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Gal^Stad
Investments Inc.

spacer July 2001
Commentary

Editors' Note: This issue's commentary comes by way of a long and winding road. Not so long ago, the Contra Guys were asked by a certain brokerage (which shall remain nameless to protect the not-so-innocent) to write an article about investing in the current difficult markets.

We dutifully pointed out that, tickled as we were by the invitation, our contrarian opinions might ruffle some feathers within their august firm. Our fears were calmed as we were solemnly assured that this publication encouraged differing points of view, so that their customers might be better informed by the broad scope of the discussion and lively debate.

Alas, after our piece was reviewed by a number of individuals within this organization, the content was judged inappropriate, and apparently capable of creating legal liabilities for the publication, so it was rejected.

Exactly what in this piece was found likely to offend the sensibilities of their customers? Judge for yourself, gentle readers, a story so extreme, and of such radical import, that it induces mighty institutions to quake in fear and armies of lawyers to slaver in anticipation. Consider yourself warned.

Enthusiasm for equity investing has dimmed for many people who got their socks knocked off by the tech meltdown. The subsequent messages from investment gurus are hardly reassuring; they range from the annoying "I told you so" recriminations from those who avoided technology stocks altogether, to the "Relax, they'll come back eventually" bromides espoused by those who rode the new economy phenomenon to the very top -- and down again.

Read any stock-related publication from the past few months and odds are that it described the markets as volatile. Go back a few years and you will notice something ironic: markets were frequently volatile, except they were usually going up.

It seems as if "volatility" has been all but stripped of any real meaning and become a vacuous euphemism for a market on the decline. On the other hand, during periods when stock prices are relatively stable, analysts remain unhappy, using adjectives like "listless" and "aimless" to describe a market that refuses to do anything newsworthy.

No doubt, words like "tumble" and "soar" make for more exciting copy, so the financial media accentuates the most abrupt moves in stock prices. See-saw patterns rarely result in much real progress in a market's valuation, but they do offer a steady diet of "news" about which analysts may weigh in with their interpretations of the day's gyrations.

Viewed from this perspective, "market instability" becomes the norm rather than the exception. But this apparent state of flux is often not very important when creating a long-term investment plan. At times, investors will be rewarded by market surges; at others, crunched by downturns. That is the nature of the game. But a few key rules will help enhance performance, turning respectable returns into outstanding results.

Let's start by tackling that tenet of long-term investing, buying and holding until kingdom come. As investors have realized to their dismay during the recent market debacle, buying into the bluest of blue-chip firms -- such as Nortel, Microsoft and Intel -- does not guarantee success.

The notion behind buying and holding without regard to price suggests that stocks with a great story are never overvalued. Of course, that is utter nonsense. At some point, when realistic valuations get eclipsed by hope and hype and spin out of control, the time comes to take a profit. Even Warren Buffett, who is renowned for his stodgy buy-and-hold approach, sells companies when the market insists they are worth much more than their fundamentals indicate.

You need the patience to be willing to hold until the market recognizes the wisdom of your investment; but once that happens, sell and scout for a sector that offers better returns. This underlines the critical investment methodology of sector rotation, an area so obvious that investors often overlook it until it almost knocks them over.

This was the main reason for our purchase of Luscar, an out-of-favour coal company, in December at $1.48 per share; we sold the stock this spring, at an average of $4.09.

Central to this sort of move is the business cycle, which dictates that different industries will be in vogue at different times. During one period, commodities are the flavour of the hour; at another time, financials or retailers have their day. Oil and gas are currently in fashion, indicating to us that this train is probably getting long in the caboose. When a peak is in sight, the departure whistle is set to blow, and it is better to hit the exit platform early rather than late.

Many investors ignore the long term altogether and set short-term price targets. This system is also flawed. The shorter the time frame, the less accurate the crystal ball. And in this game of probability, those who adopt a limited forward vision are most likely to be correct when profits are small. If the stock goes against them, many of these folks will give up and dump the position, often by using a stop-loss. This pattern of small gains and small losses is undermined by commissions, a major impediment to achieving high returns.

Conclusion: it is best to set grander, longer-term targets -- and should these come to fruition sooner rather than later, more power to you. Intrinsic to this approach is the setting of price goals, something we always recommend. This does not mean that this value should not be reassessed and altered as warranted, but by setting it and grounding yourself, odds are that your decision-making process will be better.

The quality of investment opportunities is not constant, which means that the probability of achieving excellent returns is highly variable. While many perceive that stocks have dropped far below historical highs, that is not the case.

Except for the technology sector, a large cross-section of companies is around record levels. Remove the demise of Nortel from the TSE 300 calculations, and that index recently hit an all-time high. The Dow and the Russell 5000 are within spitting distance of their tops. Those who believe in the "greater fool" theory might hope to buy high and sell higher. But if, like us, you believe that price/earnings ratios are uncomfortably stretched, and that corporate profits will remain weak for a while yet, this is a time to practice patience and await the next great buying opportunity.

This is not to say that equity's traditional competitors are particularly attractive now, either. Interest rates are low, so those who choose to lock themselves into investment certificates will be left in the dust when rates increase.

Bonds are dicey, as they too move in an opposite direction to interest rates. Those alert people who jumped in when the downturn became apparent last fall were rewarded with exquisite returns.

Remember, a key mistake that many investors make is to spotlight the rear-view mirror. It is imperative to understand that, although history is a wonderful teacher, it is the view through the windshield that is most significant.

In all likelihood, as boring as it might sound, waiting through the summer doldrums until late fall will probably prove wiser than sounding the "gotta buy" alarm bells and pouring additional funds into the market now. This demonstrates a philosophy that many of the older generation adhere to: there is a time to make money, and a time to preserve money. Capital preservation is paramount in the current circumstances.

And what should people do who have losers on their hands? A key component to investment success is tax loss planning. If you have some rabble kicking around, the summer is a good time to dump. Many investors make the mistake of waiting until tax loss selling season is in full bloom at the end of the year. All that does is increase the supply and force down prices. Best to unload early, and if you still like the investment, jump back in after the 30-day period that Revenue Canada requires to write off the loss. Better yet, buy back when tax loss selling reaches its peak.

Ultimately, there is no single ideal investing strategy that works all of the time. When you plot your financial thoroughfare, remember to continually re-evaluate your investments with an objective eye -- avoid falling in love with those that have been successful. Set price targets that represent reasonable appreciation from the buy-in price, and don't assume that your ship will come in soon.

Remember to account for asset allocation as it suits your needs and nature, and bear in mind also that, while patience is indeed a virtue, sector rotation means that what is hot now will cool in the future. And those frigid, out-of-favour investments will almost always become warm and toasty.


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