In This Issue

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THE DOOMSDAY SCENARIO

Two high-profile economists at BMO Nesbitt Burns set the cat among the pigeons last week by publishing a report on the effects that a world-wide flu pandemic could have on the global economy and individual investments.

It?s titled ?An Investor?s Guide to Avian Flu?, although Guide seems much too restrained a word in this context. This frightening document can be read in its entirety at http://www.bmonb.com/economics/reports/20050812/avian_flu.pdf but before you do, be warned: you may not sleep well once you are finished.

This is truly a Doomsday scenario if there ever was one. Imagine the worst possible thing that terrorists might do. Then multiply it 100 times. You would still not be close to the impact a world flu pandemic could have on our lives!

The authors, Sherry Cooper and Donald Coxe, say the report is not meant to be alarmist but is rather intended to encourage a prudent approach to investing. But it is hard to read the document without being alarmed ? in fact, terrified is a word that more accurately describes the emotions it unleashes. If the avian flu epidemic, which has spread through both wild and domestic birds in Asia, jumps to humans ?a global pandemic would probably be only days away?, they write. How can you read that without being alarmed?

And what would such a pandemic mean? The last truly deadly pandemic in 1918, known as the Spanish flu, killed upwards of 25 million people ? some estimates run as high as 100 million. In an avian flu outbreak, the report depicts a world in which hundreds of thousands of people are quarantined, ships and planes from affected countries are turned away, public events such as concerts and hockey games are cancelled, and health care facilities are taxed to the limit and beyond.

In the financial sector, stock markets would close down, commodity prices would crash as demand from countries like China plummeted, oil prices would tumble, demand for manufactured products would dry up, food supplies would be disrupted, and housing prices would tumble. Life insurance companies would be faced with huge payouts, banks would struggle to maintain services, and the tourism sector would come to a screeching halt. Conversely, companies that have a strong on-line sales presence could see their business increase as people stayed at home to avoid exposure ? although this assumes that delivery systems could still function.

?Depending on its length and severity, its economic impact could be comparable, at least for a short time, to the Great Depression of the 1930s,? writes Dr. Cooper in her section of the report.

And, of course, millions would die, devastating entire families. Surprisingly, based on the 1918 experience, the worst casualties would be in the 20-40 age group. The ?good news? from the Spanish flu pandemic is that the North American death toll would likely be much lower than in more densely populated areas of the world. The U.S. mortality rate at that time was about 2.5% – an estimated 675,000 people.

Assuming you lived through this nightmare, where should your money be invested to leave your family with enough to live on during the bleak days to follow?

?Cash, put options on volatile stocks, high-quality bonds, and high-quality dividend-paying stocks of companies with minimal exposure to the risks we have described will be the best survival packs,? writes Donald Coxe. ?They will provide the survivors of the pandemic with the capital to take advantage of the wide array of cheap assets that will ? however temporarily ? be available after the virus has joined its predecessors in whatever resting places the world has on offer.?

Gold, adds Sherry Cooper. ?We saw gold prices pop immediately after 9/11, and decline only after the immediate crisis abated.? She believes the U.S. dollar would also increase in value, as a safe haven currency.

Several weeks ago, in response to a member?s question on this subject, I suggested that Canadian or U.S. government bonds along with gold and diamonds could be used as financial ?insurance policies? against this type of calamity. The Cooper/Coxe report is skeptical about precious stones because widespread deaths would lead to estate sales that could flood the jewelry market. But government bonds are way up on all the ?safe? lists. Yes, the yields are pitiful but at least you know the money will be there.

So how worried should you be? Enough to review your portfolio and perhaps make some adjustments. But keep things in perspective. As Mike Miller, director of research at BMO Nesbitt Burns, says in an introduction to the report: ?Experience has taught me that extreme outcomes are rare; that forecasts based on consensus expectations are often more close to the truth than those based on outside probabilities.?

A global pandemic of avian flu on the scale of the 1918 Spanish flu has to be considered as an outside probability. Let?s hope it never becomes anything more than that. ? G.P.

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GLENN ROGERS: HOW TO INVEST IN HOMELAND SECURITY

Many IWB readers will remember Glenn Rogers, who was a contributing editor for us from 2001 until mid-2003 when he left to take a position as a senior executive in southern California. Glenn is a savvy investor who provided IWB members with many winning picks during his time with us including Vincor (sold for 42% profit) and ENI SpA, which we recently sold for a 96% profit.

Although his current position as president of Vision Entertainment in Irvine, CA limits the time available for him to write, he has agreed to submit guest columns to the IWB on occasion. This week, he looks at homeland security in the United States from the perspective of an investor seeking opportunities. Here is his analysis.

Glenn Rogers writes:

The world is a dangerous place these days and the recent events in London only serve to underscore that the ?fight them over there so we won?t have to fight them over here? is far from a fool-proof strategy. Needless to say, companies engaged in the business of providing goods and services to customers involved in protecting people or things have been garnering a great deal of interest since 9/11. So in as much as we feel somewhat vulture-like recommending securities that benefit from terrorism, I believe that every portfolio should have some exposure to the homeland security area.

As a result, I am recommending four stocks that I think will benefit from the current sad state of affairs and at least help you make some money even if you don?t feel great about the idea.

There are five general areas in the homeland security sector:

  1. Surveillance
  2. Screening and scanning
  3. Tracking individuals and materials
  4. IT and services
  5. General defense systems

I have identified companies of a reasonable size that have been showing solid growth over the past year. There are a number of smaller companies in this sector that will likely do well based on the rising tide lifting all ships theory but the ones featured here should prosper even in an environment that is less scary than the one we are experiencing now.

These stocks are best-suited to more aggressive investors who are seeking capital gains (only one pays a dividend) and who do not have a moral issue with the idea of investing in companies that are involved in areas like defense and surveillance. For a recent update on this issue, you may want to check out an article that ran on in the New York Times on Aug. 14. You can access it at: http://www.nytimes.com/2005/08/14/international/middleeast/14armor.html?ex=1124769600&en=1ff300176e16381f&ei=5070

Note that all currency figures in the recommendations that follow are in U.S. dollars.

