Good Investing means learning How to Wait

Good Investing means learning How to Wait

Patience is a highly sought virtue. To be patient is to wait, to be able to mentally insert a wedge between a linked stimulus and response and so place a stop on repetitive, habitual, often destructive behavior. Patience gives you a moment to access, step back from the brink, and bring yourself back into balance.

The idea is that we restrain our will to stop an impulsive or destructive action (often based on short term relief from tension or instant gratification) and in doing so, turn our energy in a constructive or creative direction – to use our will in a directly beneficial way. Patience, then, is the mental reflection of the restraint of will.

Dr. Gerald Epstein


The stock market is really a vehicle to help you master yourself. The money you make or lose is just a way of keeping score. The market can be insidious in taking advantage of your character weaknesses. But at the end of the day it is just reflecting back what's going on inside of you. And because of this it can help you master yourself as you learn about your own behavior under the fire of having your money at risk while being in the market.

Remember the first time you bought the stock of a listed company. It seemed surreal. There you were putting your money at risk in the stock market while facing an unknowable future. The 'uncertainty' of the future of the act tempts one to execute their idea immediately and in so doing relieve themselves of the tension of the moment. Afterwards the investor will use 'confirmation bias' to justify his action so as to make himself more comfortable with the idea of living with his decision.

There is no rush to buy a stock. The volatility of the stock market will offer the long term investor many opportunities to invest carefully. Rather than purchase a large position at once, there are advantages to building up a position over time. How you enter a stock position has a lot to do with how you exit the position. The practice of patiently building a position in a stock teaches the investor to be disciplined in holding the stock.

Incubate your stock ideas. When you think you have found an interesting investment opportunity. Sit on it awhile. Read about the company and its management team. Over time new insights will present themselves. It's human nature to jump in and relieve yourself of the uncertainty of the moment (will I or won't I). Let the investment idea develop on its own and allow it to enlighten you over time. You will find you were wise in waiting and when you do finally pull the trigger it will be a more sure handed response to the market environment.

The Current Market Environment and the Unknowable Future

The Current Market Environment and the Unknowable Future

Since the market put in its bottom in the winter of 2016, the markets have performed quite well. But as market upswings mature, segments of the market get overheated and excess optimism usually results. Several trends have emerged in the last 18 months…A lot of money has gone into big-cap growth stocks (the fang stocks). And there has been a ground swell towards passive investing via ETF’s. Big institutions need to have investing vehicles that can absorb all their buying. Big cap growth stocks and passive ETF’s fill the bill. The only problem with that is, once market prices go the other way, they all try to leave by the same door at once causing prices to plummet. Another thing that has occurred is a bottoming and rebound of the commodity sector. The difference is there is a scarcity of supply in the commodity arena, so it should be better able to absorb a lot of buying.

I evaluate the current market environment by tracking the momentum of breadth (advancing volume-declining volume) of the NYSE. Momentum (rate of change) is a leading market indicator and can give information about a market before prices actually turn. The market indexes are little more than a proxy for what all the index huggers (institutions) are doing. Index hugging is primarily caused by career risk in the investment industry. In other words…’we can all go down together but I can’t let them go up without me.’

Now as big as these institutions are; there are still other entities above them in the food chain of influence, money and power. Call them the ‘lords of the playing field’. They are I suppose that one percent or maybe even that one half of a percent that work and control the levers of the truly big money. I like to think that by tracking the momentum of the breadth of the market I can trace their steps and adjust my risk profile accordingly.

According to the breadth of the NYSE, the lords of the playing field have been slowly siphoning their money out of the market. Now I know we all face an unknowable future where more things can happen than will happen, so the only thing left to do is try to manage your risk and be aware of the potential dangers that are currently in this overheated but weakening market.

Has the Capital Cycle turned for Commodities?

Has the Capital Cycle turned for Commodities?

The commodity cycle showed early signs of bottoming in Feb 2016. Sentiment was about as low as you could get and they seemed thoroughly washed-out, suddenly they experienced a very strong up thrust move (impulse move up), leading the entire stock market back up. Check the point and figure chart for copper (copper is a good industrial metal to track for the economically sensitive sectors of the market)…

http://stockcharts.com/freecharts/gallery.html?COPX

Commodities then had a spectacular rally (Canadian market surged) which resulted in an overbought market condition. A counter trend correction then ensued as commodities sold off the sudden excess of money that flowed into it. This correction seems to have run its course in June of this year as momentum started to improve. Check the attached daily chart for the copper complex.

After eight years of monetary stimulus there is plenty of money on the sidelines ready to be put to work. It seems to be going into the economic sensitive sectors of the market (commodity related stocks and economic-sensitive sectors like technology, energy-related stocks, mining stocks and industrials).

