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Gal^Stad
Investments Inc.

spacer April 2005
Commentary

With the stock market in the doldrums, this is an apt time for our annual review of investments held outside of the Contra portfolio, along with a look back at assets covered last year. Needless to say, diversification is our watchword; we would never place all of our funds in stocks.

It's also noteworthy, however, that although our outlooks are remarkably similar on most things, there are some instances where one of us will jump, while the other's interest is less intense, or even nonexistent.

Our belief that real-estate prices are too high has proven premature, but we're not backing down from that assessment. Current prices are a function of the happy combination of low mortgage rates, easy terms from lenders and a reasonably robust economy. Should this union of favourable conditions be torn asunder, demand will inevitably peter out -- especially when you consider that people have been putting a lot of roof over their heads.

With this in mind, since last year we have sold all of our shares in commercial landlord Grubb & Ellis at prices ranging from $1.94 to $4.35. Given that it was purchased at just north of a buck and sold in less than a year, we'll accept that the Gods of Vegas were shining our way.

Another holding in the sector, Prime Group Realty, has garnered a takeover bid from the Lightstone Group at $7.25. That deal should be concluded this summer.

These developments leave RioCan as the sole real-estate holding. It's tough to get rid of this grand old REIT which has never missed a payment and has increased distributions every single year for a decade -- from 57 cents in 1995 to $1.23 in 2004. But all good things must come to an end, so a suitable exit point is being pondered.

Though the shine has dulled on the investment trust sector, demand remains hot. Not surprising, when you consider that, outside of commodities, most TSX stocks have looked lazy.

Although warnings about an investment trust bubble are becoming more frequent, the siren song of high yields continues to tempt the unwary. As one recent guest on ROB-TV said, "It's like clipping coupons." That sort of talk, which makes payouts sound as secure as government bonds, makes us cringe.

One thoughtful critic has pointed out that, not only are individual investors placed at risk, but there's also something wrong on a systemic level when so many Canadian firms are paying out their cash flow rather than reinvesting in their enterprises. How can our industries deal with the rise of new technologies and global challenges if they don't put money back into their businesses?

This is a long-term issue that warrants the attention of citizens and politicians alike, because Bay Street sure as heck seems content to milk every available nickel out of the phenomenon. (Surprise, surprise, eh?)

Though few things can be said with certainty, here's one you can take to the bank: when trusts cut distributions, their unit prices fall. Commentators may point to a high-yielding trust and say that a cut has already been priced into the units; don't you believe it.

Once the reduced payout becomes a reality, rating agencies, which tend to have an eye fixed firmly on the rear-view mirror, often respond by slashing the debt rating. As the dividend drops, the perceived risk increases, and investors demand a premium. So, lower unit prices follow lower distributions in order to maintain the risk-premium component in the yield.

When a trust falls hard, our contrarian sensibilities are tweaked. Often, our analysis will confirm the market's apprehensions, and we won't touch the company. But in some cases, we draw the conclusion that the trust is actually much stronger after the distribution has been reduced. That is because the realignment of the ratio of cash flow to distribution payments can make the trust's business model more sustainable over the long term.

For example, Clean Power Income Fund was a trust that interested one of us sufficiently at $9.05 because of its strong position in sources of renewable energy. The other, though also believing in this promising future and sharing an ecological bent, wouldn't touch the fund as long as cash flows were unable to fund the payouts.

But it got a lot more compelling for him when distributions were cut last November, from 90 cents to 70 cents per year, and the unit price followed suit, diving from $9.50 to $6.40.

The company is still having difficulties with some of its plants that generate electricity from landfill gases, but the price and juicy yield make it an attractive prospect.

One of us purchased Sun Gro Horticulture after a robust Canadian dollar and higher transportation costs forced a distribution cut. The company is North America's largest distributor of peat moss to commercial nurseries. The new distribution rate of 90 cents a year is still a heavy load for the firm to shoulder, but the company's dominant position in this essential agricultural resource gives it the ability to raise prices.

Harvesting peat from a bog might not be the most exciting business venture, unless Lagavulin -- the aristocrat of Islay whiskies -- is the result, but it is one of the few things these days that cannot be imported more cheaply from Asia.

An expansion into eastern Canada helped revenues jump by 24 per cent in the last quarter; the full-year net earnings of $18.8 million outshone the 2003 haul of $15 million, while assets moved up from $238 million to $271 million. One Contra Guy continues to avoid this one at current prices; on the general level, he fears that the sector could be hammered, while he is specifically concerned by Sun Gro's debt increase, from $56 million in 2003 to $95 million at the end of 2004.

Another position was taken by one of us in a very different kind of trust called Central Gold. The yield on this baby is a big fat zero. No, this isn't a "broken" trust, one that has fallen on hard times but that dreams of reintroducing distributions at a later date.

Central Gold basically has no revenue because its only assets are 400-ounce bars of yellow metal. If you rate the chances of the world's financial system going to hell in a handbasket at significantly greater than zero, holding gold is something of an insurance policy. But physical gold is a pain to buy and safely store. Central Gold takes care of that hassle, and it's even RRSP-eligible.