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GLENN ROGERS’ RECOMMENDATIONS

L-3 COMMUNICATIONS HOLDINGS (NYSE: LLL)

The first company on my list is also the largest. L-3 Communications Holdings has over 44,000 employees and operates in a large number of areas within the aerospace and defense sectors. The company offers solutions in secure communications, mobile satellite communications, shipboard communications, missile arming systems, radar and missile systems, and airport security equipment. They also design and manufacture screening systems for explosives, firearms in airports, security checkpoints, and commercial buildings. So if you are looking for a company that covers the waterfront and everywhere else on the security front, L-3 might be for you.

The company recorded $6.9 billion in sales in fiscal 2004 and had net earnings of $382 million ($3.33 a share, fully diluted) before taking into account a change in accounting principles. Sales grew by 35% on a year-over-year basis, which is very strong for a company of this size.

The growth is continuing in 2005. Second-quarter results released in July showed sales of slightly over $2 billion, up $395.6 million or 23% from the same quarter a year ago. Operating income was $224.9 million and fully diluted earnings per share came in at 99c. For the first half of fiscal 2005, the company has earned $1.84 a share, up from $1.42 in the same period last year.

The stock, which closed Friday at $79.40, is no bargain, trading at a P/E of 21 but given L-3?s growth rate, size, and the fact that it is one of the few stocks in this area that pays a dividend, albeit a small one at 12.5c per quarter, I regard it as a Buy with a target of $90.

Action now: Buy.

COGENT SYSTEMS INC. (NDQ: COGT)

The next company on our list is considerably smaller than L-3 and is more narrowly focused. Cogent Systems creates systems and devices that track individuals and materials.

The company?s main business is producing automated fingerprint identification systems (AFIS). Its primary customers are the ones you would expect: law enforcement, government agencies, and large corporations. Cogent also manufactures systems that are used at border crossings, which is a high-need area worldwide.

Although the company is small, with only 137 employees and less than $90 million in sales, it operates internationally. And it is showing strong growth. Second-quarter sales increased 131% year-over-year, to $39.4 million, and income grew at a blistering 96%.
What I particularly like about Cogent is that it maintains a high profit margin of 42.1%.

The stock has run up by about 30% in the past three months, although it has come back a bit lately. At these growth rates I wouldn?t bet against it moving higher from here. The stock closed on Friday at $27.

Action now: Buy with a price target of $35.

SRA INTERNATIONAL (NYSE: SRX)

SRA International is located in Fairfax, Virginia and fits into the IT and services category. They have 4,600 employees. The company provides solutions for civil governments and national security but also operates in the health care area so there is some diversification outside the defense sector.

SRA specializes in sophisticated data mining, disaster response planning, infrastructure protection, and so on. What I like about the business is that it is broadly diversified with no customer group having more than a 9% share of the revenue stream.

The firm is also heavily involved in protection against cyber attacks, which unfortunately is a growth industry. They also produce products that protect against illegal border crossings.

As a bonus, the company has been chosen one of the 100 best companies for which to work and Business Week named SRA as one of its hot growth companies. According to the company?s website, the GovernmentVar Magazine selected SRA as this year?s Government Solution Provider of the Year, which means the folks in Washington who make the purchase decisions must really like it.

This is another strong growth company. Year-end results for fiscal 2005, released earlier this month, showed that sales increased by 43% year-over-year to $881 million and by 33% to $241 million for the last quarter. Operating income grew by 44% for the year to $57.7 million and 28% for the quarter to $15.9 million.

Fully-diluted earnings per share for fiscal 2005 came in at $1.02. In their guidance for fiscal 2006, management forecasts EPS of $1.20 to $1.25. That would be an increase of 15% to 22.5%.

The stock closed on Friday at $34.30.

Action now: Buy.

ARMOR HOLDINGS (NYSE: AH)

The last company in our basket of doom and gloom stocks is a more nuts and bolts type of company, operating in the relatively low-tech side of the protection business. Armor Holdings is headquartered in Jacksonville, Florida. They have over 4,100 employees worldwide. The company is organized in three divisions, as follows:

The Aerospace and Defense Group. This division has received the most press this past year because this is the company that has been charged with providing beefed-up armored protection for the Hummers in Iraq. That happened after the news came out that marines were improvising their own protection by scrounging through garbage dumps, much to the embarrassment of the Pentagon. In fact, Armor is the sole provider to the U.S. military for armor and blast protection for this type of vehicle. The company also provides helmets and body armor for the troops as well as helicopter seating systems.

The Armor Holdings Division. Products manufactured by this group include anti-riot gear, police batons, emergency lighting products, foldable ladders, etc.

The Armor Mobility Division provides armor for non-military clients such as limousine companies, commercial trucks, and so on. They do well in areas where kidnapping is a constant threat like Iraq, Mexico, and Colombia.

The company recently reported second-quarter results. Revenue for the period was $371.6 million, up an astounding 66.1% from the same period last year. Net income was $37.4 million ($1.05 per share, fully diluted), up from $17.8 million (57c a share) a year ago. For the first six months of the current fiscal year, Armor reported EPS of $1.93 a share, an increase of 95% over a year ago. This is growth in spades! Management has revised upwards its forecast for fiscal 2005 and is now projecting EPS of $3.70 to $3.80.

The stock closed on Friday at $42.29 which means it is trading at a P/E of only 11.3 based on fiscal 2005 estimates. That makes it a bargain by homeland security standards.

Action now: Buy with a target of $48.

Final thoughts

I hope I have not depressed you with all these security-oriented stocks but, like it or not, the reality is that the Bush Administration is very defense-friendly and with the world blowing up around us we may as well have something in our portfolios to hedge against future disasters.

I have chosen to provide you with a group of stocks in this sector. You can select one or two that interest you or buy a basket of all four to achieve greater diversification. An investment of approximately US$10,000 would give you a package like this.

  • 30 shares of L-3 Communications.
  • 85 shares of Cogent
  • 70 shares of SRA International
  • 60 shares of Armor Holdings

Whichever approach you take, these stocks should reward you over the next 12 months.