The resource based Canadian market is showing clues that it is getting stronger. Canada experienced sharp increases in its five year bond (75 basis points in June and July). Its ten year bond was up 64 basis points over the same period. On top of that the Bank of Canada raised its key lending rate by 25 basis points for the first time in six years. And the Canadian dollar ran up and touched 80 dollars U.S...

Given these signals from the bond market, my feeling is the Canadian stock market has a good chance of outperforming its U.S counterpart in the ensuing months.

Stock Idea…Danaher Corp

Stock Idea…Danaher Corp

Symbol : DHR

Exchange: NYSE

Market Cap : 56.4 Billion

Revenue : 17.4 Billion
Three Year Revenue Growth : -2.6 %
Investment Type : Big Cap Value (Dividend Grower)

Price/Earnings : 26.1

Forward P/E : 18.8

Price/Book : 2.3

Price/Sales : 3.3

Price/Cash Flow : 18.9

Yield 0.65 %

Price : 81.20
Investment Stem : Akre Capital Management

Danaher Corp designs, manufactures and markets professional, medical, industrial and commercial products and services. It markets its products under the brand of Beckman Coulter, Aperio, Dexis, Chemtreat and others.

Danaher Corporation (Danaher) designs, manufactures and markets professional, medical, industrial and commercial products and services. The Company operates through four segments: Life Sciences, which offers a range of research tools that scientists use to study the basic building blocks of life, including genes, proteins, metabolites and cells, in order to understand the causes of disease, identify new therapies and test new drugs and vaccines; Diagnostics; which offers analytical instruments, reagents, consumables, software and services; Dental, which provides products that are used to diagnose, treat and prevent disease and ailments of the teeth, gums and supporting bone, and Environmental & Applied Solutions, which consists of various lines of business, including water quality and product identification. As of December 31, 2016, Danaher's research and development, manufacturing, sales, distribution, service and administrative facilities were located in over 60 countries.

Back in July of 2016 Danaher Corp spun off a separate business now named Fortive (NYSE: FTV). The spin-off made Danaher a predominately healthcare-care focused business, instead of a conglomerate with significant interests in industrial markets. The company operates in four segments: Life Sciences, Diagnostics, Dental, and Environmental & Applied Solutions. Life Sciences is the largest contributor to revenue at 32% or $5.36 billion. This segment has been a focus for management over the past 2 years, and revenue has grown 62% in 2016.

The main driver of this growth is from the acquisition of Pall in August of 2015 for $13.6 billion. The Pall acquisition brought an innovative industry leader in air and water filter technology. Management has employed growth through acquisition, but has come at a cost by adding significant leverage of $8.1 billion in debt.

The Life Science segment provides products and services that support pharmaceuticals, aerospace, and semiconductor industries. Under the segment the company operates multiple businesses from leading provider in microscopes and scientific medical instruments, to high-tech filtration, separation, and purification applications. Higher sales volumes and cost restructuring savings grew organic revenue and expanded operating income.

The Diagnostics segment supplies products and services for biomedical testing, point-of-care testing, pathology optimization, and blooding testing. All of these products help serve laboratories and hospitals diagnose and treat diseases. Demand in the U.S. was soft in 2016, but was more than offset by high growth markets like China. Diagnostics revenue increased 4.5% in 2016 on a 2.5% organic increase.

Dental develops and manufactures dental chairs, x-ray machines, laboratory equipment, and dental implants; basically a wide range of products that help treat teeth and gum disease along with helping people with their smile. Operating margins expanded 150 basis points on top of 2.5% organic growth in 2016, offset by .5% currency.

The Environmental & Applied Solutions business provides a wide range of analytical instruments, software and related consumables, disinfection systems, and industrial water treatment solutions. Revenue increase nicely at 3% organic growth, half was offset though by -1.5% foreign currency headwind. The operating profit margin profile of this segment is much different than the other three segments at 23%, 800 basis higher.

The dreaded metrics from Morningstar…

http://quote.morningstar.ca/Quicktakes/stock/keyratios.aspx?t=DHR&region=USA&culture=en-CA&ops=clear

The company’s website…

http://www.danaher.com/

Article from seeking alpha…

https://seekingalpha.com/article/4080723-one-year-later-post-spin-danaher-corporation

Danaher business lines provide a diverse revenue base that doesn't compete in many commoditized markets. With less commoditized products comes less competition, but innovation and meeting customers needs is crucial in keeping their moat.

High switching costs allow Danaher to benefit from supplier power. Supplier power is the leverage the supplier has over its customers mostly on pricing. With Danaher large equipment install base within the Life Science and Diagnostics segments, allows additional sales to funnel through to consumables. Danaher is a specialized supplier because of the innovative products and services the company provides to its customer base.

