In This Issue

THE PLAN FOR ’09

By Gordon Pape, Editor and Publisher

Investors are shell-shocked and frightened as we enter the New Year. They have every right to be. The last half of 2008 was the most traumatic period we’ve seen in the stock markets since the Great Depression and no one can predict with any degree of certainty what lies ahead.

The sudden plunge of the TSX was all the more distressing because for most of the first half of the year it was riding high. After opening 2008 at 13,833, the Composite Index took a dive in January, slumping to the 12,000 range. But then it rallied strongly on the strength of soaring commodity prices, rising to an all-time intraday high of 15,154.77 in early June. At that point, the Index was up 9.6% on a year-to-date basis and Canadians were feeling pretty comfortable, especially when they looked at what was going on across the border.

Here at the IWB, we weren’t all that sanguine, however. We warned in mid-June that the TSX was facing downward pressures and over the next several weeks advised taking part-profits or selling some securities outright. But while we expected a correction, we did not anticipate the depth and severity of what actually happened. The Composite Index finished 2008 at 8,987.70, down 35% over the full year.

Everyone who had any money invested in stocks or equity mutual funds lost money over the year, unless they shorted the market – a strategy we don’t use in the IWB because of the high risks involved. If you had a percentage of your portfolio in bonds and cash, the losses were cushioned to some degree but most people were hurt financially to some extent.

Now the question becomes: what to do in 2009? As far as the IWB s concerned, we will have two priorities: minimizing risk while starting the process of rebuilding your assets. Here’s how we plan to deal with each.

Minimizing risk. Understandably, everyone wants to preserve the assets they have left. But burying your cash in the backyard is overdoing it. Yet many people are doing the investment equivalent of that. Here’s a quote from a Globe and Mail alert I read last week: “The yield on the three-month T-bill, in great demand because it is considered one of the safest investments, was unchanged at 0.01% late Friday”. That’s U.S. T-bills they’re talking about; Canadians can do modestly better with three-month bills quoted at 0.149% as of Tuesday. That’s for amounts in excess of $20,000; if you invest less the yield is zero!

In other words, if you want your money to be absolutely safe you have to be prepared to accept virtually no return. The only difference between that and burying it in the back yard is that the money will be cleaner when you get it back!

While we advise caution in 2009, we do not recommend going to such extremes. There are many ways to earn better returns on your money with virtually no risk. For example, you can still get more than 4% on CDIC-protected five-year GICs at several financial institutions and these could be a good way to launch a new Tax-Free Savings Account. We’ll be giving special attention to this type of low-risk security in the coming months.

Rebuilding your assets. Everyone would like to recover their losses as quickly as possible. That’s natural. But that kind of thinking can get you into even more trouble. We need to be realistic and aim for returns that are achievable without undue risk.

A few weeks ago, a disgruntled reader sent me an e-mail cancelling his membership. The reason: we were not offering strategies that would enable him to compensate for the loss in the value of his Vancouver house. He said he was going to try his luck with some leveraged ETFs instead. I wished him the best. I hope he didn’t end up losing even more.

Our goal for this year will be to earn profits of 5% to 6% for our members. If that seems overly modest, it’s because we are still very wary about the economy and the outlook for the stock markets. Once the fourth-quarter earnings start to appear, the numbers are likely to be depressing and may lead to another big market downturn in January-February. Also, we expect commodity prices to continue weak for several months which will inevitably lead to more cuts in distributions from energy trusts. In short, it could get worse before it starts to get better.

Therefore we will focus our attention on securities with minimal risk, at least for the first few months of the year. The aim will be to generate profits that are somewhat better than those being offered by GICs with only marginally more risk. If conditions start to improve towards mid-year, we’ll shift gears and begin to more aggressively seek out bargain stocks with significant update potential. But that stage is several months away.

So that’s the plan for 2009. Low risk and modest returns at the start, with a gradual move to a more profit-oriented approach if and when conditions warrant. If you have any comments you would like to make on this approach, please send an e-mail and let me know. Our goal, as always, is to serve the needs of our members in the most effective way possible so if we can do better, tell us. – G.P.

THE 2008 SCORECARD

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On New Year’s Day, the newspapers reported that 2008 was the worst year for the Toronto Stock Exchange since the Great Depression, with the S&P/TSX Composite Index dropping 35%.

In fact, it was much worse than that. The 35% figure is a year-over-year number. From its high point in June, the TSX lost a staggering 6,167 points or 40.7%. And only a year-end rally which saw the Composite regain 677 points in the final three trading sessions of 2008 kept things from being far worse. On Christmas Day, the Index was off a breathtaking 45% from its high.

Only one sub-index finished 2008 in the black: the S&P/TSX Global Gold Index which was ahead a fractional 0.8% for 2008. But that’s rather misleading because several of the companies in the Index are not Canadian and don’t trade on the TSX. For some reason, there is no pure Canadian gold index.

All the other sub-indexes were hammered to varying degrees with the Capped Metals and Mining Index the hardest hit, losing 68.4%. The best performance was turned in by the Consumer Staples sector (Loblaw, Shoppers Drug Mart, Viterra, Metro Inc., etc.) which held its loss to only 7.4%.

Small-cap stocks were savaged even worse than the large caps. The TSX Venture Exchange lost 71.9% on the year, almost three-quarters of its value!

Bad as the Canadian result was, we were actually the fifth-best performer among the world’s notable exchanges. Mexico’s Bolsa Index came off best, losing “only” 24.2%. The Dow Jones Industrial Average, the U.K. Dow, and Switzerland’s SMI Index were all clustered in the -32% to -35% range. The worst results came from the Dutch, Belgian, and Finnish exchanges, all of which were down more than 50%.

While stocks were crashing, bonds ended up having a good year. The DEX Universe Bond Index finished 2008 with a gain of 6.41%, which helped to ease the pain for those with diversified portfolios. Government bonds were particularly strong as investors fled to quality; the DEX Universe Federal Bond Index was ahead 11.51% over the 12 months.

Corporate bonds, in contrast, were weak with the DEX Universe All Corporate Bond Index adding only 0.23% in 2008. However, I believe this sector offers a lot of upside potential in 2009.

So we close the books on a year to forget. Let’s hope that the 2009 scorecard ends up looking a lot better. – G.P.

 

PREDICTIONS PAST

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Over the years, my prediction track record had been pretty good. Then along came 2008. On balance, the final result doesn’t look so bad, with one glaring exception: the horrific downturn in the stock markets that began during the summer and accelerated through the autumn like one of those disastrous British Columbia avalanches. The fact that just about everyone else failed to see it coming is no excuse. The warnings were there and they worried me enough to forecast a market correction. I just didn’t expect it to get as bad as it did.

So, frankly, I’d prefer to forget I said anything at all about how 2008 would unfold. But that would be a cop-out so here’s a look back at what I forecast last January and what actually happened.

Forecast: The first half will be rough. I expressed concern about market uncertainty and said there were undoubtedly more bombs from the subprime mess that were waiting to explode. As a result, I wrote: “I would not be surprised to see one or more corrections between now and spring, with major indexes falling 5% to 10%, perhaps even more.”

Reality: That call looked prescient in mid-January when stock markets took a huge hit. But by April they had rallied back and at mid-year both the TSX and the Dow were close to the levels they had been at on Jan. 1. In fact, a few weeks earlier the TSX had reached an all-time high.