– end Glenn Rogers

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UPDATES

ROCKY MOUNTAIN CHOCOLATE FACTORY (NDQ: RMCF)

Originally recommended by Gordon Pape on Feb. 21/05 (IWB #2508) at $14.28 (split-adjusted). Closed Friday at $18.84. (All figures in U.S. dollars.)

Rocky Mountain?s share price has taken a sharp drop since the beginning of the month, when it was trading in the $24 range. The company has made no announcements and a spokesperson blamed the decline on ?the market?, saying that there has been ?no change? since it released its fiscal 2006 first-quarter results in July. COO/CFO Bryan Merryman is on holiday until September and was unavailable for comment.

The first-quarter results (to May 31) gave no indication of any problems. The company reported a revenue increase of 13% compared to the same period last year, to $5.4 million. Same-store sales at franchised retail outlets increased 4.1%. Net earnings were up 27% to $753,000 (11c a share, fully diluted), compared with $592,000 (9c a share) in the prior-year period.

“We are pleased to report another quarter of record earnings, particularly in light of the fact that earnings in the first quarter of last year were 55% higher than in the prior-year period,” Mr. Merryman said in a statement at the time the results were released. ?Our company is now the largest retail chocolatier in North America, in terms of the number of stores in operation, and we are proud to have achieved this status in a year during which earnings should set another record.”

That all sounds encouraging but I am always suspicious when a stock drops as sharply as this on no news. One possible explanation may be that profit-taking that drove the price lower triggered program selling when the price fell below $21 on Aug. 9. The relatively high trading volume on Aug. 9-10 would support that theory.

If this is the case, the pull-back would suggest a buying opportunity. The price hit an intra-day low of $17.78 on Tuesday but has then rallied from there to finish the week at $18.84. I will continue to monitor the situation and report on any further developments.

Action now: Hold/Buy. Aggressive investors who are willing to accept the risk involved may enter at this level. ? G.P.

TIME WARNER (NYSE: TWX)

Originally recommended by Glenn Rogers on May 21/02 (IWB #2219) at $19.98. Closed Friday at $18.09. (All figures in U.S. dollars.)

A well-known New York investor who has made a career and a lot of money fighting the management and directors of companies he believes are underperforming has taken on Time Warner. Carl Icahn issued a press release last week in which he recommended that the company sell off its cable division and buy back $20 billion worth of shares in the open market. He later met with Time Warner CEO Dick Parsons to discuss his ideas.

Companies controlled by Mr. Icahn along with three investment firms that support his views collectively hold about 120 million shares of Time Warner with a market value of $2.2 billion. So he has a lot of clout behind him.

He said in his statement that Time Warner?s management ?has not moved quickly enough and it has not proposed measures which would enhance [shareholder] values to the degree necessary to realize the inherent value of TWX’s well positioned and unique assets?. He also indicated that he may propose his own nominees to the Time Warner board at the next annual meeting if he doesn?t see significant progress.

The company?s share price rallied briefly after the announcement but then drifted off to close the week at $18.09.

Earlier this month, the company announced a second-quarter loss of $321 million (7c a share), due to a $3 billion reserve provision for settlement of a class-action lawsuit brought by disgruntled shareholders as a result of the AOL merger. Revenue declined 1% compared to the same period a year ago, to $10.7 billion. However, the company reaffirmed its expectation that its 2005 full-year growth rate in adjusted operating income before depreciation and amortization will be in the high-single digits, as compared to $9.9 billion in 2004.

Management also announced a $5 billion share buy-back program ? only one-quarter of what Mr. Icahn is seeking but a move in his direction.

Action now: Hold. ? G.P.

ARC ENERGY TRUST (TSX: AET.UN)

Originally recommended by Gordon Pape on March 1/04 (IWB #2409) at $15.32. Closed Friday at $21.70 (US$17.23).

ARC released its second-quarter results on Aug. 3 and they contained some good news and some bad news for investors. On the good news side, monthly distributions are being increased to 17c ($2.04 a year) effective Sept. 15. The previous payment was 15c a month so this represents a 13.3% bump.

Cash flow for the quarter was $121.8 million while payments were $84.5 million, representing a payout ratio of 69%.

Now for the bad news. Production was down 6% from the same period a year ago, continuing a pattern I have commented on previously. Management contends this is partially due to the disposition of non-core properties and says the trust spent more than $45 million on development in the quarter plus another $124 million on acquisitions. It issued new guidance which forecasts full-year production volumes of 56,000 boe/d (barrels of oil equivalent per day). However, that would still be below last year?s second-quarter figure. This is a matter of continued concern so despite the distribution increase I continue to advise against new purchases.

U.S. investors can buy ARC units through the Pink Sheets where the trading symbol is AETUF.

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 Friday at $30.68 (US$25.15).

Peyto released second-quarter results on Aug. 10 and once again they contained a lot of positive news for investors. In contrast to ARC, production increased by 21% from 18,544 boe/d in 2004 to 22,464 boe/d in the second quarter of 2005. That works out to an increase of 19% per trust unit after adjusting for debt and bonuses. Cash distributions were up 37% from the same period last year while the payout ratio remains low at 51%. However, net earnings declined to $25.7 million (27c a share) from $30.3 million (33c a share) due mainly to a $7 million jump in royalty payments.

Peyto has done very well for us since we recommended the units at a pre-split price of $9.93 about two years ago. There is still some growth potential here but it would be unrealistic to expect a continuation of the results we have seen to date. An on-going annual return in the 10% range, including distributions and capital gains, is more likely.

Analysts are divided about Peyto?s future prospects. RBC Capital Markets initiated coverage of the trust last week and awarded it a Top Pick rating with a target of $37.50. The research team, led by Patrick Bryden, praised Peyto for its ?unparalleled accomplishment? in increasing tight natural gas production from Alberta?s Deep Basin and described it as ?the lowest cost, highest netback, longest life producer in the sector?.

