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Article 1: 5 Cardinal Rules for Successful Investing

Rule 1: Invest for Value (Buy Profitable Businesses at Reasonable Prices)

Value is perhaps the most important concept to understand as an investor (next to risk). Most people intuitively understand this in their everyday lives. Unfortunately, it is less understood in the arena of stock investing. What is value? Value, in this sense, is when you get a great deal on buying an asset. In the case of investing, it is when you are able to buy $1 worth of assets for $0.80 or less. When you are making the purchase of an item, like a house, or a car, or a television, and you put extra effort into finding an item of equal or greater quality but at a lower price, you have made a value purchase. It is the same in the stock market. When you purchase a share of a company, you are buying an ownership interest in an underlying business – an asset.

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Almost any stock will have a story describing how the managers will try to make money, but if it’s a real business, it will have more than just that. It will have real products, real sales, real profits, and real business models. A successful business will generate cash flow and it will reinvest this cash flow for growth or it will pay this cash flow back to its shareholders in the form of dividends. When we find those unique opportunities to purchase successful businesses at prices well below their real or intrinsic value, we have made a value investment.

The tricky part is determining what the stock is actually worth. This is by no means an exact science (not even close) and there are many different techniques that people use with varying degrees of success. The reality is that two different people can be given the exact same information on a company and arrive at two different conclusions of what they think the company is actually worth, and neither one of them is necessarily right or wrong. So rather than trying to determine the exact intrinsic value of the company (stock) you are purchasing, focus more on fundamental principles. If a company is not profitable or is not breaking into profitability, then it is not an investment, it is a speculation.

If the company is trading at a premium price, risk increases. If that company is trading at a discounted price, risk decreases. The more solid companies you buy at attractive prices (that are making money), the better your portfolio will perform over time. The more you buy speculative ventures, which are innately impossible to value, the worse your portfolio will do over time. You may need to utilize the services of a qualified and competent advisor, but that is no substitute for maintaining your own independent thought.

If the company is trading at a premium price, risk increases. If that company is trading at a discounted price, risk decreases. The more solid companies you buy at attractive prices (that are making money), the better your portfolio will perform over time. The more you buy speculative ventures, which are innately impossible to value, the worse your portfolio will do over time. You may need to utilize the services of a qualified and competent advisor, but that is no substitute for maintaining your own independent thought.

Rule 2: Be Patient and Allow Your Investments to Grow

As human beings, most of us possess a desire for immediate gratification. This is in large part why online ‘trader’ programs and strategies have been met with such popularity as of late. The term ‘day trader’ is appealing because it essentially suggests that profits can be attained on a ‘daily’ basis. All of the worthwhile things in our lives however, were not developed on a short-term basis, but instead they required years to grow and develop and eventually begin to yield rewards. This is true with relationships, with friends; it is true with building a family, a career, and skills we wish to develop. With each of these assets, as with the act of growing a tree, at one point, we took the initial step of planting a seed and over time, with effort and care, the assets developed strong roots and began to grow. Most rationale people would never expect instant gratification with any of the most important assets in their lives and nor should they from their investments.

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When we invest, we do not just buy ideas, we do not buy hype, and we do not buy promises. When we invest, we buy a piece of an operating business for the most attractive price possible. When the business grows, we expect the value of our investment to grow with it. Anyone who has ever built a business knows that success does not come overnight.

The business must be given time to grow and so must the investment. Back in 2002, we recommended a quality company, Hammond Power (HPS.A:TSX). The recommendation met all of the requirements of an investment, in that it was a profitable and growing business that we purchased at a very attractive price. Largely unknown by the investment community, the company’s stock price remained relatively unchanged for over two years after we recommended it to clients. Over time, with continued success in the operating business, the company gradually became better known by investors and the stock began to skyrocket. From a recommendation price of $0.65 in 2002, our investment grew to $13.10 by 2007. It took several for our seeds to grow roots and begin to blossom, but our patience was rewarded with a 1,915% return. Had restlessness dictated our actions, we may have been prone to dispose of the investment during the period of inactivity, the result of which would have been a zero return. Well a return of this magnitude is not common, generating excellent returns well being patient is not an isolated event, but often a typical scenario for us, as it is for many other fundamental investors (including Warren Buffet). For those that are uncomfortable with a 3 to 5 year time horizon, I ask this: Would you rather make money by being patient, or would you rather lose money by being restless?