Forecast: The second half will see a market rally.

Reality: This was where it all fell apart. I had expected all the bad news about subprime, bad debt, and the credit crunch to be out by mid-year. It wasn’t, as we now know, and the impact on the stock markets was about as grim as it gets.

Forecast: The TSX will outperform the S&P 500.

Reality: It did, although only by a small margin. The S&P 500 was down 38.5% for the year, compared to our loss of 35%. So yes, I was right – but so what? Investors on both sides of the border lost a bundle.

Forecast: Interest rates will fall.

Reality: They sure did, to the point where Treasury bills now pay virtually nothing.

Forecast: Bonds will continue to rally.

Reality: Government bonds followed the script. Corporate bonds didn’t.

Forecast: The loonie will stabilize. I predicted it would trade in a range of US95c to US$1.05, ending the year around US$1.03.

Reality: That prediction actually looked pretty good until late September when the bottom suddenly fell out of the loonie. According to the Bank of Canada, it plummeted from US97c on Sept. 26 to US77c on Oct. 27 for a loss of 20.6% in one month. It ended 2008 at US81.66c. – G.P.

PREDICTIONS FUTURE

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In all the years I have been writing about personal finance, there has never been one that is more difficult to predict than 2009. The “expert” forecasts I’ve been reading in the media and in analysts’ reports are all over the lot. The deepest pessimists are calling for a rerun of the Great Depression, with the economy taking a decade or more to recover from the brutal beating it is experiencing. The optimists are predicting that stock markets will turn around by mid-year and the second half of 2009 will see an explosive recovery. One forecast I saw has the TSX rising 30% this year. Wouldn’t that be nice?

My feeling is that there is too much uncertainty and too many variables in play to offer any truly meaningful forecasts. However, I am prepared to make some educated guesses about how the year will unfold. Just remember that’s all they – guesses. Don’t bet the house on any of them.

The TSX and the S&P 500 will be higher at year-end than on Jan. 1. This is going to be a very difficult year for economies around the world and we clearly will not escape. During the first half of 2009 we should expect one bad news story after another: rising unemployment, more corporate and personal bankruptcies, falling house prices, dismal earnings reports, huge budget deficits, and more. It will not be a pleasant time. Survival will be the name of the game.

The impact of all this on the stock markets will be continued volatility and possibly another major correction before spring. But after that, I look for the major indexes to begin a recovery even though the economy will remain soft. The reason for this cautious optimism is that stock markets are historically leading indicators. They will reflect anticipated improvements in the economy months in advance. So if we start to see indicators of an economic recovery in 2010, the markets should be moving ahead by the second half of this year.

The precise timing is impossible to predict as is the extent of any advance. All I’m prepared to predict at this stage is that at the close of trading on Dec. 31, 2009, the TSX will be above 9,000 and the S&P 500 will be higher than 905.

Corporate bonds will outperform government bonds. There was no better place for your money in 2008 than government bonds. And U.S. Treasury bonds were the best of all because Canadian investors enjoyed a significant gain on currency exchange on top of any capital gains and interest on the bonds themselves.

It won’t be the same story in 2009. While safety will still be high on most people’s priority list, the absurdly low yields on federal government securities will encourage investors to seek out alternatives. The beneficiaries should be highly-rated corporate bonds and, to a lesser extent, provincial bonds.

Bond availabilities and pricing will vary from one broker to another depending on what they are holding in inventory and the mark-up charged. And buying individual bonds can be extremely tricky and should only be undertaken with expert advice. For example, some highly-rated Toronto-Dominion Bank bonds I looked at have what appears to be a very attractive yield to maturity but they contain a provision which adjusts the coupon rate several years before maturity to that paid by bankers’ acceptances plus 1%. So if bankers’ acceptances are yielding 1.5%, you’ll receive only 2.5% and the yield to maturity will suddenly look much less attractive. Unless you’re a skilled bond trader, use a low-cost mutual fund or an ETF.

Interest rates will edge higher towards year-end. Unless we really are heading for Great Depression II, this one is a no-brainer. With governments around the world printing money as fast as the presses can operate in an attempt to reflate their economies, it’s only a matter of time before rates stabilize and then begin to move higher. It won’t happen soon, however. No central bank wants to make the mistake of increasing rates before there are clear signs of an economic recovery. But by year-end, I expect that target rates in both Canada and the U.S. will be higher than current levels. Since they are effectively at zero in the States, there’s really nowhere to go but up.

The loonie will rise slightly. The Canadian dollar’s 20%+ decline last fall caught everyone off guard. The loonie had been expected to lose steam with the decline in commodity prices but under normal circumstances a pull-back to the range of US85c to US90c would have been more in line with reality. The situation was exacerbated by the flood of offshore money into U.S. Treasuries which pushed the value of the greenback higher. That made little sense at a time of rapidly falling U.S. interest rates, mind-boggling deficits, and multi-billion dollar bail-outs but rationality was in short supply in the fall of 2008. We should see some stability return to currency markets in 2009 with the loonie trading in the US85c range by year-end.

Oil prices will rebound. Oil has always been a highly cyclical commodity. It never moves in a straight line; just when you think a clear trend is in place, everything turns upside down. It happened again in 2008. In July, the world price of crude hit $147 a barrel (prices in U.S. dollars) and everyone knew it was only a matter of time before it reached $200. Actually, it probably is just a matter of time – it’s just going to take a lot longer than anyone expected a few months ago.

Now oil is trading around $45 and some analysts are predicting it could fall to $30 or even below. Sure it could. As recently as 1998, the average price of a barrel of crude oil was $11.91. But it didn’t last long then and it won’t this time either. But neither should we expect a return to $100 a barrel in 2009 or even in 2010.

It’s instructive to look at trends in oil prices since the end of the Second World War. For a generation, from 1946 to 1973, the average price of a barrel of domestic U.S. crude remained in a narrow trading range of about $3 on each side of $20, inflation-adjusted, according to figures published on InflationData.com.

Then came the oil shock of the 1970s. Crude broke out of its long-term pattern and within two years the price per barrel more than doubled. By 1980, it had hit an inflation-adjusted average of $95.50 a barrel. Gasoline prices soared and people became convinced that oil prices would keep rising forever.

By 1986 – only six years later – the price of a barrel of crude had plunged more than 70%! Except for a brief spike in 1990, it remained fairly flat until 1998 when, as I mentioned earlier, the bottom fell out.

After rebounding in 1999-2000, oil prices again went into a flat stage that lasted until 2003. Since then, it moved higher at an accelerating rate until the summer of this year. The last time we had a run like that was from 1973 to 1980.

The point of all this is to remind readers that although cycles can run for several years, nothing lasts forever. At current levels, the price of a barrel of oil is down almost 70% from its July high. That is the largest six-month drop in history; nothing else even comes close. We know that the energy companies aren’t going to give away the stuff; in fact they are already starting to reduce production. So at some point in 2009, supply and demand are going to come into balance. Since producers can’t turn the taps on again at a moment’s notice, inventories will begin to fall putting upward pressure on prices.

Yes, I know there is a recession on. But the last time I looked there were still traffic jams at rush hour, planes were still flying, electricity continued to be generated from oil-fired plants, and plastics were still being manufactured. The world still has not found a substitute for the gunky stuff. The price will turn around and with it the fortunes of energy stocks.

