It has been said that “a bird in the hand is worth two in the bush.” The theory states that because future earnings are less predictable than cash dividends payments in the hand, the latter is preferred by investors. Furthermore, the true experts of a company are not the analysts who forecast its prospective financial statements but rather the managers who operate the business. Returning capital to shareholders via increased dividend payments indicate to the market that the managers and directors are confident about the company’s future cash flow.

All ten of the largest common equity positions held in aggregate by clients of Baskin Financial Services Inc. in May 2012 have grown their dividends over the past 5 years. This is despite the credit crisis in 2008, European debt debacle, and Washington political gridlock.

If an investor with $100,000 in cash were to have bought equal amounts of the 10 stocks listed below on the first day of 2007, they would have expected a yield of 3.6% ($3600 in annual income) that same year. Today, 5 years later, assuming the investor did not buy or sell a single one of those shares, their cash-on-cash portfolio yield of that original $100,000 would have risen to 6.1% ($6100). This is because all ten companies have substantially raised their dividend per single share over the past 5 years.

Despite recent volatility in the stock market, there is no shortage of companies with strong balance sheets and sufficient liquidity to continue growing dividends over time. Many have recently done so, and many more will continue this trend well into the future.

*This writer does not own the securities mentioned in this column.

If this problem was not playing out in Europe the solution would be obvious. Countries that cannot or will not pay their debts default on them. The creditors take their losses and move on. The currency of the defaulting country goes in the tank, and the buying power of its citizens is cut drastically.  Discussions about austerity become irrelevant. The drop in value of the currency automatically trims everyone’s standard of living, and life goes on. Nor is this a rare event. Over the last two hundred years, twenty-two European countries have defaulted on their debt. Spain holds the record, having defaulted nine times since 1809, an average of once every twenty years or so.

In 2002, Argentina was faced with a large foreign debt, a budgetary deficit, and pressure from creditors, including the International Monetary Fund, to adopt a harsh austerity regime. The government of the day attempted to comply but was faced with growing civil unrest, rioting in the streets and increasingly violent protests.The government fell and the President was forced to flee his residence by helicopter.  Soon after, Argentina defaulted on about $100 billion of debt. The country lost access to foreign credit markets.  Its currency dropped in value by75% and the country suffered a devastating recession.  Eventually foreign creditors rolled over their debt at 25 cents on the dollar, accepting a loss of 75% of their loans. Argentina regained access to foreign credit markets, and with the new devalued currency, became a highly competitive supplier of both manufactured goods and agricultural products, but a country with much poorer citizens, who suffer to this day.

If Greece were not in the Euro zone there is little doubt that a similar scenario would have played out there by now. The events we now see taking place there are an eerie echo of what took place in Argentina ten years ago, culminating in the collapse of the Greek coalition government in the first week of this month. If Greek voters are unwilling to have austerity thrust upon them by their elected leaders, they will achieve it through other means, and this could include leaving the Euro zone and re-introducing the Drachma, which disappeared in 2001. Those voters who believe that the days of low taxes (or at least low tax compliance) cushy pensions and a high value currency will return with a new government will be sadly mistaken.  Adoption of the Euro appeared to guarantee a free lunch, but now the bills have come in, and can’t be paid. Greece has defaulted on its foreign debt six times in the last two hundred years. The seventh time appears to be getting closer daily.

While all investing carries risk, buying an asset at a discount means that the investor has limited the downside risk from the purchase price—essentially building in a margin of safety. This margin is effectively an option on the recovery of that business or restoration of that stock to investor favour. If an undervalued stock drops after purchase, the disciplined value investor buys more, having confidence in the analysis that led to the purchase in the first place.

It is not easy to be a value investor, but, in our opinion, it is the only investing strategy that works over the long run. This year, there have been takeover offers on two of our portfolio holdings. In one instance it took over five years for value to be recognized by the market. The other only took six weeks.

On March 16 of this year, Bell Canada announced that it had reached an agreement to buy Astral Media for $50 a share. The offers represented a 38% premium to Astral’s share price on March 15th.  We began acquiring shares in Astral Media for some of our clients in early 2007, when it was trading in the low $40 range. Astral Media had all the characteristics of a value investment: A low valuation to earnings, rising dividend payments, a strong balance sheet and a sustainable business model

When the recession hit, like most companies, Astral’s stock price plummeted, falling in 2008 to under $20 a share. However, Astral’s revenues, profits and dividends actually grew during the recession.  By 2010 even though its earnings were now 20% above its pre-recession levels, Astral’s stock remained in the doldrums. If a stock was a good buy at $40 and its business is improving, then it is a great buy at $20. So we acquired even more shares for new and existing clients. As we waited for Astral’s value to surface, our clients collected a nice dividend each year, a dividend which doubled between 2007 and 2011. Finally, two months ago, Astral’s takeover deal was announced.  The takeover premium recognized the value which we had seen in the company, validated our original analysis, and confirmed the wisdom of holding and adding to our position.

