

We have previously taken part-profits here so I advise continuing to hold your remaining shares.

Action now: Hold. – G.P.

RIOCAN REIT (TSX: REI.UN)

Originally recommended by Gordon Pape on April 20/98 (IWB #9814) at $10.90. Closed Thursday at $20.

RioCan, the largest REIT in Canada, reported record recurring distributable income of almost $69 million (35.8c per unit) for the quarter ending March 31, up 17% from the comparable period in 2004. This was achieved on total rental income of $148 million, an increase of 9% from the previous year.

During the quarter, RioCan redeemed some of its unsecured debentures in order to bring its leverage limit closer to the unitholder approved 60% of aggregate assets. The total cost was $20.5 million, which was fully expensed, resulting in a reduction of both net earnings and funds from operations (FFO). As a result, RioCan reported net earnings of $21.6 million (11c per unit) as compared with $38.5 million (21c per unit) for the comparative period in 2004. This is not something that should cause investors concern.

RioCan continues to pay monthly distributions of 10.5c per unit ($1.26 a year). The yield based on the current share price of $20 is 6.3%.

Action now: Hold. – G.P.

YOUR QUESTIONS

Avian flu impact

Q - CBC radio last week aired a one-hour special on the risk and impact of a global flu pandemic. The “experts” are talking not “if” but “when” it will happen. Predictions include one in two Canadians becoming sick, overwhelmed medical systems, and international borders closed to the movement of goods and people. It raises the spectre that not only lives but also life savings could be lost in economic collapse.

I can't find any reference to this in your recent IWB or MFU newsletters. It would be good to hear your opinion on this issue and potential strategies for those who believe that it is a real risk. – I.K., Kingston ON

A – We haven’t written anything about this for the same reason that we have not offered advice about what to do if a terrorist group plants a nuclear device in an American city or the West Coast of North America is devastated by a tsunami. Calamities on such a massive scale cannot be predicted and we can’t plan our finances around them. Hopefully, nothing like this will happen within our lifetimes but if it does then clearly the impact on the world’s economy would be massive.

If such a dreadful event should occur, the safest type of security to hold would be Canadian or U.S. government bonds. Barring a total societal collapse (in which case money would be the least of our worries), strong governments like ours can be expected to meet their financial obligations.

That said, bonds are only pieces of paper or, more likely, electronically-stored data, and would be vulnerable in a climate of hyper-inflation. To protect yourself against that possibility, buy gold bullion in the form of wafers and a supply of precious metals like diamonds and keep them in a safe on your premises for easy access.

The problem is that if anyone learns that you have such a cache, your home would become a prime target for thieves. That seems to be to be an even greater risk. Sometimes you can’t win! – G.P.

MEMBERS’ CORNER

Be wary of research reports

Member comment: In your Questions section in the last issue, there was a comment about advice from a broker. Specifically, the broker did not like a stock saying: "The reports written up on Frontline seem to be negative and there are not many buy ratings on this stock".

I think one should be very, very wary of institutional reports and analysts. Forgetting about all the conflict of interest issues of late, there are other problems. I had the opportunity to talk to a research analyst and got an insight into that industry. What amazed me is that analysts make their money based on selling their reports, not on whether the actual recommendation or analysis bears out. The fact is that major institutions (like pension funds and even mutual fund companies) will buy reports if it fits into their “process”. They may even buy a contrary report if their decision-making process requires X number of pro reports and Y number of anti reports.

Secondly, the large firms’ research departments come pretty much from the same schools, learning the same techniques and using much the same world view. Often it's a case of tunnel vision, with everyone talking to the same suppliers and looking at the same financial statements. Peter Lynch, no slouch he, looked at the shopping bag of his wife to see what she had bought and then looked at those companies. I don't think CIBC Wood Gundy would acknowledge that as a credible source!

This is not to discount all of this research. But I think you have to understand where it comes from and who it's written for. Any time someone does try to justify a claim by saying “our guys at research recommend that stock”, I always ask to see a scorecard for the analyst – how many picks have they got right and how many wrong? From the big banks/brokerage firms, I've never seen any such scorecard.

p.s. Kudos to the IWB for providing an annual review! – M.L.

Response: Our member makes much the same point that Tom Slee has commented on previously. Brokerage research reports should always be treated with care. In the particular case of Frontline, the research in question did not actually originate with CIBC Wood Gundy – they don’t cover the stock. It turns out the broker was quoting from a report that had appeared in The Wall Street Journal. – G.P.

Reaction to upset member

Member comment: I enjoy reading your weekly newsletter but I have to make a comment about the member that was a bit upset with your Rocky Mountain Chocolate Factory recommendation. I think his last comment about you running off with his money was totally out to lunch, to put it mildly.

If in fact you were out to take his money and run, then why would you even respond in the first place...you would be enjoying a pleasant drink in the sunshine.

Before you despair about e-mails like this one, we must always remember that it is people like this that keep us from getting too cocky, and thus making mistakes. Keep up the good work. – L.C.

Response: Thanks for your support. However, in the end I prefer to let the recommendations speak for themselves and Rocky Mountain (NDQ: RMCF) is doing just that. When those comments were published in the issue of June 20, the stock was trading at $18.23, post-split (figures in U.S. dollars). The shares closed on Friday at $22.25. That’s a gain of 22.1% in just two weeks.

The math is a little complicated so stay with me here. If you purchased shares at the time of the original recommendation, you were eligible for the 5% stock dividend that was paid on March 10 to shareholders of record as of Feb. 28. That means you received five extra shares for every 100 you bought.

Let’s assume you purchased 100 and owned 105 after the dividend. In mid-June, you received another share for every three you owned. For purposes of this example, that increased your stake to 140 shares. When the stock was recommended, the price was $19.99 so your original 100 shares cost you $1,999 plus commission. Those shares, which have now increased to 140, are worth $3,115 today, a gain of 55.8%. How sweet it is! For record-keeping purposes, the original split-adjusted price is now $14.28.

The stock is still a buy. – G.P.

That’s all for this edition. We wish a safe and happy July 4th holiday to our U.S. members and we will see you again on July 11.

Best regards,

Gordon Pape
gordon.pape@buildingwealth.ca
Circulation matters: customer.service@buildingwealth.ca

All material in the Internet Wealth Builder is copyright Gordon Pape Enterprises Ltd. and may not be reproduced in whole or in part in any form without written consent. All recommendations are based on information that is believed to be reliable. However, results are not guaranteed and the publishers and distributors of the Internet Wealth Builder assume no liability whatsoever for any material losses that may occur. Readers are advised to consult a professional financial advisor before making any investment decisions. Gordon Pape and/or members of his family may hold positions in securities mentioned in this newsletter, as may any of our contributors, either personally or through managed accounts. No compensation for recommending particular securities or financial advisors is solicited or accepted.