Those are my calls for 2009. Next year we’ll look back and see how they turned out. – G.P.

IRWIN MICHAEL: SIGNS OF STABILITY

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Contributing editor Irwin Michael joins us for this first issue of 2009 with some observations that suggest we may be seeing some early signs of stability returning to the markets. Irwin is the founder and president of the ABC funds and is one of Canada’s leading proponents of value investing. Here is his report.

Irwin Michael writes:

Although the TSX market index fell almost 300 points in December with continued volatility, there are some signs, albeit perhaps premature, that the market may be gaining some stability. For instance, certain credit indicators such as the TED spread, three-month LIBOR rates, and the VIX, a measure of market volatility, have all improved.

The securities market has also been receptive to a number of new multi-billion dollar financings over the past few weeks including Royal Bank of Canada, Manulife Financial, Great-West Life, and Bank of Montreal. All are now trading above issue price, indicating that at “a price” both Bay Street and investors will underwrite and purchase common shares. This situation is in contrast to a very inhospitable market of two or three months ago when no financings could be completed.

Another interesting fact is the precipitous decline in interest rates. Worldwide central banks are aggressively attempting to liquefy the banking system by reducing interest rates and increasing money supply to go along with stimulative government fiscal actions. Unfortunately, it generally takes a while for monetary and fiscal activity to produce tangible results.

A significant by-product of substantially lower interest rates has been the growing yield differential between U.S. Treasury bills at almost 0% and dividend-paying common shares at 5%+. True, corporate dividend payouts can be cut however there are numerous good-quality American and Canadian public companies with solid long-term dividend-paying track records. This conspicuous and expanding rate differential between low-yielding government Treasury bills and common stocks is presenting excellent yield pick-up opportunities with longer-term capital gains potential.

Looking ahead, governments and central banks are pulling out all the stops to kick-start worldwide economies. There is no question that economic, financial, and corporate news flows remain quite negative and in the course of reporting this data, the media has been quite dutiful in promoting this negativity. In consequence, investor appetite for any sort of risk is very low and many are quite content to ride out the present storm within the safety of record low Treasury bills. While this may not be a bad policy in the short run, selective investment opportunities may be missed. Moreover, at some point the year-to-year economic comparisons will stop turning down and will, in fact, show positive year-over-year growth. Clearly, the market will be looking for this development and will react quickly and positively.

As we enter 2009, while stock prices could edge lower, a number of common stocks are thinly-traded with extremely low valuations. Investor psychology is very negative and many sell-side analysts continue to mark down their price expectations. Furthermore, the present financial environment is excessively challenging and frustrating to all investors. As a value manager we believe that investors are looking less at balance sheets and income statements but, rather, they are selling whatever they can to obtain their desired liquidity. Occasionally, a diamond may fall between the cracks during the present pursuit of liquidity.

Given the present widespread negativity it might sound rather heroic to offer a positive outlook for 2009. We expect 2009 to remain challenging, volatile, and to test our patience. Nevertheless, with any perceived or real upturn in investor psychology and/or economic or corporate data we believe that this occurrence could result in a significant market run-up and an opportunity to recoup 2008 losses and beyond.

 

IRWIN MICHAEL’S UPDATES

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Canam Group Inc. (TSX: CAM, OTC: CNMGA)

Originally recommended on July 7/08 (IWB #2824) at C$10.42, US$11.09. Closed Friday at C$6.80, US$4.35 (Oct. 8).

One of our value favourites, Canam Group, has come to exemplify these unusual and difficult markets. We re-established a position in Canam towards the end of the first quarter of 2008. We were comfortable paying almost $6 per share lower than the stock’s 52-week high and roughly $4 per share lower than where we had sold our original stake. We thought that we were buying a dirt-cheap stock but, unfortunately, the shares dipped again late July through early August.

By October, it became apparent why the shares were declining without any clear fundamental reason. On Oct. 7, the shares opened just below $6.50 and suddenly plunged to a low of $3.73 per share, a decline of approximately 40%. We were dumbfounded but quickly put a bid in and actually managed to purchase a few thousand shares for our funds at $3.75. The stock then bounced and closed the day at $5 per share.

Over the next two days we saw several large blocks of stock change hands. It took us a few days to piece together the story but we finally discovered that a hedge fund was behind the volatile trading. This fund, perhaps facing redemptions, was forced to raise cash by dumping several million shares into the market, irrespective of price. It was frustrating to watch but at least we understood that the company’s fundamentals were sound.

Management apparently agreed with our assessment of Canam’s prospects. In their recent quarterly release, they announced that as of Oct. 21 the company had acquired 2,185,100 shares at an average price of $6.14 per share for a total amount of $13.4 million. The shares were purchased through the company’s normal course issuer bid that began last August for up to 4,075,000 shares.

With a book value of $8.18 per share, this buyback is accretive and represents an excellent use of the company’s strong and flexible balance sheet. Eventually, investors will focus on fundamentals instead of liquidity and the shares should return to a more realistic valuation range.

Action now: Buy at current levels. Note that although the shares trade over-the-counter in the U.S., there have been no trades there in Canam since October.

Polaris Minerals Corp. (TSX: PLS, OTC: POLMF)

Originally recommended on April 30/07 (IWB #2717) at C$9.90, US$8.94. Closed Friday at C$1.49, US$1.25.

Given today’s environment, investors need to focus on identifying the survivors. In the resource sector, this means that a company’s operations have to be either cash flow positive at current commodity prices or fully-funded through to commercial production. Despite the disappointing share price performance in 2008, we believe that Polaris Minerals has the cash flow and the balance sheet to weather the storm.

From a cash flow perspective, Polaris sold 694,000 tons of sand and gravel in the third quarter of 2008 and reported cash from operations of $635,000 despite elevated shipping and fuel costs. Importantly, lower fuel costs in the fourth quarter could add $2 to $2.50 per ton to the gross margin, which should flow directly to operating cash flow. We recently met with management, who confirmed that they would be cash flow positive in 2009, even after deducting planned exploration and development capital expenditures.

From a balance sheet perspective, the market had growing concerns about Polaris’s ability to refinance a bridge loan that had been put into place to fund the Long Beach Pier B acquisition. This one-year $20 million facility had an initial interest rate of 12% that increased to 13% and 15% if the loan remained outstanding at 91 days and 181 days respectively. On Dec. 16, Polaris ended the speculation and announced that it had entered into a $25 million bought deal for new equity at a price of $1.60 per unit. Each unit consists of one common share plus one half of a common share purchase warrant. One full warrant allows the purchase of an additional common share at an exercise price of $2.25 per share for a period of two years following the closing of the offering.

Post closing, the bridge loan will be completely repaid and the company will have approximately $13 million of cash on its balance sheet. Additional sources of liquidity include $3 million from a sale/leaseback transaction involving the company’s new berthing tugboat. Further, the company has approximately $5 million tied up in Asset Backed Commercial Paper, which could be returned as soon as January as per the recently announced agreement with the provincial and federal governments.

As long-term investors, we are willing to accept some dilution to ensure that this irreplaceable asset survives through the downturn. Management apparently shares our view and has been buying stock in the open market. Most notably, Herb Wilson, president and CEO, bought 91,000 shares at $4.39 last August and another 16,900 shares at $1.47 in December. We are always encouraged when insiders are confident enough to put more “skin-in-the-game”.