Last summer, we acquired a stake for some of our clients in an apartment rental company called Canadian Apartment REIT, or CAP REIT for short. In an environment of rising real estate prices, low interest rates and an accommodative immigration policy, we reasoned that apartment building ownership would be a good business. We started acquiring CAP REIT around $17 a share, and we continued to buy this stock for clients over the next few months. In early March 2012, CAP REIT’s stock was trading at over $22 a share, an increase of about 30% in less than a year.  We noticed that CAP REIT was now trading at a 20% premium to its closest competitor, Transglobe Apartment REIT.

Value investors always compare companies in the same industry to get a relative sense of value. After analyzing Transglobe, we struggled to understand why it was trading at such a significant discount to CAP REIT. Both CAP REIT and Transglobe had about 30,000 apartment suites, mainly in Southern Ontario. For some reason, CAP REIT was valued by the market at a premium to Transglobe, yet Transglobe offered its investors a much higher dividend yield.

Our analysis led us to sell all our CAP REIT and switch it for Transglobe. We reasoned that if Transglobe traded at a similar valuation to CAP REIT, it should be worth about $14 a share, while we could buy it at about $12. Six weeks later, that’s exactly what happened; a consortium of investors, including CAP REIT, announced it was buying Transglobe for $14.25 a share. This takeover of a portfolio investment at a premium to what we paid was a satisfying confirmation that value investing works.  We are confident that our clients will continue to reap the benefits of our investing approach.

When one hears the term “value investing”, the name Warren Buffett comes to mind. Buffett, however, will give all the credit to his mentor the late Benjamin Graham, widely credited as the founder of the value investment school of investing. Graham said:

“You’re neither right nor wrong because other people agree with you. You’re right because your facts are right and your reasoning is right – and that’s the only thing that makes you right. And if your facts and reasoning are right, you don’t have to worry about anybody else.”

Disclosure: Author owns shares in BCE.  Clients of Baskin Financial owns share in BCE, Canadian Apartment REIT and Transglobe Apartment REIT

Those who believe in mean-reversion, take note. Your opportunity awaits.

The future is uncertain, so let’s not waste time trying to predict what will happen next. Instead of worrying about the next event that will spook the market, I need to focus my attention on the “knowns” and use these facts to determine what, where and how to invest today.

Here are the “knowns” that I think investors should pay attention to at the moment:

1)      S&P 500 companies had cumulative earnings per share of $96.44 in 2011.  At today’s level, the S&P 500 is trading at a Price Earnings ratio of 14.2 times, a discount from post -World War II levels and way down from the 30 P/E level seen at its peak.  S&P 500 cumulative earnings were the highest ever in 2011

2)      The Federal Reserve/Bank of Canada is maintaining an accommodative policy and interest rates are at or near historical lows.

3)      The Dividend yield on the S&P 500 is above the 10 year Treasury yield.  Aside from early 2009, which happened to be the best buying opportunity in a generation, we haven’t seen this phenomenon since the 50’s.

4)      More on dividends: Like the S&P 500 cumulative earnings, S&P 500 dividend dollar payments are at their highest level ever.  Dividend cash payments for S&P 500 companies increased 16% in 2011.

5)      North American economies are growing.  While growth may not be robust, the evidence from rising employment, increasing corporate earnings, growing rail car loadings and port traffic, and expanding manufacturing and service indices is overwhelmingly positive.

Put it all together and you get a reasonably cheap stock market that offers dividends higher than risk-free assets in an improving economy.  With these facts in hand I can leave the worrying about unknowns to the hedge fund managers, and  I can look to create a portfolio of companies that are trading at earnings multiples that are less than the overall market, have sustainable competitive advantages and a track record of rising dividend payments.  We are finding no shortage of companies with these characteristics.

