Monthly Archive for February, 2008

The Coal sector in Canada is extremely small. Unlike the United States, Canada produces much less coal on an absolute and on a per capita basis. According to the BP Statistical Review, Canada produced 32 million tonnes oil equivalent of coal in 2006, while the USA produced 595 million tonnes of oil equivalent coal.

Metallurgical Coal, also known Coke, is a higher grade of coal which is used as a fuel and as a reducing agent in smelting iron ore in a blast furnace. While Thermal coal is often of lower quality and is used only in powering coal power plants.

In Canada, Fording Canadian Coal (TSX:FDG.UN) which is the largest Canadian coal company by market capitalization and by production. Fording makes quarterly distributions to unitholders using royalties received from its 60% interest in the metallurgical coal operations of the Elk Valley Coal Partnership. Elk Valley Coal Partnership is the world’s second largest exporter of metallurgical coal, supplying high-quality coal products to the international steel industry. Because of it’s position as a low cost producer Fording is one of the top holdings in the Tarik.ca Fundamentals Canadian Equity Fund.

Another large Canadian coal company is Royal Utilities Income Trust (TSX:RU.UN). Royal Utilities is a thermal coal producer, unlike Fording which is a metallurgical coal producer. Prairie Mines & Royalty Ltd., the operating company, is the largest thermal coal producer in Canada, mining 94% of all the thermal coal produced in 2005. With a total of eight surface mines in Alberta and Saskatchewan, the Company generates a substantial portion of its revenue from long-term contracts with major electric utility companies in the two provinces.

Other than those two companies there are no major coal producers, however there is about a dozen or so coal junior developers and minor producers including : Western Canadian Coal, CoalCorp Mining, Grande Cache Coal and Others.

In the US there is a coal ETF (NYSE:KOL), while producing good diversification, the large holdings in Chinese ADR exposes the investor to overpriced Chinese companies coal companies, who’s growth don’t justify their market prices. Furthermore, close analysis of the holdings show that the fund own consumers of coal and coal bed methane gas producers which make natural gas and not coal.

Over the last 3 years of observing and participating in the financial markets one interesting phenomena is the heavy emphasis on what to buy. Almost every analyst will tell you what to buy but rarely will anyone tell you when to sell, or any sort of exit strategy when investing in an asset class.

Over the last week I’ve read two books. One of which was “One Up On Wall Street”, by Peter Lynch who is the legendary manager of the Fidelity Magellan Fund. Notice the importance at evaluating the company’s marketing marketing metrics (i.e. market share, customer satisfaction) and financial metrics (i.e. return on equity, earnings growth). While reading the booked I picked a few of the features which Mr. Lynch looks for when deciding if he should sell an company.

1) The company has lost market share and is hiring a new advertising firm.
2) No new products are being developed, spending on research and development is curtailed.
3) Acquisition(s) in unrelated businesses. For related businesses acquired the company has paid to much for the acquisition.
4) Sharp Increases in long term debt.
5) Company has a high P/E relative to it’s peers for similar growth.
6) New products are disliked and the products currently in the pipeline keeps growing.
7) A large division in the company is exposed to an economic slump (i.e. ETrade’s Subprime Business)
8)There is no insider buying in the last year
9) The company growth rate is slowing and has been maintaining profits through cost cutting.
10) The balance sheet has deteriorated.
11) Company cuts cost but still can’t compete with foreign firms.
12) Final Demand for the product is slowing.
13) Same store sales have been falling
14) Top Management is leaving to other companies
15) The P/E is twice as high as earning growth protections.
16) Inventory are increasing
17) The company sell most of the product to one buyer who is having difficulty
18) The company offers rights to buy the stock at a discount.

Even though the financials do not have as strong fundamentals as other sectors, there is value to be found in select companies. Laurentian Bank, which was my last pick in the financial has returned over an 18% gain since January. Using similar metrics I have picked 3 Canadian financial firms which I believe will outperform the TSX Financial Index.

1) GMP Capital Trust (TSX:GMP.UN) is a Sector Outperform at $19.30

The most attractive of the Financials is GMP Capital Trust. GMP is an investment banking house, which operates in three business segments: the Capital Markets segment, which consists of the investment banking, equity research, and sales and trading capabilities of the Fund; the Wealth Management segment, which consists of the full-service investment brokerage services of the Fund, and the Private Capital Management segment, which consists of the capital, strategic direction, business and financial advice provided to mid-market and early stage companies by EdgeStone Capital Partners, L.P.