Action now: Buy at current levels.

George Weston Ltd. (TSX: WN, OTC: WNGRF)

Originally recommended on Dec. 8/08 (IWB #2843) at C$59.85, US$45.85. Closed Friday at C$59.90, US$46.94 (Dec. 30).

Although we released our initial comment on George Weston Limited only a month ago, there has been a material new development. Our investment thesis was based on backing out the implied value of Loblaw from each share of George Weston. We believed that we could purchase the Weston Foods operating division below 4.5 times EBITDA, while comparables traded at approximately eight times EBITDA. We expected that the multiple on the bakery operations would expand as lower commodity prices became reflected in the financial results. However, management subsequently announced a transaction that monetized a significant portion of this valuation discrepancy.

On Dec. 10, the company announced that its subsidiary, Dunedin Holdings, had agreed to sell its fresh bread and baked goods business in the United States to Grupo Bimbo, one of the world’s leading and largest baking companies. Grupo Bimbo, based in Mexico, paid approximately US$2.5 billion for operations that generated US$275 million of twelve-month trailing EBITDA. This equates to a 9.1 times EBITDA multiple, more than double the implied public market value of the “bread-stub”. Note that Weston Foods retains its baking and distribution operations in Canada and its other U.S. baking divisions, Interbake Foods and Maplehurst Bakeries.

Speculation regarding the use of cash proceeds quickly turned to talk of privatizing Loblaw. However, we believe that this scenario is unlikely from a value creation perspective since Loblaw already trades between eight and nine times EBITDA. Privatizing George Weston Limited would actually make more sense since the remaining U.S. and Canadian operations now trade below three times EBITDA.

However, management was quite clear that they were in no hurry to deploy the cash proceeds. They seem content to sit on almost $5 billion in cash (including $1 billion of cash held at Loblaw) and wait for an exceptional opportunity or opportunities to present themselves. Remember, amid the current market turmoil, cash is king.

Action now: Buy below $58.

– end Irwin Michael

 

TFSAS – GREAT IDEA, TERRIBLE TIMING

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Tax-Free Savings Accounts (TFSAs) are now officially here, although according to reports from various financial institutions hundreds of thousands of Canadians had already opened plans in anticipation of the Jan. 1 launch.

No wonder! These things are the most powerful savings tool since the Diefenbaker government brought in RRSPs over 50 years ago. In fact, TFSAs are even better than RRSPs in some situations.

Just think: once you put money into a TFSA, you’ll never have to pay tax on it again, or on any of the investment income you earn within the plan. You can withdraw as much as you want, whenever you want, and you won’t have to pay the government a penny. Moreover, you can put it all back in again later if you want. Talk about a win-win situation!

Perhaps I should qualify that. TFSAs are winners for individual Canadians. Future governments may look at them quite differently. And one thing is certain: while the concept is great, the timing is dreadful. Just at a time when governments are encouraging people to keep spending in order to stimulate the economy, Ottawa launches a plan that will encourage people to sock away billions of dollars in savings accounts. In a report published last fall, CIBC senior economist Benjamin Tal predicted that TFSAs would attract $20 billion worth of business in 2009 alone, rising to $115 billion over five years. That’s a lot of foregone consumer spending.

How did we end up in this situation anyway? The following excerpt from my new book, Tax-Free Savings Accounts: A Guide to TFSAs and How They Can Make You Rich, provides some answers.

No one expected much when Finance Minister Jim Flaherty stood up to give his Budget speech in the House of Commons at 4 p.m. on February 26, 2008.

The cupboard was pretty much bare. The Conservative government, anticipating an early election, had dipped deeply into the nation’s dwindling surplus the previous October when Mr. Flaherty had delivered an “Economic Statement” that was actually a mini-budget in very thin disguise.

At that time, the Finance Minister had announced a second cut in the GST, reducing it to 5% as the Tories had promised during their election campaign. He had announced a reduction of half a percentage point in the lowest tier income tax rate. He had increased personal tax exemptions across the board for all Canadians. He had cut the rates on Employment Insurance. He had announced deep cuts to the federal corporate tax rate, slashing it from 22.1% to 15% by 2012.

The total cost of all those tax goodies was estimated at a whopping $188.1 billion over the next six fiscal years. Of that, $72.7 billion was eaten up by the GST cut, $64.9 billion went to income tax savings, and $50.5 billion to the corporate tax cuts.

But after handing out all those goodies, the Conservatives discovered the Opposition parties were in no mood to force an election. Instead, they went along with every measure presented to them by the government, thwarting Stephen Harper’s plans for an early election.

That left the government with no choice but to bring in a new Budget. No one expected much. In the days leading up to the speech, the media talked about green initiatives, municipal infrastructure, more aid to students, and minor fiddles with the GST. Yawners all!

Faced with the prospect of a ho-hum Budget in what would likely be an election year (and was, as it turned out), the Finance Minister and his staff started casting around for ideas. In pre-Budget consultations with a range of business people, academics, and special interest groups, Finance Department officials kept returning to two key themes: demographics and retirement. As a sub-text, the Minister was very aware of the lingering anger among many seniors as a result of his decision to impose a tax on income trusts, which was announced on Halloween night, 2006.

So when Mr. Flaherty rose in his place on February 26, expectations were low and the public was largely uninterested. He attempted to change that right off the top.

“Mr. Speaker,” he intoned, in the usual formality of the House of Commons. “The budget is balanced. Taxes have been cut. And Canadians will now have a powerful new incentive to save money, tax-free: the Tax-Free Savings Account that we are announcing today.”

Tax-Free Savings Accounts (TFSAs), which no one had previously thought much about, were suddenly centre-stage in the most important Parliamentary event of the year.

What it all boils down to is that Tax-Free Savings Accounts exist today because political expediency required the Finance Minister to offer something in the February budget that would appeal to voters without costing the federal treasury a lot of money, at least initially. At the time, the economy was robust and no one foresaw that the country would be in a deepening recession when the program actually came into effect.

If this were a golf game, Mr. Flaherty would probably ask for a mulligan on this one. But it’s too late now. TFSAs are here to stay and over time they will help Canadians rebuild the personal wealth they lost in the crash of 2008.

During the next few weeks, we’ll carry a series of articles in the IWB on how to use these plans most effectively. Stay tuned. – G.P.

 

TFSA BOOK OFF THE PRESS

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I received my author’s copies of the TFSA book last week which means it should be in bookstores soon. Readers who reserved copies through our on-line bookstore (in association with Amazon.ca) should expect to receive their books within the next couple of weeks (the official publication date is Jan. 12). If you want to place an order at a 27% discount off the suggested retail price go to http://astore.amazon.ca/buildicaquizm-20. As of Friday, the book was sitting at number two on Amazon’s personal finance bestseller list.

If you missed it, Jonathan Chevreau of the National Post wrote a nice article about the book here: http://www.nationalpost.com/news/story.html?id=1130415

Jon and I also did a series of podcasts about TFSAs and how they work which can be viewed at
http://www.financialpost.com/money/wealthyboomer/index.html

– G.P.

 

That wraps up our first issue of the year. Our best wishes for a healthy and more prosperous 2009 and we will be with you again on Jan. 12.

