Financial Jungle

I used to think that since it was a capital intensive business, Carnival (CCL) wouldn’t qualify as a classical dividend growth story, but I stand corrected.

Carnival is the most dominating global cruise company in the world generating revenues in excess of $13 billion; trouncing the $6 billion eked out by distant second place, Royal Caribbean. The company didn’t become this big for no good reason: it has the most recognizable brand and the fattest profit margin (17.5%) in the cruise line business. For comparison, Royal Caribbean’s profit margin is only a meager 9.8%.

Carnival is also spinning out lots of cash, and it’s not afraid to share the wealth with investors. In 2007, the Miami-based company garnered an astonishing $4.07 billion of cash from business operations. Out of which, only $0.54 billion was needed for ship improvements/refurbishments, and developments to various tour assets and port facilities.

With $3.53 billion of free cash flow in hand, Carnival chose to reward shareholders with $990 million in dividends and buy back $275 million worth of shares. They reinvested the rest of $2.26 billion as part of the ongoing new shipbuilding program, including final delivery payments on 5 brand-new ships: Carnival Freedom, Emerald Princess, AIDAdiva, Costa Serena and Queen Victoria. (Carnival owned 85 ships by end of 2007.)

This 36-year old company delivered its first dividend payment of 2.5 cents a share back in February 1989. Today, the quarterly dividend balloons to 40 cents a share. In fact, payments have accelerated in recent years quadrupling over the past 8 years.

Carnival is about 20% off its high. I haven’t pinned down an entry price, but at 4% yield, less than 25% payout ratio based on free cash flow, 13.5 PE ratio, and a good growth profile, I think a reasonable entry price is near.

I don’t own the stock. I’m not a certified investment adviser. Please conduct your own research.

As mentioned in my High Yielding Dividend Stocks Flexing Muscles post, 12 independent studies concluded that investing in high yielding dividend stocks was a winning strategy for much of the previous century. Despite the overwhelming evidence, all the studies were predominantly US and UK based, so I decided to roll up my sleeves and conduct my own research in Canada.

To begin, I queried for all Canadian dividend mutual funds with at least 15-years of historical data from GlobeFund. I then manually weed out funds with too much bond or foreign content; so, only dividend funds with at least 75% common stocks, and 80% Canadian contents made the list.

Here are the final 7 funds along with their 15-year compounded return and Management Expense Ratio (MER):

1. PH&N Dividend Income (Return=14.28%, MER=1.11%)
2. RBC Canadian Dividend (Return=13.08%, MER=1.73%)
3. Scotia Canadian Dividend (Return=12.03%, MER=1.67%)
4. TD Dividend Growth (Return=11.51%, MER=1.94%)
5. CIBC Dividend (Return=9.37%, MER=1.96%)
6. Investors Dividend (Return=8.27%, MER=2.87%)
7. Mavrix Dividend & Income (Return=8.08%, MER=2.14%)

Not surprisingly, lower MER funds tend to churn out stronger performance over time. However, I don’t see the benefit of paying for MER when an investor can easily emulate these dividend funds with a handful of core holdings, and then build on them as the portfolio grows.

The average annual return for the group is 10.95%, but if I remove the MER component, gross return jumps to 12.87%. It’s worth reiterating that a typical dividend fund has a bond allocation, so a pure dividend play would see over 13% in return. For comparison, TSX’s total return over the same period is 11.27% before tracking error, or a difference of 1.60+% compounded over 15 years. Over the next 3 years or so, I anticipate financial stocks to rebound and resource stocks to cool, which would widen the lead even more.

For other benefits of dividend investing, please check out my post on Top 10 Reasons For Dividend Investing.

Since all BNN guests are having so much fun with their top picks, I don’t see why we can’t have ours. Here are my top 3 picks:

Scotiabank (BNS) - Canada’s most international bank is trading at a cheap 11.7 PE and yielding an attractive 4.2%. The market is hurting the bank even though it has no exposure to US subprime. Risk of a dividend cut is virtually non-existing, and the distribution will head higher over the horizon.

Artis REIT (AX.un) - Retail, office and industrial landlord who has a knack for acquiring undervalued properties with in-place rents significantly below-market rent rates in the booming Western provinces. Currently sports a 6.6% distribution yield, a conservative 75% payout ratio, and a healthy 49.2% debt-to-GBV. For comparison, debt-to-GBV are 55% for Calloway REIT and 61% for HR REIT.