Danaher isn't an industry leader of any of the markets it operates in, but has strategically acquired many companies over the past two decades that have provided high returns on invested capital. With these acquisitions, the company has benefited from economies of scale through selling, inventory, and distribution efficiencies.

The company is emerging from a transformative period. On July 5, 2016, Danaher split into two companies, the ongoing Danaher and the new Fortive (NYSE: FTV). Fortive is an industrial growth company comprised of Danaher's former Professional Instrumentation and Industrial Technologies businesses. Danaher is now more focused on medical technology. Danaher is a quality big cap dividend grower run by share holder friendly management. A good way to play global growth in the medical technology sector of the world economy.

In lieu of the recent weakness in the market breadth of the NYSE, it might be a good idea to hold off buying the stock until the November/December time period.

Stock Idea…Tecsys Inc

Stock Idea…Tecsys Inc

Symbol : TCS

Exchange: TSX

Market Cap : 172.0 Million

Revenue : 68.0 Million
Three Year Revenue Growth : 13.7 %
Investment Type : Small Cap Emerging Growth

Price/Earnings : 27.3

Forward P/E : 21.3

Price/Book : 5.7

Price/Sales : 2.4

Price/Cash Flow : 16.8

Price : 13.15
Investment Stem : Mawer New Canada Fund 
                                Cheap Small Caps Screen

Tecsys Inc is engaged in the development, marketing and sale of enterprise-wide supply chain management software for distribution, warehousing, and transportation logistics. It also provides related consulting, education and support services.

Tecsys Inc is a Canada-based company engaged in the development, marketing and sale of enterprise-wide supply chain management software for distribution, warehousing, transportation logistics and point-of-use. The Company also provides related consulting, education and support services. Its Supply Chain Platform with Visual Content is a technology for optimizing warehouse management operations. It offers various services, such as project management, customer support, training and technical services. The Company also offers Supply Chain Modeling And Reference Tools (SMART), which is a supply chain knowledge product. In addition, the Company offers business consulting services, including warehousing and inventory management, transportation and logistics, procurement planning, business intelligence, accounting and finance, and business process re-engineering. The Company provides hosting solutions. The Company caters to healthcare systems and high-volume distributors of discrete goods.

Tecsys Inc. is a provider of innovative supply chain management software solutions to streamline operations, reduce costs and improve customer service for distribution businesses. Its solutions touch warehouse management, distribution, transport management and purchasing & planning.

Tecsys' business has two major business lines: Complex Distribution and Health Care.

The Complex Distribution segment involves organizations that use a complex network of warehouses, distribution channels and multiple products and formats. Management has estimated this total market was worth $3B in 2014 and is increasing at a CAGR of 10% until 2019 based on Gartner estimates.

The dreaded metrics from Morningstar…

http://quote.morningstar.ca/Quicktakes/stock/keyratios.aspx?t=TCS&region=CAN&culture=en-CA&ops=clear

The company’s website…

http://www.tecsys.com/

Cash flow positive (and that's free cash flow) with no debt. Pay a dividend as well, that's rare for a company this size. Cash return of a sparkling 5.6 per cent. The Canadian 10 year bond is just over 2 per cent I think. A substantial premium. The stock seems to be a comer.

BNN comments

Robert McWhirter
(A Top Pick July 21/16. Up 8.81%.) They make the lives of hospitals more efficient with some of their supply chain management work. A high recurring revenue. Earnings are expected to double by April 2018, going from $.24-$.51, giving you a 22X PE. They are free cash flow positive. ROE is very good at 24%. Feels this still has further upside.

Robert McWhirter
This is in the hospital supply chain management. It has roughly $120 million market cap. They have 2 new modules, one for in-house pharmacies in hospitals, as well as operating rooms. It keeps track of where all the stuff is. That has doubled the revenue potential per hospital. Their pipeline sales over the last year has increased by more than the factor of 3. Year-over-year sales were up 26%. Year-over-year earnings, free cash flow and EBITDA grew over 32%. Dividend yield of 1.21%.

 Colin Fisher
(A Top Pick March 16/16. Up 13.87%.) This is a great management team that has been around for a long time, and own quite a few of the shares. There was some weird selling pressure at the end of last year. He expects to see growth on a continuing basis.

