The Canadian Rational Investor
Brian Beamish FCSI
Investing In Companies
Putting your hard earned savings to work.


Introduction


This is an introductory seminar on investing in common equities. This information is meant to be a basic understanding to the general concepts behind investing in common stock equity and by no means represents a thorough examination. I strongly encourage feedback and hope to hear your questions, as all of these seminars are an ongoing work in progress.


Growth vs. Value
Basic value screen
G.A.R.P.
C.A.N.S.L.I.M.

Companies with earnings: The first part of this seminar deals with companies that have an earnings stream. Most fundamental analysis is based on the idea that as a company earns more money their share price will appreciate. We begin with a look at the concepts of growth and value and how they relate to common stocks. We then look at three fundamental screening models that range from strictly value to strictly growth.


TSX Venture Capital Investment Model (VCIM)
Two VCIM Examples

Companies with no earnings: If a company does not have an earnings stream, fundamental analysis has a hard time associating an intrinsic value to a security. In these cases one must utilize different tools that look for indications of hidden value.


Growth vs. Value

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At any given point in the economic cycle, 'value' and 'growth' are often seen as being at the opposite ends of the investment spectrum. At one end, we find the stereotypical value investor, who will buy any shares that are priced inexpensively, even if the companies growth prospects are poor. At the other extreme, we see growth investors who will buy shares of companies that are growing rapidly without regard to how high a P/E multiple the shares might already command.


'Growth' companies are expected to generate substantial increases in earnings in future years. 'Value' stocks generally have fallen out of favor in the marketplace and are considered bargain-priced compared with book value, replacement value or liquidation value. Value stocks are typically priced much lower than stocks of similar companies in the same industry. This lower price may reflect investor reaction to recent company problems, such as disappointing earnings, negative publicity or legal problems, all of which may raise doubts about the company’s long-term prospects. The value group also may include stocks of new companies that have not been recognized by investors.

The primary measures used to define growth and value stocks are the price-to-earnings ratio (the price of a stock divided by the current year’s earnings per share) and the price-to-book ratio (share price divided by book value per share). Growth stocks usually have high price-to-earnings (P/E) and price-to-book ratios, which means the prices of these stocks are relatively high in comparison with the company’s net asset values. In contrast, value stocks have relatively low price-to-earnings and price-to-book ratios. Value stocks tend to outperform during periods of economic recovery, while growth stocks do best during the later stages of economic expansion.

Here then are some basic features of both growth and value stocks:

Value
Growth
Price/Earnings low high
Price/Book Value low high
Dividend high low (if any)
Industry mature expanding
Sector Out of favor In favor

Once an investor can get their head around the concepts of growth vs. value, market valuations don't seem so foreign. The purpose of the next few sections is to show you working models of both growth and value and a popular combination of both.


Basic Value Screen

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Based on the criteria discussed above, a basic value screen looks for companies with a low P/E and low P/BV ratios. While this screen will return companies that are relatively undervalued in comparison to the broader market it does not take into account prevailing economic conditions within their country of origin or industry specific problems. As a result, we see in this screen many Japanese companies (whose shares have been in a long downtrend) and companies that have been sold off due to regulatory problems (US securities dealers). But at the same time, this screen will produce companies who have benefited from their underlying assets appreciating (in this case, energy) as their balance sheets improve. While not exciting in nature by buying pure 'value' stocks one can be assured there is less relative downside risk should the broader market move lower.


G.A.R.P.

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Growth investors who want to buy shares of rapidly growing companies often find it necessary to accept steep P/E multiples. Other investors who are determined to purchase only reasonably priced stocks often find themselves looking at relatively unexciting companies. So the question many ask is: "if I am going to buy a growth stock and I know I am going to have to pay a premium, how much is too much?" One approach that can help with growth stock valuations is know by its acronym, GARP (growth at a reasonable price) and is an approach that reconciles both dilemmas. GARP investing combines the two popular strategies of value and growth investing. It seeks stock that has both growth potential and a reasonable price.

GARP looks for stocks with a sustainable earnings growth rate, limited variability in the track or trend-line of those earnings over recent history, but a Price/Earning multiple (P/E) that is less than that of the growth rate. PEG ratio (PE to sustainable growth) looks at how much it costs to buy a unit of growth. For instance, a stock with a P/E of 15x and sustainable forward growth of 20% would result in a PEG ratio of .75x. Inexpensive growth would suggest a PEG ratio below 1x.

This strategy affords the growth-oriented investor a tool to help determine when a high P/E becomes too high. GARP is based on the principle that any P/E ratio is reasonable if it is equal to or less than the company's annual rate of earnings growth. In other words, one should be willing to accept a P/E multiple of up to 25 if the company's earnings are growing at an annual rate of at least 25 percent. But also to have to conviction not to buy if the P/E is more. It is very important to understand that GARP investors may spend many months waiting for a market correction so that valuations come down to an acceptable range. Patients, conviction and a willingness to buy when others are selling is the hallmark of good GARP investor.

