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Harry Newton's In Search of The Perfect Investment Newton's In Search Of The Perfect Investment. Technology Investor.

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8:30 AM EST, Thursday, September 27, 2007:
There are two ways of measuring your investment -- the return on your investments and your net worth. Personally I like net worth. It takes what you started with at the beginning of the year and measures it against what you have at the end of the end -- after expenses. It gives you a better measure if you're affording your lifestyle or it's running you down.

Net worth measures how you well you did on four critical measures -- your taxes, your living expenses, returns on your investments and your earned income. Net worth washes everything out and tells whether you're ahead of the game. Net worth is the only measure that matters.

A friend called yesterday said his growth in net worth had averaged 20% a year over the last five years. That's pretty extraordinary -- until you know he's not married, has no kids, and gives cheapness a whole new meaning. He is, however, endearing in the poverty he feigns. I figure mine will be closer to 7% this year because it's been a heavy expense year -- what with a wedding, two kids in graduate school, etc.

When figuring net worth, it's legit to include assets you can sell -- like your houses and your Picassos (I wish). But don't all your other assets -- like cars, furniture, TVs, cameras -- they're all declining in value. Your upcoming garage sale won't be worth your time.

These days all net worth and rate of return calculations are marred by valuations. Increasingly, all of us own stuff that isn't valued daily like shares on the stockmarket. We have "alternative investments," like private equity funds, which we won't know the real worth of for five years. I wonder how institutions like Yale do their valuation. Today's papers reports that Yale earned 28% on its endowment for the fiscal year to June 30, 2007. That's a phenomenal return. We don't know a lot about how Yale did it, since the Endowment's annual report isn't out yet. But, from today's New York Times:

Yale’s endowment continues to be diversified, but Mr. (David) Swensen, Yale's brilliant manager, declined to say which asset class performed best. His target asset allocation for fiscal 2008 is fairly similar to the allocation for 2007. The biggest allocation — 28 percent of Yale’s funds — is in real assets. Last year, those included real estate, oil and gas and timberland, Yale’s report showed.

The second-largest allocation is to what Yale calls absolute return investments, which generally means hedge funds. Yale is slightly reducing that stake to 23 percent, from 25 percent, according to Mr. Swensen.

The endowment is also planning a slight reduction in domestic equities to 11 percent, from 12 percent. Fixed-income and private equity will remain at 4 percent and 15 percent respectively, and private equity is increasing 2 percentage points to 19 percent, Mr. Swensen said.

There are things to know about Yale's endowment:

1. It is diversified -- far more than any single investor (like you or me) could ever hope to be.

2. Yale has probably the best deal flow in the entire world. There isn't a money manager that doesn't want to manage money for Yale. Yale is a huge feather in their cap.

3. Yale publicizes its results for precisely one reason (today's NYTimes, Wall Street Journal, etc.) -- it wants to attract the deal flow.

Quote of the week:

If you don't know what you're doing, it's better not to jump. Evel Knevel

Microsoft blunders along. Vista sluggishness, Excel bugs (see yesterday) and now word of bugs in XP -- The trouble occurs when users reinstall XP's system files using the repair capability found on genuine XP CD-ROMs. (The feature is not present on "Restore CDs.") The repair option, which is typically employed when XP for some reason becomes unbootable, rolls many aspects of XP back to a pristine state. It wipes out many updates and patches and sets Internet Explorer back to the version that originally shipped with the operating system. Normally, users who repair XP can easily download and install the latest patches, using the Automatic Updates control panel or navigating directly to Microsoft's Windows Update site. However, after using the repair option from an XP CD-ROM, Windows Update now downloads and installs the new 7.0.600.381 executable files. Some Windows Updates executables aren't registered with the operating system, preventing Windows Update from working as intended. This, in turn, prevents Microsoft's 80 latest patches from installing — even if the patches successfully downloaded to the PC.

Microsoft is working on this new problem as well and will issue a fix eventually.

To repeat yesterday's advice: Don't upgrade to Office 2007. Don't use Vista. Turn off automatic upgrades on XP (too dangerous). If you ever need to repair your Windows XP computer, go here.

Is it time to short Microsoft? No. (No serious disaster story.) Would I hold Microsoft? No. (The stock is going nowhere.) If I owned it, would I sell it? Yes. (To repeat, the stock is going nowhere.)

Next time you become an airline prisoner: Glenn Deek writes

Harry, I actually found a strategy that works, I was stuck on the tarmac in Oklahoma city (diverted from Dallas) because we ran out of gas. They couldn't run the engines and the air conditioner cart broke so we sat for almost 2 hours baking in the plane, waiting for a gas truck.