Best regards,

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

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In This Issue

THE PLAN FOR ’09

By Gordon Pape, Editor and Publisher

Investors are shell-shocked and frightened as we enter the New Year. They have every right to be. The last half of 2008 was the most traumatic period we’ve seen in the stock markets since the Great Depression and no one can predict with any degree of certainty what lies ahead.

The sudden plunge of the TSX was all the more distressing because for most of the first half of the year it was riding high. After opening 2008 at 13,833, the Composite Index took a dive in January, slumping to the 12,000 range. But then it rallied strongly on the strength of soaring commodity prices, rising to an all-time intraday high of 15,154.77 in early June. At that point, the Index was up 9.6% on a year-to-date basis and Canadians were feeling pretty comfortable, especially when they looked at what was going on across the border.

Here at the IWB, we weren’t all that sanguine, however. We warned in mid-June that the TSX was facing downward pressures and over the next several weeks advised taking part-profits or selling some securities outright. But while we expected a correction, we did not anticipate the depth and severity of what actually happened. The Composite Index finished 2008 at 8,987.70, down 35% over the full year.

Everyone who had any money invested in stocks or equity mutual funds lost money over the year, unless they shorted the market – a strategy we don’t use in the IWB because of the high risks involved. If you had a percentage of your portfolio in bonds and cash, the losses were cushioned to some degree but most people were hurt financially to some extent.

Now the question becomes: what to do in 2009? As far as the IWB s concerned, we will have two priorities: minimizing risk while starting the process of rebuilding your assets. Here’s how we plan to deal with each.

Minimizing risk. Understandably, everyone wants to preserve the assets they have left. But burying your cash in the backyard is overdoing it. Yet many people are doing the investment equivalent of that. Here’s a quote from a Globe and Mail alert I read last week: “The yield on the three-month T-bill, in great demand because it is considered one of the safest investments, was unchanged at 0.01% late Friday”. That’s U.S. T-bills they’re talking about; Canadians can do modestly better with three-month bills quoted at 0.149% as of Tuesday. That’s for amounts in excess of $20,000; if you invest less the yield is zero!

In other words, if you want your money to be absolutely safe you have to be prepared to accept virtually no return. The only difference between that and burying it in the back yard is that the money will be cleaner when you get it back!

While we advise caution in 2009, we do not recommend going to such extremes. There are many ways to earn better returns on your money with virtually no risk. For example, you can still get more than 4% on CDIC-protected five-year GICs at several financial institutions and these could be a good way to launch a new Tax-Free Savings Account. We’ll be giving special attention to this type of low-risk security in the coming months.

Rebuilding your assets. Everyone would like to recover their losses as quickly as possible. That’s natural. But that kind of thinking can get you into even more trouble. We need to be realistic and aim for returns that are achievable without undue risk.

A few weeks ago, a disgruntled reader sent me an e-mail cancelling his membership. The reason: we were not offering strategies that would enable him to compensate for the loss in the value of his Vancouver house. He said he was going to try his luck with some leveraged ETFs instead. I wished him the best. I hope he didn’t end up losing even more.

Our goal for this year will be to earn profits of 5% to 6% for our members. If that seems overly modest, it’s because we are still very wary about the economy and the outlook for the stock markets. Once the fourth-quarter earnings start to appear, the numbers are likely to be depressing and may lead to another big market downturn in January-February. Also, we expect commodity prices to continue weak for several months which will inevitably lead to more cuts in distributions from energy trusts. In short, it could get worse before it starts to get better.

Therefore we will focus our attention on securities with minimal risk, at least for the first few months of the year. The aim will be to generate profits that are somewhat better than those being offered by GICs with only marginally more risk. If conditions start to improve towards mid-year, we’ll shift gears and begin to more aggressively seek out bargain stocks with significant update potential. But that stage is several months away.

So that’s the plan for 2009. Low risk and modest returns at the start, with a gradual move to a more profit-oriented approach if and when conditions warrant. If you have any comments you would like to make on this approach, please send an e-mail and let me know. Our goal, as always, is to serve the needs of our members in the most effective way possible so if we can do better, tell us. – G.P.

THE 2008 SCORECARD

On New Year’s Day, the newspapers reported that 2008 was the worst year for the Toronto Stock Exchange since the Great Depression, with the S&P/TSX Composite Index dropping 35%.

In fact, it was much worse than that. The 35% figure is a year-over-year number. From its high point in June, the TSX lost a staggering 6,167 points or 40.7%. And only a year-end rally which saw the Composite regain 677 points in the final three trading sessions of 2008 kept things from being far worse. On Christmas Day, the Index was off a breathtaking 45% from its high.

Only one sub-index finished 2008 in the black: the S&P/TSX Global Gold Index which was ahead a fractional 0.8% for 2008. But that’s rather misleading because several of the companies in the Index are not Canadian and don’t trade on the TSX. For some reason, there is no pure Canadian gold index.

All the other sub-indexes were hammered to varying degrees with the Capped Metals and Mining Index the hardest hit, losing 68.4%. The best performance was turned in by the Consumer Staples sector (Loblaw, Shoppers Drug Mart, Viterra, Metro Inc., etc.) which held its loss to only 7.4%.

Small-cap stocks were savaged even worse than the large caps. The TSX Venture Exchange lost 71.9% on the year, almost three-quarters of its value!

Bad as the Canadian result was, we were actually the fifth-best performer among the world’s notable exchanges. Mexico’s Bolsa Index came off best, losing “only” 24.2%. The Dow Jones Industrial Average, the U.K. Dow, and Switzerland’s SMI Index were all clustered in the -32% to -35% range. The worst results came from the Dutch, Belgian, and Finnish exchanges, all of which were down more than 50%.

While stocks were crashing, bonds ended up having a good year. The DEX Universe Bond Index finished 2008 with a gain of 6.41%, which helped to ease the pain for those with diversified portfolios. Government bonds were particularly strong as investors fled to quality; the DEX Universe Federal Bond Index was ahead 11.51% over the 12 months.

Corporate bonds, in contrast, were weak with the DEX Universe All Corporate Bond Index adding only 0.23% in 2008. However, I believe this sector offers a lot of upside potential in 2009.

So we close the books on a year to forget. Let’s hope that the 2009 scorecard ends up looking a lot better. – G.P.

 

PREDICTIONS PAST

Over the years, my prediction track record had been pretty good. Then along came 2008. On balance, the final result doesn’t look so bad, with one glaring exception: the horrific downturn in the stock markets that began during the summer and accelerated through the autumn like one of those disastrous British Columbia avalanches. The fact that just about everyone else failed to see it coming is no excuse. The warnings were there and they worried me enough to forecast a market correction. I just didn’t expect it to get as bad as it did.

So, frankly, I’d prefer to forget I said anything at all about how 2008 would unfold. But that would be a cop-out so here’s a look back at what I forecast last January and what actually happened.

Forecast: The first half will be rough. I expressed concern about market uncertainty and said there were undoubtedly more bombs from the subprime mess that were waiting to explode. As a result, I wrote: “I would not be surprised to see one or more corrections between now and spring, with major indexes falling 5% to 10%, perhaps even more.”

Reality: That call looked prescient in mid-January when stock markets took a huge hit. But by April they had rallied back and at mid-year both the TSX and the Dow were close to the levels they had been at on Jan. 1. In fact, a few weeks earlier the TSX had reached an all-time high.