Here then is a typical GARP screen:



CANSLIM

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How would you know they are poised for an explosive increase in value? It turns out William J. O’Neil pondered the same question. O’Neil is founder and publisher of Investor’s Business Daily, a stock market newspaper. O’Neil has been in the business of providing stock market data to institutional investors since the 1960s. In the course of that business, he created a database containing fundamental and price information on thousands of public companies. O’Neil had the wherewithal to do what you and I would love to do—find the significant attributes of the winners of the past before they took off. He used his massive database to find the 500 biggest gainers in the years 1953 – 1993. Companies like Texas Instruments, Home Depot, etc. Then he analyzed these winners to find the characteristics they had in common before they took off.

O’Neil published the results of his study in a book called "How to Make Money in Stocks." O’Neil believes he found the winning formula, the seven basic characteristics most stocks have before enormous price advances. He uses the C-A-N-S-L-I-M acronym to identify the necessary attributes.

CANSLIM specifically refers to:
Canslim = Current Quarterly Earnings Look for companies with the largest increases in quarterly earnings compared to the same quarter last year. Bigger is better! Seventy-five percent of the winners in O’Neil’s study had quarterly earnings jumps of 70% or more. The minimum acceptable increase is 18%. One caveat though, avoid stocks with tiny year-ago earnings, e.g. less than five cents. Huge increases don’t mean much if you're comparing to a minuscule year ago number.

cAnslim = Annual Earnings Consistent annual growth rates of 25% or more over the last four or five years are an important factor. Consistency is the key word. Make sure forecast earnings for next year are in line with the historical growth rate.

caNslim = New Products/Management/Highs Look for a catalyst that will propel fast earnings growth. O'Neil also includes new highs in stock price here. He wants stocks at or near their all time highs. This is the hardest aspect of the strategy for most new investors to accept. Our natural tendency is to buy stocks after they have gone down in price—not when they are at new highs.

canSlim = Supply of Stock Stock prices move as a result of supply and demand for the company’s shares. If there’s not many shares in circulation, a small amount of buying could push prices up quickly. Look for companies with 5 to 25 million shares outstanding.

cansLim = Leader Here O’Neil is talking about stock price action, not a company’s success in selling product. Look for stocks that have outperformed at least 80 percent of the rest of the market during the past year. The company should have the best performing stock in its industry.

canslIm = Institutional Ownership Institutions are mutual funds, corporate pension plans, insurance companies, etc. O’Neil likes some, but not too much institutional ownership. Look for 5% to 25% institutional ownership.

cansliM = Market Direction Very few stocks go up when the market is going down. Buy only when the market as a whole (S&P 500 Index) is going up.


Sell Fast if Stock Drops What if you buy a stock using the CANSLIM strategy and it goes down instead of up? O’Neil says you should sell it immediately if it drops 8 percent below your purchase price.

Those are the selection criteria. Once you’ve picked promising candidates, you have to decide when, if ever, to buy the stock. O’Neil looks at a stock’s price chart for guidance. He looks for stocks that have been consolidating (bouncing around a limited range) for a while, and then move up to (or close to) new highs. Here then are the result of a recent CANSLIM screen:




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Finding Value Among Venture Capital Companies

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Value is very hard to find in any market and the venture capital market is no exception. How can one judge a stock to have intrinsic value if promoters are pushing prices higher. The most basic rule for success (as in almost any speculative endeavor) is to follow the smart money. This may include bankers, indebted individuals, investment houses, wealthy individuals and large funds. Regardless of who it is, a person putting millions of dollars to work has a considerable vested interest in seeing their investment pay off.


Signals of Potential Value CRI's VCIM - Venture Capital Investment Model


Consolidations are one of the best places to start looking for instrinsic value in the venture capital arena. A consolidation (sometimes called a roll-back) is when the company exchanges a large number of shares in the market place for a smaller amount (typical consolidations are 10 old shares for 1 new share or 5 old shares for 1 new share). A Rollback is horrible if you currently own the stock and is often the final deathnel of a failed venture. With no further financings available, companies will often consolidate their stock in an effort to make it attractive again to financers. From the point of the consolidation onward a potential investor has a basic floor to work with. The company can issue new shares to finance projects but is unlikely to consolidate again for quite some time.


Shares for Debt announcements are another helpful tool. One often sees shares of debt news just after a consolidation. If an individual who is a debtor of a company converts their debt into shares it is a very big sign there exists some sort of perceived 'real' or intrisic value. By doing so, they believe the conversion price of the shares is worth the debt owed to them and feel the ownership of company stock is a better investment then being paid the debt in full. From the company's perspective, this action reduces operating costs and cleans up their balance sheet going forward (both fundamentally positive).