Boralex Power (BPT.un) - Management recently cut distribution from their long-term assets due to USD depreciation and below average hydrology; both of which were outside of management’s control. Odds are in favour of US dollar and hydrology to revert to their historical average. Boralex’s current plight is more than priced in to the 13.9% distribution yield.

What are your BNN top 3 picks?

Disclaimer: This is a fun post. Please conduct your own research before making any investment decision.

The investment saying, “dead cat bounce”, has been thrown around recently to warn investors about the nasty surprises prowling right behind the beguiling recovery of fallen financial stocks.

While I don’t know where the financial sector is headed in the short run, as a dividend and long-term investor, I try to block these little price squiggles off my mind and focus on my long-term views and investment philosophies. Without the benefit of hindsight, no one can predict where the stock market will go over the next few days, weeks or months.

I remember reading a few doom and gloom posts in the Canadian Business forum just days after the near collapse of US investment banker, Bear Sterns. Pundits plead investors to sell financials as the whole sector was being crippled by subprime, ABCP, derivative, credit, and liquidity crisis. Many critics were combing for and cherry picking web articles that supported their point of views. One of the articles even recommended the following:

“If your only nest egg is your IRA, then I suggest taking half of your money out, and paying the penalties, and buying physical silver or gold immediately from your local coin shop.”

Having radical recommendations like this displayed in a public forum is disturbing. I hope no one actually followed up on this recommendation and parked half their nest eggs in one precious metal. That would go against the principle of diversification. A wrong bet could send investors into a financial tailspin.

Sure enough, over the next 2 days, the Vanguard Financial ETF surged 5.6% and gold slid 5.9%.

“Enjoy the dead cat bounce while it lasts !!”, one critic trumpeted.

But, apparently the dead cat had 8 lives remaining as the Vanguard Financial ETF subsequently rose 4.4% and gold fell another 2.9% as of closing today. Even the two most hated Canadian banks, Bank of Montreal and CIBC, jumped nearly 20% since the March 18th low. The other 3 big Canadian banks (RY, TD, BNS) are also up a respectable 7% on average.

I’m not suggesting everyone to flee their gold investments and plunk 100% into financials. That would defeat the purpose of this post. If you believe a particular sector will stumble in the foreseeable future, why not prune gently instead of pulling out the root system entirely? The best way to keep portfolio risks in check is to maintain a reasonably diversified portfolio across all sectors, and avoid keeping a finger on the buy/sell trigger while reading these sensational forecasts from financial forums no matter how convincing or colourful they may be.

By and large, dual-class shares are unloved by investors and PF bloggers because the structure creates a double standard that gives one class of investors unfair voting power over another. ThickenMyWallet recently wrote a post on dual-class shares titled “You’re a fool if you buy…“:

The primary disadvantage of a company with a dual-class share structure is there are no effective checks and balances to management excesses such as excessive executive compensation… The larger issue is that companies with dual-class structures tend to be poorer performing stocks than their single-class structure counterparts (ask someone who invested in shares of Ford).

Yesterday, The Dividend Guy followed up with “Dual-class shares suck“:

From a statistical perspective, it would be better to hold the single-class stock in the industry you are looking at, compared to the dual-class company.

Both bloggers singled out controlling shareholder, Conrad Black, whose extravagant lifestyle single-handedly brought Hollinger International down to its knees. While both bloggers put forth rationales with strong merits, ThickenMyWallet did offer a glimpse of hope suggesting good stocks do exist in the dual-class structure.

Admittedly, I haven’t paid much attention to dual-class structure although I may have to adjust my stock selection process. So far in my endeavor, I’ve found no reasons to shy away from *all* dual-class stocks even though the door is open for management to act in their personal interests. My view is that result should speak louder than share structure, so I tend to stick with management with a strong track record of delivering excellence.

There are many profitable dual-class Canadian stocks with smoking-hot cashflow, and management teams aren’t afraid to share the wealth with generous dividend policies. Reitmans, for example, is a debt-free high quality retailer with a long history of dividend increases. Another one is Teck Cominco which hiked their dividend 10-fold since 2004. AGF Financial also recently boosted their payout by 25%. All three stocks have so much money, at least 3 years worth of dividend is parked in cash or cash equivalents.

Perhaps dual-class structures do raise some eyebrows, but a meticulous screening process should weed out the looters.