Forecast: The second half will see a market rally.

Reality: This was where it all fell apart. I had expected all the bad news about subprime, bad debt, and the credit crunch to be out by mid-year. It wasn’t, as we now know, and the impact on the stock markets was about as grim as it gets.

Forecast: The TSX will outperform the S&P 500.

Reality: It did, although only by a small margin. The S&P 500 was down 38.5% for the year, compared to our loss of 35%. So yes, I was right – but so what? Investors on both sides of the border lost a bundle.

Forecast: Interest rates will fall.

Reality: They sure did, to the point where Treasury bills now pay virtually nothing.

Forecast: Bonds will continue to rally.

Reality: Government bonds followed the script. Corporate bonds didn’t.

Forecast: The loonie will stabilize. I predicted it would trade in a range of US95c to US$1.05, ending the year around US$1.03.

Reality: That prediction actually looked pretty good until late September when the bottom suddenly fell out of the loonie. According to the Bank of Canada, it plummeted from US97c on Sept. 26 to US77c on Oct. 27 for a loss of 20.6% in one month. It ended 2008 at US81.66c. – G.P.

PREDICTIONS FUTURE

In all the years I have been writing about personal finance, there has never been one that is more difficult to predict than 2009. The “expert” forecasts I’ve been reading in the media and in analysts’ reports are all over the lot. The deepest pessimists are calling for a rerun of the Great Depression, with the economy taking a decade or more to recover from the brutal beating it is experiencing. The optimists are predicting that stock markets will turn around by mid-year and the second half of 2009 will see an explosive recovery. One forecast I saw has the TSX rising 30% this year. Wouldn’t that be nice?

My feeling is that there is too much uncertainty and too many variables in play to offer any truly meaningful forecasts. However, I am prepared to make some educated guesses about how the year will unfold. Just remember that’s all they – guesses. Don’t bet the house on any of them.

The TSX and the S&P 500 will be higher at year-end than on Jan. 1. This is going to be a very difficult year for economies around the world and we clearly will not escape. During the first half of 2009 we should expect one bad news story after another: rising unemployment, more corporate and personal bankruptcies, falling house prices, dismal earnings reports, huge budget deficits, and more. It will not be a pleasant time. Survival will be the name of the game.

The impact of all this on the stock markets will be continued volatility and possibly another major correction before spring. But after that, I look for the major indexes to begin a recovery even though the economy will remain soft. The reason for this cautious optimism is that stock markets are historically leading indicators. They will reflect anticipated improvements in the economy months in advance. So if we start to see indicators of an economic recovery in 2010, the markets should be moving ahead by the second half of this year.

The precise timing is impossible to predict as is the extent of any advance. All I’m prepared to predict at this stage is that at the close of trading on Dec. 31, 2009, the TSX will be above 9,000 and the S&P 500 will be higher than 905.

Corporate bonds will outperform government bonds. There was no better place for your money in 2008 than government bonds. And U.S. Treasury bonds were the best of all because Canadian investors enjoyed a significant gain on currency exchange on top of any capital gains and interest on the bonds themselves.

It won’t be the same story in 2009. While safety will still be high on most people’s priority list, the absurdly low yields on federal government securities will encourage investors to seek out alternatives. The beneficiaries should be highly-rated corporate bonds and, to a lesser extent, provincial bonds.

Bond availabilities and pricing will vary from one broker to another depending on what they are holding in inventory and the mark-up charged. And buying individual bonds can be extremely tricky and should only be undertaken with expert advice. For example, some highly-rated Toronto-Dominion Bank bonds I looked at have what appears to be a very attractive yield to maturity but they contain a provision which adjusts the coupon rate several years before maturity to that paid by bankers’ acceptances plus 1%. So if bankers’ acceptances are yielding 1.5%, you’ll receive only 2.5% and the yield to maturity will suddenly look much less attractive. Unless you’re a skilled bond trader, use a low-cost mutual fund or an ETF.

Interest rates will edge higher towards year-end. Unless we really are heading for Great Depression II, this one is a no-brainer. With governments around the world printing money as fast as the presses can operate in an attempt to reflate their economies, it’s only a matter of time before rates stabilize and then begin to move higher. It won’t happen soon, however. No central bank wants to make the mistake of increasing rates before there are clear signs of an economic recovery. But by year-end, I expect that target rates in both Canada and the U.S. will be higher than current levels. Since they are effectively at zero in the States, there’s really nowhere to go but up.

The loonie will rise slightly. The Canadian dollar’s 20%+ decline last fall caught everyone off guard. The loonie had been expected to lose steam with the decline in commodity prices but under normal circumstances a pull-back to the range of US85c to US90c would have been more in line with reality. The situation was exacerbated by the flood of offshore money into U.S. Treasuries which pushed the value of the greenback higher. That made little sense at a time of rapidly falling U.S. interest rates, mind-boggling deficits, and multi-billion dollar bail-outs but rationality was in short supply in the fall of 2008. We should see some stability return to currency markets in 2009 with the loonie trading in the US85c range by year-end.

Oil prices will rebound. Oil has always been a highly cyclical commodity. It never moves in a straight line; just when you think a clear trend is in place, everything turns upside down. It happened again in 2008. In July, the world price of crude hit $147 a barrel (prices in U.S. dollars) and everyone knew it was only a matter of time before it reached $200. Actually, it probably is just a matter of time – it’s just going to take a lot longer than anyone expected a few months ago.

Now oil is trading around $45 and some analysts are predicting it could fall to $30 or even below. Sure it could. As recently as 1998, the average price of a barrel of crude oil was $11.91. But it didn’t last long then and it won’t this time either. But neither should we expect a return to $100 a barrel in 2009 or even in 2010.

It’s instructive to look at trends in oil prices since the end of the Second World War. For a generation, from 1946 to 1973, the average price of a barrel of domestic U.S. crude remained in a narrow trading range of about $3 on each side of $20, inflation-adjusted, according to figures published on InflationData.com.

Then came the oil shock of the 1970s. Crude broke out of its long-term pattern and within two years the price per barrel more than doubled. By 1980, it had hit an inflation-adjusted average of $95.50 a barrel. Gasoline prices soared and people became convinced that oil prices would keep rising forever.

By 1986 – only six years later – the price of a barrel of crude had plunged more than 70%! Except for a brief spike in 1990, it remained fairly flat until 1998 when, as I mentioned earlier, the bottom fell out.

After rebounding in 1999-2000, oil prices again went into a flat stage that lasted until 2003. Since then, it moved higher at an accelerating rate until the summer of this year. The last time we had a run like that was from 1973 to 1980.

The point of all this is to remind readers that although cycles can run for several years, nothing lasts forever. At current levels, the price of a barrel of oil is down almost 70% from its July high. That is the largest six-month drop in history; nothing else even comes close. We know that the energy companies aren’t going to give away the stuff; in fact they are already starting to reduce production. So at some point in 2009, supply and demand are going to come into balance. Since producers can’t turn the taps on again at a moment’s notice, inventories will begin to fall putting upward pressure on prices.

Yes, I know there is a recession on. But the last time I looked there were still traffic jams at rush hour, planes were still flying, electricity continued to be generated from oil-fired plants, and plastics were still being manufactured. The world still has not found a substitute for the gunky stuff. The price will turn around and with it the fortunes of energy stocks.

