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Investors Beware: 4 Things to Watch Out for When Investing

This is a guest post by Peter Hodson.  Peter Hodson is CEO of 5i Research (www.5iresearch.ca), an independent and conflict-free investment research provider. Prior to founding 5i Research, he was Director of Sprott Inc., and Chairman of Sprott Asset Management LP where he managed his own $150 million fund as well as part of a team that managed more than $9 billion. He also writes regularly for the National Post.

After 17 years of working as a portfolio manager on Bay Street,  you begin to pick up on various trends, strategies and tips that can have a huge effect on your investment returns. Sometimes the practice can be in clear view, other times it is a little trickier to uncover. In order to pursue your own million-dollar journey, it is important that investors be aware of some of the tools, tricks and issues in the investment industry.

1. Mutual Funds

The first and maybe most written about topic is that of mutual funds. Quite simply, Canada is the unfortunate recipient of some of the highest mutual fund fees in the world. While it does not sound significant, saving half of a percent on management fees can make a huge difference to an individual over many years. The savings from reducing fees is one of the few ‘sure-things’ when investing. The way we see it at 5i is that if you have the ability to save even a couple of bucks while generating the same returns, why wouldn’t you? That savings, compounded over years if not decades, will result in very big dollar amounts.

Mutual funds also have a tendency to hug an index (also known as closet indexing) while charging high fees. We have seen some funds hold up to 750 positions! The reality, especially in Canada, is that if a diversified fund is holding over 50 positions, it is more than likely going to act similar to a comparable ETF. If your going to pay a fund to invest your hard earned dollars, at least make them earn it and not shadow a lower-cost ETF.

2. Research Reports

Company research reports are another area to watch out for as they are not meant for the retail investor. They are made for companies that the brokers want business from, or do business with. Large and complex documents nicely bound and printed on glossy paper are shown to executives in the hopes that the next financing or deal goes to that broker. This is also why you rarely see a negative report. There is an inherent conflict of interest when other departments do business with a client that is also on a research coverage list due to the fear that a client may take business elsewhere in light of a negative report being issued.

This conflict of interest is also why you often see confusing and non-committal types of recommendations such as sector underweight (if you like the sector, does that make it a regular hold?) and market-perform (a.k.a. “we don’t know, so assume it follows the market”). Between confusing recommendations and target prices that help to generate trading commissions, investors that follow these reports too closely could stand to lose out on some good returns.

An example I like is a Credit Suisse analyst that had a sell recommendation and $10 price target on Netflix; only to flip 16 months later when the stock was at $300 with a buy recommendation! The lost profits to those who heeded the recommendation almost make you want to cry.

Over my career I have also learned what to look for in potential investments, which are now deeply ingrained in how we look at companies at 5i Research. The number one positive signal for us is when a company pays its first dividend. The first dividend alone does not make a stock a buy necessarily but when the announcement is made, investors should pay attention.

3. Sales

One area to watch on financial statements are company sales or revenues. At 5i, we hate declining sales because it means that there is something wrong with either the company or the industry as a whole. We try not to allocate research resources to companies that will have less tomorrow than they do today. Earnings at a company may still improve through cost savings but it does not change the fact that customers are either buying less of or paying less for a good/service and this is something that we have learned to avoid.

4. Share Dilution

One final thing we like to look out for at companies is share dilution. No matter how good the prospects of a company are, if they continually issue shares and dilute your ownership, no one benefits other than the bankers doing the deals. When a share issue is carried out, we would far prefer it to have a specific purpose (such as an acquisition) and to be done at higher prices.

Beware of share issues consistently done at lower prices as these do nothing but erode value and make it all the more difficult to recoup any losses. We use the example of Katanga Mining here. Eight years ago, it had less than 100 million shares outstanding. Today, it has 1.9 billion shares. Guess what? The stock is down 92% in that time, including a 34% decline in the past year.

The million-dollar journey can be a treacherous one but we think investing is a key component to completing the journey. The goal is attainable as long as investors start early, save often and invest intelligently while keeping in mind the various tips, tricks and conflicts inherent to the investment industry. If you can avoid investment mistakes and reduce trading and fees, you goal will be far more attainable.

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FrugalTrader About the author: FrugalTrader is the founder and editor of Million Dollar Journey (est. 2006). Through various financial strategies outlined on this site, he grew his net worth from $200,000 in 2006 to $1,000,000 by 2014. You can read more about him here.

{ 14 comments… add one }
  • Robb Engen April 28, 2014, 10:33 am

    Good point about the research reports and keeping an eye on sales.