Options/Rights to Directors announcements are another useful tool for gauging value. Since many venture capital company's have little cash flow, insiders and directors are often compensated through company stock. So how does a company vest compansation to directors without it directly effecting their balance sheet? The answer, stock options. If the company issues stock options - the insider can be compensated for their hard efforts, the event has a neutral impact on the balance sheet in the short term, and should the option be exercised down the road, the company revieces additional cash from the subscription and the director is happy because the stock price has risen. The proverbial win-win-win scenario. Anyone in the investing public is perfectly within their rights to buy into any public company. This is true for insiders too, they just have to let the public know when they do it. It is this required disemination that gives shrewd investors a huge advantage.


Tangible Book Value Per Share while not an event in itself, this is a very important guage for judging value. This ratio tells the investor how many assets they are buying with every dollar they are spending. Most companies with earnings trade at a premium to their book value (above 1.0) since those earnings streams produce growth. Many takeover bids are in the 3 times book value range as the aquiring company will bid up for those desired assets. And many high growth / high beta stocks trade at even higher multiples of book value. Since VCIM looks for recently consolidated (and therefor very out-of-favor) stocks we expect these companies to be trading a deep discounts to their tangible book value. This indicator should confirm this hypothesis. Since every reporting company has to divulge all thier assets and liabilites, and since we know how many shares a company has outstanding at any given point in time, we can use this ratio to judge how much we are paying for every dollar of assets the company has [for example: a company that has $1,000,000 in assets, 10 million shares outstanding and trading at $.10 has a price to tangible book value ratio of 1.0]. Ideally, we would like this ratio to be below 1.00 (or put another way, we are buying at least $1.00 of assets for $1.00 spent). Many recent screen candidates have been trading at below .50 (for every $1.00 we spend in the market we are getting $2.00 worth of assets).


Private Placements are one good way to both follow the smart money and to buy stock at little or no cost. To generate capital many venture capital companies will offer stock on a private placement basis with incentives like further purchase warrants, tax friendly treatment and no commission charges to potential investors. The harder it is for the company to raise money, the more incentives they will offer. Once the private placement is completed there is an implied (but not guaranteed) floor on the stock at that placement price until the required holding period expires (usually about four months).


With these tools we can quickly determine value among venture capital companies. First we look for consolidations. How many shares are outstanding, the lower the better. Next, look for 'Shares-for-debt' announcement from these consolidated companies. As well, look for 'Options-to-Directors' announcements. As a confirmation of value, we require a companies price to tangible book value per share to be below 1.00. To further reduce costs and increase return we look for private placements.

Value Criteria: Consolidation + Shares for debt + Options to directors + low pr/bv + Private placements

Our primary resource for venture capital company information is the venture capital market itself. The TSX Venture Exchange is Canada's market place for small issues. Along with compliance issues and stock quotes, the TSX Venture Exchange requires all members to post pertinent information as it happens. Below is a brief example of a day's news releases on TSX Venture Exchange companies.


Through the use of VCIM, the average investor now has a simple model to gauge value in the venture capital market. You are more than welcome to go through the sites screener on a daily baisis or you could simply subscribe to CRI's OnlyDoubles NewTrades to be informed of candidates as CRI identifies them.

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VCIM - Recent Examples

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Nu XMP Ventures Ltd.

NUX first appeared on the radar screen when the company announced they were rolling the stock back (4:1 basis) on the 28th of August 2003. This left only 1,770,521 shares issued/outstanding. This in itself would draw interest but it would be almost a month after this event when the next 2 criteria on our screen were met. On September 26, 2003 the company announced a share-for-debt plan (1,750,000 shares) coupled with a private placement (2,000,000 shares). Both were done at $.10/share and with the proceeds, the company announced a property acquisition. These deals suggest there is some intrinsic value in the stock around $.10/share and that at this price the company has roughly a value of $552,052.10 (5,520,521 shares times $.10). The stock quietly traded above these levels for the next month or two but steadily rose. On November 17, 2003 another private placement was done at $.25 giving further support to the stock. Shares continued to appreciate in value as the results of their projects became available.





Pinnacle Mines

PNL first appeared on the radar screen when the company announced they were rolling the stock back (5:1 basis) on the 15th of July 2003. This left only 1,186,035 shares issued/outstanding. While the company remained halted, it was a good initial indicator of potential value and one to watch. On the 10th of September we saw the second criteria, shares-for-debt, announced. The deal was for 600,000 shares at a value of $.16 to settle outstanding debt. The company then went on to do a private placement for another 1,180,000 shares at $.16 on the 22nd of September. Once again these criteria meeting screens highlighted potential value in the company. At $.16 the company had a market cap of $474,565.60 ($.16 times 2,966,035 shares). In this example, there were warrants attached for another 1,180,000 shares at $.21. Regardless, the new stock added would still keep the market cap under $722,365.50. The stock traded in the $.20 - $.30 cent range during the announcements but soon moved higher to eventually hit a peak above $.90.