Life Cycles of Companies...Mature Companies (Large Caps) Four

Life Cycles of Companies...Mature Companies (Large Caps) Four

Non-operating Assets

A significant chunk of a firm’s value comes from its non-operating assets (cash, marketable securities and holdings in other companies). While cash and marketable securities are by themselves neutral investments, earning a fair rate of return (a low one, but a fair one given the risk and liquidity of the investments), there are two scenarios where a large cash balance can be value destructive. The first is when cash is invested at below market rates. The second arises if investors are concerned that cash will be misused by management. Returning cash to stockholders in the form of dividends or stock buybacks will make stockholders better off. Then again if the management team has a history of efficiently allocating the companies capital (acquisitions) to enhance shareholder return , the stockholders will again benefit. So once again it depends on who is managing the company and their history of handling the firm's excess capital.

Firms with substantial cross holdings in diverse businesses may find these holdings being undervalued by the market (the conglomerate discount). Spinning off or divesting the cross holdings often exposes their true value benefiting both the parent company and its stockholders. 

Spinoffs or divestitures are a particularly interesting subject and I will have more to say about them in a separate blog post.

Life Cycles of Companies...Mature Companies (Large Caps) Three

Life Cycles of Companies...Mature Companies (Large Caps) Three

Financial Restructuring

Two aspects of financing affect the cost of capital, and through it the value that we derive for a firm. First, we will look at how changes in the mix of debt and equity used to fund operations affect the cost of capital. Second, we will look at how the choices of financing (in terms of seniority, maturity, currency, and other features) may affect the cost of funding and value.

The trade-off between debt and equity is simple. Interest expenses are tax deductible and cash flows to equity are not, making debt more attractive, relative to equity, as marginal tax rates rise. Debt can also operate as a disciplinary mechanism on managers in mature firms; managers are less likely to make bad investments if they have to make interest payments each period. Debt on the other hand has its own disadvantages. The first is 'expected bankruptcy cost', since as debt increases, so does the probability of bankruptcy. One direct cost of bankruptcy is incurring legal fees and court costs, which can be exorbitant and eat away at the value of a firm. But worse still is the effect of being perceived as being in financial trouble: Customers may stop buying your products, suppliers may demand cash for goods, and employees may abandon ship, creating a downward spiral for the firm that may destroy it. 

Another disadvantage of debt is 'agency cost', arising from different and competing interests of equity investors and lenders in a firm.  Equity investors see more upside from risky investments than lenders do. As lenders become aware of this conflict of interest, they protect themselves by either writing covenants into loan agreements or charging higher interest rates. This trade off forces management to consider both the costs and benefits of taking on more debt.

The optimal financing mix is one that minimizes a company's cost of capital. The amount of a company's sustainable cash flow will help determine the optimal equity/debt balance of a firm. The more stable and predictable a company's cash flow and the greater the magnitude of these cash flows - as a percentage of enterprise value - the higher the company's optimal debt ratio can be. And because the main advantage of debt is the tax benefit, the higher the tax rate, the higher the debt ratio should be as well.

The senior management of a firm has to consider the above capital requirements of its firm and try to find the right balance to enhance long-term shareholder value. This only underlies the importance of a company's free cash flows (ability of a company to self-fund) and its return on invested capital (ability to create value over time).

to be continued...


Resources

The Little Book of Valuation

Aswath Damodaran

Life Cycles of Companies...Mature Companies (Large Caps) Two

 Life Cycles of Companies...Mature Companies (Large Caps) Two

Operating Restructuring

When valuing a company, our forecasts of earnings and cash flows are built on assumptions about how the company will be run. The value of the operating assets of the firm is a function of three variables - cash flows from assets in place, expected growth, and the length of the growth period - and each can be altered by management policies.

Cash flow from existing assets: If existing investments are being operated inefficiently, cutting costs and improving employee productivity or redeploying assets to new uses can increase cash flows.

Expected growth rate: Firms can increase their long-term growth by either reinvesting more (higher reinvestment rate) or reinvesting better (higher return on capital). They can also improve returns on existing assets to generate short term growth. For mature firms with low returns on capital (especially when returns are less than the cost of capital), extracting more growth from existing assets is likely to yield results, at least in the short term.

Length of the high growth period: The longer a firm can maintain high growth and excess returns, the higher will be its value. One way firms can increase value is by augmenting existing barriers to entry and coming up with new competitive advantages.

to be continued...


Resources

The Little Book of Valuation

Aswath Damodaran

Life Cycles of Companies...Mature Companies (Large Caps)

 Life Cycles of Companies...Mature Companies (Large Caps)

These stocks have long periods of operating and market history, with established patterns of investment and financing. But not all long standing practice is good and it is possible that changing the way these companies are run can make a difference in creating higher stock values. They might be more valuable if they used more debt to fund themselves or value could be increased by spinning out some of the company’s divisions as separate entities. See my blog on ‘resource conversion’…

 https://nivag18.blogspot.ca/2017/04/normal-0-false-false-false.html

If growth companies get the bulk of their value from growth assets, mature companies must get the bulk of their value from existing investments. 