Those are my calls for 2009. Next year we’ll look back and see how they turned out. – G.P.

IRWIN MICHAEL: SIGNS OF STABILITY

Contributing editor Irwin Michael joins us for this first issue of 2009 with some observations that suggest we may be seeing some early signs of stability returning to the markets. Irwin is the founder and president of the ABC funds and is one of Canada’s leading proponents of value investing. Here is his report.

Irwin Michael writes:

Although the TSX market index fell almost 300 points in December with continued volatility, there are some signs, albeit perhaps premature, that the market may be gaining some stability. For instance, certain credit indicators such as the TED spread, three-month LIBOR rates, and the VIX, a measure of market volatility, have all improved.

The securities market has also been receptive to a number of new multi-billion dollar financings over the past few weeks including Royal Bank of Canada, Manulife Financial, Great-West Life, and Bank of Montreal. All are now trading above issue price, indicating that at “a price” both Bay Street and investors will underwrite and purchase common shares. This situation is in contrast to a very inhospitable market of two or three months ago when no financings could be completed.

Another interesting fact is the precipitous decline in interest rates. Worldwide central banks are aggressively attempting to liquefy the banking system by reducing interest rates and increasing money supply to go along with stimulative government fiscal actions. Unfortunately, it generally takes a while for monetary and fiscal activity to produce tangible results.

A significant by-product of substantially lower interest rates has been the growing yield differential between U.S. Treasury bills at almost 0% and dividend-paying common shares at 5%+. True, corporate dividend payouts can be cut however there are numerous good-quality American and Canadian public companies with solid long-term dividend-paying track records. This conspicuous and expanding rate differential between low-yielding government Treasury bills and common stocks is presenting excellent yield pick-up opportunities with longer-term capital gains potential.

Looking ahead, governments and central banks are pulling out all the stops to kick-start worldwide economies. There is no question that economic, financial, and corporate news flows remain quite negative and in the course of reporting this data, the media has been quite dutiful in promoting this negativity. In consequence, investor appetite for any sort of risk is very low and many are quite content to ride out the present storm within the safety of record low Treasury bills. While this may not be a bad policy in the short run, selective investment opportunities may be missed. Moreover, at some point the year-to-year economic comparisons will stop turning down and will, in fact, show positive year-over-year growth. Clearly, the market will be looking for this development and will react quickly and positively.

As we enter 2009, while stock prices could edge lower, a number of common stocks are thinly-traded with extremely low valuations. Investor psychology is very negative and many sell-side analysts continue to mark down their price expectations. Furthermore, the present financial environment is excessively challenging and frustrating to all investors. As a value manager we believe that investors are looking less at balance sheets and income statements but, rather, they are selling whatever they can to obtain their desired liquidity. Occasionally, a diamond may fall between the cracks during the present pursuit of liquidity.

Given the present widespread negativity it might sound rather heroic to offer a positive outlook for 2009. We expect 2009 to remain challenging, volatile, and to test our patience. Nevertheless, with any perceived or real upturn in investor psychology and/or economic or corporate data we believe that this occurrence could result in a significant market run-up and an opportunity to recoup 2008 losses and beyond.

 

IRWIN MICHAEL’S UPDATES

Canam Group Inc. (TSX: CAM, OTC: CNMGA)

Originally recommended on July 7/08 (IWB #2824) at C$10.42, US$11.09. Closed Friday at C$6.80, US$4.35 (Oct. 8).

One of our value favourites, Canam Group, has come to exemplify these unusual and difficult markets. We re-established a position in Canam towards the end of the first quarter of 2008. We were comfortable paying almost $6 per share lower than the stock’s 52-week high and roughly $4 per share lower than where we had sold our original stake. We thought that we were buying a dirt-cheap stock but, unfortunately, the shares dipped again late July through early August.

By October, it became apparent why the shares were declining without any clear fundamental reason. On Oct. 7, the shares opened just below $6.50 and suddenly plunged to a low of $3.73 per share, a decline of approximately 40%. We were dumbfounded but quickly put a bid in and actually managed to purchase a few thousand shares for our funds at $3.75. The stock then bounced and closed the day at $5 per share.

Over the next two days we saw several large blocks of stock change hands. It took us a few days to piece together the story but we finally discovered that a hedge fund was behind the volatile trading. This fund, perhaps facing redemptions, was forced to raise cash by dumping several million shares into the market, irrespective of price. It was frustrating to watch but at least we understood that the company’s fundamentals were sound.

Management apparently agreed with our assessment of Canam’s prospects. In their recent quarterly release, they announced that as of Oct. 21 the company had acquired 2,185,100 shares at an average price of $6.14 per share for a total amount of $13.4 million. The shares were purchased through the company’s normal course issuer bid that began last August for up to 4,075,000 shares.

With a book value of $8.18 per share, this buyback is accretive and represents an excellent use of the company’s strong and flexible balance sheet. Eventually, investors will focus on fundamentals instead of liquidity and the shares should return to a more realistic valuation range.

Action now: Buy at current levels. Note that although the shares trade over-the-counter in the U.S., there have been no trades there in Canam since October.

Polaris Minerals Corp. (TSX: PLS, OTC: POLMF)

Originally recommended on April 30/07 (IWB #2717) at C$9.90, US$8.94. Closed Friday at C$1.49, US$1.25.

Given today’s environment, investors need to focus on identifying the survivors. In the resource sector, this means that a company’s operations have to be either cash flow positive at current commodity prices or fully-funded through to commercial production. Despite the disappointing share price performance in 2008, we believe that Polaris Minerals has the cash flow and the balance sheet to weather the storm.

From a cash flow perspective, Polaris sold 694,000 tons of sand and gravel in the third quarter of 2008 and reported cash from operations of $635,000 despite elevated shipping and fuel costs. Importantly, lower fuel costs in the fourth quarter could add $2 to $2.50 per ton to the gross margin, which should flow directly to operating cash flow. We recently met with management, who confirmed that they would be cash flow positive in 2009, even after deducting planned exploration and development capital expenditures.

From a balance sheet perspective, the market had growing concerns about Polaris’s ability to refinance a bridge loan that had been put into place to fund the Long Beach Pier B acquisition. This one-year $20 million facility had an initial interest rate of 12% that increased to 13% and 15% if the loan remained outstanding at 91 days and 181 days respectively. On Dec. 16, Polaris ended the speculation and announced that it had entered into a $25 million bought deal for new equity at a price of $1.60 per unit. Each unit consists of one common share plus one half of a common share purchase warrant. One full warrant allows the purchase of an additional common share at an exercise price of $2.25 per share for a period of two years following the closing of the offering.

Post closing, the bridge loan will be completely repaid and the company will have approximately $13 million of cash on its balance sheet. Additional sources of liquidity include $3 million from a sale/leaseback transaction involving the company’s new berthing tugboat. Further, the company has approximately $5 million tied up in Asset Backed Commercial Paper, which could be returned as soon as January as per the recently announced agreement with the provincial and federal governments.

As long-term investors, we are willing to accept some dilution to ensure that this irreplaceable asset survives through the downturn. Management apparently shares our view and has been buying stock in the open market. Most notably, Herb Wilson, president and CEO, bought 91,000 shares at $4.39 last August and another 16,900 shares at $1.47 in December. We are always encouraged when insiders are confident enough to put more “skin-in-the-game”.

