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Gal^Stad
Investments Inc.

spacer October 2004
Commentary

After what has been our quietest nine months on record, we are bracing ourselves for what is typically our buying season. One question that pops up with great regularity in our email inbox at this time of year is, "How many stocks will you buy?"

The answer depends on numerous factors. First and foremost, we will never be pressed to purchase just for the sake of activity. If no attractive possibilities appear, our natures suggest taking a pass and waiting patiently for better candidates.

Another factor is the number of positions currently in the portfolio. Our goal is a range between 15 and 25 stocks -- a number that allows us to remain highly focused. In our experience, it is more effective to selectively procure a manageable number of positions than to jump on the bandwagon with 60 or 300 via an index or mutual fund.

At one point, sales pared back our holdings to the low end of our desired range, raising the question of whether the portfolio was sufficiently diversified. The upside, however, was that there was ample room to acquire other companies. Because only one complete position -- Aur Resources -- has exited the portfolio this year, the Contra roster now stands at a sturdy 24 stocks.

Consequently, we are flirting with the prospect of exceeding our limit of 25 should enough healthy buys cross our radar screen. Never before have we been in our present situation, in which five positions have been partially sold (Japan Equity has been excluded from this discussion, as the sale of rights allocated to us was not material); if these are counted as fractional positions, then voila, more room in the portfolio.

Are we rationalizing? Perhaps; in our discussions, however, we have agreed that it would make sense to add up to three new companies to the portfolio.

An issue that clouds the agenda is our view on the U.S. dollar. While we don't feel as strongly that it is overvalued as we did a few years ago, we expect that further downside remains. America's public debt and budget deficit are major problems that should be attended to swiftly, but there is little evidence that Washington has the resolve to do so.

Given that the Contra portfolio is only slightly weighted to the Canadian side, we continue to soldier on in hopes of increasing the Canuck quotient. Unfortunately, making the task more complex is the fact that the pickings on the north side of the border are far slimmer than on the south.

Another matter we are grappling with: as most of you know, we do the majority of our buying between mid-December and the end of the year. Why? To take advantage of the year-end flurry of tax loss selling, which drives up the supply of stocks that have disappointed their owners, further knocking down the price.

And because prices typically rise towards the end of the year and at the beginning of the New Year, we also benefit. However, we are giving consideration to spreading out our purchases, moving back the start date to mid-November.

Part of the rationale is that mutual funds tend to dump their losers before the end of October; also, astute investors tend to wish to avoid selling when volumes shrink close to the holidays. However, the jury is out as to whether this approach would truly prove advantageous or simply prolong the amount of time we spend hovering over the Buy button.

The white-coated denizens of the Contra laboratories are also mulling over whether we should continue to purchase low-volume stocks such as Clairvest and High Liner. Recently, our interest was piqued by Brick Brewing, an outfit we both liked -- and both purchased outside of the Contra portfolio. The price hovered around 70 cents, but daily volumes rarely exceeded 10,000 shares -- in fact, there were some days when it didn't trade at all.

Companies ignored by the mainstream -- of which this was an example -- can harbour compelling value. But, all other things being equal, a rash of orders from Contra subscribers for a low-volume stock will have a more pronounced effect in the short term than on a more liquid issue.

Therefore, though we deemed Brick a funky little buy, we feared the possibility of the price bubbling over as if we'd taken the cap off a well-shaken stubby bottle.

Judging from the email and letters we receive, we know that this is a dilemma of great concern to many of you, but a practical solution has proven elusive.

What do we look for in a stock? Of importance to us is what Benjamin Graham and David Dodd termed "margin of safety." In this vein, we avoid firms that have a heavy debtload, as well as those where the liability side of the balance sheet seems to be increasing without good reason.

Over the years, we've learned the hard way -- through bankruptcies and Chapter 11 filings -- to assign this high priority to debt avoidance. It is impossible for a creditor to harrumph, "Hello, where's my money?" if there is no debt on the books. Of course, indebtedness is but one indicator of the overall financial condition of the operation; similarly, being a consistent money loser or racking up a long track record of negative cash flows cannot be considered healthy.

We also carefully review the financial ratios, including such common tools as book value and price/earnings ratio. It's also important to try to "get inside" the numbers, as book values can be easily inflated by goodwill, or just as easily diminished by undervalued real estate.

And P/E figures can be skewed if a firm decides to pile on the losses to get them out of the way, which often happens when new management arrives and decides to clear the decks.

Which reminds us: management is a big factor too, and chasing top-notch brass from one company to another as they perform their turnaround magic can be very profitable.

Although a 50-percent upside is acceptable, our goal is normally at least a double. And stocks that are in a severe downward price spiral are generally to be avoided; bad news tends to beget bad news. We like to see the formation of a base or a chart uptick, rather than fishing for the 52-week low.

Insider trading can be a major clue. If those who are ostensibly in the know are selling, it's time for the buyer to beware. On the other hand, if they are purchasing, our confidence grows.

On a related subject is management ownership: generally, more is better, though one does not want to buy into a private fiefdom where management acts like the lords of the manor rather than the servants of the shareholders.

One thing that warms our investing cockles is the sight of a whole sector that is being battered. Under such conditions it is often possible to wade into the morass and choose good companies, then wait for the whole domain to regain the public's favour.

And typically, companies that are better known to John and Jane Doe have better turnaround potential than firms that are barely on their minds at the best of times.

Whenever a sector is likely to recover because of cyclical or demographic trends, it makes corporations easier to target. In addition, it is customary that the longer a corporation is under the Contra microscope, the firmer our comprehension. And the longer an outfit keeps swimming at a reasonable pace, the more likely it is to avoid drowning.

A few other things that appeal to us: annual reports that are readable and top brass that are approachable; dividends are appreciated, even if small; credible takeover rumours enhance a play. We could go on, but even if we tried to fit them all in here, it would be hard to make the list comprehensive.

Finally, we strive for a portfolio balance, or "shape," in which the whole roster adheres to the contrarian theme, while individual members exhibit a variety of qualities and risk/reward profiles. In the course of assembling such an orchestra, the experience gained from playing this game for over 25 years guides us.

And as unscientific as it might seem, sometimes out of the swirling clouds of numbers and doubts, we respond to a gut feeling that a candidate will make a good fit. We do try to make sure there's an ear for our inner voices.


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