Rule 3: Invest with Your Mind, Not Your Emotions

Warren Buffet, who is the undisputed greatest investor in the world and often referred to as ‘the smartest man in the room,’ provided a very interesting take on the key ingredient to successful investing. He said, “Success in investing doesn’t correlate with I.Q. Once you have ordinary intelligence, what you need is the temperament to control the urges that get other people into trouble in investing.”

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This should hopefully come as welcome advice from those that once thought investment success required brilliance. Indeed, more often than not, we are our own worst enemies when it comes to investing. Emotion is the single biggest detriment to long-term investment success in the stock market. When stock market prices are climbing, meaning the underlying businesses are becoming more expensive, emotion encourages most people to become greedy. The opposite is true in a declining market, when prices are falling, and in many cases some of the underlying businesses are selling for discounted prices, most people become more fearful and consider leaving the markets. Ironically, this is the period where the best mid to long-term investments can be discovered.

The lesson to be learned here is – control the emotions of fear and greed. Understand that the market moves up and down and don’t become too excited or too depressed in either event. Let us remember the Crash of 2008. By mid-2008, stock market activity was at a climax. On the financial news, we were inundated with references to legendary levels of liquidity, M&A activity, and opportunity. The result was irrational exuberance where like in the tech boom, people thought that the rules had changed and they became willing to pay any price for overvalued assets. Then the crash came and in the second half of the year, sentiment took a 180 degree shift with the overall market losing nearly 50% in the matter of months.

It was at the trough of the market that many of our clients were asking us if they should liquidate their portfolios and stay away from the markets until certainty returned. The problem is that liquidating out of fear, and at the trough of the market, forces you to lock in your losses. The intention is always to re-enter the market during better times. Unfortunately, this timing never works the way it is intended. When we fast forward to the market recovery, the vast majority of the gains were made between March and May, with the market largely moving sideways since. Investors that had elected to lock in their profits during the market’s lowest point, in October of 2008, would not likely have gotten back into the market in time to benefit from the recovery. A quote we are quite fond of is that “success in the market is derived from time in the market and not timing the market.” Another from Warren Buffet is “if you cannot stomach your investments suffering a temporary decline of 50% or more, you have no business investing in the stock market.”

Rule 4: Diversify Your Investments

Diversification is a tool that every investor has been touted. Although the benefits have undoubtedly been explained to you at some point, it is important enough that I will explain it again. Capital has to be spread around amongst different investments types, amongst different industries, and amongst different individual companies (stocks).

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How a portfolio is diversified depends a lot on the individual and the relative importance of their investment portfolio. You can afford to take more risks (and diversify less) if you are young and without dependents. When you are older and become more dependent on your investments, your risk tolerance declines and your need for diversification increases. From experienced investors to novices, just about everybody in this day and age understands that stock market analysis is anything but an exact science. Even the greatest analyst on the planet cannot know unequivocally what will happen to a single stock or the stock market in the future. Even in the case that the analysis of a single stock is flawless, the analysis cannot predict with absolute certainty whether or not an individual company will succeed or fail.