I called the police on my cell phone they sent me to the airport police. I told them if they didn't get fuel or us off the plane, I was going to call the fire dept and report an medical emergency.

The guy on the other end said "Oh no, please don't do that, I will take care of it" and what do you know, five minutes later we had a gas truck and an air unit.

I also bitched out the airline once I returned home and received a $400 voucher.

Disbelieving, I emailed Deek back:

You actually pulled off this stunt and got away with it? And they didn’t threaten you with arrest and a stay in jail?

Gleen reponded:

I was 2 seats away from a howling baby. The lady in front of me was ready to pass out. And I am 6' 5" crammed into those little seats, I'd had enough!

Where goes Canadian Oil Sands? My friend and energy guru, Jim Kingsdale writes the excellent Energy Investment Strategies website. His latest posting concerns Canadian Oil Sands Trust, a stock I own. This is a long, piece with serious interesting analysis. Worth reading.

Canadian Oil Sands Trust (COS) owns 36.74% of Syncrude, Ltd, one of the largest and most developed oil sands operations in Canada. Sycrude has a record of profitability and has already achieved construction of the bulk of its long term capacity goals, including in July an upgrade that increased output capacity by 40% to approximately 350,000 barrels per day, or about 129,000 for COS. A de-bottlenecking upgrade will add another 50,000 b/d to capacity in five years and a final planned expansion will bring production to 500,000 b/d in about ten years.

There are two important qualities of Syncrude operations that distinguish it from other oil sands companies. First, their bitumen deposits are close enough to the surface that they are mined rather than having to be liquified and then pumped to the surface, a more expensive and energy-intensive process pursued by Nexen/Opti and others. Second, Syncrude, in addition to mining bitumen, upgrades its bitumen into a superior grade of light, sweet synthetic oil that they call “Syncrude Sweet Blend” (“SSB”). SSB sells at a price that differs from West Texas Intermediate (“WTI”) crude, the most frequently quoted oil price. Sometimes SSB is priced at a discount to WTI, as it was during 2006, but currently SSB enjoys a premium of about $5 per barrel to the price of WTI.

The business proposition of an oil sands investment is fairly simple. The company owns an enormous supply of bitumen, perhaps 50 years worth or more — nobody knows for sure. As the price of crude oil rises, the profitability of mining and upgrading bitumen is propelled upwards on a leveraged basis, since the marginal return on an extra dollar of price is 100% less delta taxes. If you think (as I do) that over the long term the price of oil will increase substantially as we get closer to and finally pass the onset of Peak Oil, then oil sands plays are a way to profit from that trend. If you think, as most Wall Street analysts do, that the longer term price of oil will not move dramatically above, say, $70, then the value of an oil sands company is much reduced. In sum, it is all a matter of what the price of oil will be in the out years.

What are the risks? If the price of oil does rise past $100 and then past $200 and so on over the next decade, what might stand in the way of vast riches for the COS shareholder? First, of course, there is the difficult problem of managing a huge, sprawling, technologically advanced and advancing enterprise located in an inhospitable environment with severe endemic labor shortages. Assuming the company continues to successfully handle these daily challenges, their task will not be simply a matter of bundling up all the profits and sending them off to shareholders. The public — and their elected representatives — will be increasingly concerned about protecting their environment and securing their “fair share” of the rising corporate profits.

Syncrude, like all oil sands companies, operates under both provincial and federal environmental regulations. Both jurisdictions specify requirements and financial penalties for failing to meet them. COS allocates about $125 million per year to satisfying the environmental specifications laid out by those governmental requirements. It estimates that Alberta’s requirements for continuing reductions in GHG emissions will add 30 cents per barrel or $7 million to its costs in 2H ‘07. National environmental standards are under development and the company estimates that its costs of compliance may be “significant”. Please see the web sites of Syncrude and COS, for further discussion of environmental problems and their remediation. The quarterly reports of COS detail its approach to environmental issues, including costs.

Issues of taxation at both the federal and provincial levels are important for oil sands operators. This year Canada passed a law that impacts trusts, of which COS is one. Recently, a study commission in Alberta released a report suggesting substantial increases be made in provincial taxes for all oil and gas operators about which I wrote last week. Taxes at either the national or provincial level could impact COS’s profitability in the out years.

Canadian taxation of trusts is similar to U.S. taxation of REITs. Companies must distribute 90% of earnings but are not taxed at the federal level. Trust taxation was initiated in part to encourage extractive industries, but eventually the advantages convinced other types of companies to shift to trust from corporate status. When such large public companies as Bell Canada contemplated becoming trusts the Federal government began to see its entire corporate tax receipts begin to dissolve. Their reaction was to pass a new law taxing dividends of trusts at 30% starting in 2011.

