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Interview

'Higher highs, lower lows' Add to ...

Unemployment is alarmingly high and debt is crippling much of the developed world, but this is an opportune time to go stock picking, says one veteran value investor.

Irwin Michael approaches 2011 optimistic about market conditions for shrewd equity investors, but with the caveat that waters could get rough.

Mr. Michael, president and portfolio manager of I.A. Michael Investment Counsel Ltd. in Toronto, has nearly four decades of experience in the investment industry. He began his career as a fixed-income manager and bond trader and later became a deep-value stock picker before launching ABC Funds in 1988.

His largest fund, the $518-million ABC Fundamental Value, gained 18.3 per cent for the 12 months ended Nov. 30. It boasts a 10-year average return of 9.8 per cent.

What's your outlook for stocks in 2011?

We've been saying all along that we expect not only the stock market, but the economy, to saw-tooth their way higher. You're going to have your good days. You're going to have your bad days. Higher highs, lower lows.

With U.S. unemployment continuing to be a problem, we expect [U.S. Federal Reserve chairman]Ben Bernanke to continue to err on the side of ease a little longer than we initially expected. And quite frankly, with rates at 1 or 2 per cent, that's one of the greatest stimulants to the marketplace. It's almost like an aphrodisiac.

Yet people are being advised to expect flaccid yields. Is that the wrong expectation?

The longer this economic recovery takes, the more bullish we get. The longer it takes to happen, the longer we think the bull cycle will be. You're not seeing a lot of white heat out there. You're not seeing a lot of speculation. Companies are responsible, and in many cases they are in the best shape they have been since the Second World War.

Nonetheless, we do expect considerable volatility. It is also, by the way, a trading market. There may be opportunities to buy a stock and sell it up 20 per cent. The market may trade within a very wide band, because there is still a lot of very nervous money out there. Investors are not totally convinced. There's still a significant fringe of negativity out there. Ireland is a problem. Does it spread to Spain, Portugal and Italy? You just don't know. In the U.S. you have elections coming up and you don't know what kind of political heat President Obama will be under. In Canada, it's still a minority government. If push comes to shove there could be an election. So there are many imponderables out there that could change the face of the market place.

So how does your strategy shift in 2011?

It's not shifting. Unemployment will be improving very slowly, so we expect interest rates will remain where they are. We are not at all comfortable with the bond market. We think bonds are long in the tooth. I mean, rhetorically, would you lend me money for 30 years at 3 per cent? So we've moved away from bonds. But on balance the risk reward ratio on stocks is good. However, the market will remain extremely volatile. We wouldn't be surprised to see the odd major selloff. You may get a week or two, or even a month or two, where the market sells off.

What is it that allows you to function when so many investors are hesitant?

What gives us a little more confidence is discipline. We are sticking with fundamentals. We are looking at companies that preferably have no debt, low price-to-earnings multiples and low cash flow multiples. We look at tangible book value, we also look at net asset value. We look at companies that have hidden assets or could be in play. We look at companies that have no following by the analysts on the Street or that everyone hates. We may not buy them, but we're going to look, because quite often when there's a lot of negativity, you get a chance to buy a well-run company cheaply.

Flexsteel Industries for example, makes furniture and automotive seating. It trades on the Nasdaq, is debt-free, has good cash flow and management is buying back the stock. It lacks any analyst coverage and won't receive any because the company doesn't need to raise any money. It looks to me like the kind of stock Warren Buffett would buy.



What areas of the market are you most upbeat about?

It's interesting, there's a phenomenon that hasn't happened since the 1950s whereby in a number of cases common stock yields are greater than bond yields. If we can find a stock with good capital gain potential, with a yield that is greater than the T-bill rate, in other words yielding 2, 3, 4 per cent, with capital gain potential of 20 or 30 per cent, we're jumping for joy. Stocks like Genworth MI Canada the mortgage insurance provider. It's still yielding 4 per cent. It's trading slightly above book value and we think the stock, currently at around $26.75, could easily be a $30 or $35 stock.

There are other stocks that may not offer a dividend, but they have a lot of potential torque in an economy that we believe will not slip into a double-dip recession but will continue to slowly but surely ratchet its way upwards. A good example in the oil and gas sector is Calgary's Flint Energy Services Ltd. Here's a stock with a market cap of more than $800-million but they do almost $2-billion of sales a year and have a reasonably good balance sheet.

We don't think the banks are cheap at two or two-and-a-half times book value, but there are a number of special situations that are quasi banks. A good example being a small trust company group called Equitable Group in Toronto. The company yields 1.6 per cent with a market cap of $370-million. It's trading at about 90 per cent of book value and seven times earnings. That's very cheap.

We bought WestJet Airlines Ltd. at $11.20 and then bought more at a lower price. A lot of people are quite negative on the airlines, watching oil prices go up.

But WestJet is sitting on $1.2-billion of cash, they have just declared a dividend and appear to be well in control of what they are doing. They established a credit card program through the Royal Bank. We think that is going to be a winner for them. We think CEO Gregg Saretsky and his team are doing a very good job. We own it in four of our portfolios.

This stock was trashed because a lot of people were concerned about a double-dip recession. But WestJet and [tour operator]Transat A.T., which we do not own, are doing well. They are the coal miners' canary for the economy, and the outlook for the economy is reasonably good.

Are there any sectors you are stepping away from?

We don't have much exposure to the mining side. We sold a little early. But we are heavier in the oil and gas side, particularly the oil sector and we are poking around the gas side.

We don't have anything in the banks. We don't own Bombardier Inc. or TransCanada PipeLines Ltd. A lot of the major names we don't own.

On the macro level, do you see us on the edge of a deflationary or inflationary period?

Short-run we see very little inflation. But we see a big dose of inflation coming in the next 12 to 24 months. The key thing stopping it is the velocity of money has not taken off. People are still afraid and not willing to take risks.





 

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