Just because the financial sector is ruing Bear Sterns’s stunning collapse doesn’t mean all dividend investors are in dire straits. Smart investors who are surviving this bear market are diversifying into sectors that don’t correlate with the financial sector. Something like the largest pipeline operator in the country, TransCanada (TRP), should fit the bill, because it’s partially immune to both subprime and recession.

TransCanada is a huge conglomerate, but its 2 family jewels are pipelines and energy. Its “network of more than 59,000 kilometres (36,500 miles) of pipeline taps into virtually all major gas supply basins in North America.” The company is also one of North America’s largest providers of gas storage, and a key power plant operator with interests in approximately 7,700 megawatts of power generation.

The pipeline stocks tend to pour in vast amounts of positive cash, but they’re not traditionally known for their growth. However, things are about to change with a glut of crude and natural gas coming on steam in and around Alberta over the next 6 or 7 years. The problem is that the real demand for energy isn’t in Alberta; it’s in Southen U.S. And if crude gets clogged up in Alberta, all producers suffer a phenomenon known as apportionment, where a shortage of pipelines is preventing cruel oil from being shipped to places where it can command top dollars. With producers and refineries crying at both ends of the pipe, companies like TransCanada and Enbridge can come in to relieve the congestion. And to profit handsomely, of course.

Pipelines, are what some people call, a business with strong economic moats. Building a pipeline is tough work. It’s notoriously expensive, complex, and you must wait maybe 2 or 3 years to reap the rewards. On top of that, management must jump through many regulatory hoops, and duke it out with relentless oppositions such as First Nations, farmers, environmentalists and workers unions. The bright side is that all these Mount Everest tall hurdles tend to chase away rookie entrants wishing to duplicate the service. That’s great for long-term shareholders looking to protect their dividend streams.

Here is a map from TransCanada’s annual report showing off their pipelines which span from Canada down to Mexico. Over at the lower right (1) is the recently acquired $3.4 billion 17,000km long ANR gas pipeline system. Next is a 50% ownership in the $5.2 billion Keystone Pipeline (2), which is TransCanada’s venture into the oil pipeline business. This 3,500 km pipeline is currently under construction, and is expected to deliver 590,000 barrels of crude per day. Operation will begin in late 2009. North Central Corridor (3) is a $983 million expansion to the existing Alberta System gas pipeline. The two dotted lines (4) are the proposed Northern Pipelines: the Mackenzie Gas Pipeline and the Alaska Pipeline.

We always think of pipeline stocks as slow moving mammoths, but the company is firing on all cylinders with its numerous growth initiatives, such as the Keystone projects, northern pipelines and expansion to their Alberta system. TransCanada, along with arch-rival EnBridge, are in the most prosperous economical environment possible despite US slipping into a recession. Back-of-the-envelope math suggests that TransCanada is investing at least $11 billion in key pipeline and power projects between 2007 and 2010. (I know I’m underestimating this.) That’s a staggering figure relative to TRP’s $20 billion market cap. In 2008 alone, management forecasts overall capital spending to be $2.9 billion.

Here’s an image of their power plants and gas storages. The key excitement in this area is the refurbishment of Bruce A Units 1 and 2 (9) which is expected to add another 19% of additional megawatt of output in 2010. A couple of other initiatives include the Portlands Energy Centre (11) and Halton Hills Generating Station (10) generating 550MW and 683 MV respectively when they’re complete.

Valuation

At 16 PE, TransCanada isn’t exactly a bargain when compared to the 13.9 historical average. (Financials are still the cheapest.) But the business is investing heavily these days to accelerate revenue, cash flow and earning growths. Given their improved growth profile, I believe buying at historical average PE is a reasonably attractive entry price, or ~$33 with 4.3+% dividend yield. TransCanada closed higher on Thursday at $38.06. I’m keeping an eye on this one.

Disclosure: I have positions in TransCanada, EnBridge and Inter Pipeline Fund.

This is the fifth post on the Dividend Increases series.

It has only been 3 weeks since my previous dividend increases post, but I feel compelled to hurry one in as Boralex Power Income Fund just announced a distribution cut from 90 cents to 70 cents, amidst external headwinds from weaker hydrology and the declining US dollar.

In 2007, BPT.un’s $42-million net cash flow related to operating and investing activities was $9-million short of the $53-million circulated to unit holders, but management has been proactive all along warning investors about the hurdles they’re facing.