In response to this change, COS (which I think has one of the smartest managements going) has taken a couple of steps to maximize shareholder returns. First it has decided that from the present time through to the time when the new dividend tax takes effect, which is estimated to be 2012 or 2013 for COS given their specific tax credit carryforwards, the company will pay dividends at the maximum feasible level. It will also, during this period, eliminate debt repayments. Prior to passage of the new dividend tax law, COS had been making substantial reductions in its debt.

Secondly , management is contemplating a change of corporate organization if the new law is not changed by the time that the new tax begins to be applicable. Management has indicated that one option is for the company to drop its trust status and become a corporation. Another option would be for it to sell out, presumably to a corporation. If COS were to become a corporation, their enormous free cash flow could be used to buy in shares on a regular basis in lieu of paying dividends and without incurring a tax. Perhaps there are other actions COS could take to enhance shareholder value, which I am convinced is a primary goal of management.

Alberta’s new proposed tax scheme is in its early days of being considered. Currently oil sands operators pay 25% of operating profit to Alberta after they have recouped their initial capital investment, which COS has done. If the new tax proposal simply means that the current tax becomes 20% greater (i.e. a 30% tax) and if that tax were then to be set in stone going forward, it would not be overly onerous. Nobody likes to see a government change the rules of the road in taxation after a company’s investment has been made based on the original tax model, particularly when there is no alternative for a company to change taxing jurisdictions. Nonetheless, the price of oil has changed very significantly since the original deal was struck and the implications of the enormous strains on Alberta’s economy caused by the expansion of oil sands operations do provide some justification for a re-evaluation of the fairness of the original tax scheme.

The question investors must ask is what are the long term intentions of the Alberta governent. Will they honor whatever new tax scheme eventuates on a long term basis or will they impose even greater taxes as time goes on, a la Venezuela. Each investor must make that judgement. Based on my sense of the moral fiber of Canadians, I am willing to believe at this point that future judgements will be fair. If the price of oil goes to $200 a barrel will the Alberta government take no action? For that matter will any government anywhere take no action? One cannot presume that. There may be some form of oil price controls or new taxes aimed at mitigating economic damage to the general economy. Such schemes may not be all bad. But that is a long way from a Venezuelan approach.

In other words, I believe that life for the oil sands investor is not likely to be perfect. A never ending increase in the price of oil, which I do believe is in the cards, will not necessarily translate into COS investors harvesting 100% of the gains that might be projected based on current regulations and taxation. On the other hand, the returns are still likely to be pretty good, I suspect.

Let me address the dividend issue. Personally, I like dividends. I think they are the sincerest indicator of a company’s success. COS pays a substantial and growing dividend, currently $0.40 per quarter, which is up 33% in 2007. Management has said it intends to increase the dividend to the maximum extent it deems prudent over the next six or seven years, as discussed above. The current dividend is supported by current free cash flow of $0.57/share, which I believe will increase to about $0.70 in the second half if the price of WTI crude stays above $70. Another 33% dividend increase for 2008 would bring the dividend to $0.53 cents. That would not surprise me. Nor would $0.60. One respected analyst (Kurt Wolff) has predicted $0.80, but I doubt that. In any case a dividend of $0.53 for 2008 would bring the yield to about 6.4%. If you believe that the price of oil — and therefore the free cash flow of COS — has much further to go in future years, then COS with a 6.4% yield and the promise of a rising dividend seems attractive to me.

How attractive is COS? Warren Buffett once commented that as a general rule a company may be said to be worth twenty times free cash flow (FCF). The Master might want to adjust this multiple depending on the outlook for future FCF and prevailing interest rate levels. Nonetheless, COS is in fact now selling at a 25% discount to 20 times its first half FCF. If FCF runs at $0.70 for Q3 and Q4 this year as I project, the 5% cap rate would give the company a buy-out value of $56 per share. Give the public market equities a 25% discount off private market value and you get $42 a share. That is about 27% more than the current $33 price. Add a 5% dividend and you get a total return of 32% if COS achieves a $42 value within one year. I think that target has a reasonable likelihood of being met unless the price of oil declines substantially.

Finally, let’s talk about the impacts of the falling U.S. dollar. There are three impacts: the direct impact on the valuation of COS stock and the COS dividend for an American investor, the impact on the global price of oil in US dollars, and the impact on COS earnings. These three impacts work in somewhat complex and offsetting ways. Given this complexity and the fact that I am not a licensed foreign exchange expert, this discussion is certainly not intended to be definitive. Rather, I want to present the bottom line as I understand it for those who want to consider the issue. Let me address the impacts in the reverse order as presented above.

