Correcting Worldwide Mismatches – Key to Sustained Recovery

Market Buzz – Correcting Worldwide Mismatches Key to Sustained Recovery

For the first time in four sessions, Toronto’s main stock index ended higher Friday as oil prices rose following a shutdown of a big Enbridge Inc pipeline supplying Canadian oil to the United States. The TSX gained traction late in the session, closing higher on the strength of the gold sector and a soaring oil price.

While down on the week, the S&P/TSX composite inde6x added 63.56 points to 12,097.09, while the TSX Venture Exchange gained 14.5 points to 1,596.5 on Friday.

The holiday shortened week was a bit of a snooze as investors seemed to be trying to squeeze one more week out of the summer. Having said this, the Bank of Canada Governor Mark Carney did provide some reasonable food for thought when he stated that the economic recovery will remain restrained until governments implement the measures they set in place to address the global imbalances discussed at the Group of 20 summit in Toronto.

The reforms initiated in June were designed to narrow the mismatches in spending/saving that helped plunge the world economy into crisis two years ago. In other words, until China starts spending and the U.S. starts or at least continues to save and pay down debt, we are not nearly out of the woods yet. Before the imbalances are solved, an exporting nation such as Canada continues to have cause for concern. Look no further than our country’s biggest ever trade deficit reported this past week for a good idea of the current pickle.

From our Canadian Small-Cap Research Universe (www.keystocks.com), we take a quick look at a company that made our clients a great deal of “cash” over the past year. The company, Cash Store Australia Holdings Inc. (AUC:TSX-V), which was recently sold for a 200 per cent gain in less than one year, posted solid year end results.

The company, an emerging pay-day loan broker in Australia, reported that its revenues for its fiscal 2010 jumped 238.2 per cent to $11.5 million from $3.4 million for the same period last year. Branch operating income increased to $2.8 million from $387,000 for the same period last year.

During 2010, the addition of 33 branches grew the company’s branch network to a total of 61 branches. The company’s corporate infrastructure was also further developed to support its long-term growth strategy. After the costs associated with the rapid addition of 33 branches over the year, positive cash flows remained strong. Management has stated the company is on track to achieve 300 branches in operation by the end of calendar 2014.

Looniversity – The Price-to-Sales Approach

The price-to-sales (P/S) ratio is an under-used, yet valuable tool in your evaluation tool box. It is calculated as a stock’s current market price divided by its sales (revenue) per share over the last four quarters (one year).

We find that because sales are a more strictly defined figure than earnings, the P/S ratio tends to give more reliable incite into a company than the price-earnings (P/E) ratio. There are countless ways in which management may inflate or suppress earnings; yet it is much more difficult, and in fact borders on fraud, to artificially create or destroy revenues.

Although the average P/S is higher in some industries than others, the acknowledged “rule of thumb” is that a stock with a P/S ratio below 0.75 can be considered under-valued. It is also generally accepted that an investor should avoid most companies with a P/S ratio above 3.0.

Although we believe the P/S ratio can be a valuable addition to your toolbox, we suggest you interpret it cautiously in certain situations:

Situation 1: Companies on the verge of bankruptcy often emerge with very low P/S ratios. This can be due to the fact that initially their sales may experience only a slight drop-off, while their share prices plummet.

Situation 2: The ratio ignores a company’s capital structure. In other words, a highly leveraged or high debt-load company can show a low P/S ratio yet remain unprofitable because of its inability to cover its interest obligations with operating income.

Situation 3: Average P/S ratios can vary significantly from industry to industry. For example, companies in the computer software industry tend to show higher average P/S ratios, yet this does not necessarily mean they are not good buys. This is because these companies typically exhibit high margins or are able to convert a great deal of their sales dollars into profits.

Try calculating the P/S ratios for all stocks in your portfolio. If all of your companies are trading at or more than twice their sales per share (a ratio of two or above), it is a good indication you are carrying excess risk.

Short Sale

An investor who sells stock short borrows shares from a brokerage house and sells them to another buyer. Proceeds from the sale go into the shorter’s account. He must buy those shares back (cover) at some point in time and return them to the lender.

Short Squeeze

While shorters sell short a stock on the hope that its price will plunge, there is always a chance that its price may begin to rise. If it does so, more and more of these “shorters” will “cover” their investments. That is, they’ll buy back the shares that they had shorted, and take a loss, since they’re now having to buy the shares at a higher price. As more and more shorters do this, the price rises (since more people are buying than selling). In investment parlance, this is a short squeeze.

Put it to Us?

Q. What is buying stock on margin and why do investors do it?

– Mary McDonald; Edmonton, Alberta.

A. To answer part one of your question, buying stock on margin is essentially borrowing coinage from your broker against the securities (stocks, bonds, etc.) you currently own and using that dough to purchase stock. Thus, investors who purchase on margin initially pay only a portion of the full transaction price. Margin requirements, or the amount you must deposit on a stock, vary based on the price of the individual security, but are generally 50 per cent of the market value of the stock if its price is $2.00 or greater. In other words, you can purchase $20,000 worth of marginable securities with only $10,000 of your own cash.

This last point is one of the major reasons investors choose to buy on margin – the concept of leverage. By putting up only half the market value of the stock, you are able to benefit from a future price rise on the full $20,000 invested. Thus, as a percentage of the money invested, your potential profit is greater than if you purchased the shares outright.

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