Rather than masking the problems and jeopardizing the fund’s long-term health, the new distribution policy will see payout easing to $41-million a year. This is a conservative move considering the fund still has $10-million in the bank. (i.e. the cash could’ve prolonged the current payout by another year while waiting for a turnaround.) If it were an oil & gas trust, management would’ve dug themselves deeper into the hole by (a) issuing new shares, and/or (b) borrowing debts.

Here’s my original analysis on Boralex Power Income Fund:

So why is the trust being punished? The answer likely lies in the unfavourable hydrology in the 3rd quarter. Hydrology is fickle science. Due to unusually low water level, their hydroelectric segment generated 22.8% less than historical average, even though that’s only for one quarter. It was only a year ago when the water current was exceptionally strong, while year-to-date, the segment is down only 6%.
…
Since power trusts are generally considered stable and boring, coupled with Boralex’s conservative balance sheet and high ratings from S&P and DBRS, I feel the distribution is safe, and the higher yield offers a margin of safety in a rare event of a distribution cut.

Obviously I was wrong about the payout being safe. Despite the relaxed distribution policy, BPT.un is still yielding an attractive 11+% based on my average purchase price, and I see the distribution chugging back up as hydrology restores to their historical average. Although I don’t think we’ll see 90 cents anytime soon unless the US Dollar is making a come back.

Disclaimer: I’m not a professional investor. It’s vital that investors perform their own due diligent, and invest accordingly.

On a brighter note, here are my dividend increases over the past 3 weeks:

• Great West - 6.4% (14% from last year)
• IGM Financial - 5.9% (13.4% from last year)
• 3M - 4.2% (4.2% from last year) More analyses from Money Gardener and Middle Class Millionaire.

There are several stable stock markets in which investing through different stock brokerage is very profitable. Several forex companies are doing online trading. The home investment or home building business is on its boom nowadays in different developing countries. If you can invest some thing then investment property is the most favorable option.

Recently, I had the pleasure to get to know one of my blog’s readers, Ryan. Like me, he is a cheapskate who likes to sniff around for dominating businesses that are selling at reasonable prices. One of the stocks on his radar screen is the US retail mammoth, Walmart. He thinks a few trends are working in Walmart’s favour:

Hello to those who are fans of Financial Jungle Blog. This will be guest post and here is my bio I am an Economic and Business student in my last year of school. My financial perspective is very debt adverse and value. My desire is to achieve a CFA and Live in Newfoundland and Labrador.

For a long time I have admired Wal-Mart’s business style and prices. What really got me interested in this stock is the beloved US consumer and their homes. The action that pushed me over the top is Wal-Mart was the first store in Canada to low prices to reflect the higher Canadian Dollars verse the US dollar. This has made me convert to shopping as much as possible at Wal-Mart. This post will discuss why you should invest in this stock and maybe take out a HELOC to do this. ( ADDED JUST FOR A JOKE )

In a nut shell here is why I think the stock will have a good 6 to 15 month run. In good times people over spend because they think that times are going to be really good. As well in bad times I think they will over correct. So I think that Wal-Mart will get a much bigger slice of the consumer’s pie even if this pie is a lot smaller. So I think this will bold really well for them.

Here are my reasons for liking the stock.

1.) Lower Housing Prices across the US is eroding home equity.

This is more evident in California and Florida that consist of 12% and 6% of the total population respectively. Might see a big jump in same store sales in these states which are hit hard with the recent housing revaluation.

2.) Without a declining or vanished housing equity the US consumer will have to deal with their credit card debt. To accomplish this why not shop for lower end products and cheaper household items? This will free up dollars that can be used to pay down debt.

3.) Unemployment up and Prices up.

This is were I think the biggest correction will take place. People do not know if their jobs will be around and this will lead to a big over correction in spending. Since a lot of spending is essential and a lot more of this spending will happen within the walls of Wal-Mart. People have to make up for increased dollars they have to spend on gas and other consumers hit by the commodity run.

4.) Effect of Baby Boomers.

This will have the biggest effect and draw to Wal-Mart for their day-to-day consumption. I say this because The US economy has been running at a great clip for basically 15 years baring the tech bubble. Usually in good times over consumption takes place and people do not save like they should.

