Golden Capital Securities

Investment Outlook

March 2001

How many of you acted upon our market call back in our November 24th Research Comment when we said that a more accurate valuation for Nortel Networks was in the range of $40?  At the time Nortel was trading very close to $60, even as high as $70 and then the stock came crashing down as John Roth, Nortel's CEO, indicated that growth in the Optical Networking market may not be as strong as originally thought.  Say goodbye to C$297 Billion in market capitalisation since the stock peaked in July 2000.

The reasons for the "downward revision in expected revenues and earnings" came as a result of the general slow-down in the demand for networking equipment and the continued business failure of companies who had ordered equipment based on the expectations of demand that never materialized.  Up until the middle of February, many Nortel investors looked through their rose coloured glasses and thought that somehow Nortel was going to buck the trend and maintain its astronomic rate of growth when almost every other company in the industry was experiencing a drop in demand.  Nortel is a great company, but it is still just a great company that makes stuff.

With the dramatic drop in the share price came calls for Mr. Roth to step down, that he had acted improperly, that he met with RBC Dominion Securities two days before making public the lower earnings announcement, an announcement that came just two days after the stock swap for JDS Uniphase's pump laser facility and that some of his senior managers had sold some stock with insider knowledge prior to the announcement.  There are now several class action lawsuits pending against the Company dependent upon who knew what, when.  

Now investors:  "How was Nortel suppose to continue to grow at 26% while the rest of the industry started to contract?"  The recent rash of lawsuits based on investors' perceived "right" to make money has made Companies overly cautious in their projections for fear of being sued if they happen to be "overstated".  The equity markets have never `promised' a certain level of return, or even that the earnings will be positive, it is all just a best guess; Some people can just guess better than others.  However, after a seven year bull market, some people have grown to expect that stocks just go up and that if a stock goes down, some one should be sued: "It's not my fault I made a bad investment."

The chart below shows quite vividly how much of the valuation of this giant of the Canadian financial marketplace has been slashed.  From a high of $124.50 in July, down to a current range of just under $30.

Source: Bigcharts.com

Now, we will acknowledge that the $40 price we targeted would still have netted a loss for investors, but as we discussed at the time, momentum investors tend to send the stock too far in either direction.  They sell too much forcing it down and then buy too much forcing it up above fair value.  Additionally, the lawsuits will likely keep the stock under a great deal of uncertainty for the next several months unless the cases are settled out of court (which is highly unlikely).  

Therefore, on a fundamental basis the stock will likely report lower than previously expected earnings for the next 2 or 3 quarters as the economy sorts itself out and networking demand continues to stagnates.  We still feel that a $40 stock price on Nortel is more appropriate and that the stock is currently oversold.  However, while Nortel and the North American economies sort themselves out there is going to be a great deal of volatility in the Nortel stock price around the $25 - $40 price range - short-term trading opportunities could abound.  

Our Technical Gurus are calling for a quick snap-up in the overall market within the next two or three weeks.  They have been unable to pinpoint a particular catalyst to spur the increase, but the trading activity seems to have reached a near term buy signal.  In particular, as individual issues decline, measures of the velocity of the declines are abating indicating that the pace of selling is slowing.  When there are no further sellers, markets tend to snap back in quick, violent rallies.  However, these rallies have to be viewed in the context of the larger, overall market picture which shows a continued downtrend.  Such rallies, when they occur, will be only countertrend moves.

One of my favourite countries in the world is Turkey.  The people are friendly, the food is excellent, and they have a fantastic bus system that runs on time (a vast difference from the rest of the Middle East).  Just last week, the Turkish government was forced to remove the recently imposed exchange rate controls on the Turkish Lira, sending the currency plummeting when compared to Western benchmark currencies like the US Dollar and the Pound Sterling.  

The causes of the collapse were a long-standing loose monetary policy, continued high level of government deficits and widespread corruption.  The mindset of the Turkish Government was that if you cannot borrow money you can always just print it to pay for your expenditures.  However, as is usually the case with printing more currency without a comparable growth in the economy, hyper-inflation has battered Turkey for years.