True diversification should start at the asset class level (stocks, bonds, cash, real estate, etc). Unfortunately diversifying outside of stocks, while necessary for most, is beyond the scope of this commentary. Our focus here will be the discussion of how many individual companies, or stocks, should be in your active portfolio. At KeyStone, we focus on two areas of the market where we believe investors can generate superior returns – high-growth small-cap stocks and dividend growth stocks. For our clients, we typically suggest holding eight to ten individual companies in each of these portfolios. Holding less exposes you to excess risk of poor performance from an individual stock. Holding more makes your active portfolio too difficult to manage. Let’s take a sample portfolio of eight stocks with the following one year returns: A(-40%); B(-20%); C(0%); D(0%); E(20%); F(25%); G(50%); and H(85%). These example returns are being used purely for illustrative purposes, but they do represent a somewhat realistic return spectrum.

If you were to diversify equally into all eight of these stocks, you would have made an average return of 15% for the year. On the other hand, if you were to select just one of these stocks (not knowing which would outperform), you would have a 50% chance of either making nothing at all or even losing money. If you were to select just 3 of the stocks, there is a reasonable chance that you would have selected A, B, and C, which would have yielded an average return of -20%. Of course, by selecting 3 stocks you could have been lucky and picked F, G, and H, yielding you an average return of 53%. The problem with concentrating into one to 3 stocks is that you are now depending on luck to guide your returns. “Hindsight is 20/20, but foresight is legally blind.” You don’t know at the beginning of the year which companies will be the losers and which will be the winners, so in order to give yourself the best chance of generating a reasonable return, you have to diversify your holdings. Anything less brings us from the realm of investment to the realm of speculation.


Rule 5: Maintain Reasonable and Achievable Expectations

Many people buy and sell stocks with an expectation of becoming wealthy within a short time span. Unfortunately, this is more of a pipe dream than a reasonable expectation. By now, you should be familiar with Warren Buffet and his reputation as “the world’s greatest investor.” He has amassed a fortune of $50 billion over a 40 year career as a buyer and seller of businesses. Yet all of his success has been generated with an average annual return of only about 22% per year. To the truly experienced investor, this return is phenomenal. To the average speculator, this return might actually appear meagre. Yet no money manager on record can boast of a higher average investment return over a long-term (over ten years) time horizon. The truth is that those that might tend to scoff at the return and consider it unimpressive have not even come close to consistently generating anything comparable.

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A big problem with maintaining overly high expectations is that most people tend to gravitate to high-risk investments in order to achieve them. In the Canadian investment market, this typically means overly high allocations to the very cyclical resource sectors of Mining and Oil & Gas. While these sectors have their place in a well diversified portfolio, overly high allocations almost always result in disaster. In the search for unrealistic returns, many investors go a step further and over allocate towards junior resource and junior high-tech. With only a few exceptions, these types of companies typically do not make any money and are pure speculations. As with the temptation of gambling, many so called investors are attracted to the prospect of the infamous “10 bagger” (a stock that multiplies in value 10 times), but as with gambling, nearly every participate that allows greed to dictate decision ends up nearly penniless.

Lest we remember the lessons from the tech boom of the late 1990s and early 2000s – long standing wisdom that insisted real companies should actually make money was thrown to the wayside as the investment community became absolutely enamoured with the prospects of generating nearly unlimited returns. Lest we also remember how quickly it took for those paper profits to disappear and how quickly those ambitions for unrealistic returns morphed into hatred for stock market investing. We have seen this again more recently with the stock market crash of 2008. Between 2002 and 2007, many speculative junior mining issues enjoyed excellent returns in the absence of actually generating any real economic value. During this period, many of those who bought and sold stock in junior mining companies undoubtedly saw a few years of triple digit returns. In the end however, after the bell sounded, these individuals were quickly left in the exact same position as those that were once seduced by the tech boom – with stock that in some cases had declined by up to 95% or more.