In contrast, CIBC World Markets reduced its rating to Sector Performer with a 12-18 month target of $33. Analysts Mark Bridges and Robert Pare said that ?Peyto offers one of the most attractive models in the coverage universe? but has become very expensive. ?We believe Peyto would need to deliver substantial growth of almost 25% per year over the next three years to justify its current valuation,? they wrote.

I concur with this view, which is why the IWB has maintained a Hold rating on Peyto for some time. There may be opportunities to buy down the road when the price of oil and gas cools (assuming it will) but for now I suggest you maintain your positions and adjust your mentality for more modest profits going forward.

The current monthly distribution is 12c per unit for a yield of 4.7% based on the current price. But members who bought at the time of my original recommendation are enjoying a yield of 14.5% based on the price they paid at that time.

The shares trade in the U.S. through the Pink Sheets where the symbol is PEYUF.

Action now: Hold. ? G.P.

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UPDATE REQUESTS

We frequently receive requests from members for updates on specific securities. We do our best to respond to these on a timely basis but all updates will only be published in the IWB so that everyone has access to them at the same time. We will not send personal updates as this would not be fair to other members.

Also, we sometimes get e-mails asking for our opinion on a security that is not on our Recommended List. We will take such requests under advisement and, if appropriate, do a write-up on the security in question at a future time. However, we cannot provide personal advice. Thanks for your understanding. ? G.P.

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YOUR QUESTIONS

Who profits from private health care?

Q – The great Canadian political debate continues but, no matter what the politicians may say, private health care is here or is coming. Which companies will benefit and make money for the investors who buy them? ? J.S.

A ? This question is very timely considering that the Canadian Medical Association raised the stakes last week by coming out in favour of some form of privatized health care. But the Liberal government remains strongly opposed to the idea as do most of the premiers and several influential lobby groups.

So if private health care is coming on any large scale, it may still be several years away. The Supreme Court recognizes the problems involved and recently agreed to a one-year suspension of its judgment on the key Quebec case that triggered the latest public controversy.

If and when a parallel medical system does evolve in Canada it will likely be slow in developing because of the tight controls that will placed on practitioners and service providers by various levels of government. I doubt that we will see anything resembling a domestic version of the infamous American HMOs for at least five years and probably longer. So it?s a long road ahead and placing financial bets on the winners at this time is premature.

That said, one industry that is sure to profit if private health care takes hold is the insurance business. Every employee will want to see appropriate coverage added to the corporate benefits package. So if you want a sure-fire winner, buy some shares in Manulife (TSX, NYSE: MFC) or Sun Life (TSX, NYSE: SLF), both of which are on our Recommended List. They should do well anyway, even if private health care never comes. If it does, it will be an added bonus for them. ? G.P.

When to sell trusts

Q – My mother recently passed on and we are in the process of liquidating her portfolio. We have some flexibility when we can sell. Much of her portfolio is in income trusts and I was wondering whether it would be better to wait until the next income distribution to sell, or simply go ahead now. Her portfolio is weighted heavily in oil and gas (e.g. Acclaim, Advantage, NAL, Pembina, Superior Plus). ? Geoff

A ? Most income trusts pay distributions monthly. This means their market price is not greatly affected by going ex-distribution. High-dividend stocks that pay quarterly, on the other hand, may see a small decline in market price on the day they go ex-dividend.

So don?t let a trust?s distribution date influence your decision. Their market price will be more affected by other factors, particularly the price of oil in the case of the trusts you mention. ? G.P.

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MEMBERS? CORNER

An expert corrects us on CO2

Member Comment: I?ve been an IWB subscriber for two years now and I intend to continue indefinitely ? I like the plain English, no b.s. style of your discussion and recommendations and I have made good money to date on most of what I chose to act on.

In IWB #2531 you talk about buying into Kinder Morgan now that they?re picking up Terasen and I agree that it makes sense to do so for the reasons you give ? mostly. I?m emailing just to provide some clarification to a statement you made in the recommendation. You said: ?The gas (carbon dioxide) is gaining favour as a way to increase yields from the Alberta Oil Sands and KMI will now be??

I?ve been working as a geologist in Alberta?s conventional and unconventional petroleum and natural gas business for a little over 23 years now including a two-year stint in management of an oil sands project geology team.

Carbon dioxide gas is only a big nuisance that is produced as a by-product of the bitumen upgrading process to lighter, synthetic crude oil (SCO) as far as our oil sands operators and projects are concerned, especially since the Kyoto Accord came into being. The place where carbon dioxide gas is expected to become more popular in Alberta is in enhanced oil recovery projects (EOR) of conventional oil pools (i.e. light oil, not heavy oil or oil sands derived bitumen).

The more mature light oil pools with declining production still have lots of residual oil left in the rock that is more difficult to extract and produce at surface so the carbon dioxide gas, which is ?miscible? (easily blended) with the oil, is injected into the oil reservoir and blends with the residual oil thereby reducing its viscosity and making it easier for the thinner oil to be produced economically from the existing oil wells. When oil was priced from $15-30/bbl it usually wasn?t economically viable to set up the expensive recovery, transportation, and injection infrastructure for the CO2 to be used for EOR projects, thus it was just vented to the atmosphere.

Now, with the increasing unpopularity of letting CO2 gas go into the atmosphere and the high expense and difficulty of just sequestering the unwanted gas underground, the high price of oil is very timely in making such EOR projects viable so more and more producers will consider setting up CO2 miscible flood EOR projects in their Alberta and Saskatchewan oil pools and thus pure CO2 will become a saleable commodity in Canada, as it has already been for some time in the U.S. There are currently only a handful of such EOR projects operating in Canada, one of which is EnCana?s Weyburn project in S.E. Saskatchewan ? I believe they?ve been buying and pipelining the pure CO2 they need from the U.S. so far because it wasn?t available in the quantities they required in Canada yet.

Keep up the good work on the IWB. I always look forward to reading it ? M.D.

Response: Thanks very much for this clarification. We always welcome such input from members with technical/professional expertise to keep us on track and to ensure the IWB is as accurate as possible. ? G.P.

That winds up our coverage for this week. We?ll be back again on Aug. 29 when contributing editor Tom Slee will join us.