The common characteristics of mature companies are:

Revenue growth is approaching growth rate in the economy.

Margins are established: The exception being cyclical or commodity firms.

Diverse competitive advantages: Some mature firms will see their excess returns go to zero and below while others will retain a significant competitive advantage (brands etc...)

Debt capacity: With more cash available for servicing debt, debt capacity should increase for mature firms, though there can be big differences in how firms react to this surge in debt capacity.

Cash build-up and return: As earnings improve and reinvestment needs drop off, mature companies will be generating more cash from their operations than they need. If these companies do not pay more dividends, cash balances will start accumulating in these firms. 

Acquisition-driven growth: As companies get larger, their internal investments have less effect on their growth rates. To remedy this they will often attempt to acquire other companies as a way to boost revenues and earnings. This does not however always add value.

Not all mature companies are large companies. Many small companies reach their growth ceiling quickly and essentially stay on as small mature firms.

The key to valuing mature companies is assessing the potential increase in value from changing the way they are run (resource conversion and corporate restructuring), these changes can be categorized into three groups: changes in operations, changes in financial structure, and changes in non-operating assets.

to be continued... 


Resources

The Little Book of Valuation

Aswath Damodaran

The Capital Cycle 2

The Capital Cycle 2

         

There is a lag between the rise in capital spending and its impact on supply, which is a characteristic of the capital cycle. The delay between investment and new production means that supple changes are lumpy (the supply curve is not smooth as displayed in economics textbooks) and prone to overshooting. In fact, the market instability created by lags between changes in supply and production has long been recognized by economists as the "cobweb effect".

The capital cycle turns down as excess capacity becomes apparent and past demand forecasts are shown to have been overly optimistic. As profits collapse, management teams are changed, capital expenditure is slashed, and the industry starts to consolidate. The reduction in investment and contraction in industry supply paves the way for a recovery of profits. For an investor who understands the capital cycle this is the moment when a beaten down stock becomes potentially interesting. However, brokerage analysts and many investors operating with short time horizons generally fail to spot the turn in the cycle but obsess instead about near-term uncertainty.

Example of Industry Capital cycle 

Business investment declines...industry consolidation...firms exit...investors pessimistic

Improving supply side causes returns to rise above cost of capital...share price outperforms

New entrants attracted by prospect of high returns....investors optimistic

Rising competition causes returns to fall below cost of capital...share price under performs

Key Takeaways from Capital Cycle Analysis

Most investors devote more time to thinking about demand than supply. Yet demand is more difficult to forecast than supply.

Changes in supply drive industry profitability. Stock prices often fail to anticipate shifts in the supply side.

The value growth dichotomy is false. Companies in industries with a supportive supply side can justify high valuations.

Management`s capital allocation skills are paramount in dealing with the capital cycle of the industry they operate in.

Investment bankers drive the capital cycle, largely to the detriment of investors.

When policymakers interfere with the capital cycle, the market clearing process may be arrested (governments supporting failing companies and industries). New technologies can also disrupt the normal operation of the capital cycle.

Long term and contrarian investors are better suited to taking advantage of the capital cycle approach.


Resources

Capital Returns

Edward Chancellor

                                                                                                                        

The Capital Cycle

The Capital Cycle

         

The Capital Cycle has to do with the ebb and flow of capital. Typically, capital is attracted into high-return businesses and leaves when returns fall below the cost of capital. This process is not static, but cyclical – there is constant flux. The inflow of capital leads to new investment, which over time increases capacity in the sector and eventually pushes down returns. Conversely, when returns are low, capital exits and capacity is reduced; over time, then, profitability recovers. From the perspective of the wider economy, this cycle resembles Schumpter’s process of “creative destruction” – as the function of the bust, which follows the boom, is to clear away the misallocation of capital that has occurred during the upswing.

The key to the "capital cycle" approach is to understand how changes in the amount of capital employed within an industry are likely to impact upon future returns. Or put another way, capital cycle analysis looks at how the competitive position of a company is affected by changes in the industry's supply side. In his book, Competitive Advantage, Professor Michael Porter of the Harvard Business School writes that the "essence of formulating competitive strategy is relating a company to its environment." Porter famously described the "five forces" which impact on a firm's competitive advantage: the bargaining power of suppliers and of buyers, the threat of substitution, the degree of rivalry among existing firms and the threat of new entrants. Capital cycle analysis is really about how competitive advantage changes over time , viewed from an investor's perspective.

To continue our discussion, high current profitability often leads to overconfidence among managers, who confuse benign industry conditions with their own skill - a mistake encouraged by the media, which is constantly looking for corporate heroes and villains. Both investors and managers are engaged in making demand projections. Such forecasts have a wide margin of error and are prone to systematic biases. In good times, the demand forecasts tend to be too optimistic and in bad times overly pessimistic.