While the speculative sectors, along with the rest of the market, have since seen somewhat of resurgence, they are still almost all trading at depressed prices relative to the pre-2008 levels and almost all of those that participated in that market remain in the red over the course of this market cycle.
Article 2: Constructing a Portfolio in Your Tax Free Saving Account (TFSA)
Rather than reiterating our take on the current market conditions, I would like to focus on a subject that may provide you with a much more tangible benefit to your portfolio - investing in your Tax Free Savings Account (TFSA). We discussed the TFSA in the May edition of the Income Stock Report, but this month we are going to revisit and expand on what we covered. It’s important that every subscriber, and Canadian investor for that matter, understands exactly what the TFSA is and how to use it. In review, the TFSA is an investment account that every Canadian over the age of 18 can set up. Like the RRSP, the TFSA is a registered tax deferred account. The key difference is that with an RRSP you write your contribution off on your current year’s tax return and then you defer any tax payments until you make withdrawals from the account. The TFSA is the exact opposite. You pay tax on your contribution in the year that it is earned, but you avoid paying any tax on any investment returns generated from your account.

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In the May edition of the report, we conducted a little mathematical experiment to highlight the wealth generating power of tax avoidance. In our experiment, a fictitious investor, in a high tax bracket maximized their TFSA contribution of $5,000 per year. Assuming that the individual generated a before tax return of 6% and invested exclusively in interest generating investments, they would be generating an after tax return of approximately 6% using the TFSA, as opposed to 3.6% without it.

That’s a 66% increase in after tax return just by using the TFSA. Even if the individual invested exclusively for capital gains, they would generate an additional 1.2% (25% more return) by utilizing the Tax Free Savings Account. Adding dividend investments into the equations would generate a result somewhere in between these two. Compounded over time, difference in total wealth generation is phenomenal.

Before we get into the step-by-step process of constructing your TFSA portfolio, let’s review some of the key points of the structure:

1. Starting in 2009, all Canadians aged 18 and older can contribute up to $5,000 per year in a TFSA.
2. Unused TFSA contributions can be carried forward to future years.
3. Funds can be withdrawn from the TFSA at any time and for any purpose.
4. Any funds withdrawn from the TFSA can be put back into the TFSA, at a later date, without reducing your accumulated contribution space.
5. Income earned in the TFSA and withdrawals from the TFSA will not affect federal income-tested credits and benefits.
6. Contributions to a spouse’s TFSA are permitted.

Now that we have discussed reasons and key points surrounding using the TFSA, we can move onto the specifics of constructing your portfolio.
STEP 1: SET UP YOUR TFSA ACCOUNT
This is pretty easy, to set up your TFSA is more or less the same fashion as you set up your RRSP or any other registered account.

All you need to do is contact your broker or financial institution, inform them of your intention and they will send you proper documentation.

Once you complete and return all of the forms, you should be ready to start trading in about a week. Once the account is ready, you deposit your contribution (up to $5,000 per year) and away you go.

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Although setting up the account is easy, there is one key factor that I want you to consider beforehand, transaction costs. They can be a killer, especially in a TFSA. For instance, say you maximize your contribution for the year and would like to diversify into 10 stocks (just an extreme example…we are not recommending $500 investments).

Many of the online bank brokerages will charge around $30 per trade. Using a full service broker can be even more expensive. Assuming we are being charged $30, what impact does this have on our net investment return. Well, if we are generating an average return of 6% per year and investing $500 in each stock, then transaction costs (just for the purchase) would equal 3% and net return would equal zero. If we sold our investment at the end of the year, then our net return would actually be -3%. Even if we used a more realistic scenario and allocated $1,000 to each investment, transaction costs could consume 50% of our return, and that’s if we are not selling at the end of the year.

The good news is that technology and increased competition are significantly reducing our transaction costs. The trick is to make sure that you are with a provider that realizes the importance of minimizing fees in their client’s portfolios. For instance, there are now numerous independent online brokerages, such as Questrade, that offer their clients fees as low as $8 per trade. The impact on investment returns can be dramatic. If you are making individual investments of over $20,000 then a $30 transaction fee is not as significant. However, since with the TFSA you can only invest a maximum of $5,000 per year, transaction fees become very important. The main point here is to understand your costs, their impacts, and what you are getting in return. The current trend is towards lower and lower fees…don’t let your current brokerage miss this.
STEP 2: CONSTRUCT YOUR PORTFOLIO
This is the fun part. For the purpose of this exercise, we are going to assume that we are using the Income Stock Report as the exclusive source of investment information for setting up the TFSA. This of course means that all of the investments in your TFSA will be dividend paying equities. Because dividends are taxed at a higher rate than capital gains, it makes perfect sense to have at least some income exposure in your TFSA portfolio.

