A basic guide on how to do Canadian equity research

Whenever I hear of a publicly traded company, I follow a fairly standard methodology to do some basic research on the firm.

In a perfect world, you try to do research before looking at the share price of the company. The whole idea of the research methodology is to pin down a valuation for the equity (or in some cases, debt) and seeing a stock price contaminates what should be an unbiased analysis. You want to come up with your own valuation, rather than looking at the market’s valuation and then thinking of ways to rationalize the stock price. Unfortunately 9 times out of 10, the first thing I do is pull up the stock quote. I’ve been trying to train myself to no longer do this, but it is really, really difficult to not see a quote attached to an article.

Once I am ready to research, I pull off these documents from SEDAR in this order:

1. If the “nearest” financial report is an interim statement, I pull down the interim financial statements and MD&A document and read them. Doing analysis on this alone is time-consuming, and you look for tidbits in the statement, get an idea of how the company is capitalized and look at the cash situation. If the “nearest” report is an annual one, I read that and the MD&A.

2. Then I read the management information circular, and look at executive compensation scheme, insider ownership, and executive biographies and get a “feel” for who is running the firm, and who is on the board.

Usually by this point, you can come up with a ballpark number and then it becomes irresistible to look at the share price and hence valuation. Which then leaves:

3. Pulling up the stock chart, and then looking at any significant price moves, and then connecting those price moves to various news releases of the company;

4. Reading every news release of the company over the past X years, chronologically, and then looking at the reaction of the stock to what is significant news;

5. Reading the latest annual report (not the glossy version, the dry financial version) with its MD&A, and/or the Annual Information Form, which is also a good document that has information that is not contained in the interim statements;

6. Insider trading is available on SEDI and can influence a decision. While insider selling is not necessarily a negative signal, whenever you see insider buying it gets your attention much more.

7. The company’s website.

Usually by this point you spent many hours of reading and synthesizing information, and should have a pretty good idea as to what makes the company “tick”. Then the next step is to have a sector-wide comprehension and start investigating competitors, and firms up and down the supply chain to get a feel for the economic variables at stake. This is a never-ending process and eventually at some point you cut it off and then make a buy/sell/leave alone decision.

Learning to prune investment candidates at stage #2 is a very good skill to have – I usually set price triggers on those companies, and when the triggers are hit, I get an email and this triggers me to take a second look at the company to see if anything has changed. In the second half of 2008, so many companies were triggering low price alerts that I had a very, very difficult time keeping up with what was literally an avalanche of securities. I probably could have performed better in 2008 had I had more time to look at all the securities that were flashing at me.

Today, there is hardly anything that triggers my low price alerts, so I am using different screens to put some companies on the research queue.

Cursory scan of mortgage markets

As 5 and 10-year yields plunge, they have had a corresponding impact on mortgage interest rates.

The best variable rates I can find are prime minus 0.75% for a 3-year variable mortgage, or prime minus 0.7% for a 5-year variable mortgage. Prime currently is 2.75%. This is still the dirt-cheap option and is preferential compared to the best available 5-year fixed rate, which is currently 3.75%.

Assuming the Bank of Canada raises rates 0.25% this September (which is not a certainty, but is a likely action) then the break-even proposition, in terms of net interest paid over a 5-year fixed period, is quite unlikely. An example of a breakeven calculation would be, on a 25-year amortization mortgage, a 0.25% rate increase every half-year in order for the 5-year fixed rate to be breakeven with the variable rate. This would correspond with a 2.5% rate increase over 5 years which seems to be unlikely given that the futures currently indicate that rates will go up by about 0.69% over the next 2.75 years.

That said, the current interest rates are historically low, and interest rates are not very predictable – it sometimes feels like one is reading tea leaves in order to get glimpses of the economic future.

As there is a real estate implication to mortgage rates, it should be noted that even though the USA has record low financing rates for mortgages, it is not sparking their real estate market.

General Market Commentary

Very little going on in the day-to-day action in the marketplace, hence very little to write about. If there was a story to write about, it would be at the extremely low yields of the US treasury market and how it continues to induce others to chase yield. Forcing people to invest in assets for income when they do not receive a fair risk-adjusted return of capital (opposed to return on capital) means making such investment decisions is a tricky endeavour.

Spot gold continues to swim at the US$1,200/Oz mark; spot crude continues to wobble between US$70 and US$85/barrel. Natural gas has been wobbling around $4.5/mmBtu, which is still quite divergent with the energy content implied with the crude contract – Natural gas has considerably lagged crude, presumably due to the implementation of cheap shale gas drilling (so-called hydraulic fracturing, or “fracking” in short).

3-month banker’s acceptance futures have also shifted slightly downward, implying less of a chance that the Bank of Canada will raise interest rates on their September 8th meeting. Three-month corporate paper is trading at a 0.91% yield. This change in the future projected rates also had the effect of taking down the Canadian dollar from roughly 97 cents to 95 cents, but this could just be white noise. The currency diversification is an interesting and separate topic, but I am happy with my mix of Canadian and US-based portfolio components.

There’s not a lot to be writing about, which gives me some time to research individual issues on my research queue. Also, since the last two weeks of August are the most heavily booked vacation days before the kids go back to school, the markets should also be relatively quiet in volume, but not necessarily price! However, at least Monday was a calm day.

