Friday, 19 December 2014

Which Large Cap TSX Stocks are Most Dangerous or Most Atractive? - Use Short Interest with Volatility

Unlike stock analysts or media pundits (bloggers included!) who only take a hit to their credibility when their stock recommendations go wrong, short sellers (see short sale definition on Investopedia) have their money where their mouth is. And perhaps due to that fact, short sellers are often right (that doesn't mean they always make money, it's a win-big, lose-big stock market trading strategy).

The recently published The Long and Short of the Vol Anomaly by Bradford Jordan and Timothy Riley (free download on SSRN) studied the inter-action of stock price volatility and the amount of short interest on stocks in the USA from 1991 to 2012. The authors discovered the intriguing relationship that though low volatility stocks outperformed the market and high volatility stocks on average, if the high vol stocks are subdivided into those the short sellers are leaving alone from those they are attacking, there is a huge and consistent gap in performance. This graph from their study shows the enormous difference in long term performance.
(click on image to enlarge)

The high vol - high short stocks are real dogs (red line in graph) and the high vol - low short stocks are real winners (light blue line)! In between, but still much better than the market index of the dotted purple line, are the significantly out-performing low vol - low short interest stocks (green line).

Those results look intriguing. We decided to to apply the idea to the large cap ($2 billion plus market cap) TSX stocks.

Finding the Short Interest and Volatility of TSX Stocks
TMX Money seems to offer the only free stock screener to find stocks with our desired combination of beta / volatility and short interest.

The Short Interest Ratio (see Wikipedia definition) is the number of shares sold short currently outstanding divided by the average daily share trading volume averaged over the past 30 trading days.

Note that lists like the Financial Post's Largest Short Positions show the companies with the most shorts sold shares outstanding but when the large companies like the banks with huge numbers of shares on the market are on the list, it is not necessarily indicative of large market price risk, especially as the authors found that the huge gains or losses were associated with very volatile stocks, which our Canadian banks are not. For instance, TD Bank currently has a very large short position plus a high short interest ratio of about 20.4x but its beta is only 0.81, well below the TSX market average of 1. Though many short sellers are expecting TD to go down (making us think that those who would want to buy TD likely won't lose out by waiting), TD doesn't make our list below of high risk & high potential reward / loss due to its low beta.

The screen capture image below shows how to filter in TMX Money based on short interest, though we could also start filtering with the beta, which is under the Trading and Volume criteria drop down menu. We found by trial and error that a beta of over 2 (i.e. twice as volatile as the TSX overall) was sufficient to bring up a small list of stocks, most of which are highly shorted but a few of which are very lightly shorted.

(click on image to enlarge)


Once the filter is applied the results do not automatically show the short interest and the beta - it is necessary to click on Edit Columns then View More Selections to select the Short Interest Ratio and 60 Mth Beta columns for display. TMX provides beta for computed over the past 60 months only (unfortunately, the 36 Mth Beta doesn't bring up anything), so we cross checked with the 36 month trailing beta from GlobeInvestor's WatchList tool by entering the stocks into a new portfolio.

The Stocks
Our comparison table below shows what we found, colour coded to match the graph from Jordan and Riley - red the dangerous highly volatile and highly shorted, blue the potentially very attractive highly volatile but lightly shorted and green the safest least volatile - least shorted combination. For added interest we've thrown in data on the Analyst recommendations and Analyst EPS dispersion, along with which of these stocks happen to be held by some popular ETFs.
(click on image to enlarge)


The dangerous highly volatile and highly shorted - Little surprise, every one of these companies is either from the energy or the materials sectors, which have been taking the brunt of recent market declines. All of them also display a high dispersion between high and low Analyst EPS estimates, which we have found to be a characteristic of stocks with more downside than upside potential. This blogger won't be buying any Tahoe Resources, Lundin Mining or MEG Energy in the near future, no matter what Analyst recommends them as a Buy!

A handful of potentially highly rewarding highly volatile but lightly shorted stocks - A big surprise here, three of four are energy related - 
  • Precision Drilling (TSX: PSK) and 
  • OANDO Energy resources (TSX: OER) - or materials - 
  • PrairieSky Royalty (TSX: PSK). 
  • The other is Air Canada (TSX: AC).

Surprise! There are energy and materials companies amongst our dozen safe-looking least volatile - least shorted stocks - For example:
  • Whitecap Resources (TSX: WCP), 
  • Keyera Corp (TSX: KEY), 
  • Peyto Exploration (TSX: PEY), 
  • Domtar (TSX: UFS) and 
  • Franco-Nevada (TSX: FNV). 
No surprise, the safe-group stocks' EPS dispersion numbers mostly fall within the lowest or middle riskiness category of that measure.

Short Sellers do NOT at all have the same opinions about the stocks as the Analyst consensus - to say the least! None of the red group is rated a Sell by Analysts, two are Holds and most - 8 of 12 - are Moderate Buys. Who would you rather believe, those who have their money at stake, or who will suffer only a dent in their reputation? As we wrote back in 2010, take Analyst recommendations with a large grain of salt. Now we can add, the short sellers are that grain of salt.