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The Income Stock Report is an excellent tool for constructing your TFSA. The point of categorizing our recommendations into 3 different risk categories is to increase the ease of your decision making process. If you are an individual who requires less volatility in their account and is dependent on the income generated, then you may wish to limit your investments to those in the Conservative-Risk portfolio.

If you can take on more risk, and want to focus on more growth and capital gains, then you may focus more on the Aggressive-Risk and Moderate-Risk portfolios. This is not to say that the Conservative portfolio does not offer growth potential, but generally speaking, more growth and return typically requires more risk. Another option is to pick and choose individual stocks from each of the model portfolios.

You can decide to start your TFSA portfolio with a single investment of $5,000 into a single stock, or you can diversify into one of our model portfolio of six stocks. Our recommendation for the first year is to choose around four stocks for your TFSA. This equates to a $1,250 inve stment per stock and allows you to benefit from diversification, while not diluting your total portfolio.Just make sure you limit those fees.
STEP 3: REVIEW AND REVISE
Now that your TFSA is set-up and full of income generating investments, you enter a very important phase of the investment process - reviewing and revising. It is important (even when investing in mutual funds) that we consistently monitor the progress of our investments. This means doing a lot of research, reading financial results, press releases, and tracking the operational progress of the company. As a subscriber to the Income Stock Report, you are of course using us for this function. Many subscribers may prefer to monitor their company’s in conjunction to using our research, but atthe very least, you need to monitor your net investment returns. Watch your company’s and rebalance as new BUY and SELL recommendations arrive. Our objective is to make this process simple and as value-added as possible, so that you can benefit from the returns generated from your portfolio, while still sleeping easy at night.
Article 3: A Little Advice for an Uncertain Market
This may seem counter-intuitive, but as an analyst, I often become more excited when the market is bearish, as opposed to when it is bullish.

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Don’t misunderstand me; I obviously enjoy seeing my stocks appreciating in value…that is of course the objective of my research. However, what I do notice is that when the market is overly bullish it becomes more and more difficult to find what I am looking for - real value.

When it comes to making macro-economic market calls, I try to continuously remind myself of a very clever maxim made by Warren Buffet – “Be fearful when others are greedy and greedy when others are fearful.” I believe, more than any other, that this is a rule that should be a guiding light to anybody’s investment decisions.

If we cycle back to almost exactly one year ago, the market was singing a very different song than it is today. The world was literally falling apart and international markets were only too happy to display this sentiment. People were fearful, yet opportunities were abundant. Some of the markets most stable, cash producing machines had stock prices that were almost falling off the chart. The fundamentals had not changed, but investors were running for cover.

At KeyStone, much like the rest of the world, we were apprehensive as to where the market was heading. But aside from that apprehension there was also some excitement. We were seeing opportunities like we had never seen before. Nobody, including ourselves, knew where the market was heading or where the credit crunch was going to take us. We did however, remind ourselves of two things…we knew that as long as there were still people on the planet, there would be some specific services that would survive and even thrive….and we also knew that even in a horrible market, pockets of strength can be found.