Why do I call this the baby boomer effect you may ask? Well its because these are the ones who have used their rising housing prices to buy that nice vacation every year and the vacation home. Their financial plan probably was based on the stock market and housing going up slightly or staying flat. Lately it hasn’t been flat it has been down. What’s going to be the side effect of this phenomenon? Who knows but I think that people are going to flocking to Wal-Mart screaming “ I’m sort X years behind on my retirement and better tighten that spending belt a LOT!” This will mean big increases in store numbers for the next few years.

5.) Down stock market

Another nest age taking a downward spiral. Think I’m going to go out and buy that really expensive bottle of wine for supper along with that Gucci pruse. WRONG! These people are going to down grade their purchases because they have no clue what’s going to happen with their finances. Again flocking to Wal-Mart.

What will make the biggest impact on Wal-Mart earnings over the next year will be # 2, # 4 and # 5. Uncertain times will mean that the US consumer will be spending more of its money to reduce debts most likely credit card debt. Maybe Wal-Mart will allow a low transfer rate as long as you maintain X amount of dollars per month at their stores? Lots of options for Wal-Mart to grow in a slowing Economy espically if the housing market and stock market slide even more.

Long Term View.

I think Dell allowing Wal-Mart to sell some of its computers is a telling story of the tired US consumer because they are trying to use WMT distribution network to help its sales. If other brands that you wouldn’t expect approach WMT in droves to team up you no this is a bad sign for the economy. The consumer is readjusting their basket of goods to lower cost merchandise. If this happens I think at this stock will have a good run for 3 to 5 years.

Disclaimer: Whatever expressed in this post is only an opinion. Please do not interpret this as a recommendation to buy.

Disclosure: I have an indirect Walmart holding through one of my Vanguard ETFs.

This post is a continuation of my original analysis on Keynote Systems.

The wait is over. I finally scooped up a few shares of Keynote Systems this morning after a stunning 25% tumble — courtesy of a downgrade by Ferris Baker Watts from buy to neutral. *

Their latest quarterly results are out and they look pretty sharp. Revenues are up 12%, and net income is break-even compared to a loss of $369 million a year ago. (Note that my calculation of net income is Non-GAAP net income minus stock-based compensation.) The company just repurchased about 1.5 million shares since November 2007, and the board authorized, yet, another 2 million shares.

Keynote Systems now only has 17.8 million shares left due to the company’s aggressive repurchase program. Who can blame them? At $9.74 (after-hour trading), it’s a highway robbery.

The stock is cheap, and I believe the arithimatic is very simple. In theory, you can go to the open market and buy the entire company for a mere $173.4 million. But, this debt-free company is worth so much more. Strip away all their employees. Strip away all their intellectual properties. Strip away all their software and computer equipments. Nevermind goodwill and intangible assets. You’re still left with:

• An empty mortgage-free headquarter that’s worth $135 million**
• A bank account with $99 million in it

That’s a total of $235 million backed by hard assets, or a case of buying one dollar for 74 cents.

Who else is saying “yes” to free money?

Another value investor, Brad from Triaging My Way To Financial Success, sent me a heads up on the bargain and picked up a few shares himself.

* Couldn’t google any explanation on the downgrade. In general, I take these ratings with a grain of salt anyway. Keynote has a potent balance sheet that enables them to buy back tons of shares; a characteristic that most analysts hate because they tend not to receive a lot of underwriting businesses from corporations who are too rich to ask for more capital.

** Estimate based on $85 millions purchase price and 6% annual appreciation since 2000.

You have to be a Vulcan to remain unrattled by the November blizzard that knocked the TSX index off by nearly 8%. All of a sudden, the market has become pessimistic, and rightfully so as many indicators are foreseeing a recession looming. It will suck if a recession storms in uninvited. After all, who will spoil us with dividend increases when cash flows aren’t there?

While many investors have their tongue frozen to the credit crunch pole, the conservative ones are now keeping their portfolios warm and toes-curled under a blanket of utility, consumer stable and health care stocks; ones that deliver essential products and services to the general population irrespective of the market cycle we’re in.

What are some of our basic needs? Food, water, electricity and heating. Last week, I highlighted Borelax Power Income Fund, which owns 10 power plants in Quebec and the state of New York. Staying on a similar theme, I recently invested a position in the Consumers’ Waterheater Income fund (CWI.un).