Economically, hyper-inflation is described as an economy experiencing an inflation rate of greater than 30% for each of three consecutive years; Turkey was averaging over 70% annually.  Once a hyper-inflationary environment has started, the level of wages, consumer goods and housing all sky-rocket in near vain attempts to keep the spending power of the currency constant.  The government prints more money to provide currency to those demanding it, and the vicious cycle continues.  It is very difficult to control and requires a great deal of political will-power and fiscal responsibility to overcome

The number of Turkish Lira required to purchase one US Dollar. 

Year	1997	1999	2000	Feb 28th, 2001
Turkish Lira to $1 USD (approx.)	180,000 TL	540,000 TL	670,000 TL	1,010,000 TL

There are numerous additional reasons for the recent economic problems but the Earthquake in 1999 caused a huge decrease in the GDP without a corresponding decrease in Governmental spending.  In 1999 the Governmental deficit was 10% of the GDP; not the budget, the deficit.  They had overspent the budget by 10% of the total of all the goods and services produced in the country.  OUCH!  Not exactly fiscally responsible.

In December of last year, the International Monetary Fund (IMF) and the World Bank came to the support of the Country and outlined a plan, including monetary loans and currency controls, that would help Turkey escape the continuing downward spiral of hyper-inflation. The Government would have to reduce the level of budget deficit, reign in their monetary policy (stop printing so much money) and peg the Lira to a fixed exchange rate.  However, what could have been the start on the road to fiscal responsibility was further aggravated by the collapse of 10 private Turkish banks, renewed calls of wide-spread corruption of those banks' senior management, and infighting and name calling within the government.  All these factors caused the break-down of the fiscal negotiations and the resulting un-pegging of the exchange rate.

"Well, just stop printing money, stop spending money and stimulate the economy", one might say.  But they cannot borrow money on the international markets as no one would want to borrow in Turkish Lira and they can't afford to borrow in a more stable currency. Turkey cannot really stop the governmental spending as the per capita GDP is only US$2,900 (1999), as a comparison in 1999, Canada was $19,200 USD.  And as we have seen with the collapse of communism and their centrally controlled price structure, it is very difficult to put price controls into effect.

"So why should I be concerned about this?" some investors might say.  Well, similar conditions have occurred much closer to home like in Mexico (several times, but most recently in 1994-5), Argentina (late 1980's, 1995 and 1998) and Brazil (late 80's and 1994) that sent their economy's reeling and took years to recouperate.  Canada was even in a similar situation in the early Eighties when our interest rates sky-rocketed to over 20%, inflation was well into double digits and several smaller banks collapsed.  The opposite, deflation, occurred in Japan in the late nineties.  Deflation is in some ways scarier than high levels of inflation as the economy shuts down rather than going into overdrive because everyone delays their purchases as items will be cheaper in the future than they are now.  

This is not a prediction that this will happen in Canada or the US in the near future, but rather that the situations that led to the economic problems occurring in Turkey have happened before and will likely happen again.  Our warning is to anyone making an investment.  For example, investors in Procter & Gamble found this out as P&G stock dropped from around $76 to just over $70, based solely on the expectation of lower earnings from write-offs in inventory that they will have to record as a result of the Turkish Lira's devaluation.  An investor must look at more than just the Earnings Per Share of company, or their revenue growth, they must also look at where that Company conducts business and what the economic situations in those areas are.  

Favourites

February was a cruel month for our Favourites Lists, after such a great month in January our swollen heads were brought back to earth.  We realised some losses in the US portfolio, but also stopped some further hemorrhaging in Lucent.  Unfortunately, as stated above, we feel that Nortel is currently undervalued at $28, however in hindsight we just should have sold it when we had the chance at the end of January.  If we were to remove that one stock our Canadian Portfolio would be up 1.4%, rather than down 5%.

Canadian Core Portfolio

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Until next month.