To Canadian Oil Sands Trust, a lower U.S. dollar (“Dollar”) in relationship to the Canadian dollar (“ Loonie”), means that COS revenue from oil sales is reduced by C$0.04 per share for each penny (roughly 1%) of increased Loonie value to the Dollar. It is a simple one-to-one cause and effect relationship because COS revenue is received in Dollars and then translated into Loonies. While the revenue relationship is direct, the impact on COS operating earnings is magnified because COS expenses are largely in Loonies. This negative impact is slightly offset by the fact that COS debt is denominated in Dollars and therefore is reduced by a falling Dollar.

On the other hand, a falling Dollar tends to support a rising price for oil. It is impossible to discern the direct impact of the Dollar/Loonie ratio on the oil price because supply and demand issues, not foreign exchange, have the primarily impact on the oil price. But in recent weeks as the Dollar has fallen rather quickly, it appears to have been an important cause for the rise in oil. A rise of $C 1.00 (roughly 1.25%) in the price of oil adds C$0.05 cents to the EPS of COS.

To summarize the impact of a falling Dollar on the earnings of COS and thereby its ability to pay dividends, there is a direct and magnified negative impact that is offset to an indeterminate degree by a positive impact on price of oil. Is the net effect zero? That may be a reasonable guess, but it is impossible to know for sure because the precise impact of a falling Dollar on the oil price of is impossible to know.

The American investor, however, is advantaged by the falling dollar in a direct one to one cause and effect relationship. As the US dollar depreciates, assuming no change in COS share price or dividend as stated in Loonies, the value of the shares and the dividend are that much greater in Dollars. To be more specific, COS’s $C 0.40 dividend was worth $US 0.364 to me a few months ago when the Loonie was worth $US 0.91. Now, as the currencies are at par, it is worth the full $US 0.40 to me. That’s the same as if I had gotten a dividend increase of 9.9%.

Putting all this together, a falling dollar has a net positive impact on the value of COS shares for the American investor. That is because the impact of the falling dollar on COS’s operating earnings, given its positive impact on the Dollar price of oil, is some amount that may be close to zero. But the value of the COS shares and dividend are increased to the American investor by the full percentage change in the depreciation of the Dollar. Thus, the expectation of a falling Dollar would be a positive influence on an American’s decision to buy or sell shares of COS, although it is certainly not the most important issue.

So, to summarize, here’s my take on Canadian Oil Sands Trust:

1. It will be an operationally leveraged beneficiary of any future increases in the price of crude oil, regardless of future changes in currency exchange rates.

2. It will benefit from increasing volume of about 43% over the next ten years.

3. It has enough bitumen to operate for the next 50 years or longer.

4. It is operated by an outstanding management team which is shareholder oriented.

5. It is more subject to the vagaries of governmental regulation and taxation than is the average company. Moreover, such regulators have a legitimate interest in protecting their environment, which is inherently harmed by the company’s harvesting of bitumen and conversion into crude oil. Thus, one can assume increasing costs to the company for environmental mitigation. But the good news is that the regulators and tax authorities have not yet totally destroyed a reasonable basis for trust with the investment community. They may yet do so, but it has not happened so far in my judgement.

6. If the price of WTI crude averages $71 in the next 12 months, I estimate the FCF of COS at $0.70. That could support a dividend of $0.53 per quarter and a stock price of $42.

The wise Navajo lady.

Sally was driving home from one of her business trips in Northern Arizona when she saw an elderly Navajo woman walking on the side of the road.

As the trip was a long and quiet one, she stopped the car and asked the Navajo woman if she would like a lift.

With a silent nod of thanks, the woman got into the car.

Resuming the journey, Sally tried in vain to make a bit of small talk with the Navajo woman. The old woman just sat silently, looking intently at everything she saw, studying every little deta il, until she noticed a brown bag on the seat next to Sally.

"What in bag?" asked the old woman.

Sally looked down at the brown bag and said, "It's a bottle of wine. I got it for my husband."

The Navajo woman was silent for another moment or two.

Then speaking with the quiet wisdom of an elder, she said: "Good trade."

This column is about my personal search for the perfect investment. I don't give investment advice. For that you have to be registered with regulatory authorities, which I am not. I am a reporter and an investor. I make my daily column -- Monday through Friday -- freely available for three reasons: Writing is good for sorting things out in my brain. Second, the column is research for a book I'm writing called "In Search of the Perfect Investment." Third, I encourage my readers to send me their ideas, concerns and experiences. That way we can all learn together. My email address is . You can't click on my email address. You have to re-type it . This protects me from software scanning the Internet for email addresses to spam. I have no role in choosing the Google ads. Thus I cannot endorse any, though some look mighty interesting. If you click on a link, Google may send me money. Please note I'm not suggesting you do. That money, if there is any, may help pay Claire's law school tuition. Read more about Google AdSense, click here and here.
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