Action now: Buy at current levels.

George Weston Ltd. (TSX: WN, OTC: WNGRF)

Originally recommended on Dec. 8/08 (IWB #2843) at C$59.85, US$45.85. Closed Friday at C$59.90, US$46.94 (Dec. 30).

Although we released our initial comment on George Weston Limited only a month ago, there has been a material new development. Our investment thesis was based on backing out the implied value of Loblaw from each share of George Weston. We believed that we could purchase the Weston Foods operating division below 4.5 times EBITDA, while comparables traded at approximately eight times EBITDA. We expected that the multiple on the bakery operations would expand as lower commodity prices became reflected in the financial results. However, management subsequently announced a transaction that monetized a significant portion of this valuation discrepancy.

On Dec. 10, the company announced that its subsidiary, Dunedin Holdings, had agreed to sell its fresh bread and baked goods business in the United States to Grupo Bimbo, one of the world’s leading and largest baking companies. Grupo Bimbo, based in Mexico, paid approximately US$2.5 billion for operations that generated US$275 million of twelve-month trailing EBITDA. This equates to a 9.1 times EBITDA multiple, more than double the implied public market value of the “bread-stub”. Note that Weston Foods retains its baking and distribution operations in Canada and its other U.S. baking divisions, Interbake Foods and Maplehurst Bakeries.

Speculation regarding the use of cash proceeds quickly turned to talk of privatizing Loblaw. However, we believe that this scenario is unlikely from a value creation perspective since Loblaw already trades between eight and nine times EBITDA. Privatizing George Weston Limited would actually make more sense since the remaining U.S. and Canadian operations now trade below three times EBITDA.

However, management was quite clear that they were in no hurry to deploy the cash proceeds. They seem content to sit on almost $5 billion in cash (including $1 billion of cash held at Loblaw) and wait for an exceptional opportunity or opportunities to present themselves. Remember, amid the current market turmoil, cash is king.

Action now: Buy below $58.

– end Irwin Michael

 

TFSAS – GREAT IDEA, TERRIBLE TIMING

Tax-Free Savings Accounts (TFSAs) are now officially here, although according to reports from various financial institutions hundreds of thousands of Canadians had already opened plans in anticipation of the Jan. 1 launch.

No wonder! These things are the most powerful savings tool since the Diefenbaker government brought in RRSPs over 50 years ago. In fact, TFSAs are even better than RRSPs in some situations.

Just think: once you put money into a TFSA, you’ll never have to pay tax on it again, or on any of the investment income you earn within the plan. You can withdraw as much as you want, whenever you want, and you won’t have to pay the government a penny. Moreover, you can put it all back in again later if you want. Talk about a win-win situation!

Perhaps I should qualify that. TFSAs are winners for individual Canadians. Future governments may look at them quite differently. And one thing is certain: while the concept is great, the timing is dreadful. Just at a time when governments are encouraging people to keep spending in order to stimulate the economy, Ottawa launches a plan that will encourage people to sock away billions of dollars in savings accounts. In a report published last fall, CIBC senior economist Benjamin Tal predicted that TFSAs would attract $20 billion worth of business in 2009 alone, rising to $115 billion over five years. That’s a lot of foregone consumer spending.

How did we end up in this situation anyway? The following excerpt from my new book, Tax-Free Savings Accounts: A Guide to TFSAs and How They Can Make You Rich, provides some answers.

No one expected much when Finance Minister Jim Flaherty stood up to give his Budget speech in the House of Commons at 4 p.m. on February 26, 2008.

The cupboard was pretty much bare. The Conservative government, anticipating an early election, had dipped deeply into the nation’s dwindling surplus the previous October when Mr. Flaherty had delivered an “Economic Statement” that was actually a mini-budget in very thin disguise.

At that time, the Finance Minister had announced a second cut in the GST, reducing it to 5% as the Tories had promised during their election campaign. He had announced a reduction of half a percentage point in the lowest tier income tax rate. He had increased personal tax exemptions across the board for all Canadians. He had cut the rates on Employment Insurance. He had announced deep cuts to the federal corporate tax rate, slashing it from 22.1% to 15% by 2012.

The total cost of all those tax goodies was estimated at a whopping $188.1 billion over the next six fiscal years. Of that, $72.7 billion was eaten up by the GST cut, $64.9 billion went to income tax savings, and $50.5 billion to the corporate tax cuts.

But after handing out all those goodies, the Conservatives discovered the Opposition parties were in no mood to force an election. Instead, they went along with every measure presented to them by the government, thwarting Stephen Harper’s plans for an early election.

That left the government with no choice but to bring in a new Budget. No one expected much. In the days leading up to the speech, the media talked about green initiatives, municipal infrastructure, more aid to students, and minor fiddles with the GST. Yawners all!

Faced with the prospect of a ho-hum Budget in what would likely be an election year (and was, as it turned out), the Finance Minister and his staff started casting around for ideas. In pre-Budget consultations with a range of business people, academics, and special interest groups, Finance Department officials kept returning to two key themes: demographics and retirement. As a sub-text, the Minister was very aware of the lingering anger among many seniors as a result of his decision to impose a tax on income trusts, which was announced on Halloween night, 2006.

So when Mr. Flaherty rose in his place on February 26, expectations were low and the public was largely uninterested. He attempted to change that right off the top.

“Mr. Speaker,” he intoned, in the usual formality of the House of Commons. “The budget is balanced. Taxes have been cut. And Canadians will now have a powerful new incentive to save money, tax-free: the Tax-Free Savings Account that we are announcing today.”

Tax-Free Savings Accounts (TFSAs), which no one had previously thought much about, were suddenly centre-stage in the most important Parliamentary event of the year.

What it all boils down to is that Tax-Free Savings Accounts exist today because political expediency required the Finance Minister to offer something in the February budget that would appeal to voters without costing the federal treasury a lot of money, at least initially. At the time, the economy was robust and no one foresaw that the country would be in a deepening recession when the program actually came into effect.

If this were a golf game, Mr. Flaherty would probably ask for a mulligan on this one. But it’s too late now. TFSAs are here to stay and over time they will help Canadians rebuild the personal wealth they lost in the crash of 2008.

During the next few weeks, we’ll carry a series of articles in the IWB on how to use these plans most effectively. Stay tuned. – G.P.

 

TFSA BOOK OFF THE PRESS

I received my author’s copies of the TFSA book last week which means it should be in bookstores soon. Readers who reserved copies through our on-line bookstore (in association with Amazon.ca) should expect to receive their books within the next couple of weeks (the official publication date is Jan. 12). If you want to place an order at a 27% discount off the suggested retail price go to http://astore.amazon.ca/buildicaquizm-20. As of Friday, the book was sitting at number two on Amazon’s personal finance bestseller list.

If you missed it, Jonathan Chevreau of the National Post wrote a nice article about the book here: http://www.nationalpost.com/news/story.html?id=1130415

Jon and I also did a series of podcasts about TFSAs and how they work which can be viewed at
http://www.financialpost.com/money/wealthyboomer/index.html

– G.P.

 

That wraps up our first issue of the year. Our best wishes for a healthy and more prosperous 2009 and we will be with you again on Jan. 12.

Best regards,

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

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