Unlike the new gold ETF Streetracks that trades in New York and tracks the price of gold through a complex web of derivatives, Central Gold is a closed-end fund that holds all of its cargo in the vault of a Canadian chartered bank. Best of all, the units were purchased at a discount to net asset value.

It currently trades at three per cent below NAV. The discount would have to be a lot deeper before it would interest the other guy. Instead, he has rolled the dice on South American Gold, a small operator with a play in Chile, at nine cents. He recognizes that the "smart" money is currently being placed elsewhere.

A trust near and dear to both our hearts -- not to mention our portfolios -- is hydro power generator Algonquin. The distributions have been steady, but the unit price seems to ebb and flow with the rates of rainfall and the river levels. Though we are not traders by nature, a recurring pattern has emerged wherein this one is a good buy when it dips under $9.25, but is ready to be sold when it gets to around $10.40. One of us cleared out completely last year, while the other has been dancing in and out.

We have vacated our coal play, Westshore Terminals -- a barn burner that we sold at just under $9. Despite the excellent return, we would have been better off to let this one run -- it's currently at $11.27. Funny how the talk about dirty coal that was omnipresent when we bought Westshore and Luscar Terminals has subsided.

One investment mentioned last year was the closed-end bond fund Aberdeen Asia-Pacific. The Contra Guy who held this, wary of interest rates going up, sold it at $9.15.

Getting to the small-cap speculative stocks that we sometimes dabble in, the trio of out-of-favour biotech stocks that one of us liked last year are even more unloved today. It's difficult to justify buying this kind of company for the Contra portfolio because most companies are too young, too poorly capitalized and have too little in the way of revenue.

In many cases, however, the charts are intriguing; there will be brief, intermittent spikes, when buyers get excited about a positive bit of news, separated by slumps.

During one of those downturns last June, the more skeptical guy bought Biomira at $1.81, and wisely sold part of his position at $4.52 when the stock popped momentarily last December. That's a time of year when we generally don't like to sell -- taxes can be deferred a year by waiting a month -- but there is a distinct difference between discipline and rigidity.

The biotech optimist kept all his shares in Biomira as well as Micrologix and Stressgen. The former company has held its own, while the latter has been a disaster. Both of these are risky, but have sufficient cash resources to stay in the game a while longer and perhaps offer the score originally sought. The skeptic didn't like these two before, and the deeply discounted current price has failed to change his mind -- he's scared off by the massive share dilutions that have occurred over the years.

It should perhaps come as no surprise that alcohol, via our agent Brick Brewing, has proven a better investment. One of us sold out at $2.24, while the other awaits a final burst of heady euphoria.

Another good one that we both bought was Atna Resources. The gold explorer has been making some progress on its project in Nevada and raised new equity at 55 cents a share.

Less successful, but more interesting, is the titanium wannabe Tiomin Resources. The company is trudging along, at a glacial pace, towards its goal of a working titanium mine in Kenya. It seems that every year brings yet another "final" agreement to be concluded with the Kenyan government.

Anyway, with the endless preliminaries out of the way, the firm is trying to nail down project financing so that the construction of the mine can start later this year. One of us put a target of 75 cents on the stock; the other thinks the Kenyans have been playing CEO Jean-Charles Potvin like a two-dollar banjo and treats this one as strictly a trader, with a buy point in the low 30s and a sell in the mid-40s.

Last in the resource camp -- and in this case, definitely least -- is Twin Mining. One of us holds this diamond explorer, which has talked the talk for quite a while, but the walk seems to exceed its grasp. This one awaits an auspicious moment to be dumped. While these plays all appeared worthwhile last year, none would be purchased at present.

A couple of positions have been added to the mix. Stratex Networks, a maker of wireless telecommunications gear, was purchased last fall when the stock slipped below $2 after the firm raised $22.9 million in new equity.

The terms were a bitter pill for existing shareholders, but steady losses forced the float dilution. A major overhaul has cut the workforce by 25 per cent; the company aims to keep a lid on costs until its new Eclipse product line can build up revenues. We both regard Stratex as a high-risk/high-reward proposition.

Verso is another beat-up company on the lower reaches of the telecom-equipment food chain. One of us recently bought it when a new CEO with turnaround expertise arrived. Lately, the company has been making noises about patents that could be potentially lucrative if they hold up and can be enforced.

There are some big question marks here; the stock has dropped from 51 cents, where it was purchased early this year, to 30 cents. The company needs to do something or it will lose its Nasdaq listing. Right now, the future seems to hold either a reverse split or exile to the OTCBB. Ugh!

On the "safe" front, ING still vacuums up our extra cash. Meanwhile, General Motors Acceptance Corp. (GMAC), long a haven, has lately made us worrisome, given the problems at General Motors. Although we haven't found others voicing our concern, we'll be cutting back on our GMAC paper, which is strictly short-term.

Overall this past year, it has been difficult to find attractive places to stash our cash. Fortunately, particularly with the profits from 2001-2003, there is money in search of a good home. Better to have this problem than to be overturning the sofa cushions for spare change.


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