Markets are unpredictable over the short-term. In periods of high uncertainty, headlines cause large variances in the price of an index and its comprising stocks. When cooler heads prevail, prices revert back to their intrinsic value. From year 2000 through today, there have been 3093 trading days. In total, 8.9% of those days have seen the TSX move by plus or minus 2% compared to the close on the previous day (155 days down more than 2% and 123 days up by more than 2%). In other words, one day out of every 11 saw a price swing of plus or minus 2%.

Because volatility is more probable than not, it is wiser to expend time and energy to discover great businesses with strong fundamentals rather than to worry about unpredictable short term price fluctuations. Companies with a history of returning capital to shareholders, trade at low valuation metrics, and demonstrate a strong competitive advantage within its sector will post stronger returns than the market over the long term.

In Warren Buffett’s words, “If I buy a farm, I’m happy if I don’t get a quote on it for 5 years and the farm does well. But people buy a stock and they look at the price the next morning to decide if they’re doing well or not. It’s crazy.”

Things have been different in the past year.  From March 31, 2011 to March 31, 2012, the S&P 500 outperformed the TSX in 9 of 12 months.  The S&P 500 rose 6.2% while the TSX fell 12.2%.  To add insult to injury, the Canadian dollar actually fell by 2% against the US dollar, making the overall differential about 20% for the year.  Why is this year so different from the nine years that preceded it?  The reasons lie in the differences between the US and Canadian economies, and in the way that the stock market indices are composed.

The most obvious difference has to do with the importance of three different parts of the economies.  In the US, information technology makes up 20.5% of the value of the S&P 500.  Apple, now the most valuable company in the world (worth $568.7 billion at the time of writing) accounts for 4.5% of the index.  Microsoft, Google and Cisco make up another 4.5%.  In Canada, the information technology sector makes up only 1.3% of the index, and about 1/3^rd of that consists of Research in Motion.   Over the last year, those four big US tech stocks gained 32.8% on average.  This has been the biggest driver for the S&P, and accounts for the entire gain during the period.  Owning all of the other 496 stocks would have produced a return of about zero.

In Canada, the biggest sector is Financial at 31%, compared to about 15% in the US.  Of the nine largest Canadian stocks, four are banks.  In the last twelve months the bank stocks have gone mostly sideways, although they have continued to pay and increase their dividends.  The other two large sectors in Canada are Energy at 26% of the Index and Materials at 20%.   The four largest Canadian companies in these sectors are Suncor, Potash, Barrick Gold and Canadian Natural Resources.  All four are down in the past twelve months, by an average of 22.5%.  In the US, Materials account for only 3% of the S&P 500, and Energy has a weighting of 11%, less than half the weight of the energy sector in Canada.

So, to put it in a nutshell, over the past year the most dominant sector in the U.S., technology, has done very well and has driven the markets up, while the two of the three largest sectors in Canada, Energy and Materials have done poorly and have driven the markets down.  Does this mean we should sell all of our energy and mining companies and go head long into high tech?  Of course not.

In the first place, chasing last year’s best performers is an almost sure road to ruin.  Experience has shown that investors always get too optimistic on the way up and bid stocks to unsustainable levels.  Those who are late to the party end up paying too much, and underperform the market  This phenomenon is commonly seen in mutual funds, where the best performers of one year become mediocre also-rans in subsequent periods.  One need only think back to Nortel at $128 and Research in Motion at $150 to understand how over-enthusiasm can lead to disaster.

Secondly, diversification is the best way to combine performance and protection from volatility.  No one knew, a year ago, that four technology stocks would be the best performers on the US markets, and no one knew that the largest commodity producers in Canada would go from stock market gods to dogs.  Having 25% of one’s portfolio in one sector, no matter how attractive, is in our view a mistake.  It invites disaster.  The Canadian stock market is notoriously concentrated in the three sectors noted above, and is thus prone to violent movements, both up and down.  Our investors need not be so exposed, and they are not.  As of this month end, our overall portfolio weighting in Energy is only 6.3% compared to 11% for the Index, in Materials 8.6% compared to 20% for the Index, and 13% in Financials, compared to 31% for the Index.  As a result, our portfolios are more stable, and outperformed the market by a large margin over the past twelve months.

Finally, one year is not a very long period for investors.  How we do over five years and ten years, or even fifteen, is much more important than the results over any twelve month period.  Of course we would like to do better than the markets every month and every year, but this aspiration must be tempered by realism.  Individual stocks and whole markets are not as predictable as we would like, nor as rational.  As value investors, we know that over time stocks trade at their real value, but at any given time, the market may give a price that is much too high or much too low.  Market discipline works better than market timing, and chasing value works better than chasing past performance.