ETF holdings differ dramatically - The benchmark market cap ETF from iShares, the S&P / TSX 60 Index fund (TSX: XIU) has a bunch of the short-sellers' targets but none of the stocks in the least-risky list. Meantime, BMO's Low Volatility Canadian Equity ETF (TSX: ZLB) has none of the short sellers' favorites and several of the least-risky group. The fundamentally weighted PowerShares FTSE RAFI Canadian Fundamental Index ETF (TSX: PXC) is a mix of the two. There are plenty of other stocks in these ETFs so performance will not be determined only by what happens to the 10% or so of the holdings which appear in our lists of this post. But look at the price performance of the three ETFs over the last six months in this Google Finance chart. XIU and PXC are down considerably, while ZLB is up!
(click on image to enlarge)


More investigation is required before buying any individual stock - No doubt some of the stocks in the respective groups will do as the research suggests - gangbusters up or down. The short seller signal is not a certainty for each and every stock. Some will do the opposite of the overall pattern. The research took baskets of stocks - much larger than the groups above - and averaged their performance, in addition to doing so over years. It's a statistical result that looks to be quite robust based on all the tests and checks the authors performed but common sense should warn us that it won't work in every case. 

As it happens, the Globe and Mail recently published the article Ten oil patch stocks that can weather the downdraft, which contains Canadian Oils Sands (TSX: COS), one of our red danger stocks. The article presents some data to support a positive assessment of COS. Maybe the short sellers are wrong and it could be a good buy after all. But the short selling interest data we have presented is, we believe, a useful element to the analysis of the company.

Disclaimer: This post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comparisons are not an investment recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a professional advisor.

Monday, 15 December 2014

Liability-Driven Investing during Retirement for the Individual

Traditional investing strategy seeks to maximize returns considering the risk involved. Asset classes are selected and weighted according to how well they fit together, for the amount of diversification they provide along with their risk and return relative to the risk tolerance of the investor. The time horizon of expected withdrawals shapes the asset allocations but the overall goal of the portfolio is to provide an adequate total return. This investing approach in retirement leads to the determination of a safe withdrawal rate that protects the portfolio from depletion before death, epitomized by the standard 4% rule (see our original here and a recent update). A portfolio may not even change at all between the savings phase of life and retirement, as we discovered when we wrote about a feasible Lifelong Portfolio consisting of a 50-50% stock-bond mix.

Liability-driven investing (LDI) takes a completely opposite tack. The goal of the portfolio is to meet future cash spending. As we remarked last week, defined benefit pension plans like the Healthcare of Ontario Pension Plan (HOOPP) are prime exponents since their sole purpose is to provide pension income as promised. The idea of LDI is to match the portfolio cash flows to the required spending - the liabilities - in terms of dollar amounts, timing and risk. We work backwards from the spending to the portfolio.

In terms of retirement income planning, the 4% rule and LDI are the ends of a spectrum of possibilities, recently brilliantly described and impartially assessed by Wade Pfau and Jeremy Cooper in The Yin and Yang of Retirement Income Philosophies.  It is well worth reading for the non-technical discussion of the practical pros and cons of the gamut of income and investing strategies.

The best way to show the differences is with some examples.

Test Case
- 65 year old man or woman,
- starting retirement, no part-time job
- portfolio worth $1 million,
- eligible for full Canada Pension Plan ($12,450/yr) and Old Age Security ($6765/yr), a total of $19,215 per year
- portfolio in a RRSSP/RRIF or other registered account, so it is all income subject to taxation (thus the portfolio allocation between dividends or capital gains from stocks vs interest from bonds doesn't matter)
- basic needs require $50,000 annual income, i.e. $30,785 after CPP & OAS, plus
- wants or discretionary luxury spending

The 4% Rule
$1,000,000 x 0.04 = $40,000
... for any and all spending needs to be adjusted upwards each year for the previous year's inflation so that spending power aka standard of living is maintained, hopefully as long as required, but historically the portfolio always lasted at least 30 years. In most historical instances, the portfolio ended up with a substantial balance, many times higher than at start of the retirement period.
... total $59,215 including CPP & OAS, or
... $9,215 above the basic needs

The big disadvantage is that though it always worked out in the past, there is no guarantee. Since nowadays future returns don't look so rosy and since many countries haven't fared as well as the USA, on which the 4% rule was based, it might be more cautious to take out less, like only 3.5% per year:
$1,000,000 x 0.035 = $35,000
... total $54,215 or
... $4,215 above basic needs

LDI Strategy
To match spending with income, it is first necessary to distinguish really essential spending with discretionary luxury spending. An image from The Yin and Yang shows it thus:
(click image to enlarge)

The Age Pension layer is CPP and OAS. On top of that, to meet needs there must be regular, no-variation, inflation-adjusted, lifetime, no-default, no-reduction income. Above that, the luxury spending can depend on more volatile assets, in the probability-based blue zone.

As a result, the portfolio gets divided between the Liability-Matching Portfolio (LMP) to meet needs and the Return-seeking risky portfolio (RP) to meet luxuries.