High profitability loosens capital discipline in an industry. When returns are high, companies are inclined to boost capital spending. Competitors are likely to follow - not wanting to lose market share while getting caught up in the spending frenzy themselves. CEO pay is often set in relation to a company's earnings or market capitalization, thus incentivizing managers to grow their firm's assets. Share prices rise as additional capacity is added, growth and momentum investors jump on board.

Investment bankers lubricate the wheels of the capital cycle, helping to grow capacity during the boom and consolidate industries in the bust. Their analysts are happiest covering fast-growing sexy sectors while increasing their commissions. Bankers earn fees by arranging secondary issues and IPO's, which raise money to fund further capital spending. Neither the M&A bankers nor the brokerage analysts have much interest in long-term outcomes. As the investment bankers' incentives are skewed to short-term payoffs (bonuses), it's inevitable that their time horizon will shrink. It's a question of incentives and human nature. Both analysts and investors are given to extrapolating current trends, thinking linearly in a cyclical process.

to be continued...


Resources

Capital Returns

Edward Chancellor

Understanding Porter's Five Forces

Understanding Porter's Five Forces

 

The tool was created by Harvard Business School professor Michael Porter, to analyze an industry's attractiveness and likely profitability. Since its publication in 1979, it has become one of the most popular and highly regarded business strategy tools. Porter recognized that organizations likely keep a close watch on their rivals, but he encouraged them to look beyond the actions of their competitors and examine what other factors could impact the business environment. He identified five forces that make up the competitive environment, and which can erode your profitability. They are as follows...

Competitive Rivalry. This looks at the number and strength of your competitors. How many rivals do you have? Who are they, and how does the quality of their products and services compare with yours? Where rivalry is intense, companies can attract customers with aggressive price cuts and high-impact marketing campaigns. Also, in markets with lots of rivals, your suppliers and buyers can go elsewhere if they feel that they're not getting a good deal from you. On the other hand, where competitive rivalry is minimal, and no one else is doing what you do, then you'll likely have tremendous strength and healthy profits.

Supplier Power. This is determined by how easy it is for your suppliers to increase their prices. How many potential suppliers do you have? How unique is the product or service that they provide, and how expensive would it be to switch from one supplier to another? The more you have to choose from, the easier it will be to switch to a cheaper alternative. But the fewer suppliers there are, and the more you need their help, the stronger their position and their ability to charge you more. That can impact your profit.

Buyer Power. Here, you ask yourself how easy it is for buyers to drive your prices down. How many buyers are there, and how big are their orders? How much would it cost them to switch from your products and services to those of a rival? Are your buyers strong enough to dictate terms to you? When you deal with only a few savvy customers, they have more power, but your power increases if you have many customers.

Threat of Substitution. This refers to the likelihood of your customers finding a different way of doing what you do. For example, if you supply a unique software product that automates an important process, people may substitute it by doing the process manually or by outsourcing it. A substitution that is easy and cheap to make can weaken your position and threaten your profitability. 

Threat of New Entry. Your position can be affected by people's ability to enter your market. So, think about how easily this could be done. How easy is it to get a foothold in your industry or market? How much would it cost, and how tightly is your sector regulated? If it takes little money and effort to enter your market and compete effectively, or if you have little protection for your key technologies, then rivals can quickly enter your market and weaken your position. If you have strong and durable barriers to entry, then you can preserve a favorable position and take fair advantage of it.

Key Points

 

Porter's Five Forces Analysis is an important tool for understanding the forces that shape competition within an industry. It is also useful for helping you to adjust your strategy to suit your competitive environment, and to improve your potential profit.
It works by looking at the strength of five important forces that affect competition:

• Supplier Power: the ability of suppliers to drive up the prices of your inputs.
• Buyer Power: the strength of your customers to drive down your prices.
• Competitive Rivalry: the strength of competition in the industry.
• The Threat of Substitution: the extent to which different products and services can be used in place of your own.
• The Threat of New Entry: the ease with which new competitors can enter the market if they see that you are making good profits (and then drive your prices down). 

By thinking about how each force affects you, and by identifying its strength and direction, you can quickly assess your position.
You can then look at what strategic changes you need to make to deliver long-term profit.

When dealing with emerging growth stocks (micro and small cap), the usual static valuation tools do not really apply (P/E, P/B, P/S, P/CF). The intrinsic value of these companies lies in management's ability to grow and develop the business for the future. That being said an investor should focus on the business model of the company and the nature of the industry in which it competes. This is where Porter's Five Forces come into play. A third factor to consider with these young growing companies is management's ability to allocate their shareholder's capital efficiently and responsibly. Management is a critical element when investing in the small cap arena.