So rather than being fearful while others were fearful, we scoured the markets in search of our prize opportunities. In the beginning of October we recommended Orvana Minerals (ORV: TSX), a gold producer with assets in the precarious country of Bolivia. Sure it was part of an industry that was being sold into the toilet, but it was a profitable producer of gold with more cash in the bank than the total value of all of its shares. Since then, the stock has moved up nearly 80%. In mid-October, we recommended K-Bro Linen Income Fund (KBL.UN: TSX). Like everything else, nobody wanted to touch it, but we knew that a very large portion of their revenues were derived from cleaning linens at hospitals and that recessions did not preclude people from getting sick. They paid a distribution and the balance sheet looked great. Since then, the company has maintained its distribution (which was 13.2%) and the shares increased 45% (total return of 58.2%). In November, we recommended Boyd Income Fund (BYD.UN:TSX), a restructured auto body franchise focused on insured auto repairs (once again recessions don’t mean people don’t get into fender benders). Not only has this stock since moved up 76%, it has also since increased its distribution on four separate occasions (total return of 86%).

I could go on, but I think I have delivered my point…which is not that we are great stock pickers (that goes without saying), but that the level of opportunities is typically a function of the magnitude of fear or greed in the market. When the market is fearful, we are usually in a ‘bear’ and opportunities expand. When the market is greedy, we are usually in a ‘bull’ and perhaps counter-intuitively, opportunities can contract.

Keeping all this in mind, where do you think we are now? At this point it is fairly obvious as to the point I am trying to make. These days, when I scroll through my financial statements and news releases, I have to be more selective of the opportunities that I find. They are still out there, but they are definitely presenting themselves in shorter and shorter supply. What I am finding is a lot of companies, often good companies, with stock charts that look steeper than the summit at Mt. Everest and what worries me is that there is often no fundamental driver as to why they are moving.

Sure the government says we are on the cusp of a recovery, but let’s not be so naïve as to think that the old problems have just disappeared. At a basic level, too much debt (particularly south of the border) got us into this mess to begin with. For years, consumers were financing elaborate lifestyles with borrowed capital. This lead to a period of very robust economic growth, but when the party ended (and it always does), the tent came crashing down. This problem has not disappeared. Simple common sense tells us that if we over consume and over leverage for years, to rebuild our balance sheet, we have to under consume and deleverage for years. Since over 2/3 of the U.S. economy is based on consumer spending, I am having a hard time figuring out where all of this future (short term) growth is going to come from.

It may seem that I am overly negative, but the truth is I am not. I am just cautiously sceptical. As an analyst, my job is not to sit on my hands because I think that the market may be overvalued. My job is to work (harder if need be) to find what opportunities exist in any market. Almost as dangerous as irrational exuberance is consistent apprehension…always thinking the market is going to fall or has further to fall. The truth is the market is too difficult (if not impossible) to time and if you want your investment portfolio to grow, you have to take the risk of getting involved.

Being cautiously apprehensive does not mean that you should avoid the market entirely; that you should liquidate your positions and wait until whatever you think is going to happen transpires. No…but it does mean that you need to be even more selective than usual about the companies you invest in and how you manage your investments.

In the spirit of cautious apprehension, I have provided a couple of simple strategic suggestions that I hope will help you to manage your way through this, or any other investment climate.

1. Layer Into Your Positions – when filling a position in a stock, you don’t have to fill it in a single trade…you do have the option of breaking the trade up into two or more pieces. If the price is great, go ahead and fill the position. If the price is questionable or starts to move away from you, be patient. There is a good chance that it will come back down to your target level.

2. Buy Strong Balance Sheets – the balance sheet provides a very good picture of the company’s financial risk. Does the company have too much debt? Is it just meeting its interest and principle payments? Does it have a reasonable strong cash balance? A strong balance sheet can mean the difference between life and death when the market eventually heads south

3. Buy Resilient Business Models – as we covered earlier in the article, there are business models out there that will prosper even in tough times. No business model is without risks, but you can reduce your risk by investing in companies that serve customers who will dry up at the first sign of economic woes.

4. Stick to Profitable Companies and Don’t Pay Too Much – buying profitable companies is the cornerstone of KeyStone’s investment strategy. Remember, when you buy a stock you are a part owner of the business. Think of it as buying a private business that you planned to manage. Would you buy a company that has never generated a profit? Would you pay so much that what profit there was would barely squeak out a return?
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