Option 1 - Buy an annuity to implement the LMP
Using Cannex's proprietary (pay-only access) website, to which this blogger has been graciously granted temporary access, we have obtained current rates for lifetime annuities. Professional planners and/or insurance agents normally would provide real quotes to investors. It's not a DIY online purchase possibility.

The Annuity / LMP:
- Single-premium,
- No guaranteed period of payments if you die early, in order that the best value of lifetime income is gained through higher mortality credits aka the money of people who die earlier than you,
- Single life, (income is lower for a couple that chooses joint life, where some or all of the annuity continues after the first spouse dies)
- Lifetime so that there is no need or desire to guess how long you will live
- Providing $30,785 income for needs spending
- Rising 2% per year, the best estimate today of future inflation, since no Canadian annuity providers actually offer annuities that directly guarantee CPI-indexing. Here we have a small but potentially significant disadvantage if inflation should unexpectedly rise above 2% for an extended period a la 1970s.

Highest income quotes (as of 12 December 2014):
  • Male - $6483 income per $100,000, or about $577,000 to buy $30,785 of total annual income
  • Female - $4761 income per $100,000, or $647,000 (more expensive since women live longer than men)
The RP portion
The RP is the remaining difference after the lump sum to buy the annuity is taken from the portfolio. It can take the same return-risk optimizing structure as and be withdrawn according to the same 4% rule as for a normal portfolio.
  • Male - $1,000,000 - $577,000 = $423,000 x 0.04 = $16,900 more per year, i.e $66,900 in total. Looks pretty good especially since basic needs are covered by the most solid lifetime guarantees available. 
  • Female - same calculation gives $14,100 income extra from the RP and $64,100 in total
Readers who want to fairly accurately estimate what a quote for an indexed annuity would cost can do this by first getting un-indexed quotes from the free Globe and Mail daily updated annuity rates table, then apply an estimate for 30 years worth do-it-yourself inflation protection as described by RetailInvestor.org.

Probably the biggest negative for this option is having to give up control, access to and ownership of the annuity lump sum. Once the annuity starts, there is no flexibility or way to back out.

Option 2 - Make your own annuity-like cashflow with Real Return Bonds in a ladder or an ETF
Real return bonds issued by the Government of Canada have the desired features for our needs - default-free AAA-rated, long term (with maturities out to 34 years from today, which handles almost all life expectancies for 65 year-olds), steady payment (twice a year like any bond) and inflation-indexed (unlike the above annuities, RRBs are linked directly to CPI increases).

The iShares Canadian Real Return Bond Index ETF (TSX symbol: XRB), or a selection of its holdings an investor could buy to create a bond ladder, can be used to create the LMP. XRB's Yield to Maturity is presently 2.33%. Reducing that gross amount by the fund's MER of 0.39%, we get a net expected yield, which if you simple buy and hold the ETF is what you will almost exactly get, of 1.94%.

The XRB Holding - A holding that is to be consumed over 30 years with that return works out to $695,000 (it's an amortization problem - 1.94%, 30 years, payments of $30,785). For a 35 year retirement duration / life expectancy, e.g. for a woman instead of a man or an earlier retirement date, the sum to invest in XRB is $777,000.

The uncertainty over life expectancy and the amount to invest is a disadvantage compared to a lifetime annuity but at least erring on the conservative side only results in more money being left in a legacy. As well, the funds remain under the control of, and accessible to, the investor at all times.

The RP portion
The two life expectancies we have used give an RP and discretionary fund withdrawal at a 4% rate of:
  • 30 years - $305,000 capital value, $12,200 income, for a $62,200 total
  • 35 years - $223,000 capital value, $8,900 income, for a total of $58,900
Bottom Line: The contrast between the 4% rule and the LDI approach presents a choice - the 4% rule allows the investor to retain complete control but no certainty of lifetime retirement income; the LDI approach allows higher and guaranteed income but loss of control over a big slice of assets. As the Yin and Yang document itself concludes,  "While neither a probability-based [the 4% rule] nor a safety-first approach [LDI] is definitively right or wrong, different people will align more easily with one or the other".

Disclaimer: This post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comparisons are not an investment recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a professional advisor.

Thursday, 11 December 2014

Investing Ideas from Two Highly Successful Pension Funds - Ontario Teachers' and Healthcare of Ontario

The Ontario Teachers' Pension Plan (OTPP), with ten-year annualized compound investment returns of 8.9% at 2013 year-end, has been recognized as the number one rated pension fund in the world, which it understandably boasts about on its website. At $140.8 billion in assets as of the end of 2013, it is also the largest in Canada according to the latest tally in the June 2014 Benefits Canada review of the top 100 plans. Another highly successful pension plan is the Healthcare of Ontario Pension Plan (HOOPP) with $51.6 billion in pension assets and a 9.7% ten-year annualized return at the end of 2013. While most of us ordinary investors can only look with envy at such fully-funded plans that deliver substantial inflation-indexed lifetime income (OTPP says it has one retiree who has been collecting a pension for over 45 years!), we've delved into their websites to see how they do it and what good ideas we can apply to our own pre- and post-retirement investing.