    I signed up for news alerts on all the companies I own shares in and it’s funny when the earnings reports come out – the press release from the company might say, “revenues up x percent and profit increase over same time last year.”

    Then the analyst report comes out and it says the revenue/profit increase is due to some one-time never gonna happen again sale of assets and that revenue and profit from normal operations actually fell by x percent.

  • Kevin April 28, 2014, 1:26 pm

    Amazing post. I like the caliber of this post. I have finding million dollar journey’s guest post topics a little weak in the last 6 months

  • Dan @ Our Big Fat Wallet April 28, 2014, 9:13 pm

    @Robb most companies do that. I work for a publicly traded company and when earnings come out only the best highlights are featured. Analysts are less biased but sometimes they don’t pick up on certain things, or use specific numbers to emphasize the opinions they have previously stated

  • SST April 28, 2014, 9:47 pm

    “Earnings at a company may still improve through cost savings but it does not change the fact that customers are either buying less of or paying less for a good/service…”

    Don’t forget all the other “destructive growth” earnings devices which have pumped up the markets these last few years: closures, lay-offs, wage & benefit reductions, stock buy backs, utilization of ultra-low interest leverage, tax avoidance, et al.

    Question to Peter: how was it working at/for Sprott? Which fund(s) did you manage in your time there? Thanks!

  • Cold Truth April 29, 2014, 11:10 am

    This was a refreshingly concise and to the point article about intelligent investing. While to many the information may not be new, I say ‘refreshing’ because the author is in a position to benefit from encouraging people to invest, yet it didn’t have that ‘used car salesman’ flavour that often comes from another guest author who works in providing investment services.

  • Sarlock April 29, 2014, 12:07 pm

    I kicked my mutual funds out the door about 7 years ago and went on my own. All I had to do was buy about 30 different large cap stocks and my performance has been very comparable to similar mutual funds — except that I got to save the 1-2% management fee. Since I am not regularly trading those stocks (buy and hold, for the most part) my trading fees are very low, less than $50 per year (much less than 0.1%).

  • Emilio April 29, 2014, 11:40 pm

    Interesting how the financial services gurus are all badmouthing the mutual funds and pushing the etfs. Easier for the financial services to make money through computerized indexing.
    Just dont forget. Etfs are the new mutual funds. When everybody is recommending them it is time to look elsewhere for investment ideas.

  • Cold Truth April 30, 2014, 9:45 am

    @Emilio. Wow. Just…. Wow.

  • Paul Unosawa April 30, 2014, 5:40 pm

    Peter Hodson recommended Contrans (TSE:CSS) in an article a year ago, and I bought in and it has done well 32% the last year with a 4% dividend.

  • A Frugal Family's Journey May 2, 2014, 12:39 am

    Nice tips MDJ…I would like to add two things that I feel are potential red flags. 1) CEO resigns, quits or gets fired; 2) Dividend Reduction.

    Take care as you continue with your journey to millionaire status!

  • SST May 4, 2014, 11:09 am

    I can only surmise that since there has been no follow-up by the OP in the week since publication, this article was merely a (paid?) marketing tool. I’ll definitely keep MDJ in mind as soon as I have financial products to sell. :)

    Would love to know why Hodson left the ‘sale of investment’ side of things and moved to the ‘sale of analysis’ side.

    As an aside, and a plug for Sprott Inc., I met Rick Rule on a number of occasions in the early 00’s. Don’t know how he is now since hitting the “big time” (I’m betting on leopards not changing), but back then he was exceptionally honest and straight forward in both his investment ideas and business; no bull whatsoever. I am a bit biased, however, as a number of his stock picks made me a nice wad of cash.

  • FrugalTrader FrugalTrader May 4, 2014, 12:44 pm

    Feel free to send money my way SST! :) However, we do not accept sponsored guest posts.

  • TM May 15, 2014, 7:18 am

    Question for Peter and readers but is there a site or quick way to query what companies on the TSX just recently started offering dividends without having to go through the news/company profiles manually?

    Cheers!

  • J.L. December 16, 2015, 4:03 pm

    I did ok on my own investing even through the meltdown in 2008, unsing stop losses to stay out of trouble. Yet after listening to 5iResearch advice about not using Stop Losses and how they prefer to buy at 52 week highs rather than at 52 week lows, I am now down HUGE on my portfolio. 5iresearch can analyze companies from a fundamental perspective at a given point in time, but taking any of their advice from their Q&A section on individual stocks has proven extremely perilous to my financial well being. INVESTOR BEWARE!

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