Stock Idea…Rocky Mountain Dealerships Inc

Stock Idea…Rocky Mountain Dealerships Inc

Symbol : RME

Exchange: TSX

Market Cap : 201.8 Million

Revenue : 951 Million
Three Year Revenue Growth : -2.6 %
Investment Type : Small Cap Value

Price/Earnings : 13.0

Forward P/E : 8.9

Price/Book : 1.1

Price/Sales : 0.2

Price/Cash Flow : 8.1

Yield 4.42 %

Price : 10.41
Investment Stem : Cheap Small Caps Screen

Rocky Mountain Dealerships Inc through its subsidiaries sells, leases and provides product and warranty support for agriculture and industrial equipment in Western Canada.

Rocky Mountain Dealerships Inc. is an agriculture equipment dealer with a network of full-service agriculture and industrial equipment stores across the Canadian Prairie Provinces. The Company operates in two segments: agriculture segment and industrial segment. The agriculture segment primarily includes sales of agricultural equipment, parts and services, and the industrial segment includes sales of industrial equipment, parts and services. Through its subsidiaries, the Company sells, leases, and provides product and warranty support for a range of agriculture and industrial equipment in Western Canada. The Company's operations in Alberta, Saskatchewan and Manitoba are conducted through Rocky Mountain Equipment Canada Ltd., under the name Rocky Mountain Equipment. It offers its customers a solution for their equipment needs through new and used equipment sales, parts sales, repairs and maintenance services, and third-party equipment financing and insurance services.

A cyclical stock coming up from its bottom as the Capital Cycle in commodities is slowly shifting to the upside. Consistently reports high ROIC numbers year after year, even during the commodity down cycle, a good sign of management’s capital allocations abilities. The huge build up of inventory that was accumulated during the 2012-2014 period is now starting to roll off. Balance sheet in good shape. Has a cash return of a staggering 11.0 %.

The dreaded metrics from Morningstar…

http://quote.morningstar.ca/Quicktakes/stock/keyratios.aspx?t=RME&region=CAN&culture=en-CA&ops=clear

The company’s website…

https://www.rockymtn.com/

Another one of Peter Lynch’s, ‘Blossoms in the Desert’ stocks…a survivor that should do well during the next upswing in the commodity cycle, pays a nice dividend while you wait. A well run company.

A Recap of Stock Ideas

A Recap of Stock Ideas

         

The first question you should ask yourself before you invest in anything is…what can I lose (risk)? Only after that has been addressed should you consider what you can make (potential reward).

Four of the five stock ideas I came up with were derived from my stock scan of the Canadian market on July 8^th. I scanned the Canadian market for both value and quality. I also wanted some growth as it is difficult to create value over time without growth, so I looked at the stock’s 3 year revenue growth rate after the scan was complete. By insisting on focusing on value I hopefully built a certain margin of safety into my investing process. It’s a good habit to get into.

I think I came up with some interesting investment ideas…a manufacturer and supplier of wire products, an exploration and development drilling company serving the mining industry, a supplier of components to the aerospace industry and an oil and gas services company.

Gigamon stands apart from the rest of my stock ideas as it is an emerging growth story from the US market. A different type of company both in its life cycle and the nature of business it is in. I got that investment idea from a different source. As it is an emerging growth company there will be more risk but potentially more reward as well if one was to invest in it. Investing in the stocks of public companies can be a varied menu.

This was a helpful exercise for me. In sifting through and selecting the stocks of my scan I decided to write my thoughts down in permanent form. There is something about writing your thoughts and investigations down on paper (cyberspace). They take on a tangible form and materialize in your physical world. It is something you can refer back to, instead of losing your thoughts to the vagaries of time and memory.

I'll check back in on these stocks from time to time to see how they are faring. I currently own one of them, High Arctic Energy Services, which I bought in March of 2016.

Stock Idea…High Arctic Energy Services Inc

Stock Idea…High Arctic Energy Services Inc

Symbol : HWO

Exchange: TSX

Market Cap : 200.1 Million

Revenue : 218 Million
Three Year Revenue Growth : 10.1 %
Investment Type : Small Cap Growth and Value

Price/Earnings : 4.7

Price/Book : 0.9

Price/Sales : 0.9

Price/Cash Flow : 7.7

Price : 3.71
Investment Stem : Cheap Small Caps Screen

High Arctic Energy Services Inc. is a Canada-based company, which focuses on providing contract drilling, completion services, equipment rental and other oilfield services to the oil and gas industry. The Company operates through providing oilfield services to customers in Canada and Papua New Guinea (PNG) segment. In PNG, the product line consists of contract drilling services, workover services and equipment rental including rig mats, cranes and oilfield related equipment. In Canada, the product line consists primarily of snubbing services and the supply of Cryogenic Liquid Nitrogen Pumping Services and equipment rentals. The Company holds distribution rights for the rental of Dura-Base mats within PNG. It provides drilling support equipment in PNG, such as camps, forklifts and trucks, on a daily rental basis and drilling support personnel on a daily rental rate basis. Its snubbing services are provided using the Stand Alone Snubbing System units and Rig Assist units.