I have been noticing some of my income trusts creeping up in price; if they go much higher, I might consider a partial liquidation.

Looking at the government bond market

Every analyst that is actively tracking the market is acutely aware that the US government bond (and this also applies to Canadian government bond) yields have been dropping dramatically over the past couple months. Here is a chart of the 10-year US Treasury note yield over the past two years (the y-axis is the percent yield times 10):

What do we see?

People that loaded up on government debt four months ago are laughing right now since they have a significant profit. But should they liquidate? What is the market anticipating? (Just as a side note, I don’t apply my “August trading is not to be taken seriously” stance on the government bond market.)

Typically institutions invest in bonds if they anticipate deflation (as having a fixed income yield in a deflationary situation is ideal) or if there is a “flight to safety” or some incident that spooks the market – such as a global economic crisis that occurred in late 2008/early 2009. Bond yields went as low as around 2.0% at that point in time.

But where is the global economic crisis today? It is obvious the market is trying to say something is going to happen, and I believe the bet is on some sort of deflation.

Even though I believe the next “swing” in monetary trends will be an inflation, this will only happen when the vast quantity of money supply out there is unleashed into the economy – right now those reserves are being held by banks that are very resistant to lending them because of credit concerns. They don’t want a repeat of late 2008, so they are buffering themselves. The catalyst to lending will be confidence in the marketplace, and right now is the most business-unfriendly administration the US has ever seen in a long, long time. Until this administration is gone and replaced by a pro-business administration, investors will not have the confidence. However, that will be the catalyst for inflation.

So until then, we might be seeing a deflationary dip as government stimulus slows down and the economy comes grinding to a halt. I don’t think we will be entering into a “new depression” by any means, but economic growth is going to be slow.

What are the implications?

1. Federal funds rates will be kept at zero for a long time. December 2011 futures are trading at 0.45%. In Canada, I would expect one more rate increase of 0.25% to 1.00% in September, and that is it for now.

2. People will struggle to find yield at an acceptable price. You can’t invest in the short-end of the rate curve, since this yields almost nothing (two-year government bonds give you less than 0.5%!). This already has been happening, especially since the last four months. Gold is also popular, which is counter-intuitive since assets decline in deflationary situations – I believe the mentality is that “bond rates are low, Gold will return nothing, but it will retain its value since it is a de facto quasi-currency.” Other commodities, such as oil, copper, etc., should depreciate unless if they also have a quasi-currency perception by the marketplace. Note that America’s economy used to dominate the commodity market, but with emerging markets (e.g. China, India, Brazil in particular) taking a higher proportion of commodities, the linkage might change somewhat.

3. Companies with debt will find financing a little tricky if they are too leveraged – low interest rates are “good” since they will be able to pay less interest on debt, but this is assuming they get extended credit since their cash-generation ability will be compromised by the deflation itself.

4. In a deflationary situation, zero-yield cash also has a positive return at the rate of the deflation itself. Any savings banks that give a positive yield (e.g. Ally at 2%) is “gravy” on top.

How low will the 10-year note yield go? I have no idea. However, at current yields, 2.6% looks very pricey compared to other alternatives that are available. It takes a very brave person to be shorting these products since it is very well believable that you could see even lower yields.

I do know when this paradigm changes to the inflationary cycle that it will be very quick – like a flash forest fire.

ING Direct gets into the chequing market

In an interesting corporate strategy shift, ING Direct is now getting into the chequing and bill payment market. The salient details are similar to the local credit union that I deal with, mainly no transaction charges and a nominal fee for other basic services (ordering cheques, writing bank drafts, etc.).

ING Direct used to start off as a basic business model where you can save your money at a high rate of return – ING Direct would then use this as collateral to write mortgages, and then make the money off the spread between the mortgage rates and the savings interest paid. As their deposit base grew, they eventually morphed from giving their clients the best rates available to just giving slightly above average rates for savings. They are now out-competed by Ally and other providers.

As there is nothing preventing competition for funds, the only barrier for customers to switch banks is simply to fill in an application form. Since the interest spread between ING Direct and Ally is 0.5% on short-term savings at present, it is a $50 difference on a $10,000 deposit for a year. While this is not a gigantic amount of money, it is likely worth it for those that can spend the 20 minutes applying and getting an account.

As for the chequing account, I was assuming that the funds you leave on deposit would be earning ING Direct’s typical interest rate on savings, but it is not – apparently the first $50,000 will earn 0.25%, and the remainder will be earning more. This is far below the 1.5% that ING Direct offers.

So what is the point of opening an account? Typically the convenience of opening such a chequing account would be that it works completely in synergy with your main ING Direct account, and offering the high rate while you keep your cash idle in the account. Instead, you still have to go through the same procedure to transfer over your money from the high rate account to the lower rate chequing account, and then make the cheque or bill payment.

I don’t think this is going to attract the type of clients that ING Direct wants, mainly those that keep large amounts of deposits in the account.

It is also interesting how most banks probably take a loss processing these accounts – the big money maker on the retail end are for mortgages, loans and credit card interest debt.