1) Save more, get more pension income - On the one hand, the 96th place  Municipal Employees' Pension Plan of Saskatchewan (MEPP) contribution rate of 8.15% each from employee and employer totalling 16.3% gives a combination 1.5% and 1.8% (two rates for different time periods) per years worked of salary non-indexed pension.

Contrast that with OTPP's current 13.1% contribution rate above the CPP limit and 11.5% up to the CPP limit (both also doubled by employer contributions) that gives a 2.0% per year of salary indexed pension, though the indexation is not guaranteed. HOOPP collects 6.9% up to the CPP limit from the employee and 9.2% above that and 1.26 times each from the employer for 15.6% and 20.8% in total. It pays out 2% per year, 75% indexed for inflation.

An additional thought for an individual investor is that the automatic deduction of pension contributions from the paycheque no doubt makes it far easier to save. The money is never seen in the bank account and the temptation to spend it never arises (see Exploiting Laziness, Procrastination and Conformity in Investing)

2) Plan monitoring and flexibility is essential - Despite being superbly managed, OTPP and HOPP must make adjustments like changing contribution rates, which affects current workers, or inflation-indexing, which affects retirees, to cope with evolving conditions. Factors that are putting pressure on these pension plans also affect us as individuals.

Rising life expectancy is one - the average OTPP member works for 26 years and collects benefits for 31 years. Something, or a combination of things, must be changed to cope - higher savings, longer working career, part-time income, reduced pension withdrawals (like the inflation indexing).

Expected investment returns is another - With 70 or 80% of the pension payout dollars at OTPP and HOOPP coming from investment profits, not from contributions, changes in future returns have a critical impact. 

For individuals, that's why we advocate the same kind of annual monitoring and adjustment - posts part 1 and part 2 - that pension plans constantly do.

3) Bond rate returns are lower and the conservatively-assessed cost of providing pension income is thereby higher, while expected inflation remains about 2% - The pension plans assess the cost of providing a pension according to expected real / after-inflation return based on an ultra-safe  long term (30+ year) bond rate. With that base a total rate of return is derived that would include an expectation for its higher return equity portfolio components. OTPP in its 2013 annual report used a real expected return of 2.85%, while HOOPP and MEPP used 4.0%.

Individual investors can use this to ballpark a range of possible numbers to answer the "how much do I need to retire?" question. For a 30-year retirement to provide $40k annual income, these are the portfolio "nest-eggs" for the rates of return:
  • 2.85% - $799k
  • 4.0% - $692k
and for a totally-safe portfolio consisting only of real-return Government of Canada bonds, at current rates (at the bottom of this Bank of Canada page with daily updated rates):
  • 0.65% - $1087k
The pension plans all assume future inflation around 2%, which is also the middle of the Bank of Canada 1 to 3% policy target range, so that's the sensible assumption we investors should use too.

4) Asset allocation includes equity to boost returns - The pension plans need the higher returns of equity to maintain their fully-funded sustainability while keeping contributions at reasonable levels. It's a trade-off that entails higher annual volatility and more uncertain long term returns. OTPP has about 36% of its portfolio in equities (if the effect of the negative allocation i.e. borrowing / leverage is removed). Non-Canadian equities are much larger than Canadian holdings and the foreign currency exposure is not hedged. HOOPP is more or less the same. Foreign equity provides diversification (volatility reduction) and a return boost. Its approach on currency is opposite to OTPP's as HOOPP hedges its foreign currency exposure. The foreign equity market exposure strategy is something individual investors can apply too by buying non-hedged Canadian funds or US funds. Conversely, many hedged funds are available for those who decide to take that tack.

5) Active management is alive, and seemingly quite well - Rejecting the oft-repeated mantra directed at individual investors, the pension plans believe strongly in active management and the possibility of out-performance.

OTPP's 2013 Annual Report on page 20 says that "Active management is a cornerstone of the plan's investment success". They don't do this willy-nilly, focusing especially on illiquid investments. The numbers seem to bear out their confidence, with their 8.9% ten year returns considerably ahead of the 7.2% figure for their benchmark.

HOOPP takes a similar stance, touting a 2.09% contribution from active management to its total 2013 return of 8.55%.

Whether an individual investor should be trying to do the same must be an individual choice and it should be based on having some sort of insight or advantage that the bulk of other investors do not have. We have previously written about circumstances where the individual investor could gain such an advantage - e.g. small illiquid stocks (which the pension funds will ignore because they are too small) and places where the market can be less efficient.

The other takeaway for investors who cannot copy the active investing success of the pension funds is that we should expect returns more akin to the passive benchmarks. Such benchmark returns are exemplified in broadly-diversified market-representative ETFs.

6) Assessing Environmental, Social and Governance (SRI / ESG) factors of potential investments is worthwhile but not decisive - Both OTPP and HOOPP state quite emphatically that it is important and worthwhile to take ESG factors into account e.g. HOOPP Annual Report 2013 (p24) "Our belief is that enterprises that effectively manage environmental, social and governance (ESG) risks will, over the longer term, generate better financial returns and reduce operating and financial risks." However, the ESG factors must be material - actually have an effect on the enterprise. And ESG factors are not on their own decisive in accepting or rejecting investments. We note in passing that the Canada Pension Plan Investment Board, which manages the investments that help sustain CPP for all Canadians, says the same.

