Value Points

First of all, let me be perfectly clear. I’ve never seen anything like the current wave of selling in my career. That includes the 1987 crash, the 1990 plunge in the wake of Iraq’s invasion of Kuwait, the utility deregulation scare of 1993-94, the Asian contagion of 1997-98 and the Great Bear Market/utility deregulation crackup of 2001-02.

All were major market events in their own rights. But none of them involved such a core debacle as the literal freezing up of the global financial system. The last time that really happened in fact was the Great Depression of the 1930s, and unfortunately there aren’t a lot of older hands from that era still around to share experiences. To be sure, there are a lot of differences between now and then. For one thing, we have almost universal deposit insurance, which has prevented the kind of withdrawal stampedes of that era. But we’re in new territory from any market crash I’ve ever been through.

My strategy since this bear market began in mid-2007 has been basically to go with what I know: hard-nosed analysis of individual companies and Canadian income trusts to determine how their businesses are holding up to the underlying stress tests of weakening economic growth, tightening credit and generation high raw material costs, which have increasingly translated into inflation. Trusts, of course, have had the added burden of restrictions on the number of shares they can issue, a provision of the “Tax Fairness Act” that will tax them as corporations beginning in 2011.

Up until exceedingly cruel September 2008, that worked reasonably well at holding down losses, as the market was still paying attention to underlying business health. Since then, however, the news on the global financial system has gotten so bad that it’s sparked indiscriminate selling, even of businesses that had posted solid second quarter earnings and are likely to do so in the third.

One of the lessons from the Great Depression—and every bear market before or since—is that liquidation into panic selling is the worst possible strategy. In fact, some studies have demonstrated that incremental investing in stocks was a profitable strategy for that decade, even for those who bought at the 1929 peak.

Unfortunately, an equally important lesson is that some companies do crack up as businesses, and most of those never make it back. That’s why I think we still have to let the third quarter numbers act as our guide on whether to buy, hold or fold. And if a company or trust is really coming apart, we have to be prepared to sell, even if it means eating an already huge loss.

That’s the primary reason I’ve been so against averaging down since this bear market began. It just makes it too emotionally and financially difficult to take losses. And with these stress tests becoming so severe, no amount of research can tell us for certain where the bombs could go off.

In this market, even a disciplined strategy of regular incremental investing in our favorites presents a risk. It is, however, a balanced one, particularly with valuations in the Canadian market even lower than they were in November 2006, following Finance Minister Flaherty’s announcement that income trusts would be taxed as corporations in 2011. In fact, the broad-based S&P Toronto Stock Exchange Trust Composite is a day’s trading from 2001 lows, when oil and gas prices were a fraction of today’s levels.

In my Monday Flash Alert, I pointed out that Advantage Energy Income Fund (TSX: AVN-U, NYSE: AAV) had announced an increase in its capital spending budget for 2008 by 25 percent. That didn’t stop the shares from plunging that day. But the actual hard news isn’t exactly the sign of a cash-poor company, one having difficulty getting access to credit or one that’s not bullish about its prospects. And we’ve seen similar signs of strength in other trusts, despite the recent ravaging of their share prices.

Below, I’ve present more food for thought in this crisis in another table. Specifically, I show share prices for the nine Canadian Edge Portfolio energy producer trusts at oil’s low for the decade at USD18.43 per barrel on Dec. 4, 2001, and at natural gas’ low of USD2.03 per million British thermal units on Sept. 28, 2001.

Several months ago, I recommended taking profits on these trusts, which were then up on average nearly 50 percent from the beginning of the year. That said, I certainly didn’t anticipate this magnitude of selling, and I don’t claim to be able to predict when it will end, either.

But consider this: Several of these trusts actually trade at lower prices than they did when oil sold for $18 and change and when gas sold for barely $2. And despite the current extreme bearishness on energy now, we’re still a very, very long way from revisiting these prices for oil and natural gas.

Moreover, these trusts are far more valuable companies today than they were then, just based on the growth of their reserves alone. That’s particularly true of October High Yield of the Month Peyto Energy Trust (TSX: PEY-U, OTC: PEYUF), as well as Penn West Energy Trust (TSX: PWT-U, NYSE: PWE) and Vermilion Energy Trust (TSX: VET-U, OTC: VETMF), and the others have grown dramatically as well. Arguably, that should also make them considerably more capable of weathering market ups and downs.

Again, as long-time readers know, I’m not a “back-up-the-truck” guy, and this isn’t a recommendation to put everything you have into energy trusts. But I can’t think of a starker reminder of how extreme the prevailing pessimism has become for energy producing trusts. That’s at least a compelling reason not to liquidate these positions, and it’s a very good argument for a disciplined strategy of incremental investing, buying as many individual issues as possible.