Best regards,

Gordon Pape

In This Issue

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THE DOOMSDAY SCENARIO

Two high-profile economists at BMO Nesbitt Burns set the cat among the pigeons last week by publishing a report on the effects that a world-wide flu pandemic could have on the global economy and individual investments.

It?s titled ?An Investor?s Guide to Avian Flu?, although Guide seems much too restrained a word in this context. This frightening document can be read in its entirety at http://www.bmonb.com/economics/reports/20050812/avian_flu.pdf but before you do, be warned: you may not sleep well once you are finished.

This is truly a Doomsday scenario if there ever was one. Imagine the worst possible thing that terrorists might do. Then multiply it 100 times. You would still not be close to the impact a world flu pandemic could have on our lives!

The authors, Sherry Cooper and Donald Coxe, say the report is not meant to be alarmist but is rather intended to encourage a prudent approach to investing. But it is hard to read the document without being alarmed ? in fact, terrified is a word that more accurately describes the emotions it unleashes. If the avian flu epidemic, which has spread through both wild and domestic birds in Asia, jumps to humans ?a global pandemic would probably be only days away?, they write. How can you read that without being alarmed?

And what would such a pandemic mean? The last truly deadly pandemic in 1918, known as the Spanish flu, killed upwards of 25 million people ? some estimates run as high as 100 million. In an avian flu outbreak, the report depicts a world in which hundreds of thousands of people are quarantined, ships and planes from affected countries are turned away, public events such as concerts and hockey games are cancelled, and health care facilities are taxed to the limit and beyond.

In the financial sector, stock markets would close down, commodity prices would crash as demand from countries like China plummeted, oil prices would tumble, demand for manufactured products would dry up, food supplies would be disrupted, and housing prices would tumble. Life insurance companies would be faced with huge payouts, banks would struggle to maintain services, and the tourism sector would come to a screeching halt. Conversely, companies that have a strong on-line sales presence could see their business increase as people stayed at home to avoid exposure ? although this assumes that delivery systems could still function.

?Depending on its length and severity, its economic impact could be comparable, at least for a short time, to the Great Depression of the 1930s,? writes Dr. Cooper in her section of the report.

And, of course, millions would die, devastating entire families. Surprisingly, based on the 1918 experience, the worst casualties would be in the 20-40 age group. The ?good news? from the Spanish flu pandemic is that the North American death toll would likely be much lower than in more densely populated areas of the world. The U.S. mortality rate at that time was about 2.5% – an estimated 675,000 people.

Assuming you lived through this nightmare, where should your money be invested to leave your family with enough to live on during the bleak days to follow?

?Cash, put options on volatile stocks, high-quality bonds, and high-quality dividend-paying stocks of companies with minimal exposure to the risks we have described will be the best survival packs,? writes Donald Coxe. ?They will provide the survivors of the pandemic with the capital to take advantage of the wide array of cheap assets that will ? however temporarily ? be available after the virus has joined its predecessors in whatever resting places the world has on offer.?

Gold, adds Sherry Cooper. ?We saw gold prices pop immediately after 9/11, and decline only after the immediate crisis abated.? She believes the U.S. dollar would also increase in value, as a safe haven currency.

Several weeks ago, in response to a member?s question on this subject, I suggested that Canadian or U.S. government bonds along with gold and diamonds could be used as financial ?insurance policies? against this type of calamity. The Cooper/Coxe report is skeptical about precious stones because widespread deaths would lead to estate sales that could flood the jewelry market. But government bonds are way up on all the ?safe? lists. Yes, the yields are pitiful but at least you know the money will be there.

So how worried should you be? Enough to review your portfolio and perhaps make some adjustments. But keep things in perspective. As Mike Miller, director of research at BMO Nesbitt Burns, says in an introduction to the report: ?Experience has taught me that extreme outcomes are rare; that forecasts based on consensus expectations are often more close to the truth than those based on outside probabilities.?

A global pandemic of avian flu on the scale of the 1918 Spanish flu has to be considered as an outside probability. Let?s hope it never becomes anything more than that. ? G.P.

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GLENN ROGERS: HOW TO INVEST IN HOMELAND SECURITY

Many IWB readers will remember Glenn Rogers, who was a contributing editor for us from 2001 until mid-2003 when he left to take a position as a senior executive in southern California. Glenn is a savvy investor who provided IWB members with many winning picks during his time with us including Vincor (sold for 42% profit) and ENI SpA, which we recently sold for a 96% profit.

Although his current position as president of Vision Entertainment in Irvine, CA limits the time available for him to write, he has agreed to submit guest columns to the IWB on occasion. This week, he looks at homeland security in the United States from the perspective of an investor seeking opportunities. Here is his analysis.

Glenn Rogers writes:

The world is a dangerous place these days and the recent events in London only serve to underscore that the ?fight them over there so we won?t have to fight them over here? is far from a fool-proof strategy. Needless to say, companies engaged in the business of providing goods and services to customers involved in protecting people or things have been garnering a great deal of interest since 9/11. So in as much as we feel somewhat vulture-like recommending securities that benefit from terrorism, I believe that every portfolio should have some exposure to the homeland security area.

As a result, I am recommending four stocks that I think will benefit from the current sad state of affairs and at least help you make some money even if you don?t feel great about the idea.

There are five general areas in the homeland security sector:

  1. Surveillance
  2. Screening and scanning
  3. Tracking individuals and materials
  4. IT and services
  5. General defense systems

I have identified companies of a reasonable size that have been showing solid growth over the past year. There are a number of smaller companies in this sector that will likely do well based on the rising tide lifting all ships theory but the ones featured here should prosper even in an environment that is less scary than the one we are experiencing now.

These stocks are best-suited to more aggressive investors who are seeking capital gains (only one pays a dividend) and who do not have a moral issue with the idea of investing in companies that are involved in areas like defense and surveillance. For a recent update on this issue, you may want to check out an article that ran on in the New York Times on Aug. 14. You can access it at: http://www.nytimes.com/2005/08/14/international/middleeast/14armor.html?ex=1124769600&en=1ff300176e16381f&ei=5070

Note that all currency figures in the recommendations that follow are in U.S. dollars.