If you live in Toronto, you recognize that heat and hot water are two of the most elementary needs. CWI rents out 1.4 million natural gas-fired water heaters to 83% of residence in the Enbridge Gas Distribution network within the Greater Toronto area. A boring business, isn’t it? Which is why this investment is so exciting in my view, because mundane businesses tend to come with less baggage, and it’s easier to evaluate if they’re cheap.

CWI’s rental fees are bundled in the customers’ natural gas bills. Brilliant! Not only do they provide essential services, the fees are buried deep inside the monthly gas utility bills which everyone almost always pay in auto-pilot mode. Very few businesses are more vital and stable than CWI; S&P agrees. The trust receives a AAA credit rating and SR-2 stability rating given its conservative balance sheet and recession proof character.

CWI’s minimal capital expenditures are mostly geared toward renewing 5% or 6% of its asset base in a given year, because a typical waterheater has a 15-year lifespan. In addition, CWI has little operating risks. A partnership agreement with Direct Energy Marketing Limited means that nearly all of CWI’s service support is outsourced in exchange for 35% of the aggregate rental revenues.

What more can you ask for in an income trust? Capital expenditures are minimal, revenue stream is stable, customer base is growing, share count is in check, and bank balance is growing.

In fact, between 2003 and 2006, CWI’s vault swelled steadily from $17 millions to $39 millions without diluting shares or eroding debt-level. With the business flush with cash, CWI recently plunked down $10 millions as a 25% down payment to acquire Toronto Hydro Energy Services units for $41 million. This represents a 6% increase to the total installed waterheaters.

The growth potential doesn’t end there. According to their website:

Beyond the existing service arrangement, the Direct Energy relationship has the potential to bring new growth opportunities to the Fund. As Direct Energy expands its home services footprint, the opportunity arises to rent water heaters to these customers. In addition, should Direct Energy successfully establish a significant base of rental water heater customers elsewhere in Canada, the Fund has right of first refusal to acquire it.

Management foresees the rental rate to rise in tandem with the rate of inflation. Between that and the growing asset base, distribution should improve by about 5% a year. Each CWI unit delivers an annual distribution of $1.29. Based on Friday’s closing of $14.93, that’s a yield of 8.64%. Anything above a 9% yield for CWI is cheap in my book.

If you happen to purchase CWI, consider the tax consequence: CWI’s distributions are not as tax friendly as most other trusts. 97% is treated as interest income with only 3% is return of capital. It’s better to hold the trust in a tax-deferred account such as RRSP. Short of that, you could hold the trust in a non-registered account of the spouse in a lower tax-bracket.

It’s a sad day yesterday as I eliminated my National Bank position after holding the stock for 21 months. Of course, it’s also one of the very first four stocks I purchased when I began my dividend-investing foray (the others were Power Financial, Bank of Nova Scotia and Saputo).

While the sentimental value of National Bank made the sell button excruciating to press, I felt it was the right decision in light of NA’s large asset-backed commercial paper burden relative to its market capitalization. The mounting writedowns should persist for several quarters, distracting management’s attention away from the day-to-day operations and growth strategies. Even without the distraction, NA’s geographical reach seems to be boxed within the Quebec province. Why don’t they just go buy something? I also have skepticisms against management, but let’s no go there.

Enough of my ranting. So, where to redeploy the proceeds? The choice is obvious: TD Bank. The more I read about the subprime fiasco and TD Bank, the more I like Ed Clark. Writedowns? What writedowns? You’d think Ed Clark is taking Tylenol to cure his ABCP migraine, but no! He’s taking Viagra to extend his reach into the United States. Officially with the Commerce Bancorp acquisition, TD blossoms to become the seventh largest bank in North America while other banks are fleeing with a tail between their legs; only the highest quality banks shine eminently during financial crisis such as the one we’re in.

The story doesn’t end here. One of TD’s prime online trading competitors, E-Trade Financial, may go bankrupt because it gobbled more home loans than its cash-flow permits. This is good news for TD, because should E-Trade files for bankruptcy, customers are only protected up to the first $100,000. Half their customers are over that limit according to Sinclair Stewart of Globe and Mail. For these clients, the sensible reaction is to lunge for a quick exit, and jostle to TD Ameritrade.