This one may offer the best value of them all so far, tremendously cheap and yet still growing. A victim of the optics of the industry the company operates in. Has a cash return of 9.6 while offering a yield of 5.3…Debt to equity ratio of 10.36…Retained earnings became positive for the first time in 2016, meaning after paying all of their expenses, they still have money left over to invest in their operations. Management appear to be astute and opportunistic capital allocators of the companies capital resources (made an acquisition last year where they bought an asset for 15-20 cents on the dollar...read the seeking alpha attachment).

The dreaded metrics from Morningstar…

http://quote.morningstar.ca/Quicktakes/stock/keyratios.aspx?t=HWO&region=CAN&culture=en-CA&ops=clear

The company’s website…

http://www.haes.ca/

A great article on the company from seeking alpha, be sure to read this.

https://seekingalpha.com/article/4007111-high-arctic-energy-services-closer-look-best-o-and-g-acquisition-2016

Peter Lynch once wrote a piece in one of his books called Blossoms in the Desert...I'll quote directly from it here...'As a place to invest, I'll take a lousy industry over a great industry anytime. In a lousy industry, one that's  growing slowly if at all, the weak drop out and the survivors get a bigger share of the market. A company that can capture an ever-increasing share of a stagnant market is a lot better off than one that has to struggle to protect a dwindling share of an exciting market...The greatest companies in lousy industries share certain characteristics. They are low-cost operators, and penny-pinchers in the executive suite. They avoid going into debt...They find niches, parts of the market that bigger companies have overlooked.'

Investing in the stock of companies when they are unpopular and their charts look lousy isn't easy. Investing is largely a psychological exercise despite the numbers that are involved. An investor has to take advantage of the market's inefficiencies and capitalize on the psychological weaknesses of the other investors who are in the market he's investing in.

 

Stock Idea…Magellan Aerospace Corp

Stock Idea…Magellan Aerospace Corp

Symbol : MAL

Exchange: TSX

Market Cap : 1.2 Billion

Revenue : 985 Million
Three Year Revenue Growth : 10.1 %
Investment Type : Small Cap / Mid Cap Value

Price/Earnings : 11.2

Price/Book : 1.8

Price/Sales : 1.2

Price/Cash Flow : 9.8

Price : 19.91
Investment Stem : Cheap Small Caps Screen

Magellan Aerospace Corporation is a Canada-based supplier of components to the aerospace industry and in certain applications for power generation projects. The Company engineers and manufactures aeroengine and aerostructure components for aerospace markets, including products for defense and space markets, and complementary specialty products. Its segments include Aerospace and Power Generation Project. The Aerospace segment includes the design, development, manufacture, repair and overhaul, and sale of systems and components for defense and commercial aviation. The Power Generation Project segment includes the supply of gas turbine power generation units. Within the Aerospace segment, the Company's product groupings include aerostructures and aeroengines. It manufactures complex cast, fabricated and machined gas turbine engine components, both static and rotating, and integrated nacelle components, flow paths and engine exhaust systems for various aeroengine manufacturers.

Another cash flow positive company with a debt to equity ratio of 18 percent, this one serving the aerospace industry with operations pretty well evenly distributed between Canada, the US and Europe. Entrenched relationship with it's major customers, Boeing and Airbus, which together make up about 40% of the company's sales. The company’s relative small size and low liquidity put it under the radar of many institutional investors despite the fact that the company has experienced steady organic revenue growth over the last 10 years with increasing profit margins.

The dreaded metrics from Morningstar…

http://quote.morningstar.ca/Quicktakes/stock/keyratios.aspx?t=MAL&region=CAN&culture=en-CA&ops=clear

The company’s website…

http://magellan.aero/

Another free cash flow company from my scan of the Canadian market on July 8th. Has a cash return of 3.8% (by way of comparison, the 10 year Canadian Bond currently sits at 2.03%). If you have faith in the global aerospace market this could be an interesting investment idea. Investing in the small and mid cap sectors of the market is the gift that keeps on giving in that it is generally under followed and under appreciated. Few of these stocks will be over-owned like the giant large caps that are always in the news in the states. The stocks in the small and mid sectors of the market generally have low expectations and few followers making earning surprises occur more on the upside instead of the downside.