Doing ESG assessment sounds quite practical and sensible, and an approach that the individual investor can apply too, which is why we have written often about Canadian companies and the type of ESG factors that research confirms is material - see the series of posts in the Sustainable Investing section of our Guide to Online Investing.

7) Costs matter - As organizations dedicated solely to providing pensions for members, the pension plans pay close attention to managing costs. Costs are one of their measured performance criteria. Despite the higher costs that active management inevitably entails, OTPP kept overall costs to 0.28% of assets in 2013, while HOOPP was at 0.31%.

The individual investor can benefit from adopting a similar cost control philosophy. Where can costs be controlled?
8) Portfolio construction and asset class selection are based on a specific role for each asset class - The pension plans do not pick asset classes by holding a chunk of everything. Each asset class has a function and the overall mix is a balance between the positive characteristic each provides and its downside. Both OTPP and HOOPP seem to perceive the asset classes the same way:
  • Equities - higher returns in the long term but higher volatility in the short term
  • Non-Canadian equities - higher returns plus reduction in volatility through diversification (i.e. a degree of non-correlation with Canadian equities)
  • Fixed income - lower volatility in the short term but lower returns in the long term
  • Corporate bonds - higher returns but more credit risk
  • Real return bonds - inflation protection but lower returns
  • Real assets (real estate, infrastructure) - long term assets for the plans' long term horizon with cash inflows providing inflation protection to match the expected pension cash outflows
  • Natural resources (commodities) - higher returns plus long term hedge for unexpected inflation but greater volatility in the short term
For an individual investor, this method of selecting the building blocks for a portfolio is quite feasible. We described a couple of portfolios based on such a principle - one inspired by our take of the ideas of Yale University endowment manager David Swensen and another that embodies a form of active management through the use of Smart Beta funds.

9)  Risk means more than asset price volatility - Market price volatility, so often presented as the only measure of risk to individual investors, is important to the pension funds. But other risks matter too, like:
  • liquidity risk, the chance of not being able to have cash to pay out when promised or needed;
  • foreign currency variations on non-Canadian holdings, since that can affect the value of assets and returns as much or more than market price changes;
  • credit risk, the chance of default, which is higher when more yield is sought from bonds;
  • inflation, especially unexpected inflation not built into the prices and returns of bonds;
  • interest rate changes, which counter-intuitively work the opposite way to what many would expect - when interest rates go down, a pension plan's future liabilities for pensions it will have to pay out go up, and that pushes plans towards being under-funded; an interest rate rise lowers the current value of the bonds held but it lowers the value of the future liabilities even more, so the plan is net better off. One way for the individual investor to think about this is exemplified in point 3 above. If you buy a series of inflation-protected real return bonds that will exactly match your future cash flow needs  you can entirely remove the interest rate and inflation risk. That is what is called a fully immunized financial situation. But as the cost for the totally-safe RRB portfolio above shows, it takes a lot more money. Most people, and pension plans, cannot save that much, so it is necessary to rely on higher investment returns to make up the gap. That's why OTPP says "Taking risk is necessary to earn the returns required to meet our pension obligations".
We have discussed these risks, and potential counter-measures, in a number of posts listed in the Risk section of our Guide to Online Investing. Diversification - across asset classes, geographies, time horizons and reaction to varying economic environments - is a key method of dealing with risk, both for the pension funds and, we suggest, for the individual investor.

Liability-driven investing (LDI) - For retirement investment, the idea of dealing with risk by tailoring the whole strategy around matching future obligations to assets is now very popular among pension funds, HOOPP being a prime exponent. In our next post, we'll explore how LDI can apply to the individual investor.

Disclaimer: This post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comparisons are not an investment recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a professional advisor.

Thursday, 27 November 2014

Which Stocks and ETFs are Safe and Secure per the Dispersion of Analyst EPS Estimates

As promised last week, today we review the stocks that look most or least attractive according to the degree of dispersion of professional analyst EPS estimates. The lower the dispersion between the highest and the lowest EPS estimate, the better; those are the most attractive stocks. We had previously done this in 2012 and the results two years later have turned out quite good as we showed last week.

The method
We use the same methods as in 2012. First, we gather a list of stocks by taking all the holdings of three popular Canadian equity ETFs with quite different strategies:
Not only does this give us a reasonably complete list of leading stocks, it also allows us to compare the ETFs in terms of analyst EPS dispersion.

The second step is to find and calculate the percent difference between high and low EPS estimates for 2015 in Yahoo Finance - e.g. Royal Bank. For a few companies not available on Yahoo (pale yellow cells in the tables), we obtained the data in our broker BMO InvestorLine's website.