GMP has an Return on Equity of 50% and a Net Profit Margins 32%. Furthermore, they are experiencing growth rates north of 30% and have been consistently raising their dividend payouts over the past few years, with a current yield north of 11%. At a current P/E of 8 times earnings this company presents tremendous value.

2) TSX Group (TSX:X) is a Buy

TSX Group Inc. owns and operates two national stock exchanges, Toronto Stock Exchange, which serves the senior equity market and TSX Venture Exchange, which serves the public venture equity market; Natural Gas Exchange Inc. (NGX), which is an exchange for the trading and clearing of natural gas and electricity contracts in North America, and Shorcan Brokers Limited (SBL), which is a fixed income inter-dealer broker.

While the recent acquisition of the Montreal Exchange is slightly dilutive, it now makes the TSX the only exchange in Canada for all equities and derivative contracts, giving it pricing power and eliminating any competition. The TSX has a 35% Net Profit Margin, a Return on Equity of 74% and is experiencing good earnings growth. While expensive for a financial at 20 times earnings, the fundamental profitability and growth warrant a higher multiple. The TSX has been constantly raising dividends, the dividend payout has increased over 450% over the last 5 years, with a current yield of 3.3%.

3) CI Financial Income Trust (TSX:CIX.UN) is a Buy

CI Financial Income Fund (CI) is a diversified wealth management firm. The principal business of CI is the management, marketing, distribution and administration of mutual funds, segregated funds, structured products and other fee-earning investment products for Canadian investors through brokers, independent financial planners and insurance advisors, including Assante Capital Management Ltd., Assante Financial Management Ltd. and IQON Financial Management Inc. CI operates through two business segments. The Asset Management provides the majority of CI’s income and derives its revenues principally from the fees earned on the management of several families of mutual, segregated, pooled and closed-end funds, structured products and discretionary accounts.

CI Financial has an Return on Equity of 37% and a Net Profit Margins 34%. Furthermore, they are experiencing growth rates north of 15% and have been consistently raising their dividend payouts over the past few years, with a current yield of 8.5%. At a current P/E of 11 times earnings this company presents reasonable value.

When watching and reading the financial press they constantly push forward the idea that the P/E (Price/Earnings) ratio is the single most important measure to value a company. However in reality P/E ratios are overused and over glorified. However, in reality we have to take many measures of value and profitability when evaluating an investment. So what is Return on Equity and how can we use it?

Return On Equity : Measures the rate of return on the ownership interest (shareholders’ equity) of the common stock owners. ROE is viewed as one of the most important financial ratios. It measures a firm’s efficiency at generating profits from every dollar of net assets (assets minus liabilities), and shows how well a company uses investment dollars to generate earnings growth. ROE is equal to a fiscal year’s net income (after preferred stock dividends but before common stock dividends) divided by total equity (excluding preferred shares), expressed as a percentage.

Over the last year I have started to emphasize heavily investing in companies with high return on equity. Companies with high return on equity quite simply have superior management producing superior profitability. Once you populate a list of companies with high return on equity, you want to pay as little as possible for these superior results from a company with a low P/E and P/B with strong earnings growths to top it off.

For example (As of Jan 1st, 2008):

*Net Margins, Return On Equity, P/E are for the trailing 12 months. P/E are based on January 1, 2008 prices.

Notice, by buying companies with above average (ROE/PE and NM/PE scores) relative to other companies in the industry you can reduce your risk by increasing your margin of safety, by avoiding overpaying for a company. In the Financial sector Laurentian Bank outperformed Citigroup by 25% through this method. In the Energy Sector, ARC Energy outperformed Canadian Natural Resources by 24.5% through this method.

Furthermore, while Apple has a high Return on Equity and Net Margins the fact that you are overpaying, at 39 times earnings reduces your margin of safety making the investment more susceptible to a downturn as we have seen this year where the stock has plunged 40%. At these new current prices Apple is still the same great company, and purchases at these level have a high margin of safety unlike before where there was a big premium. Remember a good business is not always a good stock.

As Benjamin Graham said : “In the short run, the market is a voting machine but in the long run it is a weighing machine.” Because there will always be new opportunities which will appear, there is no rush to go out and overpay for a company, be patient buy a business and not a stock.

In Conclusion, by buying a company with a high Return on Equity and a high Net Margin at a cheap prices (denoted by a high ROE/PE and NM/PE) you can increase the margin of safety on your invested capital by not overpaying for the company, while still accessing companies with superior operating results.