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GLENN ROGERS’ RECOMMENDATIONS

L-3 COMMUNICATIONS HOLDINGS (NYSE: LLL)

The first company on my list is also the largest. L-3 Communications Holdings has over 44,000 employees and operates in a large number of areas within the aerospace and defense sectors. The company offers solutions in secure communications, mobile satellite communications, shipboard communications, missile arming systems, radar and missile systems, and airport security equipment. They also design and manufacture screening systems for explosives, firearms in airports, security checkpoints, and commercial buildings. So if you are looking for a company that covers the waterfront and everywhere else on the security front, L-3 might be for you.

The company recorded $6.9 billion in sales in fiscal 2004 and had net earnings of $382 million ($3.33 a share, fully diluted) before taking into account a change in accounting principles. Sales grew by 35% on a year-over-year basis, which is very strong for a company of this size.

The growth is continuing in 2005. Second-quarter results released in July showed sales of slightly over $2 billion, up $395.6 million or 23% from the same quarter a year ago. Operating income was $224.9 million and fully diluted earnings per share came in at 99c. For the first half of fiscal 2005, the company has earned $1.84 a share, up from $1.42 in the same period last year.

The stock, which closed Friday at $79.40, is no bargain, trading at a P/E of 21 but given L-3?s growth rate, size, and the fact that it is one of the few stocks in this area that pays a dividend, albeit a small one at 12.5c per quarter, I regard it as a Buy with a target of $90.

Action now: Buy.

COGENT SYSTEMS INC. (NDQ: COGT)

The next company on our list is considerably smaller than L-3 and is more narrowly focused. Cogent Systems creates systems and devices that track individuals and materials.

The company?s main business is producing automated fingerprint identification systems (AFIS). Its primary customers are the ones you would expect: law enforcement, government agencies, and large corporations. Cogent also manufactures systems that are used at border crossings, which is a high-need area worldwide.

Although the company is small, with only 137 employees and less than $90 million in sales, it operates internationally. And it is showing strong growth. Second-quarter sales increased 131% year-over-year, to $39.4 million, and income grew at a blistering 96%.
What I particularly like about Cogent is that it maintains a high profit margin of 42.1%.

The stock has run up by about 30% in the past three months, although it has come back a bit lately. At these growth rates I wouldn?t bet against it moving higher from here. The stock closed on Friday at $27.

Action now: Buy with a price target of $35.

SRA INTERNATIONAL (NYSE: SRX)

SRA International is located in Fairfax, Virginia and fits into the IT and services category. They have 4,600 employees. The company provides solutions for civil governments and national security but also operates in the health care area so there is some diversification outside the defense sector.

SRA specializes in sophisticated data mining, disaster response planning, infrastructure protection, and so on. What I like about the business is that it is broadly diversified with no customer group having more than a 9% share of the revenue stream.

The firm is also heavily involved in protection against cyber attacks, which unfortunately is a growth industry. They also produce products that protect against illegal border crossings.

As a bonus, the company has been chosen one of the 100 best companies for which to work and Business Week named SRA as one of its hot growth companies. According to the company?s website, the GovernmentVar Magazine selected SRA as this year?s Government Solution Provider of the Year, which means the folks in Washington who make the purchase decisions must really like it.

This is another strong growth company. Year-end results for fiscal 2005, released earlier this month, showed that sales increased by 43% year-over-year to $881 million and by 33% to $241 million for the last quarter. Operating income grew by 44% for the year to $57.7 million and 28% for the quarter to $15.9 million.

Fully-diluted earnings per share for fiscal 2005 came in at $1.02. In their guidance for fiscal 2006, management forecasts EPS of $1.20 to $1.25. That would be an increase of 15% to 22.5%.

The stock closed on Friday at $34.30.

Action now: Buy.

ARMOR HOLDINGS (NYSE: AH)

The last company in our basket of doom and gloom stocks is a more nuts and bolts type of company, operating in the relatively low-tech side of the protection business. Armor Holdings is headquartered in Jacksonville, Florida. They have over 4,100 employees worldwide. The company is organized in three divisions, as follows:

The Aerospace and Defense Group. This division has received the most press this past year because this is the company that has been charged with providing beefed-up armored protection for the Hummers in Iraq. That happened after the news came out that marines were improvising their own protection by scrounging through garbage dumps, much to the embarrassment of the Pentagon. In fact, Armor is the sole provider to the U.S. military for armor and blast protection for this type of vehicle. The company also provides helmets and body armor for the troops as well as helicopter seating systems.

The Armor Holdings Division. Products manufactured by this group include anti-riot gear, police batons, emergency lighting products, foldable ladders, etc.

The Armor Mobility Division provides armor for non-military clients such as limousine companies, commercial trucks, and so on. They do well in areas where kidnapping is a constant threat like Iraq, Mexico, and Colombia.

The company recently reported second-quarter results. Revenue for the period was $371.6 million, up an astounding 66.1% from the same period last year. Net income was $37.4 million ($1.05 per share, fully diluted), up from $17.8 million (57c a share) a year ago. For the first six months of the current fiscal year, Armor reported EPS of $1.93 a share, an increase of 95% over a year ago. This is growth in spades! Management has revised upwards its forecast for fiscal 2005 and is now projecting EPS of $3.70 to $3.80.

The stock closed on Friday at $42.29 which means it is trading at a P/E of only 11.3 based on fiscal 2005 estimates. That makes it a bargain by homeland security standards.

Action now: Buy with a target of $48.

Final thoughts

I hope I have not depressed you with all these security-oriented stocks but, like it or not, the reality is that the Bush Administration is very defense-friendly and with the world blowing up around us we may as well have something in our portfolios to hedge against future disasters.

I have chosen to provide you with a group of stocks in this sector. You can select one or two that interest you or buy a basket of all four to achieve greater diversification. An investment of approximately US$10,000 would give you a package like this.

  • 30 shares of L-3 Communications.
  • 85 shares of Cogent
  • 70 shares of SRA International
  • 60 shares of Armor Holdings

Whichever approach you take, these stocks should reward you over the next 12 months.