Third, we add various bits of data that show stability, consistency and attractiveness, or the opposite:
  • number of years of profits (positive earnings) in the last five from Morningstar.ca
  • profit surprise vs analyst estimate last quarter, return on equity, total stock return (dividends plus capital gains) for the trailing one- and five-years, price-to-earnings, price-to-book, all from Globe's WatchList;
  • number of women directors, from our recent post;
  • place in our 2012 post EPS dispersion list - low (L) EPS dispersion category; medium (M) dispersion category, or high (H) dispersion group.
The attractive lowest dispersion stocks - More reward than risk
(click on image to enlarge)


There is a preponderance of good green and a lot of consistency across the table amongst the stocks with the lowest dispersion between the highest and lowest EPS estimates.
  • beta - volatility of stock price relative to the market average of 1.0 - is almost always low, and the worst stock, Finning International (TSX: FTT) has a beta (1.86) nowhere near the highest betas in the bottom group
  • profit surprises, both positive and negative, are not very large, except for one company Valeant Pharma (TSX: VRX), which is a decided outlier on several other metrics as well
  • profitability (ROE) is good across the board, as is consistency of profits and total market returns; P/E and P/B ratios seem restrained almost universally too
  • women directors are more numerous on average - 2.9 per company - compared to the higher dispersion stocks
  • half the lowest dispersion stocks are repeats from 2012
Middle EPS dispersion stocks - Potential reward but more risk too
(click on image to enlarge)

The rising range of EPS estimate dispersion, from 113% to 141% in this group, is accompanied by slightly less green and slightly more more cautious orange across the various indicators. There are higher average P/Es and fewer women directors per company.

Our surprise comparing this set of results to 2012 is that there seems to be much less differentiation from the top group. Beta seems about the same as the lowest dispersion stocks. There are not many cases of poor profitability (ROE) or inconsistent (5 yr history) profits.

A number of stocks moved down from the 2012 top group but not one moved up from the bottom group.

High EPS dispersion stocks - More risk than reward
(click on image to enlarge)

As in 2012, there is plenty of bad red and cautious orange and not much good green in the bottom group. Stocks where the high vs low EPS estimate spread exceeds about 150% look truly risky. There are many companies with volatile profits and negative market returns. Most companies are repeats from the 2012 bottom list. A handful have dropped into the bottom list from the middle but not one fell from the top list to the bottom. These companies also have a much lower average number of women directors.

Comparing the ETFs - BMO's ZLB is decidedly the least risky and most attractive
(click to enlarge image)

ZLB wins by a long shot over XIU and PXC by holding a lot less of the bottom group with the highest EPS dispersion. Only 10% of its weight is in the bottom group vs around a quarter for both XIU and PXC. ZLB has an appreciably lower weight in the top group stocks but that doesn't matter. It is not surprising that its one-year total return of 26.9% far outstrips the gains of the other two ETFs given the poor overall track record of the bottom groups stocks.

Will that continue or will XIU and PXC experience a surge to catch up to or leap ahead of ZLB? It all depends on the future of the energy companies and miners, especially gold, whose stocks dominate the listings in the highest dispersion part of the table. XIU and PXC hold them, ZLB mostly doesn't. Who knows if the tide will turn, the professional analysts certainly don't agree as their EPS estimates demonstrate.

Bottom line: Meantime, the safe route is to focus on the top two groups or ETFs like ZLB.

Disclosure: This blogger owns shares of stock symbols REF.UN, BEI.UN, CUF.UN, REI.UN, RY, CNR, NA, NWC, CU, FTS, EMA, MRU, BNS, BMO, BCE, SJR.B, ACO.X, TD, HR.UN, TRP, IFC, EMP.A, POT, IMO, SU, FCR, TCK.B as well as the ZLB and PXC ETFs that own virtually all the stocks in the tables.

Disclaimer: This post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comparisons are not an investment recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a professional advisor.

Friday, 21 November 2014

How Effective is Using Dispersion of Analyst EPS Estimates to Assess Stocks?

Two years ago our post applied the "wisdom of the crowds" principle, made famous by James Surowiecki, to analyst future Earnings Per Share (EPS) estimates to try to differentiate attractive safe Canadian stocks from the not-so-attractive companies. The academic research we uncovered at the time suggested it should be effective but it's always important to check actual results against the theory, so now let's do an update and see what has happened.

As before, we took our 2012 list of the best - the stocks with the lowest dispersion between high and low analyst next year (2013 in the 2012 post) EPS estimates - and the worst - those with the widest spread - and plugged the numbers into a GlobeInvestor WatchList to get the trailing one- and five-year total returns (the sum of capital appreciation plus dividends). Our benchmark for success is the mainstream large company ETF the iShares S&P / TSX 60 Index Fund (TSX symbol: XIU) whose holdings along with the BMO Low Volatility Canadian Equity ETF (TSX: ZLB) and the PowerShares FTSE RAFI Canadian Fundamental Index ETF (TSX: PXC) we had used to assemble 110 candidate stocks.

Low EPS dispersion stocks performed impressively well
In our comparison table below of the lowest dispersion stocks in 2012, green is good, indicating substantially better performance than the benchmark XIU. The one- and five-year total returns of the stocks with the lowest dispersion of EPS estimates in 2012 is very consistently green.
(click on image to enlarge)


In the five-year column, not a single stock under-performed XIU or had negative returns. Only three did only as well as XIU, everything else was miles ahead.