Another option is for TD Ameritrade to acquire E-Trade, a potential bargain now. I like how Derek DeCloet put it:

E*Trade’s fall is stunning. In 1999, at the peak of the Internet lunacy, it was (very) briefly worth more than the Bank of Montreal. Now it’s worth less than little Canadian Western Bank. Not five months ago, two hedge funds asked - no, demanded - Ed Clark to get out of the way and let TD Ameritrade, the Toronto-Dominion Bank’s partly-owned U.S. brokerage, merge with E*Trade. Since then, the latter has lost about $8-billion in market capitalization. Where are the hedge fund geniuses now? Awfully quiet.

E-Trade is still a prestigious brand. All Ed Clark has to do is spend a few bucks ($600 millions) to bulk up its presence in the discount brokerage space. It’ll be interesting to watch how the story unfolds.

Last week on BNN, I caught a sound bite of renowned Canadian value manager, Irwin Michael, who manages a string of sensational mutual funds. Most notably, the ABC Fundamental Value Fund, which returned a stellar 18.8% since inception 16 years ago. What I love about Irwin Michael is his uncanny ability to uncover diamonds in the rough while the shortsighted market is too busy chasing yesterday’s hottest stocks. Visit Irwin’s ABC Fundamental Value and note the propensity to divest from the market return over his 16-year tenure as the fund manager. Remarkable isn’t it?

Irwin Michael shares his wisdoms monthly on his website. I think my all time favourite has to be his contrarian take on exuberant market in December 1999. Here are a few excerpts:

This TSE index performance has been led by anything related to high technology, telecommunications or Internet whereas most other sectors such as financial services and resources, for instance, have languished most of this past year. …

Although we do not dispute the economic importance of high technology, telecommunications or e-commerce, many of the public companies associated with these sectors are outrageously expensive. …

We are particularly attracted to the natural resource and cyclical sectors which have become virtual investment pariahs. Especially cheap are oil and gas, forestry, metals and mines which have significantly under performed the popular stock averages for the past 6 months. Many companies trade at huge discounts to net asset value with low P/E and cash flow multiples. …

We are especially optimistic with regard to the Canadian dollar. …

Don’t you just love contrarians? If I didn’t know any better, I would hail Irwin as the genuine oracle of the stock market.

Okay, enough sucking up to him. What I wanted to discuss is his pick of the segment: KeyNote System. This is more of a quantity analysis, as I’m not terribly familiar with their business, but according to their website:

Keynote is the leading provider of on-demand test and measurement products for mobile communications, VoIP, streaming, and Internet performance. Connected companies will know precisely how their Web sites, content, and applications will perform on actual browsers, networks, and devices long before their customers and business is impacted.

Keynote is recently trading at around $14. They just delivered their Q3 results, and they are awesome to say it professionally. The company is debt-free and has $103.1 million in their vault. Divide that by the number of diluted shares, that’s $5.48 money-in-the-bank per share. We’re not done yet. Besides the cash, the balance sheet records $35 million worth of real estate value. This understates the true value immensely, because the figure already endured 6 years worth of capital depreciation for the purpose of tax savings. You see, Keynote bought their headquarter for $85 million back in 2000. Assuming 6% annualized appreciation, their real estate is worth $120 million today, or $6.38 per diluted share.

So when you buy Keynote for $14 per share, $11.86 is backed by cash and real estate. Not only that, it still has another $1.50 per share worth in computer equipments, software, leasehold and property improvements. All these assets validate Keynote an attractive take-over target notwithstanding the prevailing credit crunch. According to Irwin Michael, any high tech giant can absorb Keynote, use its $103 million to foot the bill, and occupy the 60% vacant space in Keynote’s mortgage-free head office.

Suffice to say, you’re getting the Keynote operations for next to nothing, and the business itself isn’t too shabby either. Revenue growth is 10% over the previous 5 years. According to Irwin Michael, Keynote should reap the rewards of its operating leverage very soon:

Once a platform has been built; incremental revenue is usually highly profitable, and the market is willing to look forward to future earnings growth. We believe Keynote is close to reaching this threshold. Management believes that if revenue can reach $100 million [FJ: it’s current at $65 million], its EBITDA margin would increase to 23% from 5% currently. This would essentially double Keynote’s free cash flow [FJ: $0.72/share over previous 4 quarters], and could result in significant investor interest.

For a non-dividend paying stock, it sure whets my appetite. For disclosure, I don’t own the stock nor have an entry price. We might be witnessing the infancy of an explosive growth, but just to be on the safe side, I want to make sure that the margin expansion materializes over the next few quarters.