– end Glenn Rogers

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UPDATES

ROCKY MOUNTAIN CHOCOLATE FACTORY (NDQ: RMCF)

Originally recommended by Gordon Pape on Feb. 21/05 (IWB #2508) at $14.28 (split-adjusted). Closed Friday at $18.84. (All figures in U.S. dollars.)

Rocky Mountain?s share price has taken a sharp drop since the beginning of the month, when it was trading in the $24 range. The company has made no announcements and a spokesperson blamed the decline on ?the market?, saying that there has been ?no change? since it released its fiscal 2006 first-quarter results in July. COO/CFO Bryan Merryman is on holiday until September and was unavailable for comment.

The first-quarter results (to May 31) gave no indication of any problems. The company reported a revenue increase of 13% compared to the same period last year, to $5.4 million. Same-store sales at franchised retail outlets increased 4.1%. Net earnings were up 27% to $753,000 (11c a share, fully diluted), compared with $592,000 (9c a share) in the prior-year period.

“We are pleased to report another quarter of record earnings, particularly in light of the fact that earnings in the first quarter of last year were 55% higher than in the prior-year period,” Mr. Merryman said in a statement at the time the results were released. ?Our company is now the largest retail chocolatier in North America, in terms of the number of stores in operation, and we are proud to have achieved this status in a year during which earnings should set another record.”

That all sounds encouraging but I am always suspicious when a stock drops as sharply as this on no news. One possible explanation may be that profit-taking that drove the price lower triggered program selling when the price fell below $21 on Aug. 9. The relatively high trading volume on Aug. 9-10 would support that theory.

If this is the case, the pull-back would suggest a buying opportunity. The price hit an intra-day low of $17.78 on Tuesday but has then rallied from there to finish the week at $18.84. I will continue to monitor the situation and report on any further developments.

Action now: Hold/Buy. Aggressive investors who are willing to accept the risk involved may enter at this level. ? G.P.

TIME WARNER (NYSE: TWX)

Originally recommended by Glenn Rogers on May 21/02 (IWB #2219) at $19.98. Closed Friday at $18.09. (All figures in U.S. dollars.)

A well-known New York investor who has made a career and a lot of money fighting the management and directors of companies he believes are underperforming has taken on Time Warner. Carl Icahn issued a press release last week in which he recommended that the company sell off its cable division and buy back $20 billion worth of shares in the open market. He later met with Time Warner CEO Dick Parsons to discuss his ideas.

Companies controlled by Mr. Icahn along with three investment firms that support his views collectively hold about 120 million shares of Time Warner with a market value of $2.2 billion. So he has a lot of clout behind him.

He said in his statement that Time Warner?s management ?has not moved quickly enough and it has not proposed measures which would enhance [shareholder] values to the degree necessary to realize the inherent value of TWX’s well positioned and unique assets?. He also indicated that he may propose his own nominees to the Time Warner board at the next annual meeting if he doesn?t see significant progress.

The company?s share price rallied briefly after the announcement but then drifted off to close the week at $18.09.

Earlier this month, the company announced a second-quarter loss of $321 million (7c a share), due to a $3 billion reserve provision for settlement of a class-action lawsuit brought by disgruntled shareholders as a result of the AOL merger. Revenue declined 1% compared to the same period a year ago, to $10.7 billion. However, the company reaffirmed its expectation that its 2005 full-year growth rate in adjusted operating income before depreciation and amortization will be in the high-single digits, as compared to $9.9 billion in 2004.

Management also announced a $5 billion share buy-back program ? only one-quarter of what Mr. Icahn is seeking but a move in his direction.

Action now: Hold. ? G.P.

ARC ENERGY TRUST (TSX: AET.UN)

Originally recommended by Gordon Pape on March 1/04 (IWB #2409) at $15.32. Closed Friday at $21.70 (US$17.23).

ARC released its second-quarter results on Aug. 3 and they contained some good news and some bad news for investors. On the good news side, monthly distributions are being increased to 17c ($2.04 a year) effective Sept. 15. The previous payment was 15c a month so this represents a 13.3% bump.

Cash flow for the quarter was $121.8 million while payments were $84.5 million, representing a payout ratio of 69%.

Now for the bad news. Production was down 6% from the same period a year ago, continuing a pattern I have commented on previously. Management contends this is partially due to the disposition of non-core properties and says the trust spent more than $45 million on development in the quarter plus another $124 million on acquisitions. It issued new guidance which forecasts full-year production volumes of 56,000 boe/d (barrels of oil equivalent per day). However, that would still be below last year?s second-quarter figure. This is a matter of continued concern so despite the distribution increase I continue to advise against new purchases.

U.S. investors can buy ARC units through the Pink Sheets where the trading symbol is AETUF.

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 Friday at $30.68 (US$25.15).

Peyto released second-quarter results on Aug. 10 and once again they contained a lot of positive news for investors. In contrast to ARC, production increased by 21% from 18,544 boe/d in 2004 to 22,464 boe/d in the second quarter of 2005. That works out to an increase of 19% per trust unit after adjusting for debt and bonuses. Cash distributions were up 37% from the same period last year while the payout ratio remains low at 51%. However, net earnings declined to $25.7 million (27c a share) from $30.3 million (33c a share) due mainly to a $7 million jump in royalty payments.

Peyto has done very well for us since we recommended the units at a pre-split price of $9.93 about two years ago. There is still some growth potential here but it would be unrealistic to expect a continuation of the results we have seen to date. An on-going annual return in the 10% range, including distributions and capital gains, is more likely.

Analysts are divided about Peyto?s future prospects. RBC Capital Markets initiated coverage of the trust last week and awarded it a Top Pick rating with a target of $37.50. The research team, led by Patrick Bryden, praised Peyto for its ?unparalleled accomplishment? in increasing tight natural gas production from Alberta?s Deep Basin and described it as ?the lowest cost, highest netback, longest life producer in the sector?.