In the one-year column, only two stocks, IGM Financial (TSX: IGM) and North West Company (TSX: NWC), had a negative (red) return. Eight stocks (highlighted in orange) had positive returns, though less than XIU's +15.2%.

High EPS dispersion stocks performed remarkably poorly
Our second table below showing the 2012 highest EPS dispersion stocks is filled with ugly red. There is very little good green or minimally acceptable orange. Only one stock - Franco Nevada Corp (TSX: FNV) - had benchmark beating returns over both one- and five-year periods.
(click to enlarge)

... and the middle EPS dispersion stocks are in between
The returns for the middle group are generally positive, more like the top group than the bottom, but display a larger amount of red and orange in the table below.
(click to enlarge)

BMO's Low Volatility Canadian Equity ETF (TSX: ZLB) in 2012 held a lot more of the low EPS dispersion stocks than either XIU or PXC as the left-most column shows. It is thus little surprise that its 26.9% one-year total return (neither ZLB nor PXC has been around five years so five-year return is not yet available) handily beat that of both its rivals.

Why picking low EPS dispersion stocks might not work as well in the future? The low EPS spread stocks are mostly in the financials, real estate and consumer sectors. Those sectors have done well. On the other hand, the high EPS spread stocks tend to be in energy and materials, both of which sectors have taken a beating in recent years. If those sectors rebound (the price of oil, gold and other commodities being such crucial uncertain variables), their returns could easily leap well ahead of the safe and steady stocks. That wouldn't necessarily mean the safe stocks would have negative returns; more likely they would under-perform.

Bottom Line: The method is not foolproof but looks darn good. Taking note of the dispersion of analyst EPS estimates appears to be an extremely useful factor to consider in stock selection. Low dispersion = good, high dispersion = risky.

This being the case, next week we'll review the current list of attractive and un-attractive stocks. We'll also compare the ETFs and their holdings.

Disclosure: This blogger owns shares of stock symbols REF.UN, BEI.UN, CUF.UN, REI.UN, RY, CNR, NA, NWC, CU, FTS, EMA, MRU, BNS, BMO, BCE, SJR.B, ACO.X, TD, HR.UN, TRP, IFC, EMP.A, POT, IMO, SU, FCR, TCK.B as well as the ZLB and PXC ETFs that own virtually all the stocks in the tables.

Disclaimer: This post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comparisons are not an investment recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a professional advisor.

Monday, 17 November 2014

Women on Boards: Pleasing Progress

A few years ago, we explored whether the presence of women on boards of directors was something investors should pay attention to. The indications we found in research and our cursory look at performance was that, yes indeed, companies with women fared better. We were curious to see how things have progressed since then. What we found looks pretty good.

Plenty more women on boards!
In 2012, the slow progression of women into the boardroom caused some controversy, e.g. the "Glacial Progress" Globe and Mail article by Janet McFarland. Corporate Canada seems to be changing fairly quickly, based on our analysis of the 100 largest companies by market cap that are publicly traded on the TSX (extracted using the TMX Money stock screener).

In November 2012, the top 100 companies had 167 women directors. Today the number is 200,a 20% increase. (We assembled this data ourselves by looking at the bios of directors under the Insiders tab of company listings on Morningstar.ca - e.g. for Royal Bank of Canada, which surprisingly is one of only three companies which have fewer women - one each - on the board than in 2012 ... but we shouldn't be too harsh on the Royal since it still has four women on its board and is thereby still in the upper echelon of the women director count as our comparison table below shows).

Though we don't show it in the table, the 15 companies that already have women are adding more than those with none at all in 2012. Seven of them added women. In contrast, only five companies went from zero to one, Catamaran jumped from zero to two, while eleven stayed at zero.

As an interesting aside, the financial sector which dominates the top of our table seems also (our impression from reading bios- we didn't count) to be the source, in the form of retired executives, of many women board members for other industries.
(click to enlarge image)


Companies with women directors score better on governance
We again took the scoring from the independent Clarkson Centre for Business Ethics and Board Effectiveness of the Rotman School at the University of Toronto (2013 scores since the 2014 update is not yet available). The results in the CCBE columns on our table for the 15 companies with four or five women directors are better than the 15 companies with no women.

... and their stock performance is generally better too
As we found in 2012, the one- and five-year total returns of companies (performance data is from the GlobeInvestor WatchList tool) with the most women directors at the top of the table look much more impressive on average, with positive returns that more often exceed our benchmarks, the TSX Composite (embodied in the iShares ETF that tracks that index with stock symbol XIC) and the large cap TSX 60 index (tracked by the iShares ETF with XIU symbol). Dividends are higher on average and five-year dividend growth is almost always positive and more often in excess of the benchmarks.

Board diversity is greater in other ways too - with the inclusion of academics.
We were a bit surprised to come across Professors in the Boardroom and Their Impact on Corporate Governance and Firm Performance by Bill Francis, Iftekhar Hasan and Qiang Wu (acknowledgement to Alpha Architect blog for the reference) that found a positive relationship between company performance and the presence of academics on boards. The paper sums up that profs are often "valuable advisors and effective monitors".