I’ll save you the trouble of reading over 1,000 pages right now and preface my three major takeaways from Warren’s writing.  First, recognize that to own a stock is to own a share in a business. Second, buy a quality business when it goes on sale. Third, as long as that business retains its competitive advantage, hold on indefinitely.
The other day, we debated selling our holdings of Royal Bank for one of the cheaper Canadian Banks, CIBC or BMO.  Sure the thesis makes sense; Royal is being valued at 15% premium to CIBC and BMO and offers a smaller dividend.   But I make sure to consult Warren on this one.   “It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.”  Warren Buffett: Letter to shareholders, 1989.

There’s a reason that CIBC and BMO trade at a discount to Royal.  BMO’s lack of revenue growth coupled with execution risk from a recent acquisition is a concern.  CIBC has also had trouble growing its revenue base and is more leveraged to Canadian retail lending.  Plus, CIBC still has exposure to potential risk from the bankruptcies of Lehman Brothers and Enron.  Royal is more expensive on a relative basis, but that doesn’t mean I should trade in my Rolls Royce for a Toyota.  Looking under the hood, we found that BMO and CIBC have always traded at a discount to Royal Bank and that neither of these companies is being valued at a huge discount to their historical trading multiples.

Royal Bank, which operates the largest Canadian banking franchise, trades at 11.8 times this year’s earnings, and offers a dividend of 4%. The bank is a wonderful company trading at a more than reasonable price, so I’m with Warren on this one.  We’re holding on indefinitely.

Disclosure: Clients of Baskin Financial own shares in Royal Bank

Empire Company is the parent company of Sobeys, one of Canada’s largest grocery chains. Empire also owns a majority stake in Crombie REIT, a publicly traded REIT, as well as Empire Theatres, a cinema chain and some commercial and residential real estate in Atlantic Canada. In 2007, Empire privatized Sobeys, a public company at the time, paying 8 times EBITDA, earnings before interest, taxes, depreciation and amortization. Looking back at this transaction five year later, no question, Empire overpaid for Sobeys. Its two Canadian competitors, Loblaw and Metro are valued at an average of 6.6 times this year’s Enterprise value to EBITDA. Fair enough. But why should Empire as a whole trade at 5 times this year’s Enterprise Value to EBITDA? Neither Loblaw nor Metro is growing any faster than Empire, nor do they have any competitive advantages.

Let’s say the current Sobeys business is worth 6.5 times expected EBITDA for 2012, about the same level as its competitors. This gives you a value of $81 a share for Sobeys. Don’t forget Empire’s ownership of Crombie REIT as well as the movie theatres and its real estate. Some analysts believe that these assets are worth another $12 a share. Then of course you have to strip out Empire’s corporate debt as well as corporate expenses which take you down $10 a share. All in you get a net asset value of 81 + 12 -10 = $83 a share for Empire. Empire is currently trading at $55.50 today, a 33% discount to its net asset value.

So while we wait for the market to value Empire properly, we get rewarded with dividend growth. The company has raised its dividend 16 years in a row, and we expect another dividend increase this summer. Its current yield is 1.6%. If this valuation discount continues further we might expect Empire to spin-out Sobeys to the public, an action Empire has taken before when Sobeys became a public company in 1998.

Disclosure: The author and clients of Baskin Financial own shares in Empire Company

Despite the price appreciation, it slipped by commentators and strategists alike that the market became even cheaper amid the height of the European debt crisis just five months ago in October 2011. 

Although price is what you pay, value is what you receive. The value for the S&P 500 is computed based on the earnings of the 500 companies that comprise the index. On March 6, 2009, the S&P 500 traded at 13.5x its last four quarters worth of earnings and 11.4x its next year’s projected earnings. By comparison, on October 4, 2011, the S&P 500 traded at an even cheaper 11.7x trailing earnings and 10.7x next year’s earnings.

Since October 4, the S&P 500 has rallied 27%.

With a buyer and seller standing on every side of a trade, we know with certainty that there were panic sellers on October 4. Clearly, this was an unwise transaction to pursue. Legendary value investor Benjamin Graham once said that “The investor’s chief problem – and even his worst enemy – is likely to be himself.” 

Panic selling often results in an opportunity loss. Opportunistic buying from such panic sellers, however, is a good way to reap future reward. 

In case you’re wondering, the S&P 500 trades historically at 15x next year’s earnings. At today’s 13.1x valuation, the market is still cheap by historical standards.