In contrast, CIBC World Markets reduced its rating to Sector Performer with a 12-18 month target of $33. Analysts Mark Bridges and Robert Pare said that ?Peyto offers one of the most attractive models in the coverage universe? but has become very expensive. ?We believe Peyto would need to deliver substantial growth of almost 25% per year over the next three years to justify its current valuation,? they wrote.

I concur with this view, which is why the IWB has maintained a Hold rating on Peyto for some time. There may be opportunities to buy down the road when the price of oil and gas cools (assuming it will) but for now I suggest you maintain your positions and adjust your mentality for more modest profits going forward.

The current monthly distribution is 12c per unit for a yield of 4.7% based on the current price. But members who bought at the time of my original recommendation are enjoying a yield of 14.5% based on the price they paid at that time.

The shares trade in the U.S. through the Pink Sheets where the symbol is PEYUF.

Action now: Hold. ? G.P.

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UPDATE REQUESTS

We frequently receive requests from members for updates on specific securities. We do our best to respond to these on a timely basis but all updates will only be published in the IWB so that everyone has access to them at the same time. We will not send personal updates as this would not be fair to other members.

Also, we sometimes get e-mails asking for our opinion on a security that is not on our Recommended List. We will take such requests under advisement and, if appropriate, do a write-up on the security in question at a future time. However, we cannot provide personal advice. Thanks for your understanding. ? G.P.

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YOUR QUESTIONS

Who profits from private health care?

Q – The great Canadian political debate continues but, no matter what the politicians may say, private health care is here or is coming. Which companies will benefit and make money for the investors who buy them? ? J.S.

A ? This question is very timely considering that the Canadian Medical Association raised the stakes last week by coming out in favour of some form of privatized health care. But the Liberal government remains strongly opposed to the idea as do most of the premiers and several influential lobby groups.

So if private health care is coming on any large scale, it may still be several years away. The Supreme Court recognizes the problems involved and recently agreed to a one-year suspension of its judgment on the key Quebec case that triggered the latest public controversy.

If and when a parallel medical system does evolve in Canada it will likely be slow in developing because of the tight controls that will placed on practitioners and service providers by various levels of government. I doubt that we will see anything resembling a domestic version of the infamous American HMOs for at least five years and probably longer. So it?s a long road ahead and placing financial bets on the winners at this time is premature.

That said, one industry that is sure to profit if private health care takes hold is the insurance business. Every employee will want to see appropriate coverage added to the corporate benefits package. So if you want a sure-fire winner, buy some shares in Manulife (TSX, NYSE: MFC) or Sun Life (TSX, NYSE: SLF), both of which are on our Recommended List. They should do well anyway, even if private health care never comes. If it does, it will be an added bonus for them. ? G.P.

When to sell trusts

Q – My mother recently passed on and we are in the process of liquidating her portfolio. We have some flexibility when we can sell. Much of her portfolio is in income trusts and I was wondering whether it would be better to wait until the next income distribution to sell, or simply go ahead now. Her portfolio is weighted heavily in oil and gas (e.g. Acclaim, Advantage, NAL, Pembina, Superior Plus). ? Geoff

A ? Most income trusts pay distributions monthly. This means their market price is not greatly affected by going ex-distribution. High-dividend stocks that pay quarterly, on the other hand, may see a small decline in market price on the day they go ex-dividend.

So don?t let a trust?s distribution date influence your decision. Their market price will be more affected by other factors, particularly the price of oil in the case of the trusts you mention. ? G.P.

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MEMBERS? CORNER

An expert corrects us on CO2

Member Comment: I?ve been an IWB subscriber for two years now and I intend to continue indefinitely ? I like the plain English, no b.s. style of your discussion and recommendations and I have made good money to date on most of what I chose to act on.

In IWB #2531 you talk about buying into Kinder Morgan now that they?re picking up Terasen and I agree that it makes sense to do so for the reasons you give ? mostly. I?m emailing just to provide some clarification to a statement you made in the recommendation. You said: ?The gas (carbon dioxide) is gaining favour as a way to increase yields from the Alberta Oil Sands and KMI will now be??

I?ve been working as a geologist in Alberta?s conventional and unconventional petroleum and natural gas business for a little over 23 years now including a two-year stint in management of an oil sands project geology team.

Carbon dioxide gas is only a big nuisance that is produced as a by-product of the bitumen upgrading process to lighter, synthetic crude oil (SCO) as far as our oil sands operators and projects are concerned, especially since the Kyoto Accord came into being. The place where carbon dioxide gas is expected to become more popular in Alberta is in enhanced oil recovery projects (EOR) of conventional oil pools (i.e. light oil, not heavy oil or oil sands derived bitumen).

The more mature light oil pools with declining production still have lots of residual oil left in the rock that is more difficult to extract and produce at surface so the carbon dioxide gas, which is ?miscible? (easily blended) with the oil, is injected into the oil reservoir and blends with the residual oil thereby reducing its viscosity and making it easier for the thinner oil to be produced economically from the existing oil wells. When oil was priced from $15-30/bbl it usually wasn?t economically viable to set up the expensive recovery, transportation, and injection infrastructure for the CO2 to be used for EOR projects, thus it was just vented to the atmosphere.

Now, with the increasing unpopularity of letting CO2 gas go into the atmosphere and the high expense and difficulty of just sequestering the unwanted gas underground, the high price of oil is very timely in making such EOR projects viable so more and more producers will consider setting up CO2 miscible flood EOR projects in their Alberta and Saskatchewan oil pools and thus pure CO2 will become a saleable commodity in Canada, as it has already been for some time in the U.S. There are currently only a handful of such EOR projects operating in Canada, one of which is EnCana?s Weyburn project in S.E. Saskatchewan ? I believe they?ve been buying and pipelining the pure CO2 they need from the U.S. so far because it wasn?t available in the quantities they required in Canada yet.

Keep up the good work on the IWB. I always look forward to reading it ? M.D.

Response: Thanks very much for this clarification. We always welcome such input from members with technical/professional expertise to keep us on track and to ensure the IWB is as accurate as possible. ? G.P.

That winds up our coverage for this week. We?ll be back again on Aug. 29 when contributing editor Tom Slee will join us.

Best regards,

Gordon Pape