We scanned the director bios for the profs too and lo and behold, though few companies seem to consider academics at all (only 16 out of the 100 largest have even one), several of the companies that do are at the top of our table, while there are none in the bottom. Mere coincidence of no significance? Probably not, board diversity helps sound decision-making by bringing together different perspectives and ways of thinking about issues.

Bottom line: The conclusion is the same as two years ago - women directors do not absolutely ensure a profitable investment but it is a positive factor to include in the analysis of a company and its stock.

Disclosure: This blogger directly owns shares of stocks mentioned with symbols BMO, BNS, CU, EMA, IFC, NA, POT and RY at the top of the list and HR.UN at the bottom, along with ETFs that contain more or less all the stocks. In addition, he has a stake in the futures of four daughters who might well one day be considered for board membership somewhere somehow.

Disclaimer: This post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comparisons are not an investment recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a professional advisor.

Friday, 7 November 2014

Currency and Inflation Effects on Model Portfolio Performance

Almost five years ago we reviewed how a broadly diversified international portfolio would have fared in the period from 1992 to late 2009. There's been more water under the bridge so let's update and expand the original analysis. We can add nine more years of data - the five from 2009 to 2013 and those back to 1988 - because Norbert Schlenker at Libra Investment Management has performed the excellent favour to investors by continuing to update the annual investment returns for a range of asset classes and making it available for free as a downloadable spreadsheet. In the intervening years we have also written about various model portfolios so we'll test those that we can to see how they might have performed (the main gap is those portfolios that invest in real estate since the spreadsheet unfortunately does not include that asset class).

The International Portfolio still performs very well
The diversification benefit of additional equity holdings in the USA, developed market countries (abbreviated as EAFE - Europe, Australasia, Far East) and Emerging markets (such as India, China, Russia and Brazil), continues to be felt, primarily by boosting returns, while the T-Bill and bond holdings dampen portfolio swings, as our chart below shows.
(click on image to enlarge chart)

Inflation continues to steadily reduce returns ...
On the chart below inflation continues to take a chunk out of returns, though at a lesser rate in recent years than the long term average. Inflation is highly unlikely to go away since it is Bank of Canada policy to target an inflation rate in a range of 1 to 3%.
(click on image to enlarge)


... and currency swings often have quite substantial effects, sometimes boosting, sometimes hindering, returns of foreign equities, which also confirms what we noted in the first post five years ago. As the Canadian dollar (CAD) declines vis-a-vis foreign currencies, the same amount of foreign currency buys more Canadian dollars. That boosts returns. When CAD appreciates, the reverse happens. Thus, in our chart, CAD gains/appreciation are shown as a negative effect on returns (of the foreign holdings) and CAD losses/depreciation have a positive effect. In the early 2000s, for example, the Canadian dollar was gaining in value and that undermined returns of foreign holdings for six years in a row as the chart shows.

Note that the currency exposure for holdings such as developed countries and emerging markets is to the currency of those countries and not the US dollar when, for example, holding ETFs that are traded in USD on US exchanges. CanadianFinancialDIY explained how and why this works in this post.

In the 26 years covered by 1988 to 2013 almost exactly half - 12 years - currency movement helped returns for a Canadian investor. The mean of the yearly gains and losses over the period is slightly negative, just under 1%. That seems to add further evidence to the conclusion we presented in a 2012 post that hedging foreign currency holdings is not really necessary in the long term.

The International portfolio grew more, with less volatility, than a similar domestic-only balanced alternative
The following comparison chart was compiled from results of the Stingy Investor Asset Mixer tool that uses the data from the Libra spreadsheet.
(click on image to enlarge)


As the table shows, the international portfolio performed better than a domestic-only portfolio with the same basic structure (35% cash & fixed income and 65% equities). This was true both during a savings accumulation phase of life or during a retirement withdrawal phase. In each life phase the international portfolio also experienced fewer down years and a higher reward (return) to risk (volatility) ratio . International diversification showed its value.

The international portfolio also gained more than either the Lifelong portfolio and the Permanent portfolio. However, both these portfolios experienced considerably lower volatility, no doubt due to the 50% allocation of both to T-Bills and bonds.

The Permanent portfolio in particular looked much less attractive during a retirement phase of 4% annual withdrawals as it had a lot more down years and minuscule total growth. The stats reinforce the idea of the Lifelong portfolio as a "good-enough" compromise, never the best but never the worst.

Finally, by way of interest only since few would advocate such an unbalanced portfolio, we include stats for the 100% domestic equity (TSX Composite) portfolio and the 100% Canadian bond portfolio. Neither grew as much as either the Canadian balanced or the Lifelong portfolio, a surprise especially with respect to equities which have the image of higher eventual growth despite higher volatility. Regular annual rebalancing (which is what the tool models) provided the returns boost (see our post Portfolio Rebalancing - What, Why and How). On the bond side, the surprise is the higher number of down years during retirement. The lower returns from bonds are more susceptible to turning negative, closer to the line between positive and negative, when withdrawals are also happening.

Disclaimer: This post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